Unit 4 – The Philosophy of Market Models

1. Introduction

Creating trading arrangements to exchange a commodity called electrical energy adds

complexity to the overall process of generating and transferring the same to the end customer.

Deviating from a vertically integrated structure towards unbundled operation requires structural

and constitutional changes. This is true for any commodity market that is undergoing the

paradigm change. In this module, we discuss various market models for trading of electricity and

the need for designing the same. Eventually, we answer the following important questions:

 What are the possible ways in which buyers and sellers can trade electrical energy?

 Which section of consumers has a choice of selecting their energy provider?

 What are the peculiarities of electricity that make market arrangements of this commodity

different from other commodities?

 What is the role and involvement of system operator in the market decisions?

Philosophy of market models is influenced by the multiple ways in which the above questions

can be answered. In this module, first we explain choices of industry structures for trading of

electricity. Next, we present the peculiarities associated with electricity and discuss how these

characteristics influence the market design. The peculiar characteristics of electricity lead to

evolvement of various markets in which the same electricity is treated as a different product. The

arrangement of these markets and their alignment and linkage with main energy market is an

issue of market architecture. The market architecture intricacies are discussed in detail.

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2. Market Models based on Contractual Arrangements

As mentioned earlier, unbundling of the conventional vertically integrated power system creates

groups of various commercial and technical activities. Since one of the major aims of

deregulation is introduction of competition, it is worthwhile to explore every avenue where

competition can be introduced. Eventually, competition provides a choice for entities to choose

another entity or a group of entities to do a profitable transaction. In electricity parlance, either

the load or an entity representing a group of loads gets a choice to select its energy provider, or

there may exist some mechanism which would cater to the electrical energy needs of these loads

at a competitive level.

The former mechanism essentially requires bilateral involvement of the entities who wish to get

into a power buy and sell contract. In this, the sellers and buyers mutually agree upon the terms

and conditions, including the price and time of delivery. A repetitive bilateral interaction

between buyers and sellers may lead to an equilibrium point where everyone is happy.

Alternatively, a similar result would be obtained if a common exchange for the commodity is set

up, where, buyers and sellers, instead of interacting with each other, communicate their

expectations to this marketplace. This represents a simultaneous market clearing process and a

common market price of electrical commodity.

While moving from a vertically integrated structure to a competitive one, various policy and

structural issues crop up. One of the important concerns is regarding the entity that should be

allowed to take part in competitive activity. Similarly, issue of rearrangement of various

elements of power system, when a new set of rules is introduced to buy and sell power, also

needs to be addressed. It is obvious that the commercial arrangements and virtual boundaries

between various functional entities can take many shapes and forms. Consequently, various

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models can be classified according to the levels at which the entities are given the choice of

buying or selling electricity.

Various trading models can be proposed based on the above discussion. The choice of choosing a

model is a policy decision and is dominated by various prevailing conditions. They need to be

accounted for before making structural changes. In [1], four basic models of industry structure

are suggested. These are:

1. Monopoly model

2. Single buyer model

3. Wholesale competition model

4. Retail competition model

Every model needs different amount of structural change and rearrangements of functions in the

industry. These models are discussed next.

2.1. Monopoly Model

In this model, a single entity takes care of all the businesses such as generation, transmission and

distribution of electric power to the end users. One of the versions of this model is shown in

Figure 4.1(A). In this, a single utility integrates the generation, transmission and distribution of

electricity. Usually (but not necessarily), in this kind of model, the monopoly lies with the

Government. It is quite natural that this kind of model should have strict regulation in order to

protect end consumers against monopoly. Most of the electric power systems followed this

model prior to deregulation.

Another version of the monopoly model is shown in Figure 4.1(B). In this model, generation and

transmission are integrated and operated by a single utility and it sells the energy to local

distribution companies, which themselves represent local monopolies.

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 Figure 4.1: Two different versions of monopoly model

2.2. Single Buyer Model

In this model, as shown in Figure 4.2, there is competition in the wholesale sector, i.e.,

generation. Here, the single buyer agency buys power from Independent Power Producers (IPPs)

in addition to its own generation. The power purchasing agency in turn sells it to state

distribution utilities or distribution companies in the service area. All power generated by

generating companies (GENCOS) must be sold only to a purchasing agency and not to any other

agency. Distribution companies (DISCOMS) are only able to purchase from the single buyer

agency. They do not have a choice of choosing their power supplier.

In this model, sales from power pool to retailers take place at a pre-set tariff price. The single

buyer or the existing utility makes a long term contract with IPPs. A contract is necessary

because, without it, a generator would be reluctant to invest large amounts of capital in a

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generating plant. The contracts are generally of life-of-plant type, indicating sale of all capacity

of generating units for its lifetime.

Figure 4.2: Single buyer model

Figure 4.3: Single buyer model with only IPPs

Figure 4.3 shows another version of this model, which has further evolved from the original

single buyer model. In this model, the single buyer does not own any generation and buys all the
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power from IPPs. The distribution and retail activities are also disaggregated. This model has an

advantage of introducing some competition between generators without the expense of setting up

a competitive market. The tariff set by the purchasing agency must be regulated because it has

monopoly over the DISCOS while monopsony over the IPPs. The single buyer model is looked

upon as a way of attracting private participation in the generation sector, especially in the

developing countries.

In this model, transmission and distribution network can be owned and operated by State and

Regional transmission utilities. Inter-state tie line should be sufficient to maintain a loose

regional power pool. Merits and Demerits of this model are as follows:

Merits:

 Private participation in power generation

 Introduction of some competition without expensive set up for a competitive market.

Demerits:

 Long term contracts. Setting up a contract is problematic.

 No true competition.

 Price is not decided by demand-supply interaction.

 End consumers' price is regulated.

2.3. Wholesale Competition Model

This model is one step closer towards competition. There is an organized market in which the

generators can sell their energy at competitive rates. The market may be organized either by a

separate entity or may be run by the system operator itself. There is not much choice for the end

user. The end user is still affiliated to the DISCOM or retailer working in that geographical area

of operation. The large customers or the bulk customers, so to say, are privileged to choose their
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energy provider. However, the definition of bulk customer is a subjective matter and changes

from system to system.

This model, as shown in Figure 4.4, provides the choice of supplier to DISCOMs, along with

competition in generation. Implementation of this model requires open access to the transmission

network. Also, a wholesale spot market needs to be developed. Since this model permits open

access to the transmission wires, it gives the IPPs to choose an alternative buyer. DISCOMs can

purchase energy for their customers either from a wholesale market or through long term

contracts with generators.

The customers within a service area still have no choice of supplier. They will be served by a

DISCOM in their area. With this model, the DISCOMs are under Universal Service Obligation

(USO), as they have monopoly over the customers. They own and operate the distribution wires.

The transmission network is owned and maintained either by government and/or private

transmission companies. System operators manage the centrally accomplished task of operation

and control.

Figure 4.4: Wholesale Competition Model

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The model provides a competitive environment for generators because the wholesale price is

determined by the interaction between supply and demand. In contrast, the retail price of

electrical energy remains regulated because the small consumers still do not have a choice for

their supplier. The distribution companies are then exposed to vagaries of the wholesale price of

the commodity. The merits and demerits of this model are as follows:

Merits:

 Choice of seller provided for DISCOMs and bulk consumers.

 The buyers and sellers can make forward contracts or buy from a wholesale marketplace.

 The price is decided by interaction between demand and supply. Hence, indicates truly

competitive price.

Demerits:

 The end consumer still doesn't have a choice. It buys power from the affiliated DISCOM.

 Rates for end consumers are regulated rather than competitive.

 DISCOMs face competition at wholesale level, while their returns are regulated.

 Structural and institutional changes required at wholesale level.

2.4. Retail Competition Model

In this model, as shown in Figure 4.5, all customers have access to competing generators either

directly or through their choice of retailer. This would have complete separation of both

generation and retailing from the transport business at both transmission and distribution levels.

Both, transmission and distribution wires provide open access in this model. There would also be

free entry for retailers. In this model, retailing is a function that does not require the ownership of

distribution wires, although, the owner of distribution wires can also compete as a retailer.

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 Figure 4.5: Retail Competition Model

This model is a multi-buyer, multi-seller model and the power pool in this model acts like an

auctioneer. It behaves like a single transporter, moving power to facilitate bilateral trading and

this is achieved through an integrated network of wires. In this pooling arrangement, there is a

provision for bidding into a spot market to facilitate merit order dispatch. The pool matches the

supply and demand and determines the spot price for each hour of the day. It collects money

from purchasers and distributes it to producers.

The advantage of this model over monopoly utilities is that competition is introduced in

both wholesale and retail areas of the system. This model is supposed to be a truly deregulated

power market model. The retail price is no longer regulated because small consumers can change

their retailer for better price options. This model is economically efficient as the price is set by

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interaction of demand and supply. In wholesale competition model, with relatively few

customers, all of them regulated DISCOMs, a spot market can be preferable but not essential.

However, in retail competition model, spot markets become essential, since contractual

arrangements between customers and producers are carried out over a network owned by a third

party. In retail competition model, metering becomes a major problem. If the number of

customers are increasing and metering capability for all the customers is not sufficient, it may

create logistical problem and provoke disputes.

Merits:

 Supposed to be 100% deregulated model.

 Every consumer has a choice of buying power.

 The price is decided by interaction of demand and supply. Hence, it is truly competitive

price.

 There is no regulation in energy pricing.

Demerits:

 Need constitutional and structural changes at both, wholesale and retail level.

 Extremely complex settlement system due to large number of participants.

 Requirement of additional infrastructural support.

3. Comparison of Various Market Model

A comparison between the four models discussed above is provided in Table 4.1. The attributes

for comparison are chosen in such a manner that the difference between two truly competitive

models - wholesale competition and retail competition gets significance. It is then obvious that

the monopoly and single buyer models will emerge to be similar models when compared on the

chosen attributes.

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 Single Wholesale
Attribute Monopoly Retail Competition
Buyer Competition

Degree of
0 1 2 3
deregulation*

Number of buyers 1 1 Many Many

Number of seller 1 Many Many Many

DISCOMs and big Everybody including

Choice available No No
customers small consumers

Requirement of Preferable, but not

No No Essential
spot market essential

Transmission Transmission as well as

Open access NA NA
network distribution network

Regulated price to
Everybody Everybody Small consumers None
be paid by

Table 4.1

4. Electricity vis-a-vis Other Commodities

The classification of market models based on contractual agreements discussed in the previous

section can be applied to most of the commodities that are traded in the market, if we assume a

certain level of abstraction by presenting only the buyers and sellers. However, when it comes to

‘electricity' as a commodity, the same laws of economics or commercial trade arrangements may

not hold good. This is because, electricity as a commodity bears different characteristics from

other commodities, or rather, electricity is physically different from other commodities. This fact

complicates the procedure of electricity trading. In other words, the trade is not as simple as an

interaction between two entities: buyer and seller. The interdependencies of actions taken by

various participants (primarily generators and loads), mandate somebody to takeover the control

of real time activities. This somebody is the system operator, who makes sure that the whole

system runs reliably and thus kept in synchronism. Thus, it is worthwhile to understand the

distinguishing features of electricity as a commodity, which are presented next.

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5. Distinguishing Features of Electricity as a Commodity

There are three basic distinguishing features of electricity. These are associated with electricity

due to its physical nature. These three basic features effectively lead to one distinguishing feature

of this commodity, the one that has commercial implications. Let us see these in details

5.1. Real Time Demand Supply Balance

Electricity cannot be stored in bulk. Other commodities can be manufactured and kept in a

warehouse until the demand for the same is sensed. A manufacturer of other commodities gets

sufficient flexibility in planning the manufacturing activity and coordinating the dispatch. The

same is not true for electricity. The demand for electricity needs to be satisfied on real time basis.

The parties involved in electricity trade perhaps would like to do it through forward contracts .

These can be contracts for physical delivery or financial in nature. In many power markets, bulk

trade of electricity (> 80%) is done through forward contracts. Forward contracts can be done

years ahead. When a certain amount of electricity is bought in the forward contract, it is the

estimate of the buyer, how much it is likely to consume during actual delivery time. However, in

real time, the actual consumption may not match the predicted consumption that had been

forecasted at the time of doing forward trade. This difference is called as imbalance. Knowledge

about this imbalance is exposed only during real time operation or slightly before that. In this

case, the system operator or some other market mechanism stands ready to make up the

imbalances (either on positive or negative side).

Due to storage limitation, the supply-demand matching decision needs to be done on a

competitive basis by letting supply and demand interact with each other. The operator buys and

sells these imbalances through some commercial mechanism. Due to this feature of electricity,

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an issue related to the speed of operation pitches in. The system operator, while making a

provision for imbalances, has to take into consideration various network interdependencies. The

system operator always has to communicate with the active participants to tell them which

generators should increase their output and which ones should decrease it. This activity is called

scheduling in advance and dispatch in real time. Since the system operator has to work with

seconds to spare, a delivery system to make up for imbalances has to be in place. In real time, the

only time available with system operator is what is allowed by the energy stored in rotating

masses of huge interconnected grid.

Thus, this exceptional feature of electricity leads to two issues related to power market design:

Imbalances and Scheduling and Dispatch. The question is how these difficult tasks get reflected

in the rules of marketplaces.

5.2. Power Flows Obey Laws of Physics

The electric power cannot be told as to where and how it should travel, once the injection and

take-off points are decided. The electric power flow over transmission lines obeys laws of

physics. Effectively, electric power cannot be stopped from flowing on a transmission line that is

already hitting its power carrying capacity. The system operator has to ensure that none of the

lines get overloaded. To do this, only freedom left with it is the selection of pattern of nodal

injections (either generation or load).

Thus, any arbitrary set of forward contracts can not be scheduled by the system operator as this

may lead to exceeding of limits of physical parameters of some of the power system elements.

Allowing only the practically feasible set of transactions during scheduling and further making

corrections while dispatching so as to keep line loadings within limits is usually termed as

congestion management.
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The concept of network congestion is shown by a simple lossless system in Figure 4.6. In this,

generator A is a cheaper generator than generator B and hence, it gets a contract of satisfying the

demand of load at bus 3 by generating 18 MW. The dispatch would be as shown in Figure

4.6(A). The power flow over all lines would be dictated by the reactance of parallel paths. In this

case, let us assume that reactance of all three lines are same. Thus, two parallel paths are

provided so as to transfer power of generator A to load at bus 3, with ratio of reactance 2:1.

Obviously, the power will flow in opposite ratio on these paths. The flows are shown in Figure

4.6(A). However, if the physical properties of the line connecting nodes 1 and 2 state that it can

carry only 3 MW, then the dispatch shown in Figure 4.6(A) left hand side is not practically

feasible. To correct it, generator B is asked to generate 4.5 MW and generator A is asked to step

down by 4.5 MW, leading to dispatch shown in Figure 4.6(B). This rearrangement of nodal

injections is one of the means of congestion management, which is peculiar to electricity. We

will discuss more about this in a separate module on congestion management.

Figure 4.6: Concept of network congestion

5.3. Generator Product Compatibility and Interactions

To ensure reliable delivery of electricity, only generation by generators at injection points and

take-off by loads at take-off points is not sufficient. The system operator must make
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arrangements for provision of allied services necessary to do this. These allied services are

usually referred to as the ancillary services. Provision of reactive power, operating reserves are

some of the commonly required ancillary services. Mostly, ancillary services are provided by

generators. In this case, one is likely to witness the interdependencies involved in providing these

services. In other words, the production of ancillary services is also dependent on production of

energy. Then, the same generator is said to be providing two different products: energy and

ancillary services.

This complicates the matter because the single generator can be simultaneously needed to

produce multiple outputs, or to produce ancillary service rather than energy. This complication is

shown in Figure 4.7, where, a generator's capacity is divided into various products. The defining

question is how much of capacity should be allocated to each product? In centralized markets

(explained later), the system operator does a joint optimization, taking into account various

technical and commercial parameters of a generator to allocate its full capacity to each of the

products.

Figure 4.7: Generation capacity allocation to various products

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5.4. Unusual Price Variation

The combined effect of various peculiarities of electricity is that it has large temporal variation in

its price. It is not prudent to run all generators throughout the day. Rather, the most economical

generators can be run throughout the day. Effectively, the price of electricity will be low during

low demand period. However, during peak demand situation, the costly generators are brought

on-line and the price of electricity goes high. Thus, marginal cost of producing energy will vary

throughout the day. Such rapid cyclic variations in the price of a commodity are unusual, and

arise due to peculiarities associated with electricity, basically, the characteristic of matching

supply and demand on real time basis. It should be noted that this peculiarity of electricity has

arrived because of one of the basic physical properties associated with it.

6. Effects of Peculiarity: Four Pillars of Market Design

We have seen the characteristic features of electricity when compared with other commodities.

How do these affect the trading activities of this commodity? For example, what if network

congestion does not allow a set of transactions to be feasible? Should the generator sell its

generation capability in a single market that makes provision for energy as well as reserves, or

should there be different markets for the same? Some subtle questions like these provide food for

thought when designing criteria of markets are to be determined.

Hunt in [1] has described the design issues arising out of characteristics of electricity as pillars of

market design. These are:

 Imbalance

 Scheduling and Dispatch

 Congestion Management

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  Ancillary Services

Figure 4.8 shows four pillars of market design arising due to the basic characteristics of

electricity.

Figure 4.8: Four Pillars of Market Design

The design of market revolves around the four pillars described above. It also depends on how

and where these issues are accommodated in the whole process of market mechanism. Some of

the pillars lead to creation of separate markets. Eventually, this gives rise to the issue of market

architecture, which is nothing but arrangement and classification of these markets. Finally, these

markets can be integrated into one efficient market or there can be cascaded markets.

7. Market Structure

Stoft in [2] defines market architecture as a map of its component submarkets. This map includes

the type of each market and the linkage between them. Where does this concept of multiple

markets come from? The answer can be traced back to various peculiarities associated with

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electricity. Four pillars of market design tend to cast the same electric energy into various

products, which are characterized by separate individual markets. Moreover, there are various

modes of energy contracts depending upon when energy trades are done. This again gives rise to

market mechanisms based on timeline of trading.

The submarkets of a power market include the wholesale spot market, wholesale forward

markets and markets for ancillary services. Somewhere in between is embedded the market for

transmission capacity. This can be a separate market altogether or can be integrated with the

energy market that takes place near real time. Similar is the case with ancillary service market.

The best way to categorize alternative trading models is on the degree to which operational

arrangements and commercial arrangements for scheduling, imbalances, congestion and ancillary

services are integrated with spot markets. Two models are most common: integrated or

centralized and decentralized.

In the rest of the module, we will give more stress on how various markets for energy and other

products are organized. For the sake of understanding, we will not go into the intricacies

involved in various modes of arrangement and levels of competition discussed in Section 3.2.

We will just represent market by a set of sellers and buyers. For this, we do the abstraction of the

market as shown in Figure 4.9, indicating sellers and buyers with some interaction facilitator.

This abstraction gets rid of questions about ownership of transmission network, power exchange,

distribution network, as well as doesn't bother about whom the buyer represents or buys for its

own. The relevant details about the same will be discussed at appropriate places. First, let us see

how markets for energy are arranged.

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7.1. Timeline for Various Energy Markets

There are many ways depending on the time of hand-shaking, where buyers and sellers can do

the transaction. Figure 4.10 shows various modes of trading based on the time-line.

Following are the common modes in which the electric energy can be traded:

1. Bilateral contracts

2. Spot market

a. Day ahead markets (Power Exchange or through pool)

b. Real time market (through pool)

Figure 4.9: Abstraction of market concept

Trading for power delivered in any particular minute begins years in advance and continues until

real time, the actual time at which the power flows out of a generator and into a load. This is

accomplished by a sequence of overlapping markets. The earliest amongst these are forward

markets that trade non-standard, long term, bilateral contracts. This generally represents energy

trading between buyers and sellers directly for the mutually agreed price. This type of trading

stops about one day prior to real time. At that point, the day-ahead market is held. The day-ahead

market is often followed by a real-time market.

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The term - spot market is used with different interpretations associated with it. According to

definitions in some of the systems, the spot market includes day-ahead and real-time market,

while in others; it just includes the real-time market. Similarly, drawing line between spot and

forward markets is not clear. According to one definition, all the markets before the real-time

market can be classified as forward markets. This is because, in many forward markets,

including day-ahead market, traders need not own a generator to sell power. If power is not

delivered in real time, then the supplier must purchase replacement power at the real time rate

and fulfill the contract. A customer who buys power in a forward market will receive either

electricity delivered by the seller or a financial compensation. Any power that is sold in the day-

ahead market, but not delivered in real time, is deemed to be purchased in real time at the real

time price of energy. The combination of day-ahead and real-time market is popularly known as

multi-settlement market system in USA.

Another way to distinguish between forward and spot markets is by considering day-ahead and

real-time markets as spot markets, while all trades taking place before that are termed as forward

or bilateral trades. This segregation emerges because both, the day-ahead as well as real-time

markets provide a system price which holds for all the market trades done through it. On the

other hand, in bilateral or forward trades, there is no single market price as such. In the rest of the

module, we prefer to define the spot market as defined just above.

There is little doubt about what should be the nature of settlements based on timeline. Much

ahead of real time, i.e., more than a week, month or years ahead, bilateral contracts provide the

best manner of trading power. One is very unlikely to have bilateral contracts near real time. The

reason is that the settlements of bilateral contracts take place very slowly. Near real time, it is

prudent to have a centrally organized market as the security and reliability issues can be tackled

centrally rather than bilaterally. Even, the day-ahead market can be centrally organized. It can
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take the form of power exchange or the pool. In other words, day-ahead market can be organized

by a separate entity or it can be integrated with the system operator activities. If the latter is

adopted, it is popularly known as a pool structure.

In general, real time transactions require central coordination, while week-ahead trades do not

require the same. Somewhere in between are dividing lines that describe the system operator's

diminishing role in forward markets. Where to draw those lines is the central controversy of

power market design. A larger role for the system operator implies a smaller role for private,

profit making entities.

7.2. Bilateral/Forward Contracts

Bilateral trading generally involves two parties interacting with each other: a buyer and a seller.

The characteristic of bilateral trades is that the price of a transaction is set independently by the

parties involved. There is no market clearing price as such. Since, electricity can not be stored, it

creates a wide fluctuation in the spot price. Forward contracts provide generators and loads with

a means of hedging their exposure to fluctuations in the spot price of electricity. The generators

can negotiate a price for their output prior to the moment of producing it. Similarly, properly

structured forward contracts provide buyers with the ability to lock in a fixed price for a fixed

quantity of electricity well in advance of delivery and consumption. Indeed, if a buyer's actual

energy usage matches its forward market purchases, it can achieve a benefit of complete price

certainty in the face of real time price volatility.

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 Figure 4.10: Seller buyer interaction based on timeline

Depending upon the quantity of power and time, the buyers and sellers resort to different forms

of trading:

 Long Term Contracts: This type of trade generally includes contract for a large amount

of power for a long time period. These types of contracts are negotiated privately and the

terms and conditions are such that they suit both the parties involved in the transaction.

 Trading Over The Counter: These transactions involve smaller amounts of energy to be

delivered. For example, the amount of energy to be delivered during different periods of

the hour, day, etc. This type of trading has much lower transaction costs and is used by

producers and consumers to refine their positions before real time.

Electronic Trading: In this, participants can enter offers to buy energy and bids to sell energy

directly in a computerized marketplace. The participants can observe the quantities and offers/

bids submitted by all participants, but do not know the party involved. The software in the

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exchange couples the matching offers. It checks whether for a newly entered bid, if there is

matching offer whose price is greater than or equal to price of the bid. If no match is found, the

bid is added to the list of outstanding bids until a new offer matches it. Otherwise, it lapses after

the market is closed. The same process is repeated after a new bid is entered. There is no market

clearing price as such.

7.3. The Spot Market

As discussed earlier, a market for any commodity provides an environment for buyers and sellers

to interact and agree on transactions, generally, the quantity and price. These interactions

progressively lead to an equilibrium point at which the price clears the market, that is, the supply

is equal to demand. If electrical energy is to be traded according to a mechanism in which the

buyers and sellers are free to interact individually, the equilibrium between the production and

the consumption can be set through repetitive interaction. In this scheme of attaining

equilibrium, the consumers make an estimation of their consumption before entering into a

contract. The generators schedule the production of their units to deliver at the agreed time the

energy that they have agreed to sell. However, in practice, neither party can meet its contractual

obligation with perfect accuracy because, for example, from a load's point of view, the actual

demand of a group of customers is never exactly equal to the value forecasted. Changes in

weather and due to some other externalities, the day ahead or before real time estimation of load

consumption can have deviation from that done few months or years back, while doing the

contract. Also, unforeseen problems may prevent generating units from delivering the contracted

amount of energy.

It can be concluded that, while a large proportion of the electrical energy can be traded through

an unmanaged open market in terms of forward contracts, such a market may not necessarily
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lead to an equilibrium that replicates real time scenario. Thus, an intermediate stage is necessary,

where a managed spot market can provide a mechanism for balancing load and generation. This

market should supersede the open energy market as the time of delivery approaches. Its function

is to match residual load and generation by adjusting the production of flexible generators and

curtailing the demand of willing customers.

In many real life markets, more than 80% of the energy traded is through the forward or bilateral

contracts. The rest is traded through the spot market. In a multi-settlement market (typically

practiced in some of the markets in USA), the spot market is sometimes made of two markets:

Day Ahead (DA) market and a Real Time (RT) market. The DA market is run for each hour or

half hour of the next day. The RT market is always run by a system operator, while the day-

ahead market may or may not be run by the system operator. In both cases, the general principle

of market clearing is the same. This and other related issues are discussed next.

7.4. Spot Market Clearing

For the sake of understanding, let us assume that the market is run by an entity called Power

Exchange (PX). The power exchange operates much like a stock exchange. The buyers and

sellers enter their needs into the power exchange. For example, a buyer would say, “I need up to

20 MW between 1600 hours and1700 hours IST. I would pay INR 3.5/ kWhr”, whereas, the

seller would enter his demand as, “I have 100 MW and would like to sell it at INR 4/ kWhr”.

When they transact with the power exchange, buyers and sellers are really talking to the

marketplace and not the individual buyers and sellers. As in a stock exchange, the power

exchange constantly updates and posts a market clearing price (MCP), which is the current price

at which the transactions are being done. Note that when buyers and sellers communicate with

Dr. Prateek Singhal/A.P/EE Page 24

the power exchange, they don‘t know whom they are dealing with. The general step by step

process of settling this market is as follows:

1. Generating companies submit bids to supply a certain amount of electrical energy at a

certain price for the period under consideration. Usually, the period is an hour or half an

hour. The bids are ranked in order of increasing price. From this, a curve that shows bid

price as a function of bid quantity is built, which is commonly known as supply curve.

Supply curve is a plot with price on y axis and quantity on x axis.

2. Similarly, demand curve is established by asking consumers to submit offers specifying

quantity and price and ranking these offers in decreasing order of price. If the load is

willing to adjust its consumption with price, the load is said to have demand elasticity. If

the load is firm, the demand curve will take the form of a vertical line with x axis

intersection indicating total cumulative firm demand.

3. The intersection of supply and demand curves represents the market equilibrium. At this

point, the supply matches the demand. This price is known as Market Clearing Price

(MCP) or System Marginal Price (SMP). All the bids submitted at a price lower than or

equal to the market clearing price are accepted and the generators are scheduled for that

much amount of power for that particular time period under consideration. Similarly, all

the offers submitted at a price greater than or equal to the market clearing price are

accepted.

4. As for settlement, the generators are paid this MCP for every MWh they are scheduled

for, while loads pay the MCP for every MWh they are cleared for.

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Illustrative Example for PX Clearing

Suppose there is a central power exchange in which all players in the market send bids and

offers. Table 4.2 shows the offers and bids supplied to the central power exchange for a

particular hour of the next day, say 10:00 AM to 11:00 AM.

Once the buyers and sellers provide offers and bids, the power exchange forms an aggregate

supply curve and aggregate demand curve. The curves are plotted on the coordinates of supply

(and demand) and price as shown in the Figure 4.11. The point of intersection of the two curves

determines the market-clearing price (MCP). At this point, the supply satisfies the demand.

From the intersection of supply and demand curves, the MCP would be set to 3200 INR/MWh

and 450 MWh will be traded through the central power exchange. The MCP is the price of

electric energy that is paid by consumers trading through the power exchange. The sellers are

also paid at a price equal to the MCP. MCP is the highest sell bid or lowest buy bid accepted in

the auction. The generator ‘S2' is called the marginal generator as its bid sets the MCP.

Over and above the forward contracts, the participants trade the residuals through the power

exchange. The objective of the power exchange clearing is to maximize the social welfare as

explained in the earlier module. It is the sum of generator surplus and the load surplus.

Quantity Price
Company
(MW) (INR)

S1 200 2400

S1 50 3000

S1 50 4000

Bids S2 150 3200

S2 50 3400

S3 100 2600

S3 50 3600

Dr. Prateek Singhal/A.P/EE Page 26

 D1 50 2600

D1 100 4600

D2 50 2200
offers
D2 150 4400

D3 50 2000

D3 200 5000

Table 4.2: Bids and offers in the power exchange

Discriminatory or Non-discriminatory Pricing?

There are few questions which are likely to remain unanswered regarding the settlement

procedure adopted in the above market clearing process. One is likely to get surprised to see all

of the generators being paid the MCP, rather than at individual bid. Except the marginal

generator, all other generators are willing to produce power for lesser price than the MCP. Then,

why are they not paid their asking price? Paying them their asking price would have reduced the

average price of electricity.

Paying generators as per their asking price is known as pay-as-bid scheme. The main reason why

pay-as-bid scheme is not adopted is that it would discourage generators from submitting bids that

reflect their marginal cost of production. Basically, the notion that the average price of electricity

would decrease by adopting pay-as-bid scheme is based on the assumption that the generators

would continue to bid in the same way as they do in the marginal pricing scheme. However, this

is not true. All the generators would instead try to guess what the MCP is likely to be and would

bid at that level to collect the maximum revenue. While doing so, some low cost generators

would bid too high. Then, in the market clearing process, these generators would not get selected

and be replaced by some other generators that have higher marginal cost of production. The

Dr. Prateek Singhal/A.P/EE Page 27

MCP would then be somewhat higher than it ought to be. Furthermore, this substitution is

economically inefficient because optimal use is not made of the available resources. In addition,

the generators are likely to increase their prices slightly to compensate themselves for additional

risk of losing revenue because of uncertainty of MCP. An attempt to reduce the price of

electricity would therefore result in a price increase.

On the other hand, in marginal pricing scheme, a seller is certain that it will be paid no less than

its cost of production if he bids at marginal cost, and may be paid more. If a seller bids less than

his marginal cost, it would lose money because his bid may set the MCP. If it bids more than its

marginal cost, it may bid more than other sellers and fail to be selected in the auction. If the

seller's bid sets the MCP, then it would recover it's running cost and if the MCP is higher than it's

marginal cost, then it would earn profit or contribution to fixed cost. It is worthwhile to know

that the supply curve, being a derivative of cost function, does not consider the fixed costs.

Figure 4.11: Calculation of market clearing price (multiple price by 200)

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Simple Bids or Complex Bids?

In the illustrative example provided above, the generators submitted simple bids consisting of

price-quantity pairs. In some system operator run markets, (typically known as centralized

model, explained later), generators submit complex bids for each of their generating units. These

bids are supposed to reflect the cost characteristics of the unit (including the marginal, start-up

and no-load costs) as well as some technical parameters (minimum and maximum output,

flexibility). Rather than simply stacking the bids, the system operator then performs a central unit

commitment that determines the production schedule and the prices for an entire day divided in

periods of half an hour or an hour. For example, suppose a thermal generator with low marginal

cost and high start up cost is shut down temporarily. In the centralized dispatch system, the

generator submits a complex bid consisting of all details mentioned above. While doing a central

unit commitment, the system operator will not only consider its marginal cost, but will also take

into account its start-up cost. On the other hand, if the market is not centrally dispatched, only

the marginal cost of the generator will be taken into account to decide its selection or exclusion.

The advantage of complex bids is that they allow the system operator to take account, the true

characteristics of the generators and thus, potentially, do a more efficient job of minimizing the

cost. Setting the price becomes a disadvantage and requires a complex optimization problem to

be solved. This leads to higher cost of computation & lower transparency.

Day-Ahead Market and Real Time Market

As mentioned earlier, imbalances arise due to deviation between the forward contracted amounts

and the actual or near real time estimation of consumption. The spot markets are meant to

provide a mechanism for handling these imbalances. However, the energy trading must stop at

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some point before real time to give the system operator to balance the system. How much time

should elapse between this gate closure and real time is a hotly debated issue.

Large coal based thermal plants take more than an hour to start up. Such generators can not bid if

the gate closure for spot market is lesser than one hour. Under these circumstances, it is

beneficial to have two energy markets: a Day Ahead (DA) market in addition to Real Time (RT)

market. A DA market, as its name implies, operates a day in advance of the RT market. A day-

ahead market becomes beneficial as follows:

1) First, it can be beneficial if generators have high start up costs and start and stop each day. In

a centralized dispatch model (explained later), the system operator integrates the start up

costs of these generators so as to come out with the start/stop decision in a longer term

dispatch process. In other words, the time horizon for optimizing dispatch decisions is a day,

not an hour or less.

2) Second, it can be beneficial if generators would otherwise be able to game the market to lift

spot prices by withdrawing capacity at short notice - a form of market power. This form of

market power is explained with the help of Figure 4.12. Figure 4.12(A) shows competitive

MCP denoted as MCP1. Now suppose, if this generator company forms a coalition with Gen

7 and temporarily closes Gen 4 on the terms of sharing the profit with Gen 7. Now, Gen 7

becomes the marginal generator and sets the MCP (i.e., MCP2), which obviously is higher

than the competitive MCP, as shown in Figure 4.12(B). If the system operator needs to plan

operations a few hours ahead of time and relies on generator promises of availability, then

under such cases, withdrawing capacity of a generator just ahead of real time leads to calling

of an expensive generation. The day-ahead contracts can remove the gaming incentive from

generators because their prices are locked in day ahead, and they can't play the same game in

the day ahead market because more alternatives are available day ahead than in real time.
Dr. Prateek Singhal/A.P/EE Page 30
3) The RT market provides volatile prices, in general. The DA market can promote demand

response. If the DA price is high, the loads can choose not to buy, and they have a day to

plan for alternative arrangements.

Figure 4.12: Change in MCP when capacity is withdrawn

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