Electricity Markets

CHRIS HARRIS is head of industry, networks and agreements in the retail division of RWE npower in the UK and has held senior positions in the generation and trading sectors of the Electricity Supply Industry. Previously he was a quantitative analyst, managing director of global derivative trading, and director of marketing in the capital markets. He has advised utilities in different parts of the world in the organisation and operation of their businesses, to align to, and optimise in, the structure of their respective electricity markets.

• Preface xixAcknowledgements xxiIntroduction 11 The Basics 71.1 How electricity works 71.2 Early development of the Electricity Supply Industry (ESI) 101.3 The lifecycle of electric power 121.4 Development, structure, coordination, legislation of the ESI 141.5 New ownership structure 151.6 Selected country examples 161.6.1 Europe 161.6.2 Development in the Americas 181.6.3 Australasia 191.6.4 Asia 201.6.5 Africa and the Middle East 202 Structure, Operation and Management of the Electricity Supply Chain 212.1 Energy sources 212.1.1 Fossil fuel 222.1.2 Nuclear 262.1.3 Renewable combustible matter 262.1.4 ‘Hot’ natural energy 262.1.5 ‘Cold’ natural energy 272.1.6 Hydrogen 272.1.7 Stored 272.1.8 Consumables 282.1.9 Integration of energy sourcing and power generation 282.2 Power generation 292.2.1 Turbine generation 302.2.2 Open cycle 312.2.3 Conventional thermal generation 312.2.4 Combined cycle 342.2.5 Combined heat and power (CHP) 342.2.6 Turbines driven by water 342.2.7 Wind 362.2.8 Non turbine generation 362.2.9 Distributed power generation 362.2.10 The production of environmental and amenity impact factors 372.2.11 Abating the production of environmental impact factors 402.2.12 Constructing the emission abatement stacks 442.2.13 Stock management 492.2.14 Flexibility 502.2.15 Reliability and availability 552.2.16 Reactive power 552.2.17 Three phase 552.2.18 Efficiency 562.2.19 Cost 582.2.20 Generation mix 592.2.21 Requirements for ancillary services 602.2.22 Plant dynamics 602.2.23 The relative value of the different forms of plant service 602.2.24 Generator hedging 612.3 High voltage transmission, network operation, system operation 622.3.1 Electrical networks 622.3.2 Functions associated with network operation 722.3.3 Coordinated planning of generation and transmission build 742.3.4 Signals to build 762.3.5 Interconnection 782.3.6 Charging mechanisms available to the grid and system operators 792.4 Distribution 812.4.1 The roles of the distribution network operator 822.4.2 Entry connection cost 832.5 Metering 842.5.1 Metering and the consumer experience 852.5.2 The metering lifecycle 852.5.3 Meter types 862.6 Supply 872.6.1 Billing 882.6.2 Consumer segmentation 892.6.3 Regulatory requirements 892.6.4 Consumer agreements 902.6.5 Supplier profit and loss profile in relation to wholesale price 932.6.6 Retail pricing 932.6.7 Hedging 952.6.8 Supplier risk and supplier charges 1012.6.9 Swing in industrial and commercial contracts 1022.6.10 Demand side management 1023 Policy – Issues, Priorities, Stakeholders, Influencers 1053.1 Agendas and policy formation 1063.2 Policy issues and drivers 1073.3 Policy outcomes and instruments 1103.4 Energy policies 1123.4.1 Policy trends 1123.4.2 Formation of policy 1153.5 Framework 1163.6 Domestic institutional players 1173.7 The role and influence of international players 1184 Liberalisation, Deregulation and Regulation 1214.1 The liberalisation paradigm 1224.2 Steps 1224.2.1 Unbundling (and de-integration) 1234.2.2 Corporatisation 1254.2.3 Ring fence some activities under state control 1264.2.4 Forced divestment and fragmentation of the incumbents 1274.2.5 Privatisation 1274.2.6 Deregulation 1274.2.7 Reregulation 1284.2.8 Further fragmentation 1284.2.9 Cross industry horizontal integration 1284.2.10 Re-consolidation 1284.2.11 Entry of financial institutions 1284.2.12 Pressure on retail deregulation 1284.2.13 Further deregulation of networks and metering 1294.2.14 Revise model 1294.3 Conditions for reform 1294.4 The role of the state 1304.4.1 The national macroeconomy 1314.4.2 Mechanisms of government influence 1314.5 Measures of liberalisation and deregulation 1324.6 Regulation 1344.6.1 Quid pro quo model for regulatory change 1354.6.2 Prescriptive model for regulation 1354.6.3 Regulatory engagement 1374.6.4 Economic regulation 1374.7 Regulators 1374.7.1 Regulatory indicators 1394.7.2 Market monitoring by the regulator 1394.7.3 Price regulation 1394.7.4 Rate of return regulation 1404.8 Industry key performance indicators 1405 Market Structures for Electricity 1415.1 The basics of plant dispatch 1435.1.1 Acquiring the information on demand 1435.1.2 Management of variation in demand in the centrally managed system 1455.1.3 Acquiring the basic information on generation capability 1465.1.4 Construction of the first trial schedule 1495.1.5 Schedule feasibility and adjustment 1505.1.6 Ancillary services 1585.1.7 Profiles within commitment periods 1585.1.8 Generator failure 1595.2 The centrally managed model 1605.2.1 Information and behaviour in centrally managed systems 1605.2.2 Introduction of Independent Power Producers (IPP’s) 1635.2.3 Consumers in the centrally managed system 1645.3 The single buyer 1645.4 The pool model 1655.4.1 The trial schedule in the pool 1665.4.2 Subsequent trial schedules and final initial schedule 1675.4.3 Demand 1685.4.4 Power capacity 1685.4.5 Penalty for failure 1695.4.6 Pool index 1695.4.7 Contracts for difference 1695.4.8 Supplier price 1705.4.9 Fixed cost recovery in the pool 1715.4.10 Price caps in static schedule 1715.4.11 Market power in the pool 1715.4.12 Information and communication in the pool 1725.4.13 Renewable and other generation with special treatment 1725.4.14 Offering and contracting strategy for generation plant in the pool 1725.4.15 Interpool relationships 1755.5 The bilateral model 1765.5.1 Contracting in the bilateral system 1765.5.2 Physical notification in the bilateral system 1765.5.3 The market operator in the bilateral market 1775.5.4 Operational strategy for contracted plant in the bilateral market 1775.5.5 Hybrid pool/bilateral markets 1785.6 Imbalance and balancing 1785.6.1 Market structure for balancing and imbalance 1785.6.2 Imbalance charging 1795.6.3 Provision of balancing 1795.6.4 Transmission effects in balancing 1805.6.5 Profile effects within the balancing period 1805.6.6 Transaction strategy 1815.6.7 Transaction cost minimisation 1815.6.8 Imbalance revenue distribution 1815.6.9 Auction choices 1815.6.10 Issues with balancing mechanisms 1825.7 Reserve contracts 1825.8 Wholesale markets 1835.9 Power exchanges 1845.9.1 The journey to power exchanges 1845.9.2 Specifics of power exchanges 1875.10 Advanced pool markets 1896 Power Capacity 1916.1 The definition of capacity 1916.2 Requirements for Capacity 1936.2.1 Generator failure 1936.2.2 Demand variation 1966.2.3 Network failure 1966.3 The basic economics of provision of capacity and reserve by generators 1976.3.1 Representation of generation capacity on the power stack 1976.3.2 Provision of capacity by a unit 1976.4 Modelling the capability of generation capacity 2006.4.1 Capacity effect of take or pay fuel supply contracts 2006.4.2 Capacity effect of annual emission limits 2026.4.3 Capacity effect of port and other infrastructure contracts 2036.4.4 Capacity effect of coal stocking 2036.4.5 Capacity effect of plant life usage optimisation 2046.4.6 The role of outage management in capacity 2056.4.7 Generation above normal maximum capacity 2056.4.8 Long term capacity 2066.4.9 Hydro 2076.4.10 Pumped storage 2076.5 Modelling capacity capability from the consumer side 2086.5.1 Modelling value of lost load as a capacity capability 2096.6 Commercial mechanisms – the generator perspective 2096.6.1 Day ahead capacity payments in pool markets 2106.6.2 Fixed cost subsidy, marginal cost energy provision 2146.6.3 Traded options and capacity contracts 2146.6.4 Self insurance for generator shortfall 2176.6.5 Mutual insurance 2186.6.6 Value from rare but highly priced energy contracts 2196.6.7 Reserve contracts 2206.7 Capacity provision – the supplier’s perspective 2206.7.1 Requirements to secure capacity by load serving entities 2206.8 Capacity provision – the network operator’s perspective 2236.9 The system operator’s perspective 2246.9.1 Cost to consumers 2246.9.2 Placing capacity obligation with the system operator 2266.9.3 Placing the capacity obligation with the regulator or ministry 2266.10 Capacity facilitation – contractual instruments 2266.10.1 Generator cover 2276.10.2 Insurance and reinsurance 2276.10.3 Traded options 2356.11 Use of options to convey probability information 2356.12 Effect of price caps on capacity and prices 2377 Location 2397.1 Infrastructure costs to be recovered 2407.1.1 Build and maintain 2407.1.2 Losses 2417.1.3 Reactive power 2417.1.4 Redundancy and security 2417.1.5 Cost of constraint 2427.1.6 Commercial losses 2427.1.7 Wheeling and interconnection 2427.2 Counterparties for payment and receipt 2427.3 Basic charging elements for location related charging 2437.3.1 Connection charges 2437.3.2 Use of system charges 2437.3.3 Calculation of capacity cost in relation to system capacity need 2457.3.4 Losses 2457.3.5 Locational element of balancing 2477.3.6 Locational element of reserve and security 2477.3.7 Regional structure for cross subsidy 2477.3.8 Constraints 2487.3.9 Reactive power 2487.4 Models for designation of electrical location 2497.4.1 Postage stamp 2497.4.2 Zonal 2507.4.3 Postage stamp with market splitting 2507.4.4 Nodal 2517.4.5 Implicit locational differentials 2537.4.6 Control area 2537.4.7 Position in voltage hierarchy 2537.5 Nodal energy prices, virtual transmission and nodal market contracts 2547.5.1 Market models 2547.5.2 Transmission allocation at system borders 2587.5.3 Connection allocation 2607.5.4 Integration of location based charging elements 2607.6 The energy complex 2607.6.1 Case examples 2607.6.2 Global opinion 2627.7 Environmental borders 2638 Environment, Amenity, Corporate Responsibility 2658.1 Environmental pressure 2658.2 Definitions 2668.2.1 Definition of production of potential impact factors 2688.2.2 Definition of impact 2698.2.3 Definition of sensitivity of impact factors once produced 2728.3 The policy debate 2738.4 Regulation and incentive for restricting emissions and other impacts 2748.4.1 Continuous limits 2748.4.2 Non instantaneous limits 2758.4.3 Environmental tolerance limits and translators 2768.4.4 Technology prescription or limits 2768.4.5 Self regulation 2778.4.6 Annual limits (caps) 2778.4.7 Cap and trade 2798.4.8 Emission allowance auctions 2838.4.9 Trade no Cap 2838.4.10 Taxes 2838.4.11 Cap and tax 2848.5 Other policy tools for environmental enhancement 2858.5.1 Feed in renewable generation 2858.5.2 Renewable obligation 2858.6 Fuel labelling and power content labelling 2868.6.1 Physical power labeling 2928.7 The cost of environmental enhancement 2928.8 Valuation of environmental factors 2928.9 Corporate responsibility 2938.10 The environmental impact of consumption 2949 Price and Derivatives Modelling 2959.1 Price processes and distributions 2969.1.1 Price processes 2969.1.2 Random walk 2969.1.3 Terminal distributions and price returns 2989.1.4 Transformation of process and Ito’s Lemma 2989.1.5 Normal and lognormal distributions 2999.1.6 Skewness 3019.1.7 The Poisson process 3019.1.8 Jump diffusion 3029.1.9 Central limit theory 3039.1.10 Extreme value theory 3039.1.11 Mean reversion 3049.1.12 Mean reversion with jump diffusion 3069.1.13 Regime switching 3079.1.14 Markov processes 3099.1.15 Spot and Forward price processes 3109.1.16 The choice between spot and forward price processes 3179.1.17 n factor processes 3189.1.18 Correlation 3189.1.19 Co-integration 3219.1.20 Conditional expectations 3219.1.21 The denominator 3259.1.22 Cost of risk 3259.1.23 Transaction cost 3279.2 Volatility modelling 3289.2.1 Term structure of volatility – TSOV 3289.2.2 Smile and skew 3359.3 Correlation modelling 3379.3.1 Cross commodity correlation modelling 3379.3.2 Commodity spread modelling 3389.3.3 Correlation between long and short duration contracts 3399.3.4 Correlation measurement using historic data 3409.3.5 Correlation models 3419.3.6 Principal components 3449.4 Pricing electricity derivatives 3469.4.1 Average rate contracts 3479.4.2 European options 3479.4.3 American options 3489.4.4 Swing options 3499.4.5 Monte Carlo Simulation 3499.4.6 Modelling with trees 3509.4.7 Modelling swing contracts using semi-analytic methods 3579.4.8 Volume options 3579.4.9 Imbalance pricing 3589.5 Establishing fundamental relationships 3599.5.1 The exogenous and endogenous worlds 3619.5.2 Price Growth 3649.5.3 Weather, climate, daylight 3659.5.4 Consumer contracts 3709.5.5 Valuation of physical assets and risks 3729.5.6 Pricing using world views 3759.6 Market completeness 3769.6.1 The completeness of markets with options 3779.7 Emission permit prices 3789.7.1 Forward price profile 3789.7.2 Banking and borrowing 3789.7.3 Volatility of permit prices 3799.8 Network price volatility 37910 Economic Principles in Relation to the ESI 38110.1 Basic economic principles in an ESI context 38110.1.1 Microeconomics and macroeconomics 38110.1.2 Classical economics 38210.1.3 Neoclassical economics 38310.1.4 The economics of the margin 38510.1.5 The demand function 38710.1.6 The production function 39110.1.7 Surplus 39210.1.8 Pareto optimisation 39310.1.9 Utility 39610.1.10 Welfare 40110.1.11 Preference 40210.1.12 Contingent valuation 40610.1.13 Valuation approaches to mortality and morbidity 40710.1.14 Policy 40710.1.15 Discriminatory pricing 40810.1.16 Problems with cross subsidy and redistribution of wealth 41110.1.17 Public goods and private goods 41310.1.18 Existence value 41410.1.19 Goods and bads 41410.1.20 Externalities 41410.1.21 Equilibrium 41510.1.22 Trade 41610.1.23 Fixed and marginal costs 41910.1.24 Cost of capital 42010.1.25 Fundamental measures 42210.1.26 Hedonic and shadow prices 42310.1.27 Price growth 42310.2 Optimal pricing by asset owners 42410.2.1 The privately owned monopoly operator 42410.2.2 Forward hedging – timing effects 42510.2.3 Fixed cost recovery 42510.3 Regulated prices 43310.4 Taxes and subsidies 43410.4.1 Deadweight loss of taxes 43510.4.2 The role of the ESI in the fiscal structure of the macroeconomy 43510.5 Games, interaction and behaviour 43610.5.1 Use of information without interaction 43710.5.2 Local consolidation 43810.5.3 Collaboration 43810.5.4 Repeated games 43910.5.5 Interactive behaviour of mid merit plant 43910.5.6 Interactive behaviour of low merit plant 44010.5.7 Reaction curves 44010.5.8 Sequential quantity response – Stackelberg game 44110.5.9 Simultaneous volume response – Cournot game 44210.5.10 Comparison of Stackelberg and Cournot outcomes 44310.5.11 Price leadership – Bertrand game 44310.5.12 Gaming and payoff matrices 44410.5.13 Nash equilibria 44510.5.14 Repeated games and cooperative games 44810.5.15 New entrance – pre-emption and optionality 44910.5.16 Gaming by institutions 45010.5.17 Auctions 45110.5.18 Focal points 45210.5.19 Supply function equilibria 45210.6 Environmental economics 45510.6.1 Valuation 45510.6.2 Environmental taxes 45610.6.3 Property rights 45910.7 Market failure 46110.8 Shocks 46210.9 The political economics of liberalisation 46411 Financial Modelling of Power Plant 46711.1 Power plant financial model 46711.2 The baseload contract 46911.2.1 Contracts on failure 47011.3 The planned flexibility contract 47011.4 The vanilla option contract 47011.4.1 Cost of the reliability contract on the option contract 47111.5 Extra flexibility 47111.6 Finance and hedging 47211.6.1 Plant failure as a limiting factor in growth and return 47211.6.2 Cost of risk 47411.6.3 Value at Risk – VAR 47511.6.4 Corporate financial measures 47511.7 Accounting 47612 Security of Supply 47712.1 Supply chain 47712.1.1 Sources 47812.1.2 Power generation capacity 47912.1.3 Transmission 48012.1.4 Distribution 48012.1.5 Suppliers 48012.1.6 Consumers 48112.2 Reserve margin 48112.2.1 Scenario approach concept of reserve margin 48112.2.2 Probability approach to reserve margin 48212.2.3 The effect of import, export and transit 48312.3 The responsibility for security of supply 484Appendix 485A.1 Plant life usage 485A.2 Power plant failure and physical risk 487A.2.1 Causes of failure 487A.2.2 Combinatorial analysis 487A.2.3 Monte Carlo modelling 488A.2.4 Cost of failure 488A.2.5 Hedging return to service 488A.2.6 State space modelling of power plant 489A.3 Reactive power 491A.4 Direct current load flow modelling 493A.4.1 Calculating transmission charges from DC load flow 495A.4.2 Calculation of losses 495References 497Index 507