EFACEC - Energy Markets

24-10-2011

1

Energy Markets

Alexandre Pais da Silva

EFACEC Academy 2

24-10-2011

2

Class Presentation

Name

Present and past functions

Previous knowledge/experience of energy markets

EFACEC Academy 3

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 4

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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 5

Contents





Market Mechanisms

Market Participants


Market Functions

EFACEC Academy 6

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Energy transaction value chain

EFACEC Academy 7

Upstream fuel producers Natural Gas

Oil Coal

Uranium

Gas transmission and storage

Wholesale trading and marketing

Electricity Generation Fossil Fuel

Nuclear Hydro

Renewables

Power transmission

Gas and Power distribution

Consumers

Retail marketers

Basic physical infrastructure

EFACEC Academy 8

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

G

G

G

Transformer Transformer Transformer

GSPs – Grid Supply Points

Inter-connection Inter-connection

Industrial User

Industrial User

G

Distribution Distribution

Commercial User

Commercial User Domestic

User Domestic User

Domestic User

G

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Contents





Market Mechanisms

Market Participants


Market Functions

EFACEC Academy 9

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 regions’s 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

EFACEC Academy 10

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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):

EFACEC Academy 11

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

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

EFACEC Academy 12

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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. Electricity’s non storable nature: complex and volatile bahaviour

Yes, energy is different……

…and specialised models and trading tools are needed

EFACEC Academy 13

Contents





Market Mechanisms

Market Participants


Market Functions

EFACEC Academy 14

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Europe: Industry organisation until the pre-90’s …

• 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

EFACEC Academy 15

…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

EFACEC Academy 16

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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?

EFACEC Academy 17

1. There is no universal answer to all these issues 2. Each country, choosing to restructure, adopts a taylored approach.

…which has usually been implemented by steps..

1.Split-off generation from transmission

2.Transmission:

• Geographical monopoly: regulated “wires” business

• (?) Separate the function of system operator: Independent System Operator

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…)

5.Implement some market structure to enable trading and competition EFACEC Academy 18

Generation

Transmission

Distribution

Supply

End User

Wholesale Market

System & Network

Operation

Competition

Competition

Regulated Natural

Monopolies

Retail Market

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

EFACEC Academy 19

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

Monopolies

EFACEC Academy 20

• degree of vertical integration • wholesale bilateral deals between

utilities • ++ planing, security • + efficiency

• main body retained with a State interest

• vertical integration • +++ security • ++ securing new investment, planning • ++ competition, efficiency

Power Boards Open IPP access

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Gross Pool

EFACEC Academy 21

(mandatory) Pool

G

G

G

Supply

Supply

Supply

• CFD’s used for volatility hedging

• unit commitment algorihm sets (minimises) clearing price

• progressive introduction of customer choice

• +++ Generation competition

• ++ planning, efficiency

• + securing new investment, security

CfDs

CfDs

G Sell

30MWh

Supply Buy

30 MWh

We agree on: - 30MWh

- @$10/MWh

Pool = $15/MWh Earn : 30 MWh x $15/MWh = $450

Pay : 30 x ($15 – $10) = $150

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

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

Multi-Market (Bilateral trading + Balancing Markets)

EFACEC Academy 22

Balancing market

G

G

G

Supply

Supply

Supply

Bilateral contracts

Bilateral contracts

Bilateral contracts

• OTC trading

• Tendering process

• day ahead adjustment

• balancing market to settle innacuracy of predictions

• +++ 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…)

EFACEC Academy 23

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

EFACEC Academy 24

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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

EFACEC Academy 25

Contents





Market Mechanisms

Market Participants


Market Functions

EFACEC Academy 26

24-10-2011

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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

EFACEC Academy 27

Market participants

EFACEC Academy 28

Regulator

End User

Distribution Owner

Transmission Owner

Inter-connector

Generator

Supplier

Power Exchange

System Operator

Trader

Energy

Electricity Market

Capacity allocations

Flows Dx UoS charges

tariffs

payments

Resolutions

Performance

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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

EFACEC Academy 29

Contents





Market Mechanisms

Market Participants


Market Functions

EFACEC Academy 30

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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

EFACEC Academy 31

Electricity trading: MIBEL

March 2007 – Agents become empowered to (Pt & Es) buy and sell power on an

hourly, 24/7 basis.

EFACEC Academy 32

Production

Transmission & System Operator

Distribution

Supply

Consumers

Wholesale Market

Retail Market

SPR OPR OPR SPR

OTC

Futures - OMIP

Spot - MIBEL

Trading

Supplier Last

Resort Supplier

Last Resort

Supplier Supplier

Last Resort Tariff

> 10 kW < 10 kW < 41,4 kW > 41,4 kW

Portugal Spain

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Wholesale derivative trading instruments

EFACEC Academy 33

Settlement Delivery Terms Conditions

Forward Contracts

Physical Firm Standardised (OTC or bilateral) Non-standardised

• quantity & quality • date of delivery • date of payment following delivery • penalties if either party fails to comply (…additional conditions)

Future Contracts

Financial Firm Secondary markets: • Weekly • Monthly • Quarterly • Yearly

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

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

Traded volumes

EFACEC Academy 34

Base load winter ~15%

Base load ~55%

Peak summer~9%

Peak winter~9%

Balancing ~3%

Day ahead ~9%

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)

• Power trading = ~3 x Consumption

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MIBEL - OMIP trading outcome

EFACEC Academy 35

OMIP

Iberian market development Reference prices Eficient risk management instruments Complement the OTC market

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 EFACEC Academy 36

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Contents





Market Mechanisms

Market Participants


Market Functions

EFACEC Academy 37

Market Functions

1. Setting market clearing prices

2. Securing generation availability

3. Balancing the system

4. Accomodating transmission constraints

5. Enabling demand side participation


7. Capturing data for settlement

8. Calculating payments

EFACEC Academy 38

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Setting market clearing prices

• Marginal Pricing ( … as opposed to average pricing..)

• ex ante pricing

– Scheduling algorithms

– Bilateral contracts

• ex post pricing

– Balancing markets

• Bid pricing

– Ancillary services

EFACEC Academy 39

Inc. Price ($/MWh)

min Gen (MW)

Max Gen (MW)

Cum (MW)

½ h demand

Average cost ($/MWh)

Marginal Gen

Marginal cost ($/MWh)

18 200 500 500 998

20 150 400 900 800

22 100 150 1050 450

450 1050 Average

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

Generation Costs

(500 x 18 + 400 x 20 + 98 x 22)/998 = 19

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

18

= (19*998 + 18,9 x 900 + 18 x 450)/ 2248 = 19,6

G@22 22

G@20 20

G@18 18

21,4

Pricing and bidding strategies

EFACEC Academy 40

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

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








EFACEC Academy 41

Securing generation availability

• Perfect energy-only

markets

• Capacity payments

• Capacity markets

• Reliability Contracts

EFACEC Academy 42

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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.

EFACEC Academy 43

Capacity Payments

• Concept:

– Replace occasional large payments due to

shortage-induced price spikes, by

–a smaller amount on a regular basis.

• Payments proportional to the amount of capacity

made available by each generator.

• 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

• 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

–too little on DSR

EFACEC Academy 44

BETA In each period t, the price was increased by CEt = VOLL × LOLPt where VOLL is the value of lost LOLPt is the loss of load probability during period t .

Auctions

Pt, Es

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

24-10-2011

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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

EFACEC Academy 45

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. EFACEC Academy 46

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Market Functions

Basic functions to be performed in any market structure








EFACEC Academy 47

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

EFACEC Academy 48

80%

85%

90%

95%

100%

30% 50% 70% 90%

rela

tive

eff

icie

nc

y

(1

00

%lo

ad

/ p

art

lo

ad

)

Load %

Siemens CCGT part-load

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Balancing the system supply and demand

EFACEC Academy 49

• Secondary Power is employed to arrest frequency deviations

• Regulating reserves replace the energy deviation that originated frequency excursion

Secondary Power offers

Regulating Energy Offers • Forecasts • Intermittent ES • Outages • Network

constraints

Thank you for you attention!

EFACEC Academy 50

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Questions and answers

EFACEC Academy 51

Quiz Time

EFACEC Academy 52

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EFACEC - Energy Markets

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