Managing Electricity Reliability Risk Through the Forward Markets

In competitive electricity markets, the vertically integrated utilities that were responsible for ensuring system reliability in their own service territories, or groups of territories, often cease to exist. Typically, the burden falls to an independent system operator (ISO) to ensure that enough ancillary services (AS) are available for safe, stable, and reliable operation of the grid, defined, in part, as compliance with officially approved engineering specifications for minimum levels of AS. In order to characterize the behavior of market participants (generators, retailers, and an ISO) in a competitive electricity market with reliability requirements, we model a spot market for electricity and forward markets for both electricity and AS. By assuming that each participant seeks to maximize its expected utility of wealth and that all markets clear, we solve for the optimal quantities of electricity and AS traded in each market by all participants, as well as the corresponding market-clearing prices. We show that forward prices for both electricity and AS depend on expectations of the spot price, statistical aspects of system demand, and production cost parameters. More important, our model captures the fact that AS are essentially call options for electricity that can potentially be used just like any other derivative to manage risk within a competitive environment. We use data from the California electricity market to test our model's viability.