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Transmission scarcity: who pays?
Transmission Scarcity: Who Pays? Transmission services should be provided under an iterative auction, based on a first-come, first-served basis, with an e x a n t e estimated charge for each transaction based on system conditions. Each transaction should be charged for its relative impact on deterioration in system conditions. Marija Ilig is a senior research scientist in the department of electrical engineering and computer science at the Massachusetts hzstitute qf Technology, where she specializes in the area of large-scale electric power systems. Leonard Hyrnan is an expert in the finance and regulation of electric utilities. The author of America's Electric Utilities: Past, Present and Future, MI: Hyman is a consultant to Smith Barney. Eric Allen holds an M.S. in electrical engineering from MIT, where he is a doctoral candidate researching optimal decision making in power systems under open access. Ziad Younes is a graduate of Ecole Polytechnique in Paris in physics and economics, and is working toward graduate degrees at the University of Paris (in industrial organization) and MIT (in technology and policy).
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Marija Ilid, Leonard Hyman, Eric Allen and Ziad Younes
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pricing transmission during periods of scarcity? Haven't we heard enough about transmission? It's over, isn't it? The utilities will hand control of transmission to a non-profit committee whose rules of governance and means of financing remain indeterminate. Those organizations, in isolation or cooperatively, will develop pricing plans, which will all produce the lower of market or rate of return on rate base. Academics from Harvard, Berkeley, and MIT have promoted competing schemes for pricing during periods of transmission scarcity, all of which will keep the lights on. The Harvard scheme is out front, so when will the losers stop carping?
Anyway, say unconcerned utility executives--busy with downsizing and securitization and foreign investments--the feds and the state regulators told us to do it. So we'll do it. And it won't hurt the bottom line. Of course they said the same sort of thing about nuclear power plants, overpriced purchased power contracts, and other regulatory impositions. The regulator told us to do it. Like other such seemingly harmless regulatory impositions, this one could cost them money. That is the point of this article. The choice of a system of pricing and rationing during periods of transmission scarcity has business consequences. It is too important
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to delegate to committees without first giving it the utmost attention.
I. The Issues The transmission network was not built for the extent of the transactions we anticipate in the competitive market. For that matter, it was not built for the current distribution of population, dem a n d for power, and likely shifts in generation patterns. With so m a n y environmental constraints imposed on it and a rate of return regime set for it, transmission improvements m a y not keep up with need. Scarcity of transmiss i o n - a n d its pricing and provision---could be a serious issue. The debate about h o w transmission service should be provided in time of scarcity has centered on several concepts: making the grid equally available to all loads at the same price on a pro-rata basis, ~nodal-price-based congestion pricing, 2 market-based determination of transmission use subject to physical curtailment, 3 and a market-based system that permits participants to ration their o w n use based on pricing considerations. 4 lthough the various proposals and assessments thereof have inundated policy makers, there is still a paucity of publication of simulation or experimental work that illustrates the differences between the proposals. This article analyzes three of the proposals for transmission pricing: those of Wu et al., 5 Hogan 6 and Ilid et al., 7 for the constraints they impose on the market. It compares the three proposals conceptually and draws
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conclusions about their differences, with emphasis on h o w those differences may affect the functioning of the marketplace. Of course, we recognize that these proposals differ in their treatment of the market system and its dynamics. For example, Hogan assumes that provision of system support is an integral part of the energy market, both of which are
The transmission network was not built for the current distribution of population, demand for power, or shifts in generation patterns.
ISO-managed. Wu et al. and Ili~ et al., by contrast, would have basic functional separation of the energy market and transmission system markets. Given this distinction, we will briefly describe the objectives of the energy markets in competitive power industry and issues related to their efficiencN without consideration for system externalities such as system constraints. Then we will examine questions unique to transmission system support, the principal topic of this article. Finally, concerning the fundamental limitations on the ISO's effectiveness in facilitating the market,
we argue that an ISO can have little effect on basic energy market efficiency, and that its key role is to provide and price transmission system services. e conclude that a functional separation between ISOs and energy markets is technically and economically justifiable. This issue was a subject of m u c h debate in California prior to that state's adoption of a structure that functionally separates the energy market from the ISO. In the Northeast, however, most proposals for restructuring of tight power pools (New England, New York, PJM) do not incorporate this functional separation. We argue here that it is not possible to build a technically sound case for keeping the two functions under the same umbrella of an ISO. To start with, we assume that at least in concept there is a fundamental difference between the energy market objectives and the objectives of system support.
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II. Energy Markets without Congestion Under open access, efficient pricing for generation is complicated, even in the simplest case, w h e n no transmission charges are accounted for. 8 The impact of an ISO that is in charge of approving various transactions on systemwide efficiency then becomes a function of the market (industry) structure adopted. To clarify this, consider the three most typical market structures debated: (1) a price-bid-based scheduling by a mandatory ISO; (2) an entirely multilateral energy market, with 39
an ISO being a provider of transmission services; and (3) a pricebid-based scheduling by a voluntary ISO.
A. Mandatory ISO Most bid-based ISOs evolving in the United States have proposed a so-called Dutch auction, similar to the United K i n g d o m ' s m a n d a t o r y poolco structure. 9 Transactions are scheduled according to their price bids in merit order (the least expensive units are fully scheduled), and there is only one so-called marginal unit which is partly used. The price of this unit determines the energy clearing price which is paid to all, even to those with m u c h lower bids than the clearing price. Under this structure, assuming that price bids are close to generation cost, an ISO has a clear measure of system efficiency1° under its jurisdiction. The short-term efficiency formula used by a mandatory ISO is identical to the formula presently used in a regulated industry, with the difference that cost is replaced by the bid price. 11 ~or the purpose of understanding the notion of systemwide efficiency as a function of energy market structure, it suffices to recognize that an ISO can be held responsible for efficient real-time use of resources in the area under its control in a mandatory ISO structure, and that the measure of efficiency is well defined. In other words, it does make sense to bundle the energy market with the system services
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provision in this type of market structure.
B. Entirely Multilateral Energy Market An entirely multilateral market assumes an arbitrary structure of market players in which competitive market participants (CMPs), or groups of them, directly negotiate energy prices for their sales and purchases. An ISO is not
In mature, large and sufficiently fluid markets the systemwide optimum is achievable without having to make prices public, at least in theory.
given the prices of energy sales in this model. Basic decision making in such markets is identical to supp l y / d e m a n d decisions in other competitive industries. Under perfect market conditions all shortrun marginal prices are the same, and the same economic equilibrium as in a mandatory ISO structure is reached. To understand the impact and responsibilities of an ISO in this structure, recognize that multilateral markets are often far from the actual economic equilibrium, especially for an industry in transition. 12 Consequently, the shortrun marginal price at which
multilateral deals are established could vary drastically, and no single energy market price w o u l d be known. In a market-structure like this, an ISO cannot be responsible for efficient use and distribution of energy across the system, since it is not given basic economic data. The main role of the ISO would be in facilitating market needs, i.e., helping to implement transactions. In other words, the ISO does not have a measure of systemwide efficiency in terms of facilitating the least expensive s u p p l y / d e m a n d deals. The ISO cannot influence efficiency explicitly in an entirely multilateral market. Ystemwide efficiency in multilateral markets is influenced, instead, by the activities of individual market participants. In mature, large and sufficiently fluid markets the systemwide opt i m u m is achievable without having to make prices public, at least in theory 13
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C. Voluntary ISO/PX Here we examine a voluntary ISO-assisted energy market without any consideration for transmission system support first; only the ISO's role as a power exchange mechanism is a n a l y z e d - i.e., the PX portion of the ISO. We can characterize the typical bid-based pool structure that is u n d e r active consideration in m a n y parts of the United States as including at least three types of economic transactions: (1) price-based bids directly into an ISO, scheduled according to merit; (2) strictly multilateral
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transactions which, given the permission of the ISO, physically inject p o w e r into one location and take out the same a m o u n t at another, with the price of these transactions not m a d e k n o w n to the ISO;TM (3) transactions between a p o w e r p r o d u c e r and the ISO, as in the U.K. system, in which the ISO schedules and determines h o w m u c h the transaction is worth, b u t the market participant m a y have another, strictly financial agreement with a third party to h e d g e against variations in the price d e t e r m i n e d by the ISO. 15 All utility-owned units presumably belong to category (1), since they are still regulated by the Federal Energy Regulatory Commission and must price sales on a cost basis) ~ The other two categories typically involve independent power producers (IPPs), which are paid the full market-clearing price, as long as they are scheduled. This market structure can be viewed as being "nested" relative to traditional horizontal structures in a regulated utility organization. The ISO, which is in charge of providing system services to all, only knows the bid prices of parties belonging to categories (1) and (3). As in the case of an entirely multilateral market structure, the ISO is not given energy prices at which multilateral trades take place. n this case the ISO cannot be held responsible for systemwide efficient operation in terms of system efficienc}¢ or for relatively price-inelastic load in terms of generation cost. There is no
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well established definition of efficiency in this case. Here an ISO is just a particular submarket in a larger market structure. This kind of "voluntary" ISO has not been studied at all with respect to its impact on achieving systemwide efficiency, or incentives to the ISO and market participants to do so. An ISO can be fully responsible for system efficiency only in a
There is a problem with assuming an ideal market. In fact, there wilt be decided advantages for some parties in a bilateralonly market
mandatory ISO market structure. In other market structures, even the basic definition of the market depends on the quality of the multilateral market. This concept is essential to understanding the role of an ISO in providing efficient and non-discriminatory transmission service to all. It is conceivable that under the wrong conditions the ISO could run a system that is less efficient than the one we have n o w . 17 That certainly would be an undesirable outcome after so m u c h effort to harness market forces in order to increase electric industry efficienc}t
D. Role of the ISO in Determining "Fair' Profit Allocation In a mandatory ISO market structure, an ISO schedules use of price-bidding-based generation to meet anticipated d e m a n d by putting in service the cheapest units first. The energy clearing price, however, is determined by the highest bid power plant which is actually scheduled. As long as a plant is used, it is paid its price bid or more. Since an ISO schedules power plants so that the total (systemwide) price of meeting dem a n d is minimized, this is the best it can do. ccording to the basic laws of competitive economics, the system equilibrium obtained by this ISO's coordinated price minimization and the equilibrium obtained in an entirely multilateral market result in the same market solution. Provided that a unique market equilibrium exists, the profit allocation to individual market participants, at which individual oppor~mities for profit are small, is the same as the profit allocation determined by the ISO's coordinated computation at which all short-run marginal prices are the same. Consequentl~ the ISO-based profit allocation is equivalent to the profits obtainable on multilateral markets. Of course, there is a problem with assuming an ideal market. In point of fact, there will be decided information, knowledge and other advantages for some participants in a bilateral-only m a r k e t - especially one with system con-
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straints--so that making an assumption of ideal conditions is less than useful. However, an ISOcoordinated scheduling has its own share of potential problems. Potentially the most critical one deals with collusion problems leading to cartel-like arrangements. Learning effective patterns for collusion of this type is much easier in an ISO-based energy market, which provides all CMPs in a repetitive manner the economic information needed to do
then nothing further needs to be done. However, if at least one line flow exceeds the maximum allowed limit, then the allowed transactions are curtailed to the fewer quantities that are feasible. In this section we briefly survey methods for transmission system support for the type of fundamental restrictions that allowed transactions impose on system users. The simplest proposal assumes
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The role of an ISO becomes much more delicate when insufficient system support exists to facilitate the most desirable transactions arrived at through energy market mechanisms. Most of what follows is concerned with the imposition of transmission constraints on market outcomes, and on a possible "good" transmission strategy.
III. Congestion Constraints in the Marketplace In many networks, the operating point that results from market driven forces produces line flows that exceed allowable operating limits. In these cases, an independent system operator (ISO) must curtail some or all of the power transactions in order to permit safe, reliable system operation. e presume that after all curtailments have been scheduled, an ISO determines whether the total set of transactions is feasible on the n e t w o r k - i.e. meets all line flow constraints. If the transactions are feasible,
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that all transactions will be given equal access to use the system, and that the charge for using the system would be such that the transmission system revenue recovered from all users is based on their relative share of power injected into the system. The industry has often embraced this approach. It is fairly straightforward to relate this approach to what is known as a postage stamp approach; the two are equivalent as long as the transmission use is charged for at a single system level, such as pool or region. This is what has effectively been proposed by NEPOOL recently as the
charge for regional network service. imilar formulae intended to charge according to amount of power wheeled become more complicated when the same region serves energy transactions that originate a n d / o r terminate outside the region providing system support. The charge for service of this type is known as wheeling or point-to-point charge for transmission and is most frequently calculated using the notion of a contract path as the most likely transmission path needed to accommodate a specific transaction. FERC, in Order 888, in effect advocates equal access to all system users, even beyond traditional system boundaries, and the basic postage stamp/contract path approach to pricing. 18 FERC and everyone else admits that postage stamp/contract path has been no more than a convenient fiction to be replaced by more adequate usage-based methods, such as MW-mile method or its variations. Several industry groups are actively working toward implementing real-time data processing for this type of transmission pricing. The main issue here is that no specific "path" can be defined, since the physical flows are likely to change throughout the interconnection, and that if the transmission revenue is to be recovered based on usage, more accurate formulae will have to be implemented. It is essential to recognize that pricing methods such as postage stamp, contract path and MWmile method serve the purpose of
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recovering just the revenue requirements of the existing transmission grid. The main problem of interest here is h o w to charge for enhancing a transmission system so that it retains an acceptable reliability level as it attempts to acc o m m o d a t e transactions requested by the energy market. This issue is directly related to the congestion pricing problem. The challenge is to price for transmission scarcity so that the system is enhanced. hen a set of proposed transactions is constrained, an ISO m u s t decide h o w to ration system service. That decision is a function of the type of information available to the ISO. If no economic information is given, the only basis for reduction is strictly technical. The technical reliability criteria, however, are not uniquely defined at present. That leaves room for substantially different solutions, ranging from simply rejecting all users by the same amount, to rejecting the transactions to which the physical constraints are most sensitive. 19It will be critical to provide the ISOs, as soon as possible, with some guidelines concerning what constitutes "equal (physical) access" in the changing industry This issue becomes even worse once the temporal aspects of technical feasibility enter the problem. Defining equal access is just as difficult w h e n computing the socalled available transmission capacity (ATC). It is not fully recognized, for instance, that ATC for a multilateral transaction is different from ATC for the same
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a m o u n t of power for transactions scheduled by a n I S O . 2° On the other hand, if we assume an industry structure in which both technical and economic information is made available to the ISO, the question of "equal access" becomes even more complex. Would the ISO declare certain power transactions to be feasible on a strictly technical basis, or should it compromise between economics and reliability? For that matter, would the ISO distinguish between transactions for social or political reasons (priority for w i n d p o w e r or orphanages)? To complicate issues further, industry proposals for restructuring already differentiate between the load curtailment procedures as financial rights which are used for accounting purposes only (which are typically pro rata load-sharebased), and the curtailment to be done in real time by an ISO. It is not clear where these two meet. In the next section, we briefly summarize and analyze the three proposals for transmission system support, each of which implies a
different type of transmission system service and pricing. Despite the technical nature and seeming neutrality of the proposals, they yield different market outcomes for different players.
IV. Three Proposals for Transmission System Support Transmission system service frameworks have been proposed by Professor William Hogan at Harvard, Professor Felix Wu and his colleagues at Berkeley and Dr. Ili~ et al. at MIT. Professor Hogan's proposal has received wide visibility, and, like Wu, is discussed only for its features of interest here. The proposal by Iliff et al., although conceived some time ago, m a y not be familiar to m a n y readers and is described here to point out its qualitative features which differ from the other two proposals.
A. The Hogan Approach This proposal envisions a very active role for the ISO in determining prices for transmission service under system constraints. The en-
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ergy market and transmission system provision are functionally and economically bundled. In its purest form, the proposal assumes that all CMPs are scheduled b y an ISO, and that energy price bids are fully k n o w n by the ISO. 21 Transmission pricing is based on ex post settlement after real-time static optimal power flow-based nodal prices are computed. There are two features of interest concerning the impact of this pricing scheme on individual users: First, d e p e n d i n g on h o w the merchandise surplus (MS) is allocated, one will see different impacts on the profits of individual C M P s . 22 Tellingly, it is conceptually impossible for an ISO to allocate the MS in a fair way, without having defined the criterion for economic fairness in a voluntary ISO, particularly since a different type of information is being p r o v i d e d by the ISOscheduled CMPs than for the multilateral transactions. (Recall that the ISO-scheduled transactions provide price bids for selling a n d / o r purchasing power, and the multilateral deals are not required to reveal their financial terms.) n the Hogan approach, financial hedging against large deviations of nodal prices is provided by means of transmission congestion contracts (TCCs), which are entirely financial instruments potentially uncorrelated with the expected value of transmission to the market participants purchasing these rights. These financial instruments (in particular
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their initial allocation) again, rely strongly on the ISO.
B. The Berkeley Approach The method proposed by Wu et al. has three basic steps: (1) All buyers and sellers negotiate in an open energy market and agree to trades which benefit all participants. The resulting energy price in the market is the uncongested price of electricity (the en-
In the Hogan approach,financial hedging against large deviations of nodal prices is provided by means of transmission congestion contracts.
ergy clearing price). (2) An ISO considers the complete set of proposed transactions and examines whether the set is feasible, i.e., does not produce any transmission line flows which exceed m a x i m u m thermal, voltage and dynamic limits determined by the ISO. If the set is feasible, no further action is needed and all proposed transactions are made. However, if line flow limit is violated, then the ISO must curtail some or all of the proposed transactions so that the line flow limit is not exceeded. The transactions that are permitted are made at the price originally agreed u p o n - - t h e
uncongested price. The ISO will also supply information to all market participants on h o w further trades m a y be m a d e without violating line flow limits. (3) The information from the ISO would, for example, allow a load to b u y more power from a generator, but only if that load simultaneously sells a given fraction of that power in order that the transaction not exceed system constraints. In this manner, submarkets for electricity in a postcongested network are formed. Trades take place in the new submarkets, and the resulting transactions bring the system to a point of o p t i m u m social welfare. he final outcomes in the two-tiered market are not affected by the ISO's choice of curtailment levels. The curtailment affects only h o w m u c h power is priced at the uncongested price and h o w m u c h is priced according to the post-congested market. 23
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C. A Two-Level Iterative Market The two-level market structure proposed by Ili~ et al. 24works differently from the other two proposals. Here are its basic steps: (1) The energy market evolves at the first level, concerned only with the financial arrangements for purchasing power in the most beneficial way, without any consideration of charges for system support, zs Prices of transactions are not public; this depends on the type of energy market (PX) in place. (2) Those making various transactions approach the ISO asynchronously--i.e., r a n d o m l y - - n o t The Electricity Journal
in a planned or coordinated w a y - - a n d request implementation of their respective transactions. (3) The ISO--based on the information about (a) transaction location, (b) duration and starting time, and (c) firmness of transaction estimates the total expected charge for system support to make this transaction feasible, while keeping the level of reliability unchanged. This information is sent back to the potential system user, which re-evaluates its intent to make the transaction using the information about the system charge as one aspect of its deterruination. The firm making the transaction is likely to iterate this information with the ISO several times before it actually settles on the a m o u n t and type of transaction served by the system. 2~As we have said, this process converges to the same social welfare solution as a mandatory ISO without the ISO having to mandate either the congestion price or the information about the sale, which could be PX-based or multilateral. 27
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he key differences between this proposal and the others
are: • This proposal takes into consideration the expected cost of the transaction ex ante. Participants k n o w what they will pay before, not after, the transaction. • This proposal captures intertemporal effects, w h e n serving transactions of varying types. • It allows full freedom for the system user to make decisions regarding quantity and price of the
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transaction, including charges for system support, without mandating a pre-specified pattern of power or price control. It is important to observe that a typical system design for normal operation is not fully optimized to accommodate present needs without having any transmission congestion. However, the system is optimized to the point of having a meaningful balance between cost
And financial hedging is uncorrelated with real-time physical processes, isn't it ? But that type of thinking leads to erroneous conclusions.
of transmission support and use of more expensive generation for given g e n e r a t i o n / d e m a n d patterns. As a system is exposed to requests to accommodate n e w transactions, the present operation could be used as a point of reference from which future reliability is measured. It is likely that some transactions will improve the reliability level, and, as such should be paid by the ISO, and not charged for using the system.
V. Implied Financial Instruments When analyzing real-time operations, there is a tendency to
view the question of financial transmission rights as a non-issue. After all, financial transmission capacity rights don't affect economic dispatch, right? For that matter, financial hedging is uncorrelated with real-time physical processes, isn't it? That type of thinking, however, leads to erroneous conclusions. When the provision of transmission service is viewed in the context of proposed energy market mechanisms, it becomes easier to understand interactions of technical and financial processes and their implications for system users. When the markets are just beginning to form, not understanding the process could have pronounced financial consequences on individual market participants, since the system is not at equilibrium--i.e., the energy costs and costs of transmission system services will not be equal to the prices charged. A correction of price toward cost could surprise some system participants, disadvantage them in planned transactions, and upset strategies based on incorrect assumptions about prices. At least in principle, the same w o u l d be equally true for transmission. nderstanding these relationships w o u l d require development of more sophisticated tools than those presently available to ISOs. If an ISO were p u t in charge of the energy market as well as in charge of system provision (as in the U.K.), it w o u l d be effective only if it engages in development of more sophisticated tools than those pres-
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ently available. Ideally, an ISO will develop software to permit parties to engage in trading of financial derivatives relevant to planning efficient use of power on weekly and monthly bases, including system maintenance needs. (This is one of the big missing pieces w h e n only a spot market exists.) Until now, little attention has been paid to the inter-temporal dependencies between financial and physical processes, and to the potential danger of some CMPs gaming the energy market. 28 Having all the required tools is even more important for the transmission market because that market m u s t provide service to all in a non-discriminatory fashion. ooking at the congestion rationing approach that uses an equal price for all and distributes use of the network on a pro r a t a basis, 29we find an implied financial instrument that requires further clarification. Independently of h o w m u c h power is served by the system (a matter decided by the ISO in real-time operation), the congestion price is settled on the basis of pro rata share of load. This type of financial instrument does not involve the participation of insurance companies or other risk hedging devices, since the congestion price is simply a settlement matter, as it is n o w in some tight power pools. An initial allocation of financial rights to system users 3° could be highly discriminator?6 and there is no way of allocating these in a fair way. Particular loads should not receive rights at no cost. This
would be discriminatory to others, and would violate basic principle of equal access. In principal, congestion rationing patterns are likely to depend on the initial use of the system; if an outside-of-region load has the initial right to use regional support, this may prevent local d e m a n d from accessing most economic generation w h e n congestion occurs. This topic is subject of lively discussion in NEPOOL as the region at-
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tempts to deal with the issue of "grandfathering"--i.e., with previous commitments to use portions of the grid in a point-topoint-like manner. Hogan promotes the use of transmission congestion contracts (TCCs) as the financial means of averaging congestion costs over time. 31 That brings us back to the relationship between financial markets for hedging against transmission congestion and the physical process. Financial markets for transmission congestion must meet certain basic conditions in order to be sustainable and efficient. Oren has argued that TCCs
might give bad short term incentives. 32 In addition, we have suggested that, d e p e n d i n g on h o w the allocation rule for MS is carried out, TCCs could also lead to disincentives for long-term efficiency through inadequate transmission investments. 33 u et al. w o u l d utilize joint forward markets for energy and transmission rights. The price of transmission congestion, then, would be an inherent part of the decision-making process for each market participant (or coalition of participants). Financial hedging for congestion under that approach is not explicit. One could envision the development of submarkets for transmission access which recognize that participants m u s t trade their rights subject to overall physical constraints. That is one way to relate physical and financial rights for congestion. The curtailment m e t h o d is an implicit distribution of financial investments whose total revenue amounts to total MS. This allocation, however, can never be fair. Ilie et al. conceive of the process of providing transmission system support as a two-level dynamic process, evolving asynchronously 34at various rates, and influenced by both technical and economic feed-forward and feedback loops. There is no obvious need for any financial instruments in order to manage the system successfully in a non-discriminatory fashion. A market participant does not have a "right" to use the system. Equal access for all--properly d e f i n e d - -
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provides that right. Participants can, of course, hedge prices in energy markets in the same way risk is mitigated in other competitive industries. Those prices and hedges incorporate an estimate by the market participant of what transmission support is worth to it. Any financial mechanism by which the CMP insures itself, at a price, against variations in system conditions, is managed and developed by the CMPs and insurance firms. The ISO plays no role in the process.
VI. Conclusions In this article, we propose an iterative auction mechanism for providing transmission system services, based on a first-come, first-served basis and an ex ante estimated charge for each specific transaction based on system conditions. Each transaction would be charged for its relative impact on deterioration in system conditions, reflecting the cost of system enhancement to bring the system back to the same reliability level as before the transaction was implemented. If a subset of transactions simultaneously requests system provision, the total charge would be estimated using the same criterion. t is essential to provide this .choice to the user, given that it is impossible to curtail transactions without affecting profits for all CMPs. Since systemwide efficiency is largely a function of how developed the energy market is, our proposal rests on charging for technical impact on the system onl}z Inherent in this proposal is
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the recognition that both the ISO's models and those of the CMPs for estimating the prices and values for using the system will be approximate. The iterative auction, until the ISO and a CMP (or group of CMPs) agree on the charge for system use is, therefore, essential. Possibly most important is the fact that the charge for system use takes place whether or not the technical constraint is reached. This is essential
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for valuing transmission equipment apart from the limits of its capacit}a 35 The concept proposed for a reliability charge to transactions in an asynchronous way,-~ according to an ex ante estimated impact of their implementation on systemwide reliability, allows for a systematic way to build up resources needed for enhancing the system so that its reliability does not deteriorate as market patterns change. The job of optimizing for reliability in response to asynchronous transactions of various durations, locations and firmness is a tremendous challenge to an ISO. We fear
that in the Wu et al. proposal this process is trivialized by requiring atl CMPs to observe DC load flowbased constraints at all times of trading. It is necessary, however, to recognize that most of the transactions will impact voltage and dynamic conditions, and this will require much more sophisticated tools to impose the cost of reliability on a system user. ngineers focus on technical issues to the exclusion of pricing and industry organization. Economists assume away technical issues. Regulators push for fast solutions that satisfy legal requirements. Everybody debates the issues in an opaque prose understandable only to electricity industry reorganization mavens. Business executives whose companies could gain or lose from the restructure of the market have shuffled these indecipherable documents off to subordinates. 37 Policy-makers have decided to ignore these arcane issues, and, instead, try to extract immediate price reductions for impatient consumers. Or so it seems. That, however, leaves us with three bottom line issues: 1. Competitive positioning before the opening of the system. Presumably those suppliers who would benefit from a particular set of rules have pressed their case with the regulators and with the ISO committees. Do the suppliers who would be disadvantaged by the proposed rules realize their position, or have they signed off because their top management doesn't realize that real business issues are involved?
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a h e a d of d e r e g u l a t i o n , inhibit the
of a c o m p e t i t i v e , efficient electric-
g r o w t h of c o m p e t i t i o n b e c a u s e
ity s u p p l y industry. R e a c h i n g that
s o m e of the p o t e n t i a l c u s t o m e r s
goal requires greater a t t e n t i o n to
1996)("Ilic" 2"); M. lliG L. Hyman, E. Allen, R. Cordero, C-N Yu, Interconnected System Operations and Expense Planning in a Chan,,~ing Industry: Coordination vs. Conlpetition, in TOPICSIN
w e r e asleep d u r i n g the prelimi-
the t r a n s m i s s i o n m a r k e t t h a n w e
REGULATORY ECONOMICS A N D POLICY SE-
n a r y j o c k e y i n g for p o s i t i o n ?
h a v e seen to date. •
W o u l d the g a m i n g of the rules,
d o w a n t to see the d e v e l o p m e n t
2. G o v e r n a n c e . In s o m e w a y s ,
C M P s in the electricity m a r k e t are
Endnotes:
h a n d i n g o v e r control o v e r assets
1. L. Fink, M. Ilid, F. Galiana, Comments on FERC NOPR: Capacity Reservation Open Access Transmission Tariffs (1996) (forthcoming in ELECTRIC POWERSYST.RES.J., 1997).
a n d t r a n s a c t i o n s to a n a d d i t i o n a l tier of q u a s i - r e g u l a t o r y b o d i e s w h i c h c o u l d subject the C M P s to a r b i t r a r y or politically-determ i n e d decisions. T h e alternative w o u l d be to u s e m a r k e t f o r c e s - rather than regulation--to drive decisions. Ironically, in the r u s h to d e r e g u l a t e , r e g u l a t o r s a n d the ind u s t r y s e e m r e l u c t a n t to trust a s y s t e m that relies h e a v i l y o n m a r ket forces. 3. P u b l i c p o l i c y . P r e s u m a b l y ,
RIES 307-32 (Kluwer Academic Publishers, 1997) (" Ilid 3"); M. Ilid, A Possible Framework for Implementing Energy Transactions Into Realtime System Operation and Pricing for System Services (March 1996) (Proceedings of the EPRI Conferences on Innovative Approaches to Electricity Pricing: Managing the Transition to Market-Based Pricing) (" Ili~ 4"); M. Ilia, F., Graves, L. Fink, A. DiCaprio, A Framework for Operations in a Competitive Open Access Environment, ELEC i., April 1996, at 61 ("Ilid 5"); M. Ilic', F. Galiana, L. Fink, A. Bose, P. Mallet, H. Othman, H., Transmission Capacity in Power Networks (Aug. 1996) (Proceedings of the Power System Computation Conference, Dresden, Germany, invited survey) (" Ilid 6").
the p u r p o s e of d e r e g u l a t i o n a n d
5. Supra note 3.
the i n t r o d u c t i o n of c o m p e t i t i o n is
6. Supra note 2.
to b r i n g a b o u t a m o r e efficient
7. Ili~ 3, supra note 4.
electricity supply, w h i c h translates to l o w e r costs a n d m o r e services for c o n s u m e r s . If ISO rules of the r o a d d o n o t e n c o u r a g e a m o r e efficient o p e r a t i o n of the s y s t e m t h a n w e h a v e today, w h y b o t h e r establishing the ISO s t r u c t u r e ? If m a r k e t forces d o the job b e t t e r t h a n r e g u l a t i o n (the p r e s u m p t i o n b e h i n d the process), w h y are w e so loath to utilize m a r k e t forces to p r o d u c e a n efficient t r a n s m i s s i o n s y s t e m , or to r a t i o n t r a n s m i s s i o n services?
F
~rom a free m a r k e t standpoint, w e s h o u l d s h e d n o
tears for electricity s u p p l i e r s w h o d o n o t p a y a t t e n t i o n to w h a t t h e y sign. S o m e b u s i n e s s p e o p l e are
2. W.W. Hogan, Contract Networks for Electric Power Transnlission, 4 I. REG. ECON., at 211. 3. F.F. Wu, P. Varaiya, Coordinated Multilateral Trades for Electric Power Networks: Theory and Implementation (June 1995) (POWER Report PWR031, Univ. of Calif. Energy Inst.) (also referred to here as the Berkeley proposal). 4. M. Ilic', A Brief Survey of Present System-Wide Functions and Their Role in Distributed Energy Markets: Limits to Distribution, PROCEEDINGS OF THE AMERICAN POWER CONFERENCE
(1995)
(" Ilid 1"); M. Ilic', S.X. Liu, Hierarchical Power System Control: Its Value in a Changing Electric Power Industry, in
s m a r t e r t h a n others. T h a t ' s life.
LIMITED SER1ES ON ADVANCES IN INDUS-
But f r o m a p u b l i c p o l i c y view, w e
TRIAL CONTROL
48
(Springer-Verlag, May
8. Although the bidding regime in an energy market seems simple enough, achieving efficient generation pricing is critically dependent on the presence of market power and arbitrage involved, in particular as the markets are forming; see D. Newbery, Power Markets and Market Power, 16 ENERGYJ., 39 (1995). 9. D. Newbery, id.; H. Singh, S. Hao, A. Papalexopoulus, Power Auctions and Network Constraints, in PROCEEDINGSOF THE 13TH A N N U A L HAWAII INTERNATIONAL CONFERENCE ON SYSTEM SCIENCES,
Jan. 1997, at 608.
10. System efficiency is defined as social welfare, i.e., total demand benefit minus total generation cost 11. Observe that the profits obtained by individual market participants are expected to be the same under perfect market conditions as the profits obtained if each participant were paid only its price bid. The analysis of
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these profits is relevant for long-run incremental financing so that generation capacity installed can be p l a n n e d with the objective of m i n i m i z i n g the risk of investments a s s u m i n g that the profit resulting from the difference between the energy m a r k e t price and its operating cost ( p r e s u m a b l y close to the b i d d i n g price) is used for recovery of the investment. This problem, however, is outside the scope of this paper. Moreover, different rules for c o m p e n s a t i n g " o l d " a n d " n e w " p l a n t s create a t r a n s i t i o n a l p r o b l e m . The old p l a n t s are still g e n e r a l l y a l l o w e d to b i d their cost, w h i l e n e w g e n e r a t i o n c o u l d b i d an a r b i t r a r y price, at least in p r i n c i p l e . This has certain d i s t o r t ing effects not d i s c u s s e d here. I m p l i cations of r e q u i r e d price b i d s to be m a d e p u b l i c are also not d i s c u s s e d here, b u t are a w e l l - k n o w n c o n c e r n in their o w n right.
18. The contract path is only relevant when wheeling power, otherwise identical to postage stamp. 19. Iliff 6, supra note 4. 20. Ili~ 5, supra note 4. 21. While more recent versions of this p r o p o s a l have been described which allow for bilateral transactions, it is straightforward to show that suboptimal solutions with regard to social welfare are only possible in this case. Moreover, several questions related to the reliability versus economic impact of bilateral transactions can be raised.
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760 (1994).
29. Fink, supra note 1. 30. S.M. Harvey, W.W. H o g a n and S.L. Pope, Transmission Capacity Reservations and Transmission Congestion Contracts, at 32 (PHB, Inc., June 1996). 31. Id., at 68-76.
14. In NEPOOL these are referred to as "self-scheduled" transactions.
17. For example, maintenance scheduling is difficult to do competitively. Under present rules, an ISO generally has no a u t h o r i t y to suggest to the p o w e r p r o d u c e r an efficient maintenance schedule, for example. Some of the major costs are likely to occur because of longer-term inefficient use of this sort.
28. Z. Younes, M. IliG Physical and Financial Rights for Imperfect Electric Power Markets (May 1997) (MIT LEES WP 97-004); Newbery, supra note 8; Singh, supra note 9; A. Svoboda, S. Oren, Integrating Price-Based Resources
ON ENERGY CONVERSION,
13. O n l y short-term efficiency is discussed. For a discussion of long-term efficiency consideration, see Singh, supra note 9.
16. Exceptions to this take place only if u t i l i t y - o w n e d plants d e m o n s t r a t e that the transmission system with which they are vertically integrated does not treat them differently from the non-utility o w n e d units. Southern C o m p a n y and m a n y others have successfully p l e a d e d their case on this point and w o n the right to m a r k e t wholesale p o w e r on a market-based, rather than cost-based, basis.
27. It is i m p o r t a n t to u n d e r s t a n d that an extreme case of a multilateral transaction is actually a b i d - b a s e d pool a la Hogan.
in Short-Term Scheduling qf Electric Power Systems, 9(4) IEEE TRANSACTIONS
12. Newbery, supra note 8; Singh, supra note 9.
15. Regional jargon for some of these transactions m a y vary; e.g., in N e w England Power Pool (NEPOOL) these are referred to as bilateral.
ing gets charged or i m p l e m e n t e d before this process settles, and only then can the next request be considered. Moreover, if s i m u l t a n e o u s requests are presented, the ISO should evaluate them simultaneously. This, generally, can be shown to reduce the charge of any user. For a numerical illustration of this iterative market, see Ilig 3, supra note 4.
32. Shmuel S. Oren, Economic Ineffi-
ciency of Passive Transmission Rights in Congested Electricity Systems with Competitive Generation, 18(1) ENERGYJ., 63 22. The difference between the price all customers p a y and the price all generators are p a i d represents the merchandise surplus. In an unconstrained system, the merchandise surplus is zero. 23. M. IliG E.H. Allen, Z. Younes, Providing for Transmission in Times of Scarcity: An ISO Cannot Do it All (May 1997) (MIT LEES WP 97-003). 24. Ili~ 1-4, supra note 4. 25. This f r a m e w o r k considers transmission congestion just as one component of the b r o a d e r system s u p p o r t n e e d e d to make the requested transaction feasible. 26. The iterations only take place between the user and the ISO at the time the CMP asks to use the system; noth-
(1997). 33. Younes, supra note 28. 34. Asynchronous, in this context, means served as requested---one at a time or simultaneously. Priority w o u l d be d e t e r m i n e d b y the time requested, duration, firmness, etc. 35. P. Lerner, Valuing Transmission Capacity U n d e r O p e n Access (May 1997) (Masters Thesis, Technology Policy Program, MIT). 36. Supra note 34. 37. This is, perhaps, akin to the issues raised b y P a r k i n s o n ' s Law of Triviality. People tend to s p e n d their time deciding issues that they u n d e r s t a n d . See C. NORTHCOTE PARKINSON, PARKINSON'S LAW AND OTHER STUDIES 3 9 - 4 9
(Ballan-
tine Books, 1975).
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Marija Ilid, Leonard Hyman, Eric Allen and Ziad Younes
p
pricing transmission during periods of scarcity? Haven't we heard enough about transmission? It's over, isn't it? The utilities will hand control of transmission to a non-profit committee whose rules of governance and means of financing remain indeterminate. Those organizations, in isolation or cooperatively, will develop pricing plans, which will all produce the lower of market or rate of return on rate base. Academics from Harvard, Berkeley, and MIT have promoted competing schemes for pricing during periods of transmission scarcity, all of which will keep the lights on. The Harvard scheme is out front, so when will the losers stop carping?
Anyway, say unconcerned utility executives--busy with downsizing and securitization and foreign investments--the feds and the state regulators told us to do it. So we'll do it. And it won't hurt the bottom line. Of course they said the same sort of thing about nuclear power plants, overpriced purchased power contracts, and other regulatory impositions. The regulator told us to do it. Like other such seemingly harmless regulatory impositions, this one could cost them money. That is the point of this article. The choice of a system of pricing and rationing during periods of transmission scarcity has business consequences. It is too important
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to delegate to committees without first giving it the utmost attention.
I. The Issues The transmission network was not built for the extent of the transactions we anticipate in the competitive market. For that matter, it was not built for the current distribution of population, dem a n d for power, and likely shifts in generation patterns. With so m a n y environmental constraints imposed on it and a rate of return regime set for it, transmission improvements m a y not keep up with need. Scarcity of transmiss i o n - a n d its pricing and provision---could be a serious issue. The debate about h o w transmission service should be provided in time of scarcity has centered on several concepts: making the grid equally available to all loads at the same price on a pro-rata basis, ~nodal-price-based congestion pricing, 2 market-based determination of transmission use subject to physical curtailment, 3 and a market-based system that permits participants to ration their o w n use based on pricing considerations. 4 lthough the various proposals and assessments thereof have inundated policy makers, there is still a paucity of publication of simulation or experimental work that illustrates the differences between the proposals. This article analyzes three of the proposals for transmission pricing: those of Wu et al., 5 Hogan 6 and Ilid et al., 7 for the constraints they impose on the market. It compares the three proposals conceptually and draws
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conclusions about their differences, with emphasis on h o w those differences may affect the functioning of the marketplace. Of course, we recognize that these proposals differ in their treatment of the market system and its dynamics. For example, Hogan assumes that provision of system support is an integral part of the energy market, both of which are
The transmission network was not built for the current distribution of population, demand for power, or shifts in generation patterns.
ISO-managed. Wu et al. and Ili~ et al., by contrast, would have basic functional separation of the energy market and transmission system markets. Given this distinction, we will briefly describe the objectives of the energy markets in competitive power industry and issues related to their efficiencN without consideration for system externalities such as system constraints. Then we will examine questions unique to transmission system support, the principal topic of this article. Finally, concerning the fundamental limitations on the ISO's effectiveness in facilitating the market,
we argue that an ISO can have little effect on basic energy market efficiency, and that its key role is to provide and price transmission system services. e conclude that a functional separation between ISOs and energy markets is technically and economically justifiable. This issue was a subject of m u c h debate in California prior to that state's adoption of a structure that functionally separates the energy market from the ISO. In the Northeast, however, most proposals for restructuring of tight power pools (New England, New York, PJM) do not incorporate this functional separation. We argue here that it is not possible to build a technically sound case for keeping the two functions under the same umbrella of an ISO. To start with, we assume that at least in concept there is a fundamental difference between the energy market objectives and the objectives of system support.
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II. Energy Markets without Congestion Under open access, efficient pricing for generation is complicated, even in the simplest case, w h e n no transmission charges are accounted for. 8 The impact of an ISO that is in charge of approving various transactions on systemwide efficiency then becomes a function of the market (industry) structure adopted. To clarify this, consider the three most typical market structures debated: (1) a price-bid-based scheduling by a mandatory ISO; (2) an entirely multilateral energy market, with 39
an ISO being a provider of transmission services; and (3) a pricebid-based scheduling by a voluntary ISO.
A. Mandatory ISO Most bid-based ISOs evolving in the United States have proposed a so-called Dutch auction, similar to the United K i n g d o m ' s m a n d a t o r y poolco structure. 9 Transactions are scheduled according to their price bids in merit order (the least expensive units are fully scheduled), and there is only one so-called marginal unit which is partly used. The price of this unit determines the energy clearing price which is paid to all, even to those with m u c h lower bids than the clearing price. Under this structure, assuming that price bids are close to generation cost, an ISO has a clear measure of system efficiency1° under its jurisdiction. The short-term efficiency formula used by a mandatory ISO is identical to the formula presently used in a regulated industry, with the difference that cost is replaced by the bid price. 11 ~or the purpose of understanding the notion of systemwide efficiency as a function of energy market structure, it suffices to recognize that an ISO can be held responsible for efficient real-time use of resources in the area under its control in a mandatory ISO structure, and that the measure of efficiency is well defined. In other words, it does make sense to bundle the energy market with the system services
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provision in this type of market structure.
B. Entirely Multilateral Energy Market An entirely multilateral market assumes an arbitrary structure of market players in which competitive market participants (CMPs), or groups of them, directly negotiate energy prices for their sales and purchases. An ISO is not
In mature, large and sufficiently fluid markets the systemwide optimum is achievable without having to make prices public, at least in theory.
given the prices of energy sales in this model. Basic decision making in such markets is identical to supp l y / d e m a n d decisions in other competitive industries. Under perfect market conditions all shortrun marginal prices are the same, and the same economic equilibrium as in a mandatory ISO structure is reached. To understand the impact and responsibilities of an ISO in this structure, recognize that multilateral markets are often far from the actual economic equilibrium, especially for an industry in transition. 12 Consequently, the shortrun marginal price at which
multilateral deals are established could vary drastically, and no single energy market price w o u l d be known. In a market-structure like this, an ISO cannot be responsible for efficient use and distribution of energy across the system, since it is not given basic economic data. The main role of the ISO would be in facilitating market needs, i.e., helping to implement transactions. In other words, the ISO does not have a measure of systemwide efficiency in terms of facilitating the least expensive s u p p l y / d e m a n d deals. The ISO cannot influence efficiency explicitly in an entirely multilateral market. Ystemwide efficiency in multilateral markets is influenced, instead, by the activities of individual market participants. In mature, large and sufficiently fluid markets the systemwide opt i m u m is achievable without having to make prices public, at least in theory 13
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C. Voluntary ISO/PX Here we examine a voluntary ISO-assisted energy market without any consideration for transmission system support first; only the ISO's role as a power exchange mechanism is a n a l y z e d - i.e., the PX portion of the ISO. We can characterize the typical bid-based pool structure that is u n d e r active consideration in m a n y parts of the United States as including at least three types of economic transactions: (1) price-based bids directly into an ISO, scheduled according to merit; (2) strictly multilateral
The Electricity Journal
transactions which, given the permission of the ISO, physically inject p o w e r into one location and take out the same a m o u n t at another, with the price of these transactions not m a d e k n o w n to the ISO;TM (3) transactions between a p o w e r p r o d u c e r and the ISO, as in the U.K. system, in which the ISO schedules and determines h o w m u c h the transaction is worth, b u t the market participant m a y have another, strictly financial agreement with a third party to h e d g e against variations in the price d e t e r m i n e d by the ISO. 15 All utility-owned units presumably belong to category (1), since they are still regulated by the Federal Energy Regulatory Commission and must price sales on a cost basis) ~ The other two categories typically involve independent power producers (IPPs), which are paid the full market-clearing price, as long as they are scheduled. This market structure can be viewed as being "nested" relative to traditional horizontal structures in a regulated utility organization. The ISO, which is in charge of providing system services to all, only knows the bid prices of parties belonging to categories (1) and (3). As in the case of an entirely multilateral market structure, the ISO is not given energy prices at which multilateral trades take place. n this case the ISO cannot be held responsible for systemwide efficient operation in terms of system efficienc}¢ or for relatively price-inelastic load in terms of generation cost. There is no
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well established definition of efficiency in this case. Here an ISO is just a particular submarket in a larger market structure. This kind of "voluntary" ISO has not been studied at all with respect to its impact on achieving systemwide efficiency, or incentives to the ISO and market participants to do so. An ISO can be fully responsible for system efficiency only in a
There is a problem with assuming an ideal market. In fact, there wilt be decided advantages for some parties in a bilateralonly market
mandatory ISO market structure. In other market structures, even the basic definition of the market depends on the quality of the multilateral market. This concept is essential to understanding the role of an ISO in providing efficient and non-discriminatory transmission service to all. It is conceivable that under the wrong conditions the ISO could run a system that is less efficient than the one we have n o w . 17 That certainly would be an undesirable outcome after so m u c h effort to harness market forces in order to increase electric industry efficienc}t
D. Role of the ISO in Determining "Fair' Profit Allocation In a mandatory ISO market structure, an ISO schedules use of price-bidding-based generation to meet anticipated d e m a n d by putting in service the cheapest units first. The energy clearing price, however, is determined by the highest bid power plant which is actually scheduled. As long as a plant is used, it is paid its price bid or more. Since an ISO schedules power plants so that the total (systemwide) price of meeting dem a n d is minimized, this is the best it can do. ccording to the basic laws of competitive economics, the system equilibrium obtained by this ISO's coordinated price minimization and the equilibrium obtained in an entirely multilateral market result in the same market solution. Provided that a unique market equilibrium exists, the profit allocation to individual market participants, at which individual oppor~mities for profit are small, is the same as the profit allocation determined by the ISO's coordinated computation at which all short-run marginal prices are the same. Consequentl~ the ISO-based profit allocation is equivalent to the profits obtainable on multilateral markets. Of course, there is a problem with assuming an ideal market. In point of fact, there will be decided information, knowledge and other advantages for some participants in a bilateral-only m a r k e t - especially one with system con-
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straints--so that making an assumption of ideal conditions is less than useful. However, an ISOcoordinated scheduling has its own share of potential problems. Potentially the most critical one deals with collusion problems leading to cartel-like arrangements. Learning effective patterns for collusion of this type is much easier in an ISO-based energy market, which provides all CMPs in a repetitive manner the economic information needed to do
then nothing further needs to be done. However, if at least one line flow exceeds the maximum allowed limit, then the allowed transactions are curtailed to the fewer quantities that are feasible. In this section we briefly survey methods for transmission system support for the type of fundamental restrictions that allowed transactions impose on system users. The simplest proposal assumes
SO.
The role of an ISO becomes much more delicate when insufficient system support exists to facilitate the most desirable transactions arrived at through energy market mechanisms. Most of what follows is concerned with the imposition of transmission constraints on market outcomes, and on a possible "good" transmission strategy.
III. Congestion Constraints in the Marketplace In many networks, the operating point that results from market driven forces produces line flows that exceed allowable operating limits. In these cases, an independent system operator (ISO) must curtail some or all of the power transactions in order to permit safe, reliable system operation. e presume that after all curtailments have been scheduled, an ISO determines whether the total set of transactions is feasible on the n e t w o r k - i.e. meets all line flow constraints. If the transactions are feasible,
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that all transactions will be given equal access to use the system, and that the charge for using the system would be such that the transmission system revenue recovered from all users is based on their relative share of power injected into the system. The industry has often embraced this approach. It is fairly straightforward to relate this approach to what is known as a postage stamp approach; the two are equivalent as long as the transmission use is charged for at a single system level, such as pool or region. This is what has effectively been proposed by NEPOOL recently as the
charge for regional network service. imilar formulae intended to charge according to amount of power wheeled become more complicated when the same region serves energy transactions that originate a n d / o r terminate outside the region providing system support. The charge for service of this type is known as wheeling or point-to-point charge for transmission and is most frequently calculated using the notion of a contract path as the most likely transmission path needed to accommodate a specific transaction. FERC, in Order 888, in effect advocates equal access to all system users, even beyond traditional system boundaries, and the basic postage stamp/contract path approach to pricing. 18 FERC and everyone else admits that postage stamp/contract path has been no more than a convenient fiction to be replaced by more adequate usage-based methods, such as MW-mile method or its variations. Several industry groups are actively working toward implementing real-time data processing for this type of transmission pricing. The main issue here is that no specific "path" can be defined, since the physical flows are likely to change throughout the interconnection, and that if the transmission revenue is to be recovered based on usage, more accurate formulae will have to be implemented. It is essential to recognize that pricing methods such as postage stamp, contract path and MWmile method serve the purpose of
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recovering just the revenue requirements of the existing transmission grid. The main problem of interest here is h o w to charge for enhancing a transmission system so that it retains an acceptable reliability level as it attempts to acc o m m o d a t e transactions requested by the energy market. This issue is directly related to the congestion pricing problem. The challenge is to price for transmission scarcity so that the system is enhanced. hen a set of proposed transactions is constrained, an ISO m u s t decide h o w to ration system service. That decision is a function of the type of information available to the ISO. If no economic information is given, the only basis for reduction is strictly technical. The technical reliability criteria, however, are not uniquely defined at present. That leaves room for substantially different solutions, ranging from simply rejecting all users by the same amount, to rejecting the transactions to which the physical constraints are most sensitive. 19It will be critical to provide the ISOs, as soon as possible, with some guidelines concerning what constitutes "equal (physical) access" in the changing industry This issue becomes even worse once the temporal aspects of technical feasibility enter the problem. Defining equal access is just as difficult w h e n computing the socalled available transmission capacity (ATC). It is not fully recognized, for instance, that ATC for a multilateral transaction is different from ATC for the same
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a m o u n t of power for transactions scheduled by a n I S O . 2° On the other hand, if we assume an industry structure in which both technical and economic information is made available to the ISO, the question of "equal access" becomes even more complex. Would the ISO declare certain power transactions to be feasible on a strictly technical basis, or should it compromise between economics and reliability? For that matter, would the ISO distinguish between transactions for social or political reasons (priority for w i n d p o w e r or orphanages)? To complicate issues further, industry proposals for restructuring already differentiate between the load curtailment procedures as financial rights which are used for accounting purposes only (which are typically pro rata load-sharebased), and the curtailment to be done in real time by an ISO. It is not clear where these two meet. In the next section, we briefly summarize and analyze the three proposals for transmission system support, each of which implies a
different type of transmission system service and pricing. Despite the technical nature and seeming neutrality of the proposals, they yield different market outcomes for different players.
IV. Three Proposals for Transmission System Support Transmission system service frameworks have been proposed by Professor William Hogan at Harvard, Professor Felix Wu and his colleagues at Berkeley and Dr. Ili~ et al. at MIT. Professor Hogan's proposal has received wide visibility, and, like Wu, is discussed only for its features of interest here. The proposal by Iliff et al., although conceived some time ago, m a y not be familiar to m a n y readers and is described here to point out its qualitative features which differ from the other two proposals.
A. The Hogan Approach This proposal envisions a very active role for the ISO in determining prices for transmission service under system constraints. The en-
.....
2 -_ 2 2
~: ~ . - _ -
-.
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ergy market and transmission system provision are functionally and economically bundled. In its purest form, the proposal assumes that all CMPs are scheduled b y an ISO, and that energy price bids are fully k n o w n by the ISO. 21 Transmission pricing is based on ex post settlement after real-time static optimal power flow-based nodal prices are computed. There are two features of interest concerning the impact of this pricing scheme on individual users: First, d e p e n d i n g on h o w the merchandise surplus (MS) is allocated, one will see different impacts on the profits of individual C M P s . 22 Tellingly, it is conceptually impossible for an ISO to allocate the MS in a fair way, without having defined the criterion for economic fairness in a voluntary ISO, particularly since a different type of information is being p r o v i d e d by the ISOscheduled CMPs than for the multilateral transactions. (Recall that the ISO-scheduled transactions provide price bids for selling a n d / o r purchasing power, and the multilateral deals are not required to reveal their financial terms.) n the Hogan approach, financial hedging against large deviations of nodal prices is provided by means of transmission congestion contracts (TCCs), which are entirely financial instruments potentially uncorrelated with the expected value of transmission to the market participants purchasing these rights. These financial instruments (in particular
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their initial allocation) again, rely strongly on the ISO.
B. The Berkeley Approach The method proposed by Wu et al. has three basic steps: (1) All buyers and sellers negotiate in an open energy market and agree to trades which benefit all participants. The resulting energy price in the market is the uncongested price of electricity (the en-
In the Hogan approach,financial hedging against large deviations of nodal prices is provided by means of transmission congestion contracts.
ergy clearing price). (2) An ISO considers the complete set of proposed transactions and examines whether the set is feasible, i.e., does not produce any transmission line flows which exceed m a x i m u m thermal, voltage and dynamic limits determined by the ISO. If the set is feasible, no further action is needed and all proposed transactions are made. However, if line flow limit is violated, then the ISO must curtail some or all of the proposed transactions so that the line flow limit is not exceeded. The transactions that are permitted are made at the price originally agreed u p o n - - t h e
uncongested price. The ISO will also supply information to all market participants on h o w further trades m a y be m a d e without violating line flow limits. (3) The information from the ISO would, for example, allow a load to b u y more power from a generator, but only if that load simultaneously sells a given fraction of that power in order that the transaction not exceed system constraints. In this manner, submarkets for electricity in a postcongested network are formed. Trades take place in the new submarkets, and the resulting transactions bring the system to a point of o p t i m u m social welfare. he final outcomes in the two-tiered market are not affected by the ISO's choice of curtailment levels. The curtailment affects only h o w m u c h power is priced at the uncongested price and h o w m u c h is priced according to the post-congested market. 23
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C. A Two-Level Iterative Market The two-level market structure proposed by Ili~ et al. 24works differently from the other two proposals. Here are its basic steps: (1) The energy market evolves at the first level, concerned only with the financial arrangements for purchasing power in the most beneficial way, without any consideration of charges for system support, zs Prices of transactions are not public; this depends on the type of energy market (PX) in place. (2) Those making various transactions approach the ISO asynchronously--i.e., r a n d o m l y - - n o t The Electricity Journal
in a planned or coordinated w a y - - a n d request implementation of their respective transactions. (3) The ISO--based on the information about (a) transaction location, (b) duration and starting time, and (c) firmness of transaction estimates the total expected charge for system support to make this transaction feasible, while keeping the level of reliability unchanged. This information is sent back to the potential system user, which re-evaluates its intent to make the transaction using the information about the system charge as one aspect of its deterruination. The firm making the transaction is likely to iterate this information with the ISO several times before it actually settles on the a m o u n t and type of transaction served by the system. 2~As we have said, this process converges to the same social welfare solution as a mandatory ISO without the ISO having to mandate either the congestion price or the information about the sale, which could be PX-based or multilateral. 27
T
he key differences between this proposal and the others
are: • This proposal takes into consideration the expected cost of the transaction ex ante. Participants k n o w what they will pay before, not after, the transaction. • This proposal captures intertemporal effects, w h e n serving transactions of varying types. • It allows full freedom for the system user to make decisions regarding quantity and price of the
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transaction, including charges for system support, without mandating a pre-specified pattern of power or price control. It is important to observe that a typical system design for normal operation is not fully optimized to accommodate present needs without having any transmission congestion. However, the system is optimized to the point of having a meaningful balance between cost
And financial hedging is uncorrelated with real-time physical processes, isn't it ? But that type of thinking leads to erroneous conclusions.
of transmission support and use of more expensive generation for given g e n e r a t i o n / d e m a n d patterns. As a system is exposed to requests to accommodate n e w transactions, the present operation could be used as a point of reference from which future reliability is measured. It is likely that some transactions will improve the reliability level, and, as such should be paid by the ISO, and not charged for using the system.
V. Implied Financial Instruments When analyzing real-time operations, there is a tendency to
view the question of financial transmission rights as a non-issue. After all, financial transmission capacity rights don't affect economic dispatch, right? For that matter, financial hedging is uncorrelated with real-time physical processes, isn't it? That type of thinking, however, leads to erroneous conclusions. When the provision of transmission service is viewed in the context of proposed energy market mechanisms, it becomes easier to understand interactions of technical and financial processes and their implications for system users. When the markets are just beginning to form, not understanding the process could have pronounced financial consequences on individual market participants, since the system is not at equilibrium--i.e., the energy costs and costs of transmission system services will not be equal to the prices charged. A correction of price toward cost could surprise some system participants, disadvantage them in planned transactions, and upset strategies based on incorrect assumptions about prices. At least in principle, the same w o u l d be equally true for transmission. nderstanding these relationships w o u l d require development of more sophisticated tools than those presently available to ISOs. If an ISO were p u t in charge of the energy market as well as in charge of system provision (as in the U.K.), it w o u l d be effective only if it engages in development of more sophisticated tools than those pres-
U
45
ently available. Ideally, an ISO will develop software to permit parties to engage in trading of financial derivatives relevant to planning efficient use of power on weekly and monthly bases, including system maintenance needs. (This is one of the big missing pieces w h e n only a spot market exists.) Until now, little attention has been paid to the inter-temporal dependencies between financial and physical processes, and to the potential danger of some CMPs gaming the energy market. 28 Having all the required tools is even more important for the transmission market because that market m u s t provide service to all in a non-discriminatory fashion. ooking at the congestion rationing approach that uses an equal price for all and distributes use of the network on a pro r a t a basis, 29we find an implied financial instrument that requires further clarification. Independently of h o w m u c h power is served by the system (a matter decided by the ISO in real-time operation), the congestion price is settled on the basis of pro rata share of load. This type of financial instrument does not involve the participation of insurance companies or other risk hedging devices, since the congestion price is simply a settlement matter, as it is n o w in some tight power pools. An initial allocation of financial rights to system users 3° could be highly discriminator?6 and there is no way of allocating these in a fair way. Particular loads should not receive rights at no cost. This
would be discriminatory to others, and would violate basic principle of equal access. In principal, congestion rationing patterns are likely to depend on the initial use of the system; if an outside-of-region load has the initial right to use regional support, this may prevent local d e m a n d from accessing most economic generation w h e n congestion occurs. This topic is subject of lively discussion in NEPOOL as the region at-
...........
¸
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46
tempts to deal with the issue of "grandfathering"--i.e., with previous commitments to use portions of the grid in a point-topoint-like manner. Hogan promotes the use of transmission congestion contracts (TCCs) as the financial means of averaging congestion costs over time. 31 That brings us back to the relationship between financial markets for hedging against transmission congestion and the physical process. Financial markets for transmission congestion must meet certain basic conditions in order to be sustainable and efficient. Oren has argued that TCCs
might give bad short term incentives. 32 In addition, we have suggested that, d e p e n d i n g on h o w the allocation rule for MS is carried out, TCCs could also lead to disincentives for long-term efficiency through inadequate transmission investments. 33 u et al. w o u l d utilize joint forward markets for energy and transmission rights. The price of transmission congestion, then, would be an inherent part of the decision-making process for each market participant (or coalition of participants). Financial hedging for congestion under that approach is not explicit. One could envision the development of submarkets for transmission access which recognize that participants m u s t trade their rights subject to overall physical constraints. That is one way to relate physical and financial rights for congestion. The curtailment m e t h o d is an implicit distribution of financial investments whose total revenue amounts to total MS. This allocation, however, can never be fair. Ilie et al. conceive of the process of providing transmission system support as a two-level dynamic process, evolving asynchronously 34at various rates, and influenced by both technical and economic feed-forward and feedback loops. There is no obvious need for any financial instruments in order to manage the system successfully in a non-discriminatory fashion. A market participant does not have a "right" to use the system. Equal access for all--properly d e f i n e d - -
W
The Electricity Journal
provides that right. Participants can, of course, hedge prices in energy markets in the same way risk is mitigated in other competitive industries. Those prices and hedges incorporate an estimate by the market participant of what transmission support is worth to it. Any financial mechanism by which the CMP insures itself, at a price, against variations in system conditions, is managed and developed by the CMPs and insurance firms. The ISO plays no role in the process.
VI. Conclusions In this article, we propose an iterative auction mechanism for providing transmission system services, based on a first-come, first-served basis and an ex ante estimated charge for each specific transaction based on system conditions. Each transaction would be charged for its relative impact on deterioration in system conditions, reflecting the cost of system enhancement to bring the system back to the same reliability level as before the transaction was implemented. If a subset of transactions simultaneously requests system provision, the total charge would be estimated using the same criterion. t is essential to provide this .choice to the user, given that it is impossible to curtail transactions without affecting profits for all CMPs. Since systemwide efficiency is largely a function of how developed the energy market is, our proposal rests on charging for technical impact on the system onl}z Inherent in this proposal is
l
July 1997
the recognition that both the ISO's models and those of the CMPs for estimating the prices and values for using the system will be approximate. The iterative auction, until the ISO and a CMP (or group of CMPs) agree on the charge for system use is, therefore, essential. Possibly most important is the fact that the charge for system use takes place whether or not the technical constraint is reached. This is essential
~
~~
"-___2~,___~
for valuing transmission equipment apart from the limits of its capacit}a 35 The concept proposed for a reliability charge to transactions in an asynchronous way,-~ according to an ex ante estimated impact of their implementation on systemwide reliability, allows for a systematic way to build up resources needed for enhancing the system so that its reliability does not deteriorate as market patterns change. The job of optimizing for reliability in response to asynchronous transactions of various durations, locations and firmness is a tremendous challenge to an ISO. We fear
that in the Wu et al. proposal this process is trivialized by requiring atl CMPs to observe DC load flowbased constraints at all times of trading. It is necessary, however, to recognize that most of the transactions will impact voltage and dynamic conditions, and this will require much more sophisticated tools to impose the cost of reliability on a system user. ngineers focus on technical issues to the exclusion of pricing and industry organization. Economists assume away technical issues. Regulators push for fast solutions that satisfy legal requirements. Everybody debates the issues in an opaque prose understandable only to electricity industry reorganization mavens. Business executives whose companies could gain or lose from the restructure of the market have shuffled these indecipherable documents off to subordinates. 37 Policy-makers have decided to ignore these arcane issues, and, instead, try to extract immediate price reductions for impatient consumers. Or so it seems. That, however, leaves us with three bottom line issues: 1. Competitive positioning before the opening of the system. Presumably those suppliers who would benefit from a particular set of rules have pressed their case with the regulators and with the ISO committees. Do the suppliers who would be disadvantaged by the proposed rules realize their position, or have they signed off because their top management doesn't realize that real business issues are involved?
E
47
a h e a d of d e r e g u l a t i o n , inhibit the
of a c o m p e t i t i v e , efficient electric-
g r o w t h of c o m p e t i t i o n b e c a u s e
ity s u p p l y industry. R e a c h i n g that
s o m e of the p o t e n t i a l c u s t o m e r s
goal requires greater a t t e n t i o n to
1996)("Ilic" 2"); M. lliG L. Hyman, E. Allen, R. Cordero, C-N Yu, Interconnected System Operations and Expense Planning in a Chan,,~ing Industry: Coordination vs. Conlpetition, in TOPICSIN
w e r e asleep d u r i n g the prelimi-
the t r a n s m i s s i o n m a r k e t t h a n w e
REGULATORY ECONOMICS A N D POLICY SE-
n a r y j o c k e y i n g for p o s i t i o n ?
h a v e seen to date. •
W o u l d the g a m i n g of the rules,
d o w a n t to see the d e v e l o p m e n t
2. G o v e r n a n c e . In s o m e w a y s ,
C M P s in the electricity m a r k e t are
Endnotes:
h a n d i n g o v e r control o v e r assets
1. L. Fink, M. Ilid, F. Galiana, Comments on FERC NOPR: Capacity Reservation Open Access Transmission Tariffs (1996) (forthcoming in ELECTRIC POWERSYST.RES.J., 1997).
a n d t r a n s a c t i o n s to a n a d d i t i o n a l tier of q u a s i - r e g u l a t o r y b o d i e s w h i c h c o u l d subject the C M P s to a r b i t r a r y or politically-determ i n e d decisions. T h e alternative w o u l d be to u s e m a r k e t f o r c e s - rather than regulation--to drive decisions. Ironically, in the r u s h to d e r e g u l a t e , r e g u l a t o r s a n d the ind u s t r y s e e m r e l u c t a n t to trust a s y s t e m that relies h e a v i l y o n m a r ket forces. 3. P u b l i c p o l i c y . P r e s u m a b l y ,
RIES 307-32 (Kluwer Academic Publishers, 1997) (" Ilid 3"); M. Ilid, A Possible Framework for Implementing Energy Transactions Into Realtime System Operation and Pricing for System Services (March 1996) (Proceedings of the EPRI Conferences on Innovative Approaches to Electricity Pricing: Managing the Transition to Market-Based Pricing) (" Ili~ 4"); M. Ilia, F., Graves, L. Fink, A. DiCaprio, A Framework for Operations in a Competitive Open Access Environment, ELEC i., April 1996, at 61 ("Ilid 5"); M. Ilic', F. Galiana, L. Fink, A. Bose, P. Mallet, H. Othman, H., Transmission Capacity in Power Networks (Aug. 1996) (Proceedings of the Power System Computation Conference, Dresden, Germany, invited survey) (" Ilid 6").
the p u r p o s e of d e r e g u l a t i o n a n d
5. Supra note 3.
the i n t r o d u c t i o n of c o m p e t i t i o n is
6. Supra note 2.
to b r i n g a b o u t a m o r e efficient
7. Ili~ 3, supra note 4.
electricity supply, w h i c h translates to l o w e r costs a n d m o r e services for c o n s u m e r s . If ISO rules of the r o a d d o n o t e n c o u r a g e a m o r e efficient o p e r a t i o n of the s y s t e m t h a n w e h a v e today, w h y b o t h e r establishing the ISO s t r u c t u r e ? If m a r k e t forces d o the job b e t t e r t h a n r e g u l a t i o n (the p r e s u m p t i o n b e h i n d the process), w h y are w e so loath to utilize m a r k e t forces to p r o d u c e a n efficient t r a n s m i s s i o n s y s t e m , or to r a t i o n t r a n s m i s s i o n services?
F
~rom a free m a r k e t standpoint, w e s h o u l d s h e d n o
tears for electricity s u p p l i e r s w h o d o n o t p a y a t t e n t i o n to w h a t t h e y sign. S o m e b u s i n e s s p e o p l e are
2. W.W. Hogan, Contract Networks for Electric Power Transnlission, 4 I. REG. ECON., at 211. 3. F.F. Wu, P. Varaiya, Coordinated Multilateral Trades for Electric Power Networks: Theory and Implementation (June 1995) (POWER Report PWR031, Univ. of Calif. Energy Inst.) (also referred to here as the Berkeley proposal). 4. M. Ilic', A Brief Survey of Present System-Wide Functions and Their Role in Distributed Energy Markets: Limits to Distribution, PROCEEDINGS OF THE AMERICAN POWER CONFERENCE
(1995)
(" Ilid 1"); M. Ilic', S.X. Liu, Hierarchical Power System Control: Its Value in a Changing Electric Power Industry, in
s m a r t e r t h a n others. T h a t ' s life.
LIMITED SER1ES ON ADVANCES IN INDUS-
But f r o m a p u b l i c p o l i c y view, w e
TRIAL CONTROL
48
(Springer-Verlag, May
8. Although the bidding regime in an energy market seems simple enough, achieving efficient generation pricing is critically dependent on the presence of market power and arbitrage involved, in particular as the markets are forming; see D. Newbery, Power Markets and Market Power, 16 ENERGYJ., 39 (1995). 9. D. Newbery, id.; H. Singh, S. Hao, A. Papalexopoulus, Power Auctions and Network Constraints, in PROCEEDINGSOF THE 13TH A N N U A L HAWAII INTERNATIONAL CONFERENCE ON SYSTEM SCIENCES,
Jan. 1997, at 608.
10. System efficiency is defined as social welfare, i.e., total demand benefit minus total generation cost 11. Observe that the profits obtained by individual market participants are expected to be the same under perfect market conditions as the profits obtained if each participant were paid only its price bid. The analysis of
The Electricity Journal
these profits is relevant for long-run incremental financing so that generation capacity installed can be p l a n n e d with the objective of m i n i m i z i n g the risk of investments a s s u m i n g that the profit resulting from the difference between the energy m a r k e t price and its operating cost ( p r e s u m a b l y close to the b i d d i n g price) is used for recovery of the investment. This problem, however, is outside the scope of this paper. Moreover, different rules for c o m p e n s a t i n g " o l d " a n d " n e w " p l a n t s create a t r a n s i t i o n a l p r o b l e m . The old p l a n t s are still g e n e r a l l y a l l o w e d to b i d their cost, w h i l e n e w g e n e r a t i o n c o u l d b i d an a r b i t r a r y price, at least in p r i n c i p l e . This has certain d i s t o r t ing effects not d i s c u s s e d here. I m p l i cations of r e q u i r e d price b i d s to be m a d e p u b l i c are also not d i s c u s s e d here, b u t are a w e l l - k n o w n c o n c e r n in their o w n right.
18. The contract path is only relevant when wheeling power, otherwise identical to postage stamp. 19. Iliff 6, supra note 4. 20. Ili~ 5, supra note 4. 21. While more recent versions of this p r o p o s a l have been described which allow for bilateral transactions, it is straightforward to show that suboptimal solutions with regard to social welfare are only possible in this case. Moreover, several questions related to the reliability versus economic impact of bilateral transactions can be raised.
July 1997
760 (1994).
29. Fink, supra note 1. 30. S.M. Harvey, W.W. H o g a n and S.L. Pope, Transmission Capacity Reservations and Transmission Congestion Contracts, at 32 (PHB, Inc., June 1996). 31. Id., at 68-76.
14. In NEPOOL these are referred to as "self-scheduled" transactions.
17. For example, maintenance scheduling is difficult to do competitively. Under present rules, an ISO generally has no a u t h o r i t y to suggest to the p o w e r p r o d u c e r an efficient maintenance schedule, for example. Some of the major costs are likely to occur because of longer-term inefficient use of this sort.
28. Z. Younes, M. IliG Physical and Financial Rights for Imperfect Electric Power Markets (May 1997) (MIT LEES WP 97-004); Newbery, supra note 8; Singh, supra note 9; A. Svoboda, S. Oren, Integrating Price-Based Resources
ON ENERGY CONVERSION,
13. O n l y short-term efficiency is discussed. For a discussion of long-term efficiency consideration, see Singh, supra note 9.
16. Exceptions to this take place only if u t i l i t y - o w n e d plants d e m o n s t r a t e that the transmission system with which they are vertically integrated does not treat them differently from the non-utility o w n e d units. Southern C o m p a n y and m a n y others have successfully p l e a d e d their case on this point and w o n the right to m a r k e t wholesale p o w e r on a market-based, rather than cost-based, basis.
27. It is i m p o r t a n t to u n d e r s t a n d that an extreme case of a multilateral transaction is actually a b i d - b a s e d pool a la Hogan.
in Short-Term Scheduling qf Electric Power Systems, 9(4) IEEE TRANSACTIONS
12. Newbery, supra note 8; Singh, supra note 9.
15. Regional jargon for some of these transactions m a y vary; e.g., in N e w England Power Pool (NEPOOL) these are referred to as bilateral.
ing gets charged or i m p l e m e n t e d before this process settles, and only then can the next request be considered. Moreover, if s i m u l t a n e o u s requests are presented, the ISO should evaluate them simultaneously. This, generally, can be shown to reduce the charge of any user. For a numerical illustration of this iterative market, see Ilig 3, supra note 4.
32. Shmuel S. Oren, Economic Ineffi-
ciency of Passive Transmission Rights in Congested Electricity Systems with Competitive Generation, 18(1) ENERGYJ., 63 22. The difference between the price all customers p a y and the price all generators are p a i d represents the merchandise surplus. In an unconstrained system, the merchandise surplus is zero. 23. M. IliG E.H. Allen, Z. Younes, Providing for Transmission in Times of Scarcity: An ISO Cannot Do it All (May 1997) (MIT LEES WP 97-003). 24. Ili~ 1-4, supra note 4. 25. This f r a m e w o r k considers transmission congestion just as one component of the b r o a d e r system s u p p o r t n e e d e d to make the requested transaction feasible. 26. The iterations only take place between the user and the ISO at the time the CMP asks to use the system; noth-
(1997). 33. Younes, supra note 28. 34. Asynchronous, in this context, means served as requested---one at a time or simultaneously. Priority w o u l d be d e t e r m i n e d b y the time requested, duration, firmness, etc. 35. P. Lerner, Valuing Transmission Capacity U n d e r O p e n Access (May 1997) (Masters Thesis, Technology Policy Program, MIT). 36. Supra note 34. 37. This is, perhaps, akin to the issues raised b y P a r k i n s o n ' s Law of Triviality. People tend to s p e n d their time deciding issues that they u n d e r s t a n d . See C. NORTHCOTE PARKINSON, PARKINSON'S LAW AND OTHER STUDIES 3 9 - 4 9
(Ballan-
tine Books, 1975).
49