Ensuring Capacity Adequacy in Liberalised Electricity Markets.

• Author: Astier, Nicolas

1. INTRODUCTION

   Wholesale electricity markets have now been liberalised for many years in numerous countries. However, many observers still raise doubts regarding the ability of decentralised market decisions to achieve the desired policy objectives. This concern has sometimes led policy-makers to impose different constraints on wholesale electricity markets. The most emblematic of such measures is probably the widespread use of a price cap, which sets an exogenous upper bound on the price at which power may be traded.

   Price caps have been repeatedly criticised for creating a so-called "missing money" problem (Cramton and Stoft, 2006). Indeed, producers' revenues are lower whenever the cap is binding, which decreases their incentives to invest in new power plants. As such, even in the absence of any market power issue, one may fear that in the long run too little new capacity will be installed compared to what would be socially optimal. Additionally, when there is a shortage of capacity and prices are at the cap, they fail to elicit socially efficient demand reductions. As a consequence the system operator (SO) has to take potentially suboptimal actions to balance the system and ensure the quality of service even at times of scarcity. For example, load is typically curtailed at the substation level, meaning consumers with a very high willingness-to-pay for power may be curtailed together with consumers with a much lower one. To tackle these issues, additional rules have been implemented in many markets in a move to restore short-term allocative efficiency and long-term investment incentives. Mechanisms interacting with wholesale electricity markets are nowadays mushrooming: explicit demand response (DR) mechanisms, interruptible contracts (similar in spirit to what is known as priority service (PS) in the economic literature), and capacity remuneration mechanisms (CRMs), such as payments for capacity or strategic reserves (SR), etc.

   Demand-side and supply-side mechanisms aimed at ensuring adequacy often coexist. It is therefore crucial to understand how they may compete and interact with one another and identify their limits. As an example, the EU State aid guidelines (European Commission, 2014) state that the development of demand-side management should be an explicit target of any CRM scheme. (1)

   This paper aims at improving our understanding of this interaction. In a first step, we show that both demand- and supply-side adequacy mechanisms can be described within a common analytical framework, contributing to the literature by clarifying how these mechanisms relate to each other. Using this framework we observe that optimal investment signals can be restored by making the marginal costs during peak states either explicit or implicit. The latter approach will often be preferred as it does not require a show of "socially unacceptable" prices. Unfortunately, these mechanisms also appear to be more vulnerable to various inefficiencies, which we describe in more detail than most of the existing literature.

   In a second step we provide two simple policy recommendations if implicit mechanisms are to be used nonetheless. First, the price cap should be set higher than the highest marginal cost of conventional generation, so that the inefficiencies of the supply-side implicit mechanism are minimised. Second, a careful investigation of the limits of implicit mechanisms should precede the implementation of a demand-side mechanism.

   The paper is organised as follows. Section 2 reviews the literature. Section 3 provides a simple common analytical framework for both DR and CRMs mechanisms, and proposes dividing these mechanisms into two families. Section 4 highlights some policy recommendations for markets where transactions explicitly based on marginal costs higher than the price cap are unlikely to be allowed. Finally, section 5 concludes.

2. LITERATURE REVIEW

   This paper relates to two main streams of literature, one on demand-response mechanisms and another on capacity remuneration mechanisms.

   Demand-side mechanisms: PS and DR

   Priority service (PS) had been studied in the economic literature well before the liberalisation of electricity markets and the subsequent debate about the missing money problem (Marchand, 1974; Tschirhart and Jen, 1979; Chao et al., 1988; Chao and Wilson, 1987; Wilson, 1989). This mechanism aims at ensuring the efficient and incentive-compatible rationing of demand in situations of supply outages, when available generation is not sufficient to cover the whole demand. However, priority service may also be used to ration demand efficiently when consumers face exogenously-fixed prices such as price caps.

   It is thus not surprising that a renewed interest in priority service emerged in recent years (e.g. Chao (2012)), as heated debates took place about what is labelled as "demand response" (DR) mechanisms (Chao, 2010; Hogan, 2010). Indeed, notably due to concerns about climate change, the issue of demand-side management is gaining more and more attention in many countries (see, for example, Zhang et al. (2017) for a case study of China).

   Although there seems to exist more shades of DR mechanisms (2) than clearly formalised definitions, the basic idea is to make sure consumers face - and thus respond to - the wholesale price or the social marginal cost of electricity (or any signal that would reflect real-time market conditions better than their prevailing tariff). Yet, the details of the implementation matter a lot, as implicit subsidies to consumers may create significant distortions (Astier and Leautier, 2018), and it may be hard to grab consumer attention (Harding and Sexton, 2017; Gillan, 2018).

   Supply-side mechanisms: CRMs

   The literature on CRMs is more recent. Broadly speaking, it has developed alongside the liberalisation of electricity markets, as many authors expressed doubts regarding the ability of unregulated markets to sustain generation adequacy on a smooth and continuous basis (see De Vries and Hakvoort (2004) for a detailed overview of such doubts). In particular, one of the main critics addressed to the energy-only market paradigm is its silence about the transient regime towards the equilibrium. Recent studies relying on system dynamics models have tried to fill this gap. For example, Hary et al. (2016) illustrated the possible emergence of costly business cycles, and Petitet et al. (2017) compared the dynamic properties of different market designs.

   There is a wide variety of mechanisms, ranging from direct payments for capacity to reliability options or strategic reserves (see e.g. Adib et al. (2008); Batlle and Rodilla (2010); Cramton and Stoft (2006); De Vries (2007); Lambin and Leautier (2018) for critical reviews of those mechanisms). (3) Those mechanisms may be technology-neutral or not, centralised or decentralised, volume-or price-based (see European Commission (2016), page 10, for a summary of those designs). In particular, the impact of CRMs, and/or the need for such mechanisms to allow plants to break even, may be different for different generation technologies (Levin and Botterud, 2015; De Maere d'Aertrycke et al., 2017). However, CRM mechanisms all consist of giving additional payments to some generators in order to make sure there will be enough capacity available at times of high demand. (4)

   So far, CRMs have most often been justified by the "missing money" problem created by price caps (Joskow, 2013; Cramton et al., 2013). Price caps are indeed present in many markets. For example, the market coupling algorithm Euphemia and European market places use a price cap of P = 3000 EUR/MWh for day-ahead transactions. In its inquiry on capacity mechanisms (European Commission, 2016), the European Commission indicated that "Where VoLL [Value of Lost Load] has been estimated by MSs it ranges from 11,000 EUR/MWh to 26,000EUR /MWh, so significantly higher than existing European price caps". (5) According to this study, the vast majority of countries having implemented some capacity mechanisms also have a price cap on day-ahead, intraday and/or balancing transactions. At least two distinct reasons seem to underlie the implementation of a price cap. First, price caps may be a tool to mitigate market power abuses, which may otherwise occur in times of scarce supply. Second, high and volatile spot prices are often perceived as a political risk by decision-makers. (6) We assume in this paper that this second aspect is present, if not prevalent.

   Some markets, such as the UK or the Netherlands, do not enforce a price cap. The present analysis does not intend to apply to such countries. These countries may nevertheless implement a CRM, as, for example, in the UK. A complementary justification given for CRMs is indeed a need to make up for a "missing market" for risk (Newbery, 2016), leading to an underinvestment in capacity. De Maere d'Aertrycke et al. (2017) illustrate this point by simulating how the limited availability of risk-hedging instruments and different liquidities for such products affect investment incentives. While the two families of mechanisms that we later highlight imply different risk profiles, the "missing money" problem is assumed to be the main motivation for implementing capacity adequacy mechanisms in this paper. The study of how risk-averse agents may react differently to both families of mechanisms is left for further research.

3. A COMMON FRAMEWORK FOR CAPACITY ADEQUACY MECHANISMS IN THE PRESENCE OF A PRICE CAP

   3.1 Framework

   Consider a wholesale electricity market in which the current structure and level of longterm assets is optimal--both on the supply-side (portfolio of power plants) and on the demand-side (portfolio of consumers' appliances). Further assume that all producers and consumers trade electricity at the wholesale price. In such an environment, textbook economics suggests that the (first-best) wholesale price in a given...