Three Lecures on Understanding Electricity Markets: Introduction

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Three Lecures on Understanding Electricity
Markets Introduction

• Derek W. Bunn
• London Business School

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• Derek W. Bunn is currently Professor and Chairman
  of the Decision Sciences subject area and
  Director of the Energy Markets Group at the
  London Business School. Having read Natural
  Sciences at Trinity College, Cambridge, he
  received at PhD in Economics from London Business
  School (1975), and was subsequently elected CEGB
  Fellow in Engineering Economics at Worcester
  College, Oxford University. Occasionally since
  then, he has been a visiting professor at
  Stanford University in California. Author of over
  180 research papers and 10 books in the areas of
  forecasting, decision analysis and energy
  economics, the latest of which are Systems
  Modelling for Energy Policy (Wiley, 1997),
  Strategic Price Risk in Wholesale Electricity
  Markets (Risk Publications, 1999) and Modelling
  Prices in Competitive Markets for Electricity
  (Wiley, 2004). He is Editor in Chief of the
  Journal of Forecasting, Honorary Editor of Energy
  Economics, as well as having served on the
  editorial boards of 12 other academic journals.
  As a prominent international advisor on energy
  economics, he has consulted for many global
  energy companies and advised a number of
  government agencies.
• London Business School, Sussex Place, Regents
  Park, London NW1 4SA, ENGLAND
  
• Tel [phone], Fax 44 (0) 20
  7724 7875,
• Email dbunn_at_london.edu

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Overview Three Lectures

• Understanding Liberalised Electricity Markets
• How the Competitive Markets Work
• Transmission, Trading and Retail Issues
• Institutional Change and Regulatory Policies
• Modelling Strategic Market Evolution
• Strategic Behaviour and Gaming
• Agent Based Simulation Methods
• 3. Econometric Modelling of Price Formation
• Fundamental and Dynamic Analysis of Prices
• Volatility and Risk Premia
• Transmission Capacity Auctions

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Todays Agenda

• Electricity and Energy Market Drivers of Change
• Global Issues in Power and Gas
• Fundamentals of Power System Economics
• Wholesale Market Mechanisms
• Price Setting and Price Manipulation
• Competitive Market Evolution
• Strategic Opportunism and Regulatory Restraint
• Tomorrow will then mainly be on
  modelling..

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The Global Context.
27 of the World Population have No
Electricity In SE Asia it is 60 In Sub
Sahara Africa it is 78 80 of those without
power are Rural, and many live on Small
Islands. Electrification is a social and
economic need, but how and who will
provide? These will require quite different
solutions from the network systems we see in
developed countries
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The Investment Challenge

• IEA projects current trends lead to a 60
  increase in world energy demand by 2030.
• 85 of this will be fossil fuel (coal, oil, gas)
• 66 will be in the developing world
• Over half of the oil will still be from OPEC
• No power costs more than no power (Indira
  Ghandi)
• Economic growth in many developing countries has
  been restrained by power shortages
• World Electricity Investment needs to be 16
  trillion and in OECD alone, 4 trillion
• For growth, replacement, and infrastructure
• But Governments now expect the Market to
  Provide.

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Electricity is produced as a commodity..
and consumed as a service
Generators
Consumers
Physical Electricity Flow
Distribution
Transmission
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Unbundling and the Introduction of Markets
Generators
Consumers
Suppliers
RETAIL MARKET
WHOLESALE MARKET
Contract Flow
Physical Electricity Flow
Distribution
Transmission
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The Standard Electricity Liberalisation .

• Wholesale Competition introduced between
  generators to lower the commodity price
• Wholesale Markets (Pools or Exchanges) facilitate
  trading
• Retail Competition introduced between retail
  distributors to lower the cost of service.
• Network Monopolies, Transmission and
  Distribution, remain Regulated.
• Full Unbundling of the Ownership of Generation,
  Transmission, Distribution and Retail usually
  advocated for efficient new entry and exit. (But
  Vertical Integration is becoming widely tolerated
  )

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Electricity Liberalisation became a world trend

• Why?
• Belief in markets to deliver more efficient
  investment and productivity gains. This should
  lead to lower prices (?)
• Ideologies Popular Capitalism, Privatisation,
  Single Markets
• Leaders and Followers
• Early 1990s Chile, NZ, UK, Norway
• Mid/Late 1990s California, NE US, Australia,
  Nordic, Spain, Germany
• 2000s Italy, France the rest of the EU,
• And then there were the crises California,
  Enron, British Energy and Blackouts ..

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But Energy Policy is delicate and contradictory.

• The Electricity Sector is being shaped by
  inherent conflicts.
• Institutional Drivers
• Economic Ideologies of Liberalisation
• Industrial Competitiveness
• Concerns about security of supply
• Responsibilities for public service
• Worries on Global Warming
• Fundamental Drivers
• Demand and Supply
• Geopolitics of Fuels
• Strategic Drivers
• Shareholder Value Growth and Returns
• Market Structure and Market Power

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Fundamentals First.

• Before competitive markets arrived, the major
  uncertainties were
• Demand Growth
• Technology Choice
• Fuel Costs
• These are still fundamental, especially the
  primary fuel markets coal, oil and gas
• And this is the way Commercial forecasting
  products still work.

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Analysts used to think demand increased
exponentially, simply with GDP and Population
German Energy Forecasts
But we are now aware of declining energy
intensities
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Total Energy Consumption per GDP
16,000
14,000
12,000
10,000
United States
United Kingdom
8,000
Germany
France
6,000
4,000
2,000
0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
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United States
United Kingdom
Germany
France
China
India
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
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Oil is still the Basic Commodity
Transport is crucial, but still widely used for
Power Generation Gas Prices are often
linked Continental European Gas Prices tend to
lag 3-6 months to a moving average of 6-9
months Oil Prices Always been difficult to
forecast Oil Prices.
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In 1982, when considering new power investment in
the UK.
Observe the implicit Random Walk thinking
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Even an apparently wide range soon appeared too
narrow
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By the 1990s, analysts thought oil was
mean-reverting
10 year High, Reference and Low Oil Price
Scenarios (US Dept of Energy)
Jan 2005 Forecast2Forecast004
H
R
L
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Gas has now become a major focus of interest.
Gas Demand
Oil Demand
CAGR 3.5 (2005 2015)
CAGR2.2 (2005 2015)
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Where are the Gas Reserves?
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Liquefaction costs trend continues
per tonne of capacity
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Global LNG Supply Sources
90
Guinea
80
Angola
Snøhvit
70
Libya
UAE
60
Yemen
Venezuela
50
Oman
Brunei
bcfd
Bolivia
40
Egypt
Malaysia
30
Trinidad
Australia
20
Indonesia
Nigeria
Algeria
10
Iran
Qatar
0
2005
2010
2015
2020
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Electricity Fundamentals Continued.

• Before competitive markets arrived, the major
  uncertainties were
• Demand Growth
• Fuel Costs
• Technology Choice
• And Investments reflected an Economic and
  Political mixture of
• High capital cost/low operating cost plant for
  baseload (eg nuclear)
• Low capital cost/high operating cost plant for
  peaks (eg gas)

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Demand Drivers are Fundamental

• In the longer term, we have
• economic activity, population growth
• technological change and conservation
• In the shorter term, we have
• weather (temperature, cloud cover, wind)
• daily and seasonal patterns of consumption
• unusual business and social events

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Typical Summer and Winter Demands
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Weather Effects on Winter Demand
Meteorological Variable
Response (MW)
Generating Unit
Temperature (a fall of 1 Celsius in
freezing conditions)
Wind (an increase of 10 knots in freezing
conditions)
Cloud cover (from clear sky to thick cloud)
Precipitation (from no rain to heavy rain)
Based on 500MW Source NGT
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Effects of popular weekly TV
shows, eg EastEnders
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Unusual TV events are harder to
predict
31000
Full-Time

600 MW
Audience
12 - 14 million
30500
30000
Demand
Half-Time
900 MW
29500
England V Germany
29000
Previous Saturday
28500
1900
1905
1910
1915
1920
1925
1930
1935
1940
1945
1950
1955
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
2055
2100
Time
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So what does this mean for the mix of generating
plant?

• Some plant has to respond quickly to demand and
  may not run for very long
• What kind of start-up and running costs do we
  need
• for this purpose?
• This is known as peaking plant
• In contrast to plant which is the cheapest to run
  continuously throughout the day and night
• Which is known as baseload plant

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German Technology Mix

• Gas is mainly peaking
• In the UK, it is mainly baseload

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The Economic Mix of Technologies

• The system consists of Peaking and Base
  Load Plant which differ in terms of
• Basic Economics
• Base load is low variable cost
• Peaking is low investment and fixed cost
• Technical Capabilities
• Peaking Plant will have to be more flexible
• with faster start-ups, and lower start-up
  costs.
• The Cost of Power from Each Technology
• Depends upon Both Fixed and Variable Costs
• And also?

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Apart from the fundamental demand cycles,In
competitive markets, the utilisation depends upon
competition in the wholesale market.In the
wholesale market, the Stack of plant is the
basic concept for price formation.
Utilisation
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Prices in Wholesale Markets (Power Pools) are
often set as followsFor Each Trading Period (eg
Hour), Demand is Forecast or Bid into the market,
Plant are Stacked According to Offer Prices ie
marginal cost plus Mark-UpMarket Price is the
Price of the most Expensive Genset Required to
meet the Forecast
Price
Demand
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Why are Wholesale Power Prices simply not
Proportional to fuel prices?
Power
Gas
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Why are Forward Prices Closer?
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Why do Electricity Market Prices Differ?
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But these change and so, Two Years later
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Hydro Intensive Systems have Prices which Depend
Upon the Weather
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But the Story of Prices in the UK was Market
Power and Regulatory Risk
Time Weighted Average Monthly Pool Prices
24 Average Price Cap
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Focus on Wholesale Markets in
context
ENGLAND WALES ANNUAL ELECTRICITY PRICE HISTORY
1990 - 2003
Source EIA
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Electricity Value Chain

• Value chain for supply of a typical
  household in Germany (2003)

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7
63
wholesale trade
transport
distribution
retail
production
9,7 ct/kWh
Additional fees and taxes (42 of total bill)
1,8 ct/kWh
0,8 ct/kWh
2,05 ct/kWh
2,3 ct/kWh
subsidies for CHP and renewables
concession fee
electricity tax
VAT
16,7 ct/kWh
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EC Breakdown of Expected Electricity Prices in
2004for 50 MWh/year small commercial customer
(/MWh)
Regulatory Benchmarking is becoming more
Prevalent.
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Key Market Issues in the Electricity
Value Chain

• The Wholesale Market
• How do Pools and Power Exchanges work?
• How is real-time Energy Balancing achieved and
  paid for?
• Efficiency of prices in the short term
• Investment signals for the longer term
• The Transmission System
• Third Party Access and Use of System Charging
• Inter Regional Trading
• System Balancing
• The Distribution Network
• Regulation
• The Retail and Energy Supply Business
• Market Segmentation and Churn Rates