Electricity Trading(1)

Electricity Trading on Power Exchange (Dissertation Report)

COMMERCIAL

Knowledge Management System

Electricity Trading on Power Exchange

Key Words : Financial Market, Retail Market, Deregulation, Load Management

Submitted by : Shri R.R.Bolisetty, Sr.Manager(OS), WRHQ, 9869223061,

[email protected]

10/1/2007


A Dissertation Proposal for

XVII National Management Programme

by

Ramachandra Rao Bolisetty

under the guidance of

Shri DK Gupta Dr. A Sahay DGM, Chairman, NMP NVVN, NTPC MDI, Gurgaon

Management Development Institute

Gurgaon 122 001

October 25, 2005


A dissertation submitted in partial fulfillment of the requirements for the award of

Post-Graduate Diploma in Business Management

by




Gurgaon 122 001

October, 2005


A dissertation submitted in partial fulfillment of the requirements for the award of

Post-Graduate Diploma in Business Management

by


under the guidance of

Shri DK Gupta Dr. A Sahay DGM, Chairman, NMP NVVN, NTPC MDI, Gurgaon



Gurgaon 122 001

October, 2005

Certificate of Approval

The following dissertation titled "Electricity Trading on Power Exchange" is hereby approved as a certified study in management carried out and presented in a manner satisfactory to warrant its acceptance as a prerequisite for the award of Post- Graduate Diploma in Business Management for which it has been submitted. It is understood that by this approval the undersigned do not necessarily endorse or approve any statement made, opinion expressed or conclusion drawn therein but approve the dissertation only for the purpose it is submitted. Dissertation Examination Committee for evaluation of dissertation

Name Signature 1. External Examiner _______________________ ___________________

2. Internal Examiner _______________________ ___________________ 3. NMP Dissertation Coordinator _______________________ ___________________

Certificate from Dissertation Advisory Committee This is to certify that Mr. Ramachandra Rao Bolisetty, a participant of the XVII National Management Programme, has worked under our guidance and supervision. He is submitting this dissertation titled Electricity Trading on Power Exchange in partial fulfillment of the requirements for the award of the Post Graduate Diploma in Business Management. This dissertation has the requisite standard and to the best of our knowledge no part of it has been reproduced from any other dissertation, monograph, report or book. (DK Gupta) (Dr. A Sahay) Organisational Advisor Faculty Advisor Deputy General Manager Chairman, NMP NVVN Limited, Management Development Institute, 3rd Floor, Core 5, Gurgaon 122 101 Scope Complex,

Lodhi Road, New Delhi 110 003

Abstract


By


The Indian electricity industry is marred by inefficiencies. The state electricity boards, which were supposed to cater to the needs of the states, failed miserably in augmenting capacities. The widening of the peak demand shortages and energy shortages compelled the government of India to take appropriate steps towards correcting the scenario. Setting up of central sector generating stations, unbundling of state electricity boards, securitisation of long pending dues, installation of regulators at central as well as at state level and enactment of electricity act 2003 are all the actions initiated in the direction of bringing in accountability and ensuring that power to all by 2012 is realised. With the enactment of Electricity Act 2003, the electricity industry in India is going through reforms and restructuring. It has been observed there are capacities unutilized in one part of the country while there are shortages in the other part of the country. Open access to the transmission network without any discrimination has opened new vistas for trading such surplus energy. The study is focused on possibility of setting up a power exchange and trading of energy over the exchange. The major findings of the study are:

1. At present around 2.5% of total energy generated in India is being traded. The trading is being carried out through traders approved by CERC. The trading is being done at a negotiated price over the open access transmission corridor availability. It is forecasted that around 8% of the total energy generated would be available for trading. Hence, even with the present set of trading arrangements, there is a huge scope for development of the markets.

2. It has been found that there is energy that often is left

unutilized for the want of market mechanism, which could facilitate trading of energy available over short notice without the present day obligations of negotiations.

3. The setting up of power exchange would apart from facilitating the trading of electricity would bring in competition in the short-term electricity markets and realize the realistic price for electricity.

4. The power exchange also would provide signals to the market

for the industry to take wise investment decisions. For carrying out the study, various conceptual models of the power trading and business models were studied. This part of the study is mostly based on the study material and textbooks written in this field of restructuring the electricity industry. Later for developing the market model and Indian perspective various articles, documents of ministry of power, Central Electricity Regulatory Commission and various web sites are extensively studied. The experience of markets around the world has given in sights into the advantages and pit falls in such a market mechanisms. The proposed model is developed in line with the developments envisaged in the Electricity Act 2003 and our National Electricity Policy. The views of experts in the field and their comments, obtained during review are summarized and appropriately incorporated in the model.

Acknowledgements

I am grateful to my guides - Dr. A. Sahay, Chairman NMP, MDI, Gurgaon, who acted as my faculty guide and Shri DK Gupta, DGM, NVVN, NTPC, Delhi, who acted as my internal guide - for their able guidance, constant encouragement, constructive criticism which inspired me to put in greater efforts into this project. I would like to express my deeper gratitude to Prof. Srikrishna A Khaparde, Professor, Electrical Engineering, IIT, Mumbai and Member, Advisory Committee, MERC for his guidance in setting the project on track and constant support and encouragement provided during the entire tenure of this project. I also put it on record, my sincere appreciation to Shri Abhijit R Abhyankar, Ph. D. Scholar, EE, IIT, Mumbai for his constant help in understanding the subject, which immensely helped in writing this dissertation project report. I would like to express my special gratitude to Shri Prabodh Bajpai, Senior Research Fellow, IIT, Kanpur who had provided me with the material to begin with and introduced me to the IIT, Bombay team, without it would have been impossible to complete the project within such short interval. A large number of my colleagues from within the organisation and friends from across the industry have helped by offering their opinions, the articles they have come across, which has helped in broadening my horizon. I also would like to put on record my sincere appreciation for all those involved in the discussions during review of the proposed model. These discussions helped me understand the areas my ignorance. Last but not the least, I would like to place my sincere gratitude to the members of my family - my wife, who have understood my obsession with the studies and unconditionally supported me emotionally by shouldering the responsibility of family front single handedly and children, who at this tender age has shown immense maturity by deferring their needs demanding my time. Mumbai Ramachandra Rao Bolisetty October 25, 2005

Table of Contents

Chapter No.

Description Page No.

1 . Market models in Electricity 1 1.1 Introduction 2 1.2 Historical Background 2 1.2.1 Regulation 3 1.2.2 Deregulation 4 1.2.3 Decentralization 6 1.2.4 Restructuring 10 1.2.5 Open Access 11 1.3 Industry Classification 12 1.3.1 Based on trading 12 a. Integrated model 12 b. Decentralized Model 13 i. Pool Model 14 ii. Wholesale competition 16 iii. Retail competition 17 1.3.2 Based on contractual model 19 a. Bilateral Agreements 20 b. Third Party Agreements 20 c. Power Exchange 20 1.3.3 Based on system operators 24 a. Transmission system operator 25 b. Independent system operator 25 1.3.4 Based on transmission ownership 26 1.3.5 Based on number of participants 27 a. Monopoly 27 b. Oligopoly 28 c. Perfect competition 28

2 . Markets in Transmission and system operation 2.1 Introduction 29 2.2 Transmission Pricing 29 2.2.1 Flat fee 30 2.2.2 Postage stamp method 30 2.2.3 Mile MW method 30 2.2.4 Contract path method 31 2.2.5 Point of Connection tariff 31 2.3 Imbalance management 32 2.4 Congestion Management 33 2.4.1 PAC Management 34 2.4.2 Counter trade 34 2.4.3 Pro-rata reduction 35 2.4.4 Bidding for residual tr.mission capacity 35 2.4.5 Nodal / Zonal pricing 36

2.4.6 ATC with constrained unit commitment 36 2.5 Ancillary services 37 2.6 Grid security 37 2.7 Hedging risks 38 2.7.1. Futures 39 2.7.2. Options 39 2.7.3. Forwards contracts 40 2.7.4. Swap contracts 40 2.7.5. Contract for Differences (CFDs) 40 2.8 Choice of system operator models 41 2.9 Choice of trading models 41 2.10 Choice of contracts 42 2.11 Choice of transmission ownership 43 2.12 Choice of transmission pricing models 43

3 . Electricity markets around the world 3.1 Introduction 45 3.1.1 Legal rationale 45 3.1.2 Economic rationale 45 3.1.3 Technological advances 46 3.1.4 Strategic aims 46 3.2 Developed Electricity Market Models 46 3.3 England and Wales 47 3.3.1 Introduction 47 3.3.2 Phase I of reforms 48 3.3.3 Pool system 48 3.3.4 Regulatory regime 50 3.3.5 Wholesale market 50 3.3.6 Retail market 50 3.3.7 Learning phase 54 3.4 Nordic Countries (Nord Pool) 55 3.4.1 Day Ahead market 59 3.4.2 Balancing market 59 3.4.3 Financial market 59 3.5 United States 60 3.6 California market 61 3.6.1 Day Ahead and Hour Ahead markets 63 3.6.2 Transmission congestion contracts 63 3.6.3 Comments 64 3.6.4 California Crisis 65 3.7 PJM Interconnection 68 3.8 New York Model 70 3.9 Developing Electricity Market Models 75 3.10 China Model 76 3.11 Japan Model 79

4 . Indian electricity industry 4.1 Introduction 82 4.2 History 82 4.3 Need for regulation / Government control 84 4.4 Evolution and present stage 85 4.5 Causes for deregulation 86 4.6 Critical issues in deregulation 87 4.7 Shifts from earlier electricity acts 88 4.8 Brief about Electricity Act 2003 89 4.9 Future directions of the industry 90 4.9.1 Restructuring 90 4.9.2 Capacity addition 91 4.9.3 Capacity utilisation 91 4.9.4 Load management 92 4.9.5 Loss management 92 4.9.6 Intrastate ABT 93

5 . Proposed model for India 5.1 Introduction 94 5.2 Present trading practices 94 5.3 Need for a Power Exchange 95 5.4 Why National Power Exchange? 95 5.5 Dispatching Mechanism 96 5.6 Electricity market 97 5.7 Basic electricity market 97 5.7.1 Day Ahead Market 98 5.7.2 Hour Ahead Market 99 5.8 Capacities on PX 99 5.9 Congestion management 100 5.10 Time line of Power Exchange 100 5.11 Transmission ownership 101 5.12 Transmission Pricing 101 5.13 System Operator 102 5.14 Settlement Mechanism 103 5.15 Financial Instruments 104 5.16 Management and participants of PX 104 5.17 Development of Real Time Market 105 5.17.1 Real time balances market 105 5.17.2 Real time congestion market 106 5.18 Ancillary services 106 5.18.1 Operating reserves 106 5.18.2 Voltage control 107 5.18.3 Primary response 108 5.18.4 Secondary response 108 5.18.5 Peaking power 109 5.18.6 Standby services 109 5.18.7 Load following 109

6 . Review of the Proposed model 6.1 Introduction 110 6.2 Views of Reviewers 110 6.3 Conclusions 114 Future directions of study 116 Points to make 117 Limitations of study 117 References 118 List of Abbreviations used 120 Annexure I: Details of Participation for review of

the model 123

List of tables

Chapter No.

Description Page No.

1 . Market models in Electricity 1.1 Load flattening effect of TOD based pricing . 9

3 . Electricity markets around the world 3.1 Bidding into Nord Pool 58

List of figures Chapter

No. Description Page

No. 1

. Market models in Electricity

1.1 Load flattening effect due to TOD based pricing 10 1.2 Vertically integrated monopoly business model 13 1.3 Decentralized business model 14 1.4 Pool business model 16 1.5 Wholesale competition business model 17 1.6 Retail competition business model 19 1.7 Double sided auction on power exchange 21 1.8 Single sided auction on power exchange 22 1.9 Merit order clearing of power requirement 22 1.10 Scenario under strategic bidding by a generator 23

3 .

Electricity markets around the world

3.1 England and Wales market model 51 3.2 NETA Electricity Market Major contractual

relationships 53

3.3 Structure of Nord Pool market 56 3.4 Price Area Congestion (PAC) management 57 3.5 Bidding into Nord Pool 58 3.6 Structure of California market 62 3.7 Market structure in PJM interconnection 69 3.8 Structure of New York Electricity Market 73 3.9 Current Power Supply System in Japan 80

List of abbreviations used

1. ABT Availability Based Tariff 2. ACE Area Control Error 3. APDP Accelerated Power Development Programme 4. ASCI Administrative Staff College of India 5. ATC Available Transmission Capacity 6. BETTABritish Electricity Trading & Transmission Agreement 7. BSES Bombay Suburban Electric Supply 8. CaISO California Independent System Operator 9. CalPX California Power Exchange 10. CCGT Combined Cycle Gas Turbine 11. CE Capacity Element 12. CEA Central Electricity Authority 13. CEGB Central Electricity Generating Board 14. CERC Central Electricity Regulatory Commission 15. CESC Calcutta Electric Supply Company 16. CFD Contract for Differences 17. CGS Central Generating Stations 18. CPSU Central Public Sector Undertaking 19. CTU Central Transmission Utility 20. DA Day Ahead 21. Discom/Disco Distribution Company 22. DSM Demand Side Management 23. EA 2003 - Electricity Act 2003 24. EPCos Electric Power Companies 25. ER Eastern Region 26. EHV Extra High Voltage 27. ERCOT Electric Reliability council of Texas 28. ESOP Employee Stock Option 29. FACTS Flexible AC Transmission System 30. FERC Federal Electricity Regulatory Commission 31. FY Financial Year 32. GEB Gujarat Electricity Board 33. Genco Generating Company 34. GUVNL Gujarat Urja Vikas Nigam Limited 35. GW Giga Watt 36. HT High Tension 37. Hz Hertz (unit of frequency) 38. IEGC Indian Electricity Grid Code 39. IIT Indian Institute of Technology 40. IOU Investor Owned Utility 41. IPP Independent Power Producer 42. ISO Independent System Operator 43. KV Kilo Volts 44. kWh kilo Watt hour 45. LDC Load Dispatch Centre 46. LMP- Locational Marginal Price 120

47. LOLP Loss of Load Probability 48. LSE Load Serving Entities 49. MCP Market Clearing Price 50. MCV - Market Clearing Volume 51. MISO - Midwest Independent System Operator 52. MOP Ministry of Power 53. MOU Memorandum of Understanding 54. MW Mega Watt 55. MWh Mega Watt hour 56. NETA New Electricity Trading Arrangements 57. NGC National Grid Company 58. NLDC National Load Dipsatch Centre 59. NR Northern Region 60. NTPC National Thermal Power Corporation Limited 61. NVVN NTPC Vidyut Vyapar Nigam Limited 62. NYISO New York Independent System Operator 63. NYPE New York Power Exchange 64. NYPP - New York Power Pool 65. OASIS Open Access Same time Information System 66. OPF Optimal Power Flow 67. PAC Price Area Congestion 68. PJM Pennsylvania-New Jersey-Maryland 69. PLF Plant Load Factor 70. POC Poitn of Connection 71. PPA Power Purchase Agreement 72. PPP Pool Purchase Price 73. PPS Power Producers and Suppliers 74. PSP Pool Sale Price 75. PTC Power Trading Corporation of India Limited 76. PX Power Exchange 77. R&M Renovation and Modernisation 78. REB Regional Electricity Board 79. REC Regional Electric Company 80. RLDC Regional Load Dispatch Centre 81. Rs. - Rupees 82. SC Scheduling Coordinators 83. SCUC Security Constrained Unit Commitment 84. SEB State Electricity Board 85. SERC State Electricity Regulatory Commission 86. SLDC State Load Dispatch Centre 87. SMP System Marginal Price 88. SO System Operator 89. SPC State Power Corporation 90. STU State Transmission Utility 91. T&D Transmission and Distribution 92. TCC Transmission Congestion Contracts 93. TP Transmission Provider 94. TPC Tata Power Company 95. TSC Transmission Service Charges 121

96. TSO Transmission System Operator 97. UI Unscheduled Interchanges 98. UK United Kingdom 99. UPSERCUttar Prdesh State Electricity Regulatory Commission 100. US - United States of America 101. VAR Volt Ampere 102. VOLL Value of Loss of Load 103. WRPC Western Regional Power Committee


Chapter 1: Market models in electricity

1.1 Introduction

The electricity industry is technically complex and

institutionally complicated. For about more than 100 years, the

industry remained vertically integrated. During that time,

engineers treated the management of this industry as a set of

optimisation challenges [13]. Making competition work in this

complex industry is to be carefully modeled. Regulation is

considered a poor substitute for a competitive market and is

only adopted where, for reasons of natural monopoly or public

interest, competition is not feasible or performs poorly without

government controls. The decade old world experience of

competition in electricity is good and not so good. However,

none of the countries have gone back on introducing

competition. This shows that competition in this industry is

feasible. Competition is what benefits consumers and benefiting

consumers should be what public policy is all about [1].

Whatever may be the market model adopted, it should be able to

deliver the consumers

Lower prices Reliable services Predictable bills and Value added services

1.2. Historical Background

In the last century, when the electrical technology was in the

infancy, government was hesitant to invest huge public capital

in unproven technology. Private investors like Westinghouse,

Edison etc., being confident of the technology, came forward for

investing. So, the government provided them with local

monopoly and assured fair return through regulated price.

Thus regulation provided risk minimization for both sides. Both

regulation and deregulation make sense and one or other is

preferable under certain conditions [2].

With the advent of efficient combined cycle gas turbines, the

economies of scale condition in support of the vertically

integrated companies no longer existed. Also, large-scale

computerisation and automation of the processes led to the

reduction of manpower requirement. The monolithic vertically

integrated firms by then were suffering from huge human

inventories, inefficiencies, and unaccountability. By now, as the

technology is proven, finances were readily available; the

condition for granting monopolies no more existed. Apart from

the above, the economists argued that competition would

encourage innovation, reduce costs, improve services and bring

in customer focus. All these and other political compulsions led

to deregulation of the electric industry.

There are many terms being used in different contexts of

making the electricity industry competitive, like regulation,

deregulation, restructuring etc, which are briefly introduced

next.

1.2.1 Regulation

The same company provided generation, transmission and

distribution in the area of its monopoly. The industry remained

vertically integrated for more than a century because of the

following reasons.

To keep the system stable, it was considered that generation and transmission needed to be under

the command and control of single entity.

The natural monopoly aspects of economies of scale, site requirements for the transmission

corridor and network characteristics.

The natural monopoly aspects of economies of scale, space requirements, aesthetics etc., which

make the competition in the distribution

uneconomical.

The economies of scale of generation and integrated development of generation and transmission.

To safeguard the interests of the consumers, it was felt

necessary by the government to control the industry through

regulation. The regulated industry grew in size over the years.

The regulatory solutions are inefficient and have some

disadvantages. The regulator looks at the scenario post-facto

and it may appear that there are efficient ways of managing the

business. Hence the regulator may disallow the expenditure of

the utilities. Thus the utilities carry the risk of good faith efforts

disallowed. Even though the regulatory solutions are inefficient,

they are successful in safe guarding the interests of the

customers.

1.2.2 Deregulation

It is to remove entry/exit barriers to the trade and industry and

to remove controls on prices. This would be disastrous to the

consumers if deregulation was done without putting necessary

safeguards in place. To introduce competition in the electricity

major changes are required such as

Time slab-wise metering of most of the consumption (need not be most of the consumers) and pricing of

electricity during different time slabs are to be made

known from the market in real time on the web

page of the retailer/distributor so as to develop

customer response.

System operation should be separated from the trading of electricity.

Transmission (and distribution, in case of retail access) network should be separated from the

trading.

Remove entry and exit barriers for all the market participants i.e. generators, distributors, retailers

and consumers.

Just declaring the industry is deregulated and providing open

access cannot produce competitive markets. The UK had made

a law permitting competitive entry and requiring open access

from 1984 onwards; but since it did not provide the trading

arrangements there were no takers until the industry was

totally restructured in 1990 [1].

While deregulating the industry, reliability is the paramount

important factor that needs to be taken care of - reliability in

terms of transient stability, adequate capacity additions in

generation and transmission and distribution networks.

Competitive markets replace the regulatory control with that of

the market participants investment decisions. It will bring in

effective utilisation of the assets and at the same time may lead

to more congestion.

1.2.3 Decentralization

Unbundling of different functions of the vertically integrated

monopoly to make the utility more resilient is all about

decentralization. The decentralised model can work decently, if

it is designed properly. It is capable of delivering competition if

it includes market-based solutions. It certainly can be designed

poorly, as the California is a glaring example.

Electricity is a commodity so different from others, that it

remained logical to remain regulated for so long. The major

difference between regulation and competition is the

responsibility of taking risks, which provides incentive to

improve. The main risks involved are

Market demand and prices Technological developments or obsolescence Credit risk and Management decisions of investment, manning,

maintenance etc.

Under regulatory regime, customers take most of the risks and

rewards while under competition the owners are subjected to

risks and rewards.

During the last 10 to 15 years, electricity industry in many

countries is changing due to country specific reasons. In

developed countries while the main reasons for change have

been lower tariff, better services and consumer choice, in

developing countries the reasons have been capacity

augmentation, building efficient systems, and reasonable tariff.

However, restructuring this industry is harder than most people

think, because electricity,

cannot be stored (storing in High Voltage batteries and in pumped storage reservoirs entails high

costs).

is transported at the speed of the light over a fragile and interactive transportation network requiring

short term and real time coordination.

traces the path of least resistance and defies the planned transmission route allocation

follows unique set of laws of physics normally has low price elasticity of demand

The common feature of the decentralized trading model is that

the system operator must take into account the origin and

destination of contracts for scheduling and dispatching. The

system operator is not intended to facilitate spot market - she

simply schedules trades that have been arranged elsewhere,

whereas in the integrated model, the system operator makes the

trades automatically. Introduction of competition poses some

really difficult problems. Rational solutions depend upon

understanding these complexities and designing ways to

account for them [1]. Restructuring, Open access and

Deregulation are the tools used to introduce competition and

improve efficiency. The elements that need to be in place for the

markets to be competitive and work efficiently are

many buyers and sellers ensuring lack of market power to any individual utility

price responsiveness of demand and supply

liquid and efficient markets accurate and timely information to all non-discriminatory access to transmission and

distribution networks

Even though the competition theory and the theory of market

power holds that market power will solve itself by the entry of

new competitors, who will drive down the prices back to the

competitive level. In reality, it may not happen. A dominant

player can set the market price. If a competitor tries to enter

that territory, the dominant player can lower the prices, lower

than the competitor and scare him off. This will result in the

new incumbent falling flat due to lack of financial muscle or it

may lead to price wars.

If the competition is limited to the wholesale market and the

retail customers are charged at a price averaged over time, then

the retail customers where the actual load can be controlled will

not have any incentive to respond. So, while designing

competition, it is necessary that the model should be so built

that there would be information available in real time to all the

actors in competition and there would be incentive for all of

them to respond to the changing scenario in the grid in real

time. Advantage of competition is that the supply will be

reliable as lights go off only when the consumer wants them to,

given the price signal. The lack of customer response is what

worries about the reliability of supply. Adequate attention to

demand response results in flattening of the load curves and

would remove the need for capacity addition. This would

require metering with respect to the time of usage.

To illustrate the effect of load flattening refer to the following

example.

Electricity consumption per

month Rate per kWh Charges for the month

Hours Contracted Actual Contracted Spot As per

Charge

(Credit)

Usage

(kWh)

Usage

(kWh)

Diff.

(kWh) Price (Rs.)

Price

(Rs.)

Contract

(Rs.)

for

difference

(Rs.)

a b c d=c-b e f g=b*e h=d*f

00-04 200 250 50 3.50 1.50 700.00 75.00

04-08 300 400 100 3.50 2.00 1050.00 200.00

08-12 450 650 200 3.50 3.50 1575.00 700.00

12-16 1000 750 -250 3.50 4.50 3500.00 -1125.00

16-20 1100 850 -250 3.50 4.00 3850.00 -1000.00

20-24 350 500 150 3.50 1.50 1225.00 225.00

Total 3400 3400 0 11900.00 -925.00

Bill as per the contract = 11900

Charges for the extra usage = 1200

Credit for the reduced usage = -2125

Net charge / credit for

difference = -925

Total Bill = 10975

Table 1.1: Load flattening effect of TOD based pricing

Figure 1.1: Load flattening effect of TOD based pricing

The basic difference with decentralized model when compared to

the integrated model is that in decentralized model it ends up

requiring not only private markets for regular Electricity, but

also markets for congestion management, imbalances, ancillary

services, provision for reserves etc, which are explained later.

1.2.4. Restructuring

During 1980s, some economists started arguing that the

monopoly is to be removed to incentivise innovation, to operate

efficiently and to discourage unnecessary expenditures and

investments. That would require the vertically integrated

companies to unbundled [13]. The aim is to remove the

monopolies and to bring in competition. This is done by

separating some functions of vertically integrated entity,

combining other functions and sometimes creating altogether

new companies. This may lead to the loss of synergies and

economies of scale of the traditional monopolistic structure.

But, if efficiency gains could offset these losses then the

restructuring also known as unbundling will result in overall

gains. While restructuring, it would be prudent to retain the

natural monopolies; like having a single transmission and

distribution network in a particular area instead of having

multiple networks, which would result in duplication of the

assets without any apparent benefits. Therefore, the

restructured industry would still retain the regulated natural

monopoly of transmission and distribution networks while

competition would be introduced in generation and retailing.

1.2.5 Open Access

Open access means that everyone gets the opportunity to use

the wires without any discrimination. But indiscriminate access

to the network poses new challenges. In a vertically integrated

electrical industry, coordination of generation and transmission

was easy as all the assets are under command and control of a

single entity. In the competitive industry, new trading

arrangements have to be set up to ensure real-time coordination

[1]. This can be accomplished by complete separation of system

operations into an independent organisation.

In addition to the real-time coordination, open access requires

arrangements for long-tem control of the transmission. In a

vertically integrated industry, utilities themselves planned and

implemented the transmission along with the generation and

distribution. However, in the deregulated environment there are

challenges of transmission expansion, pricing the transmission

rights, providing access without discrimination and

coordination with different agencies involved.

The open access when extended to the retail markets is known

as customer choice, where customer can chose the supplier

and every supplier has access to the local distribution network.

1.3 Industry Classification

The industry can be differentiated in a number of ways and

different classifications can be used to identify the models.

There are different models in existence world over.

1.3.1 Classification based on trading model

This classification assumes continued monopoly over

transmission and distribution network and system operation.

The differentiating characteristic is how the Electricity is traded

in the industry.

a. Integrated model

This is the model, which prevailed for more than a century in

many of the markets and is still in practice in many nations. In

this model, the generation, its transmission, distribution and

sales are all integrated into a single monopoly, which is under

the control of single electricity entity. The utility charges

average tariff from the customer and often would not segregate

individual costs involved in each function, which led to

unaccountability and inefficiencies. The advantage of this

model is fairly stable and easy to understand electricity bills.

Figure 1.2: Vertically integrated monopoly business model

This model was in use many of the SEBs in India and is still in

vogue in some SEBs. All the functions of electricity generation,

transmission, distribution, sales and billing are integrated into

one entity. This model is losing its relevance in India with the

restructuring drive taken up in all the states.

b. Decentralized Business Model

The following is a representative structure in the deregulated

market. There are so many other models to choose from. It is

up to the policy makers to decide on the choice of the model.

Figure 1.3: Decentralized business model

In deciding the model, they have to understand the implications

of structural change, the need for institutionalizing new

arrangements and to address new set of complications. In the

wholesale competition model, the challenge is to address the

problems of the boundaries and devising contracts. The

challenge in the retail competition model is to develop the new

settlement system and transaction costs. However, retail

competition overcomes the shortcomings of the wholesale

competition model. Different models in decentralized model can

be pool model, competition at wholesale and retail level. These

are explained further.

i. Pool model

This is the model first used in United States and in United

Kingdom. This is a model of monopsony where a single

buyer would purchase the Electricity required from the

generators. In this model the independent generators

have no option but to generate and sell only to pool. The

Monitory Flow

existing utilities will draw from the pool, which has

complete monopoly over distribution companies and final

customers. The prices at which the generators sell the

electricity to the pool would either be determined by the

market regulator or the utility signs a long-term life long

contract with the generators. These bilateral contracts

can run in parallel to the pool operation.

The system operator would normally operate the pool.

This would follow a single auction formula. All the

generators would bid into the pool and the system

operator after running an optimisation algorithm would

decided which generator to run. The buyer has no option

of choosing the supplier. This is a limited form of

competition in the wholesale segment. The market

structure is based on long-term contracts and most of the

risks are transferred to the customer through these long-

term contracts. The challenge in this model is to decide

how to ensure profits to the generator. If the profits are

paid upfront, then the issue is to ensure to run the plant

when it is required. If the profits were paid with variable

charges, then the issue would be to stop the plant when it

is not needed. Normally this model will have two-part

tariff where in fixed charges are paid when the plant puts

in certain minimum number of hours of service over the

period. Variable charges would be paid based on the

electricity generated. A similar model was in existence in

India for its central sector power plants where SEBs have

share in these power plants. The states would pay fixed

charges for their share in each CGS and would pay

variable charges based on the electricity drawn from each

CGS.

The generators have no option but to sell their Electricity

at the regulated prices or at Market Clearing Price decided

by the Single Auction Model explained under head Power

Exchanges.

Figure 1.4: Pool business model

The pool model is similar to unit commitment and

economic dispatch. In traditional unit commitment and

economic dispatch the actual cost of the electricity is

considered but in deregulated environment, the price

curves are considered and the actual cost curves are

hidden from the knowledge of general public.

ii. Wholesale competition

In this model, the entire generation is deregulated and the

generators sell the electricity in competitive wholesale

market to discoms, retailers and large customers.

Allowing only large customers in the initial phase though

will thwart development of competition, will allow the

Genco Genco IPP IPP

STU Power Pool

Disco

Customer

Disco Disco

Customer Customer Customer Customer

market to stabilize and test the waters before introduction

of competition in the retail market as well. The

disadvantage with this model is that some of the large

customers may be too large and may thwart competition

from developing.

Figure 1.5: Wholesale competition business model

With restructuring of the Indian electricity industry, this

sort of model is evolving in all the states. With the

unbundling of the state electricity utilities, the emerging

scenario is going to appear similar to this model. Some

states are ahead and some are trailing in adapting to this

model.

iii. Retail competition

This is the ultimate model of competitiveness in the

electricity industry. Countries like Norway, Sweden,

Spain, Australia, New Zealand, United Kingdom and many

states of United States are trying to put this model in

Genco Genco IPP IPP

Disco

Customer

Disco Disco


place. The greatest challenge in this model is education of

customers, who should be aware of the developments in

the markets and should be able to participate in the

market. Also, this model requires that appropriate

metering (time of the day metering), billing and settlement

process are put in place. The advantages of this model

are that it gives all the customers choice to choose the

supplier; competition in the wholesale as well as retail

markets. The disadvantage of this model is those

customers need to be metered on the time block wise, as

the price is volatile and keeps on changing on block-to-

block basis. This would result in unpredictable electricity

bills.

As in the case of the telephone service providers, there

may be a plethora of switchings between the service

providers. This model may lead to confusion in a less

educated society, as it will be difficult to decipher the

electricity bill. The smaller customers may prefer

predictable bills and value added services. The

transmission and distribution networks will be given open

access.

Genco IPP Genco IPP

Figure 1.6: Retail competition business model

It would require good amount of distribution automation

and sophisticated automation for dissemination of varying

prices of electricity over the period of time. This model

would also require consumer education, as the success of

this model depends on the extent of consumer demand

response to the supply price signal. With the exiting

infrastructure, it would be difficult to adapt retail

competition in the Indian market.

1.3.2 Classification based on contractual model

The market can be classified based on how the electricity is

contracted. It can be through a term contracts or through

Power exchanges or through pool. The pool model is explained

above and the remaining two are dealt with now. It is worth

mentioning here that the models are not mutually exclusive.

Any or all of them could co-exist.

a. Bilateral Agreements

Retailer

Customer

Retailer Disco


Disco

In this model, individual buyer and seller would enter into an

agreement for exchange of electricity at agreed terms and

conditions without entering into pool arrangements. The terms

and conditions may be agreed through negotiations or through

competitive bidding. These contracts would then be informed to

the system operator for implementation. These contracts could

be Long term extending to the life of the plant or may be Short term valid for a period typically of less than twelve months. At times a combination of both in conjunction with pool purchase/

spot purchases are used which is known as Hybrid model. The advantage of this model is flexibility. It is not mandatory to sign

bilateral contracts or to purchase through pool. Customers can

choose the mode of purchasing power based on their

convenience and requirement.

b. Third Party Agreements

In this model, a third party (trader) would get the bids of power

from the suppliers and would offer the electricity to the needy

consumers at a negotiated price or on cost plus basis. The

supplier and consumer would be relieved of the effort of

identifying the counter party. The trader would act as an

intermediary for such trades and she would secure the

payments for the electricity traded.

c. Power Exchange

This is the model normally used to trade commodities, which

operates more or less similar to a stock exchange. The sellers

and buyers would inform the Power Exchange, the quantity and

the price at which they are willing to exchange electricity. This

is known as Double Auction Model. The point of intersection

of demand and supply would determine the Market Clearing

Volume (MCV) and Market Clearing Price (MCP).

Figure 1.7: Double sided auction on Power Exchange

In other model, known as Single Auction Model, the sellers

may indicate the quantity and the price at which the electricity

that the generator would be willing to sell. The system operator

would arrange these bids in ascending order and the cut-off

point where the last unit of demand is met would determine the

MCP.

Double-sided auction model

MCV

MCP

Volume in kWh

Price in Rs. /kWh

Single sided auction model Price in Rs. /kWh

Demand

Supply

Figure 1.8: Single sided auction on Power Exchange

In this model, there are chances of price rigging through

strategic bidding.

Figure 1.9: Merit order clearing of Power requirement

It is explained with help of the above diagram.

Anticipated Demand

MCP

Volume in kWh

Merit Order

Gen

1

Gen

2

Gen

3

Gen

4

Gen

5

Gen

6

Gen

7

Gen

8

Gen

9

Gen

10

Gen

11

Gen

12

Gen

13

Gen

14

Gen

15

Supply

Rs./kWh 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

MCP = Rs.2.75/kWh

To meet the demand, the system operator would schedule full

generation up to generator 11 and partial generation on

generator 12.

However, say a particular utility owns generators 2, 4, 5, 9, 11

and 15. It can strategically bid out one of its generators forcing

the system operator to acquire more costly power from say

generator 13. This would result in increased MCP and hence all

the generators that are scheduled will be benefited by the extra

contribution. Scenario under such situation is depicted in the

next drawing.

Strategic Bid

Gen

1

Gen

2

Gen

3

Gen

4

Gen

5

Gen

6

Gen

7

Gen

8

Gen

9

Gen

10

Gen

12

Gen

13

Gen

14

Gen

15

Gen

16

Gen

11

Figure 1.10: Scenario under strategic bidding by a generator

Generator 11 is bid out of merit order, yet benefiting the utility

as a whole.

The disadvantage in this model is that price rigging can be done

by shifting the low cost generator out of service. The slope of

the price curve is an important determinant of such behaviour.

Rs./kWh 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

MCP = Rs.2.95/kWh

The steeper it is, the more likely it is that economic withdrawal

is profitable [1].

In this model also, the supplier and consumer would not know

with whom they are dealing with. The bids on the power

exchange can be submitted for Day Ahead market, in which case the bids would be submitted at 10:00 hrs and the deal

would be finalised by evening to be implemented from 00:00 hrs

of the next day. There can be bids for Intra day markets, which will be submitted any time upto an hour in advance,

which will be used to make adjustments during the day of

operation. The markets can be a combination of the above two.

1.3.3 Classification based on system operators

Electricity needs short-term coordination (Day ahead, intra day

and real time coordination). The system operator has to ensure

system security and reliability and she has to respond within

seconds to get plants to change their output if an overload

threatens [1]. Open access to the transmission and non-

discriminatory system operations are the two important features

for competition. These are the two major sources of dispute.

Another area of dispute is the responsibility of expanding the

transmission network to meet the future requirements. The

system operator may need more transmission lines for better

stability and availability of requisite transmission capacity. On

the other hand, the transmission company may not be

interested in investing due to lack of adequate returns on the

investment.

As it would not be economically viable and environmentally

feasible to build new assets, it would be ideal to operate these

assets to their maximum limits.

a. Transmission System Operator (TSO)

In this model, the system operator would own the transmission

assets. This is the model adopted by most of the European

countries in conjunction with pool operation. All the

transmission assets are at the command and control of the

system operator.

In such a model, the responsibility of providing open access to

all the participants and developing the network lies with the

TSO. During real time congestion, the system operator has to

reschedule the transactions to safeguard the security of the grid

and safety of her assets. The system operator may be reluctant

to reschedule too often. So, she has incentives to calculate

available transmission capacity on a fairly conservative basis

[1].

The Nord Pool adopted TSO model where individual countries

have their independent transmission networks and manage

them. These networks are coordinated under Nordel.

b. Independent System Operator (ISO)

This is the model adopted by many markets in United States,

Canada and Australia etc. In this model the system operation

and market operation are combined into one at Independent

System Operator (ISO). The ISO will have no assets and will

have no commercial interest in the activities of the market

participants. However, the ISO would operate the imbalances

market and ancillary services market. She will have command

over all the market participants, empowered through legislation.

In a competitive world the system operator need to be

independent for discharging the following responsibilities.

To ensure equal opportunities to all the participants for accessing the network.

To ensure integrated operation of the grid and maintaining grid security and stability at all points of

time.

Assess and monitor the demand supply situation and acquire the differences from the balancing markets.

Acquire ancillary services as and when required. Manage the network congestion.

1.3.4 Classification based on transmission ownership

The transmission assets can be developed by a monopoly

because of its characteristics as a natural monopoly. However,

this monopoly could be limited to a region, a state or a territory

or the monopoly can be extended to the whole of the country or

region of operation. If the entire country is given a national

monopoly then it is called National Monopoly. The country may be divided into number of regions and Regional Monopoly may also be granted. The development of new transmission

capacity would be the responsibility of the national

transmission utility. In such a case, regulator or central

planners should oversee the investments in the transmission

sector to ensure that adequate transmission capacity is built to

meet the future transmission requirements and the stability

considerations.

To bring in competition in the transmission sector and to

encourage innovation and competition, transmission sector may

open to multiple players with open access. In such a case, the capacity augmentation would be in the corridors where the

rate of return is attractive to the investors. The system may

need augmentation of transmission capacity for the reasons of

system considerations. Such investments would not be

forthcoming incase of competition in transmission.

1.3.5 Classification based on number of participants

This type of classification is based on the number of

participants operating in the market, from the sellers side as

well as from buyers side. If there are many sellers and single

buyer as in the case of the pool, perfect competition may exist in

the sellers market while in the buyers market, it will be a

monopoly. Different models are briefly described here under.

a. Monopoly

In this model, a single entity will have the control over the entire

market in the identified geographic territory/ jurisdiction.

Normally the monopolies will either lie with the government or

the government will have a supervisory control over the entity to

ensure that the end consumer interests are protected. When

the monopoly situation is created in the buyers market it is also

known as monopsony.

b. Oligopoly

In oligopoly, the competition is limited between few parties. The

oligopoly competition can exist either in sellers market or in

buyers market. In this market there are chances of price wars,

game plays or formation of cartel. If there are only two

participants in competition then the market is known as

Duopoly.

c. Perfect competition

In this type of competition there will be many number of market

participants each with a small share of the business that none

of the participants will have the market power. This is the ideal

market situation and it is very difficult to build a perfect

competition, as there will be some or other forms of market

imperfections.

Chapter 2: Factors influencing trading and competition

2.1 Introduction

Before competition is introduced into electricity markets, it is

essential that measures to support competition need to be

taken. The basic requirements of competition are providing

1. Adequate transmission capacity at appropriate price

without any discrimination,

2. Provision for imbalances management

3. Congestion Management

4. Providing ancillary services,

5. Ensuring the grid security and stability and

6. To hedge the risks involved in the business.

Transmission pricing and system operation thus finds

importance in bringing competition into play.

2.2 Transmission pricing

For introducing competition, it is necessary that the

participants are aware of the commodity (electricity) price and

the infrastructure (transmission) price. The knowledge about

the price and the charges involved in bringing the commodity to

the place of consumption will help in decision-making and will

produce better trading. Apart from the information about the

pricing, open access to the transmission network without any

discrimination is essential. The critical elements in providing

open access to transmission system are charges for

transmission in case of no congestion and charges for the

transmission to mitigate or manage the transmission

constraints. There are several ways of achieving these

objectives. The charges for congestion management are dealt

with under the heading congestion management. Different

methods of transmission pricing are adopted to suit the local

conditions, which are delineated here under.

2.2.1. Flat fee

This is the simplest possible transmission pricing. It can be

easily understood and the fee would be stable over the period.

The total costs of fixed charges and operation and maintenance

charges are distributed amongst all the customers who use the

transmission system.

2.2.2. Postage stamp method

This is also fairly simple way of transmission pricing.

Irrespective of the distance involved all the users would pay the

charges on the proportionate use of the transmission capacity.

In India, the postage stamp method of transmission pricing is in

use. The postage stamp pricing is used among the beneficiaries

of the region and the regional price of the transmission capacity

in Rs./MW would be worked out and billed according to the

contracted amount of electricity transmitted.

2.2.3. Mile MW method

This is a little complicated but reasonable way of pricing the

transmission capacity as both the quantity and the distance

over which the electricity is transmitted is taken as basis for

calculating the transmission charges payable by the individual

customer. The model cannot take into account actual circuit

miles of transmission line usage. Hence, notional distance of

power transmission is considered as the electricity would flow

based on the network configuration and system dynamics,

which cannot be accurately predicted.

2.2.4. Contract path method

This method uses the assigned path of electricity transportation

as the basis for calculating the transmission pricing. However,

the electricity is such a commodity that it would be difficult to

assign a path of transmission of electricity. The electricity

follows its own distinct and unique laws of physics traversing

the network following the path of least resistance.

2.2.5. Point of Connection tariff

In this method the existing total transmission charges for the

region or a state where the tariff is being introduced is

accounted for. Whatever may be the present method of

transmission tariff, the present level of revenue from

transmission is assured in POC tariff. In the new tariff, the

tariff per MW at the highest voltage level is calculated based on

the investments made and the amount of power transmitted.

Then the same at a lower voltage level it is calculated. The

calculations are done for the entire network till the lowest

voltage level is reached. Now for every node in the network the

transmission tariff is fixed based on the layers of transmission

network used. This will be a transparent and stable

transmission pricing.

2.3 Imbalance Management

Whatever model is adopted, the notion that the transactions

should be physically scheduled so that buyers and sellers

should be matched is a fiction. There are bound to be difference

between the contracted amount of electricity and the actual

delivery/consumption. This imbalance between the contracted

quantity and the real time requirement need to be bridged to

ensure the stability and the security of the transmission

network and to ensure the quality of electric supply.

In an integrated model, the system operator owns resources

necessary to provide this service. In a decentralized model, the

system operator has to acquire these resources on commercial

basis. The balances can be acquired either at regulated prices

or at market-based prices. In case of an integrated model,

arbitrary imbalance prices invite gaming. Consumers may

prefer imbalances rather than contracting at more expensive

prices.

A similar trend is seen in the Indian market also. Some

consumers prefer not to schedule their share of electricity and

instead rely on the UI power to meet their demand. It is better

to determine the imbalance price based on the market

requirements. This sends the right signal to the contracts

market and for the long-term investments for the generation.

The imbalance market gives flexibility for the generator and

consumer to deviate from the contracted quantity of electricity

as the imbalances are appropriately priced instead of punitive

prices.

2.4 Congestion management

In the pool system all the consumers would pay a common

price, MCP as mentioned earlier. When the markets are thrown

open to competition, all the buyers would seek to benefit from

the cheaper sources of electricity. This may result in congestion

over transmission network. This may create market power for

some of the generators to exploit the opportunistic situation.

In vertically integrated utilities, the generation and demand are

fairly stable and generation and transmission facilities are

augmented in a coordinated way. Also, as the system will be

under control and command of a single entity, the assets are

controlled effectively and the possibility of congestion is

minimal. In a competitive environment, the supply and demand

could vary widely with the market forces and may lead to

congestion. The congestion is managed through different ways

listed under.

Price Area Congestion (PAC) management Counter trade Pro rata reduction in capacity allocation Bidding for the residual capacity Nodal / Zonal pricing Constrained unit commitment model

However, during the phase of congestion management, the

system operator calls for additional generation in one area and

reduced generation in another area or reduced load in one area

and increased load in another area. While doing so, however,

no entity would like to lose on commercial front. As such, the

arrangement should be able to answer the issue.

2.4.1. PAC Management

Whenever, congestion is apprehended, the system operator

declares that the system is split into different price areas across

the congestion area, with higher pool prices in the area

downstream of congestion and lower prices in the area

upstream of the congestion. This will relieve the congestion on

the transmission network.

The advantage of this method of splitting the market into

different price areas is that it gives a price signal to the

generating companies to add new capacities in the area of

higher pool prices thus increasing the competition and

ultimately reducing the overall price in the long run.

2.4.2. Counter Trade

This method is used incase of real time congestion on any

transmission corridor. The system operator will offer a counter

trade to the upstream of the congestion to the extent that the

transmission corridor is relieved of congestion. The counter

trade is a notional trade, which will result in reduced generation

from the upstream of the congestion so that generation

elsewhere will be picked up to balance the system and relieve

the congestion simultaneously. The charges towards this

counter trade will accrue towards the charges of system

charges.

2.4.3. Pro-rata reduction

In case of congestion, all the participants drawing power on that

corridor will be given a pro-rata reduction of the schedules so

that the drawl on the corridor reduces to relieve the congestion.

2.4.4. Bidding for Residual Transmission Capacity

At present this method is being used in India for usage of the

residual transmission capacity left out after catering to the long-

term bilateral contracts. All the consumers would contest for

the remaining capacity available in transmission corridors of

their interest. In the absence of any congestion, as mentioned

earlier in transmission pricing, the corridor would be made

available to all the short term customers at 1/4th of the price for

the long term customers arrived at by postage stamp method.

For short-term customers, all the applications received upto

19th of every month would be bunched and access would be

allowed on first-come-first-served basis, subjected to the

availability of ATC [3]. However, in case congestion is

anticipated, then revised bids would be sought from all the

customers. These bids would be arranged in descending order

and the customers who are willing to pay higher charges would

be allowed access. However, the highest bid is capped at 5

times the floor price in case of inter regional transmission

system and 2.5 times the floor price in case of intra regional

transmission system. In case the system operator notices the

congestion in real time, due to any constraints, she would

advise a revised transmission capacity allocation by reducing

the schedules in pro-rata basis.

2.4.5. Nodal / Zonal pricing

In this method, the system operator would obtain the cost

functions of the generators and bids of consumers and would

run an optimisation algorithm, which will take into

consideration number of constraints and derive at the optimum

solution to meet the demand. In case of congestion, this

algorithm would divide the entire grid into nodes and would give

nodal prices. Or the system could be divided into number of

zones and would give the price in each zone. The zone with

higher generation would be priced low and the zone with

shortage in generation would be priced higher. In case of no

congestion, the entire system will have a single price.

2.4.6. ATC with Constrained unit commitment model

The system operator would schedule all the regular transactions

and then would indicate the available transmission capacity in

each transmission corridor for each time period of the day. This

information would be displayed on the web site of the system

operator. A similar system namely OASIS (Open Access Same-

time Information System) is in vogue in PJM interconnection

and in some other US markets. Customers would access this

OASIS and find out whether any transmission capacity is

available for the transaction they are planning. As the ATC

becomes scarce, the price of the ATC in that corridor goes high.

This would give the price signal to the market for investments in

that area. Though a little complicated this would be a

transparent system of offering open access without any

discrimination.

The model is useful in centralised dispatch model like PJM

market, NYISO etc. The unconstrained unit commitment will be

derived based on the bids and offers. If any congestion is

noticed then the constraints are introduced into the algorithm

to arrive at the economic dispatch with constraints known as

constrained unit commitment.

2.5. Ancillary Services

In a vertically integrated monopoly, all the services are bundled

in one and the charges are billed as transmission charges.

However, when the electricity is deregulated and open to

competition, all the services would be separated, called for

separately and charged. The ancillary services includes

VAR compensation Balancing power Primary response Secondary response Spinning reserve Black start facility Peaking power Standby services Load following etc.

2.6. Grid Security

The system operator should ensure that the grid is stable and

secure. The system operator should exercise such command

and control over the system that she displays transparency and

non-discrimination in dealing with different customers. The

system operator should be empowered to give instructions in

the interest of the grid.

2.7 Hedging risks

The markets are known for their volatility and electricity market

is no exception. It has been observed that competition has

introduced uncertainty in the market and the price volatility has

increased tremendously in the absence of price caps. Price

caps, however, are an inefficient way of managing the exchange.

Apart from price risks, there may be risk of supply, payment

default, market risk, congestion, inadequate information and

lack of experience. In order to hedge against these risks,

transparent financial market needs to be developed where

products like futures, options, forward contracts etc., will be

available to hedge the risk.

The marketplace for electricity need to be liquid, where many

buyers and sellers could access each other easily and have the

access to market information. Also, the market needs to be

efficient where participants ideally cannot predict which way the

prices will move. The electricity market should be equipped

with proper risk hedging instruments, taking into consideration

the special requirements of the electricity business. Even

though various derivatives are used in the electricity markets,

the following are the most widely used instruments. They are

explained in brief. However, it is to mention here that the

derivatives markets are not intended for physical delivery of the

product. Normally less than 10% of the derivative instruments

will result in physical delivery of the product, while the rest are

used to hedge the risk through the difference of the derivative

price and spot market price. The derivative instruments are

traded in the secondary market also, making them liquid assets.

2.7.1 Futures

The futures market is a type of forward market that takes place

on an organised exchange. It is a standardized contract to

exchange the commodity at a predefined fixed future date for a

negotiated price. The standard terms and conditions of the

futures contract make it easily tradable. In an efficient and

transparent market the difference between the spot price and

the futures contract will always equal to the cost to carry. As

the maturity day approaches, the future and spot prices

converge [2].

2.7.2 Options

While the futures contracts are binding to exercise the right, the

options contract provides the holder of the contract the right,

but not the obligation, to buy or sell the commodity at an agreed

price known as strike price. The holder pays a fee / premium

upfront. Whether or not the option is not exercised, the fee paid

will not be returned. The holder will exercise the option, if the

spot price is favourable compared to the option price. The

options are two types. If the option gives the right to purchase

the commodity, then it is called call option and if it gives the right to sell the product, then it is called put option.

2.7.3 Forward contracts

This contract is similar to futures contract with the difference

that the forward contracts are tailor made unlike futures. These

tailor made contracts are between two parties and normally

culminate in physical delivery. These are not traded on

exchanges and hence are not liquid. These are short term in

nature and are used for managing the price risk where the

market prices are volatile and to off set the balancing

requirements in real time.

2.7.4 Swap contracts

The swap contracts are signed between two parties to hedge

against the volatility in the price. The swap would enable the

party to isolate itself from the volatility so that it can

concentrate more on the business while the swap provider who

is a financial expert in the business of providing the risk cover

will manage the swap contracts, by swapping the variable price

with a fixed price.

2.7.5 Contract for Differences (CFDs)

In pool system, generators and consumers may enter into long

term fixed price-hedging contracts also known as Contracts For

Differences (CFDs). The generators want to hedge the risk of

pricing dipping too low lesser than the marginal cost of the

generators while on the other hand the consumers want to

hedge the risk of spot prices going through the roof. CFD would

hedge the risk for both the parties. If the spot price dipped low,

the consumer would pay the difference to the generator while if

the prices soared, the generator would refund the difference

between the strike price and spot price.

This way a single contract would hedge the price volatility for

both the generators and consumers.

2.8 Choice of System Operator models

To keep the system stable, it was considered that generation

and transmission needed to be under the command and control

of single entity. However, with the introduction of the

competition, it became apparent that it is not required that the

system need to be vertically integrated. In restructured

markets, the system operator can be a TSO or an ISO. TSO

having the ownership of transmission assets under her control

will be at ease while controlling the grid. However, due to

ownership of the transmission assets, she will be compelled to

load the transmission assets conservatively. Thus TSO model

will limit the optimum utilisation of the transmission assets.

On the other hand, ISO will try to optimise the system

operations and will try to load the transmission assets optimally

simultaneously ensuring the security of the grid.

Apart from the above, when there are multiple owners of

transmission, it will be prudent to have an independent system

operator so that there is level playing field for all the owners of

the transmission.

2.9 Choice of trading models

While it is agreed that the monopoly is not a competitive model,

if conditions in a country warrants continuing with the

monopoly due to reasons of social conditions, the monopoly may

also work well in the given circumstances. However, the

challenge would be do ensure that a system is put in place to

make people accountable for their deeds and efficiencies are not

lost due to bureaucracy.

On the other front pool model suits those countries where there

is a need to bring competition in a limited way and continue

with the retail monopoly where the competition may not yield

better returns compared to the expenditure made in putting

competition to work in the retail market. The pool model also

helps in retaining the control over the market by regulating the

pool operator.

With the competition in wholesale market, the disadvantages of

monopsony could be eliminated in this model. Thus generators

are also not put to undue disadvantage as they have choice of

selecting their buyers. Furthering competition will result in

competition in the retails market where customers have real

choice. However, it is to be ensured that the retail competition

doesnt bring into too many complications in the operation and

the gains of introducing retail competitions far outstrip the

costs involved.

2.10 Choice of contracts

The bilateral contracts provide advantage of price stability and

predictability for both the generators and consumers over long

periods of time. While major requirements of electricity can be

met through these bilateral contracts minor adjustments in the

electricity requirements can be met through short term trading

contracts. The final fine-tuning of the electricity requirements

at the real time can be done in hour ahead or spot markets

through power exchange. The advantage of this model is

flexibility. It is not mandatory to sign bilateral contracts or to

purchase through pool. Customers can chose the mode of

purchasing power based on their convenience and requirement.

2.11 Choice of transmission ownership

The national monopoly of transmission provides with the

advantage of planned development of the transmission network.

It will also help in avoidance of duplication of assets. However,

national monopoly may go against the very premise of bringing

competition and efficiencies into the system.

Similar will the case with the regional monopoly as well as state

level monopoly. We may continue with the state level monopoly

for development of intra state transmission network. For

interstate and national transmission development, we may opt

for private transmission licensees; all providing non-

discriminatory open access. This is in line with the national

electricity policy. However, while adopting such a model, we

may have to have a central planning agency in the form of CEA

to plan approve the transmission interconnections for a

coordinated development of the network.

2.12 Choice of transmission pricing

The flat fee method is too primitive and the charges will not

reflect the usage of the transmission assets. On the other hand,

the contracted path method is a theoretical concept as it is well-

established fact that electricity flow cannot be assigned a

particular transmission corridor. The pricing of postage stamp

method though simple will not reflect the actual usage of the

transmission assets. It would be better if the transmission

pricing were based on the utilisation of the transmission assets.

The Point of Connection transmission pricing would better

reflect the philosophy. As such it would be an efficient way of

allocation of transmission costs to the users of the transmission

network.

Chapter 3: Electricity markets around the world

3.1 Introduction

The rationale for development of internal electricity markets

may be classified as legal, economic, technological and strategic

aims. The reasons may be different for different countries and

may be combination of several reasons.

3.1.1 Legal rationale

World over trade barriers are being removed. European court of

justice has held that electricity is a good within the meaning of

European treaty. Freedom of movement of goods is to be

ensured. However, due to public service value, electricity is

treated a bit delicately. Nevertheless, obligation to remove the

trade barriers is a matter of primary law.

3.1.2 Economic rationale

Global competitiveness depends on lower energy costs. The cost

differential results from the tax treatment (Danish government

imposes 142.5% tax on domestic sector while it is 8% in UK),

absence of competitive energy technologies used (Coal in

Germany to Nuclear in France), different pricing policies used

(France subsidies industrial consumers from domestic

consumers while it is the opposite in Germany).

With liberalisation, management may concentrate on short-term

profits and ignore the long-term capacity additions and R&D.

Hence gains in productive efficiency may offset losses in

dynamic efficiency.

3.1.3 Technology Advances

Due to disruptive technological advances, monolithic production

facilities with high sunk cost are becoming uncompetitive with

advances in gas turbine technologies and fuel cells. EHV grids

may become obsolete and distributed generation with miniature

fuel cells may replace them.

3.1.4 Strategic Aims

Dependence on external sources of energy requirement has

shown its disastrous effects during oil shocks. Strategic aim is

to have a coordinated energy policy to reduce the impacts of

external energy markets. The ultimate aim may be to ensure

energy security or to utilise the energy sources optimally or to

achieve self-reliance for the energy requirements or to utilise the

natural resources like water resources for optimally for energy

requirements and irrigation purpose. The strategic aim differs

from country to country.

3.2 Developed Electricity Market Models

By the time deregulation started in developed countries, already

they have established a well functioning and quite efficient

electricity system. In developed countries, the driving force

behind deregulation has been to provide customers with

electricity at lower prices and offer them a greater choice of

choosing their supplier pressure from small players in the

business to reduce the control and power of large state-owned

utilities.

The most discussed deregulation has been the England and

Wales market, with growing interest in the Nordic countries

model and much attention have been paid to actions in the

United States, especially in California, New York and PJM

Interconnection. California has been considered as a model

market to which others made reference. But perceptions about

the California market are now completely changed after

California crisis. Now lessons learnt from California electricity

market have strong influence on future policy and on the

evolution of other electricity markets worldwide. Hence in this

report, some developed electricity markets have been discussed

like England & Wales electricity market of UK, Nord Pool of

Nordic electricity market, California, PJM and New York

electricity markets of US. All these market models have

different characteristics and different trading arrangements.

3.3 England and Wales

3.3.1 Introduction

In United Kingdom (UK), the electricity industry was under

monopoly of Central Electricity Generating Board (CEGB),

generating and transmitting electricity. CEGB had to purchase

from British companies and couldnt seek better terms available

abroad. It produced, bought, sold and delivered electricity to 12

Area Boards. The Area Board in turn had monopoly in their

respective territory.

3.3.2 Phase I of reforms

During 1980s, with the experience of privatizing telecom and

gas monopolies, Conservative government led by Margaret

Thatcher published government white paper on setting out the

new structure for electricity. To create competition, CEGBs

generation was separated from its transmission. The

transmission is renamed as National Grid Company (NGC).

Generation is divided into three companies, National Electric

(now Innogy), Powergen and Nuclear Electric (later renamed

after privatisation as British Energy). The 12 Area Boards were

privatized and known as Regional Electric Companies (RECs).

The RECs have monopoly in one area while 2nd tier suppliers

can supply these areas bringing in competition. RECs were

thus under substantial competitive pressure.

3.3.3 Pool system

Then pool system was introduced. Licenses were given to

parties with sound financials. Half an hourly price bids by

generators were introduced. Demand is estimated by the NGC

and Optimal Power Flow algorithm would decide the Market

Clearing Price (Single auction method). The Optimal Power Flow

algorithm would take into consideration other variables like

operating flexibility, fixed price, variable price, standby charges,

startup charges, governor response, price for primary response

and secondary response (operating margins) and price for

peaking generation and derive the Pool Purchase Price (PPP).

Pool Purchase Price (PPP) = System Marginal Price (SMP) + CE

Where,

Capacity Element (CE) = LOLP (VOLL-SMP),

Where,

LOLP = Loss of load probability

VOLL = Value of load loss

Pool Sale Price (PSP) = PPP + Scale-up margin

SMP takes into consideration fixed price, operating price and

start-up price. As LOLP increases, the CE gives a price signal to

the market to attract more investments in to the capacity

addition.

Inspite of the best efforts and estimates, the actual demand

differs. As PPP is based on the estimates of demand, the model

calls for additional payments based on actual like reserve

capacity, capacity held due to transmission constraints,

generation beyond schedules to meet the consumption.

In pool system, generators and consumers used to enter into

long term fixed price-hedging contracts also known as Contracts

For Differences (CFDs). The CFD used to be the difference

between the strike price and PPP.

The pool system resulted in escalation of electricity prices while

the fuel prices dipped. Consumer surplus was encashed by the

shareholders and the management was rewarded by stock

options.

3.3.4 Regulatory Regime

To facilitate streamlining the industry, regulator is instituted by

enacting Electricity Act 1989. The objectives of the regulator

had been to

Regulate electricity prices Promote competition Induce new capacities Ensure health and safety of employees Protect environment / society Ensure stable power supply

3.3.5 Wholesale market

Due to technological improvements and the cheaper fuel prices,

many gas based Combined Cycle Gas Turbine (CCGT) plants

came up in UK. Gas units operate most efficiently when

operated continuously (with cycle efficiency as high as 60%) and

hence would bid low to remain in operation. Peaks were met by

expensive coal power plants. So, often the SMP is set by the

coal power stations. Hence, oligopoly situation prevailed in the

electricity market.

3.3.6 Retail market

Retailing and distribution is in the hands of the monopolistic

RECs. However, the second tier suppliers comprising of

generators and other RECs provided competition. This helped

in improving the service offered to the consumer and service

response time.

The ma

Electricity Trading(1)

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