Working Paper 2011/01. Economics and Design of Balancing Power Markets in Germany INSTITUTE POWER ENGINEERING

Transcription

1 INSTITUTE POWER ENGINEERING Workng Paper 2011/01 Economcs and Desgn of Balancng Power Markets n Germany Felx Müsgens, Axel Ockenfels, Markus Peek Char of Energy Economcs Brandenburg Unversty of Technology Cottbus

2 1 Economcs and Desgn of Balancng Power Markets n Germany 1 by Felx Müsgens, Axel Ockenfels, Markus Peek Abstract: Ths artcle analyzes the economc fundamentals that govern market desgn and behavor n German balancng power markets. Then, partly based on theoretcal work by Chao and Wlson (2002), we llustrate the role of the scorng and the settlement rule as key elements of the market desgn. Wth suffcently compettve markets, a settlement rule based on unform prcng ensures effcent energy call n the balancng power market. A scorng rule based on capacty prces only ensures an effcent producton schedule. Thus, both rules together wth ratonal bddng ensure smultaneous effcency on the balancng power market and the wholesale electrcty market. Key words: Electrcty Markets, Balancng Power, Market Desgn Addresses: Prof. Dr. Felx Müsgens Unversty of Technology Cottbus Insttute of Power Engneerng Cottbus felx.muesgens[at]tu-cottbus.de Prof. Dr. Axel Ockenfels Unversty of Cologne Department of Economcs Cologne Ockenfels[at]un-koeln.de Markus Peek r2b energy consultng GmbH Cologne markus.peek[at]r2b-energy.de 1 We thank the partcpants of a workshop at RWE Supply & Tradng for valuable comments and RWE Supply & Tradng for fnancal support of ths research. All vews presented n ths artcle exclusvely reflect the authors opnons.

3 2 INTRODUCTION Balancng power s the electrc power requred to counterbalance short-term dfferences between generaton and consumpton of electrcty n a grd. These dfferences can be caused by devatons from announced schedules both on the supply and on the demand sde. The result of these devatons s ether an unexpectedly nsuffcent supply of electrcty (frequency drops below 50 Hz) or an oversupply of electrcty (frequency rses above 50 Hz). In the case of nsuffcent supply, postve balancng power s requred. It can be provded by the supply sde n the form of an extra amount of generated electrcty or by the demand sde n the form of reduced consumpton. In the case of an oversupply of electrcty, negatve balancng power has to be provded. Besdes the dstncton between postve and negatve balancng power, the balancng power products n Germany are separated nto three dfferent qualtes, namely prmary control power, secondary control power and mnutes reserve. Smply put, the qualty determnes the requrements regardng the maxmum tme span between the request and the delvery of balancng power. The four German transmsson system operators are responsble for the stablty of the electrcty grd n ther respectve control area. As a consequence, they are also responsble for procurng balancng power capactes to constantly balance electrcty generaton and electrcty consumpton n real tme. A system operator has to procure a certan amount of balancng power capacty of each of the three qualtes. The necessary amount s calculated wth probablstc models. Necessary balancng power capactes are procured n advance n an aucton. In ths aucton, bdders submt two-part bds consstng of a capacty prce bd and an energy prce bd. Bds are selected based on the capacty prce bd; successful bdders are pad ther capacty bd ( pay-as-bd ). If balancng power s physcally needed durng a perod, t s called from procured capactes. In case of a call, accepted capacty s called based on the energy bd startng wth the lowest. Once agan, pay-as-bd s used. Physcally, a techncal unt provdng balancng power capactes has to ncrease or decrease ts electrcty generaton or ts electrcty consumpton n case of a call. Dependng on the qualty ths has to happen nstantly or wthn a few mnutes. In Germany, the procurement of balancng power by means of compettve auctons started n the year Durng the past years, several changes have occurred especally wth regard to market and product desgn. The four orgnally separated markets n the dfferent regonal control areas were combned stepwse so that there s one common balancng power market n Germany today. However, the number of market partcpants,.e. supplers of balancng power, s stll relatvely small n many segments of the balancng power market. In addton, the complexty n the balancng power market makes t dffcult to nterpret market results especally n the absence of a sngle market clearng prce. Ths also makes t dffcult to nterpret prce and cost developments on ths market. For these reasons, the market and product desgn for balancng power s subject to an ongong debate. However, as of today, very lttle work theoretcal and emprcal s avalable on ths topc. One mportant excepton s Chao and Wlson (2002), whch we use as a bass for our

4 3 llustraton how balancng power markets should be organzed to ncrease market effcency. We analyze the market desgn on balancng power markets n general and the German balancng power market n partcular. Furthermore, specfc recommendatons for an mproved market desgn wll be gven where approprate. 2 We wll concentrate the analyss on secondary control power and mnutes reserve. After a dscusson of the necessty of centralzed balancng power markets n secton 2, secton 3 descrbes the fundamental factors affectng the costs of balancng power supplers. These costs consst of capacty costs to provde capacty and energy costs when provded capacty s called and therefore has to produce energy. Secton 4 covers two man aspects of balancng power market desgn. Frstly, the settlement rule s analyzed whch determnes how much successful bds are pad. Secondly, we analyze the scorng rule. The scorng rule determnes whch supplers bds are accepted. Desgnng these two rules properly s essental for an effcent market. Hence, both rules are analyzed wth regard to market effcency. Furthermore, we make propostons for mprovements wth regard to the scorng and settlement rules n the German balancng power market. Fnally, Secton 5 concludes and summarzes our recommendatons. TECHNICAL BACKGROUND AND NECESSITY OF CENTRALIZED BALANCING POWER PROVISION AND DISPATCH Generaton of electrcal power must equal consumpton at any gven pont n tme n electrcty systems. However, electrcty markets - wthout further measures - may not always ensure ths. Hence, any resultng net dfference s counterbalanced by postve or negatve balancng power capactes. In lberalzed electrcty markets, supply and demand of electrcty meet on markets, where planned electrcty generaton and planned electrcty consumpton are matched. In Germany, ths s manly done on the day-ahead market, where power for the followng day s traded untl 12 a.m. (noon). There s also an ntraday market, where devatons from planned generaton or consumpton can be balanced out. 3 Every balancng group operator s responsble for a balanced planned schedule wth a temporal resoluton of 15 mnutes. However, dfferences between planned schedules and actual generaton or consumpton wll occur. Such dfferences can be caused by load forecast errors, forecastng errors of renewable energy feed-ns, outages of power plants and devatons of scheduled average generaton and consumpton values wthn the tme perods of 15 mnutes. In such cases, balancng power s 2 For an analyss of tmng ssues n balancng power markets, refer to Müsgens, Ockenfels and Peek (2011), and for an analyss of feedback polces n balancng power markets, see Müsgens and Ockenfels (2011). Cramton and Ockenfels (2011) address the long run perspectve of relablty n electrcty markets by analyzng the economcs and desgn of capacty markets n Germany. 3 However, as today s ntraday market shows lttle traded volume, the day-ahead market s currently referred to as spot market n Germany. We follow that notaton.

5 4 requred to adjust these short-run physcal devatons after the closure of day-ahead and ntraday markets. Fgure 1 shows the dfferent electrcty markets and ther nteracton n Germany. In addton, the fgure shows whether the system operator (SO) provdes a servce centrally or dfferent balancng group operators (BGOs) are responsble ndvdually. Fgure 1: Electrcty Markets and Responsble Partes n Germany Demand Supply Balancng Group Operators (BGO) Procurement of Balancng Power Capactes n Auctons Motvate & secure operaton of resources to provde electrcty on an emergency bass! System Operator (SO) Balancng Power Markets Future & Forward Markets Day-Ahead Market BGO Intraday Markets BGO BGO Planned Schedule day ahead (PS DA ) Devatons from PS DA Fnal Planned Schedule (PS Fnal ) Balancng of Physcal Devatons from PS Fnal SO SO System Stablty (Frequency of 50 Hz) Devatons from PS Fnal In theory, balancng power could be provded ether decentralzed by the responsble balancng group operators or as a centralzed system servce by system operators. In lberalzed electrcty markets, the latter s usually done for several reasons: In the short-run, the prce elastcty of both demand and supply on electrcty markets s close to zero. On the supply sde ths s due to techncal restrctons of generaton unts. These can be start-up and shut-down tmes, load gradents and mnmal techncal loads, whch constran the short-term adjustment of electrcal power output. On the demand sde the low prce elastcty s partly a consequence of nsuffcent ncentves. In many cases ths s due to the form of electrcty supply contracts. Other reasons are restrctons n nformaton, communcaton and meterng facltes. Most consumers have nether the knowledge and the techncal opportuntes to beneft from short-term prce volatlty nor the ncentves to adjust ther electrcty consumpton n reacton to prce sgnals on the markets n the short-run. The level of system relablty and qualty of supply of electrcty s a publc good. It s ensured by the provson of an adequate amount of balancng power capactes n advance. In case of a dfference between current generaton and current consumpton the frequency n the grd devates from the target value of 50 Hz. Wthout an

6 5 adjustment by means of provdng balancng power, fluctuatons of the frequency n the grd can follow. In the end dsruptons of electrcty supply can be the consequence. Due to the grd dependence of electrcal supply all customers and generators connected to the grd would be concerned to the same extent. In case of a decentralzed balancng power system the costs of relablty of supply would be ndvdualzed. However, the costs of an nsuffcent balancng power provson caused by frequency fluctuatons and blackouts would be borne by all grd users. Hence, n the case of a decentralzed provson of balancng power the level of relablty of supply would be nsuffcent. In case of a centralzed balancng mechansm, compensatons between dfferent balancng groups can be utlzed. Indvdual defcts and surpluses can be neglected and only the aggregate devatons n the grd have to be balanced physcally. As a result both the necessary provson of balancng power capactes and the call of balancng power s lower. In the German electrcty market, the four Transmsson System Operators (TSOs) Ampron GmbH, transpower Stromübertragungs GmbH, 50 Hertz Transmsson GmbH and EnBW Transportnetze AG are responsble for the procurement and dspatch of balancng power capactes. To mantan the relablty and qualty of supply the responsble system operator procures balancng power capactes and dspatches the procured capactes to compensate short-run devatons between generaton and consumpton n real tme. Ths s done n a threestage process. In a frst step, devatons from the regular grd frequency are nstantly balanced by callng on prmary control power. Ths s done by decentralzed prmary controls, whch are located nsde the power plants. After a drop of more than 10 mhz or a rse of the same amount, these controls are automatcally actvated. If the devaton lasts for more than 30 seconds, secondary control power s actvated n a second step to release the prmary control power capactes. Capacty offerng secondary control power has to be at ts maxmum load wthn 5 mnutes after actvaton. In contrast to prmary control power, secondary control power s not provded drectly and nstantly by the power plants. Instead t s automatcally actvated by centrally located controls. To release and supplement secondary control power capactes, mnutes reserve can be used n a thrd step. After actvaton t has to be at ts maxmum load wthn 15 mnutes. COSTS AND EFFICIENT PROVISION OF BALANCING POWER Knowng the cost structures of potental supplers s one of the most crucal prerequstes for the evaluaton of the market and product desgn on balancng power markets. The cost structure concerns both fundamental costs and nterdependences between balancng power markets and the electrcty wholesale market. In ths secton, we dentfy the cost structures for provdng balancng power capactes on the one hand and for delverng balancng power on the other hand. We wll specfy these costs n detal for exemplary potental supplers, whch s the bass for the analyses of market desgn n the followng secton. After that,

7 6 effcent allocatons of power plants for provdng and delverng balancng power takng nto account the electrcty wholesale market wll be nvestgated. Techncal and economcal propertes of power plants lead to hghly complex costs of provdng balancng power. Interdependences between balancng power markets and electrcty markets ncrease the complexty even further. One way to tackle ths s the use of sophstcated fundamental electrcty market models. These can be used to compute e.g. balancng power prces based on margnal costs and generate quanttatve answers to other relevant emprcal questons. 4 In contrast to that, the am of ths artcle s to dentfy and llustrate basc economc prncples, mechansms and nfluencng factors that gude the desgn and behavor n balancng power markets. To acheve ths goal and to reduce complexty, some smplfcatons and abstractons are made, partly followng Chao and Wlson (2002). Important ones are: We nvestgate the market of postve balancng power only,.e. postve secondary control power and postve mnutes reserve. We lmt our analyss of balancng power provson and generaton to so called spnnng reserve from thermal power plants. These power plants have long start-up and shut-down tmes. Therefore, n order to be able to provde balancng power capactes, these power plants have to operate at least wth mnmal techncal load. Produced electrcty must be sold on the electrcty wholesale market. We do not take nto account pump storage plants, whch can be used to provde secondary control power. Moreover, we do not consder so called stand-by reserve, such as OCGTs or emergency power generators, whch are used to provde mnutes reserve. We assume ncreasng opportunty costs for extra-margnal generators. Furthermore, electrcty consumers as potental provders of balancng power are not taken nto account ether. We do not consder dynamc effects, whch result from start-up or shut-down processes of power plants. For the sake of smplcty, we also assume levels of effcency to be ndependent of operaton ponts. We assume an dentcal probablty of beng called for all accepted bdders. That s, we assume that wth a certan probablty all reserve s needed and otherwse none. Whle these smplfcatons lmt the applcablty of our results for quanttatve estmaton purposes, the assumptons help to understand and clarfy the fundamental economcs of balancng power markets. In fact, the smplfcatons should not nfluence the applcablty of the qualtatve results. For nstance, our fndngs can easly be extended to negatve balancng power. 4 See e.g. r2b / consentec (2010). The study quantfes by how much ncreasng shares of RES ncrease the cost for balancng power based on complex electrcty market models.

8 7 Cost Structure of Supplers If postve balancng power s called, t must be avalable on short notce. Start-up tmes of thermal power plants usually amount to several hours. Therefore, such power plants face restrctons when offerng postve balancng power capactes. Frst of all, the power plant must be operatng at least at mnmal techncal load durng the bddng perod, because t s not possble to provde balancng power from a thermal power plant when t s shut down. Furthermore, t must be possble to ncrease generaton wthn a short perod of tme ( ramp up ). Balancng power from power plants runnng n partal load s called spnnng reserve. The maxmal offered capacty s determned by the techncal parameters maxmal techncal load (nomnal capacty), mnmal techncal load and load gradent of the respectve power plant. It s further determned by the tme wthn whch the offered balancng power capacty has to be fully avalable,.e. the actvaton tme. More specfcally, the possble balancng power capacty of a thermal power plant s the mnmum of the dfference between maxmal techncal load and mnmal techncal load and the amount of capacty that can be ramped up durng the respectve actvaton tme. The latter factor can be descrbed as the product of the load gradent n MW per mnute [ CAP] and the actvaton tme n mnutes [t*], whch s determned by the specfcaton of the balancng power qualty: CAP t*. If for nstance the load gradent of a power plant s 20 MW per mnute, a suppler can offer 100 MW secondary control power, because the actvaton tme for ths product s 5 mnutes. The suppler can offer 300 MW of mnutes reserve, where the actvaton tme s 15 mnutes. The other constrant for postve balancng power s that offered balancng power capacty cannot exceed the dfference between maxmal techncal load [CAP Max ] and mnmal techncal load [CAP Mn ]. Dependng on whch constrant s bndng, the maxmal offered balancng power capacty s ether determned by the product of load gradent and actvaton tme or by the dfference between mnmal and maxmal techncal load: CAP Reserve Max Mn { CAP t CAP CAP } = mn *; In the next step we analyze the capacty costs of provdng balancng power. Two cases have to be dstngushed, namely whether a power plant s nframargnal or extramargnal. Inframargnal power plants have varable costs below the (expected) electrcty prce n the correspondng bddng perod. 5 In contrast, extramargnal power plants are characterzed by varable costs that are larger than the (expected) electrcty prce n the respectve bddng perod.. 5 For smplcty, here and n the followng we often (mplctly) assume that margnal costs do not dffer from varable costs, although these costs typcally do dffer. For a dscusson of the subtle dfferences between the concepts n the context of electrcty markets, see Stoft (2002), Ockenfels (2007), Kuntz and Müsgens (2007) or Müsgens (2006). However, for the purpose of our qualtatve analyss, the dfference s nsubstantal.

9 8 For the present, we assume that there s no uncertanty wth respect to the expected day-ahead electrcty prce. Furthermore, we assume that there s one and only one electrcty prce n the bddng perod. 6 If the varable costs [VC] of a power plant are below the electrcty prce [p DA ] wthn the bddng perod - the power plant s nframargnal - the suppler would sell all the generated electrcty on the electrcty wholesale market when not takng nto account the balancng power market. The suppler would earn a postve contrbuton margn equal to the dfference between the electrcty prce and the varable cost. Ths margn determnes the opportunty costs of shftng capacty from the wholesale to the to the balancng power market. That s, capacty costs [CC Reserve ] per MW for nframargnal unts are equal to the dfference between the day-ahead electrcty prce (whch s consdered the reference prce of other wholesale markets due to arbtrage) and varable costs: p DA VC. If a power plant s varable costs are above the electrcty prce at the wholesale market,.e. the power plant s extramargnal, the suppler would not operate the power plant when not takng nto account the balancng power market. It would not generate electrcty, because t would make losses on the electrcty wholesale market. However, to provde balancng power as spnnng reserve, the power plant must be runnng at least wth mnmal techncal load durng the bddng perod. Ths creates costs, because the generated electrcty has to be sold at an electrcty prce below varable cost on the wholesale market. Losses per MW and hour are equal to the dfference between electrcty prce and varable cost. The total amount of costs s the product of losses per MW of generated power at the wholesale market and the mnmal techncal load. Ths cost can be allocated to the (maxmal) offered balancng power capacty. 7 Hence, the capacty cost of an extramargnal suppler s equal to Mn CAP ( VC p DA ) Reserve CAP. As a result, the capacty cost functon for provdng postve balancng power s asymmetrc. It depends on techncal parameters mnmal and maxmal techncal load and load gradent and on the dfference between electrcty prce and varable costs of the respectve power plant. Summng up, the capacty costs for postve balancng power n EUR je MW are gven by: CC Reserve = DA ( VC p ) p DA CAP CAP VC Mn Reserve,f VC>,f VC p p DA DA. 6 The effects of uncertanty regardng the electrcty prce and bddng perods wth volatle electrcty prces are dscussed n Müsgens, Ockenfels and Peek (2011). 7 The current product desgn n Germany allows system operators to accept bds only partally. Ths ncreases the cost per MW of generaton capacty, because the total costs can only be allocated to a smaller amount of balancng power capacty. However, n ths secton we assume that a bd can only be ether fully accepted or rejected. The Bundesnetzagentur (the German regulator) recently decded to move nto the drecton of ndvsble offers at least for balancng power calls thus reducng ths problem.

10 9 In Fgure 2, the shape of the capacty cost curves of an exemplary CCGT for secondary control power and mnutes reserve are shown as a functon of the electrcty prce n the dayahead market. The power plant s assumed to have a maxmal generaton capacty of 400 MW, a mnmal techncal load of 30 % of the maxmal capacty and a load gradent of 20 MW per mnute. Moreover, ts varable cost s 70 per MWh. Hence, the capacty costs for the plant are zero f the electrcty prce n the day-ahead market s 70 per MWh. For prces below 70 per MWh, the power plant s extramargnal. Hence, t earns losses on the dayahead market whch must be compensated by revenues from the balancng power market. If the electrcty prce s above 70 per MWh, the plant earns money on the day-ahead market and has opportunty costs when capacty s wthdrawn to provde balancng power. Accordng to ts load gradent, ths power plant could provde 300 MW mnutes reserve, snce the actvaton tme corresponds to 15 mnutes. However, as the dfference between mnmal and maxmal techncal load s only 280 MW, the maxmal balancng power capacty of ths power plant corresponds to 280 MW. In the case of secondary control power, the amount of reserve capacty that can be provded s lmted by the actvaton tme of 5 mnutes. Because of the load gradent of 20 MW t corresponds to 100 MW. Fgure 2: Capacty Costs of a CCGT - Mnutes Reserve & Secondary Control Power (Example) If a power plant s nframargnal, capacty costs n per MW and hour are dentcal for secondary control power and mnutes reserve. For each MW of provded balancng power, the suppler has to reduce generaton of electrcty n the same amount. If, however, a power plant s extramargnal, capacty costs n per MW and hour are hgher n the case of secondary control power than n the case of mnutes reserve. In both cases, the suppler must sell electrcty on the electrcty wholesale market n the amount of the mnmal techncal load whch creates losses. Wth mnutes reserve, these losses can be allocated to 280 MW, whereas wth secondary control power they can be allocated to 100 MW only. Thus, specfc capacty costs are hgher for secondary control power and the negatve slope of the cost functon s steeper.

11 10 In addton to capacty costs, costs occur for the actual delvery of balancng power. In both cases secondary control power and mnutes reserve varable costs ncrease when balancng power capactes are actually called. The parameter h (0% < h < 100%) denotes the ex-ante probablty that a power plant s accepted capacty s called. 8 Total costs [TC Reserve ] for both nframargnal and extramargnal power plants are then the sum of capacty costs and expected costs of actual delvery: TC Reserve = DA ( VC p ) p DA Mn CAP + h VC Reserve CAP VC+ h VC,f VC>,f VC p p DA DA. Effcency on the Balancng Power Market and on the Electrcty Wholesale Market We wll start ths secton by llustratng what consttutes an optmal allocaton of power plants to balancng power markets f the goal s to mnmze total balancng power costs. Here, we mplctly assume that a central planner has access to all relevant nformaton to mplement such an allocaton (n the next secton we llustrate how effcency can be realzed n a decentralzed market system). Thereafter, we show that the allocaton remans unchanged f we nclude the wholesale market n our computatons such that we smultaneously mnmze the total costs of electrcty n wholesale and balancng power markets. Cost Effcency n the Balancng Power Market On the bass of all power plants generaton costs, mnmal techncal loads, maxmal capactes and load gradents, t s possble to determne the maxmal balancng power capacty to be provded by each power plant and both ts capacty cost and ts total cost. On ths bass, we wll now llustrate by way of example how the capactes that mnmze balancng power costs for a gven electrcty prce n the wholesale market can be determned. The upper part of Fgure 3 shows the mert order of a stylzed thermal power plant system. On the bass of the techncal parameters of each power plant and a probablty of beng called h whch n the example n Fgure 3 corresponds to 50 % for all plants - one can calculate the total costs of each power plant gven an exogenous electrcty prce. Ths s shown n the lower part of Fgure 3. The electrcty prce s set to the varable cost of a hard coal power plant and both capacty costs (fully colored bars) and expected energy costs of calls (partly transparent bars) are shown. The sum of both corresponds to the total (expected) costs of provdng balancng power. 8 As we have mentoned before, we assume an dentcal probablty of beng called for all accepted bdders

12 11 Fgure 3: Mert Order on the Electrcty Market And Total Costs on The Balancng Power Market To mnmze total costs on the balancng power market (and hence acheve effcency on ths market), t must be assured that the power plants wth the lowest total costs are used for provdng balancng power capacty. Recall that the total cost of a power plant when t provdes balancng power s the capacty cost plus the expected cost of call. Thus, mnmzng overall total costs requres that suppler s favored over suppler j f and only f CC + h VC < CCj+ h VCj. Smultaneous Cost Effcency n the Wholesale and Balancng Power Markets The provson of balancng power capactes affects generaton costs on the wholesale electrcty market. Ths was not taken nto account n the prevous example. An overall effcent allocaton of capactes requres that aggregated generaton costs (ncludng both varable generaton cost on the wholesale market and on the balancng power market) are mnmzed. The two markets are nterlnked for two man reasons: frstly, provdng balancng power from nframargnal power plants reduces generaton from these plants on the electrcty market, whch has to be replaced by power plants wth varable costs above the spot prce.

13 12 Secondly, extramargnal power plants provdng balancng power replace electrcty generaton of nframargnal power plants due to the necessty of generaton wth mnmal techncal load n the case of provdng postve balancng power. In both cases, the generaton costs on the wholesale electrcty market ncrease. When nframargnal power plants provde balancng power and hence reduce ther generaton on the spot market, the generaton of electrcty must be ncreased from power plants whch had not been generatng electrcty before. On the margn, ths leads to addtonal generaton costs p DA - VC on the electrcty market, f the varable cost of the (nframargnal) power plant s VC, because the varable cost of the new power plant, whch replaces the reduced generaton, corresponds to p DA. 9 That s, the replacement cost on the day-ahead market of wthdrawng nframargnal capacty s p DA - VC On the other hand, we have to take nto account the energy costs of actually delvered energy on the balancng power market by a power plant wth varable cost VC, whch s h VC. Hence, for the purpose of maxmzng overall effcency, an nframargnal power plant wth varable cost VC wll be favored over power plant j for provdng balancng power f the total costs (replacement costs on the wholesale market plus energy costs on the balancng market) are smaller for : ( p DA DA VC ) + h VC < ( p VCj) VC > VC j. + h VCj s equvalent to:, whch The economc nterpretaton of ths nequalty s that balancng power from nframargnal power plants should be provded frst from those wth hghest varable costs. A suppler s capacty costs ncrease by the same amount as varable costs decrease. Even though the costs of call decrease, ths cost decrease cannot be fully compensated. The reason s that the probablty of beng called s below 100%. Observe that we already know that CC = p DA - VC. Hence, the nequalty condton above s exactly the same as the one derved n the last secton, n whch we dd not take nto account the wholesale market. That s, those plants that mnmze balancng power producton also mnmze the replacement costs on the wholesale market after wthdrawng nframargnal unts. In other words, opportunty costs on one market are real costs on the other market. A smlar argument holds when balancng power s obtaned from extramargnal power plants, whch generate electrcty n the amount of ther mnmal techncal load. On the one hand, ths creates addtonal generaton costs. These add up to the product of a power plant s mnmal techncal load and ts specfc varable cost n per MWh. On the other hand, the varable costs of formerly nframargnal power plants are saved. Lookng at margnal costs, these are agan set by power plants wth varable costs of p DA. Hence, when balancng power capactes 9 In a compettve market, the prce s determned by the varable (or, generally, margnal) cost of the margnal plant. At ths prce, addtonal capacty s avalable. Hence, p DA s the margnal cost for addtonal supply (see also Chao and Wlson 2002).

14 13 are procured from extramargnal power plants, addtonal generaton costs for electrcty ncrease by VC p DA multpled by the mnmal techncal load of the respectve power plant. These addtonal costs can be allocated to the amount of provded balancng power capacty. Hence, the addtonal generaton costs on the electrcty market are dentcal to the capacty costs of an extramargnal power plant. As for nframargnal capacty, the costs for producton on the balancng power - costs of call - of h VC must be added. In concluson, an extramargnal power plant s favored over an extramargnal power plan j f ( p DA CAP VC ) CAP Mn Reserve + h VC < ( p DA CAP VC j ) CAP Mn j Reserve j + h VC j. Agan, applyng that the frst part of both sdes n the nequalty above s equal to CC, ths s the same optmalty condton as for the balancng power market alone. The reasonng above can be extended wth regard to the optmalty condton when nframargnal and extramargnal power plants are compared. The capacty costs provdng balancng power equal real addtonal costs on the wholesale electrcty market n both cases. Hence, the optmalty condton consderng the balancng power market alone and the optmalty condton consderng both markets are equvalent. MARKET DESIGN Chao and Wlson (2002) addressed the queston whether effcency can be reached n a decentralzed market system applyng results from economc ncentve theory and mechansm desgn and assumng that the market s suffcently compettve. We llustrate ther theoretcal results by way of example and also consder the mpact of market power on market desgn, and of the proposed market desgn on market entry where possble. Under the constrant that demand for balancng power n Germany s exogenously gven and prce nelastc, an effcent supply allocaton s a suffcent condton for effcency (there may be effcency mprovements from makng demand prce elastc, though). A supply allocaton s effcent f overall costs are mnmzed. In the prevous secton, we have shown that overall effcency n the case of balancng power markets requres the acceptance of the supplers wth lowest costs for the provson of balancng power capactes and expected energy call. In most balancng power markets and also n Germany, bdders who want to provde balancng power offer a capacty prce bd (ndcatng a commtment of capacty) and an energy prce bd (for the energy actually delvered). A scorng rule s used to determne the wnnng two-part bds. The scorng rule n the current German market desgn accepts bds on the bass of capacty prce bds only, startng wth the lowest. Durng the bddng perod, accepted capactes are called on the bass of energy prce bds only, agan startng wth the lowest. The settlement rule determnes how much wnnng supplers are pad. Two dfferent settlement rules are used on energy markets. 'Pay as bd' pays every accepted bd ts own bddng prce. In 'unform prcng', all accepted bds are pad the same - market clearng -

15 14 prce. 10 Accordng to the current settlement rule n Germany, accepted supplers are pad the amount of ther own capacty bds. Hence, a pay as bd rule s currently n operaton. The same apples to the payment when energy from balancng power capacty s called: supplers whose balancng power capactes are called are pad the amount of ther own energy prce bd. As energy can only be called from accepted capacty, these payments are made n addton to capacty payments. There s an ongong debate whether both settlement and scorng rule n Germany should be revsed. Alternatve settlement rules mostly favor unform prcng over pay as bd. Alternatve scorng rules dscussed are scorng rules based on expected total costs,.e. capacty cost plus expected energy cost. Based on the theoretcal work of Chao and Wlson (2002), we wll start wth a dscusson of the dfferent settlement rules advantages and dsadvantages. Accordng to the analyss, pay as bd s not the preferred choce for balancng power markets. Instead, all accepted bdders should be pad the hghest prce of all accepted bds ( unform prcng ). In a second part, we llustrate that scorng rules based on expected total cost do not lead to market effcency. Instead, an effcent scorng rule mples that acceptance of bds should be based on capacty prce bds only. One mplcaton of our analyss s that there are arguments to change the current settlement rule from pay as bd to unform prcng, and to contnue wth the scorng rule n Germany and not change to a scorng based on expected costs. Furthermore, we wll dscuss the dvsblty of bds. In the current product desgn n Germany a system operator may accept only parts of offered capacty, whch can lead to hgher costs for supplers. Settlement Rules Theoretcal and emprcal studes have analyzed advantages and dsadvantages of varous settlement rules for dfferent markets. 11 Usually, two dfferent settlement rules are compared and dscussed, unform prcng and pay as bd. 12 It turns out that under perfect competton and complete nformaton, both settlement rules lead to full effcency and exactly the same procurement costs. For unform prcng, ths s easy to see. In suffcently compettve markets, bdders wll just bd ther cost. The reason s that bddng varable cost always ensures (ndependent of the bddng of others) that one wns f and only f wnnng s proftable, that s f the market clearng prce s above one's varable cost. In other words, unform prcng reveals true costs. 10 Unform prcng s the more common settlement rule and s used for nstance n the Germany dayahead power market. 11 Because most of the arguments are well-documented and understood n the lterature, we confne ourselves here to a rather bref descrpton; see e.g. Cramton et al. (2001) and Grmm et al. (2008) for a more detaled account. 12 Another possble settlement rule s the so-called Vckrey aucton. Even though from a theoretcal vewpont ths aucton type guarantees effcency n producton, t s no relevant alternatve n the practce of balancng power markets. Ths s because the rules are complcated, bdders may get pad dfferent prces for the same servce, large bdders are pad more on average than small bdders, and procurement costs may be very hgh. For a thorough dscusson, see e.g. Grmm et al. (2008).

16 15 Ths s dfferent under pay as bd, where bddng true cost s not optmal. In the context of Calforna s electrcty wholesale market, Kahn et al. (2001, p. 70) wrote: Any belef that a shft from unform to as-bd prcng would provde power purchasers substantal relef from soarng prces s smply mstaken. The mmedate consequence of ts ntroducton would be a radcal change n bddng behavor that would ntroduce new neffcences, [ ]. The reason that bddng true costs s not optmal s that ncreasng one's bd leads to an ncrease of the proft as long as the bd s stll accepted. If all supplers have full nformaton regardng both ther own cost as well as the costs of the compettors, all supplers submt a bd equal to the margnal suppler s bd. The margnal suppler s the most expensve suppler needed to cover demand. As a consequence, wth perfect competton and complete nformaton, the wnners and payments for pay as bd are the same as for unform prcng. Now suppose there s uncertanty about the compettors' costs and strateges, but stll perfect competton. Wth 'unform prcng', one's bd s ndependent of others' behavor, so full effcency s stll reached. Wth 'pay as bd', however, effcency s unlkely, because supplers then have to guess the costs of ther compettors and bd correspondng to these guesses. On the one hand, ths s a challenge for the bdders that s lkely to ncrease transacton costs. On the other hand, t mght lead to an neffcent market outcome. The reason s that bdders wth relatvely low varable costs mght overestmate the margnal plant s costs and may hence submt a bd that s too hgh to be accepted. If at the same tme other plants wth hgher varable costs are accepted, the result s neffcent. That s, whle 'unform prcng' stll yelds full effcency, 'pay as bd' typcally does not - even wth perfect competton. Now, fnally, suppose there s mperfect competton. Here, wth 'unform prcng' supplers wth market power have ncentves to reduce supply that could otherwse be proftably operated. The reason s that reducng supply may ncrease the market clearng prce and thus the proftablty of the nframargnal unts. An analogous strategy s not possble wth 'pay as bd', because bds on one unt cannot drectly nfluence the payments for other unts. However, wth 'pay as bd' and market power, supplers have ncentves to ncrease bds beyond the varable cost of the margnal suppler. Theory does not fnd a unque rankng wth respect to effcency or procurement costs regardng the settlement rules (Ausubel and Cramton 2002). That sad, the lterature has revealed a couple of arguments why 'unform prcng' s typcally the preferred settlement rule. For one, 'unform prcng' s strategcally very smple wth competton; there s no need to guess others' costs and behavors, so that the outcome s robust aganst wrong belefs and uncertanty. Moreover, emprcs seem to suggest that, even wth less than perfect competton, the outcome wth 'unform prcng' quckly converges to full effcency wth the number of players. Second, wth mperfect competton, 'unform prcng' rewards low costs (because all wnners get the same prce) whereas 'pay as bd' rewards good guesses (because guesses determne the prce). Thrd, and related, because wth 'unform prcng' the market prce s a publc good for supplers, small players proft from the market power of large players. Exercsng market power thus deterorates the strategc player s performance n comparson to other supplers. In the long run, hgher prces therefore

17 16 promote market entrance of new supplers. Fnally, 'pay as bd' does not yeld a unque reference prce, complcatng arbtrage and reducng market transparency. In vew of these advantages of the 'unform prcng' rule, t seems understandable that relevant expermental research often fnds that 'unform prcng' performs better. As Terney et al. (2008) put t when surveyng the relevant lterature: "Bddng behavor n expermental electrcty markets desgned to replcate real-world bddng stuatons suggest that pay-as-bd auctons would rase prces above unform-prce auctons." We add that the specfc complextes of balancng power markets tend to strengthen the case for 'unform prcng'. In partcular, t seems lkely that neffcences under 'pay as bd' wll arse for several reasons. Frstly, ratonal bddng strateges requre emprcal estmates of cost functons, whch are challengng to compute. For example, market partcpants have to estmate detals of techncal unts of ther compettors to determne cost functons. Ths nvolves mnmal capactes, load gradents and varable costs. Secondly, costs also depend on the energy prce at the wholesale market, whch s volatle. Whle forwards can be used as estmates for wholesale prces, volatlty has to be estmated. 13 However, effcency wth pay as bd strongly depends on the ablty of all supplers to estmate the costs of ther compettors suffcently precsely. There s another argument ncreasng the complexty of optmal bddng on balancng power markets further. Bdders on the capacty market wll take nto account ther expected revenues from calls on the energy market. Ths necesstates accurate estmates of the revenues from the energy market. These are dffcult to determne under unform prcng. However, we wll argue that they are even harder to predct wth pay as bd. Let us consder the stuaton under unform prcng frst. Under unform prcng, bdders can smply bd ther varable cost on the energy market. However, the expected revenues from the energy market are needed when calculatng the optmal capacty bd because bdders have to subtract these revenues from ther capacty bd. Hence, supplers have to estmate market prces on the energy market for dfferent levels of calls and the assocated probabltes. 14 It s especally challengng to estmate the probablty functon emprcally. Yet these estmatons are even more complex under pay as bd. Recall that bdders do not reveal ther varable costs on the energy market wth pay as bd. Instead, to smplfy, bdders try to guess the most expensve accepted bd. The determnaton of the most expensve accepted bd requres an estmaton of the probablty dstrbuton for calls of dfferent energy levels, however. Bds on the capacty market depend on the expected proft on the energy market, whch makes an accurate estmaton regardng the energy market even more mportant. These estmates become harder when strategc bddng s an addtonal part of the equaton. Takng everythng together, we conclude that unform prcng tends to be superor to pay as bd on balancng power markets, both for the capacty and the energy part. 13 At least as long as there s no lqud optons market whch mght provde market estmates for volatlty. 14 As a sde remark, ths reasonng mght be an argument for a hgh degree of transparency n these markets (f suffcently compettve) because better predctons can ncrease effcency.

18 17 Scorng Rules Theoretcal framework Chao and Wlson (2002) show that a scorng rule for balancng power markets s effcent f the acceptance of bds s based on capacty prces only and accepted capactes are called on the bass of energy prce bds. For ths, t s assumed that markets are suffcently compettve and belefs about expected profts on the energy market are suffcently accurate. Ths result s based on two fundamental propertes. Frstly, as the energy part of the bd s not part of the scorng rule for the acceptance of bds, there s no ncentve for supplers to adjust energy prce bds to ncrease the probablty of beng accepted. In other words, the scorng rule does not nterfere wth the optmalty of truthful bddng n the (compettve) energy market. Secondly, even though the energy bd s not part of the scorng rule, varable costs and expected revenues due to calls of energy from balancng power capactes are nevertheless taken nto account. In the followng, we wll explan and llustrate ths result by Chao and Wlson and the resultng ncentves for market partcpants n more detal. Gven the decson about whch capactes provde balancng power has already been made, EM and gven a settlement rule, a suppler can compute an expected proft ( ) E that s realzed on the energy market. Ths expected proft s equal to the postve proft contrbuton,.e. the dfference between the energy market prce EM p and varable cost VC, whch s adjusted by the probablty of beng called h. More formally, the expected proft on the energy market for suppler s 15 E( R EM ) = h EM ( p VC) Ths proft s made under the condton that the correspondng suppler s capacty bd has been accepted n the step before. Because the proft only materalzes f the capacty bd s accepted, t s accounted for n the capacty bd - wth a negatve algebrac sgn. That s, the suppler ncorporates both capacty costs CC - whch typcally are the opportunty cost for not. R 15 For smplcty, we have so far assumed a constant h for all capacty regardless of varable costs. Ths mght refer to the case where ether all capacty s needed (wth probablty h) or none at all (wth probablty 1 - h). We provde just an example wth heterogeneous h across frms. We assume that the bddng perod s 10 hours, and balancng power demand s 1 MW n 9 hours and 2 MW n the remanng hour. There are two avalable technologes: a base (peak) load technology wth capacty costs of 50 (0) per hour and varable costs of 20 (70) per hour. We assume that there are numerous supplers who each own one MW of ether baseload or peakload capacty. The effcent technology mx for balancng power s 1MW baseload and 1 MW peakload. The correspondng equlbrum balancng power prces n compettve markets are 20 n the 9 hours wth low demand and 70 n the one hour wth hgh demand. Wth these energy prces, t can be readly seen that there are no equlbra wth ether two baseload or two peakload wnners. In fact, n equlbrum, the capacty bd of the wnnng peakload suppler s 0, the capacty bd of all baseload supplers s (70-20) = 350, and the capacty bds of all losng peakload supplers are - 9x(20-70) = 450. The latter bd reflects that - gven the compettve market clearng prces - a (second) peakload suppler who wants to crowd out the baseload suppler could do ths only by acceptng losses n those 9 hours where the baseload suppler can more effcently delver electrcty. As a result, wth compettve bddng, the scorng rule selects one baseload and one peakload suppler, leadng to an effcent market equlbrum n whch dfferent wnners have dfferent probabltes of beng called.

19 18 bddng on the day-ahead market - and the expected revenues on the energy market n case of acceptance of the bd n the capacty market: CC Bd = CC E( R ) = CC h EM EM ( p VC) Ths capacty bd can be nterpreted as the (opportunty) cost on the day-ahead market mnus expected profts from called energy on the balancng power market. It ndcates the smallest amount that a suppler s wllng to accept for provdng balancng power. Wth unform prcng on the capacty part of the balancng power market and suffcent competton, t s easy to see that no other bd can mprove profts: Lke on the energy market, there s no ncentve to ncrease ths capacty prce bd, because the probablty of beng accepted would decrease, whereas profts n case of acceptance would stay the same. On the other hand, there s no ncentve to decrease ths capacty prce bd ether, because ths could lead to an acceptance of the bd n a stuaton where the market prce s lower than the sum of capacty costs less expected profts on the energy market and hence to a stuaton where losses are made. Note that even though the expected proft on the energy market s antcpated by the suppler, t s not an explct part of the scorng rule on the capacty market. Ths s not necessary because the expected proft on the energy market s adequately prced nto the capacty bd. As a result, a suppler s favored over suppler j f CC Bd = CC h EM Bd EM ( p VC ) CC = CC h ( p VC ) Ths formula can be smplfed and leads to the condton for effcency on the balancng power market: CC + h VC CC j+ h VC j. As we have shown n the last secton, ths s also the condton for overall effcency. Each sde of ths nequalty represents the total cost of the respectve suppler,.e. capacty cost plus varable cost tmes probablty of beng called. Thus, a suppler s capacty bd s favored f hs total cost s lower than the other suppler s total cost. Ths s the condton for effcency on the balancng power market and also the condton derved for overall effcency. To summarze, as has been more formally derved by Chao and Wlson (2002), wth suffcently compettve markets, a settlement rule based on unform prcng ensures effcent energy call n the balancng power market, a scorng rule based on capacty prces only ensures an effcent producton schedule, and both rules together wth ratonal bddng ensure smultaneous effcency on the balancng power market and the wholesale electrcty market. An Illustratve Example In ths secton, we present a stylzed graphcal llustraton of the fundamental economc nterrelatonshps between the balancng power and the day-ahead market. However, whle graphcal examples are sometmes more ntutve, we cauton that sgnfcant smplfcatons j j. j.

20 19 have to be made. So, we recommend all readers to use our llustraton only complementary to Chao and Wlson's (2002) work and our treatment above. We start wth an exemplary day-ahead market wthout the consderaton of spnnng reserve n Fgure 4. There are fve technologes: nuclear power plants, lgnte and hard coal fred power plants, combned cycle gas turbnes (CCGT) and open cycle gas turbnes (OCGT). The load level s 55 GW. The resultng prce n the day-ahead market s p DA = 40 per MWh f the balancng power market s not consdered. Let us now assume, wthout loss of generalty, that we need MW of balancng power capacty, that 20% of nstalled capactes can partcpate on the balancng power market, 16 that mnmal load for all power plants s 50%, and that load gradents are suffcent to ramp up the remanng 50% n tme to provde balancng power. Then, the colored bars n Fgure 5 depct total costs TC of provdng balancng power for dfferent technologes. The fgure dstngushes between CC and costs for energy provson on the balancng power market. The (opportunty) costs CC are shown by the black lne n the fgure. Recall that CC = p DA - VC for nframargnal capacty and CC = VC - p DA for extramargnal capacty. The second part of total costs s the energy cost h VC = 0.5 VC. Ths s the dfference between the black lne and the upper lmt of the colored bars n Fgure 5 (here we assume CAP Mn = CAP Reserve ). We have ponted out that t s cost effcent to let those plants wth mnmal TC provde balancng power. In our example, these would all be nframargnal. However, ths would mean that, ceters parbus, nframargnal capacty reduces producton by MW. Ths cannot be an equlbrum because extramargnal capacty must then generate electrcty to compensate for any capacty wthdrawal from nframargnal capacty. Otherwse, load on the day-ahead market would not be covered. Hence, every MW from nframargnal capacty taken out of the day-ahead market must be replaced by one MW of extramargnal capacty and vce versa. However, at a prce of 40, extramargnal capacty would not fnd t proftable to enter the market. Hence, the equlbrum prce n the market wthout consderaton of balancng power cannot be the equlbrum prce n the market wth balancng power. In ths example, the electrcty prce p DA must rse to motvate the producton of capacty that was extramargnal when balancng power was not consdered Ths reflects the fact that not all capacty s prequalfed to provde balancng power. It mght help to assume that there are very many very small power plants n ths example. Every ffth of these can provde balancng power wth 50% of nomnal capacty. Hence, 10% of nomnal capacty n the market can supply balancng power. 17 It s not necessarly the case that the electrcty prce on the day-ahead market has to rse when balancng power s consdered. If mostly extramargnal capacty was called (e.g. at load level of 56 GW n the fgure) the day-ahead prce would have to decrease for an equlbrum consderng balancng power.