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Time for Transparent Scarcity Pricing

image credit: Creator:wgmbh | Credit:Getty Images/iStockphoto

Discussions about electricity markets can be so blurry.

And perhaps a bit intimidating.

About ten years ago, I represented a very small Midwestern city in an arbitration proceeding against a large utility. As I prepared with the lawyers for our hearing, we decided our strategy would be the following:

I would explain to the three arbiters how an RTO performs economic dispatch and determines the locational marginal price. I would not be able to use a single acronym in my explanation. No laptop. No PowerPoint slides.

Just me and a blank chalkboard.

RTO markets were still relatively new, and the combined age of the arbiters exceeded two hundred years.

I practiced my presentation with family, friends, and coworkers.

Anybody who would listen and stay awake.

Though I completed my mission and the municipality won the case, I was shocked how difficult it was to explain the core principle of organized wholesale markets.

Why is it so tough to explain something so simple in theory?

A decade later, I believe that many market participants still struggle to explain these concepts to regulators and the general public.

Especially during conditions of high system stress when the market experiences a shortage of operating reserves.

Scarcity pricing is triggered by the absence of operating reserves or the implementation of emergency procedures by the market operator.

If we wish to achieve a national energy portfolio dominated by intermittent renewable resources, we must do a better job to calculate scarcity pricing in our energy markets.

We need a less convoluted process devoid of ambiguous settlement charges after the fact.

We need to implement the Economic Operating Reserve Demand Curve (ORDC).

 

Why the Struggle to Explain

 

I believe we grapple with energy pricing explanations because we largely abandon the concept of a free market during periods of system stress.

Why do we do so?

Because we do not like the answer about seven percent of the time when scarcity pricing should be triggered.

Market regulators simply do not like to see high prices.

The current methodology to price energy during scarcity events mutes the true value of the next incremental megawatt to serve load.

Or in these instances, keep the lights on.

During stressful events, market operators sometimes take many non-market measures to avoid running out of operating reserves.

These subjective actions, often outside the normal merit of economic dispatch, introduce a level of ambiguity as to when scarcity pricing is triggered.

Finally, due to the current methodology to average the five-minute locational marginal pricing, we dilute the price signals to the market during scarcity events.

Price suppression is an illness in need of an immediate cure if we want to accelerate the integration of substantial intermittent renewable energy in a low cost and reliable manner.

 

The Stigma of High Prices

 

Price spikes are mistakenly perceived as a failure of the organized market.

These rare events gain headlines that shock utilities & general public. They often lead to emotional, reactionary steps by regulators all in the name of “protecting the consumer.”

While the instantaneous price spike may eventually land itself in a market monitor’s report as an interesting footnote, did it truly adversely impact the public from a broader viewpoint?

Rather than solely focus on the seven percent of the time where ballistics scarcity prices should have existed, we need to also consider the other ninety three percent of the time when the market prices were significantly more benign during a shortage of operating reserves.

In other words, we should focus on the total energy cost paid by the consumer for the year if we wish to grade the total price risk to the consumer.

Not just the seven percent of the time where scarcity pricing becomes triggered.

Like many things in today’s world, we often focus on the tail events of a probability distribution curve and decide these events represent part of the 95th percentile where things work as planned.

Recency bias , confirmation bias and availability bias are three common cognitive biases that unfortunately impact market regulators and designers during periods of high system stress.

We have seen recent examples whereby some RTO markets set records for the $ cost per MWH yet recorded annual wholesale prices lower than the previous year.

Occasional ballistic real time prices are not synonymous with a higher annual average Locational Margin Price or higher annual costs to the consumer.

 

The Big Apple Traffic Congestion Fee

A traffic congestion fee will go into effect in New York City by 2021, that will charge vehicles travelling into or within a predetermined area in the Manhattan central business district. The purpose of the plan is to reduce road congestion, shorten commutes, reduce air pollution, and raise funds for long -term mass transit upgrades.

The only way to effectively incent behavior is to charge car drivers $8 for cars & commercial vehicles and $21 for trucks.

Are wholesale markets not so different?

Scarcity pricing would reduce costly congestion on the grid by allowing the load to choose to be paid to reduce demand, reduce air pollution by allowing solar & renewable to exist at a higher penetration level, and send a transparent & proper price signal for future transportation infrastructure and services.

Short-term, short lived price spikes not only provide a market signal to support more capacity, they also indicate the need for more flexible, fast-responding resources.

In a world soon to be dominated by wind, solar & storage, we need to find a way to adequately price flexible, fast responding resources in the most transparent and easy to understand manner as possible.

 

Price Suppression

 

Price suppression is one of the more sensitive topics in the energy markets today.

Some renewable energy advocates view the term as a criticism towards the zero marginal cost characteristic of solar & wind generation.

And maybe a few even see the term as a defense argument for thermal generation to explain why the market economics now fail them.

But price suppression means something quite different.

RTO system operators sometimes need to commit higher priced generation to handle sudden, unexpected operational challenges.

Challenges like unplanned transmission or generation outages or maintaining adequate voltage due to sudden drops in wind and/or solar generation.

Market operators sometimes need to utilize operating reserves to get through these short-lived crisis moments to maintain system reliability.

Sometimes they plow through operating reserves and need to call on higher priced generation to regain the proper amount of operating reserves.

Rather than incorporating these costs into the locational marginal price of energy (LMP), these additional costs wind up buried in a lengthy settlement statement. The RTO will assign these costs to the Market Participant either based on load ratio or deviation from day ahead schedules.

By applying these settlement charges after-the-fact, the true cost to serve load is opaque.

So, while a lower Locational Marginal Price (LMP) may provide better optics on a Market Monitor Annual Report and keep unsuspecting regulators at bay, one thing will always remain true.

At the end of the day, the load will pay.

 

Why Price Suppression Hurts

 

The new world of high frequency data, digitalization, and distributed energy resources all stand ready to assist organized markets to handle the sudden, unexpected event when operators struggle to match supply & demand.

So does Demand Response & Battery Storage.

But they all need to have an accurate & transparent price to participate.

Price suppression sends the wrong investment signal to flexible, fast ramping resources. Artificially lower prices do not provide incentives to resource owners to be available during shortage conditions.

Short-term, short lived price spikes not only provide a market signal to support more capacity, they also indicate the need for more flexible, fast-responding resources.

 

Price suppression plays a large factor in the “missing money problem” plaguing the capacity market debate for the past decade.

Finally, price suppression prevents one other important resource from participating.

The speculator.

A healthy market entering a mature stage generally sees a narrowing of the spread between Day Ahead prices and the Real Time market.

By their very nature of “buying low and selling high”, speculators play an important role in providing liquidity and ultimately collapsing spreads.

Speculators often live in the virtual trading market to take advantage of the delta between Day Ahead & Real Time prices.

While they are often misunderstood and maligned, speculators have a long history of entering markets during periods of high volatility and moving elsewhere after the spreads collapse.

The collapse the DA & RT delta results in lower overall costs to the load.

 

How Would Scarcity Pricing Be Applied?

 

In an RTO/ISO market, resources are scheduled and dispatched to meet forecasted load demand plus a margin of operating reserves.

When the market does not have adequate capacity available to meet both energy & reserves, the reserves are deployed to meet energy and keep the lights on.

The net effect of this action leaves the market short of reserves.

In such an event, the price of operating reserves should reflect the value to the system of restoring marginal reserve capacity.

In a April, 2018 article, Robert Sinclair (Vice President of Potomac Economics) suggested the market can reflect this value using an Operating Reserve Demand Curve (ORDC) that sets prices for reserve products based on the marginal reliability value of reserves at each level of shortage.

  • VOLL*p(s) = Marginal Value of Reserve Capacity
  • VOLL= Value of Lost Load
  • P(s) = Probability of losing load at a reserve shortage of (s) MW

 

Let’s touch on VOLL for a moment. Once again, this topic is also a sensitive issue that often brings an emotional response as compared to a data driven answer.

The Value of Lost Load (VOLL) is the estimated amount that customers receiving electricity with firm contracts would be willing to pay to avoid a disruption in their electricity service.

Let’s face it, blackouts involve far reaching consequences for an entire socioeconomic system. As difficult as the topic may be, you should have a good idea how much you would be willing to pay to keep the lights on in different areas of your system.

Notwithstanding the strong distaste for failing to reliably serve a single customer.

Source: Potomac Economics

 

Widely considered the “Godfather of RTO Markets”, Dr. William Hogan also advocated for Electricity Scarcity Pricing Through Operating Reserves in April 2013.    

Furthermore, reserve shortage should also be reflected in energy prices because reserves are being deployed to serve energy during this scarcity event.

The graph above denotes the ninety three percent of the time whereby scarcity pricing would be relatively benign to the consumer.

If we adopted the Economic ORDC IMM Model, we would see the true incremental price of energy to serve load.

And perhaps end the never-ending debate about capacity market design because we would discover a large amount of “the missing moey.”

 

Florida Summer of 1998

I began my career in the energy markets in 1998 with Florida Power Corporation in St. Petersburgh as a power trader.

The 1998 Florida summer was not only a scorcher, but a high-pressure system decided to settle over the state.

For pretty much the entire summer.

No afternoon rain showers to bank on to curtail record load demands on a daily basis.

All in all, a perfect time to lose nearly fifty percent of your generation. Which we unfortunately experienced.

During a few extreme events, our trading team and upper management met to determine the Value of Lost Load.

Day Ahead prices in the country soared into the thousands of dollars for a few weeks.= in the summer of ’98.

Though our methodology was not as scientific as it would be today, I do remember that we decided we would pay as much as $10,000 per MWH if needed.

VOLL could help to ensure an optimum distribution to end users of the remaining electricity in the case of a power outage, as far as this is possible with the technical options available. Further developing the VOLL approach as an economic index would, thus, effectively complement other technical indices.

 

Conclusion

Public policy goals throughout the United States clearly state the desire to continue to integrate a substantial amount of additional clean energy in order to accomplish extremely ambitious carbon reduction goals by 2050.

Just look at the expected solar growth in the United States for the next three years:

Source: BTU Analytics

The BTU graph graphically spells out the clear reason why we need to implement rationale scarcity pricing ASAP. Intermittent solar power is about to achieve a significant percent of our national portfolio in the next three years.

Large scale renewable penetration poses unique operational and reliability challenges to our market operators. Fast response and flexible resources will be needed.

Wholesale markets need to reprice the value of Operating Reserves and implement scarcity pricing to send the proper incentive signal to available resources.

Controversial and complicated capacity markets are really nothing more than a substitute for scarcity pricing.

As the percentage of renewable energy increases in the overall national portfolio, we continue to learn more about how the markets need to operate.

Properly pricing energy and operating reserves will send the right signals to resources that provide the much-needed flexibility and fast ramping response.

Focusing on this problem will be easier to solve than trying to fix broken capacity markets.

The short run solution will provide the long run solution.

While it is understandable that regulators wish to shield the consumer from exposure to high prices, the current solution does not really do so in the end.

The load always pays.

 

 

Sources:

  • It’s Time to Refine How We Talk About Wholesale Markets

Author: Robbie Orvis & Mike O’Boyle

https://www.greentechmedia.com/articles/read/its-time-to-refine-how-we-talk-about-wholesale-markets

  • The Bigger Picture| FERC Requires Greater Transparency Regarding RTO/ISO Uplift

Author: Glenn S. Benson

https://electricenergyonline.com/energy/magazine/1149/article/The-Bigger-Picture-Ferc-Requires-Greater-Transparency-Regarding-RTO-ISO-Uplift.htm

  • What is Shortage Pricing & Why is it Essential in Competitive Electricity Markets

Author: Robert Sinclair

https://www.potomaceconomics.com/uncategorized/what-is-shortage-pricing-and-why-is-it-essential-in-competitive-electricity-markets/

  • Electricity Scarcity Pricing Trough Operating Reserves

Author: William Hogan

http://www.lmpmarketdesign.com/papers/Hogan_ORDC_042513.pdf

  • Seasonal Electric Demand in the Southeastern United States/Sothern Alliance Clean Energy

Author: John Wilson, Maggie Shober

https://cleanenergy.org/wp-content/uploads/Seasonal-Electric-Demand-in-SE-SACE-Final.pdf

  • Value of Lost Load: An Efficient Economic Indicator for Power Supply Security? A Literature Review.

Authors: Thomas Schroder, Wilhelm Kuck

https://www.frontiersin.org/articles/10.3389/fenrg.2015.00055/full

  • Are Solar Developers The Next Frackers

Author: Anthony Bradford

https://btuanalytics.com/power-and-renewables/are-solar-developers-the-next-frackers/

Patrick McGarry's picture

Thank Patrick for the Post!

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Discussions

Matt Chester's picture
Matt Chester on Jul 13, 2020 4:19 pm GMT

I believe we grapple with energy pricing explanations because we largely abandon the concept of a free market during periods of system stress.

Really interesting-- thanks for this article, Patrick. The power market is so unique compared with any other industry in how it works, its essential nature, and the forces governing it that it's quite easy to drown in it. I'm with you in reading this stuff every day and I must admit that sometimes my eyes glaze over. Having helpful explanations like this is critical

Richard Brooks's picture
Richard Brooks on Jul 13, 2020 5:11 pm GMT

This is a very insightful piece. I don't envy you having to explain the maximization of social welfare in the discussion of energy price optimization, using only a chalkboard. Scarcity pricing does seem to be effective in Texas, but I'm not certain this model can work in areas of the country with less natural resources, i.e. wind power. I think another model could be worth considering, that pursues a resource adequacy strategy to satisfy both State Energy Goals and system Reliability through the acquisition of essential grid services in a single objective function: https://www.naesb.org/pdf4/weq_aplan100219w1.docx

Patrick McGarry's picture
Patrick McGarry on Jul 13, 2020 5:32 pm GMT

Richard- Thanks very much for the feedback. A funny side note to the arbitration story....I found out on Sunday evening about the presentation strategy change to be ready for the Monday morning presentation. I bought two large bottles of Coke and stayed up all night to get ready. Not using acronyms is a great way to get your point across without losing an audience. The other party hired a Stamford law grad. We took one hour to make our point and beat them! Maybe the best day in my professional life! Keeping it simple is always the best strategy.

 

Richard Brooks's picture
Richard Brooks on Jul 13, 2020 9:04 pm GMT

Amen to that. Congratulations on your victory! We are living through historic times for the Energy industry; we are fortunate to be in this place at this time to witness this history unfold. Best regards.

Bob Meinetz's picture
Bob Meinetz on Jul 13, 2020 8:24 pm GMT

"In a world soon to be dominated by wind, solar & storage..."

After hearing the same pronoucements for half a century, I can't see any new basis for the notion the world will ever be "dominated" by scarce, intermittent solar and wind. They're incapable of powering a modern industrial economy, and always will be.

"Market regulators simply do not like to see high prices."

Neither do ratepayers. We can treat the symptoms - erratic prices from unpredictable, unreliable sources of energy. Or, we can treat the illness: eliminate unpredictable, unreliable sources of energy. Occam's Razor would suggest the easiest, most direct solution is probably the best.

Michael Keller's picture
Michael Keller on Jul 20, 2020 4:21 pm GMT

Spot on!

Michael Keller's picture
Michael Keller on Jul 20, 2020 4:19 pm GMT

Looks like another academic exercise decoupled from practical reality.

In point of fact, wholesale power markets are not deregulated. The current Dutch-auction scheme was created by bureaucrats, as aided and abetted by policy makers. The intent was clearly a crude attempt to mimic a free market.

The idea of charging consumers for scarcity caused by bureaucrats only leads to enriching the elite financial institutions.

Accept the fact that energy generation, transmission, and distribution is inherently monopolistic. Regulate the activity to minimize gaming of the system by the unscrupulous and provide reasonably priced energy.

Patrick McGarry's picture
Patrick McGarry on Jul 21, 2020 4:54 pm GMT

Thank you for your thoughtful and insightful feedback.

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