RISK & CAPACITY INVESTMENT INCENTIVES IN ELECTRICITY MARKETS

Peter JacksonDepartment Of ManagementUniversity Of Canterbury

Outline

My research topic/motivation Investment Optimal Plant Mix Hydro/Strategic concerns Contracts/Portfolios Market Structure/Solutions

My research…..

Evaluate the impact of investor risk on investment decisions

Explicitly deal with impact of Hydro risk Strategic behaviour Deterrence

Outcomes, Solutions Investment/Entry Pricing/Efficiency Market structure

Is not finished (hardly started!!!)

Motivation - Do electricity markets deliver appropriate security?

Security concerns were to the fore with central planners

Central planning proved uneconomic, and often over-investment resulted

Electricity markets have been created in an effort to capture economic efficiency

But private investors won’t invest unless it is economically justified

Private investors face different risks and are investing into a spot market that is susceptible to strategic behaviour

Investment and Prices – Why Invest? Generation plant

can be valued (equivalently) as a call option

Option value is dependent on pricing

Could discount or model risk more explicitly

Basic Screening Curve Analysis

Optimal Plant Mix Risk Free Not Strategic Some energy

limited plant With shortage

costs, fixed costs are recovered in equilibrium

Investment & Risk

My research focus is…… Hydro risk Strategic risk

But there are significant other risks for investors Reliability Regulatory/Political Demand growth Input prices Technological/Resource Transmission*

To a greater or lesser extent all plant faces risks but peaking plant is most vulnerable.

Energy Limited Hydro

Energy must be/should be used Inflow quantities determine total energy

available Reservoir size and plant rating determines

flexibility Inflow sequences are also important Peaking plant may never operate for its true

purpose. Being in the optimal plant mix is not the

same as being in the dispatch.

Energy Limited Hydro

Notional revaluation of fuel and capital cost based on energy available

All plant is impacted but peaking plant is worst off

Peaking Plant – Cautious Entry Given hydro variability, how much peaking

plant is required? Apart from other issues the investor need to

know inflow distribution. What is really important is the PDC, and this

can vary for a variety of reasons eg hydro inflows

But what if PDC is a result of gaming? (And gaming and hydro inflows are probably related)

What is the true underlying PDC? It may be impossible to estimate, especially for an entrant

The Impact Of Risk On Adequacy

Peaking Plant Investment

Price and quantity risk from a variety of sources Natural Strategic

Hydro generation makes forecasting particularly difficult

Not suitable for many standard forms of contract

Finance difficult to obtain given risks So how do we get any peaking plant built at all?

Wider considerations….

Standalone entry very difficult But firms have multiple generation plants,

and contracts in place = lower risk The impact on the portfolio of assets and

obligations is more relevant than the performance of the individual asset

Spot market gaming may increase returns above SRMC and incentivise investment

Strategic firms will not want to settle contract shortfalls with competitors

Deterrence Market structure may (or may not) help

NZ - Market Structure

LP Clearance Market design goals

Allocative efficiency Productive efficiency Dynamic efficiency

NZ Market S.O.E’s & Private investors Energy only market Vertical Integration Hydro influence Few Large customers

Wolak Report, 2009

Potential Solutions

Tolerate gaming Two part markets Capacity ticket systems Current proposals from taskforce

Contracts and Risk I

Consider increasing risk on generators who are unable to cover contractual obligations

Contracts & Risk II

Increasing cost of over contracting improves adequacy but this analysis assumes contracts are exogenous

What if contracts are endogenous? Equilibirum contract prices will be higher for higher risk

Customers will get more security (but pay for it)

What is the relative performance of other solutions? Market power (18% - Wolak) Capacity payments (25% - Initial market study)

Evaluation required

Future Work required

Energy limited plant “MW limited” Dynamic analysis

Plant retirement Demand growth Investment

Strategic interactions Spot market Cautious Entry Deterrence

Complementarity Formulations Evaluate remedies