Options Provided by Storage can Explain High Electricity Prices

Abstract

Generators supplying electricity markets are subject to volatile input and output prices and uncertain fuel availability. Price-risk may be hedged to a considerable extent but fuel-risk - water flows in the case of hydro and gas availability in the case of thermal plants - may not be. We show that a price-taking generator will only generate when the output price exceeds its marginal cost by an amount that reflects the value of the option to delay the use of stored fuel. The corresponding offer price is different from the theorized offer prices of static uniform auctions and more akin to pay-as-bid auction prices. We argue that the option value of delaying fuel use which is an increasing function of spot price volatility and the uncertainty about fuel availability must be considered when evaluating whether market power is present in electricity markets. The engineering approach to simulating an electricity supply curve which has been used in market power evaluations to date may lead to supply curves that are quite different from those that recognize possible fuel availability limitations even in the complete absence of market power.