Could California risk electricity problems from snags in the cap-and-trade system? | Reuters/Mike Blake

Many Californians still remember the electricity crisis in 2000 and 2001, when a combination of tangled state and federal regulations and opportunistic behavior by market participants led to soaring wholesale prices and rolling blackouts.

Could something similar happen today, but this time as a result of trading tied to policies for reducing carbon emissions and mandating a higher share of electricity produced from renewable energy?

Research led by Stanford Graduate School of Business courtesy professor Frank A. Wolak and Mark C. Thurber, associate director for research at Stanford's Program on Energy and Sustainable Development, is shedding light on that question through an advanced electricity-trading game that incorporates both California’s cap-and-trade system for reducing greenhouse gas emissions and its mandate to produce 20% of electricity from renewable fuels.

Wolak and his colleagues describe a wide array of unexpected results that emerged through a series of trading games played by teams of students from Stanford GSB.

In at least one simulation, for example, one team essentially cornered the market on Renewable Energy Certificates, the product retailers must purchase to comply with the renewable energy mandate. The team then charged sky-high prices to electricity retailers that still needed to buy certificates as the compliance deadline drew near.

Price Problems

The games also highlight what is perhaps the biggest long-term conundrum tied to regulatory mandates for solar and wind power: a pricing dynamic that sends spot-market electricity prices crashing to almost zero at times when sunlight and wind are abundant, which can make it hard for other electricity providers that are essential during periods of peak demand to recover their fixed costs.

Price crashes have already become a serious issue in Germany, where government-supported mechanisms have propelled renewables to the point that, during a few hours of the year, renewables are the nation’s largest source of electricity. Germany has actually experienced negative spot prices on days in the summer when solar output is high and electricity demand is relatively low. Negative prices also occur in US electricity markets with substantial renewable energy shares, such as California and Texas.

If you put smart people in the game, you can see how things can go wrong that you might never have expected. Frank Wolak

The problem is that conventional power plants need to be available during all hours of the year because solar and wind power plants are often unable to produce electricity. Renewables mandates have lowered average spot prices and increased their volatility, but higher spot prices at certain times of the day can provide much-needed revenue for owners of conventional generation.

“If you stuff a lot of zero-cost renewables into the system and they all produce at the same time, you kill the spot price and get an infrequent and unpredictable demand for energy from conventional units, even though you need those units to be around,” Wolak says.

Wolak argues that these problems can be addressed. One strategy, he says, is for retailers to purchase a bigger share of the electricity they sell to final consumers through fixed-price forward contracts rather than from the spot market. The guaranteed payments from forward contracts provide revenue certainty for the owner of a conventional generation unit.

Learning Through the Game

To better understand the potential problems, Wolak, Thurber, and graduate student Trevor L. Davis developed their advanced electricity trading game that incorporates California’s green policies and electricity markets.

“It’s an ideal way to study these issues because the world is so complex that sitting down and figuring out a mathematical model is far too difficult,” Wolak says. “But if you put smart people in the game, you can see how things can go wrong that you might never have expected.”

California is at the cutting edge of market-based requirements to reduce greenhouse gas emissions. In 2013, the state launched a cap-and-trade system for carbon emissions under AB 32, the 2006 law that mandates reductions in carbon dioxide emissions to 1990 levels by 2020. Companies receive allowances for a certain volume of carbon emissions, and those allowances are tradable.

A separate pillar of California’s green policy landscape, the Renewables Portfolio Standard, requires electricity retailers to procure at least 20% of their electricity from qualified renewable sources. By 2020, the renewables share requirement goes up to 33%. The utilities can meet their requirements by buying Renewable Energy Certificates. One certificate is produced each time a qualified renewable facility produces 1 megawatt hour of electricity.

The Stanford researchers spent a year programming the electricity-trading game that incorporated all these elements. In their class at Stanford Graduate School of Business, they then organized a number of games that pitted teams representing generating companies against teams representing electricity retailers.

For teams in regions with abundant solar and wind power, both spot prices and the demand for fossil-fuel electricity swung wildly during the course of each day. Prices crashed in the middle of the day. And though they spiked up again at night, the power companies didn’t always have the market clout to drive peak-time prices high enough to make up the mid-day losses. In part, that was because renewable energy comes from legions of different sources.

That wasn’t the only source of increased price volatility. Electricity retailers recognized that with a higher share of renewable energy in total demand, the large conventional generation units supplied a smaller fraction of total electricity and were therefore less able to raise spot prices through their bidding behavior. Fixed-price forward contracts are like insurance policies, and tend to stabilize energy market prices. But the retailers had little interest in buying that protection because they weren’t as worried about price spikes from the owners of large conventional generation units.

That might sound like good news for consumers. Over time, however, it can reduce the availability of “dispatchable” power plants that that can meet peaks in demand and provide electricity when solar and wind aren’t available.

One lesson from running the game, says Wolak, is that the details of the design of the various markets can make a big difference in market outcomes. For example, the researchers found that allocating carbon allowances fairly evenly among market participants at the outset of the game improved the liquidity of the market for carbon allowances, which in turn improved the performance of the overall electricity market. The researchers also found a number of ways to increase the stability of market outcomes.

“Electricity is different from all other commodities because it’s vital to all life and you don’t want things going off the rails suddenly,” Wolak said. “We don’t have much experience with markets where all of these policies interact, so it’s better to stage them in gradually. Letting it rip all at once rewards the sophisticated and intelligent players, who accumulate all the wealth — perhaps at the expense of everyone else.”

Frank A. Wolak is the Holbrook Working Professor of Commodity Price Studies in the Department of Economics at Stanford University and a professor of economics, by courtesy, at Stanford GSB. Wolak is also a senior fellow at the Freeman Spogli Institute for International Studies, the Precourt Institute for Energy, and the Stanford Institute for Economic Policy Research.