Long-term dynamics of liberalized electricity markets

Abstract

In the last 15 years, an active movement towards the liberalization of the energy markets has been registered worldwide. Many countries have restructured their electricity industries mainly by introducing competition in their power generation sectors. Although some restructuring has been regarded as successful, the short experience accumulated with liberalized power markets does not allow making any founded assertion about their long-term behavior. Long-term prices and long-term supply reliability are now center of interest. This concerns firms considering investments in generation capacity and regulatory authorities interested in assuring the long-term adequacy and security of supply as well as the stability of power markets. These issues have become particularly relevant because of severe, unexpected anomalies observed in some restructured electricity markets. Most prominent is the case of the market established in California, which suffered a sustained shortage of generation capacity, which led to an energy and price crisis in summer 2000 and 2001. Inefficiencies in the resource allocation have also occurred in some other markets as consequence of overbuilding. The power markets in UK and Argentina have registered low, unprofitable prices as a result of the massive entry of CCGT-based capacity. Signals of overinvestment are currently exhibited in some U.S. markets. Deviations from the economic long-term equilibrium are not captured by neoclassical partial equilibrium models. These models are based on the presumption that markets evolve as a sequence of optimal equilibrium states. Under this perspective, the market outcomes replicate the results of a centrally made optimization. However, some restrictive assumptions underlie this approach, namely perfect competition and agents behaving as inter-temporal optimizers. Rational expectations are a central hypothesis in equilibrium formulations. Nonetheless, the assumption of rational expectation precludes models from capturing deviations of the optimal equilibrium state, such as business cycles. In order to gain significant insight into the long-term behavior of liberalized power markets, in this thesis, a simulation model based on System Dynamics (SD) is proposed and the underlying mathematical formulations are extensively discussed. Unlike equilibrium market models, the approach presented here focuses on replicating the system structure of power markets and the logic of relationships among system components in order to derive its dynamical response. Ultimately, the approach can be reduced to the formulation of the dynamic state equations governing the system behavior. In this work, it is shown that the long-term market dynamics can be described by means of non-linear Delay-Differential Equations, which are solved numerically. This formulation is deemed to be straightforward when modeling structural characteristics inherent of liberalized power markets, such as delays, information feedbacks and bounded rationality expectations. The simulations suggest that there might be serious problems to adjust early enough the generation capacity necessary to maintain stable reserve margins, and consequently, stable long-term price levels. Because of the existence of some time lags embedded in feedback loops responsible of adjusting the supply in the long-term, market development might exhibit a quite volatile behavior. Thus, the development of power markets might be characterized by business cycles, similarly to the observed behavior of other commodity markets. The understanding on the long-run behavior of power markets is improved by means of a sensitivity analysis on some key variables. Demand growth, interest rates, market concentration and price cap policies prove to be very influential. The implications of these findings for actual power markets are discussed. Finally, an exemplary investigation by means of Monte Carlo simulations in order to assess the ability of the developed model to capture the long-term market uncertainty is presented.