Markets for reliability and financial options in electricity: theory to support the practice

The underlying structure of why and how consumers value reliability of electric service is explored, together with the technological options and cost characteristics for the provision of reliability and the conditions under which market mechanisms can be used to match these values and costs efficiently. This analysis shows that the level of reliability of electricity provided through a network is a public good within a neighborhood, and unless planned demand reductions by customers have the identical negative value as an unexpected service interruption, market mechanisms will not reveal the true value of reliability. A public agency must determine that value and enforce the reliability criteria. Furthermore, in order to get an efficient level of demand response by customers in periods of system stress, they must see real time energy prices plus they must be paid an amount equal to the suppliers´ cost of adding reliability to the system, if that amount is not included in real time prices. An illustration is provided of how VARs might be scheduled and priced in contributing to system reliability, and a co-optimization procedure is required to determine energy and reserves simultaneously, similar to the method proposed by Chen, Thorp, Thomas, and Mount as stated in M. Friedman and L. J. Savage (1948) for locational reserves. The optimization can be decomposed into a two step process - first, both required capacity and energy are selected based upon suppliers´ offers over both dimensions through the minimization of expected costs over the list of contingencies necessary to satisfy the reliability criteria. This first step commits the reserves, but energy supplies are allocated in real time based upon the previous offer prices but the actual realized state of the electric system. This procedure which satisfies physical realities has a natural parallel in financial markets that have a forward option market with a strike price, followed by real time market clearing.