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Energy Markets

Alexandre Pais da Silva

EFACEC Academy

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Class Presentation

Name
Present and past functions
Previous knowledge/experience of energy markets

EFACEC Academy

Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

EFACEC Academy

24-10-2011

Challenges

Escalating fuel prices

Impact of emissions (environment, global warming)
Development of renewable energy sources (RES)
Requirements on suppliers to incorporate RES
ETS
Burgeoning energy demands (China, India)
Concerns over security of fuel supply
Future of nuclear energy
Risk management and M&A trends (EdF, E.On, ENEL,
IBERDROLA, EDP)
Scarcity of financial resources
Will the structures put in place be robust enough to deal with
these?

EFACEC Academy

Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

EFACEC Academy

24-10-2011

Energy transaction value chain

Gas transmission
and storage

Upstream fuel producers

Natural Gas
Oil
Coal
Uranium

Electricity Generation
Fossil Fuel
Nuclear
Hydro
Renewables

Power
transmission

Gas and Power

distribution

Consumers
Retail marketers

Wholesale
trading and
marketing

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Basic physical infrastructure

G

Inter-connection
Inter-connection

Ownership and Roles:

1. Generation
2. Transmission: >= 150 kV
3. Distribution: <150kV
4. System Operator

GSPs Grid Supply Points

Transformer

Transformer

Transformer

G
Industrial
User

Industrial
User

G
G

Domestic
User

Domestic
User

Commercial
User

Distribution

Distribution
Commercial
User

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Domestic
User
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Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

EFACEC Academy

Electricity Production

Set of large assets organised in a merit order (supply stack)

Generation dispatch is constrained by:

Cost & time required to turn it on / off
Production levels at which assets can be operated {70% - 100%}
Planned and unplanned outages

In a region, the merit order will, in principle, be orgaised in order to:

min { exected cost of meeting the regionss demand by selecting na appropriate mix}

Base generation: high fixed costs , low operating costs

Peaking generation: low fixed costs, high operating costs*

Sometimes, inherited factors determine that utilities have historically adjusted

G+T investments to:
Local fuel sources
Needs of their specific customer base
Previous regulatory requirements and incentives

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Electricity Demand

Highly inelastic due to a combination of:

Necessity status in many uses
Limited use of time-of-use based
pricing and of dynamic tariffs

Highly cyclical over short periods: patterns

of economic activity over the course of a
day, week, year

Seasonal due primarily to weather patterns

Social unnacceptability of blackouts

Rational for recovering system costs (what

demand must pay):
Capacity charges (Eur/kW)

Energy charges (Eur/kWh)

Peak

Base

Peak

Day

Night

Rel. Peak capacity

Rel. Average
demand

Most expensive
production costs

Expensive
production costs

Cheaper
production costs

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Operational (in)efficiency
Minimum price formation does not necessarilly derive from the
generation system merit order as other conditions must be
considered:

Sell offers (including complex offers)

Buy offers
Outages of generating assets
Bilateral contracts
Interconnection capacities made available by TSOs
Intraday & ancillary services market participation
expectations

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Economic fundamentals of electricity markets

Pattern of demand (over the course of the day, week and year)
Characteristics of regional generation merit order (fuel type,
operating costs and constraints, ownership structure)
Availability of transmission networks
Rules governing the regional power market behaviour of its
participants

Subject to:
1. Human needs and regulation
2. Laws of physics
3. Electricitys non storable nature: complex and volatile bahaviour
Yes, energy is different
and specialised models and trading tools are needed

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Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

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Europe: Industry organisation until the pre-90s

State ownership
External financial limits set by the Government
Debt repayment based funding
Monopolies
Possible: franchised distribution or under the control of municipalities
Generation and Transmission were centrally planned:
Meet expected load (+++)
Maintain system security (++): overinvestment risk and large reserve
margins
Minimise production costs (+): higher voltage networks & efficient
technologies
plus.
Defined levels of national coal consumption
No freedom of fuel source choice
Support general fiscal policy
Government interference
Energy prices set to reflect average instead of marginal costs
Maximum demand component: capital costs for investing in required G & T
Energy component: (marginal) costs of production

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prompted the introduction of competition

No competition in generation or supply

No choice:
Distribution buys from the central generating authority at the
declared prices
End users buy from local distributor and pay declared tariff
The model gave no incentive to operate efficiently
Encouraged unnecessary investments
Cost of mistakes passed on to the public without recourse
Government interference: stop/go policy

In any case
Need to maintain strategic control of critical infrastructure
Need to centrally coordinate investment planning: adequate
capacity levels
Need to maintain plant mix by fuel and type
Retain ability to finance high capital cost investments
Need to fix responsability for maintaining system security
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Specific challenges to facilitate competition trigger

restructuring.

What structure should be in place?

How many separate owners are necessary?
How to ensure the recovery of transmission/distribution
monopolies costs?
What mechanisms are needed to establish competition
through a liquid market with many participants including the
demand side?
What mechanisms are required to maintain system security?
What mechanisms to enable the SO to balance the system,
maintain security and the quality of supply?
How to ensure optimum levels of investment?
What are the implications for equipment suppliers?

1. There is no universal answer to all these issues

2. Each country, choosing to restructure, adopts a taylored approach.
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which has usually been implemented by steps..

1.Split-off generation from transmission

5.Implement some market structure to

enable trading and competition

Wholesale
Market

Distribution

Regulated
Natural
Monopolies

System &
Network
Operation

Supply

Competition

Retail
Market

Transmission

3.Break up generation into separate

competing blocks
4.Distribution:

Entity supplying a franchised

customer base
or

Geographical monopoly: regulated

wires business

(?) supply business managing

supplies to customers (gradually)

Competition

Generation

2.Transmission:

Geographical monopoly: regulated

wires business

(?) Separate the function of system

operator: Independent System
Operator

End User
2nd EU Energy Package mid 2007 (nearly implemented ):
Unbundling & Competition in supply
Competition regulation reinforcement in generation
3rd EU Energy Package, 2009 (being implemented):
Ownership unbundling
Reinforcement of regulatory power

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Restructuring options

Monopolies
Gross Pool
Multi Market (Bilateral Trading + Balancing Markets)
Power Boards
Single Buyer
Wholesale competition
Retail competition

Assessment Criteria

Generation Competition: introduction of efficient generation, fuel bill

Integrated Planning/Operation : capital costs, plant margin,
generation mix
Efficiency: inefficiencies, staff levels, standardisation
Securing Investment
Maintenance of Security
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Monopolies
Power Boards

degree of vertical integration

wholesale bilateral deals between
utilities
++ planing, security
+ efficiency

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Open IPP access

main body retained with a State

interest
vertical integration
+++ security
++ securing new investment, planning
++ competition, efficiency
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Gross Pool
CFDs used for volatility hedging
CfDs

Supply

(mandatory) Pool

Supply

unit commitment algorihm sets

(minimises) clearing price
progressive introduction of customer
choice
+++ Generation competition

Supply

++ planning, efficiency
+ securing new investment, security

CfDs

Pay :
30 x ($15 $10) = $150
G
Sell
30MWh
Earn :
30 MWh x $15/MWh = $450

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We agree on:
- 30MWh
- @$10/MWh

Pool = $15/MWh

Earn :
30 MWh x $5/MWh = $150
Supply
Buy
30 MWh

Pay :
30 MWh x $15/MWh = $450

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Multi-Market (Bilateral trading + Balancing Markets)

OTC trading

Bilateral contracts

Supply

Bilateral contracts

Supply

Tendering process
day ahead adjustment
balancing market to settle
innacuracy of predictions

Bilateral contracts

Supply

Balancing market

+++ generation competition

++ efficiency
+ Securing new investment,
security
+ planning, transparency

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Single Buyer

Utility no longer owns generating

assets

Energy purchased from IPPs

Distribution and retail disaggregated

Need for regulation

No competitive market expenses

and complexity

Developing countries

+++ competition (PPAs), planning

+++ securing new investment,

security

++ Operation ( with PPAs)

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Wholesale competition

No central organisation is
responsible for the provision of
electrical energy

Wholesale competition

Large consumers may (?)

participate

Pool / bilateral contracts

Market Operator

TSO

Franchised supply

Price results from generation and

demand interplay

Retail prices regulated (no choice)

DSOs exposure to price risk

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Retail competition

Generation competition

Retail competition: customer choice

Wholesale market access

wires regulated businesses

Competitive markets: no regulated

prices

Metering

Communications

Data processing

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Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

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Market Mechanisms
Given a market structure:
Business processes must be defined
who does what, how and when
Energy trading must be enabled
Grid capacity should be infinite no plant constraints should
exist
Market Functions:
Physical operation must be secured
Security is key need to balance supply and demand
continuously
Data flows and associated processes

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Market participants
Regulator
System
Operator

Interconnector

Resolutions

Performance
Capacity allocations

Trader

Generator

Electricity
Market
Transmission
Owner

Power
Exchange

Dx UoS
charges

Flows

payments
tariffs

Supplier

Distribution
Owner

Energy
End User

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Main activities of Market Participants

Structuring products
Pricing
Trading
Risk management of physical and financial contracts

Generation and Transmission assets:

Valuation
Risk management
Choice of operating policies

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Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

EFACEC Academy

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Trading: role of real-time market clearing

Electricity non-storable nature
no inventory to smooth the fluctuations in production over demand over time
Real-time basis adjustments

Both predictable and non-predictable variation in generation/demand impact

prices
Sudden, short-lived price movements may result from temporary G&D
imbalances in a specified geographical area with their durations
determined by:
Asset availability
Time and cost required to ramp up/down
Ability and lead time required to manage demand
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Electricity trading: MIBEL

March 2007 Agents become empowered to (Pt & Es) buy and sell power on an
hourly, 24/7 basis.

Portugal

Production

Transmission &
System Operator

SPR

Spain

OPR

OPR

SPR

OTC

Wholesale
Market

Futures - OMIP
Spot - MIBEL

Distribution

Supply

Last
Resort
Supplier

Supplier

Retail
Market

Supplier

Last
Resort
Supplier

Trading
Last Resort
Tariff

Consumers

< 41,4 kW

> 41,4 kW

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> 10 kW

< 10 kW
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Wholesale derivative trading instruments

Settlement
Forward
Contracts

Physical

Delivery
Firm

Terms

Conditions

(OTC or bilateral)

quantity & quality

date of delivery
date of payment following delivery
penalties if either party fails to comply

Standardised

Non-standardised

(additional conditions)

Future
Contracts

Financial

Firm

Secondary markets:
Weekly
Monthly
Quarterly
Yearly

Options

Financial

Conditional

European type
American type

Asian, Swing, Swaps, etc

Contracts
for
Differences
(CFDs)

Financial

Firm

Insulates from
market price:
- when market
participation is
mandatory -

-If strike price higher than market price,

buyer pays the seller;
-If strike price lower than market price,
seller pays buyer

Standardised - PEXs
enable trader/speculator participation
enable risk transfer & sharing
price discovery

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Traded volumes
In 2007, in the EU-27:
Consumption: 2.7 million GWh
OTC contracts traded 6.3 million GWh
Spot - Exchanges ~ 820,000 GWh
Future Exchanges ~1.1 million GWh
(with EEX constituting the
overwhelming majority of this volume)

Balancing ~3%

Power trading = ~3 x Consumption

Day ahead ~9%

Peak winter~9%
Base load winter ~15%

Peak summer~9%
Base load ~55%

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MIBEL - OMIP trading outcome

Iberian market development

Reference prices
Eficient risk management instruments
Complement the OTC market

OMIP

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OTC trading (& latest EU regulations)

Trading directly between parties and not through an exchange

Usually facilitated by large brokerage firms

Decentralized market: not listed, no central exchange or meeting place

Market participants trade over the telephone, facsimile, etc.

OTC deals - are not published (but is changing):

Difficulty in assessing size of the market,
limited price transparency,
limited liquidity,
ex ante restricted number of potential market partners
often substantial transaction costs.

TSOs can provide low cost and transparent balancing services

Producers/suppliers can hedge their risks

Traders can provide liquidity by actively taking price risks

Inovation: brokers can compete with exchanges as an efficient intermediary

Massive volumes

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Contents
Energy sector challenges and market responses
Supply chain & Physical infrastructure
Electricity market fundamentals
Introduction of competition & market models
Market Mechanisms

Market Participants

Trading MIBEL-OMIP and derivatives trading

Market Functions

EFACEC Academy

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Market Functions

1.
2.
3.
4.
5.
6.
7.
8.

Setting market clearing prices

Securing generation availability
Balancing the system
Accomodating transmission constraints
Enabling demand side participation
Balancing the system
Capturing data for settlement
Calculating payments

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Setting market clearing prices

Marginal Pricing ( as opposed to average pricing..)

Inc.
Price
($/MWh)

min
Gen
(MW)

Max
Gen
(MW)

Cum
(MW)

h
demand

Average cost
($/MWh)

Marginal
Gen

Marginal
cost
($/MWh)

18

200

500

500

998

(500 x 18 + 400 x 20 + 98 x 22)/998

= 19

G@22

22

20

150

400

900

800

(500 x 18 + 400 x 20)/900=18,9

G@20

20

22

100

150

1050

450

18

G@18

18

450

1050

Average

ex ante pricing
Scheduling algorithms
Bilateral contracts
ex post pricing
Balancing markets
Bid pricing
Ancillary services

= (19*998 + 18,9 x 900 + 18 x 450)/ 2248

= 19,6

21,4

Generation Costs

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Bidding strategy is
intended to recover
full generation costs.
Shall we do the maths
of generation revenue
maximization?

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Pricing and bidding strategies

Drivers:
Marginal Costs
Demand Elasticity (perfect/
imperfect competition models)
Market share
Avoid regulatory intervention
Discourage new entry

EFACEC Academy

Requirements:
Information transparency
Reserve margin
Dynamic constraints
Must-run
Environmental

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Market Functions
Basic functions to be performed in any market structure
1.
2.
3.
4.
5.
6.
7.

Setting market clearing prices

Securing generation availability
Balancing the system
Accomodating transmission constraints
Enabling demand side participation
Capturing data for settlement
Calculating payments

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Securing generation availability

Perfect energy-only
markets
Capacity payments
Capacity markets
Reliability Contracts

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Energy only Markets

Practical and socio-behavioural problems

may prevent market equilibrium
Unavailable demand responsive technology to
short term price signals
Alternative: widespread load disconnections
unpopular - politically sensitive
social consequences (accidents, vandalism)
economically very inefficient.
Value of lost load (VOLL) >> cost of the energy not supplied.
Price spikes become unpopular, hard to explain to the lay
Vulnerable customers: heating, cooking and air conditioning.
Some political acceptance - price caps: hindrance of investment.
Investment uncertainty-risk: price spikes may not materialize and the average price varies
with temperature and precipitation
Time to plan and build market instability series of boom-and-bust cycles.

Relying solely on the market for electrical energy and its price spikes to bring about enough
generation capacity is unlikely to give satisfactory results.
Consumers purchase electrical energy PLUS a service: electrical energy with a certain
level of reliability.

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Capacity Payments
Concept:
Replace occasional large payments due to
shortage-induced price spikes, by
a smaller amount on a regular basis.

BETA

Payments proportional to the amount of capacity

made available by each generator.

where
VOLL is the value of lost
LOLPt is the loss of load probability during period t .

In each period t, the price was increased by

CEt = VOLL LOLPt

stream of revenue independent from the market

partial capital cost recovery of new generating units
By increasing the total available capacity,
reduce likelyhood of shortages
more production capacity also enhances
competition
moderates prices in the market

Need to assess:
total amount to be spent
rate to be paid per megawatt of installed capacity.
impact on technology mix
performance

Pt, Es
Auctions

Spread risk among all consumers

ST: socialization of the cost of peaking energy
benefits the risk-averse market participants
LT: incentives for economically efficient behavior:
too much capital may be invested in
generation capacity
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too little on DSR

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Capacity Markets
Mechanism

Set a generation adequacy target

Determine the amount of generation capacity required

Organized market: all energy retailers and large consumers must buy their share

Amount of capacity to be purchased is determined administratively

Price depends on the capacity on offer: may be volatile

Issues:

The time step of the market:

Suppliers prefer a shorter period: reduces the amount of capacity that they have to
purchase during periods of light load and increases the liquidity

Generation wants a longer time step (e.g. a season or a year): benefits generators
and encourages the building of new capacity

Discourages selling of capacity in a neighboring market

Method to evaluate and reward the performance of generators

Should reward reliable plants and encourage the retirement of unreliable units

Ensure incentive to maintain or improve the availability of units during critical periods

If supplier does not purchase its share of the target capacity, it must pay the market

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Reliability Contracts

Mechanism
auction reliability contracts:
LT call options with a substantial penalty for nondelivery.
reliability criteria to determine the total amount of contracts to be purchased
strike price set typically at 25% above the variable cost of most expensive expected
generator
duration of the contracts.
Bids are ranked in terms of the premium fee asked by the generators.
The premium fee P that clears the quantity Q is paid for all contracts.
Reliability contracts have a number of desirable features:
They reduce the risks faced by marginal generators because the highly volatile
prices
Uncertain revenues are replaced by a steady income from the option fees.
Amount of contracts to be auctioned can be set according to the desired reliability.
Incentive to maintain or increase the availability of generating units
Penalty for non delivery discourages bidding for contracts with less-reliable units.
Consumers get a hedge against very high prices for the money they pay above
generation costs
Consumers also get option fees determined through a competitive auction
Strike price is above competitive prices: options become active only when the
system is at risk
Interferences with the normal energy market are minimized.

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Market Functions
Basic functions to be performed in any market structure
1.
2.
3.
4.
5.
6.
7.

Setting market clearing prices

Securing generation availability
Balancing the system
Accomodating transmission constraints
Enabling demand side participation
Capturing data for settlement
Calculating payments

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Ancillary Services

Reserve
Primary Reserve:
immediate reserve e.g. AGC(5% nominal rating), DSM low frequency
relay triggered. E.g. UCTE = 3000MW
Secondary Reserve: available in 2-10 min
Emergency Reserve: available in 15 min, for sustained operation

Frequency Response (~18000MW/Hz)

Voltage Control

Black Start

Provision may be:

Mandatory
Remmunerated
bilateral contracts
spot market

relative efficiency
(100%load / part load)

100%

Siemens CCGT part-load

95%
90%
85%
80%
30%

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50%

70%

90%

Load %

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Balancing the system supply and demand

Forecasts
Intermittent ES
Outages
Network
constraints

Regulating Energy Offers

Secondary Power offers

Secondary Power is employed

to arrest frequency deviations
Regulating reserves replace the
energy deviation that originated
frequency excursion

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Thank you for you attention!

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Questions and answers

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Quiz Time

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