Integrating Renewable Energy Part 2: Electricity Market & Policy Challenges

Posted on by Highwire Earth

Written by Kasparas Spokas

The rising popularity and falling capital costs of renewable energy make its integration into the electricity system appear inevitable. However, major challenges remain. In part one of our ‘integrating renewable energy’ series, we introduced key concepts of the physical electricity system and some of the physical challenges of integrating variable renewable energy. In this second instalment, we introduce how electricity markets function and relevant policies for renewable energy development.

Modern electricity markets were first mandated by the Federal Energy Regulatory Commission (FERC) in the United States at the turn of millennium to allow market forces to drive down the price of electricity. Until then, most electricity systems were managed by regulated vertically-integrated utilities. Today, these markets serve two-thirds of the country’s electricity demand (Figure 1) and the price of wholesale electricity in these regions is historically low due to cheap natural gas prices and subsidized renewable energy deployment.

The primary objective of electricity markets is to provide reliable electricity at least cost to consumers. This objective can be further broken down into several sub-objectives. The first is short-run efficiency: making the best of the existing electricity infrastructure. The second is long-run efficiency: ensuring that the market provides the proper incentives for investment in electricity system infrastructure to guarantee to satisfy electricity demand in the future. Other objectives are fairness, transparency, and simplicity. This is no easy task; there is uncertainty in both supply and demand of electricity and many physical constraints need to be considered.

While the specific structure of electricity markets varies slightly by region, they all provide a competitive market structure where electricity generators can compete to sell their electricity. The governance of these markets can be broken down into several actors: the regulator, the board, participant committees, an independent market monitor, and a system operator. FERC is the regulator for all interstate wholesale electricity markets (all except ERCOT in Texas). In addition, reliability standards and regulations are set by the North American Electric Reliability Council (NERC), which FERC gave authority in 2006. Lastly, markets are operated by independent system operators (ISOs) or Regional Transmission Operators (RTOs) (Figure 1). In tandem, regulations set by FERC, NERC, and system operators drive the design of wholesale markets.

Wholesale energy market ISO/RTO locations (colored areas) and vertically-integrated utilities (tanned area). Source: https://isorto.org/

Before we get ahead of ourselves, let’s first learn about how electricity markets work. A basic electricity market functions as such: electricity generators (i.e. power plants) bid to generate an amount of electricity into a centralized market. In a perfectly competitive market, the price of these bids is based on the costs of an individual power plant to generate electricity. Generally, costs are grouped by technology and organized along a “supply stack” (Figure 2). Once all bids are placed, the ISO/RTO accepts the cheapest assortment of generation bids that satisfies electricity demand while also meeting physical system and reliability constraints (Figure 2a). The price of the most expensive accepted bid becomes the market-clearing price and sets the price of electricity that all accepted generators receive as compensation (Figure 2a). In reality it is a bit more complicated: the ISO/RTOs operate day-ahead, real-time, and ancillary services markets and facilitate forward contract trading to better orchestrate the system and lower physical and financial risks.

Figure 2. Schematics of electricity supply stacks (a) before low natural gas prices, (b) after natural gas prices declined, (c) after renewable deployment.

Because real electricity markets are not completely efficient and competitive (due to a number of reasons), some regions have challenges providing enough incentives for the long-run investment objective. As a result, several ISO/RTOs have designed an additional “capacity market.” In capacity markets, power plants bid for the ability to generate electricity in the future (1-3 years ahead). If the generator clears this market, it will receive extra compensation for the ability to generate electricity in the future (regardless of whether it is called upon to generate electricity) or will face financial penalties if it cannot. While experts continue to debate the merits of these secondary capacity markets, some ISO/RTOs argue capacity markets provide the necessary additional financial incentives to ensure a reliable electricity system in the future.

Sound complicated? It is! Luckily, ISO/RTOs have sophisticated tools to continuously model the electricity system and orchestrate the purchasing and transmission of wholesale electricity. Two key features of electricity markets are time and location. First, market clearing prices are time dependent because of continuously changing demand and supply. During periods of high electricity demand, prices can rise because more expensive electricity generators are needed to meet demand, which increases the settlement price (Figure 2a). In extreme cases, these are referred to as price spikes. Second, market-clearing prices are regional because of electricity transmission constraints. In regions where supply is low and the transmission capacity to import electricity from elsewhere is limited, electricity prices can increase even more.

Several recent developments have complicated the economics of generating electricity in wholesale markets. First, low natural gas prices and the greater efficiency of combined cycle power plants have resulted in low electricity bids, restructuring the supply stack and lowering market settlement prices (Figure 2b). Second, the introduction of renewable power plants, which have almost-zero operating costs, introduce almost-zero electricity market bids. As such, renewables fall at the beginning of the supply stack and push other technologies towards the right (higher-demand periods that are less utilized), further depressing settlement prices (Figure 2c). A recent study by the National Renewable Energy Laboratory expects these trends to continue with increasing renewable deployment.

In combination, these developments have reduced revenues and challenged the operation of less competitive generation technologies, such as coal and nuclear energy, and elicited calls for government intervention to save financial investments. While the shutdown of coal plants is welcome news for climate advocates, nuclear power provided 60% of the U.S. carbon-free electricity in 2016. Several states have already instated credits or subsidies to prevent these low-emission power plants from going bankrupt. However, some experts argue that the retirement of uneconomic resources is a welcome indication that markets are working properly.

As traditional fossil-fuel power plants struggle to remain in operation, the development of new renewable energy continues to thrive. This development has been aided by both capital cost reductions and federal- and state-level policies that provide out-of-market economic benefits. To better achieve climate goals, some have argued that states need to write policies that align with wholesale market structures. Proposed mechanisms include in-market carbon pricing, such as a carbon tax or stronger cap-and-trade programs, and additional clean-energy markets. Until now however, political economy constraints have limited policies to weak cap-and-trade programs, investment and production tax credits, and renewable portfolio standards.

While renewable energy advocates support such policies, system operators and private investors argue these out-of-market policies could potentially distort wholesale electricity markets by suppressing prices and imposing regulatory risks on investors. Importantly, they argue that this leads to inefficient resource investment decisions and reduced competition that ultimately increases costs for consumers. As a result, several ISO/RTOs are attempting to reform electricity capacity market rules to satisfy these complaints but are having difficulty finding a solution that satisfies all stakeholders. How future policies will be dealt with by FERC, operators and stakeholders remains to be resolved.

As states continue to instate new renewable energy mandates and technologies yet to be well-integrated with wholesale markets, such as battery storage, continue to evolve and show promise, wholesale market structures and policies will need to adapt. In the end, the evolution of electricity market rules and policies will depend on a complex interplay between technological innovation, stakeholder engagement, regulation, and politics. Exciting!

 

Kasparas Spokas is a Ph.D. candidate in the Civil & Environmental Engineering Department and a policy-fellow in the Woodrow Wilson School of Public & International Affairs at Princeton University. Broadly, he is interested in the challenge of developing low-emissions energy systems from a techno-economic perspective. Follow him on Twitter @KSpokas.

An Apple a Day: Easier said than done

Posted on by Highwire Earth

Written by Prof. Fernanda Márquez-Padilla

A few months ago, I pulled a muscle doing yoga and started going to physical therapy on a weekly basis soon after. I was supposed to do a 5-minute routine every day, and my discipline at doing so was mediocre at best. It wasn’t particularly hard, or painful, but still: it was so much easier to not do it.

At the same time, I was starting a research project on hypertensive patients’ behavior with respect to taking their medications as prescribed by their doctors (known in the medical literature as medication adherence), and had been reading about how people tend to be bad at doing so (with non-adherence considered “a worldwide problem of striking magnitude” by the WHO). “It doesn’t make much sense”, I remember thinking. Proper adherence to heart medication has been found to increase life expectancy, and significantly reduce the probability of negative health outcomes such as heart attacks, strokes, and other cardiovascular hospitalizations. And it’s “just” taking pills. Why don’t patients adhere? Then it hit me. I’m one of them: I’m terrible at adhering.

An important issue for health economics focuses on how to modify patients’ behavior. How can we motivate patients to engage in healthy conducts? Patient behavior has been found to be key for keeping individuals healthy. Improving patients’ medication adherence has great potential to reduce the costs of healthcare—especially for chronic patients who must often take specific medications for extended periods in order to manage their condition. However, modifying individuals’ behavior has been proven to be a challenging task, despite its positive implications for health outcomes and cost reductions.

A recent policy in Mexico undertaken by its largest public health provider, the Mexican Institute for Social Security (IMSS), created an interesting setup that unintentionally incentivized patients to improve their health behaviors—in this case, their medication adherence. The Receta Resurtible policy decreased the frequency with which hypertensive patients (i.e., high blood pressure) needed to see their physician and renew prescriptions, as long as their blood pressure remained stable and they were not late for renewing their prescriptions. In the new regime, patients could see their doctor every 90 days (as opposed to every 30). The policy’s main goal was to increase efficiency by eliminating arguably unnecessary check-ups from relatively stable chronic patients in order to free up clinic space and physicians’ time.

Waiting room at an IMSS Hospital. Source: paginabierta.mx

Now, why would this be an incentive for people to improve their health behavior? The key insight is that while consuming healthcare is a benefit for patients, it can also be time consuming and costly. Therefore, allowing chronic patients—who must be checked-up constantly—to go less often to see their doctor could actually be a type of “reward” that may be used to improve patient behavior. We may think of this as children being incentivized to study harder in order to avoid summer school.

In my research, I find that patients on the 90-day regime improved their medication taking behavior considerably. The number of days that they are out of medication between prescription fillings fell by 2.6 days in response to the policy (from a baseline of around 7.5 days). This is an improvement of 35%, comparable to the effects of other interventions for improving medication adherence, such as educational interventions or sending reminders to patients. My estimates suggest that patients improve their adherence as the total cost of getting their medication, which includes the non-monetary cost of actually renewing a prescription, falls. More interestingly, they further improve their behavior to be allowed to remain on the 90-day regime since they value its convenience. I was able to empirically test this thanks to great data from IMSS administrative records and a unique policy design.

Additionally, I find that patients’ health remained stable in spite of meeting with their physician less frequently. This point is particularly interesting for health policy, where the allocation of scarce medical resources should be done as efficiently as possible. Much debate has revolved around some prominent policies that seek to reallocate inputs for the production of health, such as reducing the frequency of certain procedures (i.e., consider the ongoing debate about the recommended frequency of mammograms) or allowing nurse practitioners to prescribe controlled medications. The value of these policies lies in the extent to which they can reduce the costs of providing healthcare, while not generating additional costs in terms of patients’ health or general wellbeing. In this sense, the Receta Resurtible policy appears to have increased efficiency by reducing how often patients should attend doctor’s appointments without harming their health.

I draw several general lessons on how to affect patients’ behavior from studying IMSS’s change in the frequency of prescription renewals. First, it is important to acknowledge that patients have a hard time adhering, and that sticking to a treatment is generally costly. Second, that in order to design the correct interventions to improve medication adherence, it is important to understand all the costs and benefits that patients face for engaging in any type of health behavior, and that these costs and benefits can be both monetary and non-monetary (such as the time and effort required to renew a prescription). Third, that incentives can come in the form of “getting out of something”—in this case, getting out of 8 check-ups per year. In a way, the policy created an additional benefit for improving medication adherence: the possibility of staying on the 90-day regime. This type of policy instrument may be useful to modify individuals’ behavior in other settings, and its design is particularly interesting as this type of incentive can be cost efficient and welfare improving: in this case, providing less healthcare is not only more efficient but it makes patients behave better as well, while keeping their health stable.

Perhaps next time I’ll be better at following my doctor’s suggested treatment!

 

Fernanda Márquez-Padilla holds a Ph.D. in Economics from Princeton University and is Assistant Professor at CIDE in Mexico City. Her research interests lie in the intersection of health and development economics, and is particularly interested in understanding patient behavior. She has worked as a consultant for the World Bank and RAND Corporation, worked for the Mexican Ministry of Finance, and has conducted research at Banco de México.