Opening Electricity Industry to Investors: an academic perspective

Medelec – Eurelectric
Brussels - 6 May 2015
Opening Electricity Industry to Investors:
an academic perspective
Jean-Michel Glachant
Loyola de Palacio Prof. & Director Florence School of Regulation
European University Institute (Florence)
Robert Schuman Centre for Advanced Studies
Florence School of Regulation & Loyola de Palacio Chair

FSRandLoyoladePalacioChaironEnergyPolicy
RobertSchumanCentreforAdvancedStudies
EU power market opening along 10 years of
Barroso‘s Commissions
2
Day-ahead
market
Intraday
markets
Balancing
market
Reserves/
ancillary services
markets
Explicit auctions
for transmission
capacity
Implicit
auctions
Market
coupling
Market
splitting
Capacity
markets
Bilateral /
OTC
Long term
contracts
Flexibility
market
Baseload
product
Peak load
product
Congestion
management

I will simplify around 4 blocks only …
3
Entry in
generation
Access to
1 MW
consumers
NO Entry in
generation
Entry in
generation
NO Access
to grid
NO Access
to consumers
Entry in
generation
only IF
2-
Monopoly +
LT fran.
IPPs
Access to grid NO Access to
consumers
1-
Monopoly
Access to grid
3-
Single Buyer
+ Wh. Market
4-
Wh. Market +
Eligible xMW
NO Access
to grid
Long Term
contract with
monopoly

Model 1 (-)
Monopoly
Model 2 (+)
Franchised IPPs
Model 3 (++)
Single Buyer
+ Wholesale
Competition
Model 4 (+++)
Wholesale Comp.
+ Eligible
Consumers
+ Retail S.B.
Power sector can become more like an open commodity industry
But:
• More complexity, regulation, IT infrastructure, etc
• AND More structural changes needed
Let’s simplify it a bit:
4 basic models of opening
4

Introduction “Opening power industry to investors :
4 basic industry models with or without market”
1.(Model 1) No opening
2.(Model 2) Opening to “franchised” generation
3. (Model 3) Opening to generation competition
4. (Model 4) Opening to eligible (xMW)consumers

6
Model (1) Monopoly(ies)
Generation
Transmission
Distribution/
Retail
Consumers
Generation
Transmission
Distribution/
Retail
Consumers

7
Model 1: Monopoly
Description
• Full vertical integration
– Some distribution companies may be unbundled
• Central planning of generation & network
• Cost-of-service remuneration of each
vertically integrated utility  regulated tariffs
• Wholesale transactions
– between vertically integrated utilities
– between a distributor & a vertically integrated
utility
with wheeling transmission charges
• Limited incentive regulation is possible
• Social policy obligations

8
Model 1: Monopoly
Comments
• Most risks are passed to consumers
– mistakes in investment unit size &location,
demand forecast, techno. obsolescence, etc.
• Abuse of social policy obligations (utility as tax
collector)
– indigenous fuels, fuel diversity, nuclear moratoria,
electricity discounts, local taxes, etc.
• Abuse of “Utility-sweeping”, regulatory lag &
“lack of funds”
– No adequate tariffs & rate of return to utility>
Underinvestment & excessive operational costs
• Pressure from cheaper potential new entrants

10
Model (2) Monopoly + “Franchised” Ipps
Generation
Transmission
Distribution/
Retail
Consumers
IPP
IPP
IPP
IPP

11
Model 2: Franchised IPPs
• IPPs compete to get the “monopoly power” at generation stage
• “LT contracts” give them Franchise: “quasi vertical integration”
• Central planning of generation & network is kept by incumbent
monopoly. Bad planning & bad contracting are major risks
• Limited Reform because wholesale transactions implemented
by incumbent integrated Monopoly (but Chinese trick: price
guaranteed; not volume dispatched)
• Costs of competitive bidding of IPP Franchise  regulated
tariffs (risks passed to consumers as in Monopoly model)
• Some incentive regulation is possible (performance based
contract & profit sharing; etc. )

13
(Model (3) From <Monopoly + IPPs>
to <Single Buyer + Wholesale Market >
IPP
Single Buyer
Distribution/
Retailer
Consumer
IPP Divest.
Distribution/
Retailer
Consumer
IPP
Single Buyer
Distribution/
Retailer
Consumer
IPP
Distribution/
Retailer
Consumer
Own
generation

14
Model 3: Single Buyer
Description (1)
• Less vertical integration than model 1 & 2
• Independent Power Producers (IPPs) compete to sell to the
single buyer
a/ Ex Ante competition (e.g. bids) in construction, operation &
negotiation of contracts (PPAs) with the single buyer
b/ Ex Ante & Ex Post competition: Single Buyer buy Wholesale
Market with no LT contract with IPPs
• Is Single Buyer responsible for generation adequacy? LT
contracts? Capacity Options?
• Some economic incentives with LT contracts
–“availability” payments; indexation of variable costs

15
Description (2)
• Cost-of-service, PPA contracts & social policy obligations 
regulated tariff
• Access to consumers: as in model 1. IPPs do not have retail
access
• Single Buyer (via consumers’ tariffs) can take the generators’
risk in LT contracts
• Independence of the Single Buyer becomes a critical issue
(Merit Order & economic dispatch of IPPs)
• The transmission grid becomes key implementation

16
Description (3)
• Various degrees of competition on the generation side, while the
purchasing agency can keep centralized strategic control
(capacity adequacy & technology mix; merit order)
• But if Single Buyer controls it keeps typical drawbacks of
centralized planning
• Risk of IPPs being made LT contracts is passed to consumers
 lower capital costs & easier to raise capital
• If LT contracts used it requires effective control of contracting &
implementation is needed (corruption likely)

18
(Model 4) Wholesale Market
+eligible consumers
Generator
Power Exchange
Supplier
Eligible
consumer
Generator Generator
Distributor/
Retailer
Captive
consumer
Supplier
Distributor/
Retailer
Eligible
consumer
Captive
consumer
Wholesale
market
Retail
market

19
Model 4: Wholesale competition
Description (1)
• Free transactions between distributors & generators,
thus sharing risks
• Distributors (now multiple purchasing agencies)
maintain a monopoly over final consumers 
regulated tariffs
• Social policy obligations must be charged via
regulated tariffs
• No central planning of generation, free entry
• Generation stranded costs & benefits appear

20
Description (2)
• Trading arrangements
– open access & ancillary services  system operator
– organized markets (spot, derivatives)  market
operator (not a single buyer, but an auctioneer)
– bilateral wholesale contracts
– IPPs may choose between contracts & the spot
market
– regulated network access charges

21
Comments
• IPPs may / may not be vertically integrated with
distributors (risk of self dealing)
• Issues of market power are now relevant
• Long term guarantee of supply is in principle left to the
market: will it work?
• Strong incentive to efficiency in generation
• Any pressure from consumers to arrive at retail
competition : depends level regulated tariffs

Conclusion “Opening power industry to investors : 4
basic industry models with or without market”
1. Choice of model depends appetite of public authorities for power
reforms & expectations from Power Opening (Capital flow? Technology
renewal? Efficient management? Stop energy subsidy? etc.)
2. Opening to “franchised” generation (Monopoly + Franchised
IPPs) needs limited reforms BUT all risks (volumes, technical options &
contract formulas) for consumers (except if Gov. breaches contract…)
3. Opening to generation competition (Single Buyer + Wholesale
Market) more reform needed & investment risks transferred to
generators. BUT to get capacity adequacy? Capacity incentives or not?
4. Opening to eligible (xMW)consumers (Wholesale Market +
eligible Wh. Consumers + single buyer retail) much more reform
needed & risks are transferred both to generators & eligible consumers
while retail can stay “Single Buyer ”with some “capacity incentives”?

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24
Thank you for your attention
Email contact: jean-michel.glachant@eui.eu
Follow me on Twitter / already 7 575 tweets: @JMGlachant
Read the Academic Journal I am chief-editor of:
EEEP “Economics of Energy & Environmental Policy”
My web site: http://www.florence-school.eu

Annexes
5.(Annexe 1) In-depth Wholesale Market opening: a
sequence of markets
6.(Annexe 2) From national market to international
markets

(Models 3 & 4) Electricity
characteristics influencing trade
Non-storable “Immaterial” Energy
1° Traded before delivery = trade price insurance
(= financial transaction)
2° No “storable effect” on prices (as for gas)
(“spread” Summer / Winter)
3° Production and consumption in real time
4° “Zero” tolerance of imbalances P-C
+ sensitivity to “network” constraints (congestion)
5° Collective equilibrium Total Prod= Total Cons
over one control area (zone under the control of a
“TSO”)

Electricity vs. Air Transport
1° No plane can take off or land if it is not
completely full (of passengers)
2° To go from A to B, all planes should have to
divide themselves to pass through AB but also
through AC-CB.
3° If a plane breaks over a flight, all the other
planes should have to take instantaneously all
its passengers (following 1°) or… all the other
planes break suddenly.
(Models 3&4) Electricity characteristics
influencing trade (cont.)

(Model 3&4) Wholesale market
proxies
Electricity and the sequence of markets
1° Electricity good = “system” good =
Energy + Transmission (congestion)
+ Capacity (reserves)
2° Sequence of (at least) four markets =
Day-ahead Energy Market (D-1)
+ Transmission Market (or congestion pricing)
+ (short-term and long-term) capacity/reserves
markets
+ Combination of 3 in real time  Balancing
3° = All electricity market design is ‘’complex’’

(Models 3&4) Wholesale market
architecture
• Electricity =
Energy (Day-ahead and intraday)
+ Congestion pricing
+ Reserves (and Generation Capacity
mechanisms)
+ Real Time Balancing
Intraday markets Balancing Market
Congestion pricing
Day-ahead
market
TimeDelivery
Generation capacity
mechanisms

(Model 3&4)
Day-ahead market design
• Options :
– Centralization (organized: Pool & PX) vs.
Decentralization (bilateral/OTC)
• Differences :
– Available Information
– Liquidity
– Speed for finding a market equilibrium
– Flexibility of decision and actions

Commercial (or “Financial”) Relationships
in Liberalised Electricity Markets
Generator 3Generator 2Generator 1
Supplier 1 Trader 2 Wholesaler
3
PX TSO
Final
Consumer
1
Final
Consumer
2
Final
Consumer
4
Final
Consumer
3
Final
Consumer
5
PX Sales
PX
Purchases
Bilateral Contracts
Supply Contracts

Bilateral Over-the-Counter (OTC)
vs. Power Exchange Trading
Properties
Trading Method
Over-the-Counter Power Exchange
Anonymity of
Trading
No Yes
Counterparty Bilateral Central
Counterparty
Counterparty
Risk
Yes, unless
Cleared
No
Trading Method Continuous
Trading
Typically Central
Auction

• Bilateral contracts may be:
• Customised
• Respond to the requirements of the
counterparties
• Reduce basis risk …
• But requirements of the counterparties
may not always be compatible
• Standardised
• Standard features and clauses
• Easier to negotiate
• Easier to trade in a secondary market
• Brokers may facilitate the conclusion of
bilateral contracts by matching counterparties
with compatible requirements
Bilateral trading

• Efficient, merit-order dispatch
according to offers submitted to the PX.
• Separation between generation and
supply,
the two potentially-competitive activities in the
electricity sector, which, in many countries, are
still characterised by (vertically-integrated)
dominant players.
• Greater transparency in price setting.
Prices reflect market conditions and thus vary
hour by hour.
PX prices are published daily and provide a
reliable reference.
Power Exchange - System Level Benefits

• Easier entry into the market by new
players.
Non-discriminatory access to wholesale power.
New entrants in the generation business may
sell power at fair prices.
New entrants in the supply business may buy
wholesale power at fair prices.
• Increased security of supply (IF… & only if!)
Promotion of generation capacity availability
and load management at peak times.
– More accurate price signals on the relationship
between demand and supply.
PX- System Level Benefits Ct

• Market-place where electricity is
available at market prices
• Greater flexibility in generation and
consumption strategies (revision of
scheduled generation or consumption
close to real time)
• Guaranteed payment of electricity
through a central counterparty and
guarantee requirements
PX- Participants Level Benefits

• Trading results in long/short positions
*Long positions assign the right/obligation to
withdraw power from the grid
*Short positions assign the right/obligation to
inject power into the grid
*Long and short position resulting from
trading should be balanced (injections =
withdrawals) in each delivery period
Trading of promises
and commodity delivery (1)

• “Gate Closure” is the deadline for trading
electricity to be delivered in a specified period
• Gate Closure could be from one or more days
to one hour or less before delivery time
• By Gate Closure, balanced (injections and
withdrawal) positions are declared (possibly
through balance responsible agents) to the
relevant TSO (scheduling). (The PX may itself
be a balance responsible agent)
Trading and commodity delivery (2)

• At Gate Closure the TSO takes over the
management of electricity flows over the
network
• Deviations of actual injections/withdrawals
from positions attract imbalance changes and
are settled with the TSO (balancing charges)
Trading and commodity delivery (3)

Balancing & Settlement
Agreements
Physical (or “Technical” or “Electrical”)
Relationships in Liberalised Electricity Markets
Generator 3Generator 2Generator 1
Supplier 1 Trader 2 Wholesaler
3
PX TSO
Final
Consumer
1
Final
Consumer
2
Final
Consumer
4
Final
Consumer
3
Final
Consumer
5
Connection, Use-of-System
and Balancing & Settlement
Agreements
Connection and Use-of-System
Agreements

(5) Design of Balancing -Real Time-
• Options :
– Balancing Market vs. Mechanism
– Single vs dual imbalance prices (penalties)
• Issues :
– System security vs. market efficiency
– Centralized vs. Decentralized balancing
– Market Power
– Reflectiveness & Cost allocation problem
– Impact of distorsions (Incumbent vs. New entrants)

(5) – Design of transmission markets
(or congestion pricing)
• Design of internalisation of “network” externalities
=
energy market + economic model of network constraints
• Economic models of network in energy markets
– Zonal model (EU: Nord Pool)
– Nodal model (USA: PJM)
• «Optimal» economic model of the network ?
– Zonal for “zonable” networks
– Nodal for “non-zonable” networks
• Market vs. Control by TSO
• Zonal for “non-zonable” networks
• Trade-off between energy market functioning
(liquidity) vs. ‘Gaming’ & inefficiencies
• Putting incentives on the TSO for optimal control
(e.g. UK)

RealNetworkNetworkeconomicmodel
NetworkPhysical
functioning
Market
Design
Internalisation of
all networkeffects
((nodalnodal))
Internalisation of
more important
network effets
(zonal(zonal))
market does not
internalise network
Design of internalisation of network in
energy markets: several proxies
Networkmanagem
Marketsolution

Internalisation of network constraints
by the energy market : when?
• Uncertainties in the measure of network
effects
– E.g. : Maximal transmission capacity between two
zones depends on … actual network flows
• Internalisation of the network before real
time without re-internalization in real time
– Maximal capacity in real-time becomes the minimal
capacity defined « ex ante »
– The market adds new constraints and does not
maximize the potential benefits from trade

(5) RESERVES
a/ Short-term Reserves’ markets
• Why?
– Short-term reserves are “available capacity” then
“public goods” (they cannot be provided selectively
to individual grid users)
– They are provided trough TSOs’ procurement rules
• Resources for the provision of reserves can be:
– Supplied by grid users according to license
conditions (e.g. Primary reserve: instantaneously)
– Procured by the TSO through long-term contracts
(e.g. Secondary reserve: each 5 to 15 minutes)
– Procured by the TSO through dedicated markets
(e.g. Tertiary reserve: 15 minutes to half-daily
schedule)

(5) b/ Long term Generation
capacity mechanisms
• Why? From short term to long term capacity offer
– Right level of generation capacity? Through
markets? Investing in base to peak units?
– Missing money
• Price cap
• Risk
• Market power
• Options of capacity procurement design
– Capacity payments
– Capacity markets
– Etc.

(6) From National to Regional markets
• Historically, grids have been developed
mainly to serve national markets
• ... At a time when national markets were
typically served by vertically-integrated
monopolists
• ... Which had little incentive to integrate
neighbouring markets, except for security
and stability purposes
• Therefore, regional market integration
requires:
• Harmonisation of rules
• Expansion of cross-border capacity
• Efficient management of existing capacity

Cross-border Congestion Management (1)
• Congestion occurs when the available
transmission capacity is not sufficient to satisfy
the demand for transmission services (e.g.,
from commercial transactions)
• Therefore, congestion depends:
• on the demand for transmission services
• on the available transmission capacity

• Liberalization has increased and made more
explicit the demand for transmission services
• Congestion may occur:
• within a control area
• between control areas (cross-border)
• For ex. First EC rules (e.g. Regulation n.
1228/2003) only apply to cross-border
congestion
Cross-border Congestion Management (2)

Approaches to congestion management
Basic approaches:
• Ex-post market adjustment to congestion
• Redispatching
• Counter-trading
• Ex-ante congestion management
• Explicit allocation of (physical) transmission
capacity rights (PTRs)
• Implicit allocation of transmission rights
(based on energy positions):
• Implicit Auction
• Market Splitting
• Market Coupling (market splitting among
several PXs instead of single PX)

Congestion Management in Europe
• Market splitting was dominant in:
• NordPool: between national control
areas and between Norwegian zones
• Italy GME: between different
geographical areas (for generators only)
• In other EU markets, congestion within a
control area was managed through
redispatching
• Flow-based Market Coupling has been
proposed by ETSO – Europex to solve
cross-border congestion & became EU
Target Model

Thank you for your attention
to Annexes    !

Opening Electricity Industry to Investors: an academic perspective

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