1 Introduction
1.1 The Electricity Industry and Its Value Chain
-
Thermal power plants: A fluid (most often water) is heated by the combustion of a fuel (gas, coal, oil) or by a nuclear reaction (nuclear reactor). This energy in the form of heat is then converted to electric power. In most designs, the water is turned into steam and spins a turbine driving an electrical generator;
-
Hydro power plants: The water flow coming from a reservoir or in a river spins a turbine driving an electrical generator;
-
Wind turbines: The wind flow spins a turbine driving an electrical generator;
-
Solar photovoltaic installations: Electricity is generated through the conversion of light into an electric current using the photovoltaic effect.
-
The transmission grid, that serves for the transportation of electricity over long distances, mostly through high-voltage overhead power lines;
-
The distribution grid, that represents the last stage of the grid before the consumer. It is a low-voltage grid and consists of cables and lines connected to the consumers.
1.2 The Emergence of Electricity Markets
-
In 1990, the United Kingdom privatized the electricity supply industry, followed by the deregulation in several countries of the Commonwealth, notably giving rise to the National Electricity markets of Australia and New Zealand and the Alberta Electricity market in Canada.
-
In 1991, the Norwegian electricity market is deregulated.
-
In California, the market is deregulated in 1996, followed by many other states in the USA.
-
In Europe, a European Union directive dating back to 1996 creates the framework for a liberalized European electricity market, which prompted the implementation of electricity markets throughout Europe in the early 2000s.
-
Electricity generation companies:These are companies owning electricity generation assets that are competing to sell their production on the wholesale market. They make investment decisions to build new power plants in the hopes of making returns from the sale of the electricity production on wholesale markets.
-
Transmission grid companies:They operate the high-voltage transmission grid and are responsible for grid stability and security of supply. They are regulated monopolies, and offer a neutral non-discriminatory grid access to all potential grid users (generators and consumers).
-
Distribution grid companies:They operate the distribution grids and offer non-discriminatory access to the distribution grid. They are (semi-)regulated monopolies and, in some countries, are not unbundled from retail or generation activities. In this case, there might be no competition in the retail market, as the only possible retailer in a given area is the local distribution grid company. Most European countries and American states have now implemented retail competition.
-
Electricity retail companies:They are commercial companies procuring electricity on the wholesale market in large amounts (or producing it with their own generation capabilities) and selling it to end-consumers on the retail market.
2 Theoretical Foundation and Design of Wholesale Electricity Markets
-
Provide incentives to improve capital investments and operating costs of existing and new generation assets
-
Encourage technological innovation in electricity generation
-
Shift the risk of technology choice, construction cost and operating “mistakes” from consumers (through public monopolies) to suppliers (and their private shareholders)
-
Create better incentives for transmission and distribution monopolies, that would reduce associated costs for consumers and enable more efficient wholesale and retail markets
2.1 How to Define the Price of Electricity?
2.1.1 Marginal Pricing of Electricity
-
If the energy rent earned by existing generators is consistently higher or expected to be higher in the future than their annual fixed costs—for instance because of a wholesale price increase—this indicates economic viability in investing in new generation capacity;
-
On the contrary, if the energy rent is (or is expected to be) consistently lower than the fixed costs, some built power plants are not or will not be making positive returns on investment from their electricity sale, and it is a signal that new power plants would not be economically viable.
2.1.2 Spatial Distribution of Electricity Prices
2.2 The Emergence of Different Wholesale Market Designs
-
A long-term market allows for the trading of derivative products indexed on the short-term spot price of electricity. Market participants can manage their long-term price risk based on their future consumption needs or production capabilities;
-
In the short term, a spot market allows for the physical dispatch of power plants, starting on the day-ahead of delivery down to the real time. This dispatch exercise is first done on the day-ahead of delivery as many large power plants have long start-up and ramping times. The spot market sets a spot price for electricity used to determine the dispatch of power plants in the short term and as a price reference for longer term derivative products.
-
In real time, the electricity system is steered by system operators to ensure security of supply as all system constraints must be respected to ensure security of supply.
2.2.1 Nodal and Zonal Market Designs
-
Topological changes: changes to the grid topology to re-route electricity flows and alleviate the congestions.
-
Re-dispatching measures: changes to the schedules of specific power plants to change the electricity flows throughout the grid and alleviate congestions.
2.2.2 Centralized and Decentralized Market Organizations
2.2.3 Ancillary Services
-
Balancing and frequency control: the balancing of the grid to maintain the physical balance between supply and demand at every instant. The frequency of the grid is a value that can be monitored and reflects the real-time demand-supply balance. System operators typically contract flexible generation or storage that form “reserves” that are able to quickly react to frequency variations to keep it within a given range, around 50 Hz in Europe and 60 Hz in the US.
-
Voltage control: the voltage in the electricity grid must be maintained within a given range and this is done by system operators through active and reactive power control on some generation assets.
-
Black start: this system service guarantees the ability of the electricity grid to get back in operation after a black-out event. Power plants providing this service must be able to start their operations without relying on the electricity from the grid.
-
Congestion management: system operators have the ability to steer some power plants and change their scheduled generation in order to solve expected grid congestions.
Nodal market | Zonal market | |
---|---|---|
Day-ahead spot price | Locational marginal price | Zonal market clearing price |
Market bidding | Centrally dispatched unit bidding including technical constraints | Free portfolio-based bidding with self-dispatch |
Market operation | ISOs | Power exchange and TSOs |
Real-time balancing | Through real-time market with virtual bidding between DA and RT | Balancing organized by TSOs independently of wholesale market |
Congestion management | Included in the day-ahead optimization algorithm for all transmission lines | 1. Included in the day-ahead optimization for inter-zonal congestions 2. Solved through out-of-market redispatch for intra-zonal congestions |
2.3 The Problem of System Adequacy: Capacity Mechanisms
-
The market design and regulation do not allow generators to earn enough money to cover their fixed costs. For instance, electricity prices should be able to reach very high levels in times of supply scarcity, up to the level of Value of Lost Load6 (VoLL), which is rarely allowed;
-
A reliability criterion arbitrarily set for the electricity system7 is conservative and maintains many generators in the system, increasing competition and bringing the market price and generation rents down.
3 Electricity Trading in Practice
3.1 Wholesale Electricity Trading
3.1.1 Electricity Transactions
3.1.2 Market Participants
-
Fundamental market participants are active to value and optimize physical assets in the market. They carry their “buyer” or “seller” positions until delivery, based on their specific portfolio of assets, be it consumption, generation or both;
-
Speculative market players do not have a fundamental need to buy or sell electricity. They participate in the market in hope of making a profit from buying low and selling high. Their activity has a zero-sum volume effect on the market as they do not carry positions to delivery.
3.1.3 Trading Venues
3.1.4 Liquidity
-
As a measure of overall market activity, the Churn ratio is the ratio between domestic consumption of electricity (considered an indicator of fundamental trading needs) and the volumes traded on the wholesale market. In Germany, the largest EU power market for spot and derivatives, the Churn reached 12 times the total consumption (European Commission 2017).
-
For an auction, price resiliency can be defined as the sensitivity of the market clearing price to the submission of a price-independent bid of 500 and 1000 MW for a given delivery hour on either the buy or sell side.
-
For a continuous market, the bid-ask spread is the spread between the best buy and best sell prices in the order book. The lower the bid-ask spread, the higher the chances are the prices on which buyers and sellers agree reflect the fair value of the good.
3.1.5 The Trading Sequence
3.2 Power Derivatives
3.2.1 Hedging, Sourcing and Arbitraging
-
Retailers most often offer fixed-price contracts to their clients and their margins are exposed to electricity price variations;
-
Generators’ margins directly depend on the price at which they sell electricity and they are exposed to market price variations.
3.2.2 Power Derivatives in Europe and the US
Exchange | Type of contract | Granularity | Traded maturities | Physical vs. financial |
---|---|---|---|---|
European Energy Exchange | Futures | Bidding zone (Germany) | Days, weeks, months, quarters, years | Cash settled |
European Energy Exchange | Options | Bidding zone (Germany) | Days, weeks, months, quarters, years | Cash settled |
Nasdaq | Futures | Bidding zone (Nordics) | Months, quarters, years | Cash settled |
Intercontinental Exchange PJM Real-Time Western Hub | Futures | Hub (PJM) | Days, weeks, months, quarters, years | Cash settled |
Nodal exchange Cash Settled Financial Off-Peak Power, CAISO SP15, Day Ahead | Futures | Transmission node/hub (CAISO) | Days, weeks, months, quarters, years | Cash settled |
3.3 Spot Electricity Markets
3.3.1 The Day-Ahead Spot Market
3.3.2 The Intraday and Real-Time Markets
-
Forced outages of generation units;
-
Forecast errors of demand. A drop in the temperature or a rise in cloud coverage might require additional generation resources to meet load in real time;
-
Forecast errors of intermittent Renewable Energy Sources (RES) such as wind and solar.
-
The finer granularity products allow market participants to match generation and demand for each 15-minute time step to satisfy their balancing obligations. They represent roughly 20% of the total traded volumes of the intraday continuous market;
-
The trading activity in the last 30 minutes before real-time has increased over the last years as participants benefit from trading opportunities until the last minutes. On the German Intraday 15% of intraday continuous volumes are traded in the last 30 minutes before real time (Fig. 22.15).
-
Automated trading applications are developed either in-house or by Independent Software Vendors (ISVs) and automate power trading on the basis of algorithms. The applications are connected 24/7 through APIs (Automated Programming Interfaces). This enables market participants to react quickly to fluctuations in power production and demand.
4 Looking Ahead, New Challenges for the Power Markets
-
Increased missing money: RES having an SRMC close to 0 €/MWh (as there are no fuel and emission costs, and little O&M variable costs), they have a bearish effect on wholesale spot electricity prices19 and tend to increase the “missing money” problem (first introduced in Sect. 2.3). Indeed, they cannot fully replace dispatchable generation for system adequacy, as the need for available dispatchable generation remains high to cover peak demand events with no wind nor sun;
-
Need for flexibility: furthermore, with rising RES penetration, resource adequacy and system reliability do not only depend on peak demand anymore. Production flexibility is also increasingly needed to compensate for large and short-term RES-induced production variations. Capacity mechanisms can contribute to solving the intermittency backup problem although their primary purpose is not to increase flexibility. Efficient measures, in market design and regulatory fields, will be needed to further enhance flexibility incentives in the market. Paradoxically, to further develop RES going forward, there is a need for flexibility that can currently mainly come from fossil fuels (e.g. flexible gas power plants), as demand-response and batteries remain respectively not fully exploited or too expensive on a large scale, but could emerge as a result of decentralization and digitalization trends.