Since the inception of ISOs, Locational Marginal Prices (LMPs) alone were not incentive
compatible because an auction winner who offered its avoidable costs could lose
money at the LMP. ISOs used make-whole payments to ensure market participants
did not lose money. Make-whole payments were not public creating transparency
issues. Over time, the ISOs employed methods to raise the price. They reduced but
did not eliminate make-whole payments. In addition, the new ’LMPs’ were too high
to send a good marginal entry signal and too low to send an incremental entry signal.
Some ISOs introduced capacity markets to remedy this problem. Capacity markets
brought their own set of issues. The objective of the paper is to introduce a pricing
scheme that improves on the current schemes and is more aligned with the theory of
markets with scale economies. It eliminates make-whole payments, increases transparency,
allocates the costs to period that caused them, sends better price signals, and
lowers capacity market prices. We introduce the one-pass average incremental cost
(AIC) pricing methodology to the multi-period model with multi-step marginal cost
functions, ramp and transmission constraints, and a co-optimized reserves market.
AIC prices address these issues in a positive economic way. Market rules, locational
incremental energy price (LIPs) along with LMPs produce incentive compatibility.
No market participant dispatched who offered its avoidable costs losses money. LIPs
eliminate make-whole payments making the market more transparent. Generally,
LIPs and LMPs send a good entry signals and have better economic design properties.
These properties are proved theoretically, demonstrated on small examples, and
demonstrated on actual ISO market problems.