Stoft PDF

Power System Economics (389p)
Designing Markets for Electricity © 2001

Steven Stoft
Excerpts from Part 3

Part 1: Introduction 88 p.
Part 2: Price Spikes, Reliability and Investment 110 p.
Part 3: Market Architecture 78 p.
3-1 Key Questions of Market Architecture 5 p.
1 Spot Markets, Forward Markets and Settlements
2 Controversies
3 Simplified Locational Pricing
3-2 The Pure Bilateral approach 5 p.
1 No central market
2 Central Coordination without Price
3 A Pure Transmission Market
3-3 Why Have a Spot Energy Exchange 7 p.
1 A Pure Spot Market for Energy
2 Conclusions
3-4 Real-Time Pricing and Settlement 12 p.
1 The Two-Settlement System
2 Setting the Real-time Price
3 Ex-Post Prices: The Trader’s Complaint
3-5 Why Have a Day-ahead Market? 9 p.
1 When Marginal-Cost Bidding Fails
2 Reliability and Unit Commitment
3 Efficiency and Unit Commitment
4 The Congestion Problem
3-6 Day-Ahead Market Designs 13 p.
1 Defining Day-Ahead Auctions
2 Four Designs
3 The Impact of Startup Insurance
4 Transmission Bids and Virtual Bids
3-7 Multi-Part Unit Commitment? 16 p.
1 How Big is the Unit Commitment Problem?
2 Market Design #1: A Pure Energy Auction
3 Market Design #3: A Unit Commitment Auction
3-8 A Market for Operating Reserves 11 p.
1 Bid-Based Pricing.
2 Opportunity-based pricing
Part 4: Market Power 56 p.
Part 5: The One-Line Network 63 p.
Chapter 3-1
Questions of Market Architecture
M ARKET ARCHITECTURE CONCERNS THE KEY DESIGN

ELEMENTS. While Part 2 abstracts from all questions of market design to
focus on market structure, Part 3 considers alternative designs for the realtime
market, the day-ahead forward markets and the relationship between the two.
It also discusses several controversies, such as the degree of centralization, that
have often plagued the design process. Design elements are considered in just
enough detail to allow comparisons between the main alternative approaches.
While Part 3 moves forward from real-time it does not move past the day-
ahead market, and it does not consider private bilateral markets that operate
beside the markets organized by the system operator (SO). It focuses only on
those markets that are typically part of an ISO design.
Section 1: Spot Markets, Forward Markets and Settlements.
Forward markets are financial markets while the realtime (spot) market is a
physical market. To the extent power sold in the day-ahead market is not
provided by the seller, the seller can buy replacement power in the spot market.
This is the basis of the two-settlement system that underlies one standard
market design in which the SO conducts both day-ahead and spot energy
markets.
Section 2: Controversies. Three major controversies have beset the
design of power markets. First is the conflict over how decentralized the
market should be. One view holds that both day-ahead and spot markets should
be bilateral energy markets, and the SO should have no dealings that involve
the price of energy but instead sell (or ration) only transmission.
The second conflict arises only if the day-ahead market is to be run by the
system operator (centralized). One view holds that such an auction market
should utilize multi-part bids to solve the unit commitment problem in the
Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

CHAPTER 3-1 The Key Questions of Market Architecture 3
traditional way. Another view holds that bids should specify only an energy
price.
The third conflict concerns the level of detail at which locational prices are
computed. The “nodal” view typically argues for hundreds or thousands of
locations, while the zonal view typically calls for well under one hundred. This
controversy is less fundamental and is not considered in Part 3.
Section 3: Simplified Locational Pricing. All markets discussed in
Part 3 produce energy prices that are locationally differentiated. The theory of
such prices is not presented until Part 5, so a summary of their properties is
given in Section 3. These prices are competitive and thus independent of the
market’s architecture. Because they are competitive they have the normal
properties of competitive prices; they minimize production cost for a given
level of consumption, and they maximize net benefit.
3-1.1 SPOT MARKETS, FORWARD MARKETS AND SETTLEMENTS

Trading for the power sold in any particular minute begins years in advance and
continues until real time, the actual time at which the power flows out of a
generator and into a load. This is accomplished by a sequence of markets
which often overlap. The earliest markets are typically forward markets that
trade non-standard long-term contracts. Futures contracts typically cover a
month of power during on-peak hours and are sold up to a year or two in
advance. Trading continues in less formal markets until about one day prior to
real time. Typically, just as this informal trading peters out, the system operator
holds its day-ahead (DA) market. This is often followed by an hour-ahead
(HA) market and a realtime market also conducted by the system operator.
All of these except the realtime market are financial markets in the sense
that suppliers need not own a generator to sell power. The realtime market is
a physical market, as all trades correspond to actual power flows. While the
term spot market is often used to include the DA and HA markets, this book
will use it to mean only the realtime market because it is the only physical
market. A customer in the DA market does not purchase electricity but rather
a promise to deliver electricity. If the promise is not kept, the supplier must buy
the power it failed to deliver in the spot market. It is possible to sell power in
the DA market without owning a generator and cover the sale with a spot
market purchase. A clever speculator can make money on such purely financial
transactions, but he cannot trade only in the spot market.
Financial markets need a way for traders to unwind their position. If a
supplier sells, in a financial market, 1600 MWh to be delivered evenly over the

4 PART 3: Market Architecture
sixteen peak hours of July 1, this should impose only a financial commitment.
Typically such a sale includes a clause for liquidated damages; if the power is
not delivered, the supplier must pay the cost of replacement. This always
allows the supplier the option of buying replacement power, and, except in the
most extraordinary conditions, this can be done in a subsequent market.
The most formal arrangement for purchasing replacement power occurs in
the system operator’s markets. Any power that is sold in the DA market but not
delivered in real time is deemed to be purchased in real time at the spot price
of energy. This is called a two-settlement system and has a number of useful
economic properties. They are discussed in Chapter 3-4.
3-1.2 CONTROVERSIES
Three main controversies regarding architecture have beset the design of many
power markets.
1 Central vs. bilateral markets

2 Exchanges vs. pools
3 Nodal vs. zonal pricing
The first two controversies both concern the amount of centralization. In

theory all power trades could be handled by bilateral markets in which private
traders trade directly with each other, or through a middleman (power
marketer), but not with an exchange or pool. This approach is particularly
cumbersome for balancing the system in real time. Once it is admitted that
centralization is needed, an attenuated form of the same controversy questions
the extent to which the system operator should provide coordination. Should
it collect large amounts of data on generators and compute an optimal dispatch,
or should it let generators signal these parameters indirectly through the energy
prices they bid?
Last, there is a controversy over how finely the system operator should
compute locational energy prices. A “nodal pricing” approach would define
more than a thousand distinct locations in California. When the market was
first designed the advocates of “zonal pricing” suggested that two zones would
be sufficient, though many more were added later around the edge. More were
subsequently required in the interior. This is the least fundamental of the three
controversies and is not discussed in Part 3.
Central vs. bilateral markets. The first two controversies concern the
role of the system operator (SO). Some wish to minimize its role at almost any
cost. Chapter 3-2 takes up the question of whether completely bilateral markets
are possible and concludes that the system operator must perform a centralized
allocation of transmission rights, but with the use of sufficient penalties and

curtailments the SO could be kept from making any trades. Of course, its
influence on the market would still be pervasive.
Chapter 3-3 considers the possibility of a centralized spot market in
transmission only. This would allow private bilateral markets to provide the
spot energy market, but because this arrangement makes the realtime balancing
of the system difficult and expensive, it is rejected in favor of an energy spot
market (realtime balancing market) run by the SO.
Chapter 3-5 considers the same question for the DA market, but in this case
the answer is less obvious as the time pressure is far less severe. Here the
answer hinges on the unit commitment problem and the need for coordination.
Although a private bilateral market would cause much less inefficiency, there
appears to be a strong case for at least the minimal central coordination that can
be provided by a pure-energy market run by the system operator.
Exchanges vs. Pools. Unit commitment is the process of deciding which
plants should operate. Integrated utilities have always done this using a
centralized process that takes account of a great deal of information about all
available generation. If this is done incorrectly the wrong set of plants may be
started in advance which can lead to two problems: (1) inefficiency and (2)
reduced reliability. As just noted, a bilateral market solves this problem poorly,
so a centralized DA market is preferred. The second controversy concerns the
extent of central coordination.
There are two polar positions: let generators bid only energy prices (1-part
bidding) or let generators bid all of their costs and limitations (multi-part
bidding). One-part bidding allows the SO to select the amount of generation
to commit in advance but gives it very little information about the generators’
costs and limitations. Consequently it can apply none of the usual
optimization procedures, but it can provide some coordination by purchasing
the correct quantity of power a day ahead. With multi-part bids, the SO can
select bids on the basis of the traditional optimization procedure.
Typically, this controversy focuses on comparing the existence, efficiency
and reliability of the market equilibria for 1-part and multi-part auctions.
Chapter 3-7 demonstrates that both types of markets have equilibria that exist
and that are likely to be very efficient and reliable. If there is a problem, it is
that markets have difficulty in arriving at the equilibrium of a 1-part auction
market when costs are “non-convex” as they are in power markets. This
difficulty arises from the extensive information requirements of 1-part bidding.
In such an auction, competitive suppliers should not simply bid their marginal
costs but must estimate the market price in advance in order to determine how
to bid. This is a far more difficult task than simply bidding one’s own costs as
required by normal competitive markets or by a multi-part bid auction.
Unfortunately, not enough is known about how such markets perform in
practice so no conclusion can be drawn as to which is preferable, though it
seems plausible that a two or three part auction could be designed to capture

most of the advantages of both extremes. Fortunately, the unit commitment

problem is small enough that it may not matter much which design is adopted.
(While this controversy is often lumped with the “nodal pricing” controversy,
it has only a little to do with locational prices.)
3-1.3 SIMPLIFIED LOCATIONAL PRICING

Energy prices differ by location for the simple reason that energy is cheaper to
produce in some locations and transportation (transmission) is limited. When
a transmission line reaches its limit, it is said to be congested, and it is this
congestion that keeps energy prices from equilibrating between different
locations. For this reason locational pricing of energy is equivalent to
“congestion pricing.”
The pricing of congestion is not explained until Part 5, but Part 2 makes use
of some basic concepts of congestion pricing. These can be explained without
delving into the underlying economics. The interested reader will find all of the
following results explained in Chapters 5-3, 5-4 and 5-5.
Locational prices of energy are just competitive prices, and these are unique.
They are determined by supply and demand and have nothing to do with the
architecture of the market, provided it is a competitive market. This means a
purely bilateral market that is perfectly competitive will trade power at the same
locational prices as a perfectly competitive, centralized nodal-pricing market.
Of course, a bilateral market is likely to be a little sloppier with its pricing and
not arrive precisely at the competitive equilibrium, but given enough time and
small enough transaction costs it should arrive at the full set of nodal prices just
as efficiently as a fully centralized market.
Because there is a unique set of locational prices, there is also a unique set
of “congestion” prices, which will also be called transmission prices. Again,
these are determined be competition and supply and demand conditions and
have nothing to do with the market architecture, provided the market is
perfectly competitive.
If the competitive energy price at X is $20/MWh and the price at Y is
$30/MWh, then the price of transmission from X to Y is $10/MWh.
Transmission prices are always equal to the difference between the
corresponding locational prices. If this were not true, it would pay to buy
energy at one location and ship it to the other. In that case arbitrage would
change the energy prices until this simple relationship held. This relationship
can be expressed as follows:
PXY = PY – PX,
which is read, “the price of transmission from X to Y equals the price of energy
at Y minus the price of energy at X.”

This relationship is all that is needed to understand Part 3, but it contains

one surprise that deserves attention. Because transmission prices are not based
on a cost of transporting the power (we ignore the cost of losses which is
minor) but are based instead on the scarcity of transmission (line limits),
transmission costs can be negative. In fact, if the cost of transmission from X
to Y is positive, then the cost from Y to X is certain to be negative. This is a
direct result of the above formula.
This peculiarity can be understood by noting that when power flows from
Y to X it exactly cancels (without a trace) an equal amount of power flowing
from X to Y, thus making it possible to send that much more power from X to
Y. A second consequence of the above formula is that the cost of transmitting
power from X to Y does not depend on the path chosen
All of the markets discussed in Part 3 are assumed to compute locational
prices and to operate competitively. Consequently, they will produce the
locational energy prices and transmission prices just described. In spite of their
ubiquitous presence, the reader will not need to understand details of how
locational prices are computed and nor rely on either of the properties just
discussed. They are presented merely to provide context.

Chapter 3-2
The Pure Bilateral Approach
T HE “MIN-ISO” APPROACH TO POWER MARKET DESIGN,

POSTULATES THAT THE LESS COORDINATION THE BETTER THE
MARKET.1 This philosophy underlies attempts to keep the system operator out
of the energy market. In other markets this would be possible. For example the
U.S. Department of Transportation does not buy or sell trucking services, it just
provides highways and charges for their use. This chapter examines the
inefficiencies that would result from keeping the system operator out of the
real-time energy market.
Section 1: No Central Coordination. Imagine an electricity market run as
a system of highways. Every power injection by a generator could be measured
and charged to pay for the cost of the system. Any generator could sell power
to any customer and deliver that power by injecting it at the same time the
customer used it. Unfortunately, there would be no way to prevent theft. With
trading fully decentralized, no one would know who had paid and who had not.
Section 2: Central Coordination without Price. The simplest actual
proposal for a power market suggests that all trades be registered with the
system operator who would accept only sets of trades that did not cause any
reliability problem. This proposal takes the first step towards the enforcement
of reliability and the prevention of power theft, but it does not take the second
step of specifying what happens when traders violate their schedules. In this
system the operator knows nothing of prices, and imposes no penalties.
1
Although, it does recognize the need to enforce transmission constraints it proposes to do
this with arbitrary curtailments and without the use of any market mechanism..

CHAPTER 3-2 The Pure Bilateral Approach 9
Section 3: A Pure Transmission Market. The next step is to sell

transmission rights. This improves on the previous system by removing the
arbitrariness from the distribution of transmission rights and reduces the
transaction costs by centralizing the transmission market. It does not solve the
problem of balancing the real-time market. This could be accomplished with
penalties and curtailments. These would induce the development of private
system operators. Because system operation is a natural monopoly it would be
necessary to limit their size. Although this could produce a workable power
market it would have much higher transactions costs than necessary.
3-2.1 NO CENTRAL COORDINATION

Most markets do not need any central coordination. To understand why a
power market does, imagine one without coordination. As with highways, any
supplier could use the wires and would be charged for their usage. The grid
owner would meter each supplier’s output and impose a per MWh or a annual
peak-MW charge sufficient to pay for the cost of the wires.
Without any central coordination a supplier could sign a contract with a
customer for 100 MW all day on April 1 at $40/MWh. The generator would
then inject 100 MW and the load would take 100 MW and pay the generator.
There would need to be thousands of such contracts, but this would be no
different from other markets.
The most fundamental problem with this design is that loads would steal
power. Why have a contract? Just turn on the lights. The grid operator does
not care because it gets paid for every watt transmitted—it could measure either
all injections or all withdrawals of power. Other generators and customers care
because their power is being stolen, but they have no way to prove this.
Because electricity cannot be directed by a supplier to its intended destination,
there is no way to prevent theft. Power from every generator flows to every
load.
A second problem, which would only occur if the first could be solved, is
that certain transmission lines would be overused. There are only two
approaches to protecting lines: (1) load and generation can be disconnected to
reduce flow on overloaded lines, and (2) overloaded lines can be taken out of
services. The system is already programmed to take lines out of service
instantly and automatically when they reach their limits. While this protects
lines, it also destabilizes the system which then requires extraordinary central
coordination to restore its balance. Centrally controlled circuit breakers could
be installed on all loads and generators, and these could be used to prevent

Chapter 3-3
Why Have A Spot Energy Exchange?
F ORWARD MARKETS SELL PROMISES OF POWER, THE SPOT

MARKET SELLS ELECTRICITY. But the system operator need not be
allowed to trade electricity and instead could sell transmission to bilateral
traders of electricity. Although there is nothing inherently wrong with this
process, it is slower than centralized energy trading. When balancing the
power system, time is of the essence. In fact the price mechanism is orders of
magnitude too slow to do the complete job. So to get the maximum benefit
from markets, the fastest market must be used for balancing, and that is a
centralized locational energy market.
Section 1: A Pure Spot-Market For Energy. Every deviation from balance
is handled by a sequence of procedures the first of which take place in less than
a tenth of a second. Because great speed is required, the initial process, to the
extent it is not automatic must be centrally directed. Current pricing
mechanisms are not much use in time frames under ten minutes. But at some
point, the job of equating supply and demand can be handed over to a market
mechanism. This is the real-time or “balancing” market.
System balance for a control area is determined by a combination of net
inflow and system frequency. Even if every bilateral trade using a particular
control area is in perfect balance, the system operator will be directed to either
increase or decrease generation if the system frequency is off, which it almost
always is. Consequently the operator must have some control over energy.
Section 2: Conclusions about the Real-Time Market. The essence of the
problem of system balancing is speed. Once the most time-critical part of
balancing has been handled their comes a point where price can do the job. But

CHAPTER 3-3 Why Have A Spot Energy Exchange? 15
in order to maximize the usefulness of the market, the fastest market should be
used, and that is a centralized energy market. A transmission market can only
sell transmission when two equal but opposite energy trades have been found.
Thus a transmission market is just an energy market with restrictions, and it is
inherently more expensive when great speed is needed.
Of course by spending more on market infrastructure any market can be
made faster. The usual proposal is to impose penalties on bilateral trades that
get out of balance. This appears to keep them in balance cheaply, or even at a
profit. (To stay in balance they must adjust very quickly, so this is method of
speeding up the market.) But penalties simply hide the costs, which must be
born by those with bilateral contracts. It is wiser to use a locational energy
market as the real-time market and leave bilateral trading to forward markets
that can proceed at a more leisurely pace.
3-3.1 A PURE SPOT-MARKET FOR ENERGY

The previous chapter considered three approaches to energy trading that might
have eliminated the need for a centralized real-time energy market, but all were
needlessly expensive. The real-time market needs fully centralized
coordination because electrical energy is not stored and so supply must equal
demand second by second. In fact, this requirement is so severe that even a
centralized energy market requires several types of reserves. “Regulation”
operates most quickly because it is automatically controlled. Next comes 10-
minute spinning reserves, 10-minute non-spinning reserves and finally 30-
minute non-spinning reserves. Each of these requires many generators to be
under the direct control of the system operator.
The balancing market overlaps with the 10-minute reserve markets, which,
by providing a safety net for emergencies, allow the more sluggish and less
reliable mechanism of a market-clearing price to be utilized in this time frame.
Sluggish as this process is by engineering standards, real-time electricity prices
are probably the most nimble and effective prices to be found anywhere. On
a daily basis they balance supply and demand to within a few percent as these
change at rates of up to 20% per hour. Rarely do any other markets see price
changes of this speed and then only during panics. More typically prices adjust
1000 times more slowly.
Those who demand that the real-time energy market be taken out of the
hands of the SO to be replaced by a transmission market and uncoordinated
bilateral energy trades base their demands on ideology and not a study of the
capabilities of present-day markets. The main substantive objections to energy

Chapter 3-4
Real-Time Pricing and Settlement
C USTOMERS AND GENERATORS SHOULD RESPOND TO THE SPOT

PRICE AS IF THEY HAD BOUGHT AND SOLD ALL THEIR POWER IN THE
SPOT MARKET. Typically, however, they buy and sell almost all of their
power in forward markets. Fortunately, the correct settlement system insulates
the real-time markets and preserves their incentives.
Contracts for differences (CFDs) insulate forward contracts from the real-
time (spot) price even though loads and generators trade all of the power in
their spot market after having already traded it in the forward markets. From
a trader’s point of view, the main problem with spot markets is timing of
transmission costs. These are not posted in advance but are determined along
with the price of energy in the spot market. This is often called ex-post pricing.
Although determining the real-time price is simple in theory (just set price
so supply equals demand), it is complex in practice. Most real time markets
have a large number of rules, and there is little consistency in these rules
between systems. Their purposes vary. Some are designed to limit market
power, some to protect the system from sudden shifts in supply and demand
that might result from or cause price instability. Others are the result of
software anomalies or various superstitions, but this chapter will ignore such
complexities and stick to basics.
Section 1: The Two-Settlement System. If the system operator runs a day-
ahead (DA) and a real-time (RT) market, generators should be paid for power
sold in the DA market at the DA price regardless of whether or not they
produce the power. In addition, any real-time deviation from the quantity sold
a day ahead should be paid for at the real-time price. This system allows an

CHAPTER 3-4 Real-Time Pricing and Settlement 23
almost complete separation between the markets. Even if a generator sells

essentially all of its power in the day-ahead market, it will still have the correct
incentive to deviate from that contract in response to realtime prices. In real
time the generator has the same incentives as if it were selling all of its power
in real time. Loads are treated analogously with the same effect.
If bilateral traders use contracts for differences (CFDs), and if the spot price
does not vary with location, bilateral trades will be unaffected by the spot price
even though the generators and loads sell all of their power in the spot market,
provided they generate according to their contract. In spite of this, CFDs leave
them with the proper incentive to deviate in ways that benefit the deviating
party and leave the other parties unaffected.
Section 2: Ex-Post Prices: The Trader’s Complaint. Spot prices that
differ by location impose transmission costs on traders. These cannot be
avoided by the use of CFDs, and they make trade risky. Time-of-use
transmission charges could be posted in advance as an approximation of
congestion charges, but their inaccuracy would cause an inefficient dispatch.
A reservation system would be required to avoid the most serious
inefficiencies.
A market in transmission rights would be preferable to reservations sold at
regulated prices. Such markets exist, but are limited and illiquid. Technical
and practical difficulties have prevented the development of more robust
markets, but these problems are receiving considerable attention. Transmission
rights can be financial or physical, and financial rights can be used effectively
as a reservation to assure complete protection from realtime transmission
charges.
Section 3: Setting the Real-Time Price. The real-time price should be set
to clear the market. As not all response to price changes is reflected by supply
and demand bids, if price is set strictly on the basis of these bids, it will
overshoot. This problem will grow as real-time pricing becomes more
prevalent, which will make it necessary for the system operator to improve its
understanding of the dynamic affects of price changes.

3-4.1 THE TWO-SETTLEMENT SYSTEM

If a supplier sells most or all of its power in the forward markets, the realtime
price would appear to have little effect on that producer’s behavior. In a
properly implemented two-settlement system the opposite is true. The supplier
will behave as if it were selling its entire output in the realtime market and will
still behave, when selling in the forward market, as if that were its final sale.
In this way, if the markets are competitive, suppliers (and also consumers) will
behave optimally in both markets.
Separation from Forward Transactions

Say a supplier sells Q1 to the system operator (SO) in the day-ahead market for
a price of P1. If this amount of power is delivered to the real-time market, the
settlement in the day-ahead (DA) market will hold without modification. But
what if none is delivered, or more than Q1 is delivered? In either case the DA
settlement should still hold, but there should be an additional settlement in the
real-time market. If no power is delivered to the real-time market, the supplier
is treated as if it had delivered the amount promised in the DA market, Q1, and
purchased that amount in the real-time market instead of generating it.
Consequently the supplier is still paid P1 for Q1, but is also charged P0, the real-
time price, for the purchase of Q1. In general, if a supplier sells Q1 in the DA
market and then delivers Q0 to the real-time market, it will be paid:
Supplier paid: Q1·P1 + (Q0 – Q1)·P0
This is called a “two-settlement system.” If a customer contracts for Q1 and
then takes only Q0 in real time, it is charged exactly the amount that the supplier
is paid.
Result 3-4.1 A Two-Settlement System Preserves Real-Time Incentives

When the real-time market is settled by pricing deviations from forward
contracts at the real-time price, supplier and customers both have the same
performance incentives in real time as if they traded all of their power in the
real-time market.
The incentive of this settlement rule can be revealed by rearranging the

terms as follows:
Supplier paid: Q1·(P1 – P0) + Q0 ·P0
When real-time arrives, Q1 has been determined in the day-ahead (DA) market.
Assuming the market is competitive, the generator has no control over either
price, and by real time the first term will be taken as given. The first term will
be viewed as a “sunk” cost or an assured revenue. This leaves the second term

Chapter 3-5
Why Have a Day-ahead Market?
P OWER MARKETS ARE DIFFICULT TO COORDINATE BECAUSE THEY

DO NOT SATISFY THE ASSUMPTIONS OF A CLASSICALLY
COMPETITIVE MARKET. Under classical assumptions, suppliers need to
know only their own costs, and no central coordinator is needed. For a power
market to perform efficiently, either it must be centrally coordinated or
suppliers must know a great deal about the market equilibrium price in
advance. The root of the problem is generation costs that fail to satisfy a key
economic assumption used to prove the efficiency of competitive markets.6
Because the proof of efficiency fails, uncoordinated power markets are
often believed to have no equilibrium or only a very inefficient one. In fact
they have equilibria that are extremely efficient but difficult to discover. This
chapter argues that at least a small amount of central coordination is well worth
while and should take the form of a centralized day-ahead market. The
question of whether this market should perform a full centralized unit
commitment is discussed in Chapter 3-7.
In a classic competitive market, suppliers can offer to supply (in a bilateral
market) or to bid (in an auction market) according to their marginal cost curve.
When all do so, the market discovers a perfectly efficient competitive
equilibrium. But with “non-convex” costs of generation, it becomes necessary
for generators to bid in a more complex manner.
6
Part 2 focused on the consequences of the far more serious demand-side flaws in
contemporary power markets. Part 3 ignores these and focuses on problems with generation
costs that are very small but unavoidable.

CHAPTER 3-5 Why Have a Day-Ahead Market? 35
One market design allows suppliers to continue bidding their marginal costs
but include other costs and limitations in their “multi-part” bids. This has the
advantage of allowing suppliers to base their bids on easily obtained
information: their own costs. Another approach can take the form of a
decentralized bilateral market or a centralized market with one-part energy bids.
In both cases, suppliers must account for all of their costs and limitations in
their energy price bid so they do not bid their true marginal costs.7 With this
approach, suppliers must utilized considerable information about the external
market.
This chapter argues that the second approach, with its formidable
information requirements, causes coordination problems that are more severe
in bilateral markets than in a centralized one-part-bid energy auction. It
concludes that the coordination problems in a bilateral market will be
substantial enough that this approach should not be adopted for the day-ahead
market.
If bilateral markets promised some important advantage, their reduction of
efficiency and reliability might be justified. But bilateral markets have higher
transaction costs and are less transparent than a public auction. They are also
impossible to use for settling futures contracts. Finally, adopting a centralized
day-ahead market does not preclude the operation of a bilateral day-ahead
market.
Section 1: When Marginal-Cost Bidding Fails. A cost function is “non-
convex” if costs increase less than proportionally with output. Startup costs,
no-load costs, and several other components of generation costs contribute to
making them non-convex. Consequently generation costs fail to satisfy the
conditions necessary to guarantee a competitive equilibrium. This does not
necessarily prevent the market from being very efficient, but will cause
competitive suppliers to bid above marginal cost if they cannot bid their startup
and no-load costs directly. The amount they should bid above marginal costs
depends on the outcome of the market which can only be estimated at the time
of bidding.
Section 2: Reliability and Unit Commitment. In a bilateral market,
generators must commit (start running) without knowing which other
7
Day-ahead bilateral markets could allow very complex contracts but do not because it
would make contracting too expensive.

generators have decided to commit. Because starting up is costly, they will not
start unless they expect to cover this cost, an outcome which depends on how
many other generators have started and will compete against them the next day.
The uncertainties of this problem cause a random level of commitment in a
bilateral market, and this decreases reliability.
Section 3: Efficiency and Unit Commitment. The randomness in the level
of commitment, causes inefficiency. Although this randomness is caused by
information problems, a similar phenomenon can occur because of the lack of
a market clearing price. While this second phenomenon has received more
attention, it is probably of less practical importance.
Section 4: The Congestion Problem. Transmission bottlenecks
(congestion) cause prices to differ by location and make the price more difficult
to estimate in advance. The congestion problem significantly exacerbates the
information problem of bilateral and one-part bid markets, because these need
to know the market price in advance. In bilateral markets, this leads to a
significant increase in randomness and inefficiency. A centralized one-part bid
auction provides much of the coordination needed to take account of
congestion efficiently.
3-5.1 WHEN MARGINAL-COST BIDDING FAILS

The normal description of a competitive market, found in earlier chapters,
requires bids that reflect marginal costs. In spite of all suppliers bidding their
marginal costs, they were able to recover their fixed costs through infra-
marginal (scarcity) rents. This situation obtains in markets that satisfy the
assumptions needed to prove the existence of a competitive equilibrium. These
assumptions are well approximated by many markets, but certain aspects of
power markets fail to satisfy these classic assumptions.
Without these assumptions, economics cannot prove a market has a
“competitive equilibrium.” This is a less devastating critique of a market than
is often supposed. The concept of a competitive equilibrium is quite narrow,
and a market does not cease to function without one. Instead it produces some
other type of equilibrium which may involve some market power or some
randomness. These flaws may reduce its efficiency very little. Economists,
aware of this fact, depend on it when arguing that their results apply to the real
world, which never quite conforms to their assumptions.

Chapter 3-6
Day-Ahead Market Designs
T HERE ARE MANY POSSIBLE DESIGNS FOR A CENTRAL DAY-AHEAD

MARKET, BUT ALL CAN BE DESCRIBED AS AUCTIONS. The most
obvious design just prices energy like the real-time market. A different
approach turns the system operator (SO) into a transportation service provider
who knows nothing about the price of energy but instead sells point-to-point
transmission services to energy traders.
Either of these approaches presents generators with a difficult question.
Some generators must engage in a costly startup (commitment) process in order
to produce at all. Consequently, when offering to sell power a day in advance,
a generator needs to know if it will sell enough power at a price high enough
to make commitment worthwhile. Some day-ahead (DA) auctions require
complex bids that describe the generators’ startup costs and other costs and
constraints and solve this problem for the generators. If the SO determines that
a unit should commit, it insures all its cost will be covered provided the unit
does commit and produces according to the accepted bid. Such insurance
payments are called “side payments,” and their effect on long-run investment
decisions is considered in Section 3-7.3.
The three approaches just named, energy, transmission and unit
commitment can also be combined into a single auction that allows all three
forms of bid; this is how PJM’s day-ahead market works. Generators can offer
complex bids and receive startup-cost insurance if they are selected to run.
Anyone can offer to buy or sell energy with simple energy bids, and traders can
request to buy transmission from point X to point Y without mentioning a price
for energy. PJM considers all of these bids simultaneously and clears the

CHAPTER 3-6 Day-Ahead Market Designs 45
market at a set of locational energy prices together with startup-cost insurance.

The differences in energy prices from location to location determine the prices
for transmission.
Section 1: Defining Day-Ahead Auctions. All day-ahead markets
organized by system operators are auctions. Market participants submit bids,
and the auctioneer (the SO) arranges trades according to a simple principle:
maximize the net benefit as defined by the bids. If a customer offers to pay $40
and manages to buy for $30, the net benefit is $10. The calculation for
suppliers is similar. The auction accepts the set of bids that maximize the sum
of these net benefits and sets prices so that all trades are voluntary. The four
day-ahead markets discussed here follow these simple principles and differ only
in the type of bids they allow. Some allow bids for energy, some for
transmission, and some allow complex bids that specify many costs and
limitations for each generator.
Section 2: Four Day-Ahead Market Designs. Each auction is specified
by three sets of conditions: bidding, determining which bids are accepted, and
determining the payments associated with the accepted bids. Market 1, a pure
energy market, determines nodal prices. Market 2, trades only transmission and
involves no prices for energy. Market 3 adds unit commitment to Market 1.
Market 4 combines the features of the other three and is modeled on the current
PJM market.
Section 3: Overview of the Day-Ahead Design Controversy. Forward
markets are bilateral and realtime markets are centralized. The day-ahead
market can be designed either way and this causes a great deal of controversy.
The “nodal pricing” approach specifies an energy market with potentially
different prices at every node (bus), and, almost always, specifies that the
auction should solve the unit commitment problem as well. This requires a
great increase in complexity of bids. The bilateral approach specifies that
energy trades take place between two private parties and not between the
exchange and individual private parties. To trade energy, the private parties
require the use of the transmission system, so the system operator is asked to
sell transmission.
Market 2, takes a purely bilateral approach, while market 3, takes the full
nodal pricing approach. Market 1, the simplest market, implements nodal
pricing, but not unit commitment. Market 4, the most complex, implements all
the features from both the bilateral approach and the nodal pricing approach.

3-6.1 DEFINING DAY-AHEAD AUCTIONS

This chapter concerns day-ahead markets run by system operators. These take
the form of either exchanges or pools and are operated as auctions in which the
process of selecting the winning bids is often complicated by transmission and
generation constraints. Consequently, the selection process often requires the
use of enormously complex calculations and sophisticated mathematics.
Unfortunately, the outlines of the mathematics are often presented as a way of
explaining the auction. This is unnecessary, often confusing, and generally less
precise than an approach that focuses on the intent of the calculation instead of
on the mechanics of the calculation.
A Simplified Description of Auctions

A bid acceptance procedure is often presented as a linear programming
problem represented by several large sets of inequalities, a dozen sets of
variables, and an objective function. This representation is generally an
approximation to the actual program and does not account for such power-
system procedures as contingency analysis. For the purpose of defining the
market and understanding its behavior, it is more useful and accurate simply to
specify that production cost is to be minimized subject to transmission and
generation constraints. This is the problem that the accepted bids must solve;
linear (or nonlinear) programming is one possible technique for finding the
solution. Ideally, before the market is implemented, the actual calculation
technique should be tested to see if it is accurate enough to produce a
reasonably efficient market. This is, however, no excuse for presenting the
auction economics as a linear programming problem.
Avoiding the details of the computation makes it easier to focus on more
important economic considerations such as restrictions on the form of bids, how
the winning bids are paid or charged, and penalties for non-performance. The
following section presents such fundamental information for four types of day-
ahead markets and follows certain conventions to facilitate the comparison of
these markets.
Determining Quantities
Auctions must determine the quantities sold and purchased and the price.
Although the two are closely related they are separate problems, and the same
set of bids can yield the same quantities but different prices under different
auction rules. From an economic perspective, it is quantities that determine
efficiency, and prices are important mainly to help induce the right trades.

In all four auctions described here, quantities of accepted bids are selected
to maximize total net benefit. This assumes the bids reflect the bidders true
costs and benefits. Although they may not, assuming that they do generally
encourages truthful bidding.
Total net benefit is the sum of customer and supplier net benefit, but it is
also the benefit to customers minus the cost to suppliers. This simplification
helps explain the role of price as well as the economist’s attitude towards price,
as an example will make clear. If a customer bids 100 MWh at up to
$5,000/MWh, and the bid is accepted, the benefit to the customer is $500,000.
If the market price is $50/MWh, the customers cost is $5,000 and net benefit
is $495,000. Similarly, if a generator bids 100 MW at $20/MWh, its cost is
presumed to be $2000. If the market price is again $50/MWh, its net benefit
will be 100x($50–$20), or $3000. Writing this calculation more generally
reveals that the price played no role in determining total net benefit.
Total Net Benefit = Qx(V–P) + Qx(P–C) = Qx(V–C),
where Q is the quantity traded, V the customers value, C the supplier’s
production cost, and P is the market price. Thus the problem of maximizing
net benefit can be solved independently of any price determination.
In an unconstrained system, net benefit can be maximized by turning the
demand bids into a demand curve and the supply bids into a supply curve and
finding the point of intersection. This gives both the market price and a
complete list of the accepted supply and demand bids. Unfortunately
transmission constraints and constraints on generator output (e.g. ramp-rate
limits) can make this selection of bids infeasible. In this case it is necessary to
try other selections until a set of bids is found that maximizes net benefit and
is feasible. This arduous process is handled by advanced mathematics and
quick computers, but all that matters is finding the set of bids that maximizes
net benefit, and they can almost always be found.
Determining the Market Price

In an unconstrained auction, the market price is given by the intersection of the
supply and demand curves. The price determined by supply and demand is the
highest of all accepted supply bids or the lowest price of an accepted demand
bid. It depends on whether the intersection of the two curves occurs at the end
of a supply bid, and in the middle of a demand bid, or vice versa. When the
demand curve is vertical, the intersection is always in the middle of a supply
bid, and the price is set to the supply bid price.
Whichever curve is vertical at the point of intersection has an ambiguous
marginal cost or value (See Chapter 1-5). If the demand curve has a horizontal
segment at $200 that intersects a vertical part of the supply curve that changes
from $180 to $220, then the marginal cost of supply is undefined but is in
between the left-hand marginal cost of $180 and the right-hand marginal cost

Figure 3-6.1
Either marginal cost
or marginal value is
ambiguous.
of $220. Consequently it causes no problem to say that the market price equals
both the marginal cost of supply and the marginal value of demand. [fig]
Consider how net benefit changes when an extra kW is added to the total
supply of power at zero cost. This will shift the supply curve to the right and
will have one of two consequences. Assuming that both curves are step
functions, it will either increase the amount consumed by 1 kW, or not increase
it at all. If consumption is increased, the benefit of that consumption will be the
market price, and the cost of supply (the added kWh) will be zero. The net
benefit per kW is the market price. If consumption is not increased, some
supply with a cost equal to the market price will be displaced by the new zero-
cost kWh. This leaves benefit unchanged and reduces cost, so again the net
benefit per kW is the market price. If the supply and demand curves were
smooth, the result would have been the same except there would have been a
contribution from both increasing benefit and decreasing cost. Similarly the
reduction in net benefit from extracting a kW from the system is also given by
the market price. Thus, no matter how you compute it, the marginal value of
power to the system sets the market price.
Contrary to popular belief, auctions are not designed to determine who sells
and who buys by comparing bids to the price determined by marginal-cost.
Marginal cost pricing is not a goal, it is a byproduct. Auctions determine which
set of trades is the most valuable possible (feasible) set of trades, and selects
this set. Once they have been selected, the market price at each location is set
to the marginal value or marginal cost of supply to the system at that location.12
The market price, MP, determined in this way has two properties. First, at
every location, the MP falls on the dividing line between bids that are accepted
and those that are not. If some bids are partially accepted then MP is equal to
their price. Second, given the first property, the difference between the total
12
The net benefit should be in $/h.. A kW, rather than a MW, is used to indicate that only
a “marginal” change is being made. Technically one should use calculus, but this is of no
practical significance.

amount paid by customers and the amount paid to suppliers is as small as

possible. No other price would have these two properties.
Conventions and Notation for Describing Auctions

The use of supply- and demand-curve bids is common in DA auctions.
Typically these curves are represented by either piece-wise linear functions
(connect the dots with straight lines) or step functions. Typically these allow
the bidder to specify about ten sloped lines or horizontal steps, but all that
matters is that bidders can submit a fairly accurate approximation to their actual
supply and demand curves. This will be assumed, and the details will be
ignored.
An auction market has three distinct sets of rules: one set for bidding, a
second for bid acceptance and rejection, and a third for settlement. The
description of each of the four DA markets is broken into these three
categories.
3-6.2 THE FOUR DAY-AHEAD MARKETS

Four subsequent pages give summaries of the economics of four types of day-
ahead markets. Each is a “locational” market and these locations may be either
single buses or zones containing several buses. If zones are used, the
transmission constraints will represent the market less accurately, and so a more
conservative representation of constraints may be required. This affects only
the details of the constraint specification and not the specification of the
markets.
Market 1: Pure Energy

The bids in a pure energy market are sometimes called one-part bids because,
for a given quantity of energy offered, the only a single price is specified. In
some respects this is the simplest DA market. Participants do not search for
trading partners and do not have to consider many prices in many locations.
Each trader simply trades with the exchange at the traders location. The SO’s
job is simple because it ignores the unit commitment problem. The one
difficulty, discussed in Chapter 3-7, is that suppliers cannot always bid their
marginal cost.
Market 2: Transmission
The transmission auction is equally simple for the system operator but requires
a complex pre-market step for market participants. Buyers and sellers must
find each other and make provisional energy trades that depend on whether or

not they successfully buy transmission, or power traders must be brought into
the picture to arrange such trades and must bid for transmission. In either case
the SO sells only transmission.
Market 3: Energy with Unit Commitment

Solving the unit commitment problem requires a great deal of information, so
the bids in this auction are quite complex. This is more of a burden for the
system operators than for the generators who are familiar with the required
data. The system operator must perform a complex calculation, but the
necessary software is available. The outcome is locational energy prices that
are sometimes too low to induce the needed generator to start up.
Consequently suppliers are given side-payments also calculated by the SO’s
program.
Market 4: Commitment, Pure Energy and Transmission

The market is modeled on PJM’s current market and includes all of the types
of bids allowed in the previous three markets. This is the most complex market
from the SO’s point of view, but, like market 3, it can be quite simple for
suppliers if they simply bid competitively. This requires only that they bid their
costs.
Notation used in auction market descriptions

PS(Q), and PD(Q) Supply offer curve and demand bid curve
QD Quantity demanded ( used in place of PD(Q) )
QA Quantity accepted (supply or demand)
MPX, MPXY Locational market price in DA auction for energy or transmission.
MP0, Q0 Price and quantity of a specific participant in the real-time market.
X, Y Two different locations.
Cstart Startup cost.
Cost Variable production cost. Sum of area under all PS(Q), 0 ! Q ! QA
Benefit Consumer benefit. Sum of area under all PD(Q), 0 ! Q ! QA
{} a set of prices or quantities

Market #1: A Pure, Day-Ahead Spot Market for Energy

Bidding Rules:
Format (supply): Non-decreasing PS(Q)
Format (demand): Non-increasing PD(Q) or QD
Different supply and demand bids allowed for each hour.
Bid Acceptance Rules:
Format (for both): {MPX} and {QA} for each hour.
Acceptance Problem: Maximize total NB = (Benefit – Cost).
MPX = Net Benefit, NB, of a costless kWh injected at X.
Restrictions (supply): MPX >= PS(QA)
Restrictions (demand): MPX <= PD(QA), or QA = QD
Restriction on MP: MPX can be different at each location, X, but must be the
same for all accepted bids and offers at each X.
Constraints: Transmission flow limits.
Settlement Rules:
Supply: Pay: QA x MP + (Q0 – QA ) x MP0
Demand: Charge: QA x MP + (Q0 – QA ) x MP0
Both: Q0 is the quantity actually produced or
consumed. MP0 is the real-time price.
Comments:
Because generators cannot bid their startup costs, it is generally believed they need to
submit different price bids in different hours. Loads, whose usage is largely unrelated to
price, must do the same. {QA} represents the set of accepted bid quantities, one for each
supplier and each demander; a different one in every hour.
To determine which bids are accepted, the auction first finds the set of supply and
demand bids which, if accepted, would maximize total net benefits, NB, to all market
participants. Then market price at each location is determined by asking how much NB
would be increased by making another kWh available at no cost at that location. After
introducing the free kWh, the optimal accepted bids are again determined, and this
determines a slightly higher NB. That is the value of the kWh and that value sets the price
per kWh at that location. The increase in value can come from either more consumption or
less production cost. A kWh is specified to mimic a “marginal” change which is normally
computed by taking a derivative.
A day-ahead market is a forward market, and the forward price holds if suppliers deliver
and customers take delivery of the DA quantity. Participants know they sometime cannot
make or take delivery exactly, so strategy in the day-ahead auction will depend on what
happens in the real-time market. New York, for instance, imposes a penalty of exactly (Q0
– QA ) x MP0 on generators, completely cancelling real-time payments for extra production.
This is perhaps the greatest penalty in any current ISO market.
[box]]

Market 2: A Pure, “Bilateral” Market for Transmission

Bidding Rules:
Format: {PT, Qmax > 0, from X to Y} for each hour.
Format: {MPXY}, {QA <= Qmax} for each hour.
Acceptance Problem: Maximize total NB = sum PT x QA.
MPX = Net Benefit, NB, of a 1 kW increase in the
transmission limit form Y to X.
Restrictions: MPXY <= PT of accepted bid.
MPXY is the same for all accepted bids from X to Y.
Constraints: Transmission flow limits.
Settlement Rules:
Charge: QA x MP + (Q0 – QA ) x MP0
Where Q0 is the quantity actually transmitted from X to Y,
and MP0 is the real-time price from X to Y.
Comments:
Note that PT and MPXY are prices for transmission, not energy. Even if every MPXY is
known, it is not possible to compute energy prices from transmission prices. If there are 10
locations there will be 90 pairs of locations and consequently 90 transmission prices. But
MPXY = – MPYX. Also, MPXY + MPYZ = MPXZ. All of these prices can be determined from
10 locational energy prices. Adding the same constant to these ten prices does not change
their differences and so leaves the transmission prices the same. The apparent complexity
of transmission prices masks an underlying simplicity of energy prices.
The net benefit of the transmission sold in the auction is the sum of the accepted
quantities times the price bid. This gives the value placed on the transactions by the bidders.
The extra value added by expanding the transmission capacity from X to Y by 1 kW for an
hour is called the shadow price of the line form X to Y. Setting MPXY equal to this price
makes it satisfy the two restrictions on MPXY. In addition, this price minimizes the charges
for transmission given these restrictions and gives competitive bidders an incentive to bid
their true values.
Allowing fixed-quantity bids creates difficulties, so it is probably best not to allow them.
Any rights that are purchased and not used are most likely still valuable as can be seen from
the settlement rules. If Q0 = 0, i.e. none of the rights are used, then the purchaser receives
a payment of QA x MP0 from the real-time market. This may be more or less than the cost
of the rights, QA x MP, but on average arbitrage should keep these nearly equal.
box]

Market 3: A Full “Nodal-Pricing” Market

Bidding Rules:
Supply Format: Non-decreasing PS(Q) / Cstart / ramp-rate limit / etc.
Only one supply bid is allowed per day.
Demand Format: Non-increasing PD(Q) or QD, one bid per hour.
Format (supply): Commitment: Yes / No
Format (for both): {MPX} and {QA} for each hour.
Acceptance Problem: Maximize total NB = (Benefit – Cost).
MPX is computed with the selected units committed.
Constraints: Transmission security, ramp-rate limits, etc.
Settlement Rules:
Supply: Pay: R = QA x MP + (Q0 – QA ) x MP0
Supply: Provide: Startup insurance if: Commitment = Yes
Demand: Charge: QA x MP + (Q0 – QA ) x MP0 + uplift
Comments:
Startup insurance is provided to generators who are scheduled to startup by PJM in
the DA market and who do startup and “follow PJM’s dispatch.” Following dispatch
amounts to starting up when directed to and keeping output, Q, within 10% of the value
that would make PS(Q) equal the real-time price. Startup insurance pays for the
difference between as-bid costs and market revenues, R. As-bid costs include at least
energy costs, startup costs and no-load costs.
Most generators that startup do not receive insurance payments as they make enough
short-run profits. The total cost of this insurance is less than 1% of the cost of wholesale
power. “Uplift” includes the cost of startup insurance and several other charges.
[box]

Market 4: PJM’s Day-Ahead Market*

Bidding Rules:
Format (supply): Non-decreasing PS(Q) / Cstart / ramp-rate limit / etc.
Only one supply bid is allowed per day.
Format (demand): Non-increasing PD(Q) or QD.
Format (transmission): {PT, Qmax > 0, from X to Y} for each hour.
Formats (“virtual”): Buy Q at up to PE. Sell Q at PE or higher.
Format (supply): Commitment: Yes / No
Format (both): {MPX} and {QA} for each hour.
Acceptance Problem: Maximize total NB = (Benefit – Cost)
Constraints: Transmission security, ramp-rate limits, etc.
Settlement Rules:
Supply: Pay: R = QA x MP + (Q0 – QA ) x MP0
Supply: Provide: Startup insurance if: Commitment = Yes
Demand: Charge: QA x MP + (Q0 – QA ) x MP0 + uplift
Comments:
* This description is still simplified as it leaves out PJM’s daily capacity market,
various other markets, and near-markets for ancillary services and all of the
accompanying uplift charges. However this formulation captures the central
characteristics of a flexible market containing the described Pool which uses complex
bids.
The acceptance problem solved by PJM differs from the one in Market 4 in that only
cost-savings from generation counts towards net benefit. In other words, a demand bid
can not set the price, only a supply bid can.
“Ramp-rate limit” is meant as a proxy for this and various other constraints on the
operation of generators, such as minimum down time. Startup cost, Cstart, is also meant as
a proxy for other costs that are not captured in the supply function PS(Q), such as no-load
cost.
[box]

Chapter 3-7
Multi-Part Unit Commitment?
B Y ALLOWING ONLY “1-PART” ENERGY BIDS, A DAY-AHEAD

AUCTION CAN FORCE SUPPLIERS TO SOLVE MUCH OF THE UNIT
COMMITMENT PROBLEM INDIVIDUALLY. The extreme alternative is to
allow multi-part bids so generators can specify, start-up costs, no-load costs,
ramp-rate limits and many other costs and parameters, then have a system
operator make the traditional calculation. Traditionally, utilities have used a
great deal of information about each generator and in recent years have
performed sophisticated calculations to decide which units to commit. Some
power markets, such as those in California, Alberta and Australia, abandon
this approach with little apparent degradation of the dispatch.14
Chapter 3-5 considered whether the unit-commitment problem should be
solved with the aid of a centralized auction market or a decentralized bilateral
market and concluded that the auction market is preferable. Chapter 3-6
described four auction designs two of which will be analyzed in this chapter.
Market design #1, a pure energy market allows generators only 1-part bids
that specify a price of energy which depends on their level of output, and
market design #3, a unit-commitment (UC) market allows generators to
specify a long list of parameters describing their costs and physical limits.
Utilities use huge quantities of data, sophisticated software, and advanced
mathematics to determine which units to commit in advance and how long to
keep them committed. In a pure-energy auction, all of this is replaced by a
14
Quite possibly, these systems still rely on much of the data that is no longer collected but
which operators are well aware of; this would include ramp rates.

CHAPTER 3-7 Multi-Part Unit Commitment 59
simple rule that says, use the cheapest power first.15 That this works at all is
testimony to the coordinating powers of a market, but there are a number of
unanswered questions. This chapter investigates how a market performs this
coordination and what problems it may encounter.
Section 1: How Big is the Unit Commitment Problem? Startup costs are
one of the more significant costs contributing to the unit commitment problem.
Typically, these amount to less than 1% of retail costs. More than half of these
are covered by normal marginal cost pricing. If the inefficiency caused by the
remaining startup costs were as high as 50%, the total loss from poor unit-
commitment would be less than 1/4% of total electricity costs. Quite plausibly,
actual inefficiencies caused by even the pure-energy auction may be an order
of magnitude smaller.
Fixed cost must be covered by marginal cost pricing and they are much
greater than startup costs. As they are taken out of infra-marginal rents before
fixed costs, startup costs usually are covered by energy revenues except in the
case of generators that provide only reserves.
Section 2: Market Design #1, A Pure Energy Auction. Sometimes an
efficient dispatch and marginal-cost pricing do not cover startup costs.
Example 2 considers this situation from four perspectives. Case A
demonstrates that there is no “competitive equilibrium” in the classic sense.
Case B demonstrates that an auction without startup-cost bids or side payments
can have an efficient competitive Nash equilibrium in spite of lacking a classic
competitive equilibrium. Case C considers a 1-part, pure-energy auction. This
produces an inefficient but competitive equilibrium. Case D includes the
possibility of de-commitment, i.e. failing to generate the power sold in the day-
ahead market. This possibility leads to greater over-commitment in the day-
ahead market and then de-commits to the point of an efficient dispatch.
Section 3: Design #3, a Unit-Commitment Market. A unit-commitment
market insures generators dispatched in the day-ahead market against failing
to cover their startup costs. If all generators bid honestly, and the dispatch is
always efficient, these insurance payments will interfere with long-run
efficiency by providing inappropriately large investment incentives to
generators with especially large startup costs. Because insurance payments are
15
This chapter ignores the transmission congestion problem in order to focus on the classic
unit-commitment problem which assumes a unified market.

small, the inefficiency should be small. By allowing more detailed bids, the
unit-commitment auction solves the coordination problems of the pure-energy
auction, and this should lead to a slight increase in dispatch efficiency.
Conclusion
If generators cannot bid certain cost components and physical limits, they will
find ways to include these cost in prices they can bid, and they will find ways
to compensate for their limitations. These adjustments will typically be
imperfect, but if the problem is fairly small to begin with, the adjustments
usually will be more than adequate. In spite of this optimistic view, there are
no guarantees, and it makes sense to investigate the performance of markets
with known imperfections. It also makes sense to avoid rigid restrictions such
as a restriction to 1-part bids. Because markets are good at taking advantage
of whatever flexibility is available, adding a second part to the bid may
significantly improve the outcome. By the same token, adding 20 parts to the
bid is almost surely overkill.
3-7.1 HOW BIG IS THE UNIT COMMITMENT PROBLEM?

Both a pure energy auction (Chapter 3-6, design 1) and a UC auction
(Chapter 3-6, design 3) work best when generators can simply bid their
marginal cost curves and the resulting market prices automatically cover their
startup costs. In this case the only significant inefficiency should result from
the system operator’s errors in predicting the next day’s load and new forced
outages of transmission and generation.
When marginal-cost bids do not cover startup costs, both markets can run
into problems. Fortunately total startup costs are a small fraction of total
generation cost, and the majority are probably covered by marginal-cost bids.
These two points are investigated in turn. No-load costs are another source of
difficulty and may be slightly larger than startup costs, but they are not large
enough to change these conclusions qualitatively.
The Magnitude of Startup

Costs Units
Startup costs are measured in $ per MW
Startup costs typically range from $20 of capacity started. For a unit that is
to $40/MW and not every generator started once per day, the cost flow is
starts every day. Typically, most conveniently measured in $/MWday.
generators that serve base-load, start For comparability, energy and fixed costs
less frequently, and very few start will also be converted to $/MWday in
more often. Hydro generators have many of the examples.

Chapter 3-8
A Market for Operating Reserves
A MARKET FOR OPERATING RESERVES PAYS GENERATORS TO

BEHAVE DIFFERENTLY FORM HOW THE ENERGY MARKET SAYS
THEY SHOULD. If they are cheap and would produce at full output, the
market might tell them to produce less. If they are too expensive to produce at
all, it may tell them to start “spinning,” and this may require them to produce
at a substantial level. The purpose is to increase reliability.
Spinning reserve (spin) is the most expensive type of reserve because a
generator must be operating (spinning) to provide it. Spin is typically defined
as the increase in output that a generator can provide in ten minutes.22 Steam
units can typically ramp up (increase output) at a rate of 1% per minute which
allows them to provide spin equal to 10% of their capacity.23 Spin can also be
provided by load that can reliably back down by a certain amount in ten
minutes.
The next lower qualities of operating reserves are ten-minute non-spinning
reserves, typically provided by combustion turbines, and 30-minute non-
spinning reserves. This chapter will consider only spinning reserve because it
is the most critical and illustrates many important design problems.
Spin can range from free to expensive. “Incidental spin” is provided by
generators that are not fully loaded simply because they are marginal and their
entire output is not required, but more often because they are in the process of
22
Australia often defines spin as the five-minute increase in output.
23
This value can be improved by the generator owner, and markets may lead to such
improvements.

CHAPTER 3-8 A Market for Operating Reserves 75
ramping down. Sometimes generators are given credit for spin when they are
ramping up at full speed to keep up with the “morning ramp.” While these may
meet the letter of the definition, they do not meet its spirit because they could
not help to meet an contingency such as another generator dropping off line.
Typically the spinning reserve requirement of a system is roughly equal to the
largest loss of power that could occur due to a single line or generator failure,
a “single contingency.”
Providing spin from generators that would not otherwise run is costly for
several reasons. Most importantly, generators usually have a minimum
generation limit below which they cannot operate and remain stable. If this
limit requires a generator to produce at least 60 MW, and its marginal cost is
$10/MWh above the market price, and it can provide 30 MW of spin, this spin
costs $20/MWh. In addition there would be a “no-load cost” due to power
usage by the generator that is unrelated to its output. Startup costs should also
be included.
Providing spin from infra-marginal generators, ones with marginal costs
below the market price, is also expensive. If a cheap generator has been backed
down slightly from full output, its marginal cost may be only $20/MWh while
the competitive price is $30/MWh. In this case, backing it down one MW will
save $20 of production cost but will require that an extra MW be produced at
$30/MWh. The MW of spin provided costs $10/MWh. Sometimes it is
necessary to provide spin in this manner because too little is available from
marginal and extra-marginal generators. This is typically the case when the
market price reaches $100/MWh.
The three operating reserve markets are tightly coupled to each other and
to the energy market. California demonstrated the folly of pretending
differently and managed to pay $9,999/MWh hour for a class of reserves lower
than 30-minute non-spin at times when the highest quality reserves were selling
for under $50/MWh.24 This chapter will not consider the problem of how the
markets should be coupled, although the most straightforward answer indicates
they should be cleared simultaneously using a single set of bids that can be
applied to any of the markets.
Section 1: Scoring by Expected Cost. One approach to conducting a
market for spin is to have suppliers submit two-part bids, a capacity price, R,
24
The root of this problem was a “market separation” ideology, although several peculiar
rules played a role as did FERC.

and an energy price, P. An obvious way to evaluate such bids is to score them
by their expected cost R+h·P, where h is the fraction of the time that energy is
expected to be required from a supplier of spin. This gives the expected cost
of using spin from this supplier. Unfortunately there is no single correct h,
because the amount of energy used depends on the supplier’s energy price.
Evaluating the bids by using the wrong h leads to gaming, which, depending
on the structure of the auction, can be either extreme or moderate. Although
a reasonably efficient auction based on expected-cost scoring seems possible,
this has not yet been demonstrated.
Section 2: Scoring based on Capacity Price Only.
An alternative scoring approach calls for the same two-part bids (R, P), but
evaluates them simply by picking those with the lowest capacity price, R.25
Remarkably, this works perfectly provided the bidders are exceptionally well
informed and only extra-marginal spin is needed. Sometimes spin is most
cheaply provided by infra-marginal capacity, e.g. by backing down a cheap
steam unit. For this scoring approach to work in such cases, the price of energy
from spin must not be used to set the price of spot-market energy. Separating
these two prices is, however, inefficient.
Extreme information requirements present a more serious problem with
capacity-only scoring. Bidders must know how the probability of being called
on for energy will depend on energy-price, but this depends on who wins the
auction and what they bid. In such a volatile market, this is extremely difficult
to know, and without such knowledge, bidding will necessarily be inefficient.
Section 3: Opportunity-Cost Pricing. Auctions in which suppliers offer
a capacity and an energy bid, require that they guess what their opportunity cost
will be in the real-time market. For instance if they believe the spot market
price will be $50/MWh , and their marginal cost is $49/MWh , they may offer
spin capacity for $1/MWh. If the market price turns out to be $80 and they are
not called on to provide energy, they will have missed a significant opportunity.
Of course with a low spot price they would have won their gamble. The
problem is not with the averages, but with the randomness such guesswork will
introduce into the bidding process. As a remedy to this problem, suppliers can
be paid their opportunity cost, whatever that turns out to be. Unfortunately, this
25
This approach was developed by Robert Wilson for the California ISO, and is explained
along with the problems of expected-cost bidding in (Chao and Wilson, 2001).

CHAPTER 3-8 A Market for Operating Reserves 77
raises some of the same gaming issues as two-part bid evaluation. These
remain to be investigated.
3-8.1 SCORING BY EXPECTED COST

The expected cost of spinning reserve depends on the cost of the reserve
capacity (C), the cost of the energy they provide (MC) if they are called on, and
the chance they will be called (h). Providing 10 MW of spinning reserve
capacity for two hours might cost $20, which comes to $1/MWh, so both C and
MC are measured in $/MWh. The probability h has no units and can be
specified as a percent or a fraction.
Because the expected cost of spin is C + h∙MC, it seems natural to allow
two-part bidding and score the bids using this expected cost formula. If h has
a single value known to the system operator, this is a reasonable scoring
procedure. But if the system operator is mistaken about h and the bidders know
h, the procedure is susceptible to a classic form of gaming. Say h is the correct
probability but the SO believes it is H, and the bidder bids R for C and P for
MC. The accounting works as follows:
Table 3-9.1 Accounting for and Expected-Cost Auction

Bidder’s true expected costs: C + h∙MC
Bidder’s bid: R, P
Bidder’s score (S): R + H∙P
Bidder’s expected payoff: R + h∙P
Bidder’s expected profit: R + h∙P – (C + h∙MC )
The lowest score wins. Say the bidder wants to achieve a score of S. It
must choose R = S – H∙P, where it is free to choose any energy price, P. With
this choice, profit will be:
profit = (S – H∙P ) + h∙P – (C + h∙MC ), or

profit = S – (C + h∙MC ) + (h – H ) P.
S – (C + h∙MC ) is unaffected by the bidder’s choice of P, so profit is controlled

by the term (h – H) P. For any given score, S, the bidder can achieve any profit
level by choosing the correct P ! The choice of P will determine the bidder’s
choice for R, as described, but together P and R will produce any desired level
of profit and any desired score. This depends on the bidder knowing h, and the
system operator choosing H ≠ h . If H < h, then the bidder should bid an
extremely high price for energy and a low cost for capacity. If H > h, the

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Power System Economics (389p)

Designing Markets for Electricity © 2001

Excerpts from Part 3

M ARKET ARCHITECTURE CONCERNS THE KEY DESIGN

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

3-1.1 SPOT MARKETS, FORWARD MARKETS AND SETTLEMENTS

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

1 Central vs. bilateral markets

The first two controversies both concern the amount of centralization. In

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

most of the advantages of both extremes. Fortunately, the unit commitment

3-1.3 SIMPLIFIED LOCATIONAL PRICING

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

This relationship is all that is needed to understand Part 3, but it contains

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

T HE “MIN-ISO” APPROACH TO POWER MARKET DESIGN,

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Section 3: A Pure Transmission Market. The next step is to sell

3-2.1 NO CENTRAL COORDINATION

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

F ORWARD MARKETS SELL PROMISES OF POWER, THE SPOT

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

3-3.1 A PURE SPOT-MARKET FOR ENERGY

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

C USTOMERS AND GENERATORS SHOULD RESPOND TO THE SPOT

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

almost complete separation between the markets. Even if a generator sells

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

3-4.1 THE TWO-SETTLEMENT SYSTEM

Separation from Forward Transactions

Result 3-4.1 A Two-Settlement System Preserves Real-Time Incentives

The incentive of this settlement rule can be revealed by rearranging the

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

P OWER MARKETS ARE DIFFICULT TO COORDINATE BECAUSE THEY

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

3-5.1 WHEN MARGINAL-COST BIDDING FAILS

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

T HERE ARE MANY POSSIBLE DESIGNS FOR A CENTRAL DAY-AHEAD

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

market at a set of locational energy prices together with startup-cost insurance.

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

3-6.1 DEFINING DAY-AHEAD AUCTIONS

A Simplified Description of Auctions

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Determining the Market Price

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

amount paid by customers and the amount paid to suppliers is as small as

Conventions and Notation for Describing Auctions

3-6.2 THE FOUR DAY-AHEAD MARKETS

Market 1: Pure Energy

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Market 3: Energy with Unit Commitment

Market 4: Commitment, Pure Energy and Transmission

Notation used in auction market descriptions

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Market #1: A Pure, Day-Ahead Spot Market for Energy

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Market 2: A Pure, “Bilateral” Market for Transmission

Stoft, Power System Economics © 2001 DRAFT: July 13, 2001

Market 3: A Full “Nodal-Pricing” Market