Current Tools and Policy Challenges in Electricity Markets

Around the world, governments are increasingly committed to fighting climate change through more ambitious environmental policies. Notably, the European Union has recently announced its commitment to become carbon neutral by 2050 through a new set of policies known as the European Green Deal. Focusing on the power sector, the ERC Project ELECTRIC CHALLENGES aims to explore key market design and policy issues that arise in this context. Using sound theoretical, empirical, and simulation tools, the project’s final objective is to contribute to designing policies capable of achieving the energy transition at the least cost.
As one of our first objectives, we seek to understand the strength of pricing incentives to incentivize a more active role of electricity consumers. This issue is key for deploying renewable energies, whose availability is linked to the changing weather conditions. Consumers’ response to price changes would allow transferring demand from periods with low to high renewable availability, leading to better use of renewable resources and a reduction in the need for conventional backup capacity.
Second, while the objective is that power markets will become carbon-free in two decades, it is not clear how such markets will perform. This issue is critical to understand whether final consumers will benefit from the energy transition and whether electricity markets provide enough incentives for firms to invest in renewables and storage. Our project seeks to provide key insights into these issues.
Third, beyond the current market arrangements, we seek to identify the best policies to promote investment in renewables and storage. Considering firms’ strategic behavior is important to understand whether the market structure would affect the effectiveness of such policies.

During the first 54 months of the project, we have made progress in all three areas of the project. Regarding the first, we have gathered a large set of Spanish households’ hourly electricity demand data. Since 2015, all Spanish households have paid, by default, tariffs that reflect the hourly changes in the wholesale costs of producing electricity. Hence, the experience in Spain provides a unique opportunity to test whether pricing incentives are enough to trigger a more active demand response. Analysis in this area has led to two papers: “Estimating the Elasticity to Real Time Pricing: Evidence from the Spanish Electricity Market,” with Rapson, D. Reguant, M. and J. Wang (forthcoming at the American Economic Review Papers & Proceedings) and “The Distributional Impacts of Real-Time Pricing” with Cahana, M., Reguant, M. and J. Wang.
Evidence of the weak effects of dynamic pricing led us to consider the effects of another major policy aimed at facilitating the renewables rollout: the use of storage facilities. This has led to a new publication “Storing Power: Market Structure Matters”, Rand Journal of Economics, with D. Andrés-Cerezo, which includes both a theoretical model as well as a simulation analysis on the incentives to invest in and operate storage facilities. We are also making progress on a related paper, “Renewables and Storage: Complements or Substitutes?”.
Regarding the second area of research, we have completed another publication “Auctions with privately known capacities”, with Gerard Llobet, at the Economic Journal. In this work, we build a model of competition in renewables-dominated wholesale markets for electricity. Competition-wise, there are two key differences between conventional and renewable technologies. First, the marginal cost of conventional power plants depends on their efficiency rate and on the price at which they buy fossil fuel. In contrast, the marginal cost of renewable generation is essentially zero. Second, the capacity of conventional power plants is well known, as they tend to be available at all times. In contrast, the availability of renewable plants is uncertain and intermittent. Hence, the move from fossil-fuel generation towards renewable sources will imply a change in the competitive paradigm, towards one in which marginal costs are known (and essentially zero) but firms' available capacities are private information. Under this new paradigm, our paper shows that renewables mitigate market power as compared to conventional resources. We are also making progress on a related paper, “Renewables and Storage: Complements or Substitutes?”.
We have also completed another publication, “Market Power and Price Exposure: Learning from Changes in Renewables Regulation”, with Imelda, at the American Economic Journal: Economic Policy. We demonstrate that how regulators pay for renewable output is a key determinant of market performance. In particular, theoretically and empirically, we explore the market impacts of two regulatory changes that took place in Spain in 2013-2014. We show that paying renewables according to fixed prices (as opposed to paying them at market prices plus a premium) mitigated market power, leading to both greater efficiency and higher consumer surplus
Regarding the third area, we have completed another publication, “Technology neutral versus technology-specific procurement”, with Juan Pablo Montero, at the Economic Journal. In this paper, we analyze the design of policy instruments for procuring renewable capacity. In particular, we compare technology-neutral auctions (all technologies are allowed to compete) versus technology-specific auctions. We also assess the use of quantity instruments (such as auctions) versus price instruments (such as tariffs). We show that these choices fundamentally impact technology choices and the costs for consumers of procuring new investments.

The advent of the COVID pandemic has also pushed us to analyze further project-related questions. In particular, in “The implicit cost of carbon abatement during the COVID-19 pandemic,” with A. Lacuesta, and M. Souza, we compare two alternative strategies for reducing emissions through the lens of the natural experiment brought about by the pandemic: “degrowth” versus “decoupling.” It has been published in the European Economic Review.

Our priority is to finalize the new papers we have started this year.

Periodic Reporting for period 3 - ELECTRIC CHALLENGES (Current Tools and Policy Challenges in Electricity Markets)

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