Market Design Considerations for Scarcity Pricing: A Stochastic Equilibrium Framework.

• Author: Papavasiliou, Anthony

1. INTRODUCTION

   Scarcity pricing is the principle of pricing electricity at a value above the marginal cost of the marginal unit during conditions of high system stress, according to the incremental value that flexible capacity ofers to the system in terms of keeping loss of load probability in check. Concretely, scarcity pricing is implemented by including an adder to the real-time price on top of the marginal cost of the marginal unit, and by rewarding that same adder to standby reserve capacity. The effect of this mechanism is that (i) it rewards flexible resources for being available, even if not activated, and (ii) it rewards flexible resources for reacting to system imbalances when the system is short on flexible capacity. Through economic arbitrage between generation and reserve capacities in real time and day ahead, scarcity pricing creates the potential of giving rise to a long-term investment signal for building flexible capacity or mobilizing demand response that can deliver security to the system.

   Numerical analyses of the Belgian market (Papavasiliou and Smeers, 2017; Papavasiliou et al., 2018) have demonstrated the potential of scarcity pricing to restore the financial viability of flexible technologies in Belgium, and also to create a strong investment signal for mobilizing demand response. In response to these encouraging indicators about the potential of scarcity pricing to attract flexibility in the Belgian market, the present paper discusses concrete market design measures that would enable scarcity pricing to function effectively in the context of the Belgian market design.

   We propose a range of increasingly disruptive measures for the evolution of Belgian market design that would enable scarcity pricing to deliver its intended benefits. The resulting electricity market design is analyzed using a stochastic equilibrium framework. Stochastic equilibrium allows us to quantify the impact of scarcity pricing on real-time energy and reserve prices, as well as the back-propagation of these prices to the day-ahead market through arbitrage. On the basis of our analysis, our concrete recommendation to the Belgian regulator is to proceed with the introduction of a real-time market for reserve capacity in Belgium.

2. CONTEXT

   2.1 Principles of Scarcity Pricing

   Scarcity pricing has been proposed as an approach for the precise valuation of reserve services (Hogan, 2005). The principle of scarcity pricing is to add a correction to the real-time price which rewards generators that can respond rapidly when balancing the system. The theoretical justification of the approach is that it adjusts the real-time price of energy and reserve capacity such that the resulting dispatch of profit-maximizing generators would reproduce the optimal dispatch that would be obtained if the contribution of reserve capacity towards reducing the loss of load probability would be accounted for (Hogan, 2013).

   The mechanism has an equivalent, intuitive interpretation in terms of an operating reserve demand curve (ORDC). The rationale for an ORDC interpretation can be developed as follows. Consider the marginal value of reserve capacity when there is very little capacity left. For example, in Texas, when the system reserve capacity drops below 2000 MW, the system operator follows a series of emergency actions, up to and including involuntarily curtailment of demand, in order to prevent cascading outages (ERCOT, 2019). Effectively, the marginal value of reserve capacity under these conditions is equal to the value of lost load, which in Texas is set administratively to 9000 $/MWh (ERCOT, 2019). When abundant reserve capacity is available in the system (e.g. above 5000 MW in Texas (ERCOT, 2019)), the marginal value of capacity is equal to zero. For intermediate values, the marginal value of reserve depends on the loss of load probability, (1) because a marginal increment in reserve capacity has a marginal effect on system welfare which is proportional to the loss of load probability. (2) This reasoning gives rise to the introduction of a demand function for operating reserve capacity that the system operator submits to a multi-product auction that simultaneously clears energy and reserve in the market. The effect of this demand function is that, under conditions of scarcity in reserve capacity, it lifts the energy price by a scarcity adder, which also applies to reserve capacity. A simplified formula for this adder when there exists a single type of reserve is given by the following expression:

   (VOLL- [lambda])*LOLP(R). (1)

   The notation here is as follows: VOLL corresponds to the value of lost load, [lambda] is a proxy of the marginal cost of the marginal unit, R is the amount of remaining reserve capacity, and LOLP is the loss of load probability. Note that, as the system becomes tight (R decreases), adding this term to the energy price tends to push the energy price to VOLL. The distinction with a pure energy-only market is that this occurs in a smooth and more predictable fashion, since it is not rare that the system reaches a level where LOLP(R) is non-zero, even if no load shedding occurs. When abundant capacity is available (R is very large), the adder dissipates and has no effect on the energy price.

   In a two-settlement system, the scarcity adder directly impacts in real time those resources that can rapidly be dispatched upward: they receive the scarcity adder in addition to the marginal cost of the marginal unit. But this scarcity signal is not meant to only apply to real-time operations. Arbitrage between day-ahead and real-time markets back-propagates the scarcity signal to day-ahead markets, and thus creates a favorable environment for all resources that can offer reserve capacity. Such resources are inherently required in systems with significant shares of renewable power supply. With that being said, a notable difference between scarcity pricing and capacity mechanisms is the built-in "pay for performance" attribute of the scarcity pricing mechanism. Indeed, under scarcity pricing, the stress of the system is signaled by the real-time price which is enhanced by a scarcity adder, therefore it is in the best interest of resources to perform exactly when the system is most stressed (otherwise they pay for their shortfall in real time, or forgo profit opportunities). In a capacity mechanism, this performance attribute needs to be closely specified in the mechanism (by defining an ad-hoc de-rating of capacities depending on their characteristics, or penalties for unavailability during stress events) and requires ex-post monitoring of those performances.

   2.2 Implementation of Scarcity Pricing

   Scarcity pricing in the form of operating reserve demand curves has already been implemented in ERCOT (2015), and has recently been introduced in PJM (Hogan and Pope, 2019), see also FERC number EL19-58-000 and ER19-1486-000 of May 2020. In Europe, the Belgian transmission system operator computes and https://www.elia.be/en/electricity-market-and-system/studies/scarcity-pricing-simulationpublishes scarcity prices one day after real-time market clearing, although these prices are not currently being used for settlement purposes. Furthermore, the Belgian transmission system operator has performed an ex-post simulation of how scarcity prices would have affected the Belgian market in 2017 (ELIA, 2018), based on telemetry data. In September 2020 the Belgian transmission system operator launched a public consultation on its findings regarding the design of a scarcity pricing mechanism for implementation in Belgium ELIA (2020), in response to the proposal set forth in the present paper.

   Two legal documents that have recently been published by the European Commission and the European Parliament indicate a favorable view towards scarcity pricing. Scarcity pricing is referred to as shortage pricing in these documents. The articles in question are article 44, paragraph 3 of the Electricity Balancing Guideline (3) (European Commission, 2017) and Article 20, paragraph 3 of the Clean Energy Package (4) (European Union, 2019).

   For a broader discussion of energy-only markets supported by scarcity pricing and capacity markets, as well as the ongoing debate in the European context, the reader is referred to paragraphs 1.1 and 1.2 of Papavasiliou and Smeers (2017).

   2.3 U.S. Two-Settlement Systems and the European Market Design

   Given these appealing features of scarcity pricing and the increasing experience that is accumulating through the adoption of the mechanism, the Belgian regulator issued a request in 2015 for investigating the potential impact of scarcity pricing on the financial viability of combined cycle gas turbines. The analysis (Papavasiliou and Smeers, 2017; Papavasiliou et al., 2018) concluded that scarcity pricing can have a tangible effect on the financial viability of CCGT units, in the sense that its introduction can allow these these units to recover their long-run investment costs. The Belgian regulator subsequently requested from the Belgian system operator to conduct a parallel run on how the scarcity adder would have evolved given the available reserve capacity that was recorded by ELIA telemetry in 2017 (ELIA, 2018). In addition, the Belgian regulator requested a concrete market design proposal for the specific changes that would be required in the design of the Belgian day-ahead and real-time market in order to permit scarcity prices to take effect, and back-propagate through financial arbitrage (5) to the forward day-ahead market. This is the focus of the present publication. Although the original investigation of scarcity pricing in 2015 (Papavasiliou and Smeers, 2017; Papavasiliou et al., 2018) was motivated by the financial viability of CCGT units, the present publication is further concerned with the implications of the mechanisms for demand-side resources that can ofer reserve services to the system.

   The...