Optimal Backup and Supplemental Power Pricing and Capacity Decisions in Electricity Markets

This article addresses the supply and pricing of backup power to be provided by local distribution companies to industrial self-generators. Optimal self-generation investment and backup power contracting strategies for self-generators are characterized. The paper characterizes welfare-optimal pricing and second-best pricing for a local distribution company (Disco). The paper shows that optimal subscription fee for a backup power contract should be nil, when the Disco can trade power in a spot market freely without transmission costs and self-generation is highly reliable. A further result asserts that average spot price is not optimal for a welfaremaximizing firm facing both demand and spot market uncertainty. Benchmarks for regulatory policy for backup tariffs are derived. ∗Comments on earlier drafts of this paper by Marija Ilic and Paul Kleindorfer are gratefully acknowledged. This research is part of the “Distribution Company Strategy” Project at the Wharton Risk Management and Decision Processes Center, conceived in cooperation with the larger project “Distributed Power Industry of the Future”, at the M.I.T. Energy Laboratory. This project was conceived during a Postdoctoral Research Internship with the Electric Systems Technology Institute, ABB Power T & D Company, Raleigh, NC, in the summer of 2000; support for this internship and the guidance of Dr. Le Tang are gratefully acknowledged.