Commodity-style market to lead the way

The UK government is due to finalise plans for the overhaul of electricity trading arrangements following proposals from the regulator in July. These proposals will affect players in the market in different ways – but will they achieve the desired effect?

Siân Green

In late July this year, the UK`s office of electricity regulation (Offer) published its review of electricity trading arrangements in England and Wales. Included in the report was Offer`s proposal for the restructuring of the trading Pool. The report is now in the hands of Department of Trade and Industry secretary Peter Mandelson and energy minister John Battle, who are shortly due to give their response to the regulator`s recommendations.

The regulator`s report ends a lengthy consultation process which has lasted close to a year, and marks the start of the first major change in the UK`s electricity supply industry since it was privatized. Any changes that the government decides to implement are likely to have a significant impact on many of the players in the market, and will be closely watched by other countries who have already modelled their deregulated electricity industries on the UK model.

The review was commissioned in response to concerns that wholesale electricity prices have not reflected costs, partly due to the complexity of arrangements in the pool, and partly due to the market power of the larger generators.

A need for change

Offer`s proposals are designed to increase competition in the market and make electricity Pool trading more like trading in commodity markets. Although the Pool has worked well since its implementation in 1990, criticisms of the market`s shortcomings have been evident for some time.

Criticisms have been made of the high and variable prices, the market power of some of the generators and discrimination against coal plant. Of particular concern is the complexity of price setting arrangements which has inhibited the development of derivatives markets. Concerns have also been voiced over the generators` ability to bid zero in order to be scheduled.

The costs of generation have fallen considerably in the last few years. Natural gas spot prices, minehead coal prices as well as the capital costs of new capacity have all fallen since 1994, yet there has been no corresponding reduction in wholesale prices. Pool prices have fallen by less than ten per cent in real terms since their 1993/4 peak.

In retrospect, a change in the trading system was bound to occur – it is perhaps surprising that it has taken this long. The Pool was the first mechanism of its kind, thus there was little experience to draw on from other countries. According to the regulator, considerable weight was given to the former centrally planned system in creating the Pool.

The Pool is therefore different to other commodity markets, partly for historical reasons and partly due to the fact that electricity differs from other commodities. Trading arrangements must accommodate these differences. However, the electricity market does have some characteristics in common with other commodities, and the regulator believes that there is scope for change.

The regulator`s proposed arrangements, if undertaken by the government, would remove the present provision in the Pool for all the generators to receive the same price, the SMP (system marginal price). Instead, all generators would need to find buyers through firm contracts, and so offer prices that are at least as good as elsewhere in the market. The same applies to suppliers. The process would therefore be more competitive, with greater participation from the demand side.

The arrangements proposed include three markets:

Forwards and futures markets: operating up to several years ahead if required, these would allow participants to secure cover for their anticipated demand or output.

A short term bilateral market: this would enable participants to “fine tune” their contract positions through trading. This market would operate from at least 24 hours to four hours before a trading period. It would be operated via a screen-based system in which anonymous bilateral trades would enable players to adjust their positions for each trading period. Generators, suppliers, customers and traders would submit simple offers and bids. Accepted bids would represent firm financial commitments.

A balancing market: operating from about four hours before a trading period to enable the NGC as system operator to balance generation and demand, and resolve any constraints on the transmission system.

A settlement process would calculate prices to recover the costs of dealing with imbalances and charge generators and suppliers who are out of balance.

Working with choice

The arrangements will have some level of impact on all participants in the electricity market, and will open up new opportunities. In particular, the number of traders operating in the market is expected to increase.

Traders are likely to be most active in the short to medium term forwards and futures markets. Their presence would help improve liquidity and would also provide market participants with a wider choice of risk management options.

Public electricity suppliers are likely to sign contracts in advance via the forwards market to cover at least part of their demand. However, some suppliers, particularly second tier suppliers, may choose to cover a smaller portion of their expected demand through the forwards market, and rely on the bilateral and balancing markets for the rest of their needs.

Participating in the bilateral and balancing markets would allow public and second tier suppliers to hedge against the risks of imbalance charges.

Greater flexibility would also be afforded to large consumers which, as at present, could purchase power direct from a generator. However, they would also be able to participate in the short-term markets, an attractive option for those with a variable demand. Medium sized consumers could also choose to be responsible for their own supply. They could also partake in the bilateral and balancing markets via their supplier, bringing scope for the sharing of any profits with their supplier.

On the generation side, a portfolio generator operating a range of plants, such as National Power or PowerGen, will also enter a series of bilateral long term contracts to cover its output. Such contracts are unlikely to be linked to the output of any one plant, giving the generator commercial flexibility to optimise its production schedule daily.

A portfolio generator will be able to play an active role in trading on the short term markets, enabling it to reduce its risk to imbalances. On the bilateral market, it may purchase power to back its contractual position, or it may have surplus power to offer the market. On the balancing market, a portfolio generator could submit increments and decrements for its plant in response to the system operator`s need to address imbalances.

A portfolio generator could also submit offers on the balancing market for its peaking plant. An open cycle gas turbine or pumped storage unit is designed to maximise the economic value of its flexibility. This type of plant will therefore play an active role in the short term markets, but may also be able to secure some long term guaranteed revenue streams.

Portfolios could also operate power stations at below full load in order to offer additional output into the balancing market – a riskier strategy, but one with potentially high rewards.

Most independent power producers (IPPs) are fully covered for their output by long term power purchase agreements (PPAs) and operate as baseload plants. Their activity in the forwards, bilateral and balancing markets will therefore be limited.

During the review process, some IPPs stated that any change in the trading system could require a renegotiation of their PPA contracts, particularly where Pool Purchase Price (PPP) is used as a reference price. Their concern is that this may leave them open to legal and transaction costs. The regulator accepts that these concerns should be taken into consideration, but has stated that it is unrealistic to expect trading arrangements to remain unchanged, and that any changes are unlikely to take effect before 2000, giving IPPs ample time for negotiations.

Merchant plants are more likely to operate like the portfolio generators than IPPs. These plants are designed for maximum commercial and technical flexibility, and so will be able to take full advantage of the short term markets. However, to minimize risk, a merchant plant will secure as much of its output as possible in advance of the delivery date, building up a portfolio of contracts of various durations and shapes.

Nuclear generators will be most active in the forwards and futures markets, focusing on securing baseload contract cover. Under the new regime, they will be able to self dispatch in order to meet their contractual commitments, rather than submitting low-priced offers into the Pool.

A flexible approach

The regulator believes that these proposed arrangements will offer lower prices and more competitive trading, a greater choice of markets, more scope for demand management, incentives to manage risks, increased transparency and more effective and flexible governance.

While it is likely that these proposed arrangements will increase flexibility and competition in the market, the uncertainty lies in when, and if, they will impact on end consumers in terms of price reductions. Uncertainty also lies in to what extent the government will actually implement the proposals. But whatever steps are taken, this will be a milestone in the development of electricity trading markets.

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