Back to the Future
Set in 2003, a report by Cap Gemini, Europe`s largest IT consultancy, looks at how the UK electricity market has developed and the shape of things to come.
In 1998 it was decided that “choice” ought to be central to the new trading arrangements in England & Wales. The DTI/Offer review of electricity trading arrangements swept away the old model and replaced it with a model that drew heavily upon the principles behind NordPool and the gas market in Britain. As we enter 2003, the new model has operated successfully for three years and is today proving to be the model that others seek to emulate. Indeed, even NordPool has been refined in light of the new model in England & Wales.
There have been a number of benefits due to the arrangements, benefits which stem from the following:
• Customers used to increasingly sophisticated services have asked utilities to respond with innovative utility services. This pull effect has been passed up the supply chain with generators being forced to deliver new and innovative bilateral contracts;
• Pricing has become more cost reflective and generators have been forced to examine their cost base very carefully in order to remain competitive. On average this has resulted in price reductions to customers up to 20 per cent;
• Transparency in the market place has helped liquidity in the contracting market.
In 1998 the compulsory Pool was replaced by a choice of trading arrangements. Before physical delivery, the new trading arrangements allow for a whole series of ex-ante transactions. These might be direct bilateral trades between willing buyer and willing seller, or through the Electricity Exchange, where the exchange acts as a clearing house for a standard fee, thereby eliminating counter-party risk. Trading on the Electricity Exchange is conducted via an electronic trading system. The market operates continually, with trading for each half hour period ceasing 30 minutes prior to the event. Trading is by both physical and financial traders, for any period up to five years ahead.
The following provides an example of how the ex-ante markets work.
Three months prior to the day of physical delivery, a buyer enters into a bilateral contract to purchase 250 MWh in a half hour of a particular day. However, a few days prior to the event its expectations may have changed, now expecting to sell only 200 MWh to its customers in the relevant half hour. Accordingly, the buyer would look to sell contracts to take 50 MWh in the relevant half hour. A willing purchaser could be either another buyer who expects to sell 50 MWh more to its customers, or a generator (seller) expecting to generate 50 MWh less. Alternatively, a financial trader may purchase the futures contracts to take 50 MWh in the relevant half hour, expecting to either sell the contract ex-ante at a profit, or make a profit if the price in the residual balancing market is higher than the price in the contract.
As in NordPool, the key requirement of all ex-ante trades is that they are firm financial commitments. Although choice is the key tenet of the trading arrangements, having made the choice of how one contracts in advance of physical delivery, all ex-ante commitments are deemed to be firm, regardless of whether they are bilateral or through the electricity exchange.
Although they have also been described as firm physical commitments, in reality this can never be. One cannot be forced to take or indeed generate electricity, but one can be financially committed. At the time of the 1998 Pool Review, a lot of nonsense was spoken regarding the difference between physical traders and financial traders. Some sought to treat the two differently, with suggestions such as giving the market administrator the power to adjust the positions of purely financial traders so that they “traded into balance” ex-ante. This was supposed to prevent financial traders from impacting operational decisions with respect to scheduling and despatch.
Thankfully, such distinctions were never allowed to influence the new design. Instead, all trades (and traders) are treated the same. This simplification had far reaching consequences, that saw the volumes traded grow to be many times the physical volumes generated. A liquid market resulted, in which the market power of the dominant marginal generators was considerably weakened. As had been the case in other markets, financial trades had become more significant than the underlying physical trades.
The market in 2003 has been influenced by a large number of significant factors. Whilst there is disagreement among observers as to which are the most significant, all would confirm these factors have been important in shaping the market into the success now operating in 2003.
Key players: The key players fall into the following four broad categories:-
• Successor electricity companies;
• Other suppliers; and
Successor electricity companies: These companies fall into two categories: the few regional electricity companies (RECs) that have merged with other RECs; and the major generators who have vertically integrated by purchasing a REC.
In 1999, all RECs were required to split their distribution and supply functions into separate subsidiary companies. These distinct companies were separately licensed, with their supply businesses subject to residual price control which was phased out by 2003 and distribution companies regulated via RPI-X price control.
This led to a number of consolidations between RECs who were easily able to combine similar businesses gain- ing the benefits from economies of scale. Also some of these companies have be- come vertically integrated by gaining generation capability either by building new plant or purchasing existing plant.
National Power, PowerGen and British Energy vertically integrated by each purchasing a REC. By 2003, although generation market shares have fallen, these companies still collectively generate a significant proportion of the total TWh produced. The review suggested the break up of National Power and PowerGen several times, but was never implemented. One reason was the growth of these businesses into strong global energy companies (through new investment and merger/acquisition).
Another is believed to have been that a deal was struck requiring that these large companies sign contracts to support British mining by using clean coal technologies. This was effected by replacing the coal fired boilers of existing stations with a pressurised fluidised bed (PFB) gasification unit. These PFB units power first stage gas turbines with the exhaust heat from the gas turbines recovered and passed to the existing steam turbines. Such generating capability is more expensive to install, but has greater thermal efficiency and lower emissions.
Other suppliers: Other suppliers such as multi-utilities and new entrants exerted different pressures for other reasons.
For established multi-utilities there was an obvious anomaly between the operation of the gas market and the electricity market in 1998. Most of the players in electricity were in gas and British Gas was, conversely, in electricity. It became clear that these markets could and should be harmonized to provide consistency in trading and also to ease the regulation problems.
The other pull pressure came from new entrants who expressed concern at the lack of transparency within the market with no rational economic signals being sent. This had a knock-on effect on the liquidity of the market. Without transparency it is difficult for traders to create a market able to react to economic signals.
Traders: These companies are financial and physical speculators who look to take on risks for the appropriate rewards. With the introduction of the new market mechanisms, leading to transparency and clearer economic pricing signals, a few financial institutions decided to begin trading financial instruments linked to the prices of wholesale electricity. This initial step was seen as successful and as a result more similar traders entered the market. These players have now helped to create liquid markets which are less dominated by the incumbent players. Indeed, today the volume of financial trading is ten times the volume of physical trading.
Trading issues: There has been an increased level of activity with regard to interconnector trading. This has been made possible by increasing the capacity of the existing links (with France and Scotland) and creation of three significant new links:
2) Scotland-Northern Ireland
3) Northern Ireland-Irish Republic.
The trading method (known as “superposition”) across these various links has led to harmonization in the wholesale prices across Great Britain/Ireland and to some degree France and Denmark. Superposition is an arrangement where trading across an interconnector can be superimposed so that only net trading equates to the physical flows across the link. In turn, gross trading levels are only limited to a requirement to ensure there is a match between net trading and the physical flows. For example, a 2000 MW link may have 6000 MW of trading in one direction so long as 4000 MW of trading takes place in the opposite direction.
There are currently only two generic structures for trading electricity exist across Europe; the England & Wales/NordPool concept, and the French Single Buyer model. Within the European Union, there has been much debate as to which should be the “standard” model adopted within every member country of the entire European Union.
The England & Wales model looks set to dominate, but this structural matter has yet to be resolved. One significant step that has already occurred is the requirement for all cross-border trading to be priced in Euros. In turn, this has led to all European electricity markets quoting prices on the same basis, namely Euros/MWh.
Regulation and control: Shortly after its election in 1997, the Labour Government undertook a review of utility regulation. This review concluded that gas and electricity regulation should be merged into a single function. However it was not felt appropriate to include the regulation of water and telecommunication within this function. Additionally, the new regulatory regime was required to protect the interests of customers as its primary duty
• contrasting starkly with the previous number one objective of promoting competition. This merged role was now performed by a commission of five people (formally named the Energy Regulation Commission, but widely known as Encom), operated at arms length within a policy framework set out by the government.
The perceived benefits were seen as being:
• Increased regulatory stability;
• Consistency of approach across utilities; and
• Redressing the balance between shareholder and customers.
By and large, the new regime is an improvement on its predecessors and city confidence in the market is now high, intervention is minimal and the likelihood of future regulatory intervention is seen as unlikely and unnecessary.
The future to 2015
Consideration of the current market is incomplete without looking forward to see how the market will develop. Will the short term successes of the new trading arrangements deliver similar results in the longer term? And how will further external environmental changes affect the operation of those trading arrangements? In particular, how will further structural change impact?
Overall it is expected that between 2003 and 2015, these trading arrangements will mature into a highly competitive market.
During this period many of the IPP developers will have cleared the borrowing requirements used to finance the capital costs of their developments. Additionally, these IPPs will not be tied to the terms of CfDs (Contracts for Differences) signed when the station was first built. Accordingly, these players will now have a lower cost base and be able to compete more keenly with the incumbent players.
Whilst on the retail side, the majority of smaller traders will have been driven out of the market leaving only five major traders in this market. At first sight, this may appear to lead to less competition, nothing is further from the truth. Electricity retailing is now globally recognised as a competitive market akin to the supermarket trade in that it is a high volume low margin business.
The market and legal arrangements in 2015 will not be radically different to that in 2003. However a number of evolutionary changes will have been made to address some of the minor problems, introduced by the changes made in the late 1990s.
Additionally, the NordPool will develop such that by 2015 these two markets will be very similar, with some superposition trading between these markets. This lack of further significant change will not be judged as a failure, rather a demonstration that the changes to the trading arrangements in the late 1990s did in fact deliver a competitive market.
This harmonization of competitive markets will lead (by around 2010) to the EU reviewing the acceptability of the single buyer model. After much debate it is likely the EU will decide that the single buyer model does not deliver the same level of benefits as is seen in England and Wales/NordPool.
These comparisons will not just be of a qualitative nature but also quantitative. By comparing the annual price changes between 1990 and 2010 for different customer segments, one will be able to see how the single buyer model will not have delivered significantly lower prices.
Accordingly, it is expected that an EU directive will force all member countries to introduce truly competitive market as per England and Wales/NordPool by 2015. Thus the directive will lead to a single European Electricity market, as part of a single European energy market based on the national markets and trading across these interconnections between them.
While the UK was building its trading arrangements for 2000 and considering whether or not to break up the generators further; European governments were actively galvanising utility companies into strong European energy businesses. The objective was primarily to stop foreign acquisitions of the type experienced in the UK. The resultant European utility fortresses have placed the UK industry at a disadvantage in competing effectively on a pan-European basis by virtue of sheer lack of scale.
These fortresses will invariably be national and could represent each country`s utility base with companies such as EdF, RWE, Endesa, IVO etc., leading to about 14 players. The inevitable result of competition will see the weaker of these organisations fail and a similar situation will arise in Europe as in the UK, i.e. five or six large scale players covering the whole of Europe.
Figure 1. Stockholm: future trading arrangements in England & Wales will draw heavily on the principles behind the NordPool
Figure 2. Traditional coal fired boilers of existing stations will be replaced with clean coal technology units