EPOC Winter Workshop 2010

Anthony Downward, David Young, Golbon Zakeri

Outline Motivation Background

Risk AversionRetail Markets

ModelTwo-stageEntry into retail marketOne-node exampleNZ inspired example

Conclusions Future Work

Wolak Report Early last year Frank Wolak’s report to

the Commerce Commission was released.

It highlighted some shortcomings of the NZEM, including:limited competition for thermals in dry years,only one firm with generation in both islands.

It suggested that asset swapping may improve market outcomes.

Motivation

Ministerial Review Later that year, the Electricity Technical

Advisory Group produced a discussion paper that presented three asset swap proposals.

In December last year, the government stated its intent to give Tekapo A+B to Genesis and Whirinaki to Meridian.

Virtual swaps were also proposed, where contracts for energy in either island are compulsorily traded.

Motivation

Wholesale Market Paper appearing in the Energy Journal,

examining the effect of asset swaps and divestiture in the wholesale market.

In that paper, we assume Cournot Competition and produce some counter-intuitive results, particularly due to the presence of transmission.

Background

Retail Markets Consumers enter into contracts with

retailers, reducing the risk that they would otherwise face buying from the spot market.

Retailers compete with each other for the same consumers through mainly price competition.

Retailers must pass on the risk of purchasing from the spot market to consumers.

Background

Risk Aversion There is significant risk involved in

participating an electricity retail market. Retailers purchase electricity at the spot

price and sell to consumers at predetermined fixed prices.

In New Zealand, vertical integration is common; this acts an internal hedge against spot price fluctuations.

Background

Entry in Retail Markets Before a retailer decides to participate in

the market it must determine whether it’s a profitable decision, and whether there is significant risk involved.

There may be fixed costs associated with participating in the market, which are not related to the spot price of electricity or the amount of power served.

Background

Coherent Risk Measures Artzner et al. introduced the concept of

coherent measures of risk. A coherent risk measure has the

following properties:sub-additivity,translation invariance,positive homogeneity,monotonicity.

We employ conditional value at risk (CVaR) as our risk measure.

Background

Conditional Value at Risk This is also known as average value at

risk or expected shortfall. The CVaR at level β of an uncertain

profit is given by the expected loss of the lowest 100 β % of profits.

Firms who are risk-averse will balance the expected return of their decisions against the risk associated with that decision.

Background

Conditional Value at RiskBackground

10%

Profit

Differentiated Products We model retail demands as functions

of retail prices using a differentiated products model.

This model assumes that total demand is inelastic, and consumers merely switch between retailers.

The demand of a retailer is:

Model i i j i

j

d a b p p

Wholesale Market We allow retailers to also own

generation (vertical integration). We assume that the generation is bid

into the market at cost. This is said to be a competitive equilibrium.

At the time that retail contracts are determined, the future wholesale prices are unknown, due to uncertainties around hydro inflows and outages.

Model

Entry into Retail When firms consider entering a market,

they must take into account:the fixed cost of entry,the expected returns,the risk.

In our model, the retailers decide whether or not it is in their interests to participate in each market.

Model

Summary The full model consists of three stages:

Entry – here firms make 0/1 decisions regarding whether they have a retail base at each node.

Retail competition – each firm sets a retail price at each node.

Wholesale market – the uncertainty is resolved and wholesale prices and profits are computed.

Model

2nd Stage Formulation All firms optimise the following profit

maximisation problem simultaneously.

Model

max 1

0

i i

S Wi i i j i i

j

i

E CVaR

p p a b p p P

p

Single node First we consider a situation with two

gentailers at a single node. Firm A owns a thermal plant whereas B

owns a hydro, each with capacity of 100MW.

The firms compete for customers in the retail market.

The total demand is 150MW. Water value: h ~ U[0,100]

Example

Wholesale Prices and Profits As a function of the water value, h, the

wholesale prices and profits can be computed:

Example

50, 50,, 50.

0, 50,100 50 , 50.

100 50 , 50,0, 50.

S

WA

WB

hp h

h h

hP h

h h

h hP h

h

Risk-neutral Equilibrium If firms are risk-neutral, it can be shown

that the profit from the wholesale market has no bearing on the retail pricing.

We can compute the equilibrium retail prices for both firms to be $137.50 in this case.

In this situation both firms share the retail demand equally.

Example

Best Response Now let us examine the optimal retail

prices for the firms as they increase their risk-aversion.

The hydro plant makes more profit when water values are low, whereas the thermal plant makes more profit when the water values are high.

Example

Best ResponseExam

ple

Risk vs. ReturnExam

ple

$155.00

$137.50 $137.50

$131.25

ProfitExam

ple

EquilibriumExam

ple

Retailers Entering Now suppose that we allowed retailers

to enter this market if it were profitable to do so.

Such a retailer would enter the market if the risk-adjusted profit exceeds the cost of entry.

For simplicity, in this example, we will assume that all firms share the same attitude toward risk.

Example

ProfitsExam

ple

Endogenous EntryExam

ple

Two node (inspired by NZ) In this model we have 2 nodes and 3

firms:firm A owns 2 thermal plants in the north,firm B owns 2 hydro plants in the south,firm C owns 1 thermal in the north and 1

hydro in the south. The North and South have separate

retail markets. Firm B is not in the North and firm B is not in the South.

Example

Asset SwapBefore Swap After Swap

Example

H H H

T T T

H H H

T T T

PricesExam

ple

Status Quo If the asset swap does not incentivise an

additional firm to enter into each retail market, then we find the following change in prices.

Example

North Price South Price CostA B C A B C

Before Swap 283.35 – 288.90 – 344.84 344.84 916775

After Swap 287.20 – 290.83 – 345.49 346.13 923697

Firms enter the other market On the other hand, if firm A enters the

retail market in the South and firm B enters in the North, we find the following prices.

Example

North Price South Price CostA B C A B C

Before Swap 225.12 226.90 226.90 271.34 274.05 268.53 691235

After Swap 227.79 227.79 227.79 278.17 278.17 278.17 733751

Cost of EntryExam

ple

All firms in both islands

No entry

Firm A enters South

Conclusions Risk aversion for firms can affect

whether or not they enter a market. If they do enter, whether there exists a

risk premium or discount for the consumers depends on the particular circumstances.

From our model of the asset swap, we find that this will only have a beneficial affect on consumer prices if additional retailers enter each market.

Future Work Calibrate the model to New Zealand:

What risks are retailers concerned about?What entry costs exist?

Include virtual asset swaps. Suggestions?