Market Design for the 21st Century: Recommendations for Alberta’s Power Market

Alberta’s electricity system is in transition. From a system dominated by coal generation less than a decade ago, Alberta’s electricity is now largely supplied by natural gas generation with an increasing share of variable wind and solar energy. Falling clean technology costs, federal clean electricity regulations and a rising carbon price will further shift Alberta’s supply mix away from unabated fossil fuels into one more reliant on a mix of renewables and new technologies, such as carbon-captured natural gas, small modular nuclear reactors and hydrogen generation. In this report, we consider future market designs fit for purpose for this changing electricity mix. We assess market design options based on the criteria of reliability, affordability, investor confidence and complexity. At the heart of the matter is the question of which approach is best able to deliver reliable and low emission supply at low cost to Alberta consumers. Importantly, we consider market designs suitable for the changing nature of 21st century grids with more variability on the supply side and more flexibility on the demand side. If the grid of the past involved forecasting demand and dispatching supply, increasingly grids of the future will flip this upside down by forecasting supply and dispatching demand. Alberta’s market design needs to both reflect and enable this new reality. One might ask why electricity markets require a regulatory intervention to ensure reliability. Consumers want to be able to withdraw electricity from the network when they need it, just like other goods and services. But it is unclear why electricity is so fundamentally different from other products that it requires paying suppliers for production capacity to exist. For example, consumers want cars, but they do not pay for automobile assembly plants. They want point-to- point air travel, but they do not pay for airplanes. They want a loaf of bread, but they do not pay for the existence of a bakery. All of these industries are high fixed-cost, relatively low marginal- cost production processes, similar to electricity supply. Nevertheless, all of these firms earn their return on capital invested by selling the good that consumers want at a price above the variable cost of producing it. Clearly, cars, air travel and bread are in many ways essential commodities, yet there is no regulatory invention that ensures there is sufficient production capacity for these products to meet demand. So what is different about electricity markets that necessitates a long-term resource adequacy mechanism, such as a capacity mechanism? The answer lies in how short-term markets for these products operate relative to that for wholesale electricity. This difference is the result of the regulatory history of the electricity supply industry and the technology of electricity metering, resulting in a reliability externality. This reliability externality exists for two reasons. The first is due to a cap on the short-term market-clearing price for electricity in Alberta. Price caps limit the potential downside to electricity consumers from purchasing wholesale energy from the short-term market, leading to under-procurement in forward markets. The second reason is that in the event of insufficient supply, curtailments — also known as rolling blackouts — are applied randomly. Consumers who have purchased sufficient supply in the forward market to meet their real-time energy demand are equally likely to be randomly curtailed as those who have not procured adequate amounts of energy in the forward market. For this reason, consumers have an incentive to under-procure their expected energy needs in the forward market. This reliability externality can be resolved in several ways. First, a capacity mechanism can be applied. This involves imposing capacity procurement obligations on load-serving entities and providing capacity payments to suppliers. Second, price caps in the energy market can be raised to a sufficiently high level that does not offer the same level of price protection in periods of scarcity and are likely to result in voluntary reductions in demand based on consumers’ willingness to pay, rather than rationed electricity. And third, standardized forward contracts for energy purchased are mandated to ensure that all electricity consumers procure sufficient levels of supply in forward markets far enough ahead of delivery for suppliers to ensure that supply equals demand under all possible variable renewable supply conditions. For long-run resource adequacy, we recommend neither a capacity market nor the existing energy-only market with only slight modifications. Neither delivers a suitable trade-off between reliability and affordability, neither offers attractive conditions for investment, and in the case of capacity markets there is a significant increase in complexity. Instead, we recommend a standardized forward energy-contracting approach, which combines the energy-only market with mandated forward contracting (Wolak 2022). This solution most directly resolves the reliability externality, doing so at low cost and with minimal complexity and regulatory intervention. To be clear, the standardized forward energy contract should not be confused with contracting directly with power plants, i.e., power purchase agreements. Nor is it a full requirements contract for individual load-serving entities. A key feature that distinguishes our approach is contracts that settle on average system load shapes. By separating contract settlement from actual deliveries from generators and draws from individual loads, the proper incentives at the margin are maintained (Shu and Mays 2023). It also ensures technology neutrality and avoids placing the onus on the market operator to compare contract costs across resources with vastly different production and value profiles. In addition to long-term resource adequacy concerns, Alberta’s changing electricity mix requires changes to short-term markets to ensure reliability and security of supply during operations. We recommend changes to Alberta’s energy and ancillary service markets to reflect the greater prominence of variability on the supply side and more involvement from the demand side. Specific recommendations include: • Locational pricing to better align marginal prices with true system conditions and transmission constraints, and to encourage better siting decisions for new facilities; • A multi-settlement market with the introduction of a day-ahead market to better co-ordinate dispatchable generation resources with an increasing share of variable generation resources; • New ancillary service products, such as fast frequency response, to provide the services Alberta’s system requires as the resource mix evolves; and • We encourage the widespread deployment of interval meters capable of recording customers’ consumption at the hourly or sub-hourly level so that final demand can respond to real-time price signals from the short-term energy market. There is no perfect market design. There are only better market designs that are specifically adapted for, and evolve with, changing electricity systems. With Alberta’s growing share of variable renewable energy and rapid shift towards lower emissions generation, the standardized forward energy-contracting approach coupled with changes to short-term operations, including more involvement from the demand side, can improve reliability at lower cost than the alternatives.