Arbitrage Activities for Energy Efficiency Resources in the Pjm Capacity Market

Open Access
Author:
Nagy, Stefan
Area of Honors:
Energy, Business, and Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Seth Adam Blumsack, Thesis Supervisor
  • Andrew Nathan Kleit, Honors Advisor
Keywords:
  • Energy Efficiency
  • Arbitrage
  • Capacity
  • Bidding
  • PJM
Abstract:
This study examines the effect of Energy Efficiency Projects on the Pennsylvania–New Jersey–Maryland Interconnection (PJM) Reliability Pricing Model (RPM). In particular, it focuses on the ability of Energy Efficiency (EE) resources to engage in arbitrage through bids into the RPM. There is currently no published research on the effect of this type of arbitrage behavior. This study provides the first analysis of capacity market arbitrage behavior by evaluating the market conditions necessary to engage in arbitrage and the implications that it has on market performance. Two different models are used to analyze arbitrage opportunities within the bidding structure of PJM’s RPM. A decision model, which assumes perfect information, and an option-based valuation model accounting for uncertainty are used to determine the conditions under which there is an incentive for parties to engage in arbitrage. Empirical sensitivity analysis is conducted using RPM auction data from PJM and building load data from the Philadelphia Navy Yard. Through this analysis, conditions are derived under which parties bidding energy efficiency capacity into the RPM have incentives to either follow through with investment in this capacity, or instead, to engage in arbitrage by covering their bid by purchasing lower priced capacity available in the short term market. The results of the empirical analysis provide threshold values for capacity market auction prices, which determine whether or not owners of energy efficiency resources would engage in arbitrage or follow through with an efficiency upgrade. The results of this analysis are very similar for both the recursive and perfect information models. For large commercial buildings with a peak demand of greater than 1 MW, the arbitrage strategy is profitable in expectation for the perfect information model when the total nominal capital investment cost is greater than 9.9 times the nominal annual energy savings resulting from that efficiency upgrade. Similarly, the decision to delay and engage in arbitrage will be made in the recursive game when the capital investment to annual energy savings ratio is greater than 8.8:1. For medium-sized commercial buildings with a peak demand between 0.25 and 1 MW, the arbitrage strategy is expected to be profitable, for the perfect information model, when the ratio of the total capital investment to annual energy savings is greater than 9.0:1 and is never used when this ratios is less than 8.6:1. For the recursive game, the decision to delay is made when the capital investment to annual energy savings ratio is greater than 8.6:1. For small commercial buildings, with a peak demand of less than 250 kw, the arbitrage strategy is expected to be profitable when the total capital investment to annual energy savings ratio is greater than 9.0:1 and will never be profitable when this ratio is less than 8.6:1. The decision to delay and engage in arbitrage will be made for the recursive model when this ratio is greater than 8.6:1. In comparison with typical efficiency upgrades, there is a moderate potential for owners of energy efficiency resources to engage in arbitrage. Most efficiency projects have a total capital investment to annual energy savings ratio of about 4:1, however there are a large number of efficiency upgrades that are undertaken with a total capital investment to annual energy savings ratio between 5:1 and 10:1. Compared to a profitable capital investment to energy savings ratio of about 9:1 for arbitrage activity, there is significant opportunity for efficiency resource owners to engage in capacity market arbitrage. I conclude that the arbitrage opportunity identified in this research may lead to market failures within the RPM if the bidding strategy is widely adopted by market participants. The cost of meeting installed capacity requirements may increase due to a potential shift from a three-year forward market to something closer to a spot market for capacity. In more extreme circumstances, this behavior may result in resource adequacy problems for PJM. As a result, it is recommended that PJM limit arbitrage activity by adopting policy changes to further regulate the bidding structure of the RPM.