Getting Electricity Prices Right

April 16, 2013
by Louisa Lund, Consortium for Energy Policy Research

“Relentless repetition” is the key to connecting analysis to public policy, William Hogan, Raymond Plank Professor of Global Energy Policy, said on Monday (April 15) during a presentation on recent developments in approaches to electricity scarcity pricing.

Setting up electricity markets so that prices properly reflect scarcity is a long-standing problem in organized electricity markets, Hogan explained. The idea of using operating reserve demand curves to improve scarcity pricing is one that he has been working on in a series of papers and presentations since 2005.

The problem that needs to be addressed, he said, is the “missing money” that is a generally acknowledged reality of organized electricity markets—the price paid for electricity typically will not go above the marginal cost of operation of the highest-cost electricity producers. This means that the high-cost producers who are needed in periods of high electricity demand may not receive enough revenue to recover their fixed costs. Over time, this “missing money” results in less investment in new electricity capacity and in difficult meeting minimum operating reserve requirements established to preserve the reliability of the electricity system.

The dominant solution to this problem in electricity markets has been the development of “capacity markets,” Hogan explained. Capacity markets address, at least in part, the need for additional incentives for investment, but by disconnecting costs from energy demand they fail to optimize incentives for demand response, renewable energy, and transmission investment, he said.

As an alternative or possible supplement to capacity markets, Hogan explained that it is possible to create an economic dispatch model that defines a demand curve for operating reserve capacity. Once minimal operating reserve standards are met, additional reserves still have value in reducing the threat of loss of load—a value that can be calculated by multiplying the estimated value of lost load (how much economic value would be lost by a disruption in electricity supply) by the probability of a loss of load occurring.

The outlines of this approach have been known for a number of years, Hogan explained, and have been implemented to a limited degree in several US electricity markets. What hasn’t been known is how significant such an approach would be if implemented on a large scale in a market with substantial values of lost load. Would the new approach merely turn out to be fine-tuning of prices? Or would the price of electricity change significantly with the use of operating reserve demand curves?

A chance to evaluate the implications of this model on a large scale has arisen in the Texas electricity market, where concerns about capacity adequacy have recently become acute. In his presentation, Hogan reported the results of a “backcast” analysis of how electricity prices in Texas over the past two years would have been different if an operating reserve demand curve price adder had been used. The model suggests that the impact could be significant—ranging from a price increase of approximately 50% averaged over the course of 2011 (a year of severe scarcity problems in Texas) to less than 10% in 2012 (a year in which supply problems in Texas eased significantly).

In closing, Hogan emphasized that it is not necessary to choose between better scarcity pricing and capacity markets. Both can be used together. ERCOT is likely to make a decision about whether to adopt this pricing model in the next month.

Professor Hogan spoke as part of the Energy Policy Seminar Series, which is jointly sponsored by the Energy Technology Innovation Policy research group of the Belfer Center on Science and International Affairs and the Consortium for Energy Policy Research at the Mossavar-Rahmani Center for Business and Government.

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Professor William Hogan

William Hogan, Raymond Plank Professor of Global Energy Policy

Setting up electricity markets so that prices properly reflect scarcity is a long-standing problem in organized electricity markets, Hogan explained. The idea of using operating reserve demand curves to improve scarcity pricing is one that he has been working on in a series of papers and presentations since 2005.