 So what I thought I'd talk about since you guys are going to be energy market participants is effectively the idea of just thinking through how you play in an energy market, electricity market, where there's a carbon market, renewables market, the sorts of things that we have say in California and many other jurisdictions such as in Europe and other parts of the United States and other parts of the world as well. So what I thought I'd go through is to effectively talk to you first about introducing what is a wholesale electricity market and the idea here is really to give you the foundation for the energy market game that you can be playing for the rest of the week. The other thing that we talked about is then the next step would be just what about the technology of electricity generation? How do you think about that as a player in this game as a market participant? The next is how do you think about fitting in this game? Then we'll talk about carbon pricing and talk about the two approaches that get used which is a carbon tax cap and trade and because what you're going to do in the game is you're going to play a game where there's a carbon tax as well as a game where there is a cap and trade market so it's important to understand the distinction between the two and then finally this game's also going to have renewable energy and renewable energy interacts with carbon markets and that's the other thing we'll talk about is how do these two sort of environmental policies both complement as well as interact with one another and that's basically it and then you'll mark we'll take you into the details of how we actually play the game. All right so essentially the way to think about a thermal generator is you take some sort of input fuel you convert the heat into electricity that typically can either be through combusting it in the turbine through a combustion turbine through combusting it in to heat a boiler the boiler produces steam steam turns the turbine but in the way we typically summarize that for generation units is what's called a heat rate and what the heat rate tells you is it says how many units of heat do I need to put in to get one megawatt hour of energy out of the other end now the heat rate can vary consider it can vary for a generation unit you know think very much like how you drive your car when you're driving your car at a low speed versus that sort of cruising speed your miles per gallon differ very can vary significantly similarly with heat rate but for the purpose of the game and for most cases the way that the units get run you typically think of the sort of the single heat rate or average heat rate for the generation unit then what you do with that heat rate and why that is so important to you as a participant in a market is your job then is to procure the input fuel and then you say okay if for what price might pay for the input fuel what's my heat rate multiply about those two guys together making sure your units are correct and you get the variable fuel cost of your generation unit so you know take the example of you know like a combined cycle natural gas fired unit this typically has a heat rate probably in the range of maybe you know six to eight million BTUs per megawatt hour you purchase say a natural gas suppose you buy the natural gas for five dollars per million BTU currently probably that's a little high let's say four dollars so four dollars and then we take the say seven dollars you get twenty eight dollars as your variable fuel cost that says for each megawatt hour you produce it's going to cost you twenty eight dollars in fuel to effectively produce it and so that gives you your first component of your marginal cost typically there are other costs associated with the generation unit that do vary with the volume of production that you have typically things like you know you may have to keep an individual on site or you may have to do other kinds of things these typically get embodied in a what's called variable O&M cost so variable operating maintenance cost so those typically run in the in the range of probably two to four dollars per megawatt hour depending on the technology of the plant then the other part of the story is is essentially the fact that these plants they produce carbon and essentially the simple way to think about it is is that you know once you control for the fuel that's burned in the unit the higher the heat rate the more carbon that gets emitted for megawatt hour you produce right because you're need to put in more energy to produce more the same megawatt hour now across technologies it's different because chemistry gets into it so for example it would typically if you burn natural gas for the same heat rate of the generation unit you're going to get significantly less greenhouse gases from the combustion of natural gas versus the combustion of say coal or oil to a lesser extent and that's largely because the chemistry of how combustion takes place but you basically you're gonna get you're gonna get it you're gonna get a heat rate and just to give you examples say a typical natural gas unit probably has emits probably about 0.25 times to you know probably half a ton per megawatt hour of energy that is produced the typical coal unit produces probably about 0.75 to 1 ton of CO2 per megawatt hour so that would be your emissions rate okay then this gives you your third component of the variable cost of your generation unit in a market in which carbon is priced you simply again do the same thing it works once it'll work again you take the emissions rate multiply by the price carbon and that gives you the carbon cost per megawatt hour and you know as you can see you know it doesn't take a whole lot in terms of a price of carbon for the for essentially these environmental costs to contribute a significant fraction of the variable cost and moreover given how cheap fossil fuels are these days you know it's going to take a pretty large price of carbon to to to have an impact in terms of reducing greenhouse gas emissions in the electricity sector as we'll show in a few minutes fortunately in the game we don't have to worry about bankrupting the California economy so we can set very high prices of carbon for you guys to effectively change the dispatch order to to to reduce emissions from the from the electricity sector but the real world is a bit more challenging okay so how does an electricity market actually operate well it pretty much operates the classical way you might want to think about you learned in the market's work in economics one what happens is is each supplier effectively submits their willingness to supply so what they do typically in a market as they'll say okay I'm willing to supply this much energy at most from my unit at this price so in other words I submit a price and a quantity pair for each generation unit that I own and that quantity that I submit can't be more than the capacity of the unit but but basically what I'm saying is that if the market price is above the level of my offer price then I am willing to operate my unit if the offer of market price is below my offer price then I don't want to offer and I won't be called upon to off then what happens is is that the market operator he takes each one of those price quantity pairs that you submit for your unit he aggregates them up from the lowest offer price to the highest offer price to construct a basically step function offer curve for you then he takes everybody's offer curves and he aggregates those up so when you basically get the step function that is the sum of the offer curves of all market participants right then once you get that the market clearing price is just like you would think of it as you take the aggregate supply for you cross it with the aggregate demand that occurs in the market and that sets the market clearing price and then the way it works is that if your offer price is at or below the market clearing price you're on if your offer price is at or above the market clearing price you better excuse me above the market clearing price you're off okay that's the that's the basic way that we see we set price so you know this is gives a an example of that and of what the what an offer curve might look like of sorry animation I didn't notice so what happens is is that we have the man where demand crosses the supply curve that sets the market clean price pretty simple okay so markets they typically have a offer cap so in the case of the game offer price that you can submit and in the game it's going to be $500 per megawatt hour and typically what this prevents is the fact that you'll learn all about this in the game is it prevents the million dollar bid which there can be times in the electricity market must be accepted and it must be accepted because if you don't accept that bid the demand may not equal supply and and the lights go out when that's true so there are regulatory safeguards in place once such regulatory safeguard in the real world are offered offer caps meaning the maximum offer price that you as a supplier can submit okay so how do you think about being in this market price equals marginal cost well because you would be a fool ever to bid unless one thing is true if you don't think that your actions can influence the market price okay yes you should bid actions can influence the market price and we'll talk more about what we mean by that in other words if you think the price that you offer in can impact the market price then you are not going to make near as much money by bidding in your marginal cost as you would go through the logic of why if I don't think I can influence the market clean price it is expected profit maximizing for me to bid my marginal cost for my unit what I did here as you can see is I just wrote up a simple your profits are the price minus your marginal cost C times the quantity you set so if we go through the logic and we say okay suppose that I submit an offer price that is equal to my marginal cost what happens well if the price is above my marginal cost I run and I earn that profit P minus C times Q in other words that's pretty much the maximum profit I can get right particularly of Q is my total you're gonna play we just let you submit offer prices we don't let you submit offer quantities it's just makes it easier for you and so what happens well in this case if I submit now let's go through the other side of the story which says that suppose that the market price is below my marginal cost then if I did my marginal cost I don't operate and I because if I if I operate at a price that's below my marginal cost right I'm losing money on each unit I sell and there's no amount of volume I can sell that's gonna allow me to make it up okay so now let's think through of okay I can see that that sort of works what about if I submit an offer price that's above my marginal cost what happens to my expected profit well you can see that there's going to be a set of circumstances where I don't run communities available to me so if you could go through the same logic for beating below my marginal costs yeah I'll run more often that nothing I do influences the price that I pay equal to my marginal cost everybody see that I say if it's supplier believes that offer price can influence market player in price then supplier has an incentive to submit the offer better than see yeah yeah it was implicit influence the market price what I should do is bid high but I'm going to use much of Mark's times too so so what what's happened so if I think my offer price so how does the offer price how does the market clean price get set the market clean price gets set right as you can see where supply intersects demand on this step it goes up any on the slope of that demand curve I may make more money except the thing about this diagram is what's relevant only the demand slope so think of it as what's left over market is the market demand less the willingness to supply everybody else and what I'm trying to figure out is what is their willingness to supply look like because if they're willing to supply it looks like this then the demand that I would be facing after I take into account they're willing to supply is pretty steep if they're willing to supply looks like that I'm going to summarize this is the supply a lot more this we'd say it's not a very competitive market because there's not a lot of people in there trying to supply more the unfortunate thing about electricity is it looks a lot like this a lot of the time so we get lots of good stuff which makes it fun for economists to study and to try to figure out how design so so essentially you know if you're really interested in the full math others there's paper on my website I recommend so now let's think about carbon pricing and and how carbon pricing works so there's sort of two approaches that are out one is called a carbon tax and since we're in in academia we can say tax because that's what it is and the other is is the cap and trade and what cap and trade does is essentially says we're going to set the maximum quantity and then we're going to essentially do that through the fact that people get that we allocate a certain amount of allowances and every kind of emissions needs an allowance to offset in other words unless you can't emit unless you have an allowance in the case the carbon tax we just say tell us how much you admit and we charge you a tax based on the amount of emissions that you produced okay the other thing that happens in carbon markets is we can either option these allowances or we can allocate them to market efficiency and market participants are and this is one that often sort of bedevils particularly politicians but again politicians are typically not the best students that's why they become politicians but so so what happens is is they'll sit there and say well you are given these allowances and because you were given these allowances you should just use them because you're nice person but what happens when I use the allowance and I use the allowance I'm giving up real money if the price of allowances is positive right because I can either sell that allowance to somebody else or I can use that allowance to produce my electricity so the important point is regardless if they were allocated to me or if they were purchased by me they still have the same value to me which is the price of the allowance typically say okay we've got in this is a diagram that there's one diagram that I hope you get from today it's this it's that we have two choices for setting a price of carbon one is we explicitly set the price equal to P permit and we can set this quantity of emissions is total amount of allowances were allocated and the market is going to buy the price P permit but the basic point is what's going to happen well what's going to happen is when we set a certain amount of allowances however they get allocated again and we think that the market for allowances in some way people can trade them fairly easily what happens is is that guys are going to always make the following choice they're going to say okay I can use this allowance to essentially offset my emissions or I can engage in a baby reduce my offer I can do something to reduce my emissions and what I'm going to do if the price of allowance is bigger than my marginal cost to the baby I'm going to obey if the price of allowance is less than my marginal cost of emitting I'm going to buy the allowance that I'm going to use because that's the least cost way for me to comply and that's why as you can see what I've drawn up here you can think of what that curve is that looks like a man curve that you like the demand for allowances is really the supply of a baby so what is this what is the marginal cost of each additional unit of abatement that is effectively the supply of creates if you like the demand for allowances what we've got here is saying okay if we did no abatement here's how many emissions we would have if we spent a little money we get this much more this much more this much more until finally the amount of abatement gives us the total amount of emissions equal to cap that's what sets the price all right so so what's the difference between carbon pricing in a cap-and-trade world is the fact that in a carbon tax world we have price certainty of the price of carbon it's fit we know what it is in a cap-and-trade world we only have certainty on the quantity so the other thing to think about is what makes this quantity this this demand curve this supply of abatement curve moves with the supply of abatement curve is the follow-up what do you what do you think the supply of abatement curve looks like if the price of gas or oil falls in hat well actually what would happen is that what happens let's think through it so suppose the price of oil falls fossil fuels falls what happens to people's demand for fossil fuel what happens to greenhouse gas emissions under us any kind of baseline what happens to the expense of a baby right so the curves gonna shift out it becomes much more difficult for me to pay alternatively what happens if the price of fossil fuels goes through the group what happens to the supply curve of abatement or the demand for emissions allows then everybody goes why I want to burn this oil I'm gonna go to something else something else is probably lower carbon so therefore you know the demand for allowances drops very very rapidly is this fact that greenhouse gas emissions come with burning fossil fuels and as the price of greenhouse gas emissions another one would be is what happens to the demand for abatement okay if the economy suddenly booms the economy suddenly booms out goes that curve right because basically what it's saying is the level of economic activity is much higher it's going to be much more costly for people to abate the price of allowances goes out your economy goes down the tubes okay so the argument often for cap and trade is look we have good science to tell us say how much emissions should be allowed and so that argues yes then you probably should want to set that as your cat with the case of the carbon tax we just have the issue of we set the price of carbon and we see what happens now my personal view is is it's pretty much we just know we need to price carbon so let's get on with it let's not argue about the details but at least for the purpose of the course we want to understand how this works okay so the electricity market so this is getting to the point of how does it work when we implement a carbon price and also electricity market so this shows you what's called the merit order between a coal-fired power plant a gas power plant and a gas peaker just in terms of their cheaper than that gas both are not as cheap as this gas peak okay well we know I told you that for this demand level what happens is this is the market clearing price say but then what happens is and so what we do we can say okay this is what happens if we put a carbon price on remember we talk about the fact that the heat rate is typically excuse me their emissions rate is typically higher for coal-fired units versus for natural gas-fired units and so what do we get you can see that when we put in the carbon cost of the coal for the same price of carbon we're multiplying by say 0.75 or 1 top of it for coal excuse me for gas we're multiplying by a point two five or point five hence you get the smaller box on top and then for the gas peaker it's pretty high what you can see is we just swapped the merit order price of carbon and so what's going to happen instead right is that we're going to get effectively the situation that now you can see that the coal base load unit runs just a little bit less it's the gas unit runs at full capacity the coal unit runs less we get less emissions there's two mechanisms that give us less emissions mechanism number one is we're raising the price offer price of everybody so demand for electricity shifts in and the other one is we're switching the merit order both of those effects are working or hopefully should work if we are pricing energy is that as we said it you know you can only produce it when it's available you can only produce it where it's available and you know just to give you an example you know what we typically like to talk about is this thing called a capacity factor you'll see this in some of the documents that Mark's going to give you the capacity factor of your typical California solar unit is probably about 16-18 percent what this means is it says that take the actual annual output of the unit take the capacity unit multiplied by 8 7 6 0 in other words if that unit could hypothetically run 24-7 for the entire year that's how much energy it would produce well clearly it does clearly a solar facility doesn't clearly win facility and as you can typical rooftop solar unit about 16-18 percent capacity factor typical California wing unit probably about 25 30 just give you an example typically nuclear unit in the United States is about 92% okay so nuclear very very reliable and but the great thing about renewable is that not only is it zero carbon like nuclear it's also zero marginal cost okay and so the basic idea is that it's going to run regardless of the market clinic price because as long as market clinic price is positive and then so what's really now the thermal demand less the amount that supply bear predicts okay and just to show you that this is the CDF of excuse me the probability density function or histogram of the hourly output from solar units in California in 2014 this is for wind units and the one thing you can see is this gives you the probability that you get zero solar so roughly 45% of the hour to get zero for wind it's less but the and then this gives you the sum for wind and solar output and just to show you that we have roughly about 82,000 megawatts of wind and solar capacity in the grid California but you know roughly about 50% of the hour of the year we're getting about 2,000 megawatt hours so and still there's roughly about 3% of the hours a year we're getting nothing from renewables so if you want 100% renewables be prepared to be no electricity for many hours unless you install a lot of storage so so basically the point being is that we're going to have to have a lot of dispatchable demand still out so so now let's think about computing the market clearing price with renewables just to give you an idea so this is the way to think about it with renewables is what's true is we could have when we're thinking of bidding into the market as a thermal supplier we could face the demand with no renewable output we could face the demand with about the medium level of renewable output or we could face the demand with maximum amount of thermal output and what you can see is very different prices come about for the same supply curve for the thermal units okay so you can see that price volatility is going to go up as well as like potential certainly average prices are likely to fall largely because what we're typically doing is pushing in a bunch of renewables into the market usually through support schemes such as the production tax credit or investment tax credit or renewables portfolio standards of life but but this this what happens okay so just to finish up on this is so as you can see go through and think about it is if we up the amount of renewable production what happens to the price of car because if you guys invest a whole lot of renewables what happens to the price of car goes down it goes down why because what's happening is is we're displacing a lot of costly thermal generation and replacing it with zero marginal cost renewable generation and so you know what it says is that if you have an aggressive renewables policy you're probably going to get a very low price of cargo see California see European Union emissions trading both cases what's happening is is essentially very aggressive renewables policies are essentially pushing a lot of renewables in the system which is reducing the demand for thermal capacity okay we're done