Incentive Compatible Imbalance Settlement

Imbalance settlement markets are managed by the system operators and provide a mechanism for settling the inevitable discrepancies between contractual agreements and physical delivery. In European power markets, settlements schemes are mainly based on heuristic penalties. These arrangements have disadvantages: First, they do not provide transparency about the cost of the reserve capacity that the system operator may have obtained ahead of time, nor about the cost of the balancing energy that is actually deployed. Second, they can be gamed if market participants use the imbalance settlement as an opportunity for market arbitrage, for example if market participants use balancing energy to avoid higher costs through regular trade on illiquid energy markets. Third, current practice hinders the market-based integration of renewable energy and the provision of financial incentives for demand response through rigid penalty rules. In this paper we try to remedy these disadvantages by proposing an imbalance settlement procedure with an incentive compatible cost allocation scheme for reserve capacity and deployed energy. Incentive compatible means that market participants voluntarily and truthfully state their valuation of ancillary services. We show that this approach guarantees revenue sufficiency for the system operator and provides financial incentives for balance responsible parties to keep imbalances close to zero.