Syed Babar Ali

School of Science and Engineering

Instructor: Fiaz A. Chaudhry, Ph.D., P.Eng.

EE 557 Electricity Markets – Spring 2020

Week 13 - Tuesday
Energy-only Market

Today we will look at specific characteristics of electricity that

determines how it is traded in a marketplace

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Electricity as a commodity
• Electricity is inextricably linked with a physical
delivery system!
• Physical delivery system operates much faster than any market
• Generation and load must be balanced at all times
• Failure to balance leads to collapse of system
• Economic consequences of collapse are enormous
• Balance must be maintained at almost any cost
• Physical balance cannot be left to a market

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Electricity as a commodity
• Electricity produced by different generators is
pooled
• Generators cannot direct its production to some consumers
• Consumer cannot choose which generator produces the energy it
consumes
• Electrical energy produced by all generators is indistinguishable

• Pooling is economically desirable

• Optimizes available resources to create efficiency
• A breakdown of the system affects everybody

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Electricity as a commodity
• Demand for electricity exhibits predictable daily,
weekly and seasonal variations
• Electricity cannot be stored in large quantities
• must be consumed when it is produced

• Production facilities must be able to meet peak

demand
• Very low price elasticity of electricity demand in the
short-run
• demand curve is almost vertical

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Organization of Markets
• Depending on when trades are arranged:
• Instantaneous trading – spot market
• Some time before they actually take place – forward market

• Depending on how trading is administered:

• Centralized
• Decentralized or Bilateral

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When trading is arranged….

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Spot Market

Spot
Sellers Buyers
Market

• Immediate market, “On the Spot”

• Agreement on price
• Agreement on quantity
• Agreement on location
• Unconditional delivery
Errors in load forecast (demand
side) or unpredicted generator
outages (supply side) leads to
gaps between load and
generation that must be filled
quickly

• Immediate delivery

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Spot Market

Spot
Sellers Buyers
Market

• Advantages: • Disadvantages:
• Prices can fluctuate widely based
• Simple on circumstances
• Flexible • Example:
• Immediate • Heat wave increases air-conditioning
load and drives up price
• Drought reduces hydro output and the
price increases with reduced supply in
the market

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“Managed” Spot Market
• Balance load and generation

• Run by the central system operator

• Maintains the operational reliability of the system

• Must operate on a sound economic basis

• Use competitive bids for generation adjustments
• Determine a cost-reflective spot price

• Not a true market because price is not set through

interactions of buyers and sellers

• Indispensable for treating electricity as a commodity

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 Spot Market: Market Clearing
• Generators offer their
quantities and price
Price Supply
• Offers stacked up to construct the
supply curve

• Load Serving Entities (LSEs)

Market
bid their quantities and price Clearing
• Bids also stacked to construct the Price
demand curve OR vertical
forecast
Demand
• Intersection determines the Quantity
market equilibrium
• Market clearing price and Marginal producer
transacted quantity

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 Spot Market: Market Clearing
• Everything is sold at the market
clearing price
Price supply
• Price is set by the last unit sold
• Marginal generator:
• Sells this last unit Market Extra-marginal
• Gets exactly its offer Clearing
Price
• Infra-marginal generators
• Get paid more than their offer Infra-
marginal Demand
• Collect economic profit Quantity
• Extra-marginal generators
• Sell nothing Marginal producer
• Incentivised to reduce operating costs

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 Spot Market: Supply Stack
• With simple bids, a supply stack is a monotonically
increasing, ‘convex’ curve of marginal costs

• Useful for analyzing impact of changes in multiple factors and

reflect changes in which generators are marginal

• In reality, generator bids are complex bids due to non-

convexities of generation costs

• A coal power plant would not just bid its variable cost but also
provide its no-load cost, ramping provisions and shut down
costs – supply stack is therefore more complex and requires
a mathematical engine to optimize

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Spot Market: Supply Stack

Source: GARP 2019 14

 Spot Market: Marginal Cost Pricing
• Marginal cost pricing leads to market efficiency as generators
compete on their variable costs
• The purpose is to differentiate consumption by time of use and
geographical area so costs could be conveyed to consumers in a
fair way

• Due to demand varying hourly, daily and seasonally, marginal cost

pricing reflects the true cost of supplying power
• Generators therefore look toward wholesale price spikes to recover
fixed costs
• Generator operating under constraint circumstances and therefore
displacing a cheaper generator does not set the marginal price –
instead it receives a make-whole payment

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 Spot Market: Scarcity Pricing
• Wholesale price spikes occur during scarcity periods i.e. when there is not
enough supply to meet additional demand

• Scarcity pricing is typically administratively determined that is set by

involuntary load reductions

• Economics suggests that it should be equal to Value of Lost Load (VOLL)

which is a function of duration, season, time of day, notice

• Very difficult to determine VOLL as each consumer values reliability

differently – it is also different for residential, industrial and commercial
• Operating profit for generators would be theoretically much higher during
scarcity periods and therefore VOLL is a driver of investment in a market

• Too small VOLL will not provide revenue sufficiency but will limit market
power – too high VOLL will give appropriate price signals but exposes
buyers to high prices e.g. France ~€55,000/MWh, NZ Avg ~$15,000/MWh
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 Spot Market: Why not pay as-bid?
• Would paying generators at their asking price lower average price?
• All generators would then try to guess the market clearing price
and bid as close to it as possible to get maximum profit

• Some low-cost generators would overestimate and bid too high

and therefore be replaced by higher-cost generators – market
clearing price would increase (or at best unchanged)
• Uncertainity in market clearing price causes profit-maximizing
generators to increase prices to cover additional risk of losing
revenue!

• UK is a popular exception with pay as-bid clearing in its wholesale

market – they found it to be effective due to their highly
concentrated market
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Spot Market Risks
• Market may not have much depth
• Not enough sellers: market is short
• Not enough buyers: market is long

• Lack of depth causes large price fluctuations

• Small generator may have to sell at a low price
• Small load may have to buy at a high price
• “Price risk” – volatility of spot price is subjected to both load and
generator

• Relying on the spot market for buying or selling large

quantities is bad business
• How to mitigate risk? Enter into a forward contract

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Forward Contracts
• Agreement
• Quantity and quality
• Price
• Date of delivery (not immediate) e.g. day-ahead, months, years etc.

• Paid at time of delivery

• Unconditional delivery

• Fixes a price in advance – beneficial to seller and buyer

• Two approaches:
• Decentralized or bilateral trading
• Centralized trading (also known as “pool trading”)

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How is Forward Price set?
Spot Price

Time
• Both parties forecast the spot price
• Both parties share the risk that the price differs from their
expectation
• Difference between contract price (“forward price”) and spot price
at time of delivery represents an economic profit for one or loss for
the other

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How is Forward Price set?
• If seller is more risk averse than buyer:
• Buyer can negotiate a forward price lower than expected spot
• Seller agrees to this lower price because it reduces its risk
• Difference between expected spot price and forward price is
called a premium – a price that seller is willing to pay reduce risk

• If buyer is more risk averse than seller:

• Seller can negotiate a forward price lower than expected spot
• Buyer agrees to this lower price because it reduces its risk
• Buyer is willing to pay the premium to reduce risk

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Forward Market
• Many sellers and buyers enter into forward contracts which
establishes a forward market

• Forward price represents the aggregated expectation of the

spot price, plus or minus a risk premium
• Premium adjusts with spot price realization (e.g. more-than-usual
rains leads to excess hydro output which slumps spot price. Load
Serving Entities (LSEs) would have paid much higher at forward
price. Their premium for the next year would therefore increase)

• Typical trend is to offset good periods with bad periods

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Financial Contracts
B C
A D

Financial Physical Market

contract (Spot)

X Z
Y W

• Financial contracts operate in parallel to the spot market

• These instruments provide spot price volatility hedging
• Do not involve physical delivery of electricity
• They are derived from the price of the underlying asset
(hence the name financial derivatives)
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Futures Market
• Future contracts (“futures”) allow others to participate in the
market and share risk
• Forward contracts limited to parties who take physical delivery
of electricity, while futures involve speculators (traders) that
trade forward contracts
• Futures detail the quantity of underlying asset and
standardized to facilitate trading with low transaction costs
• Futures usually involves many transactions for the same
product, multiple times over

• Information helps speculators make money e.g. long-term

weather forecast and its effect on electricity demand

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Options
• Spot, forward and futures: unconditional delivery
• Options: conditional delivery
• Call Option: right to buy at a certain price at a certain time
• Put Option: right to sell at a certain price at a certain time

• Two elements of the option:

• Exercise or strike price = price paid when option is exercised
• Premium or option fee = price paid for the option itself

• Example: Call option with an exercise price of $100 about to

expire
• If the spot market price is $90, the option is not worth it
• If the spot market price is $110, the option is worth $10 – should exercise if
value (i.e. $10) is greater than the option fee

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Contract for Differences
• Combination of call and put option i.e. always exercised. Commonly
known as Swaps (the spot price is swapped for the strike price)

• When the spot price is below

the strike price, the
difference is paid from the
LSE or retailer to the
generator
• When the spot price is
above the strike price, the
difference is paid from the
generator to the LSE or
retailer

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 Thank you

Fiaz.Chaudhry@lums.edu.pk
Tayyab.Chaudhry@lums.edu.pk

In the next lecture, we look how electricity markets

organize trading between market participants, i.e.
• Centralized
• Decentralized or Bilateral

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