Competitive wholesale electricity markets are at a turning point, caught between a rapidly decarbonizing resource mix spurred by falling clean energy prices, and market structures designed around fossil fuels. Markets are becoming increasingly ill equipped to handle large amounts of cheap renewable energy and flexible distributed energy resources.
A new research paper series led by Energy Innovation seeks to answer the critical question facing grid managers and regulators: What wholesale market design provides the best framework for reliably integrating clean resources and decarbonizing the power system at least cost?
This two-part opinion series outlines underlying questions about wholesale market reform, and introduces two separate pathways for markets to evolve.
In part one, Rob Gramlich of Grid Strategies LLC and Michael Hogan of the Regulatory Assistance Project propose maintaining today's energy markets coupled with more robust bilateral contracting to solve the challenges facing markets.
"What wholesale market design would provide the best framework for integrating reliably and at least cost the new, clean resources that will be needed to de-carbonize the power system?"
To answer this question, we need to consider how best to provide clean sources with fair access, to drive timely retirement of the fossil fuel generation they are meant to replace, and to enable new "smart" resources at the distribution/retail level. The answer encompasses both market structure (which entities perform which functions) and market design (trading, bidding and price-setting rules).
The required pace and scale of new investment in clean resources will necessarily rely on legislation or regulations exogenous to the market, such as zero-carbon portfolio standards or carbon pricing. These should be designed to address climate externalities in a way that enhances rather than substitutes for the role of the market in driving investment.
Integrating these new resources as quickly and efficiently as possible is best achieved through a program of improvements to the prevailing spot markets. Reports of the death of the existing market construct are greatly exaggerated.
Our proposed suite of known opportunities can promote a more robust central spot market in which energy prices reflect the real-time demand for all services. This, in turn, will incentivize active decentralized forward contracting between wholesale buyers and sellers, enhanced by exogenous policies that factor environmental values into the market.
If pursued deliberately, this decentralized approach is capable of driving and integrating the investment needed to deliver reliability and rapid decarbonization at the lowest reasonable cost to consumers.
A centralized spot market with decentralized forward procurement is the best approach
Our proposal relies on a central spot market, decentralized voluntary procurement of power by electricity buyers, and complementary public policy instruments that internalize to the market the externalities of greenhouse gas (GHG) emissions.
The centralized regional robust spot market for efficient dispatch and price formation
This market model includes a large spot market operated by a regional transmission organization ("RTO").
The RTO's market design would feature:
Economic dispatch based on market bids and reflecting the impact of reliability-driven security constraints on the marginal cost and price of energy;
Locational marginal prices;
Tradeable financial transmission rights with trading hubs to insure against congestion cost risk;
Energy plus reserves scarcity pricing based on the value of reliable service (or value of lost load—VOLL)
Co-optimization of energy and reserves;
Fast dispatch intervals with resource commitments made close to real time;
Consolidation of real-time balancing authorities over the largest practicable footprint and portfolio of system assets; and
Technology-neutral reliability service procurement for essential reliability services using market mechanisms where possible.
Prices determined in this centralized short-term market lay the foundation for long-term decentralized contracting of services, discussed below.
Decentralized bilateral procurement markets to manage price risk
New investment will be needed both in new clean resources and in short-term and seasonal balancing resources.
The cost of capital can be lowered by access to long-term contracts to hedge risks. Such risk-hedging options include power purchase agreements and other forms of forward risk management.
Our proposal is based on incentivizing active voluntary bilateral energy market trading of such risk-hedging arrangements. Wholesale buyers, the counterparties for such arrangements, can include utilities, competitive retail suppliers, or end users with direct access to the market.
A well-designed and well-implemented spot market lays the foundation for this activity.
Whereas generators are motivated to mitigate the risk of over-supply and sustained low energy prices, wholesale buyers will be motivated to mitigate the risk of very high prices at times when power is scarce. This basic market dynamic — mutually beneficial forward trading to mitigate risk efficiently — is enhanced rather than supplanted by good public policy that internalizes the externality costs of GHG emissions.
This can include establishing a price for carbon emissions, which augments the risks of contracting with carbon-intensive resources, or by establishing portfolio purchase standards, which introduce the risk of being unable to procure enough of certain types of energy at a reasonable price.
Such policies efficiently accelerate the decentralized procurement of desired resources (and, critically, facilitate the corresponding retirement of existing resources) rather than relying on centralized administrative procurement.
Buyers can be expected to manage these risks in a variety of ways to maximize their competitiveness and sustain their commercial viability, as long as they are in a financial position to do so. A financially stable pool of trading counterparties is a critical success factor.
State regulators should monitor and enforce credit requirements to ensure that entities serving retail customers have both the incentive and wherewithal to manage the risks associated with their supply obligations.
Evaluation of proposed market structure
The proposed market structure accomplishes a number of important objectives, including the following:
Facilitates rapid decarbonization
This model transforms the energy supply through a combination of decentralized risk allocation and management with exogenous public policy that internalizes the value of clean energy in the market.
Maximizing market-driven bilateral contracting for low-carbon resources will reduce the financial and political pressures that inevitably come to weigh on public investment, making sufficiently rapid decarbonization more likely by optimizing the balance between the role of market participants and the role of public policy.
The proposed model also best facilitates the accelerated retirement of existing fossil fuel generation by eliminating centrally administered forward procurement of capacity.
Promotes short-run efficiency, including generation and load dispatch
The proposed market design has been demonstrated to dispatch resources and manage congestion efficiently in serving two-thirds of U.S. demand.
There is no reason a market with a high share of resources with low, undifferentiated production costs cannot continue to do so. In fact, dispatch is managed efficiently in many regions today despite having large tranches of the merit order offering little or no differentiation in short-run production costs.
The key is pricing that dynamically reflects locational and operational constraints on the ability to meet the combined demand for energy and essential reliability services. Highly flexible demand, including new transport and heat loads, will make prices more reflective of the value of energy during periods of scarcity or surplus, rather than simply tracking short-run production costs.
Promotes long-run efficiency, including efficient entry and exit
This approach promotes the investment needed to meet the level of reliability consumers actually want and are willing to pay for. It supports that investment principally by incentivizing wholesale market buyers and sellers to allocate risks efficiently and hedge forward to mitigate those risks.
Minimizing centrally administered resource investment decisions reduces structural biases in favor of incumbent sources of investment and resource types. It also facilitates the necessary pace of high-carbon generation exits by eliminating the opportunity for system operators to act on the natural incentive to maintain uneconomic surpluses.
While direct investment cost may be somewhat higher under this model, societal cost is reduced by minimizing the hidden transfer of investment risks to consumers and taxpayers that they do not understand and cannot manage.
Provides reliable service at the level customers want and are willing to pay for
The goal of reliability is to economically serve customers' interests, not the interests of investors, system operators, regulators or elected officials.
This market model ensures that the price of energy reflects the true marginal cost of energy, every hour of every day, based on the actual demand for both energy and essential reliability services. It leverages the inherent flexibility of many end uses to respond to such pricing to reduce bills. This creates the right incentives for:
market players to support new investment only when new investment is needed;
investment in the kinds of resources best suited to respond to the needs of the system;
customers willing and able to be more responsive, lowering costs for all consumers; and
market players to shed surplus, uncompetitive resources.
Readily implementable approach
This approach leverages improvements on the existing market structure.
The required improvements are largely incremental though not insignificant. This represents a far less daunting challenge than throwing out the existing market construct altogether and starting over, a critical consideration given the urgency of the task at hand.
Decentralized markets model: most efficient, practical path to decarbonization
The decentralized markets approach described here supports decarbonization, short- and long-run efficiency, and reliability.
It equitably allocates risks and responsibilities among grid operators, load-serving entities, consumers, and investors. It marries market-driven investment with complementary clean energy policies. And it avoids the political wrangling associated with centralized models and the over-capacity and misallocation of resources to which these models often lead.
In part two of this two-part series, analysts Steven Corneli and Brendan Pierpont, along with Eric Gimon of Energy Innovation, propose a hybrid solution that adds long-term markets to today's short-term spot markets to support clean energy investment and reliably decarbonize the power system at least cost.