Price Volatility in Electricity Markets: A Stochastic Control Perspective

Spot prices in deregulated electricity markets in the United States and Europe have historically displayed high volatility, leading to loss of revenue in high electricity costs, weakening economic growth and lost business from long blackouts. With rapidly increasing supply of intermittent solar and wind-based power, conditions in the foreseeable future are only expected to deteriorate. Geographic price variations, while capable of being quite dramatic themselves, are a natural outcome of Locational Marginal Pricing (LMP) that takes finite transmission capacity and congestion into consideration, to produce localized electricity prices. Temporal price volatility (considerable fluctuation over periods as short as an hour in particular), however, is harder to explain. In an effort to unearth the cause of these price fluctuations, we propose to model the electricity market as a discrete time controlled stochastic process. While this is a stylized model, it facilitates the analysis of spot markets and helps exclude extraneous details that do not contribute significantly to the discussion. We show that in any such market, improving social welfare must necessarily be traded off with volatility in prices, i.e., it is impossible to reduce volatility in the price of electricity without sacrificing social welfare. We also show that, akin to communication systems, every market has a Capacity Region associated with it, that dictates and quantifies how much welfare is achievable at a given level of price volatility. In the context of renewable power sources, our investigation uncovers an intriguing phenomenon we term the volatility cliff, which suggests that with increasing penetration of intermittent renewable production, price volatility could increase to unacceptable levels, prompting the need for a complete restructuring of existing electricity markets.