Darryl R. Biggar

Managing Intertemporal Price Risks

Wholesale electricity prices are notoriously volatile. Chapter 13 discusses the tools and processes used by market participants to hedge electricity market price risks. The chapter begins with an introduction to the most common instruments used for managing risk, including swaps and caps. The chapter distinguishes price risks and cost-shifting risks and explains how each can be separately hedged. The chapter goes on to show how (under certain assumptions) an abstract generator may choose to construct a portfolio of swaps and caps to perfectly hedge the price risk that it faces. The chapter also discusses the hedging requirements of electricity consumers and how electricity consumers can construct a portfolio to hedge the price risk they face. The chapter introduces the notion that all risk cannot be hedged through arrangements between producers and consumers alone and shows how the hypothetical hedge market trader can, by selling contracts to producers and consumers, reduce the risk to which it is exposed at this level.

Efficient Investment in Generation and Consumption Assets

The previous chapters focused on the efficient use of an existing set of production and consumption resources. Chapter 9 focuses on the question of efficient investment in the creation of new production and/or consumption resources. The chapter starts with the general form of the optimisation problem. In order to gain more insight, the chapter focuses on the special case of generation with constant variable cost and constant cost of adding capacity. This leads to a relationship between the area under the price-duration curve and the unit cost of capacity. Focusing on the special case of inelastic demand, we find a relationship between the optimal mix of generation and screening curves. The chapter shows how screening curve analysis can be used to predict the outcomes of different market developments, such as an increase in generator costs or increased penetration of renewable generation. The chapter concludes with a study of incentives for investment in consumption resources.

Representing Network Constraints

The next step in the analysis is to incorporate network constraints into optimal dispatch. Chapter 6 starts this process by introducing the representation of networks and network constraints in the mathematical optimisation process. The chapter draws a distinction between meshed and radial networks and introduces the concepts of net injections and limits on power flows. This leads to the concepts of constraint equations, the matrix of power transfer distribution factors and the set of feasible injections. The distribution factors for various simple networks are set out along with the corresponding shape of the set of feasible injections. The chapter concludes with a discussion of how the set of feasible injections changes when a new link is added to an existing network.

Regional Pricing and Its Problems

The majority of this text has focused on efficient or optimal dispatch which involves setting a different locational marginal price for electricity at each node. However, some markets, including the Australian market, do not differentiate electricity prices in this way and instead set a single price for each region. Chapter 19 introduces regional pricing, discusses the problems that arise as a result and discusses how these problems might be resolved. The chapter begins with a definition of regional and/or zonal pricing and discusses the range of approaches to regional pricing. The chapter continues with a discussion of the problems that arise from regional pricing including the behaviour known as disorderly bidding. The discussion covers the impact on the efficiency of dispatch, the impact on the settlement residues and the impact on the balance sheet of the system operator. The chapter goes on to discuss how constrained-on/constrained-off payments might solve this problem, but may distort generator locational investment decisions. The chapter concludes with a discussion of the impact of regional pricing for just one side of the market (e.g., nodal pricing for generators, regional pricing for consumers).

Managing Interlocational Price Risk

Intertemporal price volatility is not the only form of risk faced by electricity market participants. In addition, traders who trade hedge contracts across differently priced locations also face interlocation price risk. Chapter 14 discusses tools and processes for hedging interlocational price risk. The chapter starts by demonstrating the importance of the merchandising surplus for hedging interlocational price risk. CapFTRs are then introduced as a tool for hedging locational price risk. It is shown how traders can use CapFTRs to construct a portfolio to hedge the risks they face. Conventional fixed-volume financial transmission rights (FTRs) are introduced and their drawbacks as a hedging instrument discussed. The chapter concludes by exploring the role of transmission right prices as a signal for investment in the network.

Market-Based Investment in Electricity Generation

Having characterised the conditions for optimal investment in generation resources, Chapter 10 explores whether private for-profit generation entrepreneurs have an incentive to make efficient investment decisions. This leads to a discussion of concerns with energy-only markets and the missing money problem. The chapter then explores the impact of price caps on the incentives for investment, which leads to a discussion of the role for capacity markets and capacity payments. The chapter concludes with a discussion of the impact of time-averaging of network charges on the incentives for generation investment.

Achieving Efficient Use of Generation and Load Resources using a Market Mechanism in an Industry with no Network Constraints

Chapter 5 asks whether the optimal dispatch outcomes characterised in Chapter 4 can be achieved through a competitive market process. The chapter begins with a description of a smart market process for the electricity industry. It is demonstrated that in the absence of market power a generator will submit an offer curve which matches its marginal cost curve and therefore the resulting dispatch outcome will be efficient. This is followed with a discussion of variations in wholesale market design, such as compulsory gross pool or net pool, single-price or pay-as-bid, and day-ahead versus real-time markets. The impact of price controls and rationing is discussed. The chapter concludes by focusing on the case of inelastic demand, introducing the concept of the price-duration curve and the load-duration curve.

Introduction to Micro-economics

Chapter 1 introduces key economic ideas which are used throughout the remainder of the text. The chapter opens with an introduction to the concept of economic efficiency, distinguishing short-term efficiency in use and longer-term efficiency in investment. The theory of constrained optimisation is introduced and immediately applied to the determination of the demand function from a consumers utility function and the determination of the supply function from a producers cost function. These concepts are combined to determine efficient outcomes in a market process, which leads to the concept of a smart market. There is a brief discussion of situations of market power, including an overview of market outcomes in both monopoly and oligopoly.