Comparison of Congestion Management Techniques: Nodal, Zonal and Discriminatory Pricing.

• Author: Holmberg, Par

1. INTRODUCTION

   Storage possibilities are negligible in most electric power networks, so demand and supply must be instantly balanced. One consequence is that transmission constraints and the way they are managed can have a large influence on market prices. The European Union's regulation 1228/2003 (amended in 2006) sets out guidelines for how congestion should be managed in Europe. System operators should coordinate their decisions and choose designs that are secure, efficient, transparent and market based.

   In this paper, we compare the efficiency and welfare distribution of three market designs that are in operation in real-time electricity markets: nodal, zonal and discriminatory pricing. Characteristics of the three designs are summarized in Table 1. The zonal market is special in that it has two stages: a zonal clearing and a redispatch. We show that in competitive markets without uncertainties the three designs result in the same efficient dispatch. However, zonal pricing with a market based redispatch (counter-trading) results in additional payments to producers in export-constrained nodes, as they can make an arbitrage profit from price differences between the zonal market and the redispatch stage. This strategy is often referred to as the increase-decrease (inc-dec) game. This is the first paper that proves these results for general networks with general production costs. Dijk and Willems (2011) are closest to our study. However, their analysis is limited to two-node networks and linear production costs. The parallel study by Ruderer and Zottl (2012) is also analyzing similar issues, but the redispatch of the zonal market that they consider is not market based, thus their model does not capture the increase-decrease game.

   1.1 Congestion Management Techniques

   Producers submit offers to real-time markets just before electricity is going to be produced and delivered to consumers. During the delivery period, the system operator accepts offers in order to clear the real-time market, taking transmission constraints into account. The auction design decides upon accepted offers and their payments. Nodal pricing or locational marginal pricing (LMP) acknowledges that location is an important aspect of electricity which should be reflected in its price, so all accepted offers are paid a local uniform-price associated with each node of the electricity network (Schweppe et al., 1988; Hogan, 1992; Chao and Peck, 1996; Hsu, 1997). This design is used in Argentina, Chile, New Zealand, Russia, Singapore and in several U.S. states, e.g. Southwest Power Pool (SPP), California, New England, New York, PJM (1) and Texas. Nodal pricing is not yet used inside the European Union. However, Poland has serious discussions about implementing this design.

   Under discriminatory pricing, where accepted offers are paid as bid, there is no uniform market price. Still, the system operator considers all transmission constraints when accepting offers, so there is locational pricing in the sense that production in import-constrained nodes can bid higher than production in export constrained nodes and still be accepted. Discriminatory pricing is used in Iran, in the British real-time market, and Italy has decided to implement it as well. A consequence of the pay-as-bid format is that accepted production is paid its stated production cost. Thus one (somewhat naive) motivation for this auction format is that if producers would bid their true cost, then this format would increase consumers' and/or the auctioneer's welfare at producers' expense.

   The third type of congestion management is zonal pricing. Markets, which use this design, consider inter-zonal congestion, but have a uniform market price inside each region, typically a country (continental Europe) or a state (Australia), regardless of transmission congestion inside the region. Denmark, Norway and Sweden (2) are also divided into several zones, but this division is motivated by properties of the network rather than by borders of administrative regions. (3) Britain is one zone in its day-ahead market, but uses discriminatory pricing in the real-time market. Initially the zonal design was thought to minimize the complexity of the pricing settlement and politically it is sometimes more acceptable to have just one price in a country/state. (4) Originally, zonal pricing was also used in the deregulated electricity markets of the U.S., but they have now switched to nodal pricing, at least for generation. One reason for this change in the U.S. is that zonal pricing is, contrary to its purpose, actually quite complex and the pricing system is not very transparent under the hood. The main problem with the zonal design is that after the zones of the real-time market have been cleared the system operator needs to order redispatches if transmission lines inside a zone would otherwise be overloaded. Such a redispatch increases accepted supply in import-constrained nodes and reduces it in export constrained nodes in order to relax intra-zonal congestion. There are alternative ways of compensating producers for their costs associated with these adjustments. The compensation schemes have no direct influence on the cleared zonal prices, but indirectly the details of the design may influence how producers make their offers.

   The simplest redispatch is exercised as a command and control scheme: the system operator orders adjustments without referring to the market and all agents are compensated for the estimated cost associated with their adjustments (Krause, 2005). In this paper we instead consider a market oriented redispatch, also called counter-trading. This zonal design is used in Britain, in the Nordic countries and it was used in the old Texas design. (5) In these markets a producer's adjustments are compensated in accordance with his stated costs as under discriminatory pricing. Thus the market has a zonal price in the first stage and pay-as-bid pricing in the second stage. We consider two cases: a single shot game where the same bid curve is used in both the first and second stage, and a dynamic game where firms are allowed to submit new bid curves in the second stage. The dynamic model is appropriate if, for example, the first stage represents the day-ahead market and the second stage represents the real-time market.

   1.2 Comparison of the Three Market Designs

   Our analysis considers a general electricity network, which could be meshed, where nodes are connected by capacity constrained transmission lines. We study an idealized market where producers' costs are common knowledge, and demand is certain and inelastic. There is a continuum of infinitesimally small producers that choose their offers in order to maximize their individual payoffs. (6) Subject to the transmission constraints, the system operator accepts offers to minimize total stated production costs, i.e. it clears the market under the assumption that offers reflect true costs. We characterize the Nash equilibrium (NE) of each market design and compare prices, payoffs and efficiencies for the three designs.

   In the nodal pricing design, we show that producers maximize their payoffs by simply bidding their marginal costs. Thus, in this case, the accepted offers do in fact maximize short-run social welfare. We refer to these accepted equilibrium offers as the efficient dispatch and we call the clearing prices the network's competitive nodal prices. We compare this outcome with equilibria in the alternative market designs.

   For fixed offers, the system operator would increase its profit at producers' expense by switching from nodal to discriminatory pricing. But we show that even if there are infinitely many producers in the market, discriminatory pricing encourages strategic bidding among inframarginal production units. They can increase their offer prices up to the marginal price in their node and still be accepted. (7) In the Nash equilibrium of the pay-as-bid design, accepted production is the same as in the efficient dispatch and all accepted offers are at the network's competitive nodal prices. Thus, market efficiency and payoffs to producers and the system operator are the same as for nodal pricing. As payoffs are identical in all circumstances, this also implies that the long-run effects are the same in terms of investment incentives.

   Under our idealized assumptions, the zonal market with counter-trading has the same efficient dispatch as in the two other market designs. We also show that producers buy and sell at the competitive nodal price in the counter-trading stage. Still producers' payoffs are larger under zonal pricing at consumers' and the system operator's expense. The reason is that the two-stage clearing gives producers the opportunity to either sell at the zonal price or at the discriminatory equilibrium price in the second stage, whichever is higher. In addition, even when they are not producing any energy, production units in export-constrained nodes can make money by selling at the uniform zonal price and buying back the same amount at the discriminatory price, which is lower, in the second stage. This increase-decrease game has been observed during the California electricity crisis (Alaywan et al., 2004), it destroyed the initial PJM zonal design, and is present in the UK in the form of large payments to Scottish generators (Neuhoff, Hobbs and Newbery, 2011). Our results show that inc-dec gaming is an arbitrage strategy, which cannot be removed by improving competition in the market. If it is a serious problem, it is necessary to change the market design as in the U.S. We show how producers' profits from the inc-dec game can be calculated for general networks, including meshed networks. Our results for the zonal market are the same for the static game, where the same offer is used in the two stages, and in the dynamic game, where firms are allowed to make new offers in the counter-trading stage.

   ...