Strategic Behavior and Market Design in Regional Climate Policy.

Date01 May 2023
AuthorTarufelli, Brittany L.

1. INTRODUCTION

Heterogeneity in market design can lead to unanticipated outcomes from sub-global climate policies. I consider a second-best problem where the efficacy of a sub-global climate policy to correct for one market failure--a negative externality from carbon emissions--can be distorted by a second market failure from the market design itself. I examine this problem in the context of U.S. electricity markets, as market designs vary by region and imperfectly overlap with regional climate policies such as carbon prices and renewables subsidies. While regional climate policies to cut carbon emissions overlap regions with different electricity market designs, previous studies of leakage from regional climate policies in electricity have not taken market design into account. Instead, previous studies have been focused on market power and market efficiency within a centralized region following market rules. (1)

I model strategic behavior in electricity markets when market designs and emissions policies are partially overlapping. My model also allows for several types of non-overlapping policies and market designs. For example, sub-regions within a given market design may have their own climate policies. Leakage across emissions-regulated and -unregulated areas within a given market region may depend on the market design. Alternatively, trading across market regions with differing market designs may occur, and emissions policies may be more prevalent under one design than another. My model generates predictions for these combinations.

There are two predominant wholesale electricity market designs in the U.S., those regions that have restructured and operate under a centralized auction market design, which I will refer to as centralized markets, and those regions operating under a decentralized bilateral trading system, which I will refer to as bilateral markets. Despite changes to market rules to encourage competition, market power persists in wholesale electricity markets. (2) The potential for exercising market power in such markets is due to some unique characteristics of electricity markets--primarily that electricity cannot easily be stored, creating opportunities for exercising market power when there are short-term supply and demand imbalances. To facilitate the challenge of balancing supply and demand, electricity trading takes place in forward contract and spot markets. Forward contract markets are used to make financial transactions to plan for and commit to electricity production for future use. Spot markets are for electricity production, distribution, and incremental trades to address last-minute supply and demand imbalances.

In related market design literature, (3) there are two main approaches used to model strategic producer behavior in imperfectly competitive wholesale electricity markets: the Cournot model (4) and the supply function equilibria model (SFE) (5) (Willems et al., 2009). I examine strategic behavior when market designs and emissions policies are partially overlapping with a Cournot model for its ability to accommodate relevant market details. Because Cournot models tend to overpredict prices, I include a forward contract market to reduce firms' sensitivity to prices in the spot market (Allaz and Vila, 1993). Bushnell et al. (2008) confirmed that after accounting for forward contracts, the Cournot model predicted prices that did not deviate significantly from observed electricity prices. For an extended discussion of modeling approaches in electricity markets, see Appendix B.

My research question is most similar to that of Fowlie (2009), who uses a Cournot model with a forward contract market to show that institutional details matter for emissions leakage predictions. By extending the model of Allaz and Vila (1993) to include a carbon price, Fowlie (2009) finds that leakage is greater with increased competition from the pro-competitive effect of a forward contract market. (6) Different from Fowlie (2009), who assumes that all producers' forward contracts are bought by speculators, I explicitly model the decisions of electricity producers and retailers in the forward contract and spot market stages of the model. My approach more closely resembles Powell (1993), who clears the forward market with the intersection of demand for forward contracts from retailers and supply of forward contracts from producers.

When Cournot models with forward contract markets are utilized, the assumption of how the forward contract market clears affects the extent of the forward contract market and the competitiveness of the spot market. Arbitrage is a standard assumption in related literature (Allaz and Vila, 1993; Green, 1999; Fowlie, 2009), but not all electricity markets have financial instruments that allow for arbitrage. In an extensive finance literature, it has been shown that in the absence of arbitrage, models can be solved via general equilibrium asset pricing, where agents' mean-variance preferences affect strategic forward contract positions and resulting spot market prices (Bessembinder and Lemmon, 2002; Anderson and Danthine, 1980; Hirshleifer and Subrahmanyam, 1993). In lieu of mean-variance preferences, I utilize a conditional value at risk (CVaR) measure, which is a coherent risk measure (Rockafellar and Uryasev, 2000). (7)

In my two-stage Cournot model, in the second stage, shocks from demand and renewable resources are realized and the spot market must clear. Oligopoly producers then engage in Cournot competition, taking as given the forward contract positions from the first stage to determine the final spot price, quantity of electricity produced, and resulting emissions levels. I approximate centralized and bilateral market designs by making assumptions about the extent of competition in each of the forward contract and spot markets, as well as whether financial speculators can participate in the markets. I assess how incomplete regulation--regulation that is only applied to some producers within a bilateral or centralized region--can affect emissions leakage for electricity producers operating under each market design. I define leakage as in Fowlie (2009), where leakage is the difference between emissions from unregulated producers under incomplete regulation, and emissions of those producers under no regulation.

As shown in Figure 1, I find that emissions leakage depends on the relative market power in centralized market regions vs. bilateral regions. Relative market power is driven by market design, where centralized markets are more competitive for a given number of players. Three key results are a) when a carbon emissions price is asymmetrically applied (8) to a bilateral region, emissions leakage is low; b) when a carbon emissions price is asymmetrically applied to a centralized region, emissions leakage is high; and c) if a carbon emissions price is applied to a centralized region and emissions leakage is to a bilateral region, leakage is again low, but increases if the bilateral region trades with the centralized region. Emissions leakage increases in more competitive markets, because producers' production and relative market shares are more responsive to relative changes in marginal costs as in Fowlie (2009), but the less competitive bilateral market can act as a structural backstop to emissions leakage.

My framework can be used as a foundation for building more detailed models of the electricity industry and to inform climate policy design when regulations overlap differing electricity market designs. For example, in 2014, the California Independent System Operator (CAISO) extended a centralized spot market over a traditionally bilateral Western electric region with the introduction of the Western Energy Imbalance Market (EIM), integrating states and regions with diverse climate policies. In February 2021, the Southwest Power Pool (SPP) launched its Western Energy Imbalance Services market, allowing more utilities from the traditionally bilateral Western electric region to join its centralized spot market. (9) The European Union's Energy Union also continues to further integrate diverse member states' energy markets to support the clean energy transition. (10) Recent initiatives, like the European Cross-Border Intraday market (XBID) further integrate electricity markets across member states with diverse climate policies. (11)

Some limitations of the model stem from simplifications made to gain tractability. The model is most appropriate for understanding short-term implications of market design across two differing regions with either limited trade or only spot market trades between them. Simplifying assumptions such as normally distributed profits, symmetric firms, no transmission constraints, (12) and considering only the interior solution can be relaxed, and numerical simulations can be performed on electricity data to quantify impacts of market design relative to a counterfactual. However, as the model is Cournot, with forward contracts, the modeler must remain aware that price effects can be overstated.

2. THEORETICAL MODEL

The theoretical model is structured to capture key elements of electricity market design. There are two primary actors in electricity markets, power producers and electricity retailers. In some regions of the country, non-utility producers can sell power directly to electricity retailers. Electricity trades in these regions follow more traditional market rules, (13) and are overseen by independent entities known as Independent System Operators (ISOs) or Regional Transmission Organizations (RTOs) (FERC, 2015). In the model, regions with centralized auction markets are referred to as centralized markets. In other regions of the country, these actors are vertically integrated (utilities) and earn a rate-regulated rate of return. Rate-regulated utilities tend to have significant excess capacity, creating opportunities for trading...

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