To pool or not to pool?

Paul Giesbertz, Konstantin PetroKema Consulting, Germany

Most European countries have adopted a power model with bilateral contracts and a voluntary power exchange. However, others, like several Asian countries, are implementing pool models which specifically offer advantages for smaller power systems in developing countries.

Click here to enlarge image

The alternative to a power pool model is a market mechanism based on bilateral contracts

Several market models for the design of liberalized power markets have been used and implemented in various countries throughout the world. Basically one could distinguish two market mechanisms:

  • power pools
  • bilateral contracts.

    In a power pool, generating companies offer price-quantity pairs for the supply of electricity. This forms an industry supply curve. The offered prices can be based on predetermined variable costs (such pools are referred to as cost-based pools) or the generators can be free to offer any price they like between certain general minimum and maximum prices (such pools are referred to as price-based pools). On the demand side, the market operator may forecast demand and dispatch generating units against this. This is called a one-sided pool. In more sophisticated pools (two-sided pools), the market operator may dispatch on the basis of a demand curve created from price-quantity bids made by the buyers on the market.

    Bids and offers are normally firm, this means that if these bids and offers are matched in the market clearing process, they result in an obligation to take, respectively, deliver the matched volumes and these volumes will be financially settled.

    The pool can operate a day-ahead market (like in the old England and Wales Pool ) or a market close to real time (e.g. five minutes-ahead). The Russian Federation is preparing a day-ahead pool with a balancing market for real time balancing. There can also be a combination of several markets (day-ahead, intra-day and five minutes-ahead).

    An example is New England in the USA. A similar model was proposed two years ago by the National Energy Policy Office (NEPO) in Thailand. However, this model has not yet been accepted for implementation.

    In the case where only a five minutes-ahead power market is operated, other sessions can still be run on the basis of non-firm offers and bids. Sessions such as these are used to create a forecast of the market prices as an indication for all of the market participants.

    Such price seeking sessions are based on non-firm offers and bids and are important to allow for demand side response in case of high market prices. Examples of such market models include New Zealand, Ontario (Canada), Singapore and South Korea (in preparation).

    Contracts

    In parallel to the pool, market participants could also enter into bilateral contracts for power. These contracts do not necessarily have to be financial bilateral contracts, but may also be bilateral contracts for physical delivery. In that case, only the differences are settled through the pool, but the dispatch of power plants is not affected by these physical bilateral contracts. Pure financial bilateral contracts offer similar advantages. However, one might want to offer maximum freedom to market participants and for that reason, allow for physical bilateral contracts.

    Bilateral contracts model

    The alternative to a power pool model is a market mechanism based on bilateral contracts. This means that sellers and buyers freely enter into bilateral contracts for power supply. Sellers will normally be generators and buyers will be distribution companies and eligible consumers. However, generators could also become a buyer (e.g. in case of a generation shortage). Likewise, consumers can become sellers. In other words, each market participant becomes a trader. Brokers can act as an intermediate between buyers and sellers.

    These types of transactions are referred to as over-the-counter (OTC). In reality, there will always be differences between the contracted volumes and the actual metered volumes. This means that the system operator will have to determine these differences (or imbalances) and will have to settle them. In more advanced markets, the system operator runs a balancing market (or regulating power market) in order to establish a market-based price for the settlement of these imbalances.


    Power pools have a number of advantages over bilateral contract-based systems, but involve higher set-up costs.
    Click here to enlarge image

    null

    In parallel to the bilateral contracts, a voluntary power exchange could be set up or could develop in the future on the initiative of the market participants. A power exchange could offer day-ahead and intra-day with the following benefits for the market participants:

    • more price transparency
    • no counter-party risk
    • anonymous trading
    • tool to optimize trading portfolio.

    Such a power exchange could be handled by the system operator as a normal trader, although the power exchange would be a special type of trader as its total of sale and purchase contracts is always balanced per definition. The power exchange will have no metered generation or consumption and will therefore never have imbalances.

    The model with bilateral contracts and a voluntary power exchange has been implemented in several European countries, with exchanges in The Netherlands, France, the

    pean countries, with exchanges in The Netherlands, France, the Scan-

    dinavian countries, Germany, Poland and Austria. One can even have several competing exchanges in one country, as was the case in Germany (EEX and LPX) and still is the case in England (UKPX and APX).

    In the bilateral contracts mechanism, there are multiple buyers and sellers with numerous bilateral transactions. Another variant of the bilateral contracts mechanism is “wheeling”. Wheeling means a limited number of bilateral transactions alongside a vertical integrated structure. Wheeling has been proposed in several countries either by integrated utilities in order to defend their existing monopoly or by regulators to introduce a limited form of competition and open access. In markets with mature competition, such wheeling form of access is not a relevant.

    Comparison

    These two differing models (pools and bilateral contracts) would be equivalent in a world without transaction costs. D. Kennedy[1] states the following: “In a world with transaction costs, the contracting model may result in a sub-optimal outcome. In other words, price and quantity that do not reflect real-time demand and supply. In a pool, prices and quantities should reflect actual demand and supply, more so depending on how far ahead of real time trading occurs. Though prices in a pool may be more volatile than in a contracts market, there are hedging instruments available (for example contracts for differences). In terms of institutional capacity, a simple contracts market is more straightforward and less expensive to set up than a power pool.”

    The advantage of pool mechanisms is that they give more optimal outcomes. The disadvantage of pool mechanisms is that higher costs would be necessary to set up such a pool. This disadvantage should not be over-estimated as the bilateral contracts mechanism would also require some form of central balancing mechanism. Also the frequently stated theoretical disadvantage of the pool mechanism, higher price volatility, is of limited relevance, as financial instruments can be used for hedging. Moreover, if the market is operated as a cost based pool, price profiles will strictly follow the short run marginal cost dynamics and volatility will be low.

    At the same time it has become apparent that both models (pools and bilateral contracts) might not be so different. A pool could have bilateral contracts alongside the pool and in a bilateral contracts mechanism a voluntary power exchange could be considered. To better illustrate the difference between both models one can distinguish between market models with central dispatch of generating units and mechanisms with self-dispatch of generating units. Normally, central dispatch of all generating units is related to mandatory pools. Self-dispatch means that generators decide on the dispatch of their own generating units and this regime applies to bilateral contracts models.

    The characteristic of central dispatch can offer important advantages:

    • It allows for more integrated treatment of generation and transmission plant. This means that transmission constraints can be managed more efficiently.
    • The principle of central scheduling and dispatch normally builds on current practices for systems that are in the process of implementing liberalized market models.
    • Central dispatch allows for the application of nodal pricing. Nodal pricing can only be applied if all relevant information for both generation and transmission are known at a central level. Theoretically this allows for provision of the right signals for usage and development of the electricity system. Examples of the application of nodal pricing can be found in the US, Singapore Chile and Argentina. Also the Russian Federation is preparing a market with nodal pricing for a system of over 7000 nodes.

    Cost-based pools

    Cost-based pools limit generators in their freedom to set offer prices. Therefore cost-based pools are often considered to be inferior in comparison to price-based pools. The nature of cost-based pool mechanics pre-determines the limited degree of price volatility. Differently, in a price-based pool environment, the high price volatility is mainly caused by the freedom in setting offer prices and by the special characteristics of electricity as a good:

    • supply and demand must always be balanced
    • storage of electricity is feasible only to a very limited extent
    • price flexibility of demand is very low.

    This always entails a risk that dominant players can use their market power to set market prices. Accusations of price manipulations have been made in several European countries (like in 2001 in the Netherlands and Germany, with extreme price peaks on respectively the APX and LPX) but also in Australia and New Zealand. The duopoly of National Power and PowerGen in England and Wales caused significant problems in the operation of old pool of England and Wales. Price manipulation (by means of capacity withdrawal) has also played a major role in the Californian crises. It is estimated that for that reason, the total costs of supply have increased by $9 billion between May 2000 and April 2001.


    Although most European countries have implemented a market model based on bilateral contracts and a voluntary power exchange, the pool model is still very relevant.
    Click here to enlarge image

    null

    Volatile pool prices and risk of market abuse entail a serious risk for possible investors for new generating capacity and therefore could endanger system security in the future.

    Cost-based pools also have some disadvantages in comparison to price-based pools:

    • Less market price response
    • Possibility of disputes on costs
    • Need for central scheduler.

    Generators in a cost-based pool are obliged to offer their units at the predetermined marginal costs of the generating units. The system marginal price is therefore less volatile in comparison to price-based pools, where generators are free to offer any price. This might lead to high or even extreme prices in periods of shortages and such price peaks will trigger demand response. Demand response (i.e., voluntary demand reduction) is an important element in well functioning markets.

    Alternative market model

    There are significant international experiences with cost-based pools, especially in South America. Chile has played a key role in the world wide trend of liberalization and deregulation. The country has 16 years of experience with a cost-based pool. Within this period the industry has been gradually privatized. It has attracted substantial volume of private investments and reliability and quality levels have been maintained despite an average yearly demand growth of seven per cent. Argentina has further improved the Chilean model mainly by creating more market participants and increasing competition. The market model in Peru is more or less a copy of the Chilean model, whereas Colombia introduced a model strongly based on the old England and Wales pool model.

    Accusations of price manipulations have been made in several European countries, but also in Australia and New Zealand

    Reference

    [1] D. Kennedy, Regulatory reform and market development in power sectors of transition economies: the case of Kazakhstan, Energy Policy 30, 2002

  • No posts to display