Ensuring Consistent Environmental and Competition Policies in Electricity Markets

1. Presentation to COMPETE and EPSA Forum: “Empowering Consumers Through Competitive Markets” David W. DeRamus, Ph.D. November 5, 2007 Ensuring Consistent Environmental and Competition Policies in Electricity Markets

2. Agenda • Need for consistent environmental and competition policies • Demand response in organized markets: • Economic debates and price implications • Policy implications

3. Need for consistent environmental and competition policies

4. Competitive markets can be effective in achieving environmental objectives • Roots of U.S. competitive electricity markets lie in federal efforts to improve efficiency and promote renewables • Move towards competitive markets not driven by ideological agenda • PURPA (1978) directed at increasing efficiency, as well as promoting cogeneration and renewables • Helped remove barriers to entry faced by competitive suppliers • Further supported by EPACT 1992, Order 888, Order 2000, etc. • Attempted to encourage marginal cost pricing as a conservation measure • Environmental Defense Fund an early advocate of “time-of-day” rates (WI, 1972) • Policymakers increasingly looking to market institutions to address emissions • Positive experience with cap-and-trade programs, e.g. SO2, NOx • Increasing efforts to implement market-based CO2 programs as alternative to traditional “command-and-control” emissions regulation

5. Competitive electricity markets are also effective tools for reducing emissions • Appropriately structured competitive markets can: • Improve system-wide economic dispatch within a given control area • Dispatch based on economics, not ownership • Major concern in unrestructured regions is market foreclosure of efficient competing generation by transmission-owning utility • Expand economic dispatch across a wider range of resources by increasing geographic scope of wholesale markets • Improve operating efficiencies and reduce outages at lower-emissions baseload plants, e.g., nuclear facilities • Provide incentives for investment in more efficient and renewable generation • Provide appropriate price signals to guide consumption and investment decisions • Offer customer access to enhanced products, e.g., “green energy” options, time-varying rates using “smart” meters, and direct load control

6. Competitive markets prices send appropriate signals regarding the incremental – or marginal – impact of consumer/producer/investor decisions • Consumer: • At the margin, what is the impact of my consumption decision on the prices I have to pay or the amount of emissions that will be produced? • Producer: • At the margin, what is the impact of my production decision on the prices that I can charge or the costs that I will incur for emissions? • Single-plant investor: • How much profit can I expect to earn relative to the marginal price-setting plant if I invest in the most efficient generation technology? • Portfolio investor: • At the margin, how much incremental risk am I incurring with an additional investment in renewable generation capacity or other “fixed cost” technology?

7. Consistent environmental and competition policy is often stymied by other regulatory or legislative efforts • Policymakers often want to “protect” ratepayers from high electricity prices, even if those prices are the result of competitive markets • Exposing ratepayers to market prices provides the necessary incentive to curtail consumption • “Protecting” ratepayers from market signals has negative short-term and long-term consequences • See, e.g. CA 2000-2001 crisis • “Amortizing” current costs of electricity over time does nothing to address the underlying problems: demand-supply imbalances, current fuel costs, etc. • Attempts by policymakers to pursue emissions policies that “protect” ratepayers from increased costs Focusing on economic incentives can help ensureconsistent environmental and competition policies

8. Promoting competitive electricity markets is sound environmental policy • Exercise of market power can reduce system-wide production efficiency, particularly in non-restructured states • Horizontal market power is the ability to increase prices above competitive levels • Focus is generally on the price effects of withholding one’s own capacity • May lead to production inefficiencies, if less efficient units are dispatched out of merit order • Vertical market power is the ability to foreclose other suppliers from the market • Focus is generally on a monopolist’s ability to exclude equally or more efficient competitors • Raises significant concerns about production inefficiencies • Of particular concern in regulated industries in which there are some limitations on regulated firms’ ability to increase prices Foreclosure of competitive generation in unrestructured states should be a significant concern for both competition policy and environmental policy

9. Foreclosure result: uneconomic dispatch of a regulated utility’s own higher-cost generation despite competitive supply alternatives Wholesale Market Utility’s Power Supply Utility Cost Wholesale Price Demand Supply Efficiency loss c1 p0 p1 q0 q1 q0’ q1’ MWh MWh Market foreclosure not only harms competition but also increases energy costs and emissions

10. Demand response in organized markets: economic debates and price implications

11. Electricity markets are conducive to demand-side participation • One purported barrier to competitive electricity markets is inelastic demand • Actual electricity markets function well under most conditions, i.e., result in competitive prices, even without active demand-side participation • Most concerns with competitive markets are directed towards what happens in periods of tight supply • Price-elastic demand is not required for robust competitive markets, as long as market structure and auction rules are good • Example: competitive procurement auctions with fixed quantity of demand can still produce highly competitive prices, even with few participants • Electricity markets are also conducive to demand side participation, if customers are exposed to relevant price signals • Some demand side programs require additional investments, e.g. “smart” meters, direct load control technology

12. Appropriately compensating demand response is still open to debate • Arguments against payments to DR as an energy resource: • Savings from foregone consumption should be sufficient compensation • In energy markets, DR is not a distinct product that can be owned and sold • Compensating DR at clearing price is a double payment that distorts the market and creates economic inefficiencies • Arguments in favor of payments to DR as an energy resource: • “Public good” attributes of DR warrant compensation in energy market • If most load is on a fixed-price tariff, peak demand will be higher than is economically efficient • “Double payment” may still produce a net welfare gain • In ancillary services markets, DR provides reliability service equivalent to supply resources – so compensation is uncontroversial

13. DR programs can provide important reliability benefits Peak demand Peak demand with DR • During extreme events, DR can provide high-value reliability benefits • Cost to electricity users of unexpected service interruption – the value of lost load – is much higher than market price caps • As it allows for true user value to be reflected in prices, DR reduces the need for price caps Price Cap Supply Unserved load at price cap

14. DR programs can lower market clearing energy prices by moving demand curve down inelastic portion of supply curve Peak demand • Small amount of DR can have large price effects with tight supply • Benefits to consumers not necessarily a “social welfare” gain: price reduction is a welfare transfer from suppliers to consumers • Price inelasticity may simply be due to fixed-rate tariffs: provide consumers with market signals • Shift to more price-elastic portion of the supply curve reduces potential market power Peak demand with DR Supply P1 P2 Q2 Q1

15. Allowing customers to respond to market prices removes inefficiencies with average cost pricing Peak demand Peak • At average tariff rate PT, consumption is at QTpeak , above the optimal competitive level QCpeak • Deadweight loss to society of over-consumption is equal to area (a+b) Off-Peak • At average tariff rate, consumption is at QTOP, below the optimal competitive level QCOP • Deadweight loss to society of under-consumption is equal to area (c) Supply P* Marginal supply cost at QTpeak Off-Peak demand a PCpeak Efficient peak clearing price b PT Tariff Rate c PCOP QTOP QCOP QCpeak QTpeak

16. With retail customers under a fixed-rate tariff, demand response payment can improve welfare in peak periods Peak demand • A DR program to encourage bidding at Pc for quantity (QTpeak - QCpeak) will reduce deadweight loss • Payment to DR is equal to area (b+c+d) • As long as (b+c+d)<(a+b), or rather (c+d)<a, social welfare is improved Supply P* Marginal supply cost at QTpeak a PCpeak Efficient peak clearing price b c PT Tariff Rate d QCpeak QTpeak

17. Need to incorporate concept of “residual demand” in order to understand impact of DR on potential exercise of market power • A critical input to a supplier’s bid decision is an estimate of its residual demand curve • The residual demand curve is constructed by subtracting the supply of other bidders from aggregate demand Aggregate Demand Supply of firm i Supply of others p p p Aggregate Supply – = p0 Residual Demand q0 q-i qi q q q • Residual demand curve is more price elastic than aggregate demand, because it includes the response to price of all other suppliers

18. Residual demand curve bidding implies that “as-bid” supply curves will deviate from marginal costs in all real markets – in all industries • Real-world, i.e., imperfect, competition in single-price auction • Individual supplier’s “bid functions” based on expectations of demand and of the bids of other suppliers • With some probability of a producer’s bid affecting market-clearing price, bid curve will exceed MC curve Price As Bid Supply Marginal Cost Gain Loss Residual Demand Quantity Appropriate for regulator to provide incentives, but not the requirement, for bids to approximate marginal costs

19. DR increases elasticity of both demand and as-bid supply curves via its impact on the “residual demand” faced by each supplier • DR shifts demand curve down to more price-elastic portion of supply curve* • DR increases elasticity of “residual demand” curve faced by each individual supplier • Increased elasticity of residual demand curve also increases elasticity of as-bid supply curve • Reduces the spread between as-bid supply curve and MC curve Price D1 D2 S1 S2 MC Effect of D shift p0 p1 Effect of S shift p2 q1 q2 q0 Quantity *The figure shows a linear supply curve for simplicity Demand response provides incentives for suppliers to bid closer to marginal costs: a market-based approach to addressing market power concerns

20. Demand response: policy implications

21. Demand response benefits are not just theoretical – substantial monetary and reliability benefits have already been realized • Estimated total DR capability nationwide: • 37,500 MW – approx. 5% of peak demand1 • RTO/ISOs incorporating DR into centralized markets • Most RTO/ISOs allow DR in energy and capacity markets • ISO-NE, NYISO, CAISO and PJM allow DR in certain A/S markets • DR can bid into ISO-NE forward capacity market • PJM estimated DR benefits: • $230 million during peak hours on August 2, 2007 • $600 million benefit during that week • CAISO demand reductions of 1000MW+ averted more widespread disruptions over 2007 Labor Day weekend 12006; FERC Staff Demand Response Assessment

22. Demand response can address remaining market power concerns in organized markets – but policies need to be consistent • A relatively small amount of DR can have a large impact on market-clearing prices in periods of tight supply • Peak-period prices still need to be allowed to rise high enough to adequately compensate peak resources • Need prices to periodically rise sufficiently above marginal cost of peaking resource to justify investment • Investment in peak resources needed for reliability, price stability, and to address market power concerns • Danger of “belts and suspenders” approach to mitigation • “Pre-emptive” market power mitigation – price caps, automated cost-based mitigation – distorts market price signals, increases investor uncertainty, and increases risk of insufficient cost recovery • Price caps limit incentives and effectiveness for “market-based” mitigation – i.e., demand response Question: How do we know that DR programs will be sufficient to address remaining market power concerns in current organized markets?

23. Current wholesale electric markets already function significantly better than simple theoretical models predict – remarkably close to a competitive ideal Example: Bushnell, Mansur, and Saravia, “Vertical Arrangements, Market Structure, and Competition in Restructured U.S. Electricity Markets”, CSEM WP 126, Feb. 2005 Clearly, something other than industry concentration is already inducing highly competitive supplier bidding behavior

24. More complex models of imperfect competition are better predictors of wholesale market performance Example: Bushnell, Mansur, and Saravia, “Vertical Arrangements, Market Structure, and Competition in Restructured U.S. Electricity Markets”, CSEM WP 126, Feb. 2005 Current institutional arrangements – including forward contracting, as well as specific auction rules – already provide incentives for suppliers to bid close to marginal costs in most hours

25. Competitiveness of actual wholesale markets is reflected in bid/cost assessment by PJM Market Monitor1 • Energy market markup analysis • Markup calculated as the difference between actual offer and imputed cost for each actual marginal unit on the system • In 2006 the markup component of LMP was $0.00 or lower in 5,351 hours (61%) • Markup was greater than $25 /MWh in 100 hours (1%) • Market Monitor conclusions: • “Markup on high load days is likely to be the result of appropriate scarcity pricing rather than market power.” • “Overall results support the conclusion that prices in PJM are set, on average, by marginal units operating at or very close to their marginal costs. This is strong evidence of competitive behavior.” 1 PJM 2006 State of the Market Report.

26. Why are market prices already so close to marginal costs in so many hours of the year? • Supplier bidding behavior is significantly affected by market expectations and uncertainty – even in uniform-price auctions • A market participant knows its own costs, but it must estimate: • Opportunity costs – including expectations of prices in other markets • Aggregate demand • Supply bids of other market participants • Financial risks associated with transactions • Uncertainty of residual demand decreases incentives for bids to deviate too far from marginal costs (risks of not being dispatched when economic) • Uncertainty of residual demand causes actual market behavior to be closer to competitive ideal than theoretical predictions of simple economic models • Uncertainty of residual demand is increased by diversity of market participants – and a diversity of strategies Expanding DR programs will further increase bidder uncertainty regarding residual demand and thus further limit deviation of as-bid supply from MC

27. Policymakers need to consider impact of demand response programs on incentives for investment in peaking capacity • Energy markets do not provide sufficient revenue to support investment in new generation, in part due to administrative price/offer caps • With demand responsiveness, market-clearing prices better reflect the value users place on uninterrupted service • During periods of binding supply constraints, prices above marginal cost appropriately reflect scarcity value – in the limit, VOLL • If markets are allowed to value scarcity appropriately, the rationale for price/offer caps disappears • DR can reduce clearing prices in some hours and can also improve confidence in market outcomes • Elimination/reduction of administrative intervention (price caps) improves supplier confidence in market outcomes • DR supports both short-term and long-term reliability • DR can complement forward locational capacity markets

28. Conclusions • Policymakers should be wary of “protecting” consumers from legitimate market price signals • Competitive electricity markets promote efficiency and other environmental objectives • Regulators should consider impact of specific environmental and competition policies on producer and consumer incentives • Reducing foreclosure of competing suppliers from unrestructured markets can provide important environmental benefits • Demand response programs can address remaining market power concerns in organized markets • Implementation of demand response in organized markets should be accompanied by removing price caps and other administrative pricing mechanisms