Generation Adequacy through Backstop Call Option Obligations Shmuel S. Oren University of California at Berkeley Presented at CREG Workshop, Bogotá, Colombia

Generation Adequacy through Backstop Call Option

Obligations

Shmuel S. OrenUniversity of California at Berkeley

Presented at CREG Workshop, Bogotá, Colombia

July 25, 2006

July 2006 All Rights Reserved to: Shmuel Oren, UC Berkeley 2

The Promised Land• Generation companies bear all the investment

risk and consumers (LSEs) bear all the price risk.

• Customers and suppliers are free to choose levels of exposure to price risk through risk management and contractual agreements.

• Forward markets and hedging instruments enable parties to manage their risk exposure

• Competitive forces drive generation capacity, technology mix and prices toward a long term equilibrium that reflect supply and demand choices for reliability and cost.

• Fixed costs of generation capacity at long run equilibrium are exactly covered by inframarginal costs and scarcity rents


MW

EnergyPrice($/MWh)

Price at7:00-8:00 p.m.

Price at9:00 -10:00 a.m.

Price at2:00 - 3:00 a.m.

GEN 1

Demand at2:00 - 3:00 a.m.

Q1 Q2 Optimal Capacity

GEN 2 GEN 3 GEN 4 GEN 5

Demand at 7:00 - 8:00 p.m.

Demand at9:00 - 10:00 a.m.

Scarcity rent

Demand Response

Inframarginal Profits

Long Run Market Equilibrium in an Energy – Only Market


Challenges to Energy Only Markets

• Steep supply function and uncertainties make scarcity rents highly volatile and sensitive to market error in determining the optimal capacity

• It is practically impossible to differentiate legitimate scarcity rents from inflated prices due to exercise of market power.

• Demand response is limited by technological barriers and operational practices

• Very high scarcity rents even if they are legitimate are politically unacceptable (reason for price caps)

• Low levels of reserves foster collusive behavior and market power abuse


Challenges to Energy Only Markets (Cont’d)

• Spot prices and scarcity rents are suppressed by regulatory price caps, market mitigation practices, deployment of operating reserves, and out of market operator actions (e.g., reliability unit commitment) so generators cannot recover their fixed costs.

• Who will pay for reserve capacity that is required to assure supply reliability.

• Capacity shortages cannot be resolved overnight and while the entry occurs the persistent scarcity rents result in wealth transfers from consumers to producers.

• Exposures in the electricity supply chain are not properly allocated to insure voluntary, socially efficient risk management practices by the market participants (free riders)


Proposed Texas Energy Only Market

• Two level system wide offer cap HCAP=$3000/MWh LCAP=$500/MWh. HCAP activated if total fixed cost recovery (FCR) by a generic peaker in a one year window (fixed or moving) is <75K/MW while LCAP activated when FCR reaches $150K/MW (Bang bang mechanism).

• Use of reserves is represented by a “proxi-generator” with a linear offer curve starting at 30% of CAP and reaching 100% of CAP at 100MW. (price reaches cap if 100MW of spin used)

• Aggressive program to stimulate demand response• ISO publishes 10 year forecast and statement of opportunity.• Offer price disclosure with short delays• Emergency Load Response mechanism (ELR) – ISO can purchase

up to one year call options with strike price at HCAP from load resources to be deployed only in lieu of involuntary curtailment and when price is at the system wide cap.


Classification of Capacity Mechanism

Regulated regionalmonopoly

Energy onlymarkets

Explicit demand for generation capacity

Re

lian

ce

on

eco

no

mic

in

ce

ntive

s Capacity payments

Strategic reservesprocurement

Contractingobligations

Capacityobligations

Operating reservepricing


Properties of a Good Capacity Mechanism

• Replicate investment incentives in functional energy only market (forward contracting)

• Facilitate risk sharing between consumers and producers

• Provide intrinsic value to consumers in exchange for risk sharing (not subsidy to generators)

• Incent new investment and enable direct participation by new entrants

• Provide stable income to generators to reduce cost of capital in exchange for windfall profit potential

• Provide reasonable opportunity to generators to recover their fixed cost on a long run basis (address the “missing money” problem)


Desired Properties (cont’d)• Incent performance and have meaningful

penalties for non-performance that reflects the damage.

• Enable generators to opt out by increasing spot price potential income in exchange for risk taking

• Enable load to opt out (self-insure) by avoiding capacity payment in exchange for taking spot price or curtailment risk

• Not interfere with bilateral forward market and voluntary risk management practices

• Allow self-provision through bilateral contracts• Mitigate credit problem• Obligations imposed on LSEs should reflect

customer base and account for load migration• Easy sunset when market provides sufficient

insurance through contracting and load response


Call Options as Price Insurance

Strike

Option Value Time

Spot SpotPayback to LSEsholding option

Definition: A call option is the right but not obligation to purchase one unit of power over the contract duration at an agreed upon strike price


Mechanics of Backstop Call Option Obligations

• Load serving entities (LSEs) required to hold at the beginning of each month hedges in the form of forward contracts and/or call options (with verifiable physical cover) totaling their share of the target capacity set by the regulator based on reliability consideration.

• Qualifying hedges must be at least three year forward- looking with forward or strike prices at or below a mandatory level set by the regulator

• Price cap should be raised to a level that reflects VOLL (e.g. $10,000)

• Mandatory strike price shall be high enough so as not to interfere with risk management activities but significantly below the energy price cap. (For example the energy price cap can be raised to $10,000/MW and the mandatory strike price set to $1000/MW).


Call Option Mechanics (cont’d)• With a $1000 strike price consumers get the same price protection

as under the current cap but will have to pay a fair market price for that protection

• Nonperforming capacity liable for difference between spot market price and strike price (liquidation damages) plus a penalty (only nonperforming generators are exposed to spot market price spikes).

• Obligation may be locational with LMP-based settlement so that option value (with same strike price) will be location dependent.

• Uncommitted capacity and firm load can sell energy at spot market prices above strike but no higher than the offer cap. (incentive for speculative entry, load response and uncommitted imports)

• Private contracts that meet the duration and strike price requirement will count toward the LSE hedging obligation.


Call Option Mechanics (cont’d)

• Hedging obligations can be met by a portfolio of supply contracts and curtailable loads (committed demand response).

• Call options may be, self provided, procured bilaterally or procured through a voluntary auction hosted by the ISO.

• Load can Opt out by offering a call option at the strike price covered by a curtailable service contract (interrupt when spot reaches strike)

• Deliverability can be assured by making call option obligations locational with physical cover. LMP based settlement with same strike price makes option prices location dependent. (like NY but without administrative prescription)


Call Option Value in a Price-Capped Energy Market

Hours

Energy Price $/MWh

Cap

Strike

Annualized Call option value$/MW

8760

Price duration curve


Hours

Energy Price

Cap

Strike

Cap

acity

Annualized Call Option Value

Price Duration Curve

Cap -Strike

Capacity

Implied Demand Curve for Capacity

Call Option PricePer Hour

8760 Q*

P*

At optimal capacity Q* the call option price P* = Average Hourly {CT fixed cost – CT energy profit with price capped at Strike}

Call Option Prices as Function of Generation Capacity Based on Opportunity Cost of Selling at

Spot


Comparison to Demand FunctionDemand function• Demand curve is set administratively • ISO procures all available capacity and adjusts LSE

obligation accordingly (discourages self-provision)• Disincentive for self-provision• No opt out for loadCall Options• Liquidation damage risk and opportunity to sell above

strike for non committed units creates intrinsic market value for option.

• Generators selling option are liable for providing energy at reduced rates (strike)

• Option price is implied by opportunity cost of selling energy above strike (market based) and can be determined through an auction mechanisms

• Option obligations never exceed target capacity- available capacity in access of target assumes the risk of cost recovery through the unmitigated spot market


Caveats and Questions

• Deliverability and physical cover• Pricing operating reserve use• Market power in the energy market• Market Power in the call options

market• What Happens if the spot energy

market does not clear• Central Procurement


Operating Reserves Pricing

• Co-optimization of energy and reserves + a “reserve penalty” that gradually raises the offer curve to the cap as function of reserve depletion.

• This implements a scarcity pricing mechanism that raises the unmitigated spot prices to the cap when X MW of reserves are deployed

Energy With Reserves

Demand

CAP

Price


Market Power in Energy• Since most generation capacity will be under

call option contracts there will be little incentive for that capacity to exercise market power.

• Uncontracted capacity may exercise market power but that will not affect consumers who are protected by the strike price.

• Only nonperforming generators are exposed to market power in the energy market so liquidation damages can be expected to be CAP – STRIKE per MW shortfall which provides a strong incentive for performance and reinsurance by generators ( e.g. in a hydro dominated systems hydro plants selling call options will have an incentive to buy insurance against drought from thermal plants.)


Market Power in Call Options

• Long term call options enable contestability from new entrants

• Competitive procurement (through auction)

• Demand function


Shape of Demand FunctionPrice

Quantity

Target Capacity

This part is realizedAs expected profits from

energy market (generators rather than consumers take the risk)


What if the Energy Spot Market Does Not Clear?

• Scarcity pricing mechanisms will automatically raise spot price to the offer cap

• If load is within the limits of the call options obligation then consumers are not affected (only nonperforming generators are exposed)

• If load exceeds call option obligations then the balance is made up through use of operating reserves, load interruption and dispatch of uncontracted capacity.

• The cost of covering the shortage even at very high prices will only increase cost to customer slightly since most of the load will be covered by the call options


The Time Step Misalignment Dilemma

• LSEs want hedging obligations to be short term (load varies, no long term contracts with customers, credit requirements)

• Generators want call options to be long term (can take it to the bank as collateral for investment loans)

• How do we bridge the gap?


Central Procurement – Works like an ancillary service product– ISO conducts an annual central auction for annual

three year (or longer) forward call options on energy with a specified strike price

– Procured quantity is based on forecasted load and reserves requirements which may be zonal

– Option offered must be covered by existing capacity, three year forward interruptible contracts or bilateral contract with min three year duration and price at or below strike price.

– LSEs holding long term contracts and curtailable load contracts with appropriate duration and price can self provide by offering call options against these contracts into the auction.


Central Procurement (cont’d)– LSE obligation (and share of cost) determined Monthly

based forecasted monthly peak load. – Cost of options allocated on a per MWh basis and over time

based on monthly LOLP calculation. – Payment to sellers and allocation of cost to LSEs at

performance time (ISO passes payment through).– For LSEs who self-provided their full obligation option

revenues offset costs. – Providers of options required to offer contracted capacity at

contract strike price and offer any additional balancing energy (beyond contracted capacity) at market clearing prices.

– Failure to perform entails financial liability for the difference between market price and strike price times the amount of undelivered energy (liquidation damages) plus penalty.


Procurement AuctionPrice

P0

P1

P2

P3

Quantity

Round 5

Round 4

starting price

clearing price

Aggregate supply curve

P4

P5

P6

Round 3

Round 2

Round 1 excess supply

Target Capacity


Summary• Self provision option enables smooth transition to

voluntary insurances. As the market matures individual hedging obligation may be relaxed if the market as a whole proves to be properly hedged.

• Multiple means of meeting hedging obligation ensures balance between investment, demand response and risk management

• Hedging products are long term to facilitate new investment response by transferring risk from the investor to consumers (represented by the LSE)

• Enables reserve generation capacity to secure a stable income stream for fixed cost recovery in exchange for a tangible obligation to produce energy at a reasonable price when needed.

• Unlike forward contracts, call options do not have a “take” obligation so the LSE can be required to hedge a larger quantity than expected peak demand.


Summary (cont’d)• LSE obligations can be revised monthly to

reflect changes in customer base.• Call option obligation functions as mandatory

insurance where capacity product is linked to energy production capability and deliverability.

• Market price of option is driven by opportunity cost of selling energy above strike price and it will decline naturally with increased generation capacity (no need for administrative demand curve and procurement does not need to extend beyond target capacity)

• Self-provision through prudent risk management practices by LSEs and demand response will lead to natural sunset of the regulatory obligation.


Ultimately, demand response and risk management practices will evolve to the point

where the Promised Land can be reached.

Documents

Generation Adequacy through Backstop Call Option Obligations Shmuel S. Oren University of California at Berkeley Presented at CREG Workshop, Bogotá, Colombia