KRP/WP/018

CAPACITY PAYMENTS IN THE COST BASED POOL PHASE

Working Paper Draft 2 Technical Advisor Team
Dr. Konstantin Petrov

21 October 1999

Contents
1.INTRODUCTION.................................................................................................................3 2.METHODS FOR CAPACITY PAYMENTS DESIGN ...........................................................4 2.1.Short run marginal cost method ..............................................................................4 2.2.Long run marginal cost method................................................................................4 2.2.1.Generation resource plan method .................................................................4 2.2.2.Generation Unit Proxy Approach ...................................................................5 3.INTERNATIONAL EXPERIENCE .......................................................................................6 3.1.England and Wales .................................................................................................6 3.2.Chile .......................................................................................................................6 4.SOLUTION FOR KEPCO ..................................................................................................7 5.FORMALISATION OF CAPACITY PAYMENT DESIGN ..................................................8 5.1.Step 1 Determination of Reference Capacity Fee ....................................................8 5.1.1.Reference Facility ........................................................................................8 5.1.2.Discount rate ................................................................................................8 5.1.3.Fixed Operation and Maintenance Cost ....................................................10 5.1.4.Discounting period ....................................................................................10 5.2.Step 2 Adjustment for actual demand and supply balance .....................................10 5.3.Step 3 Calculation of Capacity Fee Allocation Factor ............................................11

1. INTRODUCTION
It is a matter for debate whether capacity payments are necessary for the competitive electricity markets. They are often justified with the need to ensure long term stability of market participants providing to them additional (to the System Marginal Price revenue) payments (see Fig.1). The peak load pricing theory, suggests that capacity payments should be equivalent to the capacity cost of a peak load facility (e.g. gas turbine). Some energy economists argue against this position and allege that in the competitive markets, there is no need for additional price elements and market price should reflect the actual equilibrium between the demand and supply.

WON/kWh

Cost Based Pool - Picture at Hour t

Revenue/ Cost Position of Generator C

Contribution Margin

=
GenE GenA EnA GenB EnB GenC EnC EnD Demand EnE GenD SUMt SMP * EnC

SUMt Variable Cost*EnC

Figure 1: Fixed Cost Coverage through SMP

2. METHODS FOR CAPACITY PAYMENTS DESIGN

In general there are two design concept for capacity payment design: Short run marginal cost method (SRMC) Long run marginal cost method (LRMC)

Short term energy costs reflect the costs associated with meeting an extra unit of demand given the capacity on the system. If demand is higher than the available capacity, then in the short term some customer demand will not be met (unserved energy) and in the longer term new capacity will be added to the system. The excess of these costs, (i.e. the cost of unserved energy or the total cost of new capacity) over and above the marginal system energy costs, are marginal capacity costs. 2.1. SHORT RUN
MARGINAL COST METHOD

In a given period, SRMC are equal to the marginal energy cost plus costs for unsupplied demand. Actually the second term (costs for unsupplied demand) has a demand curtailment function, and will provide an additional compensation based on the system value of availability in the different time periods. 2.2. LONG RUN

MARGINAL COST METHOD

The LRMC is the cost of meeting an increase in demand, in a situation where capacity adjustments are possible. Long run marginal costs are defined as the additional

capital and operating costs incurred in the power generation system when one additional kWh is demanded. Each additional unit produced causes increase of generation capacity (time shifting of investments). Figure B shows the long term development (axis z) of load duration curve ADEF (area xy of Figure A) with peak load OA. The positive trend determines the capacity expansion required. In case of additional demand (load increment dD) the investments in new capacities will be shifted and the power stations commitment will be rearranged. The additional capacity and operating costs resulting from the incremental demand are measure of long run marginal costs.
2.2.1. GENERATION RESOURCE PLAN METHOD

This method begins with the companies current least cost resource plan, increments or decrements load and revise the least cost resource plan accordingly. The present worth cost of the two resource plans, including both capital and fuel costs, are compared and the difference represents the marginal capacity cost for the chosen increment.

..

B1 Load B A dD C D A1 C1 D1 Time(years) E 1 E F 1

MW

F O Peak Off-Peak Hours

Capacity shifting

8760

Peak

Initial capacity plan

D+d D D MW

Figure 2: Long Run Marginal Cost

Years

2.2.2. GENERATION UNIT PROXY APPROACH

The proxy approach is based on the standard capacity cost of a peak plant which would be needed if demand increases. This method suggests to calculate
capacity fee on the base of the annualized capacity cost of the reference marginal plant.

3. INTERNATIONAL EXPERIENCE
3.1. ENGLAND AND WALES In England and Wales whilst the capacity fee is paid to all available generators, SMP is only paid to generation which appeared in the unconstrained schedule and which remains available on the day. The SMP varies from half an hour to half an hour (settlement period), and usually reflects the cost of increasing output from the marginal power station, however, occasionally a reduction in output from one generator can only be accommodated by shedding load (disconnecting of some customers). On these occasions, the Loss of Load Probability (LOLP) increases to one and, the system marginal cost rises to the value of the lost load (VOLL) for the customers concerned. Capacity component is considered through charge for availability: LOLP *VOLL. The objective of this component is to give to the Generating Companies an incentive to install enough generating capacity and to be available according to the value of available capacity from the system point view. 3.2. CHILE In Chile each generator is paid a fixed annual amount per kW of firm capacity in addition to SMP. The firm capacity of each producer is the maximum power which the generating units can contribute in the peak period of the system (including reserve margin) with a certain level of reliability. The capacity fee paid to the Generators is based on the on LRMC principles. It is the annualized cost of the peak plant (usually gas turbine cost is used as a reference number) needed to cover one additional kW demand in the peak hours.

4. SOLUTION FOR KEPCO

The use of generation resource plan method is not appropriate due to the following reasons: Firstly the calculation of marginal costs is characterised with high degree of complexity and will require significant additional efforts (experts, computers, models). Secondly the marginal cost based revenue will be different for each Generation Company because of the different technical and economic characteristics of their generation facilities. Thirdly the existence of multiple calculation methods and simulation tools as well as the dependence on the input data may lead to confusing results having different numeric values and potentials for disputes between the parties involved. The use of standard capacity payment based on the capacity cost of a reference peak generation plant (e.g. gas turbine) seems to be a reasonable solution for the currency of the CBP. This approach will create a practical and simple pool design. It will allow to keep the price signals of the short term marginal cost (SMP), will provide a continual incentive to make plants available and assure additional revenues for coverage of generators fixed cost. The capacity fee will be calculated using the capacity cost of a reference peak generation plant. An additional mechanism which allows to account for the probability of meeting the hourly demand and to calculate hourly capacity prices would require additional efforts and will complicate the CBP Rules. Although such mechanism would improve the signal function of capacity payments this might create substantial fluctuations and instability of capacity payments. However, this mechanism may provide a reasonable option for the PBP. In order to ensure non-discriminatory and transparent rules for the calculation and payment of capacity fee, the Regulatory Committee of MOCIE will set and approve the procedures for determination and levels of the capacity fee prior to implementation of the CBP.

5. FORMALISATION OF CAPACITY PAYMENT DESIGN

5.1. STEP 1 DETERMINATION OF REFERENCE CAPACITY FEE Reference capacity fee should cover the capital cost and fixed operating and maintenance of reference peak capacity. In order to derive an annual capital cost value investment cost (based on market prices of plant and construction work) are spread over dynamically (using discounting procedure) over the expected technical life of assets. Consequently the annual operation and maintenance costs are added.

CF r t = CFC r t + CFOM r t

CFC r t = Ar

i.(1 + i ) Nr (1 + i ) Nr 1

C r t - reference capacity fee in WON/MW/year in period t (one year) F CFC r t - element of capacity fee covering capital cost (return on assets and depreciation) of reference generation plant in WON/MW/year in period t Ar - investment cost of reference generation plant in WON/MW i - discount rate in % N r - discounting period (technical life of reference peak demand plant in years) CFOM r t - element of capacity fee covering the operation and maintenance cost WON/MW/year in period t
5.1.1. REFERENCE FACILITY In the paper Calculation of Reference Capacity KRP/WP/31/0.2 we produced, after discussions with KEPCO, a numeric example on the basis of OCGT for three output values as shown in the table.

Type FT 8 Trent DLE V 94.2

Output MW 25,5 51,2 159,0

Efficiency (%) 38,1 41,6 34,5

Specific Price (kW/USD) 361 312 180

Source: Gas Turbine World 1998 1999 Handbook Remark: The specific price includes the main equipment (see papers Calculation of Reference Capacity Fee, KRP/WP/31/0.1and KRP/WP/31/0.2. 5.1.2. DISCOUNT RATE

Discount rate reflects the opportunity cost incurred by the investors because of the decision to invest in power plant (return the investment opportunities forgone). The investment and financial market conditions are essential to allow for financing of additional investment. Utilities are competing for finance with enterprises operating in competitive markets and thus have to accept these conditions. Equity and debt finance will only be available to utilities that agree to credit conditions posed to firms that operate in competitive industries and have a comparable credit ranking. Equity finance will only be available if a profitability (consisting of a dividend component and market value growth component) can be expected that covers the risk free rate of interest (i.e. yield of long term credible government bonds) and a risk premium. The discount rate should reflect the conditions (proportion equity/debt, effective debt interest rate and required return on equity) for acquiring of new capital to finance a peak reference plant. The existing financial information can be used to estimate the components required to evaluate the cost of capital (e.g. capital structure, rate of return). The discount rate can be calculated as weighted average cost of capital using the following formula: WACC=EPxROE+DPxDI WACC weighted average cost of capital ROE required rate of return by investors in power sector1 EP equity portion reflecting the financing of new facility DP debt portion reflecting the financing of new facility DI cost of debt reflecting the usual credit conditions for the power sector A number of values are available to KEPCO for the purposes of their planning, investment appraisal and companies evaluation. In the paper Calculation of Reference Capacity KRP/WP/31/0.2 we produced, after discussions with KEPCO, a numeric
1

In general, the rate of return on equity is somewhere in between the return on capital, which is invested free of risk (bonds) and the stock market return (the expected return on a stock market portfolio). In case of reliable statistic information CAPM (Capital Assets Pricing Model) can be used. According to CAPM the rate of return can be expressed with the following formula: ROE=RFR +(RM-RFR)*, ROE is the required rate of return RFR is the risk free rate of return (e.g. return on Government Bonds); RM is the stock market rate of return (the expected return on a stock market portfolio) is the beta coefficient (this coefficient expresses the correlation between the fluctuations of the market portfolio return and the companys individual return and is a yardstick of the market risk)

example on the basis of discount rate equal to 8 % used by KEPCO in the long term system expansion planning. 5.1.3. FIXED OPERATION AND MAINTENANCE COST Maintenance costs are the costs incurred by the operator of power station in maintaining the generation facilities as prescribed by the producer and according to the technical standards used by KEPCO. Operation Costs are the costs incurred by the operator of power station in operating the generation facilities as required by the producer and according to the technical standards used by KEPCO. KEPCO has conducted analysis on the basis of actual accounting cost incurred by CCGT adjusted to reflect the higher cost of CCGT in comparison with OCGT. In the paper Calculation of Reference Capacity KRP/WP/31/0.2 we produced, after discussions with KEPCO, a numeric example on the basis of operation and maintenance cost equal to 3 % of investment cost of reference facility. 5.1.4. DISCOUNTING PERIOD It is proposed to use the technical life of reference peak facility. In the paper Calculation of Reference Capacity KRP/WP/31/0.2 we produced, after discussions with KEPCO, a numeric example on the basis of discount period equal to 25 and 30 years. 5.2. STEP 2 ADJUSTMENT FOR ACTUAL DEMAND AND SUPPLY BALANCE The balance adjustment factor reflects the difference between a system with supply sources covering demand according to required reliability criteria and the actual system. Firstly, the level of required reserve margin according to the system reliability criteria of KEPCO should be determined. In case that probabilistic criteria is used it should reflect the probability which should be achieved in the coverage of demand peak (peaks). Excursus: The probability to meet demand (degree of reliability) varies each hour and is a function of demand and supply balance. The Loss of Load Probability (LOLP) refers to the likelihood that a generating system will be unable to serve some or all of the load at a particular moment in time due to outages of its generating units. LOLP tends to be greatest when customer usage is high (peak hours). If LOLP in a period is 0,01, there is a one percent probability of being unable to serve some or all customers load.

Similarly, if load increases by 100 kW in this period, on average, the utility will be unable to serve one kW of additional load. Since the probability of non-coverage of demand is the highest in the peak demand periods the values of LOLP in these periods is crucial for the determination of system reliability. End of Excursus Secondly, the level of expected reserve margin should be determined taking into account the installed level of capacity and expected demand. The capacity balance adjustment factor will be defined as a ratio between required level of reserve and expected actual level of reserve .
AFt = RRM ERMt

AFt - adjustment factor for the period t

RRM - required reserve margin

ERMt - expected actual reserve margin for the period t ACF = CF * AF ACFt - adjusted capacity fee in WON/MW/year for period t.
5.3. STEP 3 CALCULATION OF CAPACITY FEE ALLOCATION FACTOR The allocation factor aims to enhance the signal functions of capacity fee through increase its level in period with high demand (low supply margin) and decrease its level in periods with low demand (high supply margin). This factor can differentiate between time of year periods (e.g. summer and winter) and time of day period (e.g. day and night). Summing LOLP over all periods in a year gives a measure of how reliability the utility can serve additional load. If load increases in an on-peak period when usage is already high, the LOLP-weighted load is high and there is a relatively large impact on reliability which must be offset by an increase in generating resources. If load increases in an off-peak period where usage is low, the LOLP-weighted load is low and there may be relatively little impact on reliability. Similarly, when additional generating resources are added to a utility system, the incremental reliability improvement is proportional to the LOLP in that period.

Example: Resources

Units A:200 MW B: 200 MW C: 100 MW D:100 MW

Probabilities

Forced Outage Rate 20 % 20 % 10 % 10 %

Expected Availability 80 % 80 % 90 % 90 %

Units C D A B C,D A,C A,D B,C B,D A,B A,C,D B,C,D A,B,C A,B,D A,B,C,D

MW Available 0 100 100 200 200 200 300 300 300 300 400 400 400 500 500 600

Probability (0,2)x(0,2)x(0,1) x(0,1)=0,0004 0,004 (0,2)x(0,2)x(0,9) x(0,1)=0,0036 0,04 (0,2)x(0,2)x(0,1) x(0,9)=0,0036 0,0076 (0,8)x(0,2)x(0,1) x(0,1)=0,0016 0,0092 (0,2)x(0,8)x(0,1) x(0,1)=0,0016 0,0108 (0,2)x(0,2)x(0,9) x(0,9)=0,0324 0,0432 (0,8)x(0,2)x(0,9) x(0,1)=0,0144 0,0576 (0,8)x(0,2)x(0,1) x(0,9)=0,0144 0,0720 (0,2)x(0,8)x(0,9) x(0,1)=0,0144 0,0864 (0,2)x(0,8)x(0,1) x(0,9)=0,0144 0,1008 (0,8)x(0,8)x(0,1) x(0,9)=0,0064 0,1072 (0,8)x(0,2)x(0,9) x(0,9)=0,1296 0,2368 (0,2)x(0,8)x(0,9) x(0,9)=0,1296 0,3664 (0,8)x(0,8)x(0,9) x(0,1)=0,0576 0,4240 (0,8)x(0,8)x(0,1) x(0,9)=0,0576 0,4816 (0,8)x(0,8)x(0,9) x(0,9)=0,5184 1,000

Time Period Demand

On Peak (e.g. day time working day ) Off Peak (e.g. night time working day and Sunday)

250 MW 150 MW

LOLPon=0,0432 LOLPoff=0,0076

85 % 15 %

LOLP=0,0508

100 %

Allocation Factor for On Peak Period Duration (CPon)= LOLPon/ (LOLPoff+

LOLPon)/2=1,7
Allocation Factor for Off Peak Period Duration (CPoff)= LOLPoff/ (LOLPoff+

LOLPon)/2=0,3
LOLP and the duration of peak and off peak time periods should be determined. The example described above considers only the maximum demand in on peak and off peak periods. The demand and supply balance can be analysed in a number of time points to increase the accuracy level of capacity rate design. The complexity and the scope of quantitative work could be reduced if it is assumed that LOLP inclines to zero in the off peak periods (the system is reliable in case of low demand and excessive capacity) and allocation factors are not used. The actual availability of a generating unit can be calculated as an average of availability values in a number of settlement periods (e.g. N=3) with highest demand. This approach would allocate the capacity to three hourly periods which creates strong incentives for the generators to be available in the peak periods but increases significantly the risks to lose substantial part of capacity payments in case of missing one of the relevant peak periods. KEPCO expressed preferences for higher number of periods, respectively using the hourly availability values from the bids of the generators. Increasing the number of peak periods relevant for capacity payments would give more chances to the Generators to be available in some of them and would reduce the lost capacity payments if they have missed a peak hour relevant for this payment. However, the use of flat rate over the whole array of periods relevant for capacity payment would reduce the incentives for the Generators to be available in the peak hours where they have the highest value for the system. Additional incentive mechanism (in form of allocation factors as described above) seems to be necessary to produce signals when the availability is mostly needed. A reasonable option could be to use time of year and time of day allocation coefficients.

An example with time periods (one on peak period and one off peak period) for annual capacity fee revenues is shown below.
CPit =

h = Non

AACi

* ( ACFt / N ) * CPont +

h =Noff

AACi

* ( ACFt / N ) * CPoff

CPit - revenue capacity payment of generating unit i in settlement period h AACi h - actual available capacity of generating unit i in settlement period h Non number of settlement periods during peak period duration Noff number of settlement periods during off peak period duration N= Non+ Noff