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Price Forecasting in Spot Markets: Hidden Risks in Single-Part Bidding
the high demand hours (known in England and Wales as the Table A period) to recover the start-up and no-load costs incurred by all accepted bidders (see Figure 1).
Figure 1 illustrates this fundamental point. This figure is taken from the results of a modern production simulation model. It shows the prices that would result for the same dispatch depending upon which costs need to be recovered. Three cases are shown. One is just SRMC. The second series recovers only start-up costs (in high-load hours). The third recovers both start-up and no-load costs, i.e. the costs of inefficient production at low output levels.
Nevertheless, the E&W market rules have not been universally accepted. In both the California Power Exchange and the Australian electricity markets, the burden of bidding prices that recover start-up and no-load costs falls to bidders. The market operator will not do it for them. This rule is called "single-part bidding," to contrast it with the multiple part bids in the E&W market. If we want to forecast prices in markets that employ single-part bidding, our models must take these rules into account.
Forecasting prices is difficult in markets that employ single-part bidding. Even if a model can allow the user to specify a bid that differs from incremental cost, figuring out what the equilibrium bid strategies will be and simulating them is difficult. Most forecasters don't do this very well, even if they try. Our case study will show us why it is so difficult.
The Option Value in Dispatch
Units that serve intermediate loads (or mid-merit in English terminology) are very different from base load units. The latter can be valued largely on the basis of expected prices. For units that are marginal, the majority of value is option value. That means that the money lies in knowing when to exercise the option to operate. The decision to operate, however, depends upon the distribution of prices - not just on the expected, or average, value of the price.
Table 1 shows two different price structures with the same average, or expected, value, namely $20. The price structure difference between Case 1 and Case 2 is that Case 2 shows a lot of variation; half the time the price is above average and half the time it is below average, while the prices in Case 1 are flat. In Cases 1 and 2 the plant operates all the time, as if it were baseload. In both cases we just break-even. In Cases 3 and 4 we still consider the varying price structure, but we now imagine that the plant is flexible and consider how to operate to maximize profit. In Case 3 we assume perfect flexibility. The plant is operated only when it is profitable. Case 4 represents operating flexibility, so we are only able to turn the plant off half the time that it is unprofitable. These simple examples show that exercising the option to operate or shut down is the key to profitability for mid-merit plant, and that profits can be limited by operating constraints.