Dissertation: Extended Abstract

Testing Financial and Real Market Operations in Restructured Electricity Systems: Four Theoretical and Empirical Studies

Junjie Sun
Department of Economics, Iowa State University
Ames, Iowa 50011-1070

November 3, 2006

Motivation for Dissertation:

The electric power industry is one of the largest infrastructure industries in the U.S. Since the 1990s, the U.S. electric power industry has undergone tremendous changes from a heavily regulated and vertically integrated monopoly industry to a more market-oriented environment consisting of smaller specialized firms more open to competition and supervised with lighter regulations. This restructuring process is echoed on a broader level by the deregulation movements in other infrastructure industries such as telecommunications, transportation (e.g., airlines) and other energy industries (e.g., water and gas).

Different from other infrastructure industries, electric power has two distinct features. First, it is extremely expensive, if not impossible, to store power energy. Thus, almost all electric power is delivered through transmission lines for immediate consumption once it is produced. Second, the power flow among transmission paths cannot be controlled and monitored perfectly due to the underlying physical network structure. These two features contribute to the fact that there is now a tendency for transmission lines across and within major U.S. electric power markets to become congested. This has a substantial impact on the locational marginal price system and the overall reliability of the wholesale power market.

To help relieve transmission congestion, and to improve reliability and efficiency, in April 2003 the U.S. Federal Energy Regulatory Commission (FERC) proposed a complicated market design called the Wholesale Power Market Platform (WPMP) for common adoption by all U.S. wholesale power markets. One important aspect of the WPMP is the recommended use of financial transmission rights (FTRs) to hedge the risk of volatile energy prices caused by congested transmission lines. Versions of the WPMP have been implemented in New England, New York, the Mid-Atlantic states, the Midwest, and the Southwest, and have been adopted for implementation in California. In the academic research community as well as among industrial stakeholders, whether FTRs can serve as an effective and efficient hedge instrument as well as whether the overall WPMP design provides a reliable and efficient market environment remain hot issues for debate.

This dissertation research investigates and tests financial and real market operations in the restructured U.S. wholesale power industry. Specifically, four related studies have been undertaken to address four different issues at four different levels.

Study 1: U.S. Financial Transmission Rights: Theory and Practice [Download]

Financial Transmission Right (FTR) as a financial hedge instrument against volatile wholesale electricity prices has been widely adopted in the major U.S. wholesale power markets. However, the current literature often shows that FTR decreases efficiency and reduces social welfare. One main problem is that their models do not have a stochastic component. Since FTR is designed to hedge the uncertain profit streams that market participants face, it is no surprise to find that the absence of uncertainty renders the FTR being a source of inefficiency. The contributions of this paper are in two-folds. First, it provides a comprehensive reviews of both theoretical and empirical studies of FTRs in the current literature. Second, in this paper I construct a simple two-node electric network model and show that once stochastic shocks are introduced the acquisition of optimal FTRs by the risk averse market traders will increase and in general will strictly increase the social welfare compared with the case where there are no FTRs available. This result presents a counterexample to the somewhat negative views about FTRs held by other economists in the literature and provides some economic explanations to the fact that FTRs are widely adopted as a financial hedge instrument in the major U.S. wholesale power markets.

Study 2: Evaluating the Performance of Financial Transmission Rights Auction Market: Evidence from the U.S. Midwest Energy Region [Download]

Different from the theoretical nature of the first study, this paper investigates a specific FTR market, namely the the FTR auction market in the Midwest energy region (MISO), using econometric estimation tools. Specifically we are interested in analyzing the performance of the MISO FTR auction market. The data are monthly FTR auction clearing prices and associated congestion revenues for the period April 2005 - March 2006. Based on the preliminary statistical analysis, we summarize and present the stylized facts about the MISO FTR auction market. Moreover, we fit the data with linear regressions and nonparametric kernel regressions, and carry out a bootstrap-based goodness-of-fit test on the linear versus kernel fits. The revenue sufficiency results suggest that the MISO FTR market is systematically losing money, which suggests that the market participants exhibit some degree of risk affection. More data are needed in order to obtain meaningful economic analysis such as estimating the impact of an agent's risk preference on his willingness to pay for the premium of FTR in this complex market. It would be especially helpful to acquire the actual bidding and asking prices of market participants in the MISO FTR auctions over time.

Study 3: Dynamic Testing of Wholesale Power Market Designs: An Open-Source Agent-Based Framework [Download]

Distinct from the first two studies, this paper goes a further micro level to examine the market design issues in the general wholesale power market context. Specifically we want to test the FERC's Wholesale Power Market Platform (WPMP) design that has been implemented or adopted in major wholesale power markets in the U.S. Strong opposition to the WPMP persists among some industry stakeholders, due largely to a perceived lack of adequate performance testing. This study reports on the agent-based modeling development and open-source implementation (in Java) of a computational wholesale power market organized in accordance with core WPMP features and operating over a realistically rendered transmission grid. The traders within this market model are strategic profit-seeking agents whose learning behaviors are based on data from human-subject experiments. Our key experimental focus is the complex interplay among structural conditions, market protocols, and learning behaviors in relation to short-term and longer-term market performance. Findings from a dynamic 5-node test case are presented for concrete illustration. These findings reveal the complicated effects of daily load profiles, transmission congestion, and production capacity limits on locational marginal price determination, even in the absence of strategic offer/bid behaviors by traders. Furthermore, with traders being able to submit their offers strategically, it it found that traders (Generators) are able to acquire substantial market power without any explicitly collusions. This suggests that the core WPMP design features, as captured in our current computational framework, do not prevent the considerable exercise of market power by traders.

Study 4: DC Optimal Power Flow Formulation and Solution using QuadProgJ [Download]

This last study focuses on an critical optimization component of my third paper that the optimal hourly locational marginal prices (LMPs) and commitment/dispatch quantities have to be cleared by a means of DC Optimal Power Flow (OPF) procedure in the wholesale power market. In this paper, we first establish that a commonly used DC OPF approximation in per unit form can be represented as a strictly convex quadratic programming (SCQP) problem subject to mixed equality and inequality constraints, given a physically meaningful Lagrangian augmentation. We derive explicit matrix representations for this SCPQ problem for both fully connected and arbitrarily connected transmission grids. We then show how these SCQP problems can be solved using QuadProgJ, a Java SCQP solver newly developed by the authors that implements the well-known dual active-set SCQP algorithm by Goldfarb and Idnani (1983). QuadProgJ appears to be the first open-source SCQP solver developed completely in Java. QuadProgJ is specifically designed for the fast and efficient desktop solution of relatively small research and training SCQP problems with a maximum count of about 1300 decision variables plus constraints. Several numerical examples are provided to illustrate the accuracy of QuadProgJ, including 3-node and 5-node DC OPF case studies taken from power systems texts and ISO-NE/PJM training manuals.