Schweppe - Electricity Spot Pricing

THE KLUWER INTERNATIONAL SERIES IN ENGINEERING AND COMPUTER SCIENCE

POWER ELECTRONICS & POWER SYSTEMS

Consulting Editor

THOMAS A. LIPO University of Wisconsin - Madison

SPOT PRICING OF ELECTRICITY

by

FRED C. SCHWEPPE Massachusetts Institute of Technology

MICHAEL C. CARAMANIS Boston University

RICHARD D. TABORS Massachusetts Institute of Technology

ROGER E. BOHN Harvard Business School

KLUWER ACADEMIC PUBLISHERS BOSTONjDORDRECHTjLONDON

Distributors for North America: Kluwer Academic Publishers 101 Philip Drive Assinippi Park Norwell, Massachusetts 02061, USA

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Library of Congress Cataloging-in-Publication Data

Spot pricing of electricity/by Fred C. Schweppe ... let al.]. p. cm. - (The Kluwer international series in engineering and computer science. Power electronics and power systems) , Includes index

ISBN-13: 978-1-4612-8950-0 DOl: 10.1007/978-1-4613-1683-1

e-ISBN-13: 978-1-4613-1683-1

I. Electric utilities-Rates. I. Schweppe, Fred c., 1933-HG6047.E43S66 1987 338.4'336362 - dcl9

2. Commodity exchanges. II. Series.

Copyright 1988 by Kluwer Academic Publishers. Fourth Printing 2000.

Softcover reprint of the hardcover 1st edition 2000

87-36643 CIP

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher, Kluwer Academic Publishers, 101 Philip Drive, Assinippi Park, Norwell, Massachusetts 02061

DEDICATION

To Mary Alice Sanderson, long live the sponge; and to our children, Carl, Christina, Constan-tine, Daniel, David, Edmund, Fritz (Charles), Kristen, and Malaika.

Shortly before completion of this book Fred C. Schweppe, our friend, colleague and senior author died suddenly. Fred created spot pricing and proved, again, that "The forecast is always wrong!"

T ABLE OF CONTENTS

Preface ,,-, Overview

J.I Goal of Book 1.2 Three Steps to an Energy Marketplace 1.3 How Will Customers Respond? 1.4 Encl"li,+, Marketplace Operation: A Developed Country 1.5 Energy Marketplace Operation: A Developing Country 1.6 Discussion of Chapter I

Supplemcnt to Chapter I: Summary of Issues Historical Notes and References: Chapter I Notes

PART I: THE ENERGY MARKETPLACE Preface to Part I: The Energy Marketplace 2 Behavior of Hourly Spot Prices 2.1 Definition of Hourly Spot Price 2.2 Components of Hourly Spot Prices 2.3 Operating Cost Components 2.4 Quality of Supply Components 2.5 Aggregated Network 2.6 Revenue Reconciliation Components 2.7 Buy-Back Rates 2.8 Expected Price Trajectories 2.9 Price Duration Curves

vii

XVII

3 3 9

II 15 19 19 20 26 27

29 29 31

32 34 35 38 41 42 44 45 47

bmohandesCalloutwhen using the PDF file, add 17 to the number here

viii Contents

2.10 Customer Response 2. II Discusion of Chapter 2

Historical Notes and References: Chapter 2 Notes

3 Energy Marketplace Transactions 3.1 Criteria for Choice of Transactions 3.2 Customer Classes 3.3 Price-Only Transactions 3.4 Price-Quantity Transactions 3.5 Long-Term Contracts 3.6 Optional and Custom-Tailored Transactions 3.7 Why No Demand Charge? 3.8 Relationship to Present-Day Transactions 3.9 Customer-Owned Generation: Avoided Costs 3.10 Special Customer Treatment 3.11 Wheeling Rates 3.12 Discussion of Chapter 3


4 Implementation 4.1 Energy Marketplace: Operation 4.2 Energy Marketplace: Planning 4.3 Customer: Operation 4.4 Customer: Planning 4.5 Calculation of Hourly Spot Prices 4.6 Utility: Operation 4.7 Utility: Planning 4.8 Regulatory Commission: Operation and Planning 4.9 Discussion of Chapter 4


5 A Possible Future: Deregulation 5.1 A Deregulated Energy Marketplace 5.2 Short-Term Operation and Control 5.3 Long-Term Operation and Planning 5.4 A Scenario 5.5 Discussion of Chapter 5


PART II: THEORY OF HOURLY SPOT PRICES 6 Generation Only 6.1 Generation Fuel and Variable Maintenace: ).(t) 6.2 Generation Quality of Supply, YQs(t): Cost Function Approach 6.3 Generation Quality of Supply, YQs(t): Market Clearing Approach 6.4 Generation Self-Dispatch 6.5 Multiple Time Periods 6.6 Discussion of Chapter 6


49 51 51 53 55 56 57 58 63 66 68 69 71 75 76 76 77 77 80 81 82 87 90 95 97

102 106 107 108 109 109 III 112 115 117 123 125 126 127

129 131 132 137 143 146 147 148 149 149

7 Generation and Network 7.1 Problem Formulation: Real Power Only 7.2 General Result 7.3 Network Loss: '1u(t) 7.4 Network Maintenance: '1M.k(t) 7.5 Network Quality of Supply: '1QS.k(t) 7.6 Two-Bus Example ' 7.7 Price Difference Across a Line 7.8 Customer-Owned Generation: Self-Dispatch 7.9 Aggregated Networks 7.10 Reactive Energy and Voltage Magnitudes 7.11 Discussion of Chapter 7


8 Revenue Reconciliation 8.1 Modify Spot Prices: Aggregate Reconciliation 8.2 Buy-Back Rate 8.3 Surcharge-Refund 8.4 Revolving Fund 8.5 Modify Spot Prices: Decomposed Reconciliation 8.6 Fixed Charges 8.7 Nonlinear Pricing 8.8 Revenue Neutrality 8.9 Discussion of Chapter 8

Historical Notes',and References: Chapter 8 Notes

"

9 $pot Price Basei Rates 9.'1 Predetermined Price-Only Transactions 9.2 Price-Quantity Transactions 9.3 Lorig-Term Contracts 9.4 Special i::ustomer Contracts 9.5 Wheeling Rates 9.6 Discussion of Chapter 9


]0 Optimal Investment Conditions 10.1 Overall Problem Formulation 10.2 Generator Investment Conditions 10.3 Customer Investment Conditions 10.4 Transmission Investment Conditions 10.5 Revenue Reconciliation for Optimum Systems 10.6 Long-Run Versus Short-Run Marginal Cost Pricing 10.7 Discussion of Chapter 10


REFERENCES

ix

151 152 154 159 160 161 162 168 170 172 175 175 175 176 177 178 184 188 189 191 195 195 199 200 201 202 205 206 213 222 227 231 235 236 236 237 238 240 245 247 248 248 252 253 254

255

x Contents

ANNOT ATED BIBLIOGRAPHY

APPENDICES A Power System Analysis and Control A.I Network Flows A.2 Local Controllers A.3 Mathematical Models for System Dynamics AA Power System Dynamics

Further Reading Notes

B Power System Operation B.I Short-Term Load Forecasting B.2 System Economics B.3 System Security BA Automatic Generation Control (AGC) B.5 Interconnected Systems

Further Reading Notes

C Power System Planning CI Multiple Attribute Decision Making Under Uncertainty C2 Long Range Load Forecasting Models C3 Production Cost Models CA Financial Models C5 Generation Expansion Programs C.6 Network Expansion Programs C.7 Feedback Couplings

Further Reading NOles

D DC Load "low D.I General Relationships D.2 A Potpourri of Results D.3 Three-Bus Example

Notes E Customer Response Model Structures E.I Single Period E.2 Multiple Period

Notes

F FAPER F.I Basic Concepts F.2 FAPER Designs F.3 Variations on the Basic Concept FA Analysis of Multiple FAPER Response F.5 Incentives to Install FAPERS F.6 Discussion G Expected Behavior of Spot Prices

261

267 269 269 275 277 277 279 279 281 281 283 288 291 292 294 294 295 295 299 301 305 306 308 309 310 311 313 313 317 320 325 327 327 331 333 335 335 336 338 339 339 339 341

G.l Introduction G.2 24-Hour Trajectories G.3 Price Duration Curves G.4 Impact of Customer Response on Variable Energy Costs H Interchange of Derivative and Expectation Operators

INDEX

xi

341 342 345 345 347

349

ACKNOWLEDGMENTS

Xhe .title page of this book lists four names, but as the bibliography shows, spOt pricing has had many more authors. The folIowing is an attempt to acl

xiv Acknowledgments

The overall effort was given a key boost when Henry Jacoby and Loren Cox, Directors of MIT's Center for Energy Policy Research, organized the Box-borough Conference on Homeostatic Control in 1979. If we had listened more carefully to Loren's advice over the years, spot pricing might have progressed much faster than it has. David White, Director of MIT's Energy Laboratory, was an early and continuously sustaining supporter of the ideas.

Early research efforts were supported under the sponsorship of Charlie Smith and Ray Dunlop at DOE, which provided a quick, if short, start. The PSC of Wisconsin offered the next installment. Rod Stevenson at the University of Wisconsin helped formulate and complete this early study on the impact of spot pricing for industrial applications.

In California, the moral support of Rusty Schweickart, then Chairman of the California Energy Commission, and John Bryson, then Chairman of the Cali-fornia Department of Public Utilities, led to two key projects, one funded jointly by Pacific Gas and Electric and Southern California Edison with AI Garcia and Jack Runnels as two extremely helpful project monitors. A foll\ow-up, was funded by the California Energy Commission guided and assisted by John Wilson.

The California studies started a continuing and extremely productive colla-boration with John Flory of Utility Customer Interfaces. The world needs more individuals of his caliber.

At one point in the spot pricing evolution (as developed for regulated utili-ties), we were pulled into the great debate on deregulation. This led to interesting and stimulating discussions with a variety of people such as Leonard Hyman of Merrill Lynch Pierce Fenner and Smith, Joe Pace ofNERA, and William Berry, president of Virginia Electric. Interactions with Richard Schmalensee and Paul Joskow of MIT helped formulate our approach to deregulation.

When we first met Robert Peddie, then Chairman of the Southeastern Distri-bution Board in England, he was already well along with his exciting, visionary approach to residential customer-utility interactions, called the CALMU system. Subsequent discussions and interactions with him and his CALMU system had a significant impact on our own efforts. ,

Bernie Hastings of Detroit Edison did not sit down to write theoretical spot pricing papers or to do simulation studies. Instead he simply went ahead and saw to the actual implementation of spot prices for some of Detroit Edison's industrial customers. This was the first implementation of the basic ideas of spot pricing.

John Phillips, Chairman of the California Energy Coalition, is a very special individual whose support, ideas, and enthusiasm, combined with his strong advocacy of utility-customer partnering, aided spot pricing in ways that can never be quantified.

The Integrated Communications Systems Inc. (ICS) demonstration of their Transtext system for Georgia Power residential customers provided us with an opportunity to evaluate the variable energy costs (i.e. spot prices) for many of

xv

the participating utilities. These numerical studies of diverse utilities have greatly increased our own understanding of the real issues and concerns. We thank Doug Bulleit and Paul Spaduzzi of ICS for the opportunity to work with them and with their participating utilities.

Meta Systems of Cambridge, Massachusetts provided us with the opportun-ity to do spot pricing studies (such as for ICS) in a consulting, rather than academic, mode of operation, with all the subsequent advantages to the sponsors of faster response and the ability to keep data confidential. Meta Systems funded the final stages of word processing for this book and should play a key role in future spot price applications.

A DOE-funded project on wheeling helped solidify and expand some of the basis spot pricing concepts. The project monitor, Jeff Skeer, provided critical comments on various drafts of the wheeling report that have had an impact on the book itself. An EPRI funded project, monitored by Larry Carmichael, has been very valuable in the development of alogrithms for response by residential customers to energy marketplace spot prices. The Division of Research of the Harvard Business School supported the fourth author for work on spatial pricing and customer response.

One very important group of individuals left out of the above chronological ordering are the faculty and staff of MIT's LEES/EPSEL who were impacted by spot pricing, even though they were not directly involved in it. Spot pricing has;11ever been a favorite funding area for research agencies. As a result there havibeen some very lean years. Those of us involved in the effort usually did

nOl~brjng our fair sha~ of financial support into the laboratory. The faculty and staff;of the laboratories (and in particular the various Directors: Gerry Wilson, Tom Lee and Jim Mekher) have to be thanked for putting up with being leaned on for many _years - as does Barbara Smith, who somehow kept us all rolling. Mary Alice Slmderson managed to make sense out of the unintelligible, many times.

The last (but definitely not least) group left out of the chronological order is the students who have been involved in the effort. Students make or break a research university like MIT.

The most important Ph.D. thesis relative to spot pricing was written by the fourth author of this book while he was at MIT [1982]. This thesis contains. many of the basic ideas found in this book as well as discussions of customer response. Richard Schmalensee of the Sloan School of Management was the thesis supervisor and Paul Joskow of the Department of Economics was a thesis reader who insisted that high standards be maintained. We thank both these men for the important role they played.

The original industrial load modeling research that motivated the spot pricing concepts was done by the Yon gut Manichaikul for his Ph.D. thesis [1978], which combined mathematical analysis with the results of his talking to a lot of industrial plant operators and the rubbing grease off of motor name plates. Mike Ruane's Ph.D. thesis [1980] provided a general stochastic framework for

xviii Preface

written to serve as a single, integrated sourcebook on the theory and imple-mentation of a spot price based energy marketplace.

The book is written for electric power engineers interested in operation, planning, and load management; for economists interested in electric power regulation and pricing; and for utility regulators and overall policy makers. It is a "how to" book, written so it can be used by those who are mainly interested in the application of the concepts and techniques. Detailed mathematical deriva-tions are also provided for those who are interested.

A spot price based energy marketplace has many benefits for both the electric utility and its customers. These benefits include improvements in operating efficiency, reductions in needed capital investments, and customer options on the type (reliability) of electricity to be bought. A spot priced based energy marketplace is a win-win situation for both the regulated utility and its customers. The customer's lifestyles improve because the customers are receiv-ing more service from the use of electric energy per dollar spent. The utility has a more controllable, less uncertain world in which to operate.

A spot price based energy marketplace can be implemented using today's proven technologies. However, its existence stimulates the development of new microelectronic technologies and hence enables further exploitation of the microelectronic revolution in communication and computation.

The spot price based energy marketplace concepts were originally developed to meet the present and future needs of the complex, interconnected, sophis-ticated power systems of developed countries. However, the basic ideas are also applicable to the smaller, rapidly growing, less sophisticated power systems often found in other parts of the world.

The spot price based energy marketplace was developed to be applicable to present-day structures wherein a privately owned utility is regulated by some government agency, or the utility is government owned and operated. However, the energy marketplace introduces the possibility of various degrees of deregula-tion wherein some generation is provided by privately owned, less regulated companies.

Spot pricing is the natural evolution of existing techniques for power system operation, planning, load management and the economic theory of marginal cost pricing. This book relates spot pricing to existing rate structures, direct load control techniques, interruptible contracts, interutility sales, and power system operation.

Organization of Book

Chapter I provides an overview of spot pricing and the issues to be covered. The rest of the main text is subdivided into two parts.

Part I (Chapters 2 through 5) consists of three main chapters that show how hourly spot prices behave, discuss various types of energy marketplace trans-actions, and address implementation of a spot price based energy marketplace from both the utility and customer points of view. The final chapter of Part I

xix

briefly explores the possible evolution of the energy marketplace (as developed for a regulated utility) into a system of deregulated generation.

Part II is a sequence of chapters (6 through 10) that develop the theory of spot prices starting with simple cases and progressing toward more complex and realistic situations.

Appendices provide background material and supplemental detail. The book is written so that it can be read in different sequences. All readers

should begin with Chapter I. The text is organized to discuss behavior and implementation (Part I) before going through the technical theory (Part II). This is the appropriate sequence for readers interested primarily in broad applicabil-ity and implementation issues, since they do not have to wade through a lot of equations. However, some readers may find it preferable to read Part n before Part I to get the detailed theory first.

Readers with a limited background in power systems operation and planning should begin by glancing at Appendices A, B, and C. These appendices provide a brief overview of the main power system concepts affecting an energy market-place.

SPOT PRICING OF ELECTRICITY

J. OVERVIEW

This chapter provides an overview of the book and the spot price based energy marketplace.

Section 1.1 discuspes the goals of the book. The three steps to an energy marketplace are introduced in Section 1.2. (These three steps are expanded in Chapters 2, 3 and 4 respectively.) Section 1.3 addresses customer response to an energy marijetplace. Sections 1.4 and 1.5 discuss energy marketplace operation for developed and developing countries. A supplement to Chapter 1 provides a summary of issues relevant to a spot price based energy marketplace.

SECTION 1.1. GOAL OF BOOK

The electric utility industry today is undergoing rapid and irreversible changes. Volatile fuel costs, less predictable load growth, a more complex regulatory environment and a deceleration in conventional technical progress are impor-tant examples of these changes. Yet the need for growth in productivity and efficiency, and for increased flexibility to handle future uncertainties, is stronger and more challenging than ever. The utility industry, which has matured into a toO-billion-dollar industry in the United States and constitutes a substantial economic sector in all industrialized countries, must evolve to meet this challenge. New directions for the utility industry are being sought by many interested parties in the government, the private sector, and the universities. One such direction has been widespread interest in utility-customer cooperation through

3

4 J. Spot pricing of electricity

innovative rates characterized by broader options and better use of information on utility costs and customer needs.

The goal of this book is to provide a theoretically sound, yet practical foundation for the implementation of utility-customer transactions based on today's needs. Our goal is to meet four criteria:

o Freedom of Choice: Provide customers with options on the cost and reliabil-ity of supply and how they choose to use electric energy.

o Economic Efficiency: Motivate customers to adjust their own electric energy usage patterns to match utility marginal costs.

o Equity:l Reduce customer cross-subsidies-i.e. a customer's charges are based on the utility's costs to serve that customer.

o Utility Control, Operation and Planning: Consider the engineering require-ments for controlling, operating and planning an electric power system.

Present-Day Transactions

Most transactions between utilities and their customers today fall far short of meeting these four criteria. Flat and time-of-use rates are related to actual marginal costs in only a gross, average sense. The demand charge is an anach-ronism with at most a tenuous relationship to marginal costs; it usually en-courages counterproductive customer behavior. Load management approaches often involve direct utility control (i.e., the big brother approach) and sometimes encourage wasteful customer behavior. Cross-subsidization between customer classes and within a given class is rampant. Utility-customer transac-tions are typically specified without considering the engineering problems of controlling, operating, and planning an electri\ power system.

The failure of most present-day utility-customer transactions to meet today's needs can be traced to their historical foundations. They were established by individuals unconcerned with power system control and operation, during times when communication and computation were very expensive, when there was less incentive to use electricity in an efficient fashion, and when cross-subsidies were of limited concern to society.

The four basic criteria cannot be achieved by putting "band-aids" on the present-day approaches. They cannot be achieved by adding modern microelec-tronics whose functions are based on present-day approaches.

The four basic criteria can be achieved only by returning to the first principles of economics and engineering and by viewing the utility and its customers as a single integrated system. The result of this integration is the spot price based energy marketplace, which is the subject of this book. Energy Marketplace Transactions

Students taking an introductory course in economics are taught that the best way to achieve

I. Overview 5

o Economic efficiency o Equity o Customer freedom of choice

is the use of marketplace where market clearing prices are determined by supply and demand. For example, when a lot of fresh produce (e.g., lettuce) is available, the prices go down and consumption goes up. During other times of the year, or after a hard freeze, the supply goes down and prices go up to reduce consumption.

Five ingredients for a successful marketplace are

I. A supply side with varying supply costs that increase with demand 2. A demand side with varying demands which can adapt to price changes 3. A market mechanism for buying and selling 4. No monopsonistic behavior on the demand side 5. No monopolistic behavior on the supply side

Electric energy is an ideal textbook-type commodity relative to the first four ingredients, i.e.:

I: Figures 1.1.1 and 1.1.2 illustrate the effect of changing supply-demand .. conditions on supply costs. Figure 1.1.1 shows measured marginal fuel costs

, while Figure 1.1.2 shows total marginal costs (for a different utility) which :also includes nonfuel effects such as quality of supply/reliability premiums and recovery of embedded capital costs (revenue reconciliation). These

marginal.~cost variations are highly correlated with variations in demand i levels.'

2. Industrial processes and space conditioning are only two examples from a host of demands that are price responsive even to current rate structures.

3. The existing market mechanism (billing for electric power, etc.) can be adapted. Industrial customers who already have recording demand meters needed no new hardware to implement a marketplace with prices varying each hour (assuming they also have a telephone). The details of creating a market mechanism are the subject of this book.

4. Monopsonistic behavior is difficult on the demand side because the number of customers ranges from thousands to millions.

Relative to the fifth ingredient, electric energy is not an ideal textbook example for a marketplace because the supply side is a monopoly that is either govern-ment regulated or government owned. However rate-of-return regulation is used today to limit the ability and incentives to behave monopolistically. This would continue with spot pricing.

Throughout almost all of this book, we define

6 1. Spot pricing of electricity

Week 1

20 40 eo eo 100 1~ l~ 1~

Hou~

Week 2

:~ 20 40 eo 80 100 120 \40 leo

Figure 1.1.1. Measured marginal fuel costs.

Energy Marketplace The buying and selling of electric energy between independent customers and a regulated or government owned utility.

The one exception is Chapter 5, where we discuss the possibilities of deregula-tion of generation.

The energy marketplace is designed explicitly to include engineering issues associated with power system control and operation. Hence all four of the original criteria (efficiency, freedom of choice, equity, and control/operation) are met.

In the energy marketplace, all utility-customer transactions are based in a self-consistent fashion on a single quantity, the hourly spot price. The hourly spot price is determined by the demand at that hour and the hourly varying costs and capabilities of the generation, transmission and distribution systems. The

MUs/kWh .-----y-EA-R-' -PE-'K-O-'y-S-S-UM-M-AR-Y----. 500

'00

300

200

'00

10 12 16 19 22 24 Hours

Mils/kWh .-----y-E'-R -2 P-=-:AK-=D-:Ay....,S-:UM-M-:A=-Ry,-----, 300

200

'00

Hours

Figure 1.1.2. Total marginal costs.

1. Overview 7

MIlS/kWh.-----y-E-=AR-'-Ty-,.P-,.'CA-:L-:cOA-y-,S-UM-M-=AR-:y---, 300

200

100

Summer

Wmter / LY2; \1\:\ '2 ,s 22 24

Hours

MUs/kWh .-----=yE-:AR:-2-T-=YP-::'CA-L-::"DA-:y-,S-UM-:M-:AR:-Y----, 300

200

100

'2 "

2' HOUTS

hourly spot price is defined In terms of marginal costs subject to revenue reconciliation. 2

In the energy marketplace, there is closed-loop feedback between the utility a'lld its customers. Jhe whole electric power system (generation, transmission, distribution, and customers) is controlled and operated in an integrated fashion, without removing tne customers' freedom of choice. This is made possible by the d1versity in customers' characteristics, desires and needs .

. The . benefits of well-designed, real-time, utility-customer feedback are clear, or will be after reading this book. However, so are the metering and communic~tions costs associated with conveying the necessary information. Therefore, the energy marketplace transactions are designed to match benefits to transactions costs. Some customers (e.g., large industrial) might see prices updated each hour, while other customers (e.g., residential) might normally see prices updated each billing period. However, a residential customer who wants to exploit hourly price variation has the option of seeing more frequent price updates, provided the customer pays the additional costs.

What is the Difference?

The initial reaction of many people to spot pricing is that the major difference between spot prices and present-day transactions is that spot prices have complex time variations. Actually, present-day prices also exhibit complex time variations, so the major difference is in the nature of the price variations, not their presence. As one example, consider Figure 1.1.3, which plots the historical variation of prices (jkWh) for one utility. The hourly cost (spot price) varia-tions of Figures 1.1.1 and 1.1.2 simply exhibit finer time detail. As a second example, consider an industrial customer with a 5/kWh energy charge and a

II I. Spot pricing of electricity

/kwh

"'-

8.0 r-

7.0 ....

,""r- I..r-~

6.0 r- I- :-....

,""I""

5.0

...

I-4.0

3.0 hrrfT J FMAMJJASOND JFMAMJJASON DJFMAMJJASOND

1979 1980 1981

Figure 1.1.3. Example of monthly variations in residential prices, under conventional rates.

5 $/kW demand charge based on the energy used during the customer's peak hour during the month. The corresponding energy rate paid by the industrial customer is plotted in Figure 1.1.4. It displays a dramatic time variation which bears little resemblance to either Figure 1.1.1 or 1.1.2.

A second difference lies in the nature of the, relationship between the utility and its customers. In a spot price based energy marketplace, the utility and its customers are partners working together to achieve the maximum benefit from electric energy usage at minimum cost. The amount of such partnering found in present-day utility-customer relationships is small at best.

Present-day flat and time-of-use rates are specified by formulas based on expected costs, rates of return on equity, etc. An hourly spot price is based on the same principles, but the formula is solved every hour by computers instead of once a year or once per month (for fuel adjustment clauses). Present-day direct load control and present-day interruptable contracts are special cases of energy marketplace transactions. Present-day power system operation often involves a real-time spot market for purchases and sales between utilities. The spot price based energy marketplace simply extends this spot market to include the customers. Thus it can be concluded that

The spot price based energy marketplace is the logical evolution of present-day rates and load management techniques, married with present-day practices of power system opera-tion, the concept of utility--customer partnering, and the availability of inexpensive communications and computation equipment.

Rate Paid by Customer /kWh

505

I. Overview 9

Energy Charge: 5 /kWh Demand Charge: 5 $/kW

5r-----------,~-------------------------o Hour of Peak Specified by Customer 720 Hours

fipire 1.1.4. Effective p~ice variations resulting from demand charge, under conventional rates.

SECTION 1.2. THREE STEPS TO AN ENERGY MARKETPLACE

A spot pric~ based energy marketplace that meets the four criteria of Section 1.1 can be achieved in three steps:

Step I: Define hourly spot prices and evaluate their behavior. Step II: Specify an appropriate set of utility-


o Transmission distribution network losses and capacities o Aggregated customer demand patterns

The hourly spot price is a random process (e.g. see Figures 1.1.1 and 1.1.2). Its future value cannot be predicted perfectly because of random equipment outages and demand variations.

An hourly spot price can be determined for a utility which is buying energy from, as well as seJling energy to its cutomers. The buy-back hourly spot price can be either greater or less than the selling hourly spot price.

Step II: Specify Utility-Customer Transactions

All utility-

I. Overview H

transactions. Some price-quantity transactions are cheaper to implement than some price-only transactions.

Long-term contracts are fixed price and fixed quantity. Thus they are like present-day commodity contracts, and like present-day long-term contracts between utilities they can extend hours, day, months and years into the future. As an example, suppose that on January I an industrial customer contracts for 1000 kWh of energy to be delivered between 10 and 11 AM on July I, for lOjkWh. If, when July I finally comes, the price between 10 and II AM is actually 9 /kWh, the actual cash flow is as follows:

If Customer Uses 1000kWh 2000 kWh

OkWh

The Customer Pays $100 $100 + $90 = $190 $100 - $90 = $10

Thus the incremental cost of the customer's usage that hour is 9/kWh. Such transactions enable a customer to buy an insurance policy by locking in 1000kWh at 1O/kWh, even though the customer still sees the spot price for actual usage.

A variation on this long-term contract is the option wherein the customer buys the.'fight to buy up to a fixed amount of energy at a fixed price. The customer ex~rcises the option ,if the hourly spot price turns out to be greater than the o(9tiqn price. ' Step III: fmplement Energy Marketplace Implementation of the energy marketplace involves the utility and its customers

. .; operatmg as' partners.

Utility implementation concerns include real-time calculation/prediction of hourly spot prices, metering-{;ommunications-billing, and system control center operation using the new control signal called price. The impact of the energy marketplace on utility long-term investment decisions is also of concern.

Customers who choose to exploit the energy marketplace potentials must implement the appropriate response systems, which could range from simple manual response to sophisticated digital control. The utility can provide the control mechanism as a service to customers.

SECTION 1.3. HOW WILL CUSTOMERS RESPOND?

A key question for a spot price based energy marketplace is: How will customers respond (change their usage patterns) to price changes? Two ways to try to answer this question are

o Use direct observations of actual responses o Use models of response

i 2 I. Spot pricing of electricity

Unfortunately, not enough direct observations of the right type are available today. There are a lot of data (and studies) on customer response to time-of-use rates, which are a special case of a spot price based transaction. However, there is a large difference between a time-of-use rate's behavior and that of, for example, Figures 1.1.1 and 1.1.2. This difference combined with the nonlinear nature of customer response makes an extrapolation of response from time-of-use results a vague guideline at best. Interruptible rates and certain types of direct load control are also special cases of spot price based transactions, but their method of implementation makes it very difficult to draw conclusions for an energy marketplace type operation. There are various implementations of one- and 24-hour-type spot prices in operation, but the data coming from them are still too limited to provide a basis for any general conclusion.

When enough direct observations are not yet available, it is necessary to resort to the use of models. Models can range in sophistication from statistically based computer simulations or optimizations to simple mental pictures obtained by having an industrial plant manager spend a few hours showing one around the plant and explaining the processes and operating constraints.

We will now provide some discussion on what we know of customer response in the industrial and residential sectors (discussions on response mechanisms are given in Section 4.3). Industrial Response We have modeled (at various levels of detail) over 20 industrial customers in different parts of the U.S.A. This experience showed that five issues to be considered when talking to an industrial customer are

o The negative initial reaction syndrome o The importance of nonphysical and noneco~omic factors o The difference between a demonstration and the real world o The importance of advance knowledge o The nonlinear character of the response

The initial reaction of an industrial plant manager to the idea of facing a one-hour or 24-hour update spot price can be expected to be negative. However, in most cases this negative reaction can be turned around. For example, a negative reaction to the possibility of very high energy rates at certain times can be countered by the existence of very low energy rates at other times and the death of the demand charge. As a second example, an initial negative reaction based on the concept of moving entire work shifts around can often be coun-tered by discussing large electricity-using devices whose operation can be res-cheduled without affecting more than a few workers. As a third example, an initial negative reaction about uncertainty associated with rapidly varying rates (hours to days) can be replaced by an appreciation that a fluctuating market is a place where money can be made. One customer who actually was on a

I. Overview 13

one-half-hour update of spot prices complained that during some seasons of the year the price didn't vary enough to make any money.

When we started looking at industrial response, we naively assumed that response depended only on the physical character of the plant and the economics of its operation. However, in the real world other factors also play a key role. These factors included the nature of union contracts, the manage-ment of the company (locally owned or part of a big corporation), and the character of the work force (social background), the location of the plant (was it safe to work there at night). We studied two plants with identical SIC codes located within twenty miles of each other. However, they had completely different response capabilities.

It became very clear during our interactions that industrial response to a one-year test or demonstration program would be much less than for a real-world spot price based energy marketplace that won't go away in 12 months. Many customers could greatly improve their response capabilities by relatively minor additions of new control, process, etc., equipment. However, such modif-ications could not be cost justified for a mere demonstration or test.

Industrial response can be greatly increased if the customers know a few hours to a day in advance when exceptionally high or low prices will or are expected to occur. Such lead or warning time allows rescheduling of high-energy-consuming processes with much less cost. The use of a 24-hour update

pr:~vides a "hard price" a day in advance. For a one-hour spot price, it is i~()rtant for the utility to provide a forecast of future prices (the same forecasts which formed the blise for updating the 24-hour spot price). The importance of

w?!r~ing.or lead time.is another reason why it is difficult to extrapolate from time of use or interruptible response to energy marketplace response.

Industrial response is usually a very nonlinear function of price. Doubling the price from $ to 10/kWh may create little response, while doubling it from 10 to 20 /kWh could cause sizable reaction because of the threshold effects. It is also clear from our studies that price differentials during a day can be equally if not more important than the absolute value of the price.

Residential Response Residential response is entirely different from industrial response. Our studies and ponderings on residential response to a spot price based energy marketplace lead to the conclusion that the key issue is the character of the electronic support system that is provided. One cannot expect the typical residential customer to interact effectively with a spot price based energy marketplace without electron-ic support. If a residential customer has available a well-designed microprocess-or-based information and control system with user-friendly interface, extensive response can be expected. Residential customers without such support available should, in general, see only very simple spot price type rates.

The cost of microelectronics is continuing to fall at a rapid rate. Therefore a k~y issue in residential response is how long it will take before the costs of such

14 I. Spot pricing of electricity

electronics become less than the benefits (to the customer and/or utility) of the resulting response. Some might argue that such a time has already arrived.

The importance of warning time and the nonlinearity of response apply to both residential and industrial customers.

Example of Customer Benefits

Why is it that putting customers onto a spot price makes them better off and simultaneously makes the utility (or the utility's other customers) better off? Of course one of the precepts of free market economies is that prices based on a marketplace send better signals than do fixed price. But that is a theoretical argument, and while it can be made rigorous (as we do in Chapter 6), it is not very intuitive initially.

Therefore let's look at a simple example: an industrial customer who has to pump a lot of water (or other fluids) into storage tanks. For the sake of familiarity, consider a municipal water department which has to fill its water tanks daily. Suppose the customer is initially on a two level time-of-day rate with prices which vary over time but in a predetermined and rigid way. (If the customer is initially on a flat rate or a rate with a demand charge, then there are even more benefits from spot pricing in the following example.) Then it will pump water every night and every weekend, at the same hours every week. If it cannot fill the tanks completely during the low price period (which in some time-of-day rates is necessarily less than 12 hours long), it will wait until the tanks get to the low limit, then resume pumping. This will often mean that it resumes pumping in the afternoon or early evening, just at the tail end of the high price period. The customer will keep the same timing of usage every week that a particular rate is in effect, and every day of the week, without adjusting for generator outages, changes in electricity generating costs, etc.

Now switch this customer to a 24 hour upaate spot price. At worst, the customer can continue its old pumping schedule as if it were still on predeter-mined time-of-day prices. Assuming that the old time-of-day rate and the spot price based rate were calculated based on comparable formulas, its bill for electricity would then stay the same and the cost for the utility to serve it would stay the same. (If the old rate had a hidden cross subsidy, in either direction, then the bill could change by the amount of that cross-subsidy.)

However, our spot pricing customer will start adjusting its pumping schedule each day, based on the hourly prices for the following day. It will plan to pump in all the lowest cost hours, which may not necessarily be consecutive. Because each day's schedule will be different, it wilI start heavy pumping at a different time each day. On days when the overall spot price turns out to be low (often but not always these will be weekends) it may pump almost all day, to fill up longer term storage areas, and give more flexibility on high priced days. (This requires some kind of forecasting, but no matter how unsophisticated the forecasting method, over the course of a year the customer is never worse off than just ignoring this opportunity to store for more than a day.) Different

I. Overview 15

seasons of the year and different generator outage situations will automatically lead to appropriate behavior by the customer, without elaborate formal mech-anisms. (e.g. look at Figure 1.1.1 and 1.1.2.)

On some days the customer may have unusually high demand for pumping services (e.g. due to a fire). On these days it will know that it can get energy when it needs it, albeit perhaps at a high price. To the extent it has some discretion (e.g. the fire has been put out, but the tanks are still below a safe level) it can choose to reduce demand during the peak peak priced hours. All such decisions are entirely up to the customer, not the utility.

Obviously the customer's benefits from spot pricing depend on how much operating flexibility it has (or can get, by making selective investments). They also depend on the hour to hour and day to day price variation - the higher the variation, the more the customer stands to save by shifting its usage.

How about the utility's costs? If the customer does not respond to spot prices, the utility sees the same demand pattern as before and is no worse off. However if the customer makes any response at all, the utility is guaranteed to be made better off because all responses will shift energy use from times of high spot prices to times of low spot prices.

We could construct similar examples for other situations, but the basic point is clear. If the customer does not change its behavior, then neither it nor the utility are worse off. (Except perhaps for shifts in cross subsidies. In principle

. thl:lSpot prices could be adjusted to preserve cross subsidies, and we will mention thltt at an appropria,te point.) The more the customer changes behavior, the better off both parties are. And highly variable spot prices make the benefits for bo~hparties bigger. Why No Numbers? We have devbted a lot of time and effort to trying to understand how industrial and residential customers will respond. We firmly believe large response will occur. (Otherwise we wouldn't have written this book.) However, readers who go beyond Chapter I will find that we have chosen not to present explicit numbers or even case studies on customer response. One reason for this decision was the desire to keep the size of the book under contro\. However, the main reason is that our understandings have not reached the point where we can provide numerics that can be extrapolated to cover a utility service territory. We are like the classical blind men feeling different parts of an elephant. We have a lot of information but still are not certain what the overall elephant looks like. However, we do know that it is big.

SECTION 1.4. ENERGY MARKETPLACE OPERATION: A DEVELOPED COUNTRY

A simplified example of a sophisticated energy marketplace in operation in a developed country is used to illustrate its basic functions.

Figure 1.4.1 summarizes the main energy marketplace transactions and in-formation flows. For simplicity, only one customer is shown. We will discuss each box in Figure 1.4.1 separately.

Hi I. Spot pricing of electricity

Generation transmission distribution system. The energy marketplace has a long-range impact on generation and network capacity requirements. In many situations, the result is a reduction in installed capacity (per unit of demand) and less reliance on generation peaking units.

Power system operation. All of the basic present-day power system operating functions continue in an energy marketplace, but some of the functions are modified. Short-term-demand forecasts now include the effects of price. Unit commitment logics incorporate the effect of price feedback. Operating reserve requirements are carried by the load or generation, whichever is least expensive. All of these changes reduce total system costs.

Meter. A recording meter measures and stores hourly energy usage for each customer. It is read once a month and used to compute the monthly bill.

Price-only transactions. At ten minutes before the hour, the one-hour update spot price is computed based on a 70-minute forecast of system operation conditions (fuel costs, losses, generation reserve margin, and network capabili-ties) and demand (taking into account price effects). The one-hour update spot price is automatically communicated in digital form over telephone lines to the computers of those customers who are on the one-hour update. It holds for one hour.

At 3 PM of each afternoon, the hourly spot prices for the 24-hour period starting at 3 AM of the next morning are computed using forecasts of operating

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Long Term Contracts

Customer's Scheduling

and Control

Computer

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Figure 1.4.1. Functions and information flow in an energy marketplace.

I. Overview 17

conditions. Customers on a 24-hour update price can receive the 24 numbers by telephoning the utility any time after 4 PM. Prices are available in verbal or digital format. Next-day prices are also communicated using newspapers and TV.s

Price-quantity transactions. The price-quantity transactions are available only to those customers on a one-hour update spot price. At ten minutes before each hour, an interruptible energy rate for the subsequent hour is computed, based on system operating conditions and forecasts of how much interruptible energy will be purchased by customers. It is communicated in digital form over telephone to those customers who request it. Customers who choose to buy interruptible energy do so by communicating the secure energy level they want, so that all usage above that level is at the interruptible price. If the utility experiences short-term emergency operating conditions (such as a major genera-tion forced outage), the reduction required from each customer is computed and communicated via telephone to the customer's computer.

Short-term price forecast. Forecasts of the hourly spot price for each hour of the next week are made available if requested by the customer via telephone, in either verbal or digital format. Naturally these are only forecasts and can be wrong.

Billing. Customer bills are computed each month by summing the metered and recorded hourly energy use and multiplying by the spot price that existed ai" the corresponding hour. "::Long-term price hrecasts. Monthly and yearly price forecasts are made by the tltiliJY itself or by in'dependent information consultants who are not part of the e~ctric. utili ty.

Long-term contracts. Long-term fixed-price-fixed-quantity contracts are written through energy brokers who contract directly with the customers. These transactions have no effect on power system operation.

Now consider the customer boxes of Figure 104.1. Three different customers will be discussed:

o A large industrial customer who sees one-hour update spot prices, purchases interruptible energy, and has a long-term contract.

o A sophisticated residential customer seeing 24-hour update spot prices. o A simple residential customer seeing 24-hour update spot prices.6

Large industrial customer (foundry). This industrial customer is a foundry with many metalworking machines (1 kW to 100 kW), electrical metal melting (10 MW to melt, 1 MW to maintain molten), lighting, and space conditioning in the office. This customer has a sophisticated computer system which is used for both production scheduling (hourly for the next day and week) and direct control of scheduled processes. There are two individuals responsible for this customer's interaction with the energy marketplace: a production scheduler and a production manager. The production manager is concerned with long-term

HI I. Spot pricing of electricity

(monthly to yearly) issues and makes longterm contracts by combining long term price forecasts with forecasts of this customer's future electricity needs and cash flows. The production scheduler is concerned with hourly and daily opera tion and provides the inputs into this customer's control and scheduling computer.

The scheduling of plant operation is done by combining the shortterm price forecasts with the specified product mix that the plant is to produce. Metal melting is always scheduled to occur at the time of lowest forecast prices. When there is sufficient variation in the spot price, some of the largest metalworking machines (that require only a few operators) are scheduled to times of low prices. The office space conditioner is scheduled to make use of preheating and precooling the building (predictions of future outside temperature is an input to the optimization logic). When prices get extremely low at night, some of the metal curing processes that are normally done using natural gas are switched to electric energy. The price-quantity transactions are adjusted so that metal melting is always done on an interruptible price-quantity basis. During times when there is a large difference between the secure and interruptible prices, the secure level of energy purchase is reduced so that some of tht> other end uses are also on the interruptible rate (unless the plant has a very tight production schedule to meet). All of those scheduling operations are done automatically by the computer using input instructions and data provided by the production scheduler.

The direct control function of the computer makes minor adjustments on the actual hourby-hour operations depending on how the hourly spot prices actually behave (i.e., corrects for differences between actual spot prices and the short-term forecasts). When the utility calls for an interruption, the computer drops the overall energy usage to the specified secure level by turning off the processes which had already been classified as being interruptible.

The plant management is happiest when the spot prices have large time variations, as it is these variations that offer an opportunity to save money.

A sophisticated residential customer. This sophisticated residential customer under the 24-hour update spot price has a small, special-purpose computer which automatically dials the utility once each day to get the 24 prices for the next day. The computer then controls the space conditioning and water heating to meet this customer's desires (as told to or learned by the computer) with minimum cost. If the prices rise above a critical level specified by this customer, the computer warns the customer so manual control of usage can be undertaken if desired. The computer acts as an expert system to help the customer diagnose his/her own needs/desires and make rational decisions during normal and very high price variation days.

A simple residential customer. This simple residential customer also sees a 24-hour spot price but has no computer. Most of the time, this simple customer ignores the price variations and operates as usual. However, during the few critical times of the year when the price gets very high, the customer exercises

I. Overview 19

manual control. This customer learns of such times by reading the newspaper and/or listening to announcements made by the utility over the radio and TV.

SECTION 1.5. ENERGY MARKETPLACE OPERATION: A DEVELOPING COUNTRY

The example implementation of Section 1.4 emphasizes utility and customer computers talking to each other. This is reasonable for high-technology parts of the world where both the electric power system and some of the customers are very sophisticated. Our second example considers a developing part of the world where the electric power system is being expanded as fast as possible to meet and fuel the needs of a rapidly changing, less sophisticated society.

Instead of repeating the box-by-box discussion of Figure 1.4.1, we discuss the main differences between this case and the sophisticated implementation of Section 1.4.

In a developing-country implementation, only large industrial and the largest commercial customers see 24-hour and one-hour update spot prices. The 24-hour update is used for most cases. Residential customers (who have meters) see flat rates which mayor may not be updated each billing period. 7

For the developing country, all long-term contracts and price forecasts are provided by the utility itself.

The biggest difference is that for the developing country, new industrial and commercial facilities are built knowing, from the start, that they will be seeing energy marketplace spot prices. Thus their basic design incorporates control swilehes, storage capabilities, fuel switching capabilities, etc., that enable fast anG~large response to~changing prices. With a large labor force, fancy digital hardwarejs not needed for control. This yields a much more price-responsive industrial load than found in the developed country, where industries were built assumingth


the book strongly believe that a spot price based energy marketplace is the logical and inevitable successor of the present-day system. The key question is not if it will happen, but when, how and to what degree.

We would like to make a general comment on the appearance of some of our results. Certain of our formulas lead to price behavior which is quite different than conventional utility rates, and sometimes is even counter-intuitive. For example, line overload conditions on a single transmission line can affect spot prices throughout a network, raising some prices and lowering others. Another example is that spot prices for customers and generators are entirely symmetric. Results such as this reflect the physical and economic reality of electric power systems. In fact in many cases power system practice has been similar to spot prices for inter-utility sales, but customers have not been allowed to participate on the same basis. For example, inter-utility sales of economy energy have long been based on hourly prices, and have treated buying and selling symmetrically. In other cases, the anomalies are due to regulatory issues such as revenue reconciliation. They occur in any pricing system, although spot pricing sometimes makes them more visible by removing hidden cross-subsidies.

One side effect of the way spot prices reflect physical and economic reality is that spot pricing can be used to evaluate non-spot rates and transactions. For example, if spot prices paid to a small power producer would over time give it higher payments than the present-day rate, then at present the small power producer is cross-subsidizing the utility's other customers.

SUPPLEMENT TO CHAPTER I: SUMMARY OF ISSUES

An energy marketplace is based on the same fundamental principles that underlie the present-day utility system. However, its operation and effect are radically different. As a result, many issues arise. These issues are summarized here. They will be discussed in detail in subsequent chapters.

This material is included as a supplement to the main text because not all readers will want to wade through it at this time. However, many readers will eventually find it useful to have a concise summary, and we decided to include it at the beginning rather than the end of the book.

Table I.S.I lists the issues to be discussed. In the following discussion on the issues of Table I.S.I, the energy market-

place is compared with present-day transactions such as

Flat Rates: $jkWh fixed for all hours. Specified roughly one year in advance. Time-Of-Use (TOU) Energy Rates: Rates ($jkWh) vary with hour of day, day

of week, season of year. Specified one year in advance. Direct Load Control (DLC): Utility has ability to directly turn off or limit kW

usage of individual customer devices or groups of devices. Incentives specified one year in advance.

Demand Charge: $jkW at time of customer peak demand during month (possibly with yearly rachet). Specified one year in advance.

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1. Overview 21

Table I.S.1. Issues Relevant to Energy Marketplace Implementation

Changing the Status Quo Transactions Costs Utility Operating Costs Utility System Operation Utility Capital Costs to Meet Demand Utility Sustem Planning Utility Demand Forecasting Utility Revenue Stability Customer Options Customer Education Customer Understanding Customer Response Customer Cross-Subsidies Role of Regulatory Commission Impact on Microelectronic Industry

Changing the Status Quo Introduction of the energy marketplace constitutes a major change in the status quo. Individuals as we\1 as institutions usua\1y resist change. Utility rate makers and regulatory personnel are comfortable with present-day procedures. Utility operators and planners are used to making decisions without detailed considera-tion of rates and customer reactions. Customers may not be happy with the bills thty presently pay, but often suspect that change is just another way for the uttfity to extract more money. Customers who benefit from cross-subsidization undr present-day rates will be extremely unhappy with an energy marketplace wb'ereiRthey have to pay a fairer share of the costs. Industrial customers may

h~l.Ve built their plants in ways that require modifications to be able to respond effectively to price changes.

The costS: and problems associated with changing the present system con-stitute the single largest obstacle to the implementation of an energy market-place.

Fortunately, an energy marketplace can be implemented by a gradual tran-sition from the present system. For example, implementation can start with large industrial customers and be extended to sma\1er customers on a voluntary basis. The benefits of the marketplace can thus become familiar to customers and the utility before its more comprehensive adoption.

Developing countries do not have as severe a status quo problem as that faced by developed countries.

Transactions Costs The costs of changing the status quo will be large, but transient in nature. The transactions costs of the additional metering, communication and computation needed for an energy marketplace .will continue through time. Thus one basic principle underlying the specification of energy marketplace transactions is that the associated costs never exceed the additional resulting benefits, i.e., transac-


tional costs determine how customers are matched to types of transactions. The microelectronic revolution is driving transactional costs down at a rapid rate. Utility Operating Costs These costs include fuel, losses and maintenance associated with generation, transmission and distribution. Ideally, customer-utility transactions result in customers shifting some usage to times when the operating costs are low. Flat rates provide no such motivation. TOU rates can result in some desirable demand shifting, but because of the unpredictability of the actual times of utility low and high costs a year in advance (see Figures 1.1.1 and 1.1.2), TOU rates can also cause undesirable load shifts. OLe could have a sizeable impact on utility operating costs if it can be exercised as a part of the normal system operation (i.e. if there is no limit on its usage). However, OLe often involves contracts with customers which limit the number of utility control actions, so the reduction in annual operating costs is greatly reduced. Demand charges motivate customers to reduce their own monthly peak in a manner which usually has little or no effect on the utility's operating costs.

A spot price based energy marketplace can yield major reductions in utility operating costs because customers see prices directly related to the actual operating costs occurring at that time.

Utility System Operation The control and operation of an electric utility system is done by a highly sophisticated combination of computer hardware and software, communica-tions, and human judgment. Both economics and system security are of concern. Flat and TOU rates usually have little positive impact on control and operation, but TOU rates can complicate system operations by causing sharp jumps in system demand at times of TOU changes. Some types of OLe impose heavy demands on system operators. Good models which predict OLe impacts on demand can be difficult to develop. If there are limits on the number of possible OLe actions, the system operators become gamblers who have to guess when to use a limited resource in an uncertain world. This also holds true for many present-day interruptible contracts.

The energy marketplace's ability to vary prices in response to actual con-ditions provides system operators with a powerful new control signal. Good models for predicting short-term demand response are obtainable. Spot prices are control signals which are available all the time and which can get as large as needed, as often as needed, while still reducing overall customer bills.

To maintain system security, power systems always try to operate with sufficient operating reserve. The energy marketplace provides a mechanism for moving some or all of these operating reserves from the generators to the customers.

Utility Capital Costs to Meet Demand

Ideally, customer-utility transactions reduce the required investments for new

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I. Overview 23

generation, transmission and distribution by providing very strong incentives for customers to reduce usage during those few critical hours of a year when the utility system is approaching its capacity.9 Customers on TOU rates usually have little incentive to reduce demand at such critical times because the swing in TOU rates is too small, and the high TOU rates are in effect for many hours a week. Similarly, demand charges provide an incentive for customers to behave in a way which has a beneficial impact on utility capital requirements only in those rare instances when the customer's monthly peak hour happens to corres-pond to a critical time. DLC can provide the utility with short-term load relief only during those times when the particular appliances under control are being used by the customers (e.g., residential air conditioning cycling may not be very useful during the winter). DLC often has very limited value in long-term emergency situations (e.g., oil embargoes, coal strikes, and nuclear mora-toriums), because of the limitations imposed by customer contracts on the maximum frequency of its use.

An energy marketplace enables major utility capital investment savings for both the short-term and long-term emergency conditions. The size of the pricing signals during the few critical hours can be very large compared to TOU variations because TOU rates correspond to average conditions. Demand relief can be obtained during Fall and Spring, if it is needed because of unexpected equipment outages combined with maintenance scheduling. In major long-term emtrgencies, spot pricing can be viewed as a method of rationing by price. This iscwore desirable forLboth the utility and its customers than the use of rotating blackouts, brownouts, or any other arbitrary rationing scheme.


Even more important is the fact that spot prices provide closed loop feedback control which reduces the impact of uncertainty.1O

The major determinants of long-term (many years) load behavior are exoge-nous quantities such as the general state of the economy, demographic trends, and the price of electricity relative to gas and oil. Long-term predictions of OLC impacts present special problems because many of the OLC techniques are vulnerable to customer countermeasures, which customers learn over time as the OLC is exercised more and more. The detailed information on customer usage patterns and priorities provided by marketplace transactions is a major aid to the long-term modeling problem.

Utility Revenue Stability In an ideal world, a regulated utility receives revenues which cover its costs plus a reasonable rate of return on investment. In the real world, life is not so simple. TOU rates have caused revenue stability problems because utilities have found it difficult to specify TOU rates that yield the specified revenue targets. An energy marketplace introduces similar problems. However, the ability to con-tinuously adjust prices to market conditions makes it possible to greatly reduce revenue stability problems associated with modeling customer response. These problems will decline as data becomes available to develop the necessary models.

Customer Options

Customers have a growing desire to make their own decisions on the type of electric service they purchase. OLC and interruptible contracts are steps in this direction. However, an energy marketplace provides customers with a richer spectrum of options and allows more freedo,m of choice.

Customer Education An energy marketplace results in increased customer awareness of the value of electric energy. When customers have to decide how to respond, they automatic-ally begin to consider the value of the services provided by electric energy. This educational process greatly improves the relationship between the customers, the utility and the regulatory commission.

Customer Bills

Customers almost always say they want to reduce their monthly electricity bills. Actually they are willing to pay a higher bill if it is associated with tangible benefits they understand, such as increased comfort or production. Spot pricing gives customers maximum control over their bills.

The time average of TOU rates is higher than the time average of spot prices. Thus customers with flat usage see a reduction of their bills in the energy marketplace.

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I. Overview 25

Customers (like utilities) do not want to face uncertainty. Customers would like to be able to know what their bills are going to be in the future. In an energy marketplace, the customer's ability to control can be used to reduce bill uncer-tainty if desired. The energy marketplace also provides a mechanism (via long-term fixed-price-fixed-quantity contracts) for a customer to buy a type of insurance policy if uncertainty is particularly important. The uncertainty in hourly spot prices does not translate directly into an inability to predict future monthly bills with reasonable accuracy, because the summing of hourly costs into monthly bills introduces a lot of averaging. Present-day fuel adjustment clauses can introduce more uncertainty in monthly bills than spot pricing.

Customer Understanding Customers need to understand what is going on. Customers can readily under-stand TOU rates for energy, but are often confused by demand charges and DLC contracts which include limitations and conditions on utility control.

Spot pricing is a concept customers can understand because they are used to seeing prices which fluctuate in response to supply and demand conditions (e.g., the price offresh produce and airline tickets). An energy marketplace can result in a smaller and more easily understood set of transactions than that presently used by many utilities. Today, many utility rate books are thick documents that take training (and a lot of patience) to understand.


transactions provide a limited vehicle for reducing such cross-subsidies. An energy marketplace cannot completely eliminate cross-subsidies, but it can greatly reduce them. If cross-subsidies such as life-line rates are decreed to be socially desirable, they can be incorporated into an energy marketplace.

Role of Regulatory Commission Investor-owned utilities operate under regulatory commissions. An energy mar-ketplace changes the role of the regulatory commission.

In an energy marketplace, the regulatory commission no longer determines the actual values of the rates. Instead the commission determines the formulas which are used to compute the spot prices. This is a logical evolution from present practice, such as fuel adjustment clauses. It has the advantage that the commission is oper~ting at a higher level of decision making which is more appropriate to its basic function.

An energy marketplace gives the commission more options on how to provide the utility with incentives for efficient operation.

Impact on Microelectronics Industry

The microelectronic revolution has given birth to many new, dynamic compa-nies which are trying to introduce new communication, computation and control systems into the electricity market. However, many vendors have become extremely frustrated with the present-day electric utility situation because it is not clear what sort of product is marketable. The establishment of an energy marketplace will specify the ground rules for such vendors and provide them the opportunity to exploit their capabilities and offer innovative products to the customers. This will result in reduced costs for transactions and customer response.

Discussion of Supplement

All of the above utility, customer, regulatory and vendor issues have to be considered when deciding whether to follow the energy marketplace path and, if so, what directions to take. We believe that careful weighing of the costs and benefits will show an energy marketplace to be a clear winner in virtually all situations.

HISTORICAL NOTES AND REFERENCES-CHAPTER I

As discussed in Section I. I, a spot price based energy marketplace can be viewed as the logical evolution of present-day practice in any of the three fields: rate making, load management, and power system operation. As a result, the back-ground literature base underlying spot pricing is huge. At the end of each chapter we will use these "Historical Notes and References" to help the reader sort through the literature. However, we readily admit to failing to reference all the related work. In some areas we simply chose not to take the space to provide a comprehensive survey. Furthermore, we try hard but we are only human; i.e. we don't know everything.

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I. Overview 27

We do provide at the end of the book an Annotated Bibliography of our own reports and papers. Thus a small part of the overall subject is reasonably well covered.

To our knowledge, Vickrey [1971] was the first to explicitly propose a spot price based type of s~stem similar to Section 1.1. He called it responsive pricing. We do not use his terminology because, unfortunately we were well into our "spot pricing" research before we learned of his work.

Another term coming into usage in the literature is "real time" rates (or prices). The hourly spot price based rates discussed in this book are real-time rates. However, a real-time rate is the same as a spot price based rate only if it is based in a self-consistent, logical fashion on hourly (or some similar short-time span) spot prices, i.e., marginal cost with revenue reconciliation. Hence, real-time rates that are not the same as spot price based rates can and do exist. However, in many cases, one cannot tell the difference without exploring the basis under which the real-time rate is established.

At the present time, the electric utility industry in the U.S. and Europe seems to be moving (continuously, albeit slowly) towards implementation of an energy marketplace of the type discussed in Section 1.2. Tabors, Schweppe, and Cara-manis [1988) summarizes existing rates and load management schemes that are either directly spot price based or closely related. The report will undoubtedly be o,ut of date by the time this book is published. However, it is a place to start f


8. A variation on this approach is to replace the use of prices to allocate a scarce resource by allocating each industry energy credits, where a kWh used during critical times requires the use of more credits. This leads to the possibility of bartering among customers (see Williams, 1984).

9. Such times often do not correspond to times of peak system demand because of maintenance scheduling and random equipment outages.

10. In theory, feedback can sometimes aggravate the effect of uncertainty and even lead to an unstable system. However, spot prices are computed in a fashion which provides desirable feedback.

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I. THE ENERGY MARKETPLACE

I of this book is designed to provide the reader with an understanding . spot price based energy marketplace without having to go through the

UO;;Lall

2. BEHAVIOR OF HOURLY SPOT PRICES

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The hourly spot price for electric energy is the foundation of our approach to an energy marketplace. This chapter provides a review of hourly spot price ci)ncepts. Mathematical details can be found in Part II. The Annotated Biblio-giaphy'contains an extensive list of references and discusses their contents.

The hourly spot price is determined by the supply/demand conditions that exist at thai hour. In particular it depends on that hour's:

o Demand (in total and by location) o Generation availability and costs (including purchases from other utilities) o Transmission/distribution network availability and losses

This chapter provides the reader with an understanding of the composition and interpretation of hourly spot prices.

Sections 2.1 through 2.4 define the hourly spot price and its components. Section 2.5 discusses the special case where an aggregated network model is used instead of explicitly considering individual network lines. Section 2.6 discusses revenue reconciliation. Section 2.7 discusses buy-back rates. Sections 2.8 and 2.9 discuss two measures of hourly spot price behavior: expected price trajectories and the price duration curve. The chapter concludes with Section 2.10, which considers customer response.

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32 I. The energy marketplace

SECTION 2.1. DEFINITION OF HOURLY SPOT PRICE Define

Pk(t): Hourly spot price for kth customer during hour t ($/kwh) dk(t): Demand of kth customer during hour t (kwh) d(t): Total demand of all customers during hour t (kwh) del) = Lk dk (t)

An hourly spot price can be quantified in various ways. The basic approach used in this book is

Pk (I): Marginal (or incremental') cost of providing electric energy to cllstomer k during hour ( taking into consideration both operating and capital costs ($/kwh).

Definition of Marginal Cost

The hourly spot price (without revenue reconciliation) is given by the marginal cost, i.e.

(Total cost of providing electric energy to all customers now and through the future]

The derivative of (2.1.1) is evaluated subject to constraints such as

Energy Balance: Total generation equals total demand plus losses.

(2.1. I)

Generation Limits: Total demand during hour t cannot exceed the capacity of all the power plants available at hour t.

Kirchoff's Laws: Energy Rows and losses on a -network are specified by physical laws.

Line Flow Limits: Energy Rows over a particular line cannot exceed specified limits without causing system operating problems.

Revenue Reconciliation

The basic definition of (2.1.1) involves only marginal costs without considera-tion of revenue reconciliation - i.e. without consideration of embedded capital costs and rate of return on investment.

A key property of marginal cost based spot prices (equation 2.1.1) is They tend to recover both operating and capital costs.

Since generation is assumed to be dispatched optimally, marginal costs exceed average variable operating costs. Thus, charging customers at marginal costs yields revenues that exceed total variable operating costs; and this difference can be applied towards the capital costs. An optimum power system's marginal costs yields revenues which exactly match operating and capital costs. Unfortunately,

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2. Behavior of hourly spot prices 33

in the real world, this difference will usually either over- or underrecover capital costS.2 Mechanisms for revenue reconciliation are discussed in Section 2.6.

NUMERICAL EXAMPLE. Consider a utility with two generators where

Generator I Generator 2

Capacity IOOOMW IOOMW

Operating Costs 2/kWh

IO/kWh

Assume the generators are optimally dispatched (i.e. Generator I is used until demand exceeds 1000 MW). Then, ignoring losses and capital costs, it follows that

If Demand If Demand

Assume

1000MW, then: 1100 MW, then:

Utility Operating Cost ($(hr) 20,000 30,000

o Maximum demand = 1100 MW

Average Op. Cost ((kWh) 2 2.72

Spot Price ((kWh)

2 10

o Benefit customers receive from using electric energy is 5 (kWh

gefine short-term social welfare as . .

S1;ivr't-T~rm Social We:lfare = Customer Benefit - Utility Operating Costs Assume customers behave in their own best interest, i.e. are not willing to pay 1O(kWh fCir a benefit worth only 5 (kWh. Then it follows that

Equals Customer Minus Short-Term

Demand Benefit Costs Social Welfare (MW) ($) ($) ($)

If customers pay spot prices, the demand will be cut-off an 000 MW and: 1000 50,000 20,000 30,000 If customers pay average operating costs, then: 1100 55,000 30,000 25,000

Hence short-term social welfare is higher if customers see spot prices instead of average operating costs. Now change the conditions and assume the customer benefit is 15 (kWh instead of 5 jkWh. Then for both pricing schemes

Demand = 1100 MW Customer Benefit = $165,000


Utility Cost = $30,000 Social Welfare = $135,000

The utility's revenues (price times demand) are

If customers pay spot prices, then: If customers pay average operating cost, then:

Utility Revenue ($) 110,000

30,000

Utility Revenue Minus Costs ($) 80,000

o

The $80,000 profit made by the utility under spot pricing can be used to pay the capital costs of the two generators; however, this may either over- or un-derrecover the actual capital costs of the plants. We will return to this issue in Section 2.6.

SECTION 2.2. COMPONENTS OF HOURLY SPOT PRICES

The hourly spot price associated with the kth customer during hour t is viewed as the sum of individual components defined byJ,4

Pk(t) = Yr(t) [Generation Marginal Fuel] + YM(t) [Generation Marginal Maintenance] + YQs(t) [Generation Quality of Supply] + YR (t) [Generation Revenue Reconciliation] + ~L.k (t) [Network Marginal Losses] + ~QS.k(t) [Network Quality of Supply] + ~R.k(t) [Network Revenue Reconciliation] (2.2.1)

Quality of supply components arise when generation or network capacity limits are being approached. Thus they serve as curtailment premiums or reliability surcharges. The components of (2.2.1) are often combined into groups such as

[System Lambda]s A(t) yet) 'lk (I)

YF(t) + YM(t) A(t) + YQs(I) I/u(t) + ~QS.k(t)

[Marginal Value of Generation] [Marginal Value of Network Operation] (2.2.2)

The hourly spot price is decomposed into components as in (2.2.1) because each component of (2.2.1) has a physical/economic interpretation. However, it is important to note that (as will be shown shortly)

The various components of (2.2.1) are not necessarily independent of each other.

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For example, the loss component 'fJL.k(t) depends on system lambda, A(t). The network components of the hourly spot price depend on the customer

index k because different customers are located at different parts of the network. This spatial pricing results from the differences in line losses and the fact that individual lines can become overloaded in one part of the network while over the remaining lines flows are sustainable. In practice, spot prices will be the same for most customers in a specific class, e.g., service at 13 kV in the Sanderson Township. Section 2.5 introduces aggregated network models which eliminate some of the complications associated with spatial pricing.

SECTION 2.3. OPERATING COST COMPONENTS

The operating cost components of the hourly spot prices are usually the largest. They are:

Generation Fuel and Operations: A(t) Network Losses: 1)L,k (I)

Generation Marginal Fuel and Maintenance: let) The system lambda, A(t), component of the hourly spot price is the derivative of generation total fuel and maintenance costs with respect to demand this hour. Ideally it is obtainecLas the output of the unit commitment generation dispatch logics used in many modern electric power system control centers. System lam~da (as it is defirted in this book) includes the effect of purchases and sales th' utili!y may make with external, interconnected utilities.

In general, A(t) tends to increase with increasing total demand d(t). The A vs. demand curve varies over time since it depends on forced (and scheduled) power plant outag1s, water availability, purchase-sale opportunities, load-following costs as affected by ramp and must-run constraints, etc. When these intertem-pora! constraints are important, A(t) may be heavily influenced by planned future events. For example, in a system with a lot of hydro storage, the incre-mental generator is sometimes a hydro unit. The system lambda at those times is calculated based on the anticipated running cost of a fossil unit which will need to generate more when the reservoirs are empty.

NUMERICAL EXAMPLE. Consider a 14-generator system (no transmission losses) with maximum demand of 2000 MW where

Plant Capacity Operating Cost MW /kWh

1 Nuclear 1000 2 I Coal 800 3 12 Gas Turbines 100 each 10

Figure 2.3. J shows how the availability of the nuclear and coal plants affects the A vs. demand curve.


Case 1: 80th Nuclear and Coal Available

A $/kWh 10

3 2

f-

Nuclear

Case 2: Coal Not Available

10

~ 2

Nuclear

Case 3: Nuclear Not Available

10

Coal 31-------' 2

r

1000

1000

800 1000

Gas Turbine

Coal

18002000 d kWh

Gas Turbine

I

18002000 d

Gas Turbine

1800 2000 d

Figure 2.3.1. Effect of plant availability on A vs. demand curve.

Network Losses: '1L.k(t) This component arises from the energy losses resulting from transmission and distribution. It is shown in Chapter 7 that, assuming a quadratic dependence of losses on line flows, 1]L,k(t) is given by

oL(t) [A.(t) + }'Qs(t)] fJdk(t) (2.3.1)

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" az;(t) = [A(t) + I'Qs(t)] ~ 2R;z;(t) adk(t)

dk(t): Demand of kth customer during hour t (kWh) z;(t): Energy flowing over line i during hour t (kWh) L(t) : Total losses during hour t (kWh)

= L L,[z,(t)] ,

L;[z,(t)] losses in line i R;z7(t)

R;: Constant6 depending on resistance of line i

The effect of dk(t) on total losses and/or individual line losses depends on the physical location of the kth customer in the network. This dependence (as determined by Kirchoff's laws) is discussed in detail in Chapter 7 and in Appendices A and D.

The marginal network loss component can be quite important at times of high demand even if annual percentage losses are relatively small.

NUMERICAL EXAMPLE. Consider a two-bus, one-line system with all generation on ~ne bus and demand d(t) on the other. There is only one flow z(t), so

z(t), = d(t)

aztO '= 1 ad(t) , L(t) = Ri.~t)

.~ and (2.3.1) yields

ryl(t) = [A(t) + I'Qs(t)]2Rd

Schweppe - Electricity Spot Pricing

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