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Power System Economics

The document provides an overview of power system economics and the key concepts involved in introducing competitive electricity markets. It discusses the different participants in the system such as generators, transmission operators, distribution network operators, retailers, regulators and consumers. It also covers important concepts like treating electricity as a commodity, effects of location and time on prices, and the need for unbundling of generation, transmission and distribution functions.

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50% found this document useful (2 votes)

637 views378 pages

Power System Economics

Uploaded by

mazinkaiser2174

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

Power System Economics:

Introduction
Daniel Kirschen

Generation

Transmission

Distribution

Customer

Wholesale Market and Transmission Wires

Retailer Retailer Retailer

Retail Market and Distribution Wires

Customer Customer Customer Customer

• Monopolies are inefficient

u No incentive to operate efficiently
• Costs are higher than they could be
u No penalty for mistakes
• Unnecessary investments

• Benefits of introducing competition

u Increase efficiency in the supply of electricity
u Lower the cost of electricity to consumers
u Foster economic growth

• Privatisation
u Government-owned organisations become private, for-profit
companies
• Competition
u Remove monopolies
u Wholesale level: generators compete to sell electrical energy
u Retail level: consumers choose from whom they buy electricity
• Unbundling
u Generation, transmission, distribution and retail functions are
separated and performed by different companies
u Essential to make competition work: open access

IPP IPP IPP IPP IPP

Wholesale Market and Transmission Wires

Disco Disco Disco Disco

Customer Customer Customer Customer

Wholesale Market and Transmission Wires

Retailer Retailer Retailer

Retail Market and Distribution Wires

Customer Customer Customer Customer

• Treat electricity as a commodity

• Examples of commodities:
u A ton of wheat
u A barrel of crude oil
u A cubic meter of natural gas

• A Volt of electricity?
• An Ampere of electricity?
• A MW of electricity?
• A MWh of electricity?

© D. Kirschen 2006
Effect of cyclical demand
•High load period
•Light load period •Need to run less
•Need only the most efficient generators
Load efficient generators •Marginal cost is high
•Marginal cost is low

Time
00:00 06:00 12:00 18:00 24:00

• Electrical energy cannot be stored economically

• Electrical energy must be produced when it is consumed
• Demand for electrical energy is cyclical
• Cost of producing electrical energy changes with the load
• Value of a MWh is not constant over the course of a day
• A MWh at peak time is not the same as a MWh at off-
peak time
• Commodity should be “MWh at a given time”

100 MW 200MW

• Price of electricity at A = marginal cost at A = 50£/MWh

• Price of electricity at B = marginal cost at B = 100£/MWh
• Transmission constraint segments the market
• Commodity should be “MWh at a given time and a given location”

100 MW B
A 100 MW

100 MW 200MW

• Consumers expect a continuous supply of electricity

• Commodity should be “MWh at a given time and a given
location, with a given security of supply”
• Need to study how we can achieve this security of supply

B 285 MW
126 MW π2=11.25 $/MWh

1 2
159 MW 66 MW
50 MW 60 MW

Power flows from

π3=10.00 $/MWh 3 high price to low
75 MW
price!
D
300 MW
© D. Kirschen 2006
Effect of the laws of physics

Exporting oranges
from Norway to
Spain?

• Competitive market will work only if it is fair

• One participant should not be able to prevent others from
competing
• Management of the network or system should be done
independently from sale of energy
u One company should not be able to prevent others from
competing using congestion in the network
u “Open access” to the transmission network
u Separation of “energy businesses” from “wires businesses”
• Energy businesses become part of a competitive market
• Wire businesses remain monopolies

• Monopoly vertically-integrated utility

u One organisation controls the whole system
u Single perspective on the system
• Unbundled competitive electricity market
u Many actors, each controlling one aspect
u Different perspectives, different objectives
• How to make the system work so that all participants are
satisfied (i.e. achieve their objectives)?

• Produces and sells electrical energy in bulk

• Owns and operates generating plants
u Single plant
u Portfolio of plants with different technologies
• Often called an Independent Power Producer (IPP) when
coexisting with a vertically integrated utility
• Objective:
u Maximize the profit it makes from the sale of energy and other
services

• Owns and operates distribution network

• Traditional environment:
u Monopoly for the sale of electricity to consumers in a given
geographical area
• Competitive environment:
u Network operation and development function separated from sale
of electrical energy
u Remains a regulated monopoly
• Objective:
u Maximize regulated profit

• Buys electrical energy on wholesale market

• Resells this energy to consumers
• All these consumers do not have to be connected to the
same part of the distribution network
• Does not own large physical assets
• Occasionally a subsidiary of a DISCO
• Objective:
u Maximize profit from the difference between wholesale and retail
prices

• Runs the computer system that matches bids and offers

submitted by buyers and sellers of electrical energy
• Runs the market settlement system
u Monitors delivery of energy
u Forwards payments from buyers to sellers
• Market of last resort run by the System Operator
• Forward markets often run by private companies
• Objective:
u Run an efficient market to encourage trading

• Maintains the security of the system

• Should be independent from other participants to ensure
the fairness of the market
• Usually runs the market of last resort
u Balance the generation and load in real time
• Owns only computing and communication assets
• An Independent Transmission Company (ITC) is an ISO
that also owns the transmission network
• Objectives:
u Ensure the security of the system
u Maximize the use that other participants can make of the system

• Government body
• Determines or approves market rules
• Investigates suspected abuses of market power
• Sets the prices for products and services provided by
monopolies
• Objectives
u Make sure that the electricity sector operates in an economically
efficient manner
u Make sure that the quality of the supply is appropriate

• Buys electricity from a retailer

• Leases a connection from the local DISCO
• Participation in markets is usually limited to choice of
retailer
• Objectives:
u Pay as little as possible for electrical energy
u Obtain a satisfactory quality of supply

• Often participates actively in electricity market

• Buys electrical energy directly from wholesale market
• Sometimes connected directly to the transmission
network
• May offer load control ability to the ISO to help control
the system
• Objectives:
u Pay as little as possible for electrical energy
u Obtain a satisfactory quality of supply

• Basic concepts from microeconomics

u Fundamentals of markets
u Theory of the firm
u Perfect and imperfect competition
u Contracts
• Organisation of electricity markets
Ignore the network
• Participating in electricity markets

• Security and ancillary services

u Energy services
u Network services
u System perspective Take the network
u Provider perspective into consideration
• Effect of network on prices
• Investing in transmission
• Investing in generation

Daniel Kirschen
University of Manchester

© 2006 Daniel Kirschen 1

Let us go to the market...
• Opportunity for buyers and
sellers to:

ß compare prices

ß estimate demand

ß estimate supply

• Achieve an equilibrium
between supply and demand

© 2006 Daniel Kirschen 2

How much do I value apples?
Price
One apple for my break

Quantity

© 2006 Daniel Kirschen 3

How much do I value apples?
Price
One apple for my break

Take some back for lunch

Quantity

© 2006 Daniel Kirschen 4

How much do I value apples?
Price
One apple for my break

Take some back for lunch

Home-made apple pie

Home-made cider?

Quantity

Consumers spend until the price is equal to their marginal utility

Price
• Aggregation of the
individual demand of all
consumers
• Demand function:

q = D(π )
Quantity • Inverse demand function:

π = D−1 (q)

© 2006 Daniel Kirschen 8

Elasticity of the demand
Price • Slope is an indication of the
elasticity of the demand
• High elasticity
High elasticity good
ß Non-essential good
ß Easy substitution

Quantity
• Low elasticity
ß Essential good
Price ß No substitutes

• Electrical energy has a very

Low elasticity good low elasticity in the short
term

Quantity
© 2006 Daniel Kirschen 9
Elasticity of the demand

• Mathematical definition:

dq
q π dq
ε= = ⋅
dπ q dπ
π

• Dimensionless quantity

© 2006 Daniel Kirschen 10

Supply side

• How many widgets shall I produce?

ß Goal: make a profit on each widget sold
ß Produce one more widget if and only if the cost of producing it is
less than the market price

• Need to know the cost of producing the next widget

Extra maintenance costs

© 2006 Daniel Kirschen 16

Supply curve
• Aggregation of marginal
Price or marginal cost cost curves of all suppliers
• Considers only variable
operating costs
• Does not take cost of
investments into account
• Supply function:

Quantity π = S −1 (q)

• Inverse supply function:

q = S(π )
© 2006 Daniel Kirschen 17
Market equilibrium

Price Supply curve

Willingness to sell

market
market equilibrium
clearing
price

Demand curve
Willingness to buy

volume Quantity
transacted

© 2006 Daniel Kirschen 18

Supply and Demand

Price
supply

equilibrium point

demand

Quantity

© 2006 Daniel Kirschen 19

Market equilibrium
q* = D(π * ) = S(π * )
Price
supply π * = D−1 (q* ) = S −1 (q* )

market • Sellers have no

clearing incentive to sell for less
price
• Buyers have no
demand incentive to buy for
more!
volume Quantity
transacted

© 2006 Daniel Kirschen 20

Centralised auction

• Producers enter their bids:

quantity and price
ß Bids are stacked up to
construct the supply curve Price
• Consumers enter their offers:
quantity and price
ß Offers are stacked up to
construct the demand curve
• Intersection determines the
market equilibrium:
ß Market clearing price
ß Transacted quantity
Quantity

© 2006 Daniel Kirschen 21

Centralised auction
• Everything is sold at the market
clearing price
• Price is set by the “last” unit Price supply
sold
• Marginal producer:
ß Sells this last unit
Extra-marginal
ß Gets exactly its bid
• Infra-marginal producers:
ß Get paid more than their bid
ß Collect economic profit demand
Infra-
• Extra-marginal producers: marginal
Quantity
ß Sell nothing

Marginal producer

© 2006 Daniel Kirschen 22

Bilateral transactions
• Producers and consumers trade directly and
independently
• Consumers “shop around” for the best deal
• Producers check the competition’s prices
• An efficient market “discovers” the equilibrium
price

© 2006 Daniel Kirschen 23

Efficient market

• All buyers and sellers have access to sufficient

information about prices, supply and demand
• Factors favouring an efficient market
ß number of participants
ß Standard definition of commodities
ß Good information exchange mechanisms

© 2006 Daniel Kirschen 24

Examples
• Efficient markets:
ß Open air food market
ß Chicago mercantile exchange

• Inefficient markets:
ß Used cars

© 2006 Daniel Kirschen 25

Consumer’s Surplus
• Buy 5 apples at 10p
• Total cost = 50p
Price
• At that price I am getting
apples for which I would 15p
Consumer’s surplus
have been ready to pay
more 10p
• Surplus: 12.5p
Total cost

5 Quantity

© 2006 Daniel Kirschen 26

Economic Profit of Suppliers
Price Price
supply supply

π
Profit
demand

demand Cost
Quantity Quantity
Revenue

• Cost includes only the variable cost of production

• Economic profit covers fixed costs and shareholders’
returns
© 2006 Daniel Kirschen 27
Social or Global Welfare

Price
supply
Consumers’ surplus

+
Suppliers’ profit demand

= Social welfare Quantity

© 2006 Daniel Kirschen 28

Market equilibrium and social welfare

Operating point
π π
supply supply

Welfare loss
demand
demand
Q Q

Market equilibrium Artificially high price:

• larger supplier profit
• smaller consumer surplus
• smaller social welfare
© 2006 Daniel Kirschen 29
Market equilibrium and social welfare

Welfare loss
π π
supply supply

demand
demand
Operating point
Q Q

Market equilibrium Artificially low price:

• smaller supplier profit
• higher consumer surplus
• smaller social welfare
© 2006 Daniel Kirschen 30
Market Equilibrium: Summary
• Price = marginal revenue of supplier
= marginal cost of supplier
= marginal cost of consumer
= marginal utility to consumer
• Market price varies with offer and demand
ß If demand increases
• Price increases beyond utility for some consumers
• Demand decreases
• Market settles at a new equilibrium
ß If demand decreases
• Price decreases
• Some producers leave the market
• Market settles at a new equilibrium
• Never a shortage
© 2006 Daniel Kirschen 31
Advantages over a Tariff
• Tariff: fixed price for a commodity
• Assume tariff = average of market price
• Period of high demand
ß Tariff < marginal utility and marginal cost
ß Consumers continue buying the commodity rather than switch to
another commodity
• Period of low demand
ß Tariff > than marginal utility and marginal cost
ß Consumers do not switch from other commodities

© 2006 Daniel Kirschen 32

Concepts from the Theory of the Firm

Daniel Kirschen
University of Manchester

© 2006 Daniel Kirschen 1

Production function

y = f ( x1,x 2 )
• y: output
• x1 , x2: factors of production
y
x2 fixed x1 fixed
y

x1 x2

Law of diminishing marginal products

• Some factors of production can be adjusted

faster than others
ß Example: fertilizer vs. planting more trees
• Long run: all factors can be changed
• Short run: some factors cannot be changed
• No general rule separates long and short run

© 2006 Daniel Kirschen 3

Input-output function

y = f (x 1 ,x2 ) x 2 fixed

The inverse of production function is the

input-output function
x 1 = g ( y ) for x 2 = x 2

Example: amount of fuel required to produce a

certain amount of power with a given plant

© 2006 Daniel Kirschen 4

Short run cost function

c SR ( y ) = w 1 ⋅ x 1 + w 2 ⋅ x 2 = w 1 ⋅ g ( y ) + w 2 ⋅ x 2

• w1, w2: unit cost of factors of production x1, x2

c SR ( y )

© 2006 Daniel Kirschen y 5

Short run marginal cost function
c SR ( y )

Convex due to law

of marginal returns

y
dc SR ( y )
dy
Non-decreasing function

y
© 2006 Daniel Kirschen 6
Optimal production

• Production that maximizes profit:

max { π ⋅ y − c SR ( y ) }
y

d { π ⋅ y − c SR ( y ) }
=0
dy

dc SR ( y ) Only if the price π does not depend

π=
dy on y ⇔ perfect competition

© 2006 Daniel Kirschen 7

Costs: Accountant’s perspective
• In the short run, some costs are
variable and others are fixed
• Variable costs:
ß labour Production cost [¤]
ß materials
ß fuel
ß transportation
• Fixed costs (amortised):
ß equipments
ß land
ß Overheads
• Quasi-fixed costs Quantity
ß Startup cost of power plant
• Sunk costs vs. recoverable costs
© 2006 Daniel Kirschen 8
Average cost
c( y ) = c v ( y ) + c f
c( y ) c v ( y ) c f
AC ( y ) = = + = AVC ( y ) + AFC ( y )
y y y

Production cost [¤] Average cost [¤/unit]

Quantity Quantity
© 2006 Daniel Kirschen 9
Marginal vs. average cost

MC AC
¤/unit

Production

© 2006 Daniel Kirschen 10

When should I stop producing?

• Marginal cost = cost of producing one more unit

• If MC > ! next unit costs more than it returns
• If MC < ! next unit returns more than it costs
• Profitable only if Q4 > Q2 because of fixed costs

Average cost [£/unit] Marginal

cost
[£/unit]
π

Q1 Q2 Q3 Q4

© 2006 Daniel Kirschen 11

Costs: Economist’s perspective
• Opportunity cost:
ß What would be the best use of the money spent to make the
product ?
ß Not taking the opportunity to sell at a higher price represents a
cost
• Examples:
ß Growing apples or growing kiwis?
ß Use the money to grow apples or put it in the bank where it
earns interests?
• Includes a “normal profit”
• Selling “at cost” does not mean no profit

© 2006 Daniel Kirschen 12

Perfect competition

• Perfect competition
ß The volume handled by Price supply
each market participant is
small compared to the
overall market volume
ß No market participant can Extra-marginal
influence the market price
by its actions
ß All market participants act demand
Infra-
like price takers
marginal
Quantity

Marginal producer

© 2006 Daniel Kirschen 13

Imperfect competition

• One or more competitors can influence the

market price through their actions
• Strategic players
ß Participants with a large market share
ß Can influence the market price
• Competitive fringe
ß Participants with a small market share
ß Take the market price
• Cournot and Bertrand models of competition

© 2006 Daniel Kirschen 14

Cournot model in a duopoly
Competition on quantity

Problem for firm 1: maxπ ( y 1 + y 2 ) y 1 − c ( y 1 )

e
y 1

y 1 = f 1 ( y e2 )

• Strategic player operates at a marginal cost less than the

market price
• Ability to manipulate prices is a function of:
ß Market share si = y i Y

ß Elasticity of demand ε

© 2006 Daniel Kirschen 17

Bertrand model in a duopoly

• Competition on price
• Firm that sets the lowest price captures the
entire market
• No firm will bid below its marginal cost of
production because it would sell at a loss
• At equilibrium, both firms sell at the same price,
which is the marginal cost of production
• Equivalent to competitive equilibrium!
• Not a realistic model!

© 2006 Daniel Kirschen 18

Risks, Markets and Contracts

Daniel Kirschen
The University of Manchester
Concept of Risk

• Future is uncertain
• Uncertainty translates into risk
ß In this case, risk of loss of income
• Risk = probability x consequences
• Doing business means accepting some risks
• Willingness to accept risk varies:
ß venture capitalist vs. old-age pensioner
• Ability to control risk varies:
ß Professional traders vs. novice investors

© 2006 Daniel Kirschen 2

Sources of Risk
• Technical risk
ß Fail to produce or deliver because of technical
problem
• Power plant outage, congestion in the transmission system

• External risk
ß Fail to produce or deliver because of cataclysmic
event
• Weather, earthquake, war

• Price risk
ß Having to buy at a price much higher than expected
ß Having to sell at a price much lower than expected

© 2006 Daniel Kirschen 3

Managing Risks

• Excessive risk hampers economic activity

ß Not everybody can survive short term losses
ß Society benefits if more people can take part
• Business should not be limited to large companies with deep
pockets

• How can risk be managed:

ß Reduce the risk
ß Share the risk
ß Relocate the risk

© 2006 Daniel Kirschen 4

Reducing the Risks
• Reduce frequency or consequences of technical
problems
ß Those who can should have an incentive to do it!
• Owners of power plants when outages are rare
• Owners and operators of transmission system when congestion is
small
• Reduce consequences of natural catastrophes
ß Design systems to be able to withstand rare events
• Enough crews to repair the power system after a hurricane
• Avoid unnecessarily large price swings
ß Develop market rules that do not create artificial spikes in the
price of electrical energy
• Should only be done to a reasonable extent

© 2006 Daniel Kirschen 5

Sharing the Risks

• Insurance:
ß All the members of a large group each pay a small amount to
compensate a few that have suffered a big loss
ß The consequences of a catastrophic event are shared by a large
group rather than a few
• Security margin in power system operation
ß Limits the consequences of rare but unpredictable and
catastrophic events
ß Increases the daily cost of electrical energy
ß Grid operator does not have to pay compensation in the event of
a blackout

© 2006 Daniel Kirschen 6

Relocating Risk

• Possible if one party is more willing or able to

accept it
ß Loss is not catastrophic for this party
ß This party can offset this loss against gains in other
activities
• Applies mostly to price risk
• How does this apply to markets?

© 2006 Daniel Kirschen 7

Spot Market

Spot
Sellers Buyers
Market

• Immediate market, “On the Spot”

ß Agreement on price
ß Agreement on quantity
ß Agreement on location
ß Unconditional delivery
ß Immediate delivery

© 2006 Daniel Kirschen 8

Examples of Spot Markets

• Examples
ß Food market
ß Basic shopping
ß Rotterdam spot market for oil
ß Commodities markets: corn, wheat, cocoa, coffee
• Formal or informal

© 2006 Daniel Kirschen 9

Advantages and Disadvantages

• Advantages:
ß Simple
ß Flexible
ß Immediate
• Disadvantages
ß Prices can fluctuate widely based on
circumstances
ß Example:
• Effect of frost in Brazil on price of coffee beans
• Effect of trouble in the Middle East on the price
of oil

© 2006 Daniel Kirschen 10

Spot Market Risks

• Problems with wide price fluctuations

ß Small producer may have to sell at a low price
ß Small purchaser may have to buy at a high price
ß “Price risk”
• Market may not have much depth
ß Not enough sellers: market is short
ß Not enough buyers: market is long
• Buying or selling large quantities when the market is
short or long can affect the price
• Relying on the spot market for buying or selling large
quantities is a bad idea

© 2006 Daniel Kirschen 11

Example: buying and selling wheat

• Farmer produces wheat

• Miller buys wheat to make flour
• Farmer carries the risk of bad weather
• Miller carries the risk of breakdown of flour mill
• Neither farmer nor miller control price of wheat

© 2006 Daniel Kirschen 12

Harvest time

• If price of wheat is low:

ß Possibly devastating for the farmer
ß Good deal for the miller
• If the price is high:
ß Good deal for the farmer
ß Possibly devastating for the miller

© 2006 Daniel Kirschen 13

What should they do?
• Option 1: Accept the spot price of wheat
ß Equivalent to gambling
• Option 2: Agree ahead of time on a price that is
acceptable to both parties
ß Forward contract

© 2006 Daniel Kirschen 14

Forward Contract

• Agreement:
ß Quantity and quality
ß Price
ß Date of delivery (not immediate)
• Paid at time of delivery
• Unconditional delivery

© 2006 Daniel Kirschen 15

Forward Contract

Contract (1June)
1 ton of wheat at £100
on 1 September

Maturity (1 September)
Seller delivers 1 ton of wheat
Buyer pays £100
Spot Price = £90
© 2006 Daniel Kirschen
Profit to seller = £10 16
How is the forward price set?
Spot Price

Time
• Both parties look at their alternative: spot price
• Both forecast what the spot price is likely to be
© 2006 Daniel Kirschen 17
Case 1:
• Farmer estimates that the spot price will be
£100
• Miller also forecasts that the spot price will be
£100
• They can agree on a forward price of £100

© 2006 Daniel Kirschen 18

Case 2:
• Farmer estimates that the spot price will be
£90
• Miller also forecasts that the spot price will be
£110
• They can easily agree on a forward price of
somewhere between £90 and £110
• Exact price will depend on negotiation ability

© 2006 Daniel Kirschen 19

Case 3:
• Farmer estimates that the spot price will be
£110
• Miller also forecasts that the spot price will be
£90
• Agreeing on a forward price is likely to be
difficult

© 2006 Daniel Kirschen 20

Sharing risk

• In a forward contract, the buyer and seller share

the risk that the price differs from their
expectation
• Difference between contract price and spot price
at time of delivery represents a “profit” for one
party and a “loss” for the other
• However, in the meantime they have been able
to get on with their business
ß Buy new farm machinery
ß Sell the flour to bakeries

© 2006 Daniel Kirschen 21

Attitudes towards risk

• Suppose that both parties forecast the same value spot

price at time of delivery
• Equal attitude towards risk
ß Forward price is equal to expected spot price
• If buyer is less risk adverse than seller
ß Buyer can negotiate a forward price lower than the expected
spot price
ß Seller agrees to this lower price because it reduces its risk
ß Difference between expected spot price and forward price is
called a premium
ß Premium = price that seller is willing to pay to reduce risk

© 2006 Daniel Kirschen 22

Attitudes towards risk

• If buyer is more risk adverse than seller

ß Seller can negotiate a forward price higher than the
expected spot price
ß Buyer agrees to this lower price because it reduces
its risk
ß Buyer is willing to pay the premium to reduce risk

© 2006 Daniel Kirschen 23

Forward Markets
• Since there are many millers and farmers, a
market can be organised for forward contracts
• Forward price represents the aggregated
expectation of the spot price, plus or minus a
risk premium

© 2006 Daniel Kirschen 24

What if...
Spot Price

Forward
Price

Time
• Suppose that millers are less risk adverse
• Premium below the expected spot price
• Spot price turns out to be much lower than forward price
because of a bumper harvest
© 2006 Daniel Kirschen 25
What if...
Spot Price

Forward
Price

Time

• Farmers breathe a sigh of relief…

• Millers take a big loss
• The following year the millers asks for a much
bigger premium
• Is agreement between the millers and the
farmers going to be possible?
© 2006 Daniel Kirschen 26
Undiversified risk

• Farmers and millers deal only in wheat

• Their risk is undiversified
• Can only offset “good years” against “bad years”
• Risk remains high
• Reducing the risk further would help business

© 2006 Daniel Kirschen 27

Diversification

• Diversification: deal with more

than one commodity
• Average risk over different
commodities

© 2006 Daniel Kirschen 28

Physical participants vs. traders

• Physical participants
ß Produce, consume or can store the commodity
ß Face undiversified risk because they deal in only one
commodity
• Traders (a.k.a. speculators)
ß Cannot take physical delivery of the commodity
ß Diversify their risk by dealing in many commodities
ß Specialize in risk management

© 2006 Daniel Kirschen 29

Trading by speculators
• Cannot take physical delivery of the commodity
• Must balance their position on date of delivery
ß Quantity bought must equal quantity sold
ß Buy or sell from spot market if necessary
• May involve many transactions
• Forward contracts limited to parties who can take
physical delivery
• Need a standardised contract to reduce the cost of
trading: future contract
• Future contracts (futures) allow others to participate in
the market and share the risk

© 2006 Daniel Kirschen 30

Futures Contract

2 tons at £110

1 ton
2 tons at £90 at £ 95

1 ton
at £115

All contracts for wheat

on 1 September

© 2006 Daniel Kirschen 31

Futures Contract
Shortly before 1 September Spot Price £100

bought 2 tons at £110

bought 1 ton at £ 95
sold 1 ton at £115

sold 2 tons at £110

sold 2 tons at £90

Delivers 4 tons
Sells 2 tons at £100
bought 2 tons at £90
sold 1 ton at £95

bought 1 ton at £115

Sells 1 ton at £100

© 2006 Daniel Kirschen 32

Futures Contract

bought 2 tons at £110

bought 1 ton at £ 95
sold 1 ton at £115
sold 2 tons at £100
sold 2 tons at £110 net profit: £ 0
sold 2 tons at £90

bought 2 tons at £90

sold 1 ton at £95 Spot Price = £100
sold 1 ton at £100
net profit: £15

bought 1 ton at £115

© 2006 Daniel Kirschen bought 3 tons at £100 33
Importance of information
• Speculators own some of the commodity before it is
delivered
• They carry the risk of a price change during that period
• Need deep pockets
• Without additional information, this is gambling
• Information helps speculators make money
• Example:
ß Global perspective on the harvest for wheat
ß Long term weather forecast and its effect on the demand for
gas and electricity

© 2006 Daniel Kirschen 34

Options
• Spot, forward and future contracts: unconditional delivery
• Options: conditional delivery
ß Call Option: right to buy at a certain price at a certain time
ß Put Option: right to sell at a certain price at a certain time
• Two elements of the price:
ß Exercise or strike price = price paid when option is exercised
ß Premium or option fee = price paid for the option itself

© 2006 Daniel Kirschen 35

Example of Call Option

• Call Option with an exercise price of £100

• About to expire
• If the spot market price is £90 the option is worth
nothing
• If the spot market price is £110 the option is worth
£10
• Holder makes money if value > option fee

© 2006 Daniel Kirschen 36

Example of Put Option

• Put Option with an exercise price of £100

• About to expire
• If the spot market price is £90 the option is worth
£10
• If the spot market price is £110 the option is worth
nothing
• Holder makes money if value > option fee

© 2006 Daniel Kirschen 37

Financial Contracts

• Contracts without any physical delivery

B C
A D

Financial
contract Physical Market
(Spot)

X Z
Y W

© 2006 Daniel Kirschen 38

One-way contract for difference

• Example:
ß buyer has call option for 50 units at £100 per unit
ß spot price goes up to £110 per unit
ß holder calls the option to buy 50 units at £100
ß buyer owes seller £5000 (50 x £100)
ß seller owes the buyer £5500 (value of 50 units)
ß seller transfers £500 to the buyer to settle the contract

© 2006 Daniel Kirschen 39

Two-Way Contract for Difference

• Combination of a call and a put option for the

same price --> will always be used
• Example 1: CFD for 50 units at £100
ß spot price = £110
ß buyer pays £5500 on spot market
ß seller gets £5500 on spot market
ß seller pays buyer £500
ß buyer effectively pays £5000
ß seller effectively gets £5000

© 2006 Daniel Kirschen 40

Two-Way Contract for Difference

• Example 2: CFD for 50 units at £100

ß spot price = £90
ß buyer pays £4500 on spot market
ß seller gets £4500 on spot market
ß buyer pays seller £500
ß buyer effectively pays £5000
ß seller effectively gets £5000
• Buyer and seller “insulated” from spot market

© 2006 Daniel Kirschen 41

Exchanges
• “Location” where the market takes place
• Can be electronic
• Trading
ß Spot
ß Forwards
ß Futures
ß Options
• Participants must provide credit guarantee
• Needs rules, policing mechanisms

© 2006 Daniel Kirschen 42

Organisation of Electricity Markets

Daniel Kirschen
Differences between electricity and other commodities

• Electricity is inextricably linked with a physical delivery

system
u Physical delivery system operates much faster than any market
u Generation and load must be balanced at all times
u Failure to balance leads to collapse of system
u Economic consequences of collapse are enormous
u Balance must be maintained at almost any cost
u Physical balance cannot be left to a market

© Daniel Kirschen 2005 2

Differences between electricity and other commodities

• Electricity produced by different generators is pooled

u Generator cannot direct its production to some consumers
u Consumer cannot choose which generator produces its load
u Electrical energy produced by all generators is indistinguishable
• Pooling is economically desirable
• A breakdown of the system affects everybody

© Daniel Kirschen 2005 3

Differences between electricity and other commodities

• Demand for electricity exhibits predictable daily, weekly

and seasonal variations
u Similar to other commodities (e.g. coffee)
• Electricity cannot be stored in large quantities
u Must be consumed when it is produced
u “Just in Time Manufacturing”
• Production facilities must be able to meet peak demand
• Very low price elasticity of the demand
u Demand curve is almost vertical

© Daniel Kirschen 2005 4

Balancing supply and demand

• Demand side:
u Fluctuations in the needs
u Errors in forecast
• Supply side:
u Disruption in the production
• Spot market:
u Provides an easy way of bridging the gap between supply and
demand

© Daniel Kirschen 2005 5

Spot market for other commodities

• Characteristics of a spot market:

u Unconditional delivery
u Immediate delivery
u Price determined through interactions of buyers and sellers
u Price tends to be volatile because market is short term
• To reduce the price risk, buyers and sellers tend to trade
mostly through longer term contracts
• Spot market is used for adjustments
• Spot market is the market of last resort

© Daniel Kirschen 2005 6

Spot market for electrical energy

• Demand side:
u Errors in load forecast
• Supply side:
u Unpredicted generator outages
• Gaps between load and generation must be filled quickly
• Market mechanisms
u Too slow
u Too expensive
• Need fast communication
• Need to reach lots of participants

© Daniel Kirschen 2005 7

“Managed” spot market

• Balance load and generation

• Run by the system operator
• Maintains the security of the system
• Must operate on a sound economic basis
u Use competitive bids for generation adjustments
u Should ideally accept demand-side bids
u Determine a cost-reflective spot price
• Not a true market because price is not set through
interactions of buyers and sellers
• Indispensable for treating electricity as a commodity

© Daniel Kirschen 2005 8

“Managed” spot market
Generation Generation
Load Load
surplus deficit surplus deficit

System operator

Control
Managed Spot Market actions

Spot
price

Bids to Bids to
Bids to Bids to
increase increase
decrease decrease
production load
production load
© Daniel Kirschen 2005 9
“Managed” spot market

• Also know as:

u Reserve market
u Balancing mechanism

• In North America, the day-ahead hourly market is often

called the spot market

© Daniel Kirschen 2005 10

Other markets

• Well-functioning spot market is essential

u Ensures that imbalances will be settled properly
• Makes the development of other markets possible
• Spot price is volatile
• Most participants want more certainty
• Reduce risk by trading ahead of the spot market
• Forward markets and derivative markets help reduce
risks
• Forward markets must close before the managed spot
market

© Daniel Kirschen 2005 11

Why is the spot price for electricity so volatile?

Load
Peak load

Minimum load
Time
00:00 06:00 12:00 18:00 24:00

© Daniel Kirschen 2005 12

Demand curves for electricity

£/MWh
Minimum load Peak load

Daily fluctuations

MWh

© Daniel Kirschen 2005 13

Supply curve for electricity

£/MWh

Peaking generation

Base generation

Intermediate generation

MWh

© Daniel Kirschen 2005 14

Supply and demand for electricity

£/MWh
Minimum load Peak load

πmax

πmin

Price of electricity fluctuates during MWh

the day
© Daniel Kirschen 2005 15
Supply and demand for electricity

£/MWh
πext
Extreme
peak
Normal peak
πnor

MWh
Small increases in peak demand cause
large changes in peak prices
© Daniel Kirschen 2005 16
Supply and demand for electricity
£/MWh
πext Normal supply

Reduced supply

πnor

Normal peak

MWh
Small reductions in supply cause
© Daniel Kirschen 2005 large changes in peak prices 17
Price duration curve

100

0
0 20 40 60 80 100
Percentage of Hours

PJM system (USA) for 1999

Actual peak price reached $1000/MWh for a few hours
(Source: www.pjm.com)
© Daniel Kirschen 2005 18
Forward markets

• Two approaches:
u Centralised trading (also known as “Pool Trading”)
u Bilateral trading

© Daniel Kirschen 2005 19

Pool trading

• All producers submit bids

• All consumers submit offers
• Market operator determines successful bids and offers
and the market price

• In many electricity pools, the demand side is passive. A

forecast of demand is used instead.

© Daniel Kirschen 2005 20

Example of pool trading
Bids and offers in the Electricity Pool of Syldavia for the period from 9:00
till 10:00 on 11 June:

Bids Company Quantity [MWh] Price [$/MWh]

Red 200 12.00
Red 50 15.00
Red 50 20.00
Green 150 16.00
Green 50 17.00
Blue 100 13.00
Blue 50 18.00
Offers Yellow 50 13.00
Yellow 100 23.00
Purple 50 11.00
Purple 150 22.00
Orange 50 10.0
Orange 200 25.00

© Daniel Kirschen 2005 21

Example of pool trading
30

Orange
25
Yellow
Purple

Red
20
Blue
Price [$/MWh]

Green
Green
Red
15
Blue Yellow
Red
Purple
Orange
10

0
0 100 200 300 400 500 600 700

Quantity [MWh]

© Daniel Kirschen 2005 22

Example of pool trading
30

Accepted offers
Orange
25
Yellow
Purple

Red
20
Blue
Price [$/MWh]

Green
Market price Green
Red
15
Blue Yellow
Red
Purple
Orange
10
Accepted bids

5
Quantity traded

0
0 100 200 300 400 500 600 700

Quantity [MWh]

© Daniel Kirschen 2005 23

Example of pool trading

• Market price: 16.00 $/MWh

• Volume traded: 450 MWh

Company Production Consumption Revenue Expense

[MWh] [$]
[MWh] [$]
Red 250 4,000.
Blue 100 1,600
Green 100 1,600
Orange 200 3,200
Yellow 100 1,600
Purple 150 2,400
Total 450 450 7,200 7,200

© Daniel Kirschen 2005 24

Unit commitment-based pool trading

• Reasons for not treating each market period separately:

u Operating constraints on generating units
• Minimum up and down times, ramp rates
u Savings achieved through scheduling
• Start-up and no-load costs
u Reduce risk for generators
• Uncertainty on generation schedule leads to higher prices

© Daniel Kirschen 2005 25

• Why not pay the generators what they bid?

u Cheaper generators would not want to “leave money on the table”
u Would try to guess the SMP and bid close to it
u Occasional mistakes Ë get left out of the schedule

u Increased uncertainty Ë increase in price

© Daniel Kirschen 2005 32

Bilateral trading

• Pool trading is an unusual form of market

• Bilateral trading is the classical form of trading
• Involves only two parties:
u Seller
u Buyer
• Trading is a private arrangement between these parties
• Price and quantity negotiated directly between these
parties
• Nobody else is involved in the decision

© Daniel Kirschen 2005 33

Bilateral trading

• Unlike pool trading, there is no “official price”

• Occasionally facilitated by brokers or electronic market
operators
• Takes different forms depending on the time scale

© Daniel Kirschen 2005 34

Types of bilateral trading

• Customised long-term contracts

u Flexible terms
u Negotiated between the parties
u Duration of several months to several years
u Advantage:
• Guarantees a fixed price over a long period
u Disadvantages:
• Cost of negotiations is high
u Worthwhile only for large amounts of energy

© Daniel Kirschen 2005 35

Types of bilateral trading

• “Over the Counter” trading

u Smaller amounts of energy
u Delivery according to standardised profiles
u Advantage:
• Much lower transaction cost
u Used to refine position as delivery time approaches

© Daniel Kirschen 2005 36

Types of bilateral trading

• Electronic trading
u Buyers and sellers enter bids directly into computerised
marketplace
u All participants can observe the prices and quantities offered
u Automatic matching of bids and offers
u Participants remain anonymous
u Market organiser handles the settlement
u Advantages:
• Very fast
• Very cheap
• Good source of information about the market

© Daniel Kirschen 2005 37

Example of bilateral trading

Generating units owned by Borduria Power:

Unit Pmin [MW] Pmax [MW] MC [$/MWh]

A 100 500 10.0
B 50 200 13.0
C 0 50 17.0

© Daniel Kirschen 2005 38

Example of bilateral trading

Trades of Borduria Power for 11 June from 2:00 pm till 3:00 pm

Type Contract Identifier Buyer Seller Amount Price

Date [MWh] [$/MWh]
Long term 10 January LT1 Cheapo Energy Borduria Power 200 12.5
Long term 7 February LT2 Borduria Steel Borduria Power 250 12.8
Future 3 March FT1 Quality Electrons Borduria Power 100 14.0
Future 7 April FT2 Borduria Power Perfect Power 30 13.5
Future 10 May FT3 Cheapo Energy Borduria Power 50 13.8

Net position: Sold 570 MW

Production capacity: 750 MW

© Daniel Kirschen 2005 39

Example of bilateral trading

Pending offers and bids on Borduria Power Exchange at mid-morning

on 11 June for the period from 2:00 till 3:00 pm:

11 June 14:00-15:00 Identifier Amount [MW] Price [$/MWh]

Bids to sell energy B5 20 17.50
B4 25 16.30
B3 20 14.40
B2 10 13.90
B1 25 13.70
Offers to buy energy O1 20 13.50
O2 30 13.30
O3 10 13.25
O4 30 12.80
O5 50 12.55

© Daniel Kirschen 2005 40

Example of bilateral trading
Electronic trades made by Borduria Power:

11 June 14:00-15:00 Identifier Amount [MW] Price [$/MWh]

Bids to sell energy B5 20 17.50
B4 25 16.30
B3 20 14.40
B2 10 13.90
B1 25 13.70
Offers to buy energy O1 20 13.50
O2 30 13.30
O3 10 13.25
O4 30 12.80
O5 50 12.55

Net position: Sold 630 MW

Self schedule: Unit A: 500 MW
Unit B: 130 MW
Unit C: 0 MW
© Daniel Kirschen 2005 41
Example of bilateral trading
Unexpected problem: unit B can only generate 80 MW
Options: - Do nothing and pay the spot price for the missing energy
- Make up the deficit with unit C
- Trade on the power exchange

11 June 14:00-15:00 Identifier Amount [MW] Price [$/MWh]

Bids to sell energy B5 20 17.50
B4 25 16.30
B3 20 14.40
B6 20 14.30
B8 10 14.10
Offers to buy energy O4 30 12.80
O6 25 12.70
O5 50 12.55

Buying is cheaper than producing with C

New net position: Sold 580 MW
New schedule: A: 500 MW, B: 80 MW, C: 0 MW
© Daniel Kirschen 2005 42
Pool vs. bilateral trading

• Pool • Bilateral
u Unusual because administered u Economically purer
centrally u Price set by the parties
u Price not transparent u Hard bargaining possible
u Facilitates security function u Generator assume
u Makes possible central scheduling risk
optimisation u Must be coordinated with
u Historical origins in electricity security function
industry u More opportunities to
innovate

Both forms of trading can coexist to a certain extent

© Daniel Kirschen 2005 43

Bidding in managed spot market
Borduria Power’s position:
Unit Psched Pmin Pmax MC
[MW] [MW] [MW] [$/MWh]
A 500 100 500 10.0
B 80 50 80 13.0
C 0 0 50 17.0

Borduria Power’s spot market bids:

Type Unit Price Amount
[$/MWh] [MW]
Bid (increase) C 17.50 50
Offer (decrease) B 12.50 30
Offer (decrease) A 9.50 400

Spot market assumed imperfectly competitive

Bids/offers can be higher/lower than marginal cost
© Daniel Kirschen 2005 44
Settlement process

• Pool trading:
u Market operator collects from consumers
u Market operator pays producers
u All energy traded at the pool price
• Bilateral trading:
u Bilateral trades settled directly by the parties as if they had been
performed exactly
• Managed spot market:
u Produced more or consumed less Ë receive spot price

u Produced less or consumed more Ë pay spot price

© Daniel Kirschen 2005 45

Example of settlement

• 11 June between 2:00 pm and 3:00 pm

• Spot price: 18.25 $/MWh
• Unit B of Borduria Power could produce only 10 MWh
instead of 80 MWh
• Borduria Power thus had a deficit of 70 MWh for this hour
• 40 MW of Borduria Power’s spot market bid of 50 MW at
17.50 $/MWh was called by the operator

© Daniel Kirschen 2005 46

Borduria Power’s Settlement
Market Type Amount Price Income Expense
[MWh] [$/MWh] [$] [$]
Sale 200 12.50 2,500.00
Futures Sale 250 12.80 3,200.00
and Sale 100 14.00 1,400.00
Forwards Purchase -30 13.50 405.00
Sale 50 13.80 690.00
Sale 20 13.50 270.00
Sale 30 13.30 399.00
Power Sale 10 13.25 132.50
Exchange Purchase -20 14.40 288.00
Purchase -20 14.30 286.00
Purchase -10 14.10 141.00
Spot Sale 40 18.25 730.00
Market Imbalance -70 18.25 1,277.50
Total 550 9,321.50 2,397.50
© Daniel Kirschen 2005 47
Example of an electricity market: NETA

• NETA = New Electricity Trading Arrangements

• Market operating in England and Wales since April 2001
• Relies on bilateral trading as much as possible
• Replaced the Electricity Pool of England and Wales,
which was a centralised market
• Extended to Scotland on 1 April 2005 (BETTA)

© Daniel Kirschen 2005 48

NETA Timeline

Forward Markets
Balancing
Electronic Power Mechanism Settlement
Exchange
Process
Real
Gate Closure Time

T-several months T-1day T-1hr T T+1/2 hr

Bilateral Centralized

© Daniel Kirschen 2005 49

Price volatility in the balancing mechanism

© Daniel Kirschen 2005 50

Participating in Electricity Markets:
The Generator’s Perspective

Monopoly Oligopoly Perfect Competition

• Monopoly:
u Monopolist sets the price at will
u Must be regulated
• Perfect competition:
u No participant is large enough to affect the price
u All participants act as “price takers”
• Oligopoly:
u Some participants are large enough to affect the price
u Strategic bidders have market power
u Others are price takers

• All producers have a small share of the market

• All consumers have a small share of the market

• Individual actions have no effect on the market price

• All participants are “price takers”

y : Output of one of the generators

max {π .y − c(y)}
y
Production cost
Revenue
d {π .y − c(y)}
=0
dy
Independent of quantity
produced because price taker

dc(y) Adjust production y until the marginal

π=
dy cost of production is equal to the
price π
© D. Kirschen 2006 4
Market structure
• No difference between centralised
auction and bilateral market
• Everything is sold at the market Price
clearing price supply
• Price is set by the “last” unit sold
• Marginal producer:
u Sells this last unit Extra-marginal
u Gets exactly its bid
• Infra-marginal producers:
u Get paid more than their bid
u Collect economic profit demand
• Extra-marginal producers: Infra-marginal
Quantity
u Sell nothing

Marginal producer

• No incentive to bid anything

else than marginal cost of
production Price supply

• Lots of small producers

u Change in bid causes a change
in stacking up order
• If bid is higher than marginal
cost
demand
u Could become extra
marginal and miss an Quantity
opportunity to sell at a
profit

• If bid is lower than marginal

cost
Price supply
u Could have to produce at a loss
• If bid is equal to marginal cost
u Get paid market price if marginal
or infra-marginal producer

demand

Quantity

• A firm exercises market power when

u It reduces its output (physical withholding)

u It raises its offer price (economic withholding)

in order to change the market price

u Option 1: offer to sell only 9 units and hope that the price rises
enough to compensate for the loss of volume

u Option 2: offer to sell the 10th unit for a price higher than $15 and
hope that this will increase the price

• Profit increases if price rises sufficiently to compensate

for possible decrease in volume

max { y i ⋅ π ( Y ) − c ( y i ) } yi : Production of generator i

yi
Y = y 1 +L + y n
d
{ y i ⋅ π (Y ) − c ( y i ) } = 0
is the total industry output

dy i
Not zero because of
market power
dπ ( Y ) dc ( y i )
π (Y ) + y i =
dy i dy i

 y i Y dπ ( Y )  dc ( y i )
π ( Y ) 1 + =
 Y dy i π (Y )  dy i

 y i Y dπ ( Y )  dc ( y i )
π ( Y ) 1 + =
 Y dy i π (Y )  dy i
dy
y π dy
ε=− =− ⋅ is the price elasticity of demand
dπ y dπ
π
yi
si = is the market share of generator i
Y
< 1 · optimal price for generator i is
 si  dc ( y i ) higher than its marginal cost
π ( Y ) 1− =
 ε (Y )  dy i

• Imperfect correlation with market share

• Demand does not have a high price elasticity
• Supply does not have a high price elasticity:
u Highly variable demand
u All capacity sometimes used
u Output cannot be stored

ËElectricity markets are more vulnerable than others to the

exercise of market power

© D. Kirschen 2006 12
Elasticity of the demand for electricity
Price • Slope is an indication of the
elasticity of the demand
• High elasticity
High elasticity good
u Non-essential good
u Easy substitution
Quantity
• Low elasticity
u Essential good
Price
u No substitutes

Low elasticity good • Electrical energy has a very

low elasticity in the short term

Quantity

Price of electrical energy in England and Wales [£/MWh]

Min Max Average

January 2001 0.00 168.49 21.58

February 2001 10.00 58.84 18.96

March 2001 8.00 96.99 20.00

Value of Lost Load (VoLL) in England and Wales: 2,768£/MWh

$/MWh
πext
Extreme
peak
Normal peak
πnor

MWh
Small increases in peak demand cause
© D. Kirschen 2006 large changes in peak prices 15
Price spikes because of reduced supply
$/MWh
πext Normal supply

Reduced supply

πnor

Normal peak

MWh
Small reductions in supply cause
© D. Kirschen 2006 large changes in peak prices 16
Increasing the elasticity reduces price spikes and the
generators’ ability to exercise market power
$/MWh

πmax

πmin

MWh
© D. Kirschen 2006 17
Increasing the elasticity of the demand

• Obstacles
u Tariffs
u Need for communication
u Need for storage (heat, intermediate products, dirty clothes)

• Not everybody needs to respond to price signals to get

substantial benefits

• Increased elasticity reduces the average price

u Not in the best interests of generating companies
u Impetus will need to come from somewhere else

• ALL firms benefit from the exercise of market power by

one participant
• Unilaterally reducing output or increasing offer price to
increase profits is legal
• Collusion between firms to achieve the same goal is not
legal
• Market power interferes with the efficient dispatch of
generating resources
u Cheaper generation is replaced by more expensive generation

• Bertrand model
u Competition on prices
• Cournot model
u Competition on quantities

• Each firm must consider the possible actions of others

when selecting a strategy
• Classical optimisation theory is insufficient
• Two-person non-co-operative game:
u One firm against another
u One firm against all the others
• Nash equilibrium:
u given the action of its rival, no firm can increase its profit by
changing its own action:

Ω i (ai* ,a j )≥ Ω i (ai ,a j ) ∀i,ai

• Example 1 PA PB
CA = 35 . PA €/h
u
A B π = 100 − D [¤ / MWh]
u CB = 45 . PB €/h
CA(PA) CB(PB)

• Bid by A?
• Bid by B?
• Market price?
Inverse demand curve
• Quantity traded?

© D. Kirschen 2006 22
Bertrand Competition
• Example 1
PA PB
u CA = 35 . PA €/h
u CB = 45 . PB €/h A B π = 100 − D [¤ / MWh]
• Marginal cost of A: 35 €/MWh CA(PA) CB(PB)

• Marginal cost of B: 45 €/MWh

• A will bid just below 45 €/MWh
• B cannot bid below 45 €/MWh because it would loose money on every MWh
• Market price: just below 45 €/MWh
• Demand: 55 MW
• PA = 55MW
• PB = 0

• Example 2 PA PB

u CA = 35 . PA €/h A B π = 100 − D [¤ / MWh]

u CB = 35 . PB €/h CA(PA) CB(PB)

• Bid by A?
• Bid by B?
• Market price?
• Quantity traded?

© D. Kirschen 2006 24
Bertrand Competition
• Example 2 PA PB
u CA = 35 . PA €/h
u CB = 35 . PB €/h A B π = 100 − D [¤ / MWh]
CA(PA) CB(PB)

• A cannot bid below 35 €/MWh because it would loose money on every MWh
• A cannot bid above 35 €/MWh because B would bid lower and grab the
entire market
• Market price: 35 €/MWh
• Identical generators: bid at marginal cost
• Non-identical generators: cheapest gets the whole market
• Not a realistic model of imperfect competition

PA PB
• CA = 35 . PA €/h
• CB = 45 . PB €/h A B
• π = 100 − D [¤ / MWh] CA(PA) CB(PB)
• Suppose PA= 15 MW and PB = 10 MW
• Then D = PA + PB = 25 MW
• π = 100 - D = 75 €/MW
• RA= 75 . 15 = € 1125 ; CA= 35 . 15 = € 525
• RB= 75 . 10 = € 750 ; CB= 45 . 10 = € 450
• Profit of A = RA - CA = € 600
• Profit of B = RB - CB = € 300

For PA=15MW and PB = 10MW, we have:

Demand Profit of A

25 600
300 75

Profit of B Price

PA=15 PA=20 PA=25 PA=30

25 600 30 700 35 750 40 750
PB=10 300 75 250 70 200 65 150 60
30 525 35 600 40 625 45 600
PB=15 375 70 300 65 225 60 150 55
35 450 40 500 45 500 50 450
PB=20 400 65 300 60 200 55 100 50
40 375 45 400 50 375 55 300
PB=25 375 60 250 55 125 50 0 45

Demand Profit A
Profit B Price

PA=15 PA=20 PA=25 PA=30

• Price decreases as supply increases

• Profits of each affected by other
Demand Profit A • Complex relation between production
Profit B Price and profits
© D. Kirschen 2006 29
Let’s play the Cournot game!

PA=15 PA=20 PA=25 PA=30

Equilibrium solution!
A cannot do better without B doing worse
Demand Profit A B cannot do better without A doing worse
Profit B Price Nash equilibrium
© D. Kirschen 2006 30
Cournot competition: Example 1

Demand Profit of A
PA=25
40 625 CA = 35 . PA ¤/h
PB=15
225 60 CB = 45 . PB ¤/h

Profit of B Price

• Generators achieve price larger than their marginal costs

• The cheapest generator does not grab the whole market
• Generators balance price and quantity to maximise
profits

PA PB PN
• CA = 35 . PA €/h ...
A B N
• CB = 45 . PB €/h
CA(PA) CB(PB) CN(PN)
• …
• CN = 45 . PN €/h π = 100 − D [¤ / MWh]

40.00

35.00 Total production of other firms

30.00

25.00

20.00 Production of firm A

15.00

10.00

5.00
Production of another firm
0.00
0 2 4 6 8 10
Number of Firms

60.00 Price
50.00

50.00
40.00
Demand
40.00
30.00
30.00
20.00
20.00

10.00 10.00

0.00 0.00
0 2 4 6 8 10
Number of Firms

700.00

600.00
Profit of firm A
500.00

400.00

300.00 Total profit of the other firms

200.00

100.00 Profit of another firm

0.00
0 2 4 6 8 10
Number of Units

• Supply functions equilibria

u Bid price depends on quantity
• Agent-based simulation
u Represent more complex interactions
• Maximising short-term profit is not the only possible
objective
u Maximising market share
u Avoiding regulatory intervention

• Electricity markets do not deliver perfect competition

• Some factors facilitate the exercise of market power:
u Low price elasticity of the demand
u Large market shares
u Cyclical demand
u Operation close to maximum capacity
• Study of imperfect competition in electricity markets is a
hot research topic
u Generator’s perspective
u Market designer’s perspective

• Buy at the spot price

u Lowest cost, highest risk
u Must be managed carefully
u Requires sophisticated control of the load
• Buy from a retailer at a tariff linked to the spot price
u Retailers acts as intermediary between consumer and market
u Risk can be limited by placing cap (and collar) on the price
• Interruptible contract
u Reasonable option only if cost of interruption is not too high
u Savings can be substantial

• Buy from a retailer on a time-of-use tariff

u Shifts some of the risk to the consumer
u Need to control the load to save money
• Buy from a retailer at a fixed tariff
u Lowest risk, highest cost
u Two components to the price: average cost of energy and risk
premium

• Best type of contract depends on the characteristics of

the consumer:
u Cost of electricity as a proportion of total cost
u Risk aversion
u Flexibility in the use of electricity
u Potential savings big enough to justify transactions cost

• Must forecast prices

u Much harder than load forecasting because price depends on demand
and supply
u Supply factors are particularly difficult to predict (outages, maintenance,
gaming, locational effects)
u Good accuracy for average price and volatility
u Predicting spikes is much harder

• Must optimize production taking cost of electricity into account

u Complex problem because of:
• Production constraints
• Cost of storage (losses, loss of efficiency in other steps,…)
• Price profiles

© D. Kirschen 2006 43
The retailer’s perspective
• Sell energy to consumers, mostly at a flat rate
• Buy energy in bulk
u Spot market
u Contracts
• Want to reduce risks associated with spot market
• Increase proportion of energy bought under contracts
• Must forecast the load of its customers
• Regional monopoly: traditional top-down forecasting
• Retail competition: bottom-up forecasting
u Difficult problem: customer base changes
u Much less accurate than traditional load forecasting

Energy Price
90.00 Energy Consumed

Energy Released
250
80.00

70.00
200

60.00
$/MWh

MWh
50.00 150

40.00

100
30.00

20.00
50

10.00

0.00 0
1 2 3 4 5 6 7 8 9 10 11 12
Period
© D. Kirschen 2006 47
Example

• Energy cycle in a pumped storage plant is only about

75% efficient
• Difference between high price and low price periods must
be large enough to cover the cost of the lost energy
• Profit is unlikely to be large enough to cover the cost of
investments
• Pumped hydro plants can also make money by helping
control the system

Daniel Kirschen
Introduction

• Electricity markets rely on the power system infrastructure

• Participants have no choice to use a different system
• Cost to consumers of outages is very high
• Consumer have expectations for continuity of service
• Cost of this security of supply must match its benefit

© Daniel Kirschen 2005 2

System security

• System must be able to operate continuously if situation

does not change
• System must remain stable for common contingencies
u Fault on a transmission line or other component
u Sudden failure of a generating unit
u Rapid change in load
• Operator must consider consequences of contingencies
• Use both:
u Preventive actions
u Corrective actions

© Daniel Kirschen 2005 3

Preventive actions

• Put the system in a state such that it will remain stable if

a contingency occurs
• Operate the system at less than full capacity
• Limit the commercial transactions that are allowed

© Daniel Kirschen 2005 4

Corrective actions

• Taken only if a disturbance does occur

• Limit the consequences of this disturbance
• Need resources that belong to market participants
• Ancillary services that must be purchased from the
market participants by the system operator
• When called, some ancillary services will deliver some
energy
• However, capacity to deliver is the important factor
• Remuneration on the basis of availability, not energy

© Daniel Kirschen 2005 5

Outline

• Describe the needs for ancillary services

u Keeping the generation and load in balance
u Keeping the security of the transmission network
• Obtaining ancillary services
u How much ancillary services should be bought?
u How should these services be obtained?
u Who should pay for these services?
• Selling ancillary services
u Maximize profit from the sale of energy and ancillary services

© Daniel Kirschen 2005 6

Needs for ancillary services
Balancing production and consumption

• Assume that all generators, loads and tie-lines are

connected to the same bus
• Only system variables are total generation, total load and
net interchange with other systems