Helga ZOGOLLI, Orest KOKONESHI^*

Abstract. The electricity sector worldwide is undergoing a transformation of its institutional structure as a consequence of the complex interactions of political, economic and technological forces. The focus of this analysis is the role of electricity PX-s in the recently liberalized electricity markets of Europe and the key questions considered are the functioning of these PX-s with respect to electricity characteristics, market design and regulatory framework.

In Europe, very little attention has been paid to the role of these new marketplaces and to the issue of market design in general. The main purpose was analyzing how these marketplaces facilitate the trading of electricity and the role they can play in the construction of a competitive electricity market. An analysis of PX requires taking into account the ”double-duality” of such institutions. One, PX-s are both a market and an institution. As a market they facilitate the trading of electricity and determine an equilibrium price. As an institution PX-s have their own objectives and constraints, and play a role in the market design of the overall electricity market. Two, the relationship between electricity PX-s and liberalization is neither linear nor one-way: liberalization encourages the creation of such marketplaces yet marketplaces are more than the results of the process; they are also a driving force of the liberalization process.

INTRODUCTION

The liberalization process in Europe

The genuine role of a PX is to match the supply and demand of electricity to determine a public market-clearing price. A developed PX can also provide a market for electricity derivatives like futures and options. Participants include generators, distribution companies, traders and large consumers.

While one of the main objectives of the liberalization process is to ensure long run efficiency, short-run markets are critical for sending the proper signals for long term investment decisions, e.g. in transmission and generation. Hence, there is a need to design adequate short-run markets to achieve long-run efficiency gains. For this purpose PX-s, represent an important tool for ensuring the creation of competitive electricity markets at the wholesale level.

Figure 1: Power exchanges in Europe 2007)

Figure 2: Creation of organized day-ahead markets in Europe

Objective and questions
In Europe, very little attention has been paid to the role of these new marketplaces and to the issue of market design in general. Hence the main purpose of this work is to analyze how these marketplaces facilitate the trading of electricity and the role they can play in the construction of a pan-European competitive electricity market. Since the development of these marketplaces is a very recent phenomenon, almost no academic work has been done on this topic in Europe. However, countries like the US, the UK and the Nordic Countries, which started the liberalization of their electricity industry at the beginning of the nineteen nineties, have greater experience with market organization.

An analysis of PX requires taking into account the ”double-duality” of such institutions. First, PX-s are both a market and an institution. As a market they facilitate the trading of electricity and determine an equilibrium price. As an institution PX-s have their own objectives and constraints, and play a role in the market design of the overall electricity market. Second, the relationship between electricity PX-s and liberalization is not linear or one way: liberalization encourages the birth of such marketplaces but marketplaces are not only the results of, they are also a driving force of the liberalization process.

In spite of the clear objective and reasons for liberalizing electricity markets, many fundamental problems remain. The first results of liberalization have shown the difficulty of implementing competition in an industry previously organized as a monopoly. In the US, the meltdown of the electricity market in California has showed the risk of restructuring markets. The UK pool which was long cited as an example of restructuring was declared a failure and all of its market rules have recently been replaced. These initial problems do not prove that liberalization is doomed but show that accurate design of the market is a fundamental issue.

The study of electricity PX-s is at the heart of economics theory and especially of industrial economics and the main purpose is: What is the most efficient industrial organization? This is divided in two categories. The first deals with theoretical aspects of market functioning and market design with respect to the liberalization of the electricity industry and the emergence of PX-s. The second category of questions looks at PX-s as organized markets where supply and demand meet.

The focus of this project will be in the economic theory models of market functioning and their application to electricity markets. Another focus will be the electricity Market Monitoring and Practice. It was not the aim of the project to examine or to evaluate the various remedies for reducing market power. However, it is useful to have some idea of the types of market mitigation methods that may be implemented by a market monitoring or regulatory authority in order to determine what the market detection techniques are more likely to be useful for this purpose.

Establishment of a PX will create new possibilities for increased trade. Therefore, in our project, we have studied and analyzed, as an example, the development of the regional electricity trading market in South East Europe (SEE). Here we have been is concentrated within the following 3 objectives:

1. Determination of level of interest for regional trade platform

The first objective is to determine the level of interest among stakeholders (TSOs, Ministries, Regulators, and Traders) in participating in regional trading platforms in SEE.

2. Benchmarking of trade platform initiatives

The second objective is to identify the most appropriate and effective platform with which to establish confidence in the regional marketplace and to accomplish the goal of increasing trade in the region through a uniform and transparent process. In doing so, we have reviewed and benchmarked the current initiatives for regional trading platforms. Currently, there are proposals from Borzen in Slovenia and OPCOM in Romania to take on the task of setting up regional trading platforms.

3. Bank’s potential role

The third objective is to provide recommendations on what role the Banks may have in this regional trading process, and also to look at what level of capital may be required.

MARKET ANALYSIS

The objective is to describe briefly the concepts of these two polar extreme models between which all other market models are ranged.

References models: perfect competition / monopoly

Perfect competition

According to the theory of perfect competition, and assuming a market for a homogeneous product with many buyers and sellers, the most efficient outcome is achieved if firms price at marginal cost. The model of perfect competition is based on four central assumptions.

• Atomicity: there are so many buyer and sellers that no single buyer and no single seller can affect the price.
• Product homogeneity: the productprovided by the different competitors is exactly the same.
• Free entry / exit: any firm can enter or exit the market freely.
• Perfect information: all the players know the prices set by all the firms.

Each firm sets its price at the level of its marginal costs to maximize its profits. Hence, if a firm sets a price above the price of other firms it sells nothing. If a firm sets a price below the other firms’, it will have to supply all of the market demand for the product. If a firm charges less than marginal costs, it will fail to break even for that unit of output. Results: in the perfect competition model marginal revenue equals price and each firm is price taker.

There are generally two types of equilibrium in perfect competition: short run and long run equilibrium. In the short run there is too little time for new firms to enter the industry while in the long run new firms can enter.

Monopoly

Figure 4: Monopoly equilibrium

The monopoly model assumes that there is one single firm, which supplies a well-defined market and that entry in the industry is blocked. The firm, called the monopolist, sets price p or a quantity q at a value that maximizes its profit. Since price and quantity are related to demand D(p) it is does not matter if the monopolist chooses the optimal price or the optimal quantity. The level of supra profit depends on the elasticity of demand. The monopolist is therefore price maker, figure 5 shows that the difference between the monopoly equilibrium price and the perfect competition price depends on the elasticity of demand, represented by the slope of the demand curve. When demand is inelastic the marginal revenue of selling an extra unit is low because a small increase in the quantity leads to a large drop in price.

A monopolist can increase the price of a good by restricting its level of output. The ability to increase prices is limited by the elasticity of demand.

Oligopoly competition

Since both perfect competition and pure monopoly are extreme cases, rarely seen in practice, to analyze real markets, are developed alternatives models. The objective of these models is to cover the broad range of oligopoly competition between perfect competition and monopoly. Oligopoly competition refers to a market structure where a few players coexist. Each firm believes its profits are affected by the actions of others firms, and that these actions also influence the profits of other firms. Taking perfect competition and monopoly models as the end points, there is an infinite number of theoretical possibilities for oligopoly models, all of which differ mainly in the assumptions used to characterize market structure and firm interdependencies in detriment of its own interests.

The Cournot Model

Cournot developed the first model of oligopoly competition in 1838 (Cournot, 1838), this model takes into account the interdependencies between firms. Cournot’s assumption of is that each firm will choose a level of output with respect to the rival’s production decisions. Thus, in such a model players compete on quantity. The basic model is a duopoly model (n=2) where each firm has identical constant marginal production costs and faces linear demand.

The two axes define the output of the firms, so that any point represents their respective production volumes. In this model the reaction curve represents how much each firm would produce given an output decision from the other firm. The intersection of the two curves defines the equilibrium where each firm has maximized profit, given the output of the other. This equilibrium is a Nash equilibrium (which is a situation where each player’s predicted strategy must be that player’s best response to the predicted strategies of the others players) since each firm is following its best course of action, given its expectations about its rival’s actions and that the expectation are fulfilled.

Under the Cournot model the price depends of the level of output:

P(Q)     =    a – bQ                                                                                           (1)

where P is the market price and Q the total volume of output.

The total level of output is the sum of the production of each firm:

Q          =    ∑ qn    =    q1+ q2                                                                       (2)

where q1 is the volume produced by firm 1 and q2 the volume produced by firm 2

The profit of each firm n is defined by the difference between its revenues and total cost:

 n         =    P(Q) qn – cqn (3)

 n         =    (a – bQ) qn- cqn                                                                       (3.1)

 n         =    (a – bQ-c) qn   (3.2)

where c is the unit cost.

In the Cournot model each firm assumes that the other will keep its level of production. Hence, firm n maximizes its profit by differentiating n with respect to qn. The maximum level of output is found by calculating the first order conditions:

d 1/dq1    =    0                                                                                              (4)

For firm 1 the maximum level output is then defined by:

d 1 / dq1 =    P(Q)+(dP /dQ) q1 – c        =    0                                           (5)

d 1 / dq1  =    a – 2bq1 – bq2 – c                                                               (5.1)

Hence, the level of production of firm 1 is express using the level of production of firm 2:

q1        =    (a-c) / 2b – 0.5 q2                                                                       (6)

This equation defines the reaction function of firm 1 to the level of output of firm 2. Similarly the reaction function of firm 2 is:

q2 = (a-c) / 2b – 0.5 q1                                                                                 (7)

The equilibrium solution is defined by the intersection of the two curves:

q1        = (a-c) / 2b – 0.5 [(a-c) / 2b – 0.5 q1], so

q1        = (a-c) / 3b                                                                                         (8)

 The Bertrand Model

Bertrand (1883) extended Cournot’s model of by changing the rivalry notions using prices rather than quantity. In the simplest version of the model, two firms set their prices simultaneously. Since the two products are perfect substitutes the firm which sets the lower price will attract all the demand for the product in question. Again, we can use a reaction curve, only this time for prices rather than quantities. It is critical for the model that each firm has identical cost curves; otherwise the one which has lower marginal costs will always supply the entire demand. The Bertrand equilibrium is achieved when each firm’s expectations about the price behavior of its rival are realized. The fundamental result of the Bertand’s model is that industry has price and output level similar as under perfect competition. The reasoning is the following: when firm 1 has selected its price to maximize its profit, the best strategy for firm 2 is to undercut firm 1 by a small margin and take all the market. Hence, the best response of firm 1 is to undercut firm 2. This process ends when neither of the two firms can go any lower, i.e. when price equals marginal costs. For any price of a rival, a firm will opt for a price that is just lower. Equilibrium is obtained when price equals marginal costs.

CASE STUDIES / APPLICATION FUNCTIONALITY

Implementation of the Power-Exchange in South East Europe

Creation of a regional power market is a stepwise development. In an interconnected electricity system bilateral trade of electricity will start, first on a national basis, followed by trade on a more regional basis. The level of regional trade will be based on existing possibilities of transmission capacities in the grid and existing rules for transmission tariffs, wheeling arrangements etc.

Existing arrangements for trade should not be cancelled if they do not destroy future development. It is experienced that standardization of contracts available for trade will stimulate the trade, and initiative for such a development exists and should be stimulated. When trade of standardized contracts has reached a certain level of liquidity, it is possible to establish clearing solutions to remove a significant part of the counterparty risk from the trading participants. This will stimulate the trade additionally.

Transparency of prices and other market information is extremely important for development of a regional market.

Here we will go through three main topics:

1)   to determine the interest of potential market participants in trading via a standardized platform (clearinghouse, exchange, or both) featuring Bank-provided credit support. The international trade of electricity is an important part of the national power market and that regional trade can be improved by the development of a regional trading platform and also support the notion that cross border trade can be improved by introduction of a trading platform.

Figure 6: Regional Electricity Trading

There exist numerous trading platforms in different markets around the world. The development of bilateral trade and exchange trade of electricity work in parallel. There are some criteria that can be used to evaluate initiatives for creating a regional PX. Clearing of trade will reduce the counterparty risk significantly and this has resulted in increased trade in many markets.2)   to identify the most appropriate and effective platform with which to establish confidence in the regional marketplace and to accomplish the goal of increasing trade in the region through a uniform and transparent process.

A normal development of such regional markets is to start with trade of bilateral contracts, standardization of bilateral contracts, introduction of exchange trade with standardized contracts, clearing services and introduction of trade with derivatives. This can also be a natural development of events in the South East Europe (SEE) region. The support from the TSOs has proven to be very important for development for power trade. TSOs can support power trade by ensuring equal access to the transmission network, and in particular they can support PX-s by allocating a share (or all) interconnector capacity to the PX, as well as show their trust in the PX by buying grid losses at the PX to secure some initial volumes.

3)   to provide an analysis of the Bank’s potential role, and an approximation of any credit requirement that would accompany such a role. So even the banks could be engaged to stimulate the development. They could support ongoing tests to achieve coordinated allocation of transmission capacity, establish guarantee mechanisms for trade, and also consider investing in companies that establish a regional trading platform

The European hybrid model

The freedom granted to member states by the EU electricity Directive and its different implementations in national law explains the heterogeneous market design of the electricity markets. Although each market has its own specificity, a kind of dominant model is emerging. Hence, in European countries the design of their electricity wholesale market shares some principles. These characteristics can be classified into three categories: organized and bilateral markets, role of the transmission system operator and allocation mechanisms for interconnection capacity. Table 5 (see pg. 47) shows the overview of Europe electricity organized marketplaces.

Figure 7: The hybrid model

It is useful to define an analytical framework that includes PX-s, which are called the ”hybrid model”. The relationships between the electricity market and the technical system are shown schematically in figure 7. The lower part shows a simplified representation of the technical system: generators feed into networks, which deliver electricity to loads. The top right and left corners of the figure contain the primary actors in the electricity market, sellers and buyers. The top center box represents the electricity market where they interact.

Figure 8: Overview of electricity organized market places in Europe

Often the interaction between buyers and sellers does not take place directly, but is mediated by traders, brokers or an organized market such as PX-s. Hence, in most countries electricity markets are organized in four different markets while physical delivery is the responsibility of an independent system operator. These markets are a bilateral market known as an over the counter market (OTC), one or more voluntary PX, a balancing market and a mechanism for allocating interconnector capacity.

The bilateral market is the most important in terms of volume. For example, it represents more than 90% of total consumption in the Netherlands, Germany and France and 75% in the Nordic countries. Bilateral trades occur between two parties on a confidential basis. Most of the time the contracts sold in this market is tailor made, which explains why this market is very heterogeneous. The contracts can differ in many points: starting dates, duration, and delivery areas.

Competition in an electricity PX spot market is driven by generator, distributors, traders and large consumers submitting bids for buying and selling electricity. The PX-s match supply and demand and publish a market-clearing price (MCP). The balancing mechanism, i.e. market or regulated, is the responsibility of the system operator. Every hour, all participants inform the system operator of their physical transactions. This mechanism determines the price for any deviation measured between a participant’s declaration and the real flows in the grid. The interconnector capacity market organizes the allocation of interconnector capacity between two countries. When using market-based mechanisms, this market is divided into different auctions divided into different timeframes, i.e. daily, monthly and yearly auctions. The combination of these markets shapes the actual electricity markets.

The transmission system operator (TSO) is an independent organization that is responsible for physical delivery and, due to the monopoly nature of this function, is regulated at national level. The TSO acts as an interface between the technical system and economic transactions in the market. The role of the TSO in the hybrid model is comparable to the role of the TSO in most markets. However there are some differences. Since the network is a natural monopoly, network operators need to be independent of market players in order not to distort competition. The primary role of the TSO is to manage the electricity grid to insure physical delivery. The TSO maintains system stability and manage the energy balance within its dedicated area. This area is defined geographically according to national or regional boundaries. To provide added system reliability and robustness, control zones are interconnected which allow transfer of power across boundaries and different areas. When actual generation and loads deviate from the amounts that were previously notified by market parties, the TSO maintains the power balance using balancing mechanisms. If the market has projected power demands well, adjustments required to balance the dispatch pattern will be small, but they are crucial for system stability. Finally, the TSO also manages congestion, maintains reliability of service and provides ancillary services for transport. These activities are centralized due to the very short time scale involved. Hence decisions made at the time of operation are controlled by the TSO while other activities made some time before the physical delivery can be delegated to others entities, i.e. market participants, PX-s, with the results passed on to the TSO.

The last important feature of the hybrid model is the allocation methods for interconnection capacity between countries. Cross-border trading represents a critical aspect in the development of a pan-European market. Again the EU Directive provides no specific guidance. Hence, different methods for the allocation interconnection capacity coexist though recent developments have shown a preference for explicit auctions. Before liberalization, the main purpose of interconnectors between countries was system stability, the development of cross-border trading created congestion. Thus, an auction is an allocation mechanism that can be used to distribute this scarce resource. The capacity is allocated to the highest bidder. Explicit auctions separate energy flows from transmission capacity. Hence, once interconnection capacity has been secured by a market participant, the participant will need another transaction for energy. This can be done on the bilateral market or on a PX.

THE MAJOR CONCLUSIONS FROM THE ANALYSES ARE:

Creation of a regional power market is a stepwise development. There is a need for an organized trading platform to be established in the SEE region in addition to the traditional trade. As a part of the organized trading platform there can be established clearing solutions that can reduce the counterparty risk for trade both in OTC trade and in exchange trade. Transparency of prices and other market information is extremely important for development of a regional market.

In the last part of the project the different solutions for a regional trading platform is discussed, going through three main topics:

1)   to determine the interest of potential market participants in trading via a standardized platform featuring Bank-provided credit support.

2)   to identify the most appropriate and effective platform with which to establish confidence in the regional marketplace and to accomplish the goal of increasing trade in the region through a uniform and transparent process.

3)   to provide an analysis of the Bank’s potential role, and an approximation of any credit requirement that would accompany such a role. So even the banks could be engaged to stimulate the development. They could support ongoing tests to achieve coordinated allocation of transmission capacity, establish guarantee mechanisms for trade, and also consider investing in companies that establish a regional trading platform.

There is a need for an organized trading platform to be established in the SEE region in addition to the traditional trade. As a part of the organized trading platform there can be established clearing solutions that can reduce the counterparty risk for trade both in OTC trade and in exchange trade.

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^* ”Vitrina” University, Tirana, Albania