ELECTRICITY MARKET DESIGN:

Coordination, Pricing and Incentives

William W. Hogan

Mossavar-Rahmani Center for Business and Government

John F. Kennedy School of Government
Harvard University
Cambridge, Massachusetts 02138

ERCOT Energized Conference

Austin, TX

May 2, 2008
ELECTRICITY MARKET Electricity Restructuring

The case of electricity restructuring presents examples of fundamental problems that challenge
regulation of markets.

Marriage of Engineering and Economics.

o Loop Flow.
o Reliability Requirements.
o Incentives and Equilibrium.

Devilish Details.
o Retail and Wholesale Electricity Systems.
o Market Power Mitigation.
o Coordination for Competition.

Jurisdictional Disputes.
o US State vs. Federal Regulators.
o European Subsidiarity Principle.

1
ELECTRICITY MARKET Energy Market Pricing

Consider three cases of interest that present difficult challenges for regulators. A focus on pricing
illustrates an important thread of modeling and analysis. Constrained optimization provides a
central organizing framework.

Design Framework: Locational Marginal Pricing

LMP. Bid-based, security constrained economic dispatch.

Design Implementation: Scarcity Pricing

Better scarcity pricing to support resource adequacy.

Design Limitation: Uplift Payments

Unit commitment and lumpy decisions. Coordination and bid guarantees.

2
ELECTRICITY MARKET Transmission Management
Defining and managing transmission usage is a principal challenge in electricity markets.

Transmission Capacity Definitions

Contract Path Flow-Based Paths Point-to-Point

Contract Path Fiction Parallel Flows Flows Implicit

OASIS Schedules Flowgate Rights Financial Transmission

and TLR FGRs Rights
FTRs

3
ELECTRICITY MARKET Order 888 and the Contract Path
Under Order 888 the FERC made a crucial choice regarding a central complication of the electricity
system.

A contract path is simply a path that can be designated to form a single continuous electrical path
between the parties to an agreement. Because of the laws of physics, it is unlikely that the actual
power flow will follow that contract path. Flow-based pricing or contracting would be designed to
account for the actual power flows on a transmission system. It would take into account the
"unscheduled flows" that occur under a contract path regime. (FERC, Order 888, April 24, 1996, footnotes 184-
185, p. 93.)

Why is this important? A quick tutorial follows.

4
NETWORK INTERACTIONS Loop Flow
Electric transmission network interactions can be large and important.

Conventional definitions of network "Interface" transfer capacity depend on the assumed

load conditions.

Transfer capacity cannot be defined or guaranteed over any reasonable horizon.

POWER TRANSFER CAPACITY VARIES WITH LOAD

(WITH IDENTICAL LINKS, TRUE CONSTRAINT ON LINE FROM OLDGEN TO BIGTOWN)

Is The "Interface" Transfer Capacity

900 MW? Or 1800 MW?

OLDGEN OLDGEN
900 MW 600 0 MW 600
=m =m
ax ax
300 MW

INTERFACE

INTERFACE
900 MW 600 MW 1800 MW

BIGTOWN W
BIGTOWN
0 M
30 W 00
0 MW M 1800 MW 12

NEWGEN NEWGEN

5
NETWORK INTERACTIONS Loop Flow
There is a fatal flaw in the old "contract path" model of power moving between locations along a
designated path. The network effects are strong. Power flows across one "interface" can have a
dramatic effect on the capacity of other, distant interfaces.

Transmission Impacts Vary Across the Eastern System

Transfer Capability Impacts
1000 MW from VACAR to BG&E/PEPCO
0.2
Transfer Interface Impact (1000 MW)
Contract Path
0.0
-0.2
Assumption
-0.4
(Impact = 0)
-0.6
-0.8
-1.0
-1.2
-1.4
-1.6
-1.8
-2.0
-2.2
-2.4
-2.6
EC DU MA TV
A R EC KE EC W A N
AC to
to
M AR /C
P& AR to
.E
CA DU YPP
AA to Lt to VP R KE to
C VP oV DU to /C M
P KE OH P& AA
/C L C
P&
L

Interface in Eastern Interconnected System

Source: VEM, Winter Operating Study, December 1993.

6
ELECTRICITY MARKET Order 888 and the Contract Path
Under Order 888 the FERC made a crucial choice regarding a central complication of the electricity
system.

A contract path is simply a path that can be designated to form a single continuous electrical path
between the parties to an agreement. Because of the laws of physics, it is unlikely that the actual
power flow will follow that contract path. Flow-based pricing or contracting would be designed to
account for the actual power flows on a transmission system. It would take into account the
"unscheduled flows" that occur under a contract path regime. (FERC, Order 888, April 24, 1996, footnotes 184-
185, p. 93.)

We will not, at this time, require that flow-based pricing and contracting be used in the electric
industry. In reaching this conclusion, we recognize that there may be difficulties in using a
traditional contract path approach in a non-discriminatory open access transmission environment,
as described by Hogan and others. At the same time, however, contract path pricing and
contracting is the longstanding approach used in the electric industry and it is the approach familiar
to all participants in the industry. To require now a dramatic overhaul of the traditional approach
such as a shift to some form of flow-based pricing and contracting could severely slow, if not derail
for some time, the move to open access and more competitive wholesale bulk power markets. In
addition, we believe it is premature for the Commission to impose generically a new pricing regime
without the benefit of any experience with such pricing. We welcome new and innovative proposals,
but we will not impose them in this Rule. (FERC, Order 888, April 24, 1996, p. 96.)

Hence, although the fictional contract path approach would not work in theory, maintaining the
fiction would be less disruptive in moving quickly to open access and an expanded competitive
market!

7
ELECTRICITY MARKET Pool Dispatch
An efficient short-run electricity market determines a market clearing price based on conditions of
supply and demand. Everyone pays or is paid the same price.

SHORT-RUN ELECTRICITY MARKET

Energy Price Short-Run

Marginal
(/kWh)
Cost
Price at
7-7:30 p.m.

Demand
7-7:30 p.m.

Price at
9-9:30 a.m.

Price at Demand
2-2:30 a.m. 9-9:30 a.m.

Demand
2-2:30 a.m.

Q1 Q2 Qmax
MW

8
NETWORK INTERACTIONS Locational Spot Prices
The natural extension of a single price electricity market is to operate a market with locational spot
prices.

It is a straightforward matter to compute "Schweppe" spot prices based on marginal costs

at each location.

Transmission spot prices arise as the difference in the locational prices.

LOCATIONAL SPOT PRICE OF "TRANSMISSION"

Energy Price Short-Run
(/kWh) Marginal
Cost

Price differential =
Demand

MW A Pa = 51 Marginal losses
+ Constraint prices
Constraint

B
Energy Price Short-Run
Marginal

Pb = 66
(/kWh)
Cost

C
Demand

Pc = 55
MW
Energy Price Short-Run
(/kWh) Marginal
Cost

Demand

MW

Price of "Transmission" from A to B = Pb - Pa = 15

Price of "Transmission" from A to C = Pc - Pa = -4

9
NETWORK INTERACTIONS Locational Spot Prices
Locational prices ($/MWh) arise from the standard formulation of security constrained economic
dispatch to balance generation and load at each location. For instance, in PJM there are several
thousand locations with thousands of constraints for each of thousands of contingencies.

Bid-Based, Security-Constrained, Economic Dispatch

Max B(d ) C ( g )
d ,g ,x, y

subject to
dg = y :p
K ( x, y ) 0. :

PJM Real Time Hourly LMP Values for 20080224

Range 551.94 550.57 23.80 127.90 126.10 21.06 138.60 137.61 16.42
Max 516.16 434.34 16.38 142.74 71.28 14.18 166.06 109.89 11.13
Average 69.79 -5.18 -0.53 66.17 -4.88 -0.53 48.86 -2.22 -0.44
Min -35.78 -116.23 -7.42 14.84 -54.82 -6.88 27.46 -27.72 -5.29

Start of Real Time LMP Data 100 100 100 1200 1200 1200 1800 1800 1800
Node Date PnodeID Name Voltage Equipm Type Zone TotalLM CongestioMarginalLossPricTotalLMP CongestioMarginalLossPriceTotalLMP CongestioMarginalLossPrice
1 20080224 1 PJM-RTO ZONE 75.90 0.34 0.06 71.84 0.20 0.06 51.63 0.07 0.04
2 20080224 3 MID-ATL/APS ZONE 97.78 19.30 2.97 90.79 16.52 2.69 60.51 6.89 2.11
3 20080224 51291 AECO ZONE 46.33 -33.86 4.69 91.28 15.17 4.53 48.86 -6.21 3.55
4 20080224 8445784 AEP ZONE 43.55 -28.48 -3.47 32.42 -35.94 -3.22 37.52 -11.51 -2.49

424 20080224 32406789 107 DIX138 KV TR76 34LOAD COMED 41.23 -28.37 -5.90 32.16 -34.15 -5.27 35.61 -11.59 -4.32
425 20080224 32406793 109 APT138 KV TR72 12LOAD COMED 42.72 -28.66 -4.12 33.46 -34.39 -3.73 36.73 -11.74 -3.05
426 20080224 32406795 109 APT138 KV TR73 12LOAD COMED 42.69 -28.66 -4.15 33.43 -34.39 -3.76 36.71 -11.74 -3.07

8075 20080224 49498 ZIONSV115 KV 1B12 LOAD METED 92.57 15.14 1.93 93.33 19.83 1.92 59.47 6.41 1.54
8076 20080224 49499 ZIONSV115 KV 2B12 LOAD METED 92.57 15.14 1.93 93.33 19.83 1.92 59.47 6.41 1.54
8077 20080224 32413125 ZUBER 138 KV T1 LOAD AEP 40.57 -31.29 -3.64 32.11 -36.24 -3.23 36.19 -12.85 -2.48
End of Real Time LMP Data

10
NETWORK INTERACTIONS Locational Spot Prices
Locational spot prices for electricity exhibit substantial dynamic variability and persistent long-
term average differences.

From MISO-PJM Joint and Common Market, http://www.jointandcommon.com/ for March 3, 2008, 9:55am. Projected 2011 annual average from 2006
Midwest ISO-PJM Coordinated System Plan.

11
NETWORK INTERACTIONS Financial Transmission Rights
A mechanism for hedging volatile transmission prices can be established by defining financial
transmission rights to collect the congestion rents inherent in efficient, short-run spot prices.

NETWORK TRANSMISSION FINANCIAL RIGHTS

A Pa = 51

Constraint

C Pb = 66

Pc = 55

Price of "Transmission" from A to B = Pb - Pa = 15

Price of "Transmission" from A to C = Pc - Pa = -4

DEFINE TRANSMISSION CONGESTION CONTRACTS BETWEEN LOCATIONS.

FOR SIMPLICITY, TREAT LOSSES AS OPERATING COSTS.
RECEIVE CONGESTION PAYMENTS FROM ACTUAL USERS; MAKE
CONGESTION PAYMENTS TO HOLDERS OF CONGESTION CONTRACTS.
TRANSMISSION CONGESTION CONTRACTS PROVIDE PROTECTION
AGAINST CHANGING LOCATIONAL DIFFERENCES.

12
ELECTRICITY MARKET A Consistent Framework
The example of successful central coordination, CRT, Regional Transmission Organization (RTO)
Millennium Order (Order 2000) Standard Market Design (SMD) Notice of Proposed Rulemaking
(NOPR), Successful Market Design provides a workable market framework that is working in
places like New York, PJM in the Mid-Atlantic Region, New England, and the Midwest.

The RTO NOPR Order SMD NOPR "Successful Market Design"

Contains a Consistent Framework
Bilateral Schedules
at Difference in Nodal Prices

License Plate Access Charges

Market-Driven Investment
Coordinated
Spot Market

Bid-Based,
Security-Constrained,
Economic Dispatch
with Nodal Prices

07/05
Financial Transmission Rights
07/02
(TCCs, FTRs, FCRs, CRRs, ...) 12/99
5/99

PoolcoOPCOISOIMOTranscoRTO ITPWMP: "A rose by any other name "

13
ELECTRICITY MARKET Path Dependence
The path to successful market design can be circuitous and costly. The FERC reforms in Order
890 illustrate path dependence, where the path chosen constrains the choices ahead. Can Order
890 be reformed to overcome its own logic? Or is FERC trapped in its own loop flow?

Paths to Successful Market Design

t SMD
arke Bilateral Schedules
M
ed
at Difference in Nodal Prices

niz "Last

License Plate Access Charges

ing

Market-Driven Investment
ga
r nc
Coordinated

O a
Spot Market Resort"
Ba
l ion Bid-Based,

iss
Security-Constrained,
Economic Dispatch
m
ns hts
with Nodal Prices

Tra Rig Rules

C
Financial Transmission Rights
(TCCs, FTRs, FCRs, CRRs, ...) 890
AT Explode
888 Reform

Standardization
Transparency ISO
PX
Contract Zonal
"Simple,
Quick" Path

TLR Flowgate

14
ELECTRICITY MARKET A Consistent Framework
Regional transmission organizations (RTOs) and independent system operators (ISOs) have grown
to cover 75% of US economic activity.

Bilateral Schedules
at Difference in Nodal Prices
License Plate Access Charges

Market-Driven Investment

Coordinated
Spot Market

Bid-Based,
Security-Constrained,
Economic Dispatch

with Nodal Prices

Financial Transmission Rights

(TCCs, FTRs, FCRs, CRRs, ...)

PJM Locatinal Prices 1/15/08

700
600
500
400
Price ($/MWh)

300
Max
200
Min
100
0
-100 1 3 5 7 9 11 13 15 17 19 21 23
-200
-300
Hour

15
ELECTRICITY MARKET Resource Adequacy
There is a simple stylized connection between reliability standards and resource economics.
Defining expected load shedding duration, choosing installed capacity, or estimating value of lost
load address different facets of the same problem.

A Simple Reliability Model

MW
Curtailment

Capacity

Load Duration

Duration
Peaker Fixed Charge
Optimal Duration
Value Lost Load

(Steven Stoft, Power System Economics, IEE Press, Wiley Interscience, 2002, p. 138)

16
ELECTRICITY MARKET Resource Adequacy
The simple connection between reliability planning standards and resource economics illustrates a
major disconnect between market pricing and the implied value of lost load.

Reliability Planning Standard

and Value of Lost Load
Implied Average Value of Lost Load

$80,000
Twenty Four Hours in Ten Years
Average Value of Load Load ($/MWh)

$70,000

$60,000

$50,000
Peaker Fixed Charge
$40,000 Optimal Duration
Value Lost Load
$30,000

$20,000

$10,000

$0
0 5 10 15 20 25
Annual Duration of Load Curtailm ent (Hours)

Peaker fixed charge at $65,000/MW-yr.

17
ELECTRICITY MARKET Reliability Standards
There is a large disconnect between long-term planning standards and market design. The
installed capacity market analyses illustrate the gap between prices and implied values. The larger
disconnect is between the operating reserve market design and the implied reliability standard.

Reliability Standard and Market Disconnect

Implied Average Value of Lost Load

$80,000
One Event in Ten Years
Average Value of Load Load ($/MWh)

$70,000

$60,000
Twenty Four Hours in Ten Years
$50,000

$40,000
Optimal?
$30,000
Price Cap
$20,000

$10,000

$0
0 5 10 15 20 25
Annual Duration of Load Curtailm ent (Hours)

Peaker fixed charge at $65,000/MW-yr.

Implied prices differ by orders of magnitude. ( Price Cap $10 ; VOLL $10 ; Reliability Standard $10 )
3 4 5

18
ELECTRICITY MARKET Pricing and Demand Response
Early market designs presumed a significant demand response. Absent this demand participation
most markets implemented inadequate pricing rules equating prices to marginal costs even when
capacity is constrained. This produces a missing money problem. The big R regulatory
solution calls for capacity mandates. The small r approach addresses the pricing problem.

SHORT-RUN ELECTRICITY MARKET

Energy Price Short-Run

Marginal
(/kWh)
Cost
Price at
7-7:30 p.m.

Demand
7-7:30 p.m.

Price at
9-9:30 a.m.

Price at Demand
2-2:30 a.m. 9-9:30 a.m.

Demand
2-2:30 a.m.

Q1 Q2 Qmax
MW

19
ELECTRICITY MARKET Generation Resource Adequacy
A variety of market rules for spot markets interact to create de jure or de facto price caps. The
resulting missing money reduces payments to all types of generation.

A Market Price Duration Curve A Price Cap Results in "Missing Money"

P($/MWh) P($/MWh)
Missing Money

Returns for Peak Generator

Price Cap
Returns for Mid-Range Generator

A A
$85 Returns for Base Load Generator $85

B B
$35 $35
C C
$15 $15

8760 (Hours) 8760 (Hours)

Missing money reduces the payments to all types of generation.

If market prices do not provide adequate incentives for generation investment, the result is a
market failure. The market design defect creates the pressure for regulators to intervene to
mandate generation investment.

20
ELECTRICITY MARKET Generation Resource Adequacy
A workable energy only market would eliminate the missing money problem and provide an
alternative to the growing prescriptions of installed capacity markets. The concept is not that there
should be no market interventions. But the interventions should not overturn the market.

An Energy Only Market Outline

Implicit demand for inflexible load would define the opportunity costs as the average value
of lost load (VOLL).

An Illustrative Demand for Electricity

Price
Inflexible Total
Responsive
Demand Demand
Demand
P ($/MWh) P ($/MWh) P ($/MWh)
$20,000 $20,000 $20,000

+ =
$10,000 $10,000 $10,000

Demand
$30 $30 $30

Q (MW) Q(MW) Q(MW)

30,000 15,000 45,000

Involuntary curtailment of inflexible demand has an opportunity cost at

the average value of lost load (VOLL).

21
ELECTRICITY MARKET Generation Resource Adequacy
An Energy Only Market Outline

Operating reserve demand curve would reflect capacity scarcity.

Illustrative Reserve Demand

P ($/MWh)
$20,000
Reserve
Demand
3%

$10,000
Energy
$30 Demand
7%

Q(MW)

There is a minimum level of operating reserve (e.g., 3%) to protect

against system-wide failure. Above the minimum reserve, reductions
below a nominal reserve target (e.g., 7%) are price senstive.

22
ELECTRICITY MARKET Generation Resource Adequacy
An Energy Only Market Outline

Market clearing eliminates the missing money.

Normal "Energy Only" Market Clearing Scarcity "Energy Only" Market Clearing

P ($/MWh) P ($/MWh)
Generation Generation
$20,000 $20,000
Supply Supply

Energy +
$10,000 Energy + $10,000
Reserves
Reserves $7,000

$30 $30

Q(MW) Q(MW)

When demand is low and capacity available, When demand is high and reserve reductions apply,
reserves hit nominal targets at a low price. there is a high price.

23
ELECTRICITY MARKET Operating Reserve Demand

Operating reserve demand is a complement to energy demand for electricity. The probabilistic
demand for operating reserves reflects the cost and probability of lost load. Pricing operating
reserves could provide the missing money.

Example Assumptions

Expected Load (MW) 34000 Operating Reserve Demand

Std Dev % 1.50%
7,000
Expected Outage % 0.45%
Std Dev % 0.45% 6,000

5,000
Expected Total (MW) 153 Marginal VEUE
P ($/MWh)

4,000
Std Dev (MW) 532.46
VOLL ($/MWh) 10000 3,000

2,000
Under the simplifying
assumptions, if the dispersion of 1,000

the LOLP distribution is 0

proportional to the expected load, 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00%
the operating reserve demand is Q (% of load)
proportional to the expected load.
Total value is of same magnitude
as the cost of meeting load.

24
ELECTRICITY MARKET Operating Reserve Demand
Existing market designs underprice scarcity and provide poor signals for investment. Hence we
have the resource adequacy debate. A market approach would be reinforced by adopting an
explicit operating reserve demand curve.

The maximum generation outage

contingency quantity provides a
vertical demand curve that adds
horizontally to a probabilistic Operating Reserve Demand
operating reserve demand curve.
12,000

If the security minimum will 10,000

always be maintained over the Security Minimum
monitored period, the VEUE price 8,000
P ($/MWh)

at r=0 applies. If the outage

6,000
shocks allow excursions below Demand=Minimum + Marginal VEUE
the security minimum during the
4,000
period, the VEUE starts at the
security minimum. 2,000 Marginal
A realistic operating reserve VEUE
demand curve would address the 0
0 500 1000 1500 2000 2500
missing money problem and help
Q (MW)
jump start greater demand
participation.

25
ELECTRICITY MARKET Better Scarcity Pricing
Improved pricing through an explicit operating reserve demand curve raises a number of issues.
Demand Response: Better pricing implemented through the operating reserve demand curve would provide an
important signal and incentive for flexible demand participation in spot markets.

Price Spikes: A higher price would be part of the solution. Furthermore, the contribution to the missing money from
better pricing would involve many more hours and smaller price increases.

Practical Implementation: The NYISO and ISONE implementations dispose of any argument that it would be impractical
to implement an operating reserve demand curve. The only issue is the level of the appropriate price.

Operating Procedures: Implementing an operating reserve demand curve does not require changing the practices of
system operators. Reserve and energy prices would be determined simultaneously treating decisions by the operators as
being consistent with the adopted operating reserve demand curve.

Multiple Locations: Transmission limitations mean that there are locational differences in the need for and efficacy of
operating reserves. This would continue to be true with different demand curves for different locations.

Multiple Reserves: The demand curve would include different kinds of operating reserves, from spinning reserves to
standby reserves.

Reliability: Market operating incentives would be better aligned with reliability requirements.

Market Power: Better pricing would remove ambiguity from analyses of high prices and distinguish (inefficient) economic
withholding through high offers from (efficient) scarcity pricing derived from the operating reserve demand curve.

Hedging: The Basic Generation Service auction in New Jersey provides a prominent example that would yield an easy
means for hedging small customers with better pricing.

Increased Costs: The higher average energy costs from use of an operating reserve demand curve do not automatically
translate into higher costs for customers. In the aggregate, there is an argument that costs would be lower.

26
ELECTRICITY MARKET Energy Pricing and Uplift Payments
Energy dispatch is continuous but unit commitment requires discrete decisions. Bid-based,
security constrained, combined unit commitment and economic dispatch presents a challenge in
defining market-clearing prices.

Continuous convex economic dispatch

o System marginal costs provide locational, market-clearing, linear prices

o Linear prices support the economic dispatch

Discrete, economic, unit commitment and dispatch

o Start up and minimum load restrictions enter the model

o System marginal costs not always well-defined
o There may be no linear prices that support the commitment and dispatch solution

27
ELECTRICITY MARKET Energy Pricing
Energy dispatch is continuous, convex and yields linear prices.1 A simplified example with two
generating units illustrates the total and marginal costs.

Aggregate Cost Illustration Marginal Cost Illustration

Total Variable Cost Marginal Variable Cost

35000 120 A
A&B A&B

Marginal Cost ($/MWh)

30000 100 B

25000 80
Total Cost

20000 A
60
15000 B
40
10000

5000 20

0 0
0 100 200 300 400 500 0 100 200 300 400 500

Load Load

1
Paul R. Gribik, William W. Hogan, and Susan L. Pope, Market-Clearing Electricity Prices and Energy Uplift, Harvard University, December 31,
2007, available at www.whogan.com.

28
ELECTRICITY MARKET Energy Pricing and Uplift
Unit commitment requires discrete decisions. Now the second unit (B) has a startup cost.

Aggregate Cost: Two Generator Example Marginal Cost: Two Generator Example
Total Commitment and Dispatch Cost Marginal Cost

40000 120
35000 MC v

Marginal Cost ($/MWh)

V 100
30000
Total Cost

25000 80

20000 A 60
15000
A&B 40
10000
5000 20

0 0
0 100 200 300 400 500 0 100 200 300 400 500
Load Load

Marginal cost-based linear prices cannot support the commitment and dispatch. The solution has
been to make uplift payments to assure reliable and economic unit commitment.

29
ELECTRICITY MARKET Energy Pricing and Uplift
Selecting the appropriate approximation model for defining energy and uplift prices involves
practical tradeoffs. All involve uplift payments to guarantee payments for bid-based cost to
participating bidders (generators and loads), to support the economic commitment and dispatch.

Uplift with Given Energy Prices=Optimal Profit Actual Profit

Restricted Model (r)

o Fix the unit commitment at the optimal solution.

o Determine energy prices from the convex economic dispatch.

Dispatchable Model (d)

o Relax the discrete constraints and treat commitment decisions as continuous.

o Determine energy prices from the relaxed, continuous, convex model.

Convex Hull Model (h)

o Select the energy prices from the Lagrangean relaxation (i.e., usual dual problem for pricing
the joint constraints).
o Resulting energy prices minimize the total uplift.

30
ELECTRICITY MARKET Minimum Uplift
Economic commitment and dispatch is a special case of a general optimization problem.

v ( y ) = Min f ( x)
x X

s.t. g ( x ) = y.

From the perspective of a price-taking bidder, uplift is the difference between actual and optimal profits.

Actual profits: ( p, y ) = py v ( y )
Optimal Profits: * ( p ) = Max { pz v ( z )}
z

Uplift ( p, y ) = *
( p ) ( p, y )
Classical Lagrangean relaxation and pricing creates a familiar dual problem.

L ( y , x, p ) = f ( x ) + p ( y g ( x ) )
{
L ( y, p ) = Inf f ( x ) + p ( y g ( x ) )
x X
}
{ {
L* ( y ) = Sup L ( y, p ) = Sup Inf f ( x ) + p ( y g ( x ) )
p p x X
}}
The optimal dual solution minimizes the uplift, and the duality gap is equal to the minimum uplift.

v ( y ) L* ( y ) = Inf Uplift ( p, y ) .
p

31
ELECTRICITY MARKET Energy Pricing and Uplift
Comparing illustrative energy pricing and uplift models.

Comparison of Example Marginal Costs Comparison of Example Uplift Costs

Implied Marginal Cost Implied Uplift

35.00
140
MC d
Marginal Cost ($/MWh)

30.00
120 MC r Ur
MC h
100 25.00

Uplift ($/MWh)
80 20.00

60 15.00

40 10.00
Ud
Uh
20 5.00

0
0.00
0 100 200 300 400 500 0 100 200 300 400 500
-5.00
Load
Load

Both the relaxed and convex hull models produce standard implied supply curve. The convex
hull model produces the minimum uplift.

32
ELECTRICITY MARKET Energy Pricing and Uplift
Alternative pricing models have different features and raise additional questions.

Computational Requirements. Relaxed model easiest case, convex hull model the hardest. But
not likely to be a significant issue.

Network Application. All models compatible with network pricing and reduce to standard LMP in
the convex case.

Operating Reserve Demand. All models compatible with existing and proposed operating reserve
demand curves.

Solution Independence. Restricted model sensitive to actual commitment. Relaxed and convex
hull models (largely) independent of actual commitment and dispatch.

Day-ahead and real-time interaction. With uncertainty in real-time and virtual bids, expected real-
time price is important, and may be similar under all pricing models.

33
ELECTRICITY MARKET Electricity Restructuring Summary

With current technology, property rights are difficult to define and there is a continuing need for
coordination to support markets. Regulation must adapt to the requirements of hybrid markets.

Little r regulation: Design rules and policies that are the best possible mix to support
competitive wholesale electricity markets.
o Necessary functions for energy markets.
Real-time, bid-based, security constrained economic dispatch with locational prices.
o Necessary functions for energy markets with effective long-term hedges.
Financial transmission rights (FTRs).
o Valuable functions for energy markets with effective long-term hedges.
Day-ahead energy market with associated reliability unit commitment.
Transmission planning and investment protocols.
o Necessary features of everything else
Rules and pricing incentives compatible with the above.
Ancillary Services
Resource Adequacy

Big R regulation: Frame every problem in its own termsinadequate demand response,
insufficient infrastructure investment, or market powerand design ad hoc regulatory fixes that
accumulate to undermine market incentives. The slippery slope.

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William W. Hogan is the Raymond Plank Professor of Global Energy Policy, John F. Kennedy School of Government, Harvard
University and a Director of LECG, LLC. This paper draws on work for the Harvard Electricity Policy Group and the Harvard-Japan
Project on Energy and the Environment. The author is or has been a consultant on electric market reform and transmission issues for
Allegheny Electric Global Market, American Electric Power, American National Power, Australian Gas Light Company, Avista
Energy, Barclays, Brazil Power Exchange Administrator (ASMAE), British National Grid Company, California Independent Energy
Producers Association, California Independent System Operator, Calpine Corporation, Canadian Imperial Bank of Commerce,
Centerpoint Energy, Central Maine Power Company, Chubu Electric Power Company, Citigroup, Comision Reguladora De Energia
(CRE, Mexico), Commonwealth Edison Company, Conectiv, Constellation Power Source, Coral Power, Credit First Suisse Boston,
Detroit Edison Company, Deutsche Bank, Duquesne Light Company, Dynegy, Edison Electric Institute, Edison Mission Energy,
Electricity Corporation of New Zealand, Electric Power Supply Association, El Paso Electric, GPU Inc. (and the Supporting
Companies of PJM), Exelon, GPU PowerNet Pty Ltd., GWF Energy, Independent Energy Producers Assn, ISO New England, Luz del
Sur, Maine Public Advocate, Maine Public Utilities Commission, Merrill Lynch, Midwest ISO, Mirant Corporation, JP Morgan,
Morgan Stanley Capital Group, National Independent Energy Producers, New England Power Company, New York Independent
System Operator, New York Power Pool, New York Utilities Collaborative, Niagara Mohawk Corporation, NRG Energy, Inc.,
Ontario IMO, Pepco, Pinpoint Power, PJM Office of Interconnection, PPL Corporation, Public Service Electric & Gas Company,
PSEG Companies, Reliant Energy, Rhode Island Public Utilities Commission, San Diego Gas & Electric Corporation, Sempra
Energy, SPP, Texas Genco, Texas Utilities Co, Tokyo Electric Power Company, Toronto Dominion Bank, Transnergie, Transpower
of New Zealand, Westbrook Power, Western Power Trading Forum, Williams Energy Group, and Wisconsin Electric Power
Company. The views presented here are not necessarily attributable to any of those mentioned, and any remaining errors are solely
the responsibility of the author. (Related papers can be found on the web at www.whogan.com ).

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