BU5053 Introduction to Energy Economics

Application of D&S Framework

Wholesale Electricity Markets

UK Electricity Industry

D&S Model of Wholesale Market

Wind Intermittency and Wholesale Markets

Energy Units used in Electricity Industry
Energy – particularly electricity measured in kilowatt or megawatt hours
etc.

e.g. For Electricity Power Station Need to distinguish between Power

measured in Watts etc – links to Economic Capacity and Energy

Power Measurement Energy Measurement

Value Symbol Name Value Symbol Name
3 3
10 W kW kilowatt 10 Wh kWh kilowatt
hour
6 6
10 W MW megawatt 10 Wh MWh megawatt
hour
9 9
10 W GW gigawatt 10 W GWh gigawatt
hour
12 12
10 W TW terawatt 10 Wh TWh terawatt
hour
 .

Electricity System elements

•Generation
•Transmission (High Voltage & Low
Voltage)
•Distribution (Supply)

Source Joskow (2006)

 The UK Electricity System
.

Source: BERR
Changing Market Structure in UK Electricity Industry

Traditionally – No markets vertically integrated monopolies all 4 parts

Generation - Transmission - Distribution - Retail

De-regulation & Privatization

Generation – Wholesale Markets Created

Transmission - Private Regulated Monopoly (Single Industry Firms)

Distribution - Private Regulated Local Monopolies Single Industry Firms

Retail - Market created

After privatisation – many structural change in industry,

Power generation - Currently Approx 30 major power producers in UK

Major Firms British Energy, E.ON UK, RWE npower , EDF Energy, Scottish
and Southern Energy, Scottish Power

Sell electricity in Wholesale Electricity Market

Transmission
Dominated by National Grid Company (NGC) – Private Monopoly regulated
by OFGEM

Electricity distribution networks

14 distribution network operators (DNOs) each responsible for a distribution
services area. Private Monopolies – regulated by OFGEM

Retail Electricity Supply Since 1999 all customers able to choose supplier

Customers contract with suppliers.

Suppliers contract with Network companies and power generators
Electricity Wholesale Markets

Generation
Transmission
Distribution
Retail

How should these markets work in theory ?

How these markets work in UK Case

Impact of Intermittency & Increasing Wind Power

Electricity Physical Characteristics

Non-storability

Generation must equal demand every moment

Electricity flows follow every feasible route between generators and

loads

Transmission constraints

Large variations in demand & supply

Need for spare capacity

Demand fluctuates by day and across year.

Source: NationalGrid (www.nationalgrid.com)

Long periods where capacity unused.

Load Factor = (measure of output compared to the maximum output which

could be produced (capacity) )

UK Typical load factors 2008

Coal Gas Nuclear Biomass* Onshore Offshore

Wind Wind
Average 81% 81% 77% 80% 27% 37%
load
factor
Source House of Lords (2008)

Wholesale market must reward generators even where only

generate for peak demand

Generation Sources – used in different ways

“Base load” - minimum underlying demand

“Peak load” - periods high demand
Economics of Wholesale Markets (Joskow, 2008)

Consider Electricity system with 2 types of possible power plants

Plant Type Capital Cost Operating Cost
£000/MW £000/MW/Hour
Base “Nuclear” 2400 0.2
Peaking 800 0.8

Base High Fixed Costs + Low Marginal Operating Costs

Peaking Lower Fixed Costs + Higher Marginal Operating Costs

Government – Sets up Wholesale Electricity Market

Objective – Get private investors to invest in appropriate combination

of Base and Peaking capacity to satisfy demand every instant
 Example Peaking vs Base Plant Costs

Total Costs £000 Each Plant Type Depend on Number of

Hours Operated (Maximum in Year 8760 (=365*24))

Total Costs Total Costs

Hours Operated Base/MW Peaking/MW
0 2400 800
1000 2600 1600
2000 2800 2400
3000 3000 3200
4000 3200 4000
5000 3400 4800
6000 3600 5600
7000 3800 6400
8000 4000 7200
9000 4200 8000

Marginal Cost of Extra Hour MWh Output

Base Load Plant = 0.2 e.g. (2600-2400)/1000
Peaking Plant =0.8 e.g. (1600- 800)/800
Point Of Intersection - Number of hours of operation where worth
switching to Base load generator

2667 hours
If One MW power required for 2666 hours per year (or less) –
Cheapest to supply it with peaking plant

If One MW power required for 2668 hours per year (or more) –
Cheapest to supply it with base plant
Assume – lowest cost way supplying demand is combination Base
Load & Peak Load Plant

Here assume private investors

Invest in 17000 MW of Base Load Plant
Invest in 5000 MW of Peak Load Plant

Short Run Industry Marginal Cost Curve/Industry Supply Curve

Cb =0.2 when demand <= 17000 MW

Cp = 0.8 when demand > 17000 MW & <= 22000 MW

Infinite when demand > 22000 MW

Short Run Marginal Cost Curve/Industry Supply Curve

SR Marginal Cost

Cp

Cb

0
17000 22000 MW
 Reminder MC, MR & Total Costs and Producer Surplus
Market Level
Profit/Producer Surplus/Rent - Producing Q* at price P*

P*

Q*
Total Cost – Producing Q*
Wholesale Market
Can market provide sufficient rewards for investment in Peaking
and Base capacity?

Market Revenue needs to cover Capital and Operating Costs

Consider different possible demand conditions

Market Equilibrium
Quantity Supplied = Quantity Demanded

State 1 Normal Operating Conditions

Market Price = Marginal Cost of Plant which clears market

Normal Operating Conditions State 1a
Note
Price Base Load Unused Capacity

Peaking Plant Not Operating

Neither Plant Covering Fixed

Costs
D1a

P= Cb

0
Q* 17000 22000 MW
Normal Operating Conditions 1b)
Note
Price Base Load Full Capacity

Peaking Plant Operating but

D1b not at Full Capacity

Base Load Receives Quasi-

rent Contributing to Fixed
Costs

P=Cp Peaking Plant Not Covering

Fixed Costs
Base Load
Quasi-rent
Cb

0
17000 Q* 22000 MW

In Normal Operating Conditions – Peaking Plant cannot cover fixed Costs

State 2 Excess Demand

Small Number of Hours where

Actual Demand > Peak Capacity Available

Market Price = Determined by Demand Curve

Market Cleared “on Demand Side”

Consumers bid up price reflecting value placed on consuming

less electricity

This value known as Value of Lost Load or VOLL

 Note
Excess Demand Conditions 2)
Base Load Full Capacity
D2
Price Peaking Plant Full Capacity

Base Load & Peaking Plant

Receive Rents Contributing to
P Fixed Costs
Scarcity- Scarcity-
Rents
Rents
Base Load
Peaking
Cp
Quasi-Rents –
Base Load

Cb

0
17000 22000 MW
Summary - Simple Competitive Wholesale Market

State 1) In Normal Operating Conditions – Full Capacity of System

not used

State 2) Excess Demand Conditions - Small Number of hours full

capacity of system

Prices rises generating scarcity rents cover fixed costs

Implications for Prices

Stable periods - prices approx equal to variable operating cost of the

marginal plant

Short periods prices volatile and high

Incentives in Simple Competitive Market

1) If efficient mix capacity and plant mix

All plants recover fixed costs from Competitive Market

Requires Prices sufficiently above Peaking Plant MC during excess

demand hours

2) If too little plant & capacity

Prices rise too far above Peaking Plant MC during excess demand hours
- excess profits/rents - entry by other firms profitable

3) If too much plant & capacity

Prices do not rise sufficiently above Peaking Plant MC during excess

demand hours - peaking plant (and other) not cover fixed costs – exit
from industry
Wholesale Market Design

Range of market rules applied in practice

What transactions should market cover?

Gross Pool - all transactions via pool ,e.g. England & Wales
until 2001. Generators receive pool price.

Net Pool – generators can agree bilateral contracts with retailers

& inform ISO. e.g. Chile, Nord Pool, PJM, England & Wales
from 2001 (NETA/BETTA)

What is the wholesale price?

Marginal Pricing – most expensive generator sets price for

everyone who has not signed bilateral or hedging contract –
most markets

Pay as Bid - NETA/BETTA

UK Wholesale Electricity Market-

2001 British Electricity Transmission & Trading Arrangements

(NETA/BETTA)

Bilateral trading between generators, suppliers, traders and

customers

Series of markets operating on a rolling half-hourly basis.

Three stages to wholesale market, plus a settlement process.

Forward/Futures contract market

Participation
Short-term bilateral markets Voluntary
Balancing Mechanism
Settlement Process Obligatory
Example UK NETA/BETTA
 Mean daily prices £/MWh
APX Power UK Electricity 8/4/2008 -8/4/2010
Spikes in UK Wholesale Prices Spot Base Load Index 52.8
RPD 17:30-18:00 82.2
RPD 18:30-19:00 79.8
RPD 19:00-19:30 74.9
RPD 19:30-20:00 70.1

Source Reuters, APX

Paying for Capacity – Missing Money Problem

Key Component of analysis of simple wholesale market – price rises

sufficiently in excess demand/scarcity periods

Market Imperfections may mean Prices do not rise high enough

Induce “Missing money” problem (Joskow)

Fixed costs not covered & hence insufficient incentive to invest in

new plant capacity
Potential Sources of the Missing Money Problem

Model of Market requires real time demand response

But Typically few customers see real time prices

Control of network limited. Except for largest customers

individuals not able to choose level of reliability

System operators (ISO) behaviour

a) Hold operating reserves – keep probability of blackouts low.

b) Reduce voltage when shortage

c) Transmission network characteristics - ISO may require out

of market bilateral contracts with specific generators
depress wholesale prices in high demand period
Potential Sources of the Missing Money Problem cont.

Use of Price Caps by Regulators - “High” wholesale prices may also

signal use of market power by producers

Impact of above factors reduces responsiveness of the wholesale

price to demand changes

Other Factors – reducing investment incentives

Price volatility
Contract structure - retail competition
Regulatory Behaviour

Capacity markets
Increasingly electricity market design include payments for availability

e.g. Australia, US PJM , UK (part of recent Electricity Market reforms)

now, Germany in planning
Increasing Wind Power & Wholesale Electricity Markets in UK

How might this change way it operates?

Why was it decided need for Capacity market in UK?

Background
EU 20% of all energy renewable by 2020

The UK Renewable Energy Strategy DECC(2009)

30% of electricity generated, Much from wind power, on and offshore

Current Generation Capacity (around 80 GW) dominated by Coal & Gas.

Transition to 2020 implies
•Change in generation mix
•Increase in overall capacity

e.g. OFGEM Project Discovery - Energy Market Scenarios

If 2020 targets met - around 40GW installed Wind capacity 2025
OFGEM (2009) – Green Transition Scenario
Implications – Simple Analysis
Assume
Wind Power – lowest marginal cost (C) always used when available
Two levels of Wind Output –Low Q(low) Or High Q(high)

Two other producers, Coal marginal cost D ; Gas marginal cost E

Where E>D>C

Wholesale Market Price = Marginal Cost of Most expensive plant used

Uncertain wind power means peak capacity varies PC(low) Or PC(high)

Scenario “2010”: Wind Power insignificant part of total electricity generation

Scenario “2020”: Wind Power significant part of total electricity generation

In Each consider Wind Variability impact in 1) Normal & 2) Excess demand

conditions
 Scenario “2010” Wind Power Insignificant In Overall Generation Mix
1) Normal Demand Conditions - Example
Supply (Low)

Supply (High)

E P(high wind) = P(low wind)

D
C

Demand (Normal)

0
Q(low)Q(high) Output kWh
Wind Variability Impact - No Price Change (this particular case) – Small Change Load
Factor of Peaking Plant
 Scenario “2010” Wind Power Insignificant In Overall Generation Mix
2) Excess Demand Conditions - Example
Supply (Low)

P(low wind)
Supply (High)
P(high wind)

D
C

Demand (Excess)

0
Q(low)Q(high) PC(low) PC(high Output kWh

Impact Wind Variability - Price Change – No Change Load Factors

 Scenario “2020” Wind Power Significant In Overall Generation Mix
1) Normal Demand Conditions
Supply (Low) Supply (High)

P(low wind) = E

D
P(high wind) = C

Demand (Normal)

0
Q(low) Q(high) Output kWh

Impact Wind Variability - Changes Price, Output & Load Factors of Other Plant
 Scenario “2020” Wind Power Significant In Overall Generation Mix
2) Excess Demand Conditions
Supply (Low) Supply (High)

P(low wind) =

P(high wind) = D
C

Demand

0
PC(low) PC(high
Impact Wind Variability – Changes Price, Quantity, Load Factors of other Plant
Reduces Number of Excess Demand Periods
Wind Intermittency Impact

Low Wind Power in Overall Generation Mix

Normal Demand - No/Small Price Change – Small Load Factor Change of

Peaking Plant
Excess Demand - Price Change – No Change Load Factors

High Wind Power in Overall Generation Mix

Normal Demand - Potential Large Change in Price & Load Factors of Other
Plant
Excess Demand - Potential Large Change in Price & Load Factors of Other
Plant – reduce number excess demand periods

Overall – potential increased price variability (?) reducing load factors non-
wind generators

Possible High Wind – Lower rents for traditional generators which is required
to cover fixed costs
Implications for UK Wholesale Electricity Market of Increasing Wind
Pöyry (2009): ‘Impact of Intermittency: How wind variability could change
the shape of the British and Irish electricity markets’
http://www.poyry.com/linked/group/study

Assumed Installed Wind capacity Used Historical Records of wind

strength

Model
•Impact on Wholesale Market
•Hour to Hour Changes – how fast wind output can change (ramping
up/down)
Model Simulations - Variations in Wind with Increased Wind
Capacity

Load factors of Traditional Generators Fall considerably

Source: Pöyry (2009)

Greater volatility in Wholesale electricity Market – with higher
extremes

Higher Price Spikes & Volatility

2020 Simulation Price Spike £1300/MWh

2030 Simulation Price Spike £8000/MWh

Minimum prices negative - Wind power run for
ROC revenue only

Price spikes required to cover fixed costs of plant used for peak demand
Increased Risk
•operating peaking plant
•government intervention

Negatively affect investment incentives Non-renewable generation?

Side-affects - gas market?

Electricity Market Reform – Introduced Capacity Market

Summary - How does Wholesale Market provide investment
incentives?

Theory: for Market to operate efficiently

Demand low – met by generators with lowest short run marginal

production costs

Demand high –generators with higher short run marginal costs start
producing

Periods of high demand - Spikes in prices

Cover fixed costs of high cost producers

Provide investment incentives for peaking capacity

Wholesale Electricity Markets

Practice

Range of designs applied in practice e.g. pool versus pay as bid,

capacity payments

No clear best design

Are capacity payments necessary? Missing Money Problem

Increasing Wind Power - UK Capacity market introduction

.