Early August will see the electricity regulator publishing final arrangements for electricity trading in England and Wales. PEi examines the new market structure and what it means for players in the market, both old and new.
In October 1998 the UK government accepted proposals by the electricity regulator for an overhaul of electricity trading arrangements in England and Wales. Ten months on, the regulator is ready to publish its market definition report setting out the exact design and structure of the new market, which should be up and running by autumn 2000 following legislation supporting the changes.
This ten-month review of electricity trading arrangements, known as RETA, was triggered by government concerns over the future of the coal industry and the growing use of natural gas in the electricity industry. The government was concerned that current trading arrangements in the England and Wales Pool disadvantaged coal fired generation compared to natural gas, and that this would jeopardise the coal industry and lead to an over-dependence on natural gas fired generation.
Consumer groups and smaller generators had also voiced concerns over the dominance of the larger generators in the market and their ability to distort prices. These problems were exacerbated by the complex and non-transparent trading procedures. The market was therefore perceived as uncompetitive and illiquid, discouraging new entrants and preventing the development of derivative trades.
In October 1997, the government asked Offer, the regulator, to review trading arrangements and to propose a new market-based structure that would remove distortions and create a more liquid trading environment. These proposals were published in July 1998, and after government approval three months later, the RETA programme began.
The RETA programme has been overseen by Offer and the Department of Trade and Industry and the detail of the new trading arrangements has been developed by a steering and implementation group comprised of senior members of the industry and customer groups. Expert groups helped the steering group review and recommend proposals in specific technical areas, and public consultations were also held to heighten the transparency of the process.
The aim of RETA has been to develop a structure that will improve market efficiency and offer more choice and opportunity for participants while maintaining system security and fuel diversity. The new arrangements, which will apply to England and Wales, represent a fundamental change to the entire industry. RETA has brought together the different positions and needs of many different players, from generators and suppliers to traders, consumers and analysts. While Offer originally envisaged a target date of April 2000 for the implementation of the new market arrangements, delays have meant that implementation will not happen until late 2000.
The delays have caused frustration for some participants, particularly the small generators and the traders who want to see a more open competitive environment. Speaking at a recent conference, “Beyond the Pool”, held in London in June, Martin O`Neill, MP, chairman of the Trade and Industry Select Committee, expressed his dismay at the delays, stating that the government would like to see the reforms “done and dusted” by April 2000. O`Neill put the delays largely down to the complexity of the reform process and the merger of the electricity and gas regulators into a single operation. He was also highly critical of what he called “feet draggers” – the manipulant and dominant players that had slowed the process of reform.
Offer`s July 1998 proposals for trading arrangements envisaged a market-based system similar to other commodity markets around the world, featuring a mixture of forward and bilateral trading with a balancing mechanism near delivery time and a post-delivery settlement process (see PEi October 1998).
The finalized arrangements are closely based on the original proposal made by Offer. A forwards market, operating up to several years ahead, will be put in place and will evolve in response to demand. Trades on this market will be bilateral and will be as long-term as participants want. In addition to this, a short term bilateral market (STBM), operating from 24 hours to 4 hours before delivery time, will enable participants in the market to fine tune their positions.
Bilateral trades will be made between two parties, via a broker, or via the power exchange if one is developed. A liquid bilateral market will be important in promoting competition, and this depends largely on the nature of the balancing mechanism: if a small volume of trade takes place on the balancing mechanism, the bilateral contract market will be more liquid.
When the STBM closes (gate closure), a balancing mechanism will open, with National Grid, in its role as system operator, accepting bids for increments (incs) or decrements (decs) of generation or demand in order to balance the system. All bids must be firm cash bids. The four-hour balancing mechanism is necessary for ensuring that the system works effectively and is therefore designed mainly for residual trading rather than large volume trades.
National Grid will select bids made into the balancing mechanism. Imbalance prices will be set for positive and negative imbalances. Although it as not been finalised as to exactly how these prices will be set, they will reflect the full cost of resolving imbalances and so will include the prevailing commodity price and the costs associated with short delivery timescales.
Offer believes that this system will incentivise participants to balance their positions by gate closure rather than risk being out of balance. Liquidity in the bilateral markets will therefore be maximized, and the actions that National Grid needs to take will be minimized.
At `Beyond the Pool`, many parallels were drawn between the existing natural gas trading arrangements and the new electricity trading arrangements. Currently on the gas market, only around two or three per cent of trading takes place on the `flex` market, with the majority of trades taking place on a longer term basis. Peter Webster, managing director of MEB Trading, said that MEB Trading makes around 97 per cent of its trades on the gas market one month forward, and that daily bidding was generally a last resort. It is this scenario which the RETA programme wants to emulate.
The balancing mechanism will also bring the opportunity for participants to provide ancillary services, i.e. services which are essential for quality of supply, including satisfactory voltage and frequency and providing restoration of power after system failure. These services have traditionally been provided by the large generators, but other players have found they can provide these services on a commercial basis and this is expected to increase with the new trading arrangements.
Following balancing, there will then be a settlement process to reflect differences between contract positions and metered volumes of output and to recover other costs borne by market participants.
A market operator (MO), that will provide all services and systems in respect of the bilateral markets and the balancing and settlement mechanism, will operate the new market. In March 1999, the National Grid advertised for expressions of interest from parties for providing these systems. Twenty-four expressions of interest were initially received, and there are now nine candidates on the shortlist that will be invited to tender.
Participants in the balancing mechanism will sign a Balancing and Settlement Code (BSC) which is a set of rules and regulations for parties to adhere to. All incs and decs in the balancing mechanism must be attributable to a BSC signatory.
The BSC will form an integral part of the governance structure of the new arrangements. Offer and the RETA programme recognised that the current governance arrangements are inflexible and unsuitable. A key part of governance of the new arrangements will be the flexibility to implement change effectively and efficiently when needed. Any modifications to the processes will be consulted on and then implemented on a fast-track basis.
A power exchange
One of the biggest debates during RETA has been whether Offer should procure a power exchange system, or whether the market should be left do develop this. Offer`s July 1998 proposals suggested that a power exchange could be established to allow participants to trade electricity via a screen-based trading system operating alongside the STBM, but in May 1999, it announced that it would not procure a power exchange as part of the reforms. Dorcas Batstone, RETA project manager at Offer, said that procuring and exchange would be an inappropriate measure, and that one will emerge from the market if the demand exists.
The decision to leave power exchange development to the market has been widely welcomed by industry players, in particular the International Petroleum Exchange (IPE). IPE, one of Europe`s leading futures and options exchanges, has expressed strong interest in providing a power exchange for the electricity market and believes that it would be a successful venture providing that there is enough confidence in the primary market. IPE analyst Luke Jemmett stated that IPE looked at the possibility of establishing a secondary market three years ago, but at that time the structure of the Pool and the lack of competition precluded such a development.
Jemmett noted that other commodity markets in the world have developed highly successful secondary markets and that this is one area where the England and Wales Pool has failed. A secondary market would have considerable benefits, for example improving `visibility` with a screen-based trading system which would allow players to see market sentiment towards future prices and improve decision-making. It would also allow players to compete on price and lower barriers to entry.
One of the key motivations behind revamping the electricity trading arrangements was to reduce the market power of the larger generators, namely PowerGen, National Power and Eastern. The fundamental changes that the new arrangements will bring, together with National Power`s and PowerGen`s forced capacity divestments, will ensure that there will be a major shift in balance of power in the market. This could impact on the shareholder value of several players.
National Power is one generator that has lost a large part of its market share since the Pool was first introduced. After the company`s sell off of the 4000 MW Drax power station – a divestment forced by the regulator – National Power`s share of the generation market will have fallen to just 12 per cent from its original 40 per cent. The company saw the restrictions of its domestic market several years ago, however, and has built up a strong international private power development business which it will have to further expand if it is to keep shareholders happy.
PowerGen is more dependent on the domestic market than National Power. Its exposure to the competitive market will therefore be relatively high, and its recent acquisition of distributor East Midlands Electricity may increase this exposure.
Another player in an exposed position is generator British Energy, which is sensitive to output volume and price. As a nuclear generator, British Energy is currently dependent on being able to bid a high volume of power into the Pool and receive a reasonable return. If prices fall under the new regime, then the company may begin to see losses. However, the company recently made a bid for the supply business of distributor Swalec and is growing internationally with its joint venture with PECO Energy, AmerGen.
Nevertheless, these companies will continue to be major players in the new market while still allowing room for new and smaller entrants, including companies such as the Energy Group, Centrica, industrial companies; traders; US companies, and European utilities such as RWE, Veba and Tractebel.
PowerGen and British Energy are typical of utilities attempting to reduce their exposure to risk. ScottishPower, National Grid Company and Scottish and Southern are other examples of companies that have gone down the route towards either vertical integration or diversification into telecoms, for example. PowerGen has always stated that it believes that there are many synergies to be obtained from a vertical structure. However, some of those synergies that it has sought for so long may now be tempered by Offer`s review into distribution and supply which may see these two businesses – which are currently integrated – becoming separated.
But controlling exposure to risk is what the new market is all about for participants, and new skills will be required. Companies participating in the market will have to be able to understand and quantify their risks and exposure and be able to act upon this; they will need to carry out accurate demand forecasting; and will need to understand trading.
Above all, suppliers and generators alike will have to maximize their competitive advantage by looking at their core competencies. From there, a decision can be made as to whether to manage risk internally, or contract out. A generator, for example, will have the majority of its output covered by long-term bilateral contracts to reduce exposure to risk. If it decides to manage risks internally, it will need a trading arm to sell the remainder of its output with potentially high yields (and losses). Alternatively, it could offload this output to a trader through a sales agreement, removing risks of losses. Either way, each player will have numerous options for managing risks, with traders offering different services and with the market itself offering various types of products.
For the market to work, however, it is imperative that participants receive the appropriate price signals so that they can manage their portfolios. Good price signals will be dependent on the liquidity and transparency of the contracts market, and this in turn depends on how the balancing mechanism will work and how imbalance prices are calculated.
RETA has not yet finalized how imbalance prices should be set. RETA is keen to discourage too much trade from taking place on the balancing mechanism; but if imbalance prices are too high, players will be discouraged from taking risks, reducing liquidity and leaving the system operator with few options for balancing. If imbalance prices are low, players will have a distorted perception of risk, which could be equally bad for system stability. A balance therefore needs to be struck.
According to the IPE`s Luke Jemmett, transparency also depends on prices being visible, i.e. widely available, as well as valuable and actionable. The contracts market must fulfil these requirements if it is to avoid distortions and promote competition. Information transparency is also crucial.
Another issue of debate has been security of supply. It is believed that the market will deliver this through ancillary services such as load management and options contracts. However, response times and short-run costs are an issue here, and National Grid Company, as the system operator, may be forced to take action, in extreme cases to `keep the lights on`.
Although there are issues still to be resolved, doubtless most utilities and traders will be focussing on building the skills they need to succeed in the new market. As MEB Trading`s Webster put it: “Lots of money will be made and lost”.
Figure 1. Operational structure of the new trading arrangements
Figure 2. Proposed governance structure for the new market
Figure 3. Possible structure of imbalance prices in the balancing mechanism