Market Architecture

1. Market Architecture Robert Wilson Stanford University

2. New Markets in Basic Industries • Privatization / “Liberalization” (worldwide)Deregulation / “Restructuring” (in U.S.) • Communications, Energy, Transport, Water • Motives:  Efficiency &  InvestmentArguments:  Scale   Contestability Markets “get prices (incentives) right” Light-handed regulation suffices • Implementation requires Market Design

3. Elements of Market Design • Inputs: Scarce resources. Outputs: Products, services.Instruments: Tradable rights and contracts.Markets: Physical forward and spot. Financial hedges.Prices: Bids. Allocation rules. Settlement rules. • Efficiency: Gains in short-run. Investments long-run. • Incentives: • Procedures invulnerable to gaming • Rules + Incentives  Efficiency (2nd Best) • Mitigate or control market power

4. Wholesale Electricity Markets • Energy: Long-forward. Day-ahead, Day-of. Real-time. • Markets: Bilateral. Exchange. Spot [ = Real-time] • Transmission: Day-ahead. Real-time. • Managed by SO [ = System Operator] • Markets: Congestion pricing, or purchase counterflow • Reserves: Capacity = Day-head. Energy = Real-time. • Markets: Auctions by SO. Real-time control by SO. • Hedges: Energy (Futures, CFDs). Transmission. • Markets: Auctions by SO. Secondary markets.

5. Simplified Electricity Market Transmission Capacity BA Supply Incs in A || in B Supply into A net of Demand in B Congested Price in A P(A) Uncongested Energy Price Demand into A net of Supply in A P(B) Congested Price in B Supply Decs in B || in A Imports into Region A Exports from Region B Transmission: Uses A-Incs & B-Decs [ Transmission Charge = P(A)  P(B) ] Spot Market: Uses all Incs & Decs Note: actual market has many zones or nodes

6. Design Issue #1Centralized v Decentralized(Complete v Incentives) • Centralized = consolidated marketsSO optimizes everything: energy, trans., reservesPrices = shadow prices on constraints • Prices are right if model good & data accurate • Decentralized = separated marketsPX clears markets, SO conducts auctionsPrices = clearing prices • Prices are right if markets are complete & perfectly competitive

7. Institutional Perspectives • Centralized designs are based on • Relational contracting. SO = Traders’ agent.Organizational structure inherited from utilities. • Objectives = reliability, coordination, pricing. • Incentives = sanctions. Abuses are penalized. • Decentralized designs are based on • Voluntary participation, bidding, availability.Few markets based on simple market clearing. • Objectives = efficiency, competition, min-SO. • Incentives = market prices for deviations.

8. Theoretical Perspectives • This debate is like 1930s Lange-Lerner.Basic fact is primal-dual equivalence of quantity and price mediated mechanisms. • Can incomplete and imperfect markets match optimization? • Requires good price discovery & repeat mkts. • Is decentralization necessary to promote competition and strengthen incentives? • Centralized designs cannot provide sufficient incentives if pricing is constrained (Vickrey).

9. Examples of Incompleteness • Simple contracts with retail customers • So demand highly stochastic (and no storage!) • Energy: Forward markets clear each hour independently. No contingent contracts. • Transmission: Scarce resources arenot priced when large zones are used. • Reserves: Capacity is priced imperfectly on relevant quality dimension -- response time.These are a few among many.

10. Example of Gaming • Centralized: set price at each node. • Nodal Price = Energy Price + Injection Chargefrom[Demand = Supply] & [Trans.  Capacity] • Decentralized: 1st clear DA energy market,2nd adjust energy in zones, 3rd use incs/decs. • Gaming: bidder sells huge quantity day-ahead that the SO is forced to sell back at low-priced dec in the spot market. Enter at congested node! • This is inevitable consequence of unpriced scarce resources (i.e., incomplete market).

11. Other Effects of Incompleteness • Impaired Efficiency • Intertemporal effects are ignored.Startup costs, ramping constraints,… • Flexible resources & reserves are under-priced.Due to lack of contingent planning or contracts. • Entrants attracted to wrong locations.Due to unpriced transmission constraints. • Sequence of markets depends on rational expectations. Anticipate transmission charge. • Impaired Competition • Each incompleteness invites gaming.

12. Remedies for Incompleteness • Sequence of markets • Repeated trading of simple contracts(long-forward, day-ahead, hour-ahead, spot) approximates complete market.Transmission is similar if pricing is locational at nodes. • Better price discovery • Iterative auction approximates Walrasian modelbut requires good activity rules.Example: “use it or lose it” options. • Complex market-clearing procedures • Requires consolidated markets run by SO ?

13. Summary • Can centralization work well? [complete] • Strengthen competition, or use incentive-compatible settlement rules (e.g., Vickrey). • Can decentralization work well? [incentives] • It works - systems are operating successfully.Most are seen as promoting competition. • But to price efficiently and prevent gaming requires effectively complete markets. • Can this be done without consolidated market?Working hypothesis is ultimately yes - after many improvements to control gaming.

14. Design Issues #2, #3(Addressed in text of paper) • Design details of each market • Energy: bilateral contracting, or an exchange. • Transmission: • Implementing nodal pricing in decentralized market • Markets for hedges, firm transmission rights • Reserves: design of two-dimensional auctions (available capacity, contingent energy supply). • Mitigation of market power • Divestiture. Contract cover. Supply auctions.

15. Comparisons with Other Industries • Transport industries with similar issues but different solutions: • Gas pipelines • Rail networks • Telecommunication networks • To what extent are solutions derived from: • Technical differences? • Point-to-point transport • Ownership and control? • Each network privately owned and managed, no SO!