[BETA] Fortnightly

SPECIAL SERIES Part 4

Energy Risk & Markets

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How to set reserve levels for full requirements auctions.

Last month, Risk Capital's Tom Brady identified numerous risk factors that should be considered when pricing load-following contracts. These risks included various temperature, load, and price risks that create enormous uncertainty around the cost to serve such commitments. This month, we present a method for estimating reserves for load and price risk using sophisticated modeling techniques. In addition, because all models have flaws, we present one approach for accounting for this model risk in the bid price.

The analysis presented uses historic examples from 2003 market price and load levels in the PJM region to demonstrate how bid prices can incorporate market price and model risk. We use the PSEG load market in 2003 as a basis for our discussion.

Typical Contract

Our initial example centers on estimating a bid price for a typical full-requirements contract. These contracts have a variable amount of demand. This deal has a historical load maximum of approximately 300 MW. A load servicer will enter a bid price that the customers will pay for the energy. The load servicer then must supply this energy at the prevailing spot price (assuming it does not have any other sources of owned generation or contractual supply). This contract is defined as serving the period from February 2003 through September 2003.

The first step of the bid-price process should be to determine the "zero-value price." That is, the bid one would expect to give in order to break even. In this example, the "zero value price" amounts to $42.19/MWh. Table 1 provides a summary of the average load to the customers and the related cost of that energy if the energy is supplied at the hourly spot price. Simply dividing the average cost of the energy supplied by the average load generates the bid price (Note: This approach assumes no discounting for simplicity).

Monte Carlo simulation was used to generate reasonable scenarios of load given different weather conditions. Each scenario also generates a different set of spot prices the load servicer would have to pay to serve this load. This analysis indicates that the load servicer should bid something greater than $42.19 to expect a positive net return. However, there is a tremendous amount of uncertainty around this estimate. Market risk and load-profile uncertainty generates $9.7 million in risk that cannot be ignored when bidding for the right to serve this load.

Table 2 provides a summary of the distribution of results from modeling a PSEG Full Requirements Contract in January of 2003.

The second step in the process is to determine the risk-adjusted bid price. There are a number of risks that should be considered in the bid price. The most significant include:

Load/Market Risk - quantified by the earnings at risk (EaR) of the transaction ($9.8 million in this example);

Credit Risk - dependent on the customers and counterparties responsible for paying for the energy delivered. Auctions serve a diversified set of customers. Therefore, it is reasonable to