Retail Electricity Markets with Risk Aversion and Asset Swaps

1. EPOC Winter Workshop 2010 Anthony Downward, David Young, Golbon Zakeri Retail Electricity Markets with Risk Aversion and Asset Swaps

2. Outline • Motivation • Background • Risk Aversion • Retail Markets • Model • Two-stage • Entry into retail market • One-node example • NZ inspired example • Conclusions • Future Work

3. Wolak Report • Early last year Frank Wolak’s report to the Commerce Commission was released. • It highlighted some shortcomings of the NZEM, including: • limited competition for thermals in dry years, • only one firm with generation in both islands. • It suggested that asset swapping may improve market outcomes. Motivation

4. Ministerial Review • Later that year, the Electricity Technical Advisory Group produced a discussion paper that presented three asset swap proposals. • In December last year, the government stated its intent to give Tekapo A+B to Genesis and Whirinaki to Meridian. • Virtual swaps were also proposed, where contracts for energy in either island are compulsorily traded. Motivation

5. Wholesale Market • Paper appearing in the Energy Journal, examining the effect of asset swaps and divestiture in the wholesale market. • In that paper, we assume Cournot Competition and produce some counter-intuitive results, particularly due to the presence of transmission. Background

6. Retail Markets • Consumers enter into contracts with retailers, reducing the risk that they would otherwise face buying from the spot market. • Retailers compete with each other for the same consumers through mainly price competition. • Retailers must pass on the risk of purchasing from the spot market to consumers. Background

7. Risk Aversion • There is significant risk involved in participating an electricity retail market. • Retailers purchase electricity at the spot price and sell to consumers at predetermined fixed prices. • In New Zealand, vertical integration is common; this acts an internal hedge against spot price fluctuations. Background

8. Entry in Retail Markets • Before a retailer decides to participate in the market it must determine whether it’s a profitable decision, and whether there is significant risk involved. • There may be fixed costs associated with participating in the market, which are not related to the spot price of electricity or the amount of power served. Background

9. Coherent Risk Measures • Artzner et al. introduced the concept of coherent measures of risk. • A coherent risk measure has the following properties: • sub-additivity, • translation invariance, • positive homogeneity, • monotonicity. • We employ conditional value at risk (CVaR) as our risk measure. Background

10. Conditional Value at Risk • This is also known as average value at risk or expected shortfall. • The CVaR at level βof an uncertain profit is given by the expected loss of the lowest 100 β% of profits. • Firms who are risk-averse will balance the expected return of their decisions against the risk associated with that decision. Background

11. Conditional Value at Risk Profit Background 10%

12. Differentiated Products • We model retail demands as functions of retail prices using a differentiated products model. • This model assumes that total demand is inelastic, and consumers merely switch between retailers. • The demand of a retailer is: Model

13. Wholesale Market • We allow retailers to also own generation (vertical integration). • We assume that the generation is bid into the market at cost. This is said to be a competitive equilibrium. • At the time that retail contracts are determined, the future wholesale prices are unknown, due to uncertainties around hydro inflows and outages. Model

14. Entry into Retail • When firms consider entering a market, they must take into account: • the fixed cost of entry, • the expected returns, • the risk. • In our model, the retailers decide whether or not it is in their interests to participate in each market. Model

15. Summary • The full model consists of three stages: • Entry – here firms make 0/1 decisions regarding whether they have a retail base at each node. • Retail competition – each firm sets a retail price at each node. • Wholesale market – the uncertainty is resolved and wholesale prices and profits are computed. Model

16. 2nd Stage Formulation • All firms optimise the following profit maximisation problem simultaneously. Model

17. Single node • First we consider a situation with two gentailers at a single node. • Firm A owns a thermal plant whereas B owns a hydro, each with capacity of 100MW. • The firms compete for customers in the retail market. • The total demand is 150MW. • Water value: h ~ U[0,100] Example

18. Wholesale Prices and Profits • As a function of the water value, h, the wholesale prices and profits can be computed: Example

19. Risk-neutral Equilibrium • If firms are risk-neutral, it can be shown that the profit from the wholesale market has no bearing on the retail pricing. • We can compute the equilibrium retail prices for both firms to be $137.50 in this case. • In this situation both firms share the retail demand equally. Example

20. Best Response • Now let us examine the optimal retail prices for the firms as they increase their risk-aversion. • The hydro plant makes more profit when water values are low, whereas the thermal plant makes more profit when the water values are high. Example

21. Best Response Example

22. Risk vs. Return $137.50 $137.50 Example $131.25 $155.00

23. Profit Example

24. Equilibrium Example

25. Retailers Entering • Now suppose that we allowed retailers to enter this market if it were profitable to do so. • Such a retailer would enter the market if the risk-adjusted profit exceeds the cost of entry. • For simplicity, in this example, we will assume that all firms share the same attitude toward risk. Example

26. Profits Example

27. Endogenous Entry Example

28. Two node (inspired by NZ) • In this model we have 2 nodes and 3 firms: • firm A owns 2 thermal plants in the north, • firm B owns 2 hydro plants in the south, • firm C owns 1 thermal in the north and 1 hydro in the south. • The North and South have separate retail markets. Firm B is not in the North and firm B is not in the South. Example

29. Asset Swap Before Swap After Swap Example T T T T T T H H H H H H

30. Prices Example

31. Status Quo • If the asset swap does not incentivise an additional firm to enter into each retail market, then we find the following change in prices. Example

32. Firms enter the other market • On the other hand, if firm A enters the retail market in the South and firm B enters in the North, we find the following prices. Example

33. Cost of Entry No entry Example Firm A enters South All firms in both islands

34. Conclusions • Risk aversion for firms can affect whether or not they enter a market. • If they do enter, whether there exists a risk premium or discount for the consumers depends on the particular circumstances. • From our model of the asset swap, we find that this will only have a beneficial affect on consumer prices if additional retailers enter each market.

35. Future Work • Calibrate the model to New Zealand: • What risks are retailers concerned about? • What entry costs exist? • Include virtual asset swaps. • Suggestions?