Rethinking the Price Formation Problem–Part 2: Rewarding Flexibility and Managing Price Risk

Part 1 of this two-part article describes the impact that uncertainty has on the design and analysis of price formation policies in the non-convex auctions conducted by U.S. wholesale electricity market operators. Using first a toy model and then a large-scale test system, Part 2 demonstrates the difference in prices under the idealized benchmark of ex ante convex hull pricing defined in Part 1 versus existing methods, in particular documenting the potential for suppression of volatility and therefore under-compensation of flexibility by existing methods. The examples highlight that inefficient spot price formation can induce inefficient forward commitments of generators, necessitating out-of-market intervention to restore a reliable and efficient operating plan. Given the potential side effects of existing policies for investment and operation, we suggest two elements in a reoriented approach to the price formation problem: first ensuring that prices exhibit full-strength volatility, and second ensuring that risk-averse market participants have sufficient ability to manage this volatility.