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Economic Inefficiencies of Cost-based Electricity Market Designs

Francisco D. Munoz, Sonja Wogrin, Shmuel S. Oren, and Benjamin F. Hobbs

Year: 2018
Volume: Volume 39
Number: Number 3
DOI: 10.5547/01956574.39.3.fmun
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Abstract:
Some restructured power systems rely on audited cost information instead of competitive bids for the dispatch and pricing of electricity in real time, particularly in hydro systems in Latin America. Audited costs are also substituted for bids in U.S. markets when local market power is demonstrated to be present. Regulators that favor a cost-based design argue that this is more appropriate for systems with a small number of generation firms because it eliminates the possibilities for generators to behave strategically in the spot market, which is a main concern in bid-based markets. We discuss existing results on market power issues in cost- and bid-based designs and present a counterintuitive example, in which forcing spot prices to be equal to marginal costs in a concentrated market can actually yield lower social welfare than under a bid-based market design due to perverse investment incentives. Additionally, we discuss the difficulty of auditing the true opportunity costs of generators in cost-based markets and how this can lead to distorted dispatch schedules and prices, ultimately affecting the long-term economic efficiency of a system. An important example is opportunity costs that diverge from direct fuel costs due to energy or start limits, or other generator constraints. Most of these arise because of physical and financial inflexibilities that become more relevant with increasing shares of variable and unpredictable generation from renewables.



Energy Transition in Oil-Dependent Economies: Public Discount Rates for Investment Project Evaluation

Fatih Karanfil and Axel Pierru

Year: 2024
Volume: Volume 45
Number: Special Issue
DOI:
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Abstract:
Selecting welfare-enhancing projects necessitates determining the present value of cash flows from a public policy perspective. For an oil-exporting economy, the domestic energy transition often implies displacing oil from domestic consumption. Economic dependence on oil affects the public discount rate for oil price-related cash flows in two opposite ways: On the one hand, it renders the economy more volatile, which lowers the risk-free discount rate; on the other hand, it increases the correlation between consumption and the oil price, which results in a higher risk premium. To study these opposite forces, we first derive the public discount rate for an oil price-related investment project. Our framework considers economic uncertainty, an oil price-related risk premium, and allows for valuing oil at its opportunity cost. We illustrate our methodology using data from a panel of 26 oil-exporting countries. The results indicate that a risk-free discount rate of 3.1% is appropriate for our panel. However, to discount oil price-related cash flows, a risk premium of 1.4% needs to be added to the risk-free rate, which yields a risk-adjusted real discount rate of 4.5%. We find significant disparities between country-specific public discount rates. Additionally, for each country, we assess the present value of reducing domestic oil consumption by a barrel per day from 2023 to 2040, breaking down the different effects. Oil-exporting countries can use our estimates for making investment or policy decisions.





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