Reliability concepts and market power

Fernando L. Alvarado
Professor, The University of Wisconsin 

Invited Seminar at the U. S. Department of Energy

December 4, 2000

December 4, 2000 © 2000 Fernando L. Alvarado 1

 Outline
• Reliability basics overview
• Some market power issues

December 4, 2000 © 2000 Fernando L. Alvarado 2

 Basics overview (assumptions)
• Exactly two technologies
– Each technology has a known price
• No market power
• Inelastic demand
• Reliability event occurs when demand
exceeds supply

December 4, 2000 © 2000 Fernando L. Alvarado 3

 Deterministic Demand and Supply, low demand case

Price

Demand (inelastic)
Maximum
available
power

Available supply

Quantity (power) Clearing

price
December 4, 2000 © 2000 Fernando L. Alvarado 4
Deterministic Demand and Supply, high demand case
Clearing
price
Price

Demand (inelastic)
Maximum
available
power

Available supply

Quantity (power)

December 4, 2000 © 2000 Fernando L. Alvarado 5

 Probabilistic Demand, high demand case

Probability of low prices

Outage
probability
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 The piece-wise nature of the supply curve

Generator 6
Generator 5
Generator 2
Generator 1

Generator 3

Generator 4

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 The effect of a generator outage

Old
Outaged supply
generator limit
New
supply
limit

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Effect of demand uncertainty
Probability
and generator outage
p2

Probability p1

n-1 secure

insecure

Outage probability is p1*p2

December 4, 2000 © 2000 Fernando L. Alvarado 9
 Generator 1A

Generator 2A

December 4, 2000
Generator 3A

Generator 4A Secure
System A

Generator 5A
Low price

Generator 6A

Generator 1B

© 2000 Fernando L. Alvarado

Generator 2B

Generator 3B
System B

Generator 4B
High price
n-1 insecure

Generator 5B
10
 System B
System A
High price
Low price n-1 secure
n-1 secure

December 4, 2000 © 2000 Fernando L. Alvarado 11

 System B
Flow
System A
Low price
Low price n-1 secure
n-1 secure

December 4, 2000 © 2000 Fernando L. Alvarado 12

 Temptation: construct a composite supply curve
unnecessary

Low price
n-1 secure

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Situation with line transmission limits
Max
flow
System B
Flow
System A
Low price
Low price n-1 insecure
n-1 secure
Outaged
generator Normal conditions
Max
Unable flow
to clear

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Use of distributed reserves
Max
flow
System B
Flow
System A
Low price
Low price n-1 secure
n-1 secure

December 4, 2000 © 2000 Fernando L. Alvarado 15

 Features of the example
• Only two areas (one flowgate)
• Radial
• Demand is inelastic
• Time delays are not an issue
• Generators have no startup/shutdown costs
or restrictions or minimum power levels

December 4, 2000 © 2000 Fernando L. Alvarado 16

 Observations
• Demand elasticity is important
• Locational aspects of reserves matter
– LMP for reserves
• Ramping rates matter
• In deregulated markets only units explicitly
committed to reserves are available
– In regulated markets and in PJM all units are
• Reliability requires that we increase supply
– Standby charges tend to reduce supply (Tim Mount)

December 4, 2000 © 2000 Fernando L. Alvarado 17

 Reality
• Many flowgates
• Networked sysyem
• Demand can be elastic
• Time delays important
• Generators have fixed
costs and restrictions
• Load is uncertain
December 4, 2000 © 2000 Fernando L. Alvarado
• Transmission outages
exacerbate problems
• If one firm dominates
a technology, market
power occurs (next)
• If one firm dominates
a location, market
power results
18
 Market Power?
• The ability to raise
prices significantly
above the efficient
economic equilibrium
December 4, 2000 © 2000 Fernando L. Alvarado
• Disclaimer: the slides
that follow are not
really a market power
study but rather they
represent a simplified
illustration of how
higher prices could
result as a result of
market concentration.
19
 Market Power: Assumptions
• There are exactly two technologies
– Each technology has a fixed marginal price
  availability of the expensive technology
– Limited availability of the cheap technology
– Cheap technology has fixed costs to recover
• Demand is inelastic
– First deterministic, then probabilistic
• All suppliers but a schedule all their cheap power
• Supplier a owns P MW in n1 equal-sized generators
– Supplier a can “withhold” one or more generators
– Bidding above marginal cost is not allowed, withholding is

December 4, 2000 © 2000 Fernando L. Alvarado 20

 The piece-wise nature of the supply curve revisited

Demand
Supplier a generator 2

Supplier a generator 1
Other suppliers

If generators bid marginal price, Clearing

the generators surplus is zero price
December 4, 2000 © 2000 Fernando L. Alvarado 21
 Red generator decides to withhold one generator
Clearing
price

blue supplier
Surplus for

red supplier
Surplus for
Withheld
generator

Red supplier now Of course blue supplier

has large surplus has even LARGER surplus!
December 4, 2000 © 2000 Fernando L. Alvarado 22
 If margins are increased Answer: you may end
up with less capacity
Question: and how are the than you thought
expensive technology units
supposed to recover their
fixed costs if they always
clear at their marginal cost? Raising prices
would require
collusion

Clearing
Now it is not possible for red
price
supplier to withhold and gain
December 4, 2000 © 2000 Fernando L. Alvarado 23
 If demand is uncertain Probability p that
withholding will
result in surplus
2
Price

P1
price 1
Quantity (power)

The expected surplus Since 1 is cheap unit’s marginal

gain is: p*(2-1)*P1 cost, there is no expected surplus loss
December 4, 2000 © 2000 Fernando L. Alvarado 24
 Additional observations
• If the margin to the “knee” is Pm, any
supplier with a total ownership above Pm
may profit from withholding
– If more than one supplier meets this conditions,
chances are that someone will withhold

December 4, 2000 © 2000 Fernando L. Alvarado 25

 Effect of “granularity”
Surplus is P*(2-1) for
demand above this level

With only one

generator, it is
impossible to
withhold and
benefit P

For two generators, surplus

is P*(2-1)/2 for demand
above this level
December 4, 2000 © 2000 Fernando L. Alvarado 26
 Effect of “granularity,” three generator case

Surplus is P*(2-1)/3 for Surplus is 2P*(2-1)/3 for

demand above this level demand above this level

December 4, 2000 © 2000 Fernando L. Alvarado 27

 Effect of “granularity”

Surplus
With n=1, there is no surplus
Surplus with n=2

Surplus with n=3

Surplus with n=4

Demand level

Surplus with n

December 4, 2000 © 2000 Fernando L. Alvarado 28

 Observations and assumptions
• For “worst case” effect, assume n=
• Assume withholding will occur
– Withholding “softens” the supply curve
• High cost periods needed for fixed cost recovery
• Demand is probabilistic
• Suggestion: market power occurs if expected
surplus exceeds fixed cost recovery
– This is also a signal for system expansion
• This means that in the absence of uncertainty, expansion will
occur when expected profits exceed long run marginal costs

December 4, 2000 © 2000 Fernando L. Alvarado 29

 Effect of number of suppliers on supply curve
Price

l i er
upp

s
es

r
10 supplie
s
n

lie r
ier
O
pl

upp
up
2s

3s

Demand
December 4, 2000 © 2000 Fernando L. Alvarado 30
 Effect of demand uncertainty on fixed cost recovery
Period during which
fixed cost recovery
can take place
Price

Withholding increases the period during

which surplus accrues but reduces the
amount that accrues

Demand
December 4, 2000 © 2000 Fernando L. Alvarado 31
Price The effect of demand uncertainty on fixed cost recovery

Period during which

fixed cost recovery
can take place

Demand
December 4, 2000 © 2000 Fernando L. Alvarado 32
 Numerical studies
• Demand is 60/70/80/90/95% of “knee”
•  for demand varies from 0 to 20%
• Demand probability distribution is normal
• Supplier has  equal size units available
• There are 3/6/10/15/ suppliers
We illustrate the fixed costs that can be recovered
for each of the case combinations above according
to our earlier withholding assumptions
December 4, 2000 © 2000 Fernando L. Alvarado 33
 Fixed cost recovery without market power ( suppliers)
250

Thousands per year per MW

200 99%
Demand level as a percentage
of available capacity
150

95%
100

90%
50

80%
0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

Variance of demand (per unit)

December 4, 2000 © 2000 Fernando L. Alvarado 34
  suppliers, demand level as a parameter
200

Fixed cost recovery (thousands per MW-year) 180

60%
70% Even for high
80%

160
90%
95%
demand levels, some
demand variance
140
is essential for
120 cost recovery
100

80

60

40

20

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 35

 15 suppliers, demand level as a parameter
250

Fixed cost recovery (thousands per MW-year)

200
For high enough demand levels
cost recovery is possible
150 even without demand
variance
60%
100 70%
80%
90%
95%

50

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 36

 10 suppliers, demand level as a parameter
300

Fixed cost recovery (thousands per MW-year)

250

200
For high demand levels
demand variance can become
irrelevant
150

60%
70%
80%
100 90%
95%

50

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 37

 6 suppliers, demand level as a parameter
400

Fixed cost recovery (thousands per MW-year)

350

300

250

200

60%

150 For low demand levels it is 70%

80%
90%
very difficult to recover 95%

100
fixed costs
50

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 38

 4 suppliers, demand level as a parameter
450

Fixed cost recovery (thousands per MW-year)

400

350

300

250 For high demand levels, high variance

can even be slightly detrimental to profits
200 60%
70%
80%
150 90%
95%

100

50

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 39

 3 suppliers, demand level as a parameter
450

Fixed cost recovery (thousands per MW-year)

400

350

60%
300 70%
80%
90%
250 95%

200
With three or less suppliers, it becomes feasible
150 at high variances to recover fixed costs by
100
withholding at low demand
50

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 40

 Demand level 60%, number of suppliers as a parameter
50
 suppliers
Fixed cost recovery (thousands per MW-year)
15 suppliers
45 10 suppliers
6 suppliers
4 suppliers
40 3 suppliers

35

30

25

20
At low demand and low
variance it is impossible
to recover fixed costs
15

10

0
0 2 4 6 8 10 12 14 16 18 20
Demand Variance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 41

 Dem and level 70% , num ber of suppliers as a param eter
120
 suppliers
Fixed cost recovery (thousands per MW-year) 15 suppliers
10 suppliers
6 suppliers
100 4 suppliers
3 suppliers

80

60

40
At higher demand with 3 suppliers
it is possible to recover
20
costs at low variance

0
0 2 4 6 8 10 12 14 16 18 20
Dem and V ariance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 42

 Dem and level 90% , num ber of suppliers as a param eter
400

Fixed cost recovery (thousands per MW-year) 250

Dem and level 80% , num ber of suppliers as a param eter
350
Fixed cost recovery (thousands per MW-year)

300

As demand increases, withholding becomes

200

 suppliers
250 profitable even when there are many suppliers
15 suppliers
10 suppliers
150 6 suppliers
4 suppliers
200 3 suppliers
 suppliers
15 suppliers
100 10 suppliers
150
6 suppliers
4 suppliers
3 suppliers
100
50

50

0
0 2 4 6 8 10 12 14 16 18 20
0
0 2 4 6 Dem and
8 V ariance
10 (percent)
12 14 16 18 20
Dem and V ariance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 43

 Dem and level 95% , num ber of suppliers as a param eter
450

Fixed cost recovery (thousands per MW-year)

400

350

300

250

200

150

100
Only in the case  suppliers
15 suppliers
10 suppliers
50
of infinite suppliers is it 6 suppliers
4 suppliers

0
impossible to recover costs 3 suppliers

0 2 4 6 8 10 12 14 16 18 20
Dem and V ariance (percent)

December 4, 2000 © 2000 Fernando L. Alvarado 44

 Comments on numeric results
• The number of suppliers has a strong influence on cost
recovery
– Below a certain number of suppliers, cost recovery by
withholding becomes easier
• There are demand threshold levels beyond which there
is a jump in the ability to recover costs
• All studies assume that supplier can adjust level of
withholding after learning the demand
– Lower returns when this is not true, study underway
• Demand variance has a strong influence on ability to
recover costs, sometimes with a threshold level

December 4, 2000 © 2000 Fernando L. Alvarado 45

 Final remarks
• Two-technology suppliers can lead to higher
than marginal prices as the knee of the supply
curve is approached
• Larger number of suppliers reduces this effect
• Market power studies should consider fixed
cost recovery issues
• We did not even look at congestion or voltage
problems!

December 4, 2000 © 2000 Fernando L. Alvarado 46