Power station in operation

+ Power market regulation is hard for governments to operate. Does game theory provide a better way to incentivise acceptable prices and stable supply?

A common problem government regulators have to address in the power industry is finding a way to balance a desire for low power prices now with security of supply in the future. I believe we can draw a vital lesson from the successful Russian use of game theory to improve the regulatory mechanism for balancing local wholesale power markets.

Keeping the lights on

To meet the always-on needs of the population, base load and peak demand must both be managed and accounted for. But with low energy prices desirable for customers, there’s a danger that suppliers won’t have an incentive to maintain peak-load generators which are only used for a few hours per year. Government intervention is required to correct these market shortcomings.

To correct this effect some countries operate a Capacity Market. In this situation the payment operators receive is split into two: an electricity payment in USD/MWh (unit of currency per megawatt hour of energy supplied into the grid) and a monthly capacity payment denominated in USD/MW (unit of currency per megawatt of available power plant capacity in a period). The second payment covers the fixed costs of generation, i.e. maintenance costs and investment returns, regardless of actual output. 

The volume and price of capacity is usually defined in annual or four-yearly auctions run by the regulator and this mechanism is already in use in some states of the USA, Russia and most recently the UK

Market failure

This approach sounds intelligent but doesn’t work properly on mature and saturated OECD markets, unless clever regulation is set. 

The mature markets are characterized by declining per capita energy demand driven by a gradual decoupling of energy demand from economic growth. This phenomena - called ’The Grand Transition‘ in the recent World Energy Scenarios 2016 - encourages OECD countries to produce more GDP by consuming less primary energy and power at the same time. On power markets it creates a positive imbalance between supply and demand (i.e. many power plants are operating that customers cannot afford). 

The challenge of bringing power systems back in to balance lies in proper price setting rules in the Capacity Market auction. If no price floor is set at the auction, suppliers tend to opt for ’price taking’ bids, i.e. a supplier offers to operate its generating assets for free to pass selection in the hope that other players will offer priced bids to form a marginal price. Because the risk of not passing selection and getting zero revenue is high under this system, everybody is likely go this way – so it encourages excess generation. This system aims to cover the fixed costs of plant operation but discredits the capacity market mechanism by quickly bringing prices to zero.   

Conversely, if the price floor is set (and 100% of installed generation is warranted with minimal revenue), the capacity selection quickly degenerates into a plane tariffing system – again not what a government meant under ‘affordable and market oriented power supply’. Once paid per MW installed, power generation companies become reluctant to decommission any old facilities, leaving customers to pay extra for excess capacity. So in solving one energy market failure, regulators face another one. 

Playing a proper game helps

In Russia, this failure was corrected using game theory to create more nuanced incentives within the auction process on the national wholesale power market (OREM). Using this approach, the regulator in Russia reduced the financial burden on customers by encouraging the decommissioning of 15GW (or around 13% installed capacity) of redundant power generation until 2020.

In 2015 as part of Competitive Capacity Selection for 2016 (KOM), the Russian regulator promised that suppliers would be paid 100% of the target capacity price, but only if a maximum of 87% of installed capacity was offered for selection and the rest was scheduled for decommissioning. If suppliers maintained all 100% of their current generation they would only receive 84% of the price.

In keeping with the dynamics of game theory, as suppliers participated in the auction the different power suppliers opted to ‘distrust’ each other by offering almost 100% of capacity available, believing their competitors would not reduce capacity. In this ‘prisoner’s dilemma’ type outcome, suppliers ended up being paid less, and this reduced the ultimate price paid by consumers whilst leaving security of supply at a sufficient level.

In this example, the effects of game theory forced suppliers to react in a way that restored order to the market, optimised the amount of energy generated and produced a rational price for consumes. I believe this is a great example of smart policy making, which follows the principles of strategic theory, and one that other highly regulated markets could learn from.

What do you think might stop the use of game theory in other power markets?