Pricing in Non-Convex electricity markets

Deregulation of the electricity markets has brought several interesting topics to the research agenda. Switching from a monopoly based industry to the free market industry has not been straight forward. The competitive segments of the deregulated electricity markets, the wholesale market and the retail market, have evolved in different ways across the globe, and consequently there are different market designs and different pricing mechanisms. If we assume that a neoclassical economic model applies to the electricity market, then the monotonically increasing supply curves of all generators would be aggregated to create the industry supply curve. Similarly, the monotonically decreasing demand curves of all consumers would be aggregated to create the industry demand curve. The competitive equilibrium price for electricity would be set at the level where the two curves intersect. It is important to highlight that convexity is a property that economic models require for a competitive equilibrium. However electricity treated as a commodity has several characteristics that do not fit into the neoclassical economic model. First of all, electricity cannot be stored; therefore the total production should always match total consumption. In addition, electricity generators have several operational requirements to avoid problems with the technology used, such as minimum and/or maximum output, start-up and shut down costs, and minimum ramp rates. These requirements generate non-convexities in the production function. Moreover, generators are committed to production in indivisible units, which also creates non-convexities. On the demand side, it has been seen that the demand function is extremely inelastic, which may contribute to high spikes in prices.nhhph