Theoretical Foundations of Electricity Market Design

Spring School

Goal

This course provides a self-contained set of lectures to bring PhD students and practitioners up to speed on electricity market design. The goal is to offer some economic tools and simulation models using elements of game theory, auction theory, and industrial organization that will allow students to understand the basic functioning of modern electricity markets. The course is set up as a one-week intensive series of lectures and tutorials in a hybrid format (online/physical).

Audience

The course is targeted at starting PhD students and advanced Master students but welcomes post-docs and other professionals as well (regulators and industry).

Prerequisites

The focus of the course is on economic theory and modeling, so participants are expected to be familiar with basic concepts of game theory (such as Nash equilibria and backward induction), some knowledge on differential equations and constrained optimization.

The course is open to students with an engineering or operations research background. They will be provided with preparatory reading material regarding game theory.

Content

The course starts with an introduction of electricity markets, its special characteristics and the bench-mark peak-load pricing model. It then highlights limitations in the form of non-convexities in production costs, the role of reserve markets in the prevention of black-outs and transmission constraints. We then proceed with describing the different products that are typically traded in the European electricity market. The main differences with the U.S. style power markets are highlighted.

Next, some attention is paid to modeling competition in multi-unit markets in the form of Cournot models, Supply Function Equilibria (SFE) and multi-unit auctions. Market power is the ability of firms to set price above marginal cost. We discuss some indicators of market power.

Electrical power is one of the most volatile commodities, and risk management is therefore important. Producers and consumers can sign long-term delivery contracts and trade financial derivatives to manage their risks. If complete financial markets do not exist and firms are risk-averse, then investment decisions will become sub-optimal.

Long-term contracts may reduce the incentives of firms to unilateral abuse market power but might also change the incentives for firms to tacitly collude or exclude entry of potential competitors. We check the effects of multi-stage competition and arbitrage between different time periods.

In the last part of the course, we touch upon capacity markets. Those are government-run procurement markets in which firms receive a payment in return for some investment and availability.

Note that the focus of the course is on economic theory and modeling, although we will occasionally provide some empirical evidence. As part of the course students will be asked to develop simple optimization models with GAMS (or other optimization software of their choice). In one of the tutorials, we would like to run a few economic experiments.