Electricity Markets under Deep Decarbonization

Abstract

This paper considers the evolution of electricity market design as systems shift toward carbon-free technologies. Large-scale energy system models commonly project that in many decarbonized systems, a majority of energy will be provided by wind and solar resources. Two characteristics of these resources, variability and zero marginal cost, are likely to lead to increased price volatility on diurnal and seasonal timescales. In the standard risk-neutral optimization framework, volatility does not pose any theoretical issues for market design. Because revenue volatility has the potential to lead to a higher cost of capital for investments in competitive markets, however, many observers have questioned the viability of competitive models for resource adequacy as wind and solar grow in importance. To assess the role of risk management in overall market performance, we construct a stochastic equilibrium model incorporating financial entities as hedge providers for investors in generation capacity. Unlike in the standard optimization framework, the cost of capital in the equilibrium framework is endogenously determined by interannual revenue volatility and the risk measures used by market participants. Surprisingly, exploratory numerical tests suggest that overall investment risk may be lower in systems dominated by variable renewables due to reduced exposure to fuel price uncertainty. However, changes in investment risk are not uniform across resource types, and increased risk for peaking and backup resources contributes to lower reliability in the modeled future systems.

Keywords: Equilibrium, market design, power systems, resource adequacy, risk trading