Electricity Markets: Theory
and Practice
Ajay Pandey
IIM Ahmedabad
Structure of Presentation
• Basics on Competition and Markets in the
Electricity Sector- A Refresher
• Electricity Market design Principles
• FERC’s Standard Market Design
Basics of Competition and Markets in the
context of Electricity Sector
Basics: Why Electricity
Markets?
• Competition
• Obviously, the main reason
• Generation (and Supply) is potentially competitive
unlike “wires” part of the sector
• Markets maximize welfare in case they are
perfectly competitive
• Price Discovery
• Prices important in consumption and production
Competition
• Competition “for” the market
– Entry and exit barriers
• Competition “in” the market
– Level and non-discriminatory “playing field”
Both are expected to lead to efficient resource allocation
and prices, in the long-run and short-run respectively
Markets
• Markets are voluntary arrangement between suppliers
and consumers to transact any
commodity/goods/services
– Key word is “voluntary” and not through administrative fiat.
– Regulations can be there but non-priced based.
• Markets can fail due to …
– Externalities
– Property right enforcement issues
• Market failure requires regulations but state and
regulators can also fail……
Why Competition and Electricity
Markets need to be designed?
• The electricity sector consists of natural
monopoly (“wires”) business and potentially
competitive (generation and supply) businesses.
• Therefore, competition and markets have to be
by design so that “Natural Monopoly” part of the
sector does not interfere with the competitive
parts.
• Since electricity markets are designed, there can
be alternative designs.
Necessary Conditions
• “Wires” business should not have
commercial/any interest upstream and
downstream
– Unbundling
• “Wires” should be controlled by the technical
considerations alone
– Security-constrained dispatch
– ISO
• Centralized Coordination and control is required
so that competing players do not violate security.
Other Important “Caveats”
• Competition can be induced by markets
only if the entities are commercial
• Competition will be non-existent if the
subsidies are administered through select
players
• Regulated prices can weaken the market-
induced competition
• Efficient markets require efficient upstream
and downstream markets
Competition in the Sector
• Policy Issues
– Competition at what level?
• Wholesale and/or retail
– Model of whole sale competition
• Energy market
• Capacity market
– Model for retail competition
• Open access with default supplier
• Separation of DNO from supplier
Electricity Market Design Principles
Electricity Market Design Principles
• Social welfare should be maximized
• Competition for the market leads to most efficient capacity addition
and competition in the market leads to most efficient generation (in
terms of energy costs).
• Competition from demand side means that those who are willing to
pay are supplied the quantity demanded.
• Transmission should not interfere with competition
• Transmission access should be non-discriminatory for competition
“for” and “in” the market.
• Prices should reflect marginal cost (and value) of electricity
• Prices should also reflect marginal losses and congestion induced by the
drawing entities at a location
• Hedging should be allowed without affecting the competition
• Potential for exercise of market power should be monitored and mitigated,
ex ante.
Objectives of the Market Design
• All “economic costs” should be recovered, more
so if the investment has to come from
commercial entities.
• Prices should be cost (and value) reflective.
• Prices should be reflective of forward looking
costs, i.e., of supplying electricity competitively
in the future.
• Prices should signal where network should
expand and generation capacity should add.
• Prices should result in adequate capacity being
available.
Costs to be Recovered
At Wholesale level-
• Generation Capacity related costs
• Energy or use of generation capacity costs
• Ancillary service such spinning reserves etc.
• Transmission capacity related costs
• Transmission losses & congestion costs, if any
At Retail level-
• Distribution capacity related costs
• Distribution losses
• Consumer-specific investment related costs
• Consumer servicing costs
Elements of Electricity Markets
• Long-term competitive procurement
market
• Bilateral/ Financial (cash settled
futures/options) Medium term market
• Spot (day ahead physical) Market
• Intraday (physical) market
• Balancing (physical) Market
• Ancillary Services
Integration of Various Elements
• Spot market prices are/ can be used for settling
medium term or long term derivatives or even
bilaterals
• Any of these markets can be used to hedge and
procure by buyers and for supply by suppliers
• And hence unless any element is badly designed,
the prices should be consistent
• Spot prices, if from competitive market having
depth, provide reference prices for other markets
Spot Market Designs
• Exchange Model
• Decentralized, voluntary and required coordination with System
Operator
• Price discovery usually independent of transmission and no attempt
at optimization across generation and transmission
(NETA, UK, Most EU markets, India)
• Pool Model
• Centralized, compulsory (sometimes voluntary, Net Pool) and
integrated with the System Operator for market clearing and dispatch
• Standard Market Design of FERC (as in PJM) discovers prices at
different nodes using algorithms to optimize across generation,
transmission and factoring in losses and congestion, if any
• Intraday, balance and ancillary services markets are integrated with
the spot market
(PJM, US, Canada, Philippines, Australia, Iberia, Russia etc.)
Choices and Concerns in Market
Design
• Demand side bidding
• Bilateral contract driven market with imbalance market /
Net pool
• Gross pool with hedging
• Energy-only market or separate capacity payments
• Price cap specifications
• Mechanism for ensuring capacity adequacy
• Wholesale-retail price linkage
• Competition at retail level and hedging level
• Basis of pooling and recovering joint costs
• Transmission pricing
• Market power/ level of competition
Markets in Practice
Gross Pool with Capacity charge separation-
• PJM and New England, USA
• Philippines
• Chile
• England and Wales Pool till NETA
Gross Pool, Energy only-
• NEM Australia
• Old California Market
Net Pool, Energy only-
• NETA UK
• Nordic pool
FERC’s Standard Market Design
Key Points
• Non-discriminatory Open access Transmission
Tariffs
• Independent Transmission Providers (ITPs)
• Interaction of Spot markets and Bilateral
Contracts
• Locational Marginal Pricing and Congestion
• Long-term Resource Adequacy
• Market Power Monitoring and Mitigation
Open Access Transmission
Tariffs
• Access Charges to recover embedded
costs based on customer’s load ratio
share
• Applicable to all customers
• No physical rights on transmission
capacity
Locational Marginal Prices
• Cost of supplying additional MW at the
same location taking into account flow
induced losses and
congestion/decongestion
• Financial transmission rights to hedge
against LMP
• Bids can specify maximum congestion
charge or commit to pay congestion
charges
Markets and Contracts
• Day ahead and real time market for energy and
ancillary services
• All load scheduled only in day ahead market
including “bilaterals” subject to system feasibility
• Imbalances settled in real time markets
• Market clearing prices for each node
• ITP operates wholesale day ahead and real time
markets
Long-term Resource Adequacy
• ITP must forecast the demand
• Works with advisory committee to determine
future resources
– Generation, transmission and demand
response
• Assigns each LSE a share of future resources
based on its share of load
• LSE must submit plans for resources adequacy
with 12% reserve and are penalized/ curtailed
for lack of resources on time.
Market Monitoring
• MMU assesses annually
– Market concentration
– Demand response
– Transmission constraints
• MMU identifies on an ongoing basis
– Market design flaws
– Economic and physical withholding
– Barriers to entry and to competition
Thanks!
