The price of flexibility in electricity markets

Electricity markets differ in the flexibility they have in meeting power imbalances on short notice in a controlled fashion. Flexible markets can adjust operations to absorb random disruptions in power generation or demand. However, in markets with energy-only trading, where the producers are compensated only based on the energy delivered but not necessarily produced, there is no explicit remuneration for this flexibility. We argue that in such markets, flexibility is implicitly priced via persistent premiums in the day-ahead market (i.e., a positive average difference between day-ahead and real-time prices). Specifically, we develop a stylized game-theoretic model to characterize day-ahead premiums in equilibrium when the market is subject to the risk of a significant but low-probability disruption. Although arbitrageurs can reduce persistent day-ahead premiums by selling in the day-ahead market and buying in real-time, this strategy carries substantial downside risk, which ultimately curtails their trading activity in equilibrium. Consequently, flexible generators exert market power by limiting their committed production in the day-ahead market. While persistent day-ahead premiums incentivize more flexible resources (e.g., battery storage capacity), it is not clear that they constitute an economically efficient incentive mechanism for increasing flexibility.