Price formation without fuel costs: the interaction of demand elasticity with storage bidding (2407.21409v2)

Abstract: Studies looking at electricity market designs for very high shares of wind and solar often conclude that the energy-only market will break down. Without fuel costs, it is said that there is nothing to set prices. Symptoms of breakdown include long phases of zero prices, scarcity prices too high to be politically acceptable, prices that collapse under small perturbations of capacities from the long-term equilibrium, cost recovery that is impossible due to low market values, high variability of revenue between different weather years, and difficulty operating long-term storage with limited foresight. We argue that all these problems are an artefact of modelling with perfectly inelastic demand. If short-term elasticity to reflect today's flexible demand (-5%) is implemented, these problems are reduced. The interaction of demand willingness to pay and storage opportunity costs is enough to produce stable pricing. This behavior is illustrated by a model with wind, solar, batteries, and hydrogen-based storage, where the price duration curve is smoothed with a piecewise linear demand curve. This removes high price peaks, reduces the fraction of zero-price hours from 90% to around 30%, and guarantees more price stability for perturbations of capacity and different weather years. Furthermore, we show that with demand elasticity, the long-term optimisation model exactly reproduces the prices of the short-term model with the same capacities. We then use insights from the long-term model to derive simple bidding strategies for storage so that we can also run the short-term model with limited operational foresight. We demonstrate this short-term operation in a model optimised using 35 years of weather data and then tested on another 35 years of unseen data. We conclude that the energy-only market can still play a key role in coordinating dispatch and investment in the future.

• The paper demonstrates that incorporating elastic demand eliminates market pricing artifacts such as prolonged zero-price events.
• It employs a piecewise linear demand model with a -5% short-term elasticity and storage bidding to smooth price duration curves and stabilize operator revenues.
• The study validates its framework using 70 years of weather data, aligning long-term capacity expansion with short-term operational models.

Analyzing the Dynamics of Price Formation in Energy Markets with Elastic Demand and Renewable Energy Integration

The paper "Price formation without fuel costs: the interaction of elastic demand with storage bidding" by Brown et al. (2024) offers an in-depth analysis of price dynamics in electricity markets transitioning towards high shares of variable renewable energy (VRE) sources, like wind and solar power. The research addresses critical challenges faced by energy-only markets in this scenario, primarily the concern that price signals might break down due to the absence of conventional fuel costs that traditionally drive market pricing.

Key Findings and Methodological Insights

The authors argue that many of the perceived shortcomings in energy market models—such as prolonged zero-price phenomena and volatility in revenue—stem from the typical assumption of inelastic demand. By incorporating demand elasticity into the modeling framework, Brown et al. demonstrate that these issues are largely artifacts of simplistic modeling assumptions. They employ a piecewise linear demand with a -5% short-term price elasticity and illustrate significant stabilizing effects on prices through a comprehensive model that integrates wind, solar, battery storage, and hydrogen-based systems.

A noteworthy outcome of this incorporation is the smoothing of price duration curves, reducing the frequency of extreme price events. This structural change ensures more consistent revenue streams for operators and a more reliable economic signal for system investments, thus preserving the functionality of the energy-only market despite high VRE penetrations. For instance, the application of an elastic demand model reduced zero-price hours drastically while also containing high-price events within more acceptable bounds.

To further validate their approach, the authors extend their analysis by juxtaposing long-term capacity expansion models with short-term operational models, drawing on 70 years of weather data. Their findings reveal that with elastic demand, the electricity prices derived from long-term models are consistent with those from short-term simulations, suggesting that price stability can be achieved regardless of foresight levels. The paper also emphasizes the vital role storage bidding plays in anchoring prices even when future market conditions are uncertain.

Practical and Theoretical Implications

The implications of this research are both theoretical and practical. From a theoretical standpoint, it challenges the traditional assumptions in electricity market modeling by showing that real-world demand elasticity can reconcile many of the contradictions seen in prior literature. Practically, it advocates for the integration of demand-side responsiveness as a viable pathway to ensuring market stability and cost recovery in high-renewable scenarios.

Moreover, the paper posits that demand elasticity not only stabilizes market prices but also facilitates efficient storage operation under conditions of myopic foresight. This is illustrated by their findings, wherein heuristic storage bidding strategies, when combined with elastic demand, achieve similar outcomes to those generated under perfect foresight assumptions.

Future Directions and Speculations

Looking ahead, the comprehensive approach taken by Brown et al. highlights several potential avenues for further exploration. One critical area involves refining demand elasticity models to better encapsulate sector-specific behaviors such as those from electric vehicles and industrial sectors. Additionally, while the paper maintains a focus on Europe, international applications and the consideration of diverse market regulations pose interesting challenges and opportunities for further research.

The broader narrative surrounding this paper is optimistic regarding the viability of energy-only markets, contingent upon the incorporation of realistic demand elasticity. As energy systems evolve in response to increased renewable penetration, this research underscores the need for a paradigm shift in how markets are modeled and operated, emphasizing adaptive structures that can leverage demand flexibility.

In conclusion, Brown et al.'s paper makes a compelling case for revisiting the foundational assumptions underlying electricity market simulations. It presents a robust framework that through the lens of elasticity, reconciles many of the theoretical discrepancies and practical concerns identified in maintaining market equilibria amidst rapid renewable energy advancements.