Economic Planning – Theory and Current Practice Dan Woodfin Director, System Planning Joint...

Economic Planning – Theory and Current Practice

Dan WoodfinDirector, System Planning

Joint PLWG/CMWG Meeting2/4/2011

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Goal of this presentation

• Illustrate concepts• Encourage consistent terminology in discussions• Provide background on current practice

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Economic Planning Need and History

• Need– Historically, vertically-integrated utilities would develop powerflow cases

containing the most economic dispatch of their generation fleet– The tradeoff between the cost of the transmission system upgrades and the

cost of dispatching higher cost units to resolve any post-contingency overloads in those cases was an internal decision, subject to regulatory oversight

– In a deregulated market, where various market participants and consumers may be affected differently by transmission projects, an appropriate mechanism to assess this tradeoff was needed

• History– ERCOT began to investigate appropriate criteria for the ERCOT nodal

market, given the cost recovery/transmission service regime in the Region in late 2004, prepared a White Paper, and proposed criteria during 2005

– TAC and its subcommittees reviewed the criteria options and in Apr 2006 selected the criteria that ERCOT has used since; The TAC Criteria was incorporated into the Planning Charter that was approved by the Board in Jan 2009

PLWG/CMWG

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Applicability

• Reliability Projects – Transmission projects that are needed to meet reliability criteria that could not otherwise be met in planning studies by the simultaneously-feasible dispatch of available generation

• Economic Projects – Transmission projects that allow reliability criteria to be met at a lower total cost than the continued dispatch of higher cost generation, subject to the established economic criteria

PLWG/CMWG

Economic planning criteria may be used to decide WHICH of

several potential projects will be recommended, but they are not used to determine IF a reliability

project will be built

Economic planning criteria is used to decide both IF a potential

economic project will be recommended, and WHICH of

several potential projects is preferred

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Evaluation of Economic Projects (Ideally)

• Estimate the Net Present Value (NPV) of the cost of transmission project

• Estimate the NPV of the benefits due to the transmission project over the life of the project – There are several different benefit measures that could be

considered (more on this later)• If the benefits are greater than the cost of the project, the

project is deemed economic

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Projecting System Dispatch

• To estimate the benefits from a proposed transmission project, it is necessary to simulate the future hourly dispatch of generation with and without the project

• ERCOT uses a model that calculates the hourly security-constrained, least-cost unit commitment and economic dispatch of all generation to serve forecasted system load assuming cost-based dispatch of generation

• The model requires forecasts of hourly load (by bus), fuel prices, generating unit operating and cost parameters, installed generating capacity, and transmission system characteristics and ratings.

PLWG/CMWG

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Practical Considerations

• From a practical standpoint, it is not possible to forecast the dispatch cost savings over the 30-40 year life of the transmission project. Instead:– The cost savings are projected over the 1-5 year timeframe for

which cases are available– A qualitative assessment is made of whether the savings are

reasonably expected to continue– The cost savings are annualized and compared to the annual

carrying cost of the transmission project. If the annualized cost savings are greater than the annual carrying cost of the project, the project is deemed economic

• Due to the uncertainty in many of the inputs, ERCOT typically performs scenario analysis with the inputs having the highest sensitivity on the decision under analysis– RPG participants have input as to what scenarios should be

analyzed

PLWG/CMWG

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Estimating Transmission Project Cost

• Estimated transmission project costs are solicited from the TSP that is expected to build the project– Built-in incentive to provide accurate cost estimate, else the value to the

TSP of the RPG Review for its regulatory approval and cost recovery proceedings for the project is diminished

• Incremental costs are used– Costs of accelerations/delays in other projects should be appropriately

considered

• Annual Carrying Cost– A generic first-year carrying charge rate, based on posted financial

assumptions, has been calculated. – The capital cost of a proposed project is multiplied by this rate to get the

first year revenue requirement for the project– Based on current financial assumptions, this rate is 16.8% or

approximately 1/6. • This is the source of the frequently mentioned “6-year payback,” although that

is a misnomer

PLWG/CMWG

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• The graphic below illustrates the assumed savings and costs based on using the annualized dispatch cost savings compared to the first year project revenue requirement:

Costs Over Time

0 40

ModeledYears

Prod. Cost Savings

Project Rev. Requirement

Year

$

Assume Static Costs (e.g. no gas price increase)

1st Year Revenue Requirement

is the highest

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Economic Terminology

PLWG/CMWG

p

S

D

q

P

CS

PS

The economic value, or Societal Surplus (SS), of a product is the sum of the Consumer Surplus (CS) and Producer Surplus (PS). In other words, the economic value is shared by consumers and producers.

Producer surplus is due to all producers being paid the market clearing price although some would have been willing to be paid less.

Consumer surplus is due to all consumers paying the market clearing price although some would have been willing to pay more.

From 4/2006 TAC Meeting

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Important Equalities

• Changes in consumer surplus are equal and opposite to changes in producer revenue – In a market with efficient pricing of congestion rights, where the

proceeds of the sale of these rights are returned to consumers

• Changes in societal surplus are equal and opposite to changes in producer costs – For an equal quantity served

– An algebraic proof of this is available

PLWG/CMWG


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Options

• Societal Impact Test: the increase in the societal surplus (equal to the reduction in production costs) due to a project must exceed the incremental cost of the project

• Consumer Impact Test: the increase in consumer surplus (equal to the reduction in generator revenues) due to a project must exceed the incremental cost of the project

PLWG/CMWG


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Test Comparison

Societal Impact Test:

• Considers only whether a project has benefit to society as a whole and not whether consumers or producers receive the short-term benefit

• Since consumers pay all costs in the long term, they ultimately benefit from decisions which increase the societal surplus

• Individual projects may not immediately benefit consumers (and may cause consumer costs to go up in the short term)

• May not recommend projects to fix load pockets with high LMPs, but some of this congestion may be solved through generation siting

Consumer Impact Test:

• Consumers pay for all transmission investment, so it seems congruous to fund projects that repay consumers

• Can justify bad projects, such as removal of transmission capacity

• Consumer impacts are hard to predict because they are affected by generator bidding behavior and terms of bilateral contracts

• Transmission projects that pass only the consumer test inefficiently transfer revenue from generators to consumers, with a resulting long-term impact on generation investment.

PLWG/CMWG


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TAC Criteria Incorporated into Planning Charter

PLWG/CMWG

Passes Consumer

Test (Generator Revenue

Reduction)

Passes Societal

Test (Production

Cost Reduction)

Proposed Project

RecommendEndorsement

by Board

Reject

YES YES

NO NO

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Questions?

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Appendix 1

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Appendix 1

• Illustrative example using supply curve shift due to transmission project

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PLWG/CMWG

p

S

D

q

P

CS

PS

Same figure, vertical demand curve for ease of illustration

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PLWG/CMWG

p

S

D

q

P

CS2

A proposed transmission project allows lower cost generation to be used to serve the load, effectively shifting the supply curve down to S’

The new Consumer Surplus is CS2

The new Producer Surplus is PS2S’

p’PS2

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PLWG/CMWG

D

q

P

CS

The change in Consumer Surplus due to the project is the Consumer Surplus with the project minus the Consumer Surplus without the project – illustrated as ΔCS

Consumers consume the same amount but pay a lower price

S’p

p’

S

ΔCS

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PLWG/CMWG

p

S

D

q

P The proposed transmission project also changes the Producer Surplus, illustrated as the difference between the area of PS1 and PS2

It lowers production costs (shifts the supply curve down) but also lowers the prices received

S’

p’PS2

PS1

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PLWG/CMWG

D

q

P

CS

PS

The change in the Societal Surplus is the sum of the change in Consumer Surplus and the change in the Producer surplus, illustrated as the area in red. In this case with the vertical demand curve, it is the area between the two supply curves, or the change in production cost.

S’p

p’

S

ΔSS

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Appendix 2

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Appendix 2

• Several highly simplistic examples, just to show basic concepts • Assumptions:

– Two areas with no transmission currently between them– Two generators potentially available in each area, one with a

high cost and another with a low cost, constant across output– Proposed transmission line between areas costs 10000 and

resolves constraints• Different Examples are constructed by varying the

availability/size of each generator or the load in each area– If generator is not available in a particular example, it is shown

with Gen Cap=0– Changes from reference case inputs highlighted in yellow– Dispatch and related results are shown for two cases “W/O

Transmission” and “W/ Transmission” for each Example

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Example 1

Area A Area B

Load A Gen 1 Gen 2Production

CostGenerator Revenue Gen Profit

Price In Zone Load B Gen 3 Gen 4

Production Cost

Generator Revenue Gen Profit

Price In Zone

Total Production Cost

Total Generator Revenue

Generator Revenue - Production Cost

Example 1Gen Cap 1000 0 0 1000

Gen Cost 35 70 35 80

W/O Transmission 100 100 0 3500 3500 0 35 900 0 900 72000 72000 0 80 75500 75500 0

W/ Transmission 100 1000 0 35000 35000 0 35 900 0 0 0 0 0 35 35000 35000 0

Summary: Δ Societal Surplus 40500Sufficient low cost generation to displace high cost generation without raising prices Δ Consumer Surplus 40500If first year revenue requirement of project is less than $40,500 (i.e. the capital cost is less than $242,500) then the project would pass under Δ Generator Surplus 0either test

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Example 2

Area A Area B

Load A Gen 1 Gen 2Production Cost



Production Cost


Price In Zone




Example 2 - Ref to Example 1Gen Cap 900 100 0 1000

Gen Cost 35 70 35 80

W/O Transmission 100 100 0 3500 3500 0 35 900 0 900 72000 72000 0 80 75500 75500 0

W/ Transmission 100 900 100 38500 70000 31500 70 900 0 0 0 0 0 70 38500 70000 31500

Summary: Δ Societal Surplus 37000Overall lower cost generation is available; price increase to small load in Area A is offset by price reduction to large load in Area B Δ Consumer Surplus 5500

Δ Generator Surplus 31500

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Example 3

Area A Area B




Production Cost


Price In Zone





Gen Cost 35 70 35 80

W/O Transmission 900 900 0 31500 31500 0 35 100 0 100 8000 8000 0 80 39500 39500 0

W/ Transmission 900 900 100 38500 70000 31500 70 100 0 0 0 0 0 70 38500 70000 31500

Summary: Δ Societal Surplus 1000Insufficient production cost savings to warrant line; price increase to large load in Area A overrides price reduction to small load in Area B Δ Consumer Surplus -30500


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Example 4

Area A Area B




Production Cost


Price In Zone





Gen Cost 35 70 35 80

W/O Transmission 500 500 0 17500 17500 0 35 500 0 500 40000 40000 0 80 57500 57500 0

W/ Transmission 500 900 100 38500 70000 31500 70 500 0 0 0 0 0 70 38500 70000 31500

Summary: Δ Societal Surplus 19000Sufficient production cost savings to justify line; price increase to load in Area A overrides price reduction to load in Area B Δ Consumer Surplus -12500


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Example 5

Area A Area B




Production Cost


Price In Zone





Gen Cost 35 70 35 80

W/O Transmission 100 100 0 3500 3500 0 35 900 500 400 49500 72000 22500 80 53000 75500 22500

W/ Transmission 100 500 0 17500 17500 0 35 900 500 0 17500 17500 0 35 35000 35000 0

Summary: Δ Societal Surplus 18000Sufficient production cost savings to justify line; price reduction to load in Area B with no increase in Area A Δ Consumer Surplus 40500

Δ Generator Surplus -22500

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Example 6

Area A Area B




Production Cost


Price In Zone





Gen Cost 35 70 35 80

W/O Transmission 300 300 0 10500 10500 0 35 700 100 600 51500 56000 4500 80 62000 66500 4500

W/ Transmission 300 800 100 35000 63000 28000 70 700 100 0 3500 7000 3500 70 38500 70000 31500

Summary: Δ Societal Surplus 23500Sufficient production cost savings to justify line; large price increase to small load in Area A overrides Δ Consumer Surplus -3500less-significant price reduction to large load in Area B Δ Generator Surplus 27000

Economic Planning – Theory and Current Practice Dan Woodfin Director, System Planning Joint...

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