Missing Incentives for Flexibility in Wholesale Electricity Markets

Abstract

In most liberalized electricity markets, flaws in short-term price formation have led to a "missing money" problem wherein average energy prices are too low to support an efficient level of capacity. Recent growth of wind and solar generation has exposed another category of flaws related to intertemporal constraints, such that energy prices are not volatile enough to support an efficient level of flexibility. In theory, electricity markets convey the value of flexibility through time-varying prices, encouraging market participants to invest in resources able to match production and consumption profiles to grid needs. Real-world market clearing procedures, however, make several simplifications that suppress volatility relative to the theoretical ideal. This paper describes five mechanisms by which current wholesale electricity market price formation may fail to provide full-strength incentives for flexible resources. Instead of restoring price volatility, market designers may choose to define flexibility products that act as a proxy for full-strength prices. However, these products cannot replicate theoretically ideal incentives precisely, with potentially important consequences for small-scale and distributed resources. The analysis could help guide ongoing efforts to ensure that systems have the capability to respond to growing variability and uncertainty in an efficient way.

Keywords: Electricity markets, flexibility, price formation, resource adequacy