Incentivos para Una Oferta Adecuada en Los Mercados de Electricidad:una Aplicación Al Sector Eléctrico Mexicano

Incentives for Supply Adequacy
in Electricity Markets
An Application to the Mexican Power Sector
Víctor G. Carreón-Rodríguez and Juan Rosellón*

Fecha de recepción: 29 de septiembre de 2008; fecha de aceptación: 11 de noviembre de 2008.
Abstract: This paper studies resource adequacy, i.e. the market design dilemma of
ensuring enough generation capacity in the long run. International experiences
have shown that it is difficult that the market alone provides incentives to attract
enough investment in capacity reserves. We analyze various measures to cope
with this problem, including moth-ball reserves, capacity payments, icap and call
options. We then construct a model to analyze the structure of incentives for the
expansion of electricity supply in the spot market, and capacity in the long run
electricity reserve market. Through a game-theory model, we analyze price con-
vergence in three markets: the peak spot market, the non-peak spot market, and
the long-run capacity reserve market. We finally carry out a simulation for Mexi-
can power generation. The combination of cfe’s virtual market, together with ca-
pacity payments, has eventually resulted in capacity generation expansion simi-
lar to what would be attained in an open electricity market, such as the one
modelled in our study. But this does not necessarily imply that the Mexican elec-
tricity industry will not need in the future –if the generation market is fully open
to private investment– some of the discussed capacity incentive mechanisms.
Keywords: Electricity generation, resource adequacy, capacity markets, capacity
payments, capacity reserves, Mexico.
Incentivos para una oferta adecuada en los mercados de electricidad:

Una aplicación al sector eléctrico mexicano
Resumen: Este artículo estudia el tema de resource adequacy, esto es, el dilema de
diseño de mercado para asegurar capacidad de generación suficiente en el largo
plazo. Las experiencias internacionales han demostrado que es difícil que el mer-
cado, por sí mismo, provea incentivos suficientes para atraer inversión en reservas
de capacidad. Analizamos varias medidas para lidiar con este problema, incluyen-
do reservas moth-ball, pagos por capacidad, icap y call options. Elaboramos des-
* Víctor G. Carreón-Rodríguez, [email protected], Centro de Investigación y Docencia

Económicas (cide); Juan Rosellón, [email protected], Centro de Investigación y Docen-
cia Económicas (cide) and Technische Universität Dresden (tu Dresden). We are grateful to
William Hogan and an anonymous referee for insightful comments. Rosellón acknowledges
support from the Repsol-ypf-Harvard Kennedy School Fellows program, the Fundación México
en Harvard, and the Comisión Reguladora de Energía.
economía mexicana nueva época, vol. xviiI, núm. 2, segundo semestre de 2009 249
250 Víctor G. Carreón-Rodríguez and Juan Rosellón: Incentives for Supply Adequacy in Electricity Markets
pués un modelo para analizar la estructura de incentivos para la expansión de la

oferta de electricidad en el mercado spot, así como de la oferta de capacidad en el
mercado de reservas de electricidad de largo plazo. Mediante un modelo de teoría
de juegos, analizamos la convergencia de precios en tres mercados: el mercado spot
“pico”, el mercado spot no pico, y el mercado de reservas de capacidad de largo
plazo. Finalmente, efectuamos una simulación para la generación de electricidad
en México. La combinación del mercado virtual de cfe junto con los pagos de capa-
cidad, eventualmente ha resultado en una expansión de la capacidad de genera-
ción similar a la que se hubiera obtenido en un mercado de electricidad abierto, tal
como el que modelamos en nuestro estudio. Pero esto no necesariamente implica
que la industria eléctrica mexicana no necesitará en el futuro –si el mercado de
generación se abre totalmente a la inversión privada– de algunos de los mecanis-
mos de incentivos a la capacidad que se discuten en este estudio.
Palabras clave: Generación de electricidad, resource adequacy, mercados de
capacidad, pagos de capacidad, reservas de capacidad, México.
jel classification: L51, L52, L94.
Introduction
R ecent electricity power crises around the world have dramatically

showed how crucial reliable electricity supply is. Generation reserves
had declined in many markets since liberalization by the end of last de-
cade (iea, 2002). Examples are Australia, where reserves dropped signifi-
cantly after the reform (starting from a significant initial overcapacity);
Norway, where there was a 2 per cent decrease in 1991-2000; and Califor-
nia, with a 7.5 per cent decrease during 1990-1998. Changes in reserve
margins have frequently taken place from starting large reserves, so that
current reserves generally remain above 16 per cent. Additionally, various
electricity crises have arisen in systems that heavily depended on hydro-
power (e.g. Brazil). However, there is concern on whether reformed elec-
tricity markets will be able to attract sufficient investment in generation
capacity, due to the characteristics of electricity markets, such as:

Reliability in electricity markets is understood as the sum of adequacy and security
standards. Adequacy (security) is associated with the long run (short run). Security describes
the capability of the system to deal with contingencies, and includes the so called ancillary
services. Adequacy addresses the ability of the system to continuously meet the consumer
energy requirements (Singh, 2002; Oren, 2003).

De Vries and Neuhoff (2003) carry out an extensive analysis of the market and institutio
nal failures in the electricity industry.
• The inelasticity of short-term electricity demand and supply functions,

which implies that the long-run supply-demand balance cannot always
be achieved through a market clearing price.
• The favourable environment for strategic behaviour by generators un-
der tight market situations.
• The lack of long-term (beyond one or two years) forward electricity
markets.
• The lack of incentives for final consumers to engage in long-run con-
tracts, since they are usually isolated from spot prices by regulated
tariffs (see Bouttes, 2004; Vázquez, Rivier and Pérez Arriaga, 2002).
Our paper studies the electricity market long run design problem of en-
suring enough generation capacity to meet present and future demand.
Reform processes worldwide have shown that it is difficult that the mar-
ket alone provides incentives to attract enough investment in capacity
reserves, due to market and institutional failures. We first study several
measures that have been proposed internationally to cope with this problem,
including strategic reserves, capacity payments, capacity requirements,
and call options. The analytical and practical strengths and weaknesses of
each approach are discussed.
We then construct a model to analyze the structure of incentives for
the expansion of electricity supply in the spot market, and capacity in the
long run electricity reserve market. Through a game-theory model, we ana
lyze price convergence in three markets: the peak spot market, the non-
peak spot market, and the long-run capacity reserve market.
We finally carry out a simulation for Mexican power generation, which
has been subject to a modest reform process and is characterized by large
efficiency differences among plants. First, we construct a benchmark using
the merit order model for dispatch, given the generation costs for each
technology actually employed in Mexico. Then we compare it with the real
cost of electricity generation, as reported by Comisión Federal de Electri
cidad (cfe).

Stoft (2002) explains how a market with a perfectly inelastic demand function can still
achieve the socially optimal volume of generating capacity.

Demand is not always only inelastic due to regulated tariffs. In many countries, consumer
rates are not regulated. However, if meters are read only annually (or monthly), it is not
possible to distinguish the time of electricity consumption, and consumers still do not have a
short-term reaction to prices.
I. Resource Adequacy: Several Measures
Various measures have been proposed to ensure generation resource ade

quacy. They can be analyzed in terms of their degree of centralization and
the amount and price of capacity (Knops, 2002; De Vries, 2004; Oren, 2000,
2003). In this section, we analyze both the theoretical fundamentals as
well as the international experience on these measures.
I.1. Centralized Resource Adequacy
There are two extremes regarding resource adequacy and investment in

capacity reserves. One extreme is a fully centralized solution, where a
vertically integrated utility manages congestion and ancillary services
using its own generation resources. This is the well known “wheeling”
model used in North America, in regions that have not gone into a libera
lized structure and lack a spot market (Hunt, 2002). The Mexican model is
currently another centralized market, where private independent power
producers sell all their energy to the public monopoly, cfe, under long-term
power purchase agreements (Carreón-Rodríguez, Jiménez San Vicente and
Rosellón, 2007; Madrigal and De Rosenzweig, 2003).
“Moth ball” reserves are another centralized alternative. The moth ball
reserve would imply a strategic reserve of generation capacity, with
operations centrally controlled by government (in terms of output and
price) and that would only be used during emergencies. Subsidies are fi-
nanced through public funds, and supply of capacity reserves is then a
public service obligation (Knops, 2002).
I.2. Decentralized Resource Adequacy
An opposite extreme on resource adequacy is a decentralized solution,

where market determines price and quantity of capacity. Different energy
markets are alienated, and a sequential equilibrium is reached in the spot
market, the forward energy market, the market for capacity reserves, and
the forward transmission market through voluntary participation of

In Norway, there is direct State ownership of some peaking plants (Gülen, 2002).
agents (Wilson, 2002). Different decentralized models have been tried in-
ternationally as in the United Kingdom, Australian Victoria pool, Texas
and California. The aim has been to have traders manage the spot market,
as well as congestion and ancillary services. Hunt (2002) argues that the
basic problem of a decentralized model is that separated markets for con-
gestion energy, imbalance energy and ancillary services create high prices,
shortages, bureaucracy and new transaction costs.
This view is endorsed by Joskow (2003), who shows that wholesale
markets that separate energy and individual ancillary service markets
are subject to strategic non-coordinated behavior that leads to price increa
ses. Some theoretical studies try to find the optimality conditions for the
separated markets approach (e.g., Wilson, 2002; Chao and Wilson, 2002).
However elegant in theory, the electricity industry practice has evidently
shown the inconvenience of separating the different markets. Borenstein
(2002) also agrees that electricity markets do not fulfill the conditions for
full competition to work, so that decentralized sequential and efficient
equilibrium of the different electricity markets is impossible.
The “energy-only” market solution is studied in De Vries and Neuhoff
(2003). A spot market run by the Independent System Operator (iso) takes
care of resource adequacy through price spikes, which signal the need of
investment in generation capacity. It is shown that there are not enough
incentives for generators to invest in capacity whenever there are eco-
nomic uncertainty and demand fluctuations. Moreover, when generators
and consumers are risk averse, the level of investment in generation is
below the optimal social level, since energy-only market designs do not
have the institutions that allow long-term contracts to develop sufficiently.
Likewise, complete reliance on price spikes is not advisable, because they
are usually not politically acceptable and subject to manipulation from
generators.
Regulators worldwide are then very concerned that energy prices are
not enough to guarantee resource adequacy, and thus have implemented
several policies. Texas changed to generation adequacy assurances, and
ferc’s Standard Market Design (smd) also recognized the need of contracted
provision of capacity reserves (ferc, 2002). California in 2001 also chan
ged its market approach to capacity supply, and prompted a proposal for
an available capacity requirement (acap) to be imposed on load serving
entities (lses). Several methods have also been proposed in the literature
on investment in reserve capacity, such as capacity payments, require-
ments, subscriptions and options. These mechanisms are analyzed below.
I.3. Capacity Payments
Generators get capacity payments so as to make their generation capacity

available (whether they get dispatched or not). The price of capacity is
administratively set, while the market determines the capacity level. Ca-
pacity payments are collected from consumers through an uplift charge.
Oren (2003) explains that capacity payments derive from the peak-load
pricing theory, so that energy is priced at marginal cost and capacity pay-
ments recover fixed costs. Optimally, the shadow price of capacity con-
straint equals the incremental cost of capacity.
In international practice, capacity payments have been used in Spain
(together with bilateral capacity contracts), Peru, Argentina (before 2000),
Colombia, Chile and the UK (before neta). Two different kinds of capacity
payments have been applied: fixed payments and fluctuating payments.
Fluctuating payments were implemented in the early UK electricity
market. The merit-order pricing rule was modified during periods of high
demand, when reserve capacity margins were low. The market price was
then defined as the average of the price of the last accepted offer to generate
(lao) and the value of lost load (voll), weighted by the loss of load probabi
lity (lolp):
Market price = lolp * VOLL + (1-LOLP) * LAO
where 0 ≤ lolp ≤ 1. Then, the greater the surplus reserve capacity the
smaller lolp is. Generators would ideally add capacity if the expected sum
of all these payments over all hours of the year were greater than the cost
of installing new capacity. This formula also implied a price cap for voll, if
the system were short of power. Meanwhile, fixed payments per mw were
implemented in Argentina, where the Secretaría de Energía set a payment
during peak demand blocks, and in Spain, where the compensation de-
pended on availability and technology of power plants.
In Mexico, cfe uses capacity payments in its “shadow” or internal mar-
ket to provide remuneration to generators for making available their gene
ration capacity. They are collected from consumers through an uplift
charge. Such payments are rooted in the theory of peak-load pricing, so
that energy is priced at marginal cost and a capacity payment is used to
recover the fixed capacity cost. In practice (such as in boot contracts), the
split between capacity and energy charges depends on how the capacity
charge is calculated. If it is assumed that the majority of capital costs are
determined by the capacity needed to meet demand at its peak, a bigger

proportion of fixed costs can be attributed to capacity. In practice, cost allo
cation between capacity and energy charges has varied at several places
and times. The main differences have been related to the amount of fixed
costs allocated to the capacity and the energy charges, so as to attain one
or more policy objectives. For example, the more fixed costs are allocated
to the energy variable charge, the more a firm depends on sales to recover
its long run investment. Therefore, a policy assigning more fixed costs to
the energy charge generally has the effect of promoting gas consumption.
Capacity payments could also be combined with price caps (Interna-
tional Energy Agency, 2002). Hobbs, Iñón and Stoft (2002) show that this
could imply a reduction in price volatility without affecting capacity re-
serves. However, price caps can also have an undesired locational effect,
since generators would look for high price-cap areas.
Oren and Sioshansi (2003) analyze payments for reserve capacity in a
joint day-ahead energy and reserves auction under imperfect information.
Capacity payments are made based on the generator’s opportunity cost,
while reserves are procured using energy only bids. The revelation prin-
ciple is applied to show that generators have an incentive to understate
their costs, so as to capture higher capacity rents. Similarly, Joskow and
Tirole (2004) analyze the effects of capacity payments in a general welfare
model of the effects of electricity market failures. They find that when an
uplift charge is applied both during peak and non-peak periods –and when
the iso carries out large purchases–, building of base load capacity might
be discouraged and the peak price would be pushed down. In case of rela-
tively small purchases, peak capacity decreases when the uplift charge is
applied only during the peak period, while off-peak capacity decreases
when the uplift is applied during both peak and off-peak periods.
Likewise, Knops (2002) points out that fluctuating capacity payments
happen in the short run, whereas the relevant time for investment in ca-
pacity reserves is the long run. Similarly, Singh (2002) points out that
setting the optimal level of capacity payments is a subjective task, while
Gülen (2002) considers that the lolp method is not adequate for largely
hydro-based systems (such as Brazil), because the lolp would be very

For instance, in the United States gas cost allocation to charges has varied from an
“Atlantic Seaboard” method, which assigned 50 per cent (later 100%) of fixed costs to the
commodity charge, to the “Straight Fixed Variable” method, which allocates all fixed costs to
the capacity charge.

See also Newbery (1995).
small during wet seasons, which would imply disproportionate low reve-
nues for thermal generators.
These assessments were somewhat consistent with international prac-
tice. In the UK, the lolp system was manipulated by large players at the
end of the pre-neta period (Green, 2004). Argentina substituted its fixed
capacity payment mechanism with a hybrid system of payments and con-
tracts. Fixed payments negatively affected the long-term financial situa-
tion of thermal generators, and even distorted merit order dispatch. In
several other countries, capacity payments also led to the construction of
inefficient peaking units, promoted the inefficient use of one fuel over oth-
ers, and eliminated availability incentives during deficit supply.
I.4. Capacity Requirements
Capacity requirements oblige generators to keep a predetermined level of

reserve capacity. This level is centrally established by the iso (or the regu-
lator) to lses through an administratively forecast of demand. Conversely
to capacity payments, the price is determined by the market once the
amount of reserve capacity is set. lses buy “capacity tickets” to meet the
expected peak load of consumers times (1+x), where x is the expected re-
serve margin to deal with estimated reliability to cope with random out-
ages. Tickets are typically put up for sale by generators who are also able
to export their reserve capacity to other markets. Long-term capacity re-
serves are like price insurance required to generators by the iso. They can
then be treated as a private good, whose levels are imposed by the iso.
These mandatory levels compensate consumers for several obstacles re-
lated to political constraints to set electricity tariffs efficiently, and tech-
nological barriers on metering control.
Requirements on capacity are used in the Northeast of the US [Penn-
sylvania, New Jersey, Maryland (pjm), New York and New England] where
lses must arrange for Installed Capacity (icap). pjm implemented a bid-
based icap markets, on day-ahead and month-ahead schemes. lses can
trade their icap with other lses. The icap requirements can be met through
self supply, bilateral transactions with suppliers, monthly auctions, defi-
pjm initiated monthly and multi-monthly capacity markets in 1998, while daily capacity

markets started in 1999. See Hobbs, Iñón and Kahal (2001) for an in depth analysis of icap
issues in pjm.
ciency-spot market auctions, and capability several-month period auc-

tions. Capacity might be exported from (or imported to) the pjm area. pjm
can recall energy exports from capacity resources as needed. When capacity
is recalled, generators are paid the market price. lses must own capacity re
sources greater than, or equal to, their expected peak-load, plus a reserve
margin. If an lse is short of capacity, it pays a penalty proportional to the
daily amount of deficiency in capacity times the number of days. These
need to be multiplied by the capacity deficiency charge. When the system
itself is short of capacity, the deficiency charge is the double of a capacity
deficiency rate equalling the annual fixed cost of a combustion turbine,
plus transmission costs (pjm, 2003).
Creti and Fabra (2004) make a theoretical analysis of the pjm icap mar-
ket with a game theory model. In a first stage, generators compete in the
capacity market and receive payments for committed capacity before de-
mand is realized. In a second stage, once demand is realized, generators
compete in the domestic and foreign markets. Finally, suppliers get their
payments for the energy sold. They analyze the role of the regulator in
choosing the capacity requirement, and a price cap for the monopoly and
the perfect competition cases.
Creti and Fabra find the generator’s trade-off between foregone export
revenues and the commitment of capacity resources. The difference be-
tween foreign and domestic prices then determines the opportunity cost of
committing capacity reserves. Two types of equilibria are possible for the
firm’s optimal behavior. When the price cap is “big” enough, capacity re-
sources are able to cover the needed capacity requirement (market clear-
ing equilibrium). When the price cap is too “low”, the generator’s opportu-
nity costs will not be covered, and there will be a capacity deficit (capacity
deficit equilibrium). In any case, the regulator should set the price cap in
terms of the firm’s opportunity cost of complete capacity commitment, and
the capacity requirement according to peak demand, in order to avoid
shortages.
The icap system then crucially depends on the capacity level and the
capacity price cap. The calculation of the former variable is subjective,10

Joskow and Tirole (2004) also propose a model which combines capacity requirements
with capacity price caps, that might potentially restore investment incentives.
10
For instance, in the New York iso a demand curve is constructed as an alternative to
valuing an additional icap above the fixed capacity requirement (Harvard Electricity Policy
Group, 2003).
while the optimality of the latter one depends on the price difference be-
tween the domestic and foreign markets. So that if the financial transmis-
sion right (ftr) market is subject to market power, that will be reflected in
the icap market. Stoft (2003) analyzes how price caps, operating-reserve
requirements and icap requirements and penalties determine investment
when suppliers have no market power. Stoft proposes a system in which
engineers set minimum requirements for reliability and regulators set
price caps, so that the combination of both policies results in efficient un-
regulated investment.
icap mechanisms have not provided in practice adequate investment
signals, and have been subject to market manipulation of the plants’
availability so as to increase their revenue. The pjm pool was deficient du
ring some periods of 2000 because generators increased their exports
when export prices surpassed the pjm market internal price.11 In January
2001, there were price spikes of more than $300 mw-day with a deficiency
in system capacity. In New England, scarcity rents have not provided in-
centives to supply the needed operating reserves and energy during tight
conditions.12 Similar results have taken place in the New York iso (Patton,
2002).
In summary, the icap system is generally flawed because:
• It relies on a subjective capacity level estimation, which depends on fuel

prices, load shapes, generation stocks and elasticity of demand for re-
serves.
• It depends on the price differences across adjacent markets.
• It derives from short-term rather than long-term adequacy concerns,
which is inconsistent with the long-run nature of resource adequacy.
• It has not provided incentives to build new generation facilities and,
conversely, has contributed to keep old inefficient plants in place (Har-
vard Electricity Policy Group, 2003).
Therefore, the icap systems have made several modifications. For example,
iso New England proposed a new locational installed capacity (licap) mar-
11
pjm solved its problem of capacity leaking to neighbouring systems, by requiring gene
rating companies to commit for longer periods, if they wanted to sell icap credits.
12
The average scarcity rents in New England of $10,000 mw-Year, are very low when com-
pared to the fixed cost of a new reserve capacity facility, estimated in between $60,000-$80,000
mw-year (Joskow, 2003).
ket since the capacity markets in New England were registering, at cer-
tain times, prices of zero, while generation in constrained areas needed to
be valued more highly (Davis, 2004).13 The licap proposal included deriv-
ing prices from demand curves estimated for Maine, Connecticut, metro-
politan Boston and the rest of New England. The idea is that for such di-
verse markets, locational capacity requirements better correspond to the
specific conditions at each market. Likewise, pjm has developed a new
methodology for peak load obligation, and has changed the month-ahead
and day-ahead markets to a price-taker auction, while retaining manda-
tory participation in the day-ahead market. Even more, ferc’s original smd
also criticized icap requirements, and alternatively proposed the use of
resource adequacy requirements with targeted curtailments, penalties for
undercontracting and long-term contracting mandatory measures (ferc,
2002). Chandley and Hogan (2002) argue that this is a further flawed poli-
cy because it does not solve the many difficult issues faced in an icap design.
They think that a kind of energy-only solution –together with financial
hedging contracts and demand-side measures– would be the best option,
so that prices clear the energy and reserve markets, and scarcity costs are
properly signaled.
I.5. Call Options
Capacity requirements set a capacity requirement level, as well as the

value of its maintenance, in a subjective way. Call options are then pro-
posed as an alternative system that represents a more objective value of
capacity (Vázquez, Rivier and Pérez Arriaga, 2002), and which explicitly
bundles generation adequacy with price insurance. Desired capacity is
also centrally established, while price is decentrally determined but with
consumers hedged against huge price spikes.
Therefore, as for capacity requirements, under the call options system
the total volume of capacity is administratively determined; there is a de
facto price cap, and generating companies receive payments for their ca-
pacity as well. However, the real differences between the two systems are
with respect to real-world incentives. With call options, generating compa-
nies have fewer incentives for gaming. Specifically, they have a proper in-
13
Creti and Fabra (2004) deduce, from their theoretical model, the possibility that ca-
pacity markets clear at zero prices, if there is no spread between national and foreign
prices.
centive for estimating how much capacity they can reliably offer in the fu-
ture, and for making as much capacity available as possible in real time.14
Typically, the system operator purchases call options from generators
in a competitive bidding process that covers desired capacity.15 The buyer
exercises the option if the spot price is greater than the strike price, and
receives a premium equal to the difference between these prices.16 The
strike price of options then functions as a price-cap in case of emergencies,
and high penalties are imposed for failure to deliver when the option is
called. This assures that promised capacity is made available when most
needed, as during peak periods. 17
The price cap of a call options system works as consumer protection. It
will assure that prices stay within a socially acceptable range. Regulatory
intervention then becomes an insurance against price volatility. However,
as in the icap system consumers still bear the risk (and benefits) of overin-
vestment. Likewise, the system operator now bears the uncertainty of
whether the options are used or not, while generating companies bear a
risk of not being able to provide as much power as they committed to. How-
ever, generators now face a more stable revenue horizon compared to an
uncertain and volatile income for peak generation in the icap system. The
expected generators income for prices above the strike price equals the price
of the call options, and generators now get a fixed payment for the option.
Prices and corresponding capacity payments are market based premia
from the market players’ strategies for risk management.
14
Doorman (2000) suggests an alternative capacity mechanism, based on capacity subs
criptions.
15
Alternatively, lses could be the buyers of options through bilateral contracts with generators.
16
Option premiums work as substitute efficient signals, compared to price signals gener-
ated by capacity requirements (Singh, 2002).
17
A specific call-option mechanism for the electricity market in Colombia is proposed in
Vázquez, Rivier and Pérez Arriaga (2002). The regulator requires the system operator to buy a
prescribed volume of reliability contracts, which allow consumers to get a market compatible
price cap in exchange for fixed capacity remuneration to generators. Reliability contracts then
consist of a combination of a financial call option with a high strike price, and an explicit pen-
alty for generators in case of non-delivery. The regulator carries out a yearly auction of option
contracts, and sets the strike price (at least 25 per cent above the variable cost of the most ex-
pensive generator) and the volume of capacity to be auctioned. Generators decide how to divide
their total capacity and price into different blocks, so that capacity assigned to each generator
is a market result rather than an administrative outcome. This proposal is very sensitive to
market power. Therefore, implementation requires that the maximum amount a generator can
bid is limited to its nominal capacity. Likewise, portfolio bidding is not allowed, and the win-
ning bids cannot transfer their obligations of physical delivery to other generators.
Oren (2003) claims that the provision of supply adequacy through lse’s
hedging obligations captures several important features. If lses’ obliga-
tions are adjusted to reflect fluctuations in forecasted peak demand, a
secondary market for call options would emerge and permit trading of
such instruments. However, while secondary markets permit lses to ad-
just their positions periodically, price volatility increases the lses’ risk.
Call options hedging is then another ancillary service, and lses can get
them through bilateral contracts (with the iso acting as a provider of last
resort). The danger is that this may interfere with incentives in the con-
tract market, and be perceived by lses as an alternative to prudent risk
management. In countries where there is not a well-developed financial
market, lses or generators may assume more risk than they might handle.
The regulator should need to set a minimum contracting or hedging level
on lse, and this would lead to non-market arbitrariness. Likewise, the
capital market might not be able to provide long term financing for gene
ration investment according to the associated high risk. This might raise
the cost of capital so much, that the investment level will be far away from
an efficient resource adequacy level.
II. The Model
In this section, we set a simple model to analyze some of the facts covered
in the above discussion. Our objective is to see if markets give the right
incentives to generation plants for installing enough capacity to satisfy
current demand, in the spot market, and enough capacity for the long-run
reserve market. One of the most important characteristics of this model is
that we assume that there are no regulations in any of these markets.
The crucial actor is the system operator (so), who is in charge of the
dispatch to satisfy demand at any point in time. There exist at least three
structures for an so (Wilson, 2002; Stoft, 2003). Each of them determines
the way expansion in energy supply and capacity is reached.18 The first
one is a decentralized independent so (iso) (as in California), the second is
18
The iso has a natural monopoly over its functions. Several design issues arise regarding
the iso’s organization and institutional characteristics, such as governance, incentives,
regulation, and economic objective functions. Regarding congestion of transmission lines, the
objective function of an iso should consider the minimization of difference in nodal prices, and
the maximization of total energy traded in the electricity system.
a centralized iso (as in pjm),19 and the third option is an integrated dispatch
control and transmission operator or transco (as in the United Kingdom).
A centralized iso imitates vertically integrated functions through an over-
all optimization of operational decisions, and long-term contracting among
participants. Wilson (2002) argues that centralization does not provide the
right incentives for cost minimization, since pool bids not always reflect
actual costs (like in the UK electricity market). On the contrary, a tiny de-
centralized iso would manage transmission and reserves with small intru-
sion into energy markets. A decentralized iso provides more incentives for
competitiveness, but entails deficiencies in coordination, incomplete mar-
kets and mechanisms, and imperfect pricing. In a decentralized iso, the
pool dispatch function is ideally separated from other economic activities.
Thus, centralization is preferable under the presence of vigorous competi-
tion and adequate technical and economic optimization of an electricity
industry, while decentralization is better when incentives for cost mini
mization are more important than coordination in electricity markets.
A transco approach is similar to a centralized iso, but with a dispatch con-
troller that also owns the transmission network. In the case of the United
Kingdom, such conditions made possible the implementation of a transco.
In the United States, however, it is difficult to impose it due to the property
structure of the transmission network.
In this paper, we assume a free market set up where all plants are open
to choose capacity and prices, given the information provided for a decen-
tralized iso.20 Also, plants decide to supply energy only for the peak period,
for both the peak and the non-peak periods, or for the long-run reserve
market. There are no restrictions about participation in any of these mar-
kets. So, this set up is reproducing the merit order model, as it is developed
below, with some simplification assumptions that let us get an explicit
equilibrium, in which we can compare and rank generation prices for
these three markets.21
19
Hybrid designs allowing for different degrees of centralization are also possible: central
control of transmission and reserves by an iso, together with forward markets for energy.
20
We also assume, for simplicity, that the decentralized iso takes care of financial
transactions in addition to the physical operations of the system. That is, the iso also
carries out the “px” functions. In practice, these functions can of course be separated.
21
In practice, generation plants with market power might carry out bid strategies, in order
to increase the spot price. According to Stoft (2002, pp. 320-322), some of these strategies
include quantity distortions (output is decreased below its competitive level), price distortion
(price is increased above its competitive level) and quantity withholding (producing less than
would be profitable).
II.1. Merit Order Model
We will analyze the profit-maximizing behavior of a power plant as follows

(see figure 1). There exists a sequence of decisions that any generation
plant (gp) must take. First, after the decentralized iso announces the expec
ted demand for the next period,22 any generation plant must choose one of
three possibilities: a) supply for the short-run spot market, b) offer capac-
ity for the long-run reserve market, or c) stay out of the market. We re-
strict plants to choose only one of these alternatives. First, the generator
might supply energy in the short-run market (or pool), or capacity in a
long-run market for capacity reserves, or not supply at all. Second, if the
generator decides to supply for the spot market, it must choose to sell en-
ergy only for the peak period (only for the peak hours, these plants are
called “peaking plants”), or for both, peak and non-peak (offering energy
all the time).23 Once all gps have made their decisions, the market24 plays
and decides the actual demand for the three markets. After this, all gps
get their payoffs by computing their expected profits.
This is the more general context for analyzing the power plant’s behav-
ior in the spot and long-run reserve markets. A particular case would be
the perfect competition model, where power plants entering the spot mar-
ket are ordered by the decentralized iso according to their bids. After that,
they are dispatched until demand is satisfied. If we think of a vertically
integrated system, then the perfect competition model is more accurate.
However, if we think of a new market architecture, where plants will be
free to choose, the model analyzed in this paper is better. It would allow
getting the right implications; for example, the strategic behavior of plants
trying to drive prices up in order to get higher profits.
22
We abstract from any specific time span, since we want to stress the behavior of power
plants when deciding about any of the submarkets.
23
In this model, we allow plants to decide between “peak”, and “non-peak and peak”. Al-
though this is an analytical assumption, it helps to approximate a model to the peaking plants
and base-load plants practice behavior of electricity markets.
24
We introduce “the market” as a player to illustrate that the environment plays an important
role in determining actual demands (in the spot market and in the long run reserve market).
Actual demands could differ from the expected ones forecasted by the decentralized iso.
Figure 1. Sequence of decisions
SO
Expected demand in spot

(x) and reserve (y) markets
GP
Enter long-run
No enter (n) Enter spot reserve market (r)
market (s)
GP Non-peak
Peak and peak
period (p) periods (bp) Demand is
realized (d)
Payoff is M M M Payoff is
realized realized
Demand is Demand is
realized (d) realized (d)
Payoff is Payoff is
realized realized
Source: Authors’ own elaboration.
The conditions that characterize the optimal behavior of generators

under these scenarios should hopefully provide the decentralized iso with
key clues to evaluate the impacts of different pricing rules, that seek to
enhance supply of energy and capacity reserves.
In order to analyze this mechanism, and following the sequence of deci-
sions shown in figure 1, we use the tool of sequential games.
where:
[
Definition 1: A sequential game is given by ' N, An n 1 , un n 1 , P, Z ,
N N
]
(i) N is the set of players
(ii) An is the set of actions available for player n = 1,2,..., N
(iii) un is the payoff function for player n = 1,2,..., N
(iv) P is the player function
(v) Z is the set of histories in G
Therefore, in this mechanism we have the following elements. The set

[ ]
of N players is N SO, M , [GPn ]n 1 , where so is the decentralized in
N 2
dependent system operator, M is the market (its only role is to set the ac-
tual demand), and there are N − 2 power plants, denoted by GPn. We as-
sume plants are risk neutral.
The decentralized iso’s set of actions is Aso = [0,ß) × [0,ß). So, any pair
de = (x, y)∈[0,ß) × [0,ß) denotes the expected demands in the spot and in
the long-run reserve markets, respectively. The market’s set of actions
is Am = [0,ß), denoting the actual demand in any of these markets. The
GPn ’s set of actions is Agp = {n, s, r, p, bp} for n = 1,2,..., N − 2.
The set of histories is Z = {φ, de,den, des, der, derd, desp, desbp, despd,
desbpd}.25 For example, despd means that the decentralized iso expects a
demand de = (x, y), the gp decides to enter the sport market and supply
energy for the peak period, and the market chooses an actual demand of d.
The terminal histories are T = {den, derd, despd, desbpd}.26 The non-termi-
nal histories are NT = {φ, de, des, der, desp, desbp}.
The player function, defined as P : NT→N, assigns one (o more) player (s)
to any non-terminal history. Thus, P (φ) = SO, P(de) = {GPn}nN−2 e
= 1 , P ( d s) ⊂
{GPn} n = 1 (in this case, the only power plants which are called to play are the
N−2
ones that decided to enter the spot market), P ( der) = M, P ( desp) = M, and
P ( desbp) = M.
Finally, the payoff function for any power plant is given by its producer
surplus, which will be defined below. In this context, actual demand and
the bids made by all power plants participating in any particular market
will determine the final prices.
Therefore, we will be looking for the equilibrium in this game, in particu-
lar, for a Perfect Subgame Nash Equilibrium,27 which is stated as follows.
Definition 2. A strategy profile is a Subgame Perfect Nash Equilibrium if

it is a Nash Equilibrium in each subgame.
Following definitions 1 and 2, we are looking for a configuration of plants
in which no plant has incentives to move from one market to another. Based
on this model, we will analyze if this mechanism has the right structure to
give incentives to satisfy the actual demand in the spot market, and to ex-
25
The variable φ denotes the beginning of the game. That is, there is no history behind; no
player has been called to play.
26
We define a terminal history as a history where no player is called to play. After any of
these histories, payoffs are realized. By the same token, we define a non-terminal history as a
history where there is time for one of the players to play.
27
For a more complete development of a sequential game, as well as Nash and Perfect
Subgame Nash Equilibrium, see Osborne and Rubinstein (1994).
pand the generation capacity in the long-run reserve market. Moreover,

we can compare with the outcomes provided by the perfect competition
model, where the strategic behavior is not possible.
II.1.1. Incentives for expansion of capacity
In this section, we will analyze the generation plant’s strategic behavior in

the short-run spot market. The only choice for them is to choose to generate
electricity for the non-peak period or for both, the non-peak and peak pe
riods, once they decided to enter the spot market. After finding the producer
surplus they get in this market, we will allow plants to decide whether to
generate for this market, or to offer capacity for the long-run reserve mar-
ket, or to stay out of the generation market, by comparing the payoff they
would get from these decisions. In this context, all generators will make
their decisions depending on the expected profits they would get in each
market.
II.1.1.1. The Spot Market
The spot market works as follows. Each generator decides voluntarily

whether or not to participate in this market. Once it decides to participate,
it chooses to supply for the peak, or for the non-peak and peak periods. The
decentralized iso coordinates the market with operations in real-time and
forecasting for a time period in advance from an engineering technical
scope, as well as from an economic perspective. Based on the expected de-
mand for the non-peak period, each participating generator makes a mer-
it order bid based on its capacity and costs. Then, in the real-time market,
the decentralized iso ranks the bids and offers economic dispatch service,
based on marginal-cost power pricing. That is, generators are dispatched,
according to their price bids, from the lowest to the highest one until de-
mand is satisfied. After that, the market price in the non-peak period is
the price bid of the last dispatched generator (called the marginal plant).
For the peak period, the decentralized iso and the participating genera-
tors (the earlier ones plus the peaking plants) follow the same rules.28
Let us consider the following set up. There are N − 2 generators. Each ge
nerator n = 1,2,..., N − 2 has a capacity of Qn and a cost of Cn (Qn).29 Each
28
It is important to note that this mechanism minimizes generation costs in both periods.
29
This cost includes the capacity fee and the energy fee.
Figure 2. Non-peak and peak demand
0RICE
.ON PEAKDEMAND STEPSUPPLYCURVE

C .
C .
C . 0EAKDEMAND
C .
C
C
C
Q QQ QQ Q Q. 1UANTITY
QQ Q
generator makes a merit order bid based on Qn and Cn. Suppose that each ge
nerator makes a bid of cn for each unit of capacity that it is willing to supply.
That is, generator n offers qn units of capacity at a cost of cn for each unit.
Without loss of generality we suppose that c1 < c2 < ... < cn-2. So, we have
ordered plants according to their bids, and name them accordingly. The
generation capacities for these plants are Q1, Q2,..., Qn-2 and they could
offer q1, q2,..., qn-2 to the spot market. It is allowed to set qn ≤ Qn, so that
power plants are not offering their total capacity. By doing this they could
have a positive impact on prices, since following this strategy by the more
efficient plants implies that more costly plants must be dispatched.
We now make the following assumptions. If the generator decides to
participate in the spot market, it offers all capacity in the peak period, or
in non-peak and peak ones; that is, qn = Qn. Let P = P(q) be the inverse de-
mand function, which includes the peak load. We assume that this func-
tion is linear in both the peak and non-peak periods. This inverse demand
function has the shape shown in figure 2. In this figure, we have ranked
all generators according to their bids. The quantity supplied in the market
is the sum of all quantities supplied by each of these plants. That is, the
supply curve is the upward sloping step curve shown in this same figure.
Then, price and quantity are defined according to the rules described
above. For example, in this case the price in the non-peak period will be
pnp = cn-5, and the quantity supplied will be qnp = q1 + q2 + ... + qn-6 + qn-5.
Figure 3. Supply and demand in the spot market

0NP 0P
P
C
C
P
C
C P
C C
C P
C
C P
C
C
P
C C
Q
The additional quantity supplied for the peak period is qp = qn-4 + qn-3, and
the price would be pp = cn-3 > cn-5= pnp.
From now on, we simplify this model furthermore. We assume that
each plant has only one unit of capacity. This makes computation easier
without loss of generality. In this context, we compute the market price for
generation, the quantity supplied by generators, the producer surplus and
the consumer surplus. Based on this information, each firm will decide to
supply for the peak period or for both, non-peak and peak.
Thus, we have that q1 = q2 = ... = qn-2 = 1. From the total number of gene
rators, there are Nbp of them supplying in both non-peak and peak periods,
Np plants supplying only for the peak period, Nr supplying capacity for the
long run reserve market, and No staying out of the market. This configura-
tion of plants satisfies Nnp + Np +Nr +No = N-2. This situation is depicted in
figure 3. In this figure, we do not show the offers made by the Nr partici-
pating in the long run reserve market. Therefore, given the demand func-
tion and the bids made by these generators, we get the following results.
There are seven plants choosing to supply energy for both periods.
Their costs are cn for n = 1,2,...,7. Given the actual demand, only six plants
are dispatched. On the other hand, there are six plants offering capacity
only for the peak period. Their costs are for c pn for n = 1,2,...,6. Considering
the additional demand for the peak period, four more units are dispatched.
Note that the seventh plant is out of the market, since its cost is higher
than the costs of the first four plants in the peak period, even though it is
making an offer for both periods.
For the non-peak period (this includes only plants supplying energy for
peak and non-peak periods) we have the following results. The price, paid
to these plants, set by the marginal plant (plant 6) is
pnp = c6
and quantity is
Σq =6
6
qnp = n
n=1
The producer surplus is
PSnn p= p - cn= c6- cn for n = 1,2,..., 6
and total producer surplus is

6 6
Σ Σc
np
TPS = (p - cn)= 6c6 - n
n=1 n=1
Finally, consumer surplus is

1
CSnp = - (6) [P(0) - c6] = 3[P(0) - c6]
2
For the peak period we have the following (this includes all plants sup-
plying energy for the spot market). In this case, the marginal plant (plant
4) has a bid of c4p. This is the case shown in figure 3. The price prevailing in
the peak period will be the one set by the marginal plant; that is, the
maximum between c6 and c 4p. Therefore, the price in the peak period will be
pp = max {c6np, c4p}

4
qn= 4 Σ
Quantity has increased by qp = units.
n=1
So, total quantity is
Qp = qnp + qp = 10
Additional producer surplus, obtained by the peaking plants, is
PSnp= p - cnp= pp- cnp for n = 1,2,..., 4
the additional surplus obtained by plants that supply energy all the time is
PSnn p= p - cn= pp- cn for n = 1,2,..., 6
and additional consumer surplus:

1
CSp = - (4) [P(7) - pp] = 2[P(7) - pp]
2
Therefore, total producer surplus is
np
TPS = 6c6 - ( Σ
6
n=1
)( Σ
4
cn + 4pp - cnp + 6pp - cn
n=1 n=1
)( Σ
6
)
and total consumer surplus is TCS p = 3[P(0)- c6 ]+ 2 [P(7)- pp]
So, we have that pnp ≤ pp, which is the result we should expect.
Let us analyze the behavior of plant 1 in this market. Its decision of
offering only for the peak, or for the non-peak and peak periods, depends
on the marginal plant in each period. Given that c6 < c4p, we have pnp < pp.
Then, this plant gets a higher producer surplus by offering energy in the
peak period, since PS1np = pnp - c1 < pp - c1 = PS1 p. For the same arguments,
all plants offering for both periods have incentives to move to the peak
period only.30 This strategic behavior would induce an increase in the price
of the non-peak period. On the other hand, it could also be that pnp = pp
(which would seem a strange case for electricity markets. However, con-
30
We say that plants could move from the “non-peak and peak” periods to the “peak” period,
in the sense that some plants might wish to become peaking plants only. However, this
would be rare for the case of base-load plants, such as nuclear, geothermal or coal plants.
This statement would therefore make more practical sense for plants using natural gas.
Therefore, we should expect that combined cycle plants would be the peaking plants.
sider the following scenario. Many plants with very low bids decide to offer
energy only for the peak period. In this case, the price in the peak period
will be the same as that of the marginal plant setting the price in the non-
peak period). In this case, all plants are indifferent between the two deci-
sions. Thus, all plants will decide depending on the cost of the marginal
plant being dispatched in each period. Therefore, the actual prices for the
non-peak and the peak periods depend on the configuration of plants
choosing to serve each period.
np p
Let cm and cm be the bids of the marginal plants dispatched in the non-
∂PSkn
peak and peak periods, respectively. Then, we have that ∂c km ≥ 0 for k=
np, p.That is, the higher (lower) the bids of these plants, the higher (low-
er) the producer surplus of all plants in that period. Therefore, the incen-
tives to move from one period to the other will depend on the configuration
of each set of generators. No plant will move if cmnp = cmp.
Finally, by the arguments discussed above, an equilibrium in this mar-
ket is a configuration of plants {N*np, N*p } such that cmnp = cmp.31 This gives a
Nash Equilibrium32 in this market, since no plant has incentives to move
from one period to the other. So, total expected demand is satisfied in non-
peak and peak periods. Moreover, we get that cmnp = cmp, which is the stable
equilibrium, since the model gives the right incentives to get this result
whenever prices are different. It is important to note that this result could
not prevail if there were some frictions, such as impossibility to move
among markets. One important case where we find different prices, more
generally cmnp < cmp , is the perfect competition market, where all plants are
ordered according to their bids. Therefore, in vertically integrated mar-
kets we expect that prices will be higher in the peak period. However,
there are other possibilities as we find in this model.
Now we proceed to analyze the long-run reserve market. In this case,
we compute the expected profits of a generator that decides to offer capacity
in this market. We then compare these profits with profits it would get in
the short run spot market. Based on this, the generator will decide the
strategy that maximizes its profits.
31
The case of equal prices in peak and non-peak periods is an extreme analytical case of no
base-load technology (such as nuclear plants), and only peaking power plants. This by no
means reflects the practice of electricity markets. However, this result is very important be-
cause it gives the right incentives to supply energy in the spot and long-run reserve markets,
and sheds light on the strategic behavior of plants to drive prices up.
32
See Osborne and Rubinstein (1994) for the concept of Nash equilibrium and the logic
behind it.
II.1.1.2. The long-run reserve market
In this section we model the behavior of the generation plants that choose
to supply capacity for the reserve market in the long run. This is an uncer-
tain market, since the size of the additional demand at that particular
point in time is unknown. All plants deciding to participate in this market
have a probability of being dispatched. The bigger the additional capacity
demanded in this market at that time, the higher the probability of being
dispatched. Clearly, given the merit order mechanism, the generator with
the lowest bid will be dispatched for sure. For the other plants, it will depend
on the combination between the size of the actual increase in demand at
that moment in time, and the cost configuration of all power plants choos-
ing that market.
In order to analyze this market, we construct a simple model that gives
us some hints of what could happen. We assume that additional demand
might be y = 1,2,3,..., Y units of electricity. There exists a probability distri-
bution over this additional demand; the lower the quantity, the higher the
probability. Let P be a probability distribution over Y given by {py}y=1 y
. So,
py is the probability of having an additional demand of y for y=1,2,3,..., Y
where p1 > p2 > ... > py, py > 0 for y = 1,2,3,..., Y and y=1
Y
Σ py=1.
Suppose that each plant, n, entering this market makes a bid. It will
offer one unit of capacity at a cost of cn. Once all plants willing to supply
capacity for the long run reserve market make their offers, they are
ranked according to their bids. Say we have Nr plants in the market. Then,
the ordering will be c 1r < c2r < ... < cNr r . Given this ordering, we compute the
expected producer surplus for entering this market.
Plant 1 will get c 1r with probability p1, c2r − c 1r with probability p2, c3r − c 1r
with probability p3, and so on. That is, recalling Y
that it is risk averse, it will
get an expected producer surplus
re Y
of PS
re
y Σ
= y=1 y
p (c yr − c 1r ). Thus, plant n will
get an expected profit of ∏ y = yΣ= i py cy − cn .
r r
∂PSre
Therefore, we have the following results in this market. First, ∂c rnn <0 ;
that is, the lower the costs of plant n, the higher the expected profits. Then,
the less costly plants are the ones that are more likely to enter this mar-
ket. Second, if we have a probability distribution P given by py where p1 >
... ... Y
p2 > > pN, py > 0 for all y = 1,2,3, ,Y and y=Σ1 py = 1 that is stochastically
dominated by the probability distribution P, then the expected profits for all
generators will be higher under P than under P. Therefore, the higher the
expected demand, the higher the expected profits in the long-run reserve
market. In this case, more generators will be willing to supply capacity for
∂ ∏nre
this market. Third, ∂ ( cmr – cnr ) > 0 . That is, the bigger the difference between
the n’s bid and the bids of the other firms (which are more costly), the
higher the expected profits of generator n. Therefore, the less costly gen-
erators, with respect to all generators in the market, are the ones that are
more likely to enter this market.
Finally, we compare these expected profits with the profits in the short-
run spot market. Think of generator 1, the less costly one, for the case de-
picted in figure 3, above.
In the non-peak period, it would get c6 – c1. In the peak periodY , it would
re
get c 4p – c1. In the long run reserve market, it would get ∏1 = y= Σ1 py cyr– c1.
Given that c6 < c4 , it prefers the peak period than the non-peak period. How
p
Y
Σ1 py cyr > c4p, this generator will prefer to supply capacity for the
ever, if y=
long-run reserve market. That is, if the average expected cost in the long
run reserve market is bigger than the price bid of the marginal plant in
the peak period, then generator 1 would get higher profits in the long-run
reserve market. So, plant 1 will choose to supply capacity for the long-run
reserve market. Therefore, we have the following general result.
Proposition 1: The Subgame Perfect Nash Equilibrium in this game is a

configuration of plants {N o* , N s* , N r*}, such that N o* + N s* + N r* = N−2 and
N np
*
+ N p* Y= N s* , where no plant has incentives to move. That is, where
cm = cm = y=1 Σ py cyr .
n p p
Finally, based on these profits, we see that there are incentives for
building more capacity for the reserve market for two reasons. First, new
potential generators would use better technologies, which imply lower
costs and higher expected profits for them. Second, given that demand is
growing over time, the more costly plants will likely be dispatched even
though more capacity is installed. The only case when these more costly
plants are displaced from the market is when the growth rate of demand is
lower than the growth rate of new capacity. In this case, there would be
gains in consumer surplus, since the new generation is entering at lower
cost and, therefore, there would be lower generation prices.
Moreover, in the long run this new capacity would enter the non-peak
period, the peak and the long run reserve market, depending on the configu-
ration of plants that are generating electricity at that moment in time.
These new plants will get producer surplus that is strictly positive. It would
be a matter of choice whether they enter the spot market or the long run
reserve. This decision would depend on the market prices that are expected
to prevail in each one. However, it is important to note that generation pri
ces could not decrease over time if the expansion in capacity grows at the
same or lower rate than demand. Finally, there is room for strategic be-
havior since plants always have incentives to drive prices up by moving
from one market to another (it is easy to find markets with such charac-
teristics).
III. Simulation
In this section we make a simulation to compute the generation cost in

Mexico for 2004. We want to find the minimum generation cost, according
to the merit model discussed above, and compare it with the actual cost
for the Mexican electricity sector. All data used in this exercise come from
cfe. The year used for comparison is 2004 only for the interconnected sys-
tem.33 Total installed capacity (in mw) is given for each technology. The
load factor (the efficiency of the power plant) is the weighted average for
each technology depending on the capacity of each plant. Load factors for
2003 are used for the computation in 2004 (we think there is no problem,
since there is almost no change from year to year). One important caveat
applies for hydroelectricity, since the load factor depends on the previous
raining season and could imply some bias in the computation of the
weighted average.
On the other hand, demand is needed to compute the amount of power
required for the peak and non-peak periods. It is classified in three groups:
a) base demand, which is required 24 hours a day; b) intermediate demand,
which is required during some hours almost all days a year; finally, c) peak
demand, which is required for some hours some days a year. For 2004 we
have the following estimation. Total demand is 212 480.47 gwh. Base de-
mand is 187 837.06 gwh, intermediate demand is 12 179.11 gwh and
peak demand is 12 464.3 gwh (this is the additional demand that we mod-
eled in our game and appears in figure 3 as 4 extra units). We classify the
first two as non-peak and the last one as peak demand for our simulation.
Therefore, the non-peak demand is 200 016.17 gwh and the peak demand
is 12 464.3 gwh. Finally, since 10 per cent of total demand is satisfied by
33
Baja California is not connected to the rest of the country. For this reason, we eliminate
in the simulation both its supply and demand. We also eliminate other small subsystems.
self supply, cogeneration, etc., we used only 90 per cent of the total demand
reported for 2004 for our estimation.
Finally, data about costs, load factors and capacity for each technology
is presented in table 1. Also, following the merit order model, this table
shows the dispatch order for each one.
Table 1. Technology data for the Mexican electricity system

Technology Total Load Cost Dispatch Total Cumula
capacity factor ($/kWh) order genera- tive
(mw) tion (mw) generation
(mw)
Carbon 2 600 0.73 0.33 1 1 417 1 417
Dual 2 100 0.75 0.33 2 1 176 2 593
Geothermic 230 0.57 0.43 3 97 2 690
Hydro 9 900 0.22 0.51 4 163 4 321
Combined cycle 9 865 0.70 0.78 5 5 169 9 490
Steam 14 179 0.58 0.93 6 6 155 15 645
Nuclear 1 365 0.88 0.95 7 892 16 537
Wind 2 0.40 1.23 8 0.65 16 537
Turbogas 2 890 0.52 1.32 9 1 115 17 653

Source: copar, cfe.
We use monthly data for 2004 as our simulation exercise, by using a

seasonality factor computed from the total generation in that month. Ta-
ble 2 shows the results for this simulation.
Following the merit order dispatch, the cost of generation in the peak
period is higher than the cost for the non-peak period. This is the case be-
cause the Mexican power system is a vertically integrated market, where
all decisions are made by the so. If plants were allowed to move from one
market to another, we might get the result predicted by our model. Once
the generation plants observe these prices, they will have incentives to
move from the non peak to the peak period. In this way, the price will
equalize after some lower cost plants go to the peak period.
Table 2. Simulation results for the Mexican power system

Month Non-peak Marginal Cost Peak Marginal Cost
demand plant ($/kWh) demand plant ($/kWh)
(mw) (mw)
January 14 110 Steam 0.93 879 Steam 0.93
February 13 328 Steam 0.93 831 Steam 0.93
March 15 072 Steam 0.93 939 Nuclear 0.95
April 14 339 Steam 0.93 894 Steam 0.93
May 14 598 Steam 0.93 910 Steam 0.93
June 15 638 Nuclear 0.95 974 Turbogas 1.32
July 16 327 Nuclear 0.95 1 017 Turbogas 1.32
August 16 719 Nuclear 0.95 1 042 Turbogas 1.32
September 15 571 Nuclear 0.95 970 Turbogas 1.32
October 15 890 Nuclear 0.95 990 Turbogas 1.32
November 14 121 Steam 0.93 880 Steam 0.93
December 14 301 Steam 0.93 891 Steam 0.93

Source: Authors’ own calculations based on copar, cfe.
On the one hand, there is some monthly seasonality in the consumption of

electricity. The highest consumption is during July and August. The low-
est consumption months are from January to May. In January, February,
April and May, the marginal plants in both periods are the steam ones.
Therefore, the generation cost is the same for peak and non peak periods.
In March, the marginal one is the nuclear. For the other months, there are
differences in the marginal plants during the peak or non peak periods. In
these cases the cost is higher for the peak one. In a fully open generation
market, we could expect some movement of plants from the non peak to
the peak period, as stated in proposition 1. Therefore, the results predicted
by proposition 1 hold, depending on the actual sizes of demand in non-
peak and peak periods.
On the other hand, during July and August the reserve margin is only
1 per cent, while for June and September the reserve margin is 5 per cent.
In these four months we do not have a reliable system, because the reserve
margin is below international standards, given by 6 to 9 per cent. So, the

Mexican power system was lucky not to have any disturbance in its
system.
Finally, we compare our simulation with data reported by cfe about
total generation in 2004. This allows us to reach some conclusion about the
performance of the system. That is, to know if cfe is following the merit
order model for dispatch. Table 3 shows actual total generation and simu-
lated generation by technology.
Table 3. Actual and simulated generation by technology

Technology Simulated generation Actual generation
(Gwh) (Gwh)
Carbon 16 725 17 883
Dual 13 890 7 915
Geothermic 1 142 2 922
Hydro 19 827 25 076
Combined cycle 63 498 63 696
Steam 69 170 65 783
Nuclear 4 697 9 194
Wind 3 6
Turbogas 2 281 2 772
Total 191 232 195 247

Source: Authors’ own calculations based on copar, cfe.
There are some differences between our simulation and the actual genera-
tion. The most important ones are the hydro, dual and nuclear technolo-
gies. For the hydroelectricity, the possible explanation is that the load fac-
tor we used in our simulation is smaller than the actual one. This is a
possibility, if we think that 2003 was a wet year. In that situation, the load
factor for these plants can be bigger. However, this could be a special year.
It is no guarantee that this will happen all years. The differences for the
dual technologies could reflect congestion problems because, in general,
these are located in the most congested zones. Therefore, cfe could decide
not to dispatch some of them and replace by more costly ones. On the other
hand, these plants were replaced by hydro ones, due to the argument
above. Finally, nuclear generation is smaller in our simulation because
the starting cost of this technology is so high, that the best strategy is to
dispatch this plant all the time. Moreover, since its capacity is needed dur-
ing six months, the best strategy is to put it in all the time. Finally, there
exists a small difference in total generation, which is not so relevant.
IV. Conclusions
Ideally, the energy and the reserve markets should not be separated, and
the so could run day-ahead markets and spot markets that take care of im
balances and reach equilibrium of all electricity markets in an integrated
way. Market players would then meet their long run expectations on de-
mand-supply balance in well-developed forward markets. That is, energy
and reserve pricing would take care of supply adequacy. However, in practi
ce electricity markets are sometimes implemented together with transito-
ry resource-adequacy policies. Capacity payments and requirements pres-
ent several inconveniences both in theory and practice. The most advanced
developments in the literature point to combine them with some type of
hedging instruments, such as call options, so that regulatory intervention
is focused on promoting liquid markets for energy risk management.
Following this discussion in the literature, we proposed a simple model
to explain the strategies of the generation plants in the spot market, to-
gether with the long run reserve market, to satisfy the expected demand.
We found the expected costs of generation in the spot market, for the non
peak and the peak periods, and in the long-run reserve market. We then
compared our simulated dispatch with the actual dispatch for the Mexi-
can electricity system for 2004. There are some disparities that can arise
because of differences in the load factor, congestion costs or entry costs,
which are omitted from our simulation. However, the total generation is
very similar. But the fact that total generation is similar to that in practice
does not really prove how realistic the modeled prices and dispatch order
are. What is shown is that the model is a good approximation that needs
to be strengthened furthermore, in order to incorporate some of the short-
comings discussed above. Moreover, we should compare actual and simu-
lated total costs to get more robust results. So, if data about generation
tariffs were available, it could be possible to compare them with simulated
tariffs.
Mexico does not currently have an open market. Only in recent years
cfe argues that a mock (or shadow) market has been implemented inside
the vertical integrated state monopoly. This virtual market seeks to emu-
late a competitive market. It uses an optimization model where the least-
cost dispatch is based on actual generation costs (merit order rule) in one-
day-ahead and real-time markets. The one-day-ahead market establishes
production, consumption and price schedules for each of the hours of the
following day. The differences between forecasted and actual schedules
are cleared at real-time prices. Bids are actually submitted to the system
operator (cenace) by the different “programmable” thermal cfe’s genera-
tion plants, which are administratively separated so that they function as
different power producers.34
In this virtual market, payments to generators include a “capacity”
payment intended to foster the development of generation capacity re-
serves. It then seems that the combination of this virtual market (with
still some elements of central control and subsidy scheme of the state-
owned holding company), together with capacity payments, has eventu-
ally resulted in capacity generation expansion similar to what would be
attained in an open electricity market, as the one modeled in our study.
But this by no means proves that the Mexican electricity industry will not
need in the future some of the additional capacity expanding mechanisms
discussed in this paper.
Our model, that simulates a “market” solution to assure resource ade-
quacy, has also some simplifying assumptions that should be relaxed in a
more general setting. First, plants have only one unit of capacity. This as-
sumption eliminates problems about capacity payments and strategic be-
havior trying to push price up in one of the three submarkets. Second,
plants are risk neutral and there is not discount. This assumption assures
enough capacity for the long-run reserve market. Third, we ignore the rest
of the electricity system, avoiding possible congestion in the transmission
lines, among others.
Finally, this is a static setting. Plants have no chance to move from one
submarket to other over time, and costs for different technologies might
34
“Non-programmable” generators are small producers that only supply power according
to a previously set energy delivery schedule.
vary over time. In addition, in a dynamic setting the long-run peak-period

price could be expected to intertemporally attract investments (“calling
effect”). Therefore, we cannot conclude that any electricity system does not
need an additional mechanism to assure resource adequacy, or that the
“market” is the “right” mechanism.
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Incentivos para Una Oferta Adecuada en Los Mercados de Electricidad:una Aplicación Al Sector Eléctrico Mexicano

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Incentivos para Una Oferta Adecuada en Los Mercados de Electricidad:una Aplicación Al Sector Eléctrico Mexicano

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Incentives for Supply Adequacy

Víctor G. Carreón-Rodríguez and Juan Rosellón*

Incentivos para una oferta adecuada en los mercados de electricidad:

* Víctor G. Carreón-Rodríguez, [email protected], Centro de Investigación y Docencia

pués un modelo para analizar la estructura de incentivos para la expansión de la

jel classification: L51, L52, L94.

R ecent electricity power crises around the world have dramatically

• The inelasticity of short-term electricity demand and supply functions,

I. Resource Adequacy: Several Measures

Various measures have been proposed to ensure generation resource ade­

I.1. Centralized Resource Adequacy

There are two extremes regarding resource adequacy and investment in

I.2. Decentralized Resource Adequacy

An opposite extreme on resource adequacy is a decentralized solution,

I.3. Capacity Payments

Generators get capacity payments so as to make their generation capacity

Market price = lolp * VOLL + (1-LOLP) * LAO

determined by the capacity needed to meet demand at its peak, a bigger

I.4. Capacity Requirements

Capacity requirements oblige generators to keep a predetermined level of

ciency-spot market auctions, and capability several-month period auc-

• It relies on a subjective capacity level estimation, which depends on fuel

I.5. Call Options

Capacity requirements set a capacity requirement level, as well as the

II. The Model

II.1. Merit Order Model

We will analyze the profit-maximizing behavior of a power plant as follows

Figure 1. Sequence of decisions

Expected demand in spot

Source: Authors’ own elaboration.

The conditions that characterize the optimal behavior of generators

Therefore, in this mechanism we have the following elements. The set

Definition 2. A strategy profile is a Subgame Perfect Nash Equilibrium if

pand the generation capacity in the long-run reserve market. Moreover,

II.1.1. Incentives for expansion of capacity

In this section, we will analyze the generation plant’s strategic behavior in

II.1.1.1. The Spot Market

The spot market works as follows. Each generator decides voluntarily

Figure 2. Non-peak and peak demand

.ON PEAKDEMAND STEPSUPPLYCURVE

Source: Authors’ own elaboration.

Figure 3. Supply and demand in the spot market

Source: Authors’ own elaboration.

The producer surplus is

PSnn p= p - cn= c6- cn for n = 1,2,..., 6

and total producer surplus is

Finally, consumer surplus is

pp = max {c6np, c4p}

Additional producer surplus, obtained by the peaking plants, is

PSnp= p - cnp= pp- cnp for n = 1,2,..., 4

PSnn p= p - cn= pp- cn for n = 1,2,..., 6

and additional consumer surplus:

Therefore, total producer surplus is

II.1.1.2. The long-run reserve market

Proposition 1: The Subgame Perfect Nash Equilibrium in this game is a

In this section we make a simulation to compute the generation cost in

Table 1. Technology data for the Mexican electricity system

Carbon 2 600 0.73 0.33 1 1 417 1 417

Dual 2 100 0.75 0.33 2 1 176 2 593

Various measures have been proposed to ensure generation resource ade

margin is below international standards, given by 6 to 9 per cent. So, the