The Wholesale Electricity Market in Britain – 1990-2001.doc

UK electricity market 28/01/20The Wholesale Electricity Market in Britain 1990-2001Steve Thomas Steve Thomas is currently on sabbatical at PPE, UFRJ in Brazil.PSIRU,University of Greenwich, LondonAugust 20011Introduction22.The structure of the British electricity industry33.The Design of the Power Pool and NETA33.1The Power Pool33.2NETA44.Why was it believed the Power Pool failed?44.1Poor Design of the Pool54.2Concentration of the market54.3Lack of consumer competition64.4Dominance of transitional contracts, increased nuclear output and new gas-fired plants built by the retail supply companies64.5Vertical integration of generation and retail supply74.6Conclusions on the Pool85.Why was so much money invested in new power plants?85.1Why was the plant built?85.2The results of the dash for gas95.3Investment in a competitive generation market106.NETA10Tables13Table 1 Generation sector structure 1990 and 2000 (Market share)13Table 2 Current capacity of generators in Britain (inc Scotland)13Table 3 Distribution industry structure13Table 4 Retail supply industry structure14Table 5 Industry priorities at time of reform15Table 6 Characteristics of electricity systems structure and resources16Table 7 Design characteristics of the wholesale electricity markets17In the pre-privatisation electricity industry in Britain, the telephones in the main company, the Central Electricity Generating Board (CEGB), were fitted with an “engineers button”, which an engineer could use to give his calls priority over all other calls. In the post-privatisation industry, if there had been an over-ride button, it would be for the commodity traders.1IntroductionThere are five main elements to the British model of electricity reform: introduction of a wholesale electricity market; introduction of a retail electricity market; de-integration; regulation using incentive methods; and sale of nationally-owned assets to private shareholders. However, it is the first of these that is key. Generation represents the main cost element in consumers electricity bills. Without the introduction of competition in power generation, the other elements would be either pointless, or would be not likely to result in major price reductions, or would not be new. De-integration and the introduction of retail electricity competition would seem to offer little benefit if generation was to remain a regulated monopoly. The use of incentive regulation is merely a change of methodology from the normal rate-of-return approaches and, experience in UK suggests not a major shift. Changes of ownership from public to private and vice versa have occurred throughout the history of electricity supply industry. There is no convincing evidence to suggest that merely changing from public to private ownership will improve the efficiency of the sector.However, the idea of a wholesale electricity market was new and had the potential to significantly affect electricity prices. The assumption that if a competitive market replaces a monopoly cost-plus activity, prices will be reduced is intuitively plausible. However, the idea that a competitive market in power generation was possible was counter to all the assumptions within the electricity industry. The need for supply and demand to balance every second of the day, the infeasibility of storing electricity, the key role of electricity in society and other factors made the engineers that ran the industry argue that electricity was unique and could not possibly be traded as if it was no different to pork bellies.A combination of the low prestige of electrical engineers in the 1980s resulting from, for example, uneconomic nuclear power programmes and the problems from acid rain, and the high prestige of market solutions as proposed by Reagan/Thatcher disciples meant that the voice of engineers carried less authority than it previously had. As a result, the British Model was born and engineers became no more than support staff for the economists, commodities traders and accountants that ran the new companies.On the face of it, experience in Britain seems to have proved the free marketers right. The price of power has come down, and, far from collapsing as some engineers predicted it would, the system seems to have become more reliable. There was also a flood of new investment in power plants that must make Brazilian and Californian consumers green with envy. However, a closer look at the system shows that all is not well. Wholesale power prices remain about a third over the price of power from new entrants, so in the area where markets should be strong, forcing prices down to the long-run marginal cost, the wholesale market has failed.As a result of this and other problems, the British government decided in 1997 to abandon the wholesale market design that was implemented in 1990, including the Power Pool. This was a market design that consultants had sold all round the world to countries with as diverse needs as Ukraine, Brazil and Gujarat (India) and with the active support of the World Bank. The replacement design, the New Electricity Trading Arrangements or NETA, was introduced in March 2001. While no disasters have occurred yet, early experience suggests that serious design problems exist that must be solved soon if major problems are not to arise.Three questions arise from British experience: Why was it believed the Power Pool failed? Why were so many new power plants built after the 1990 reforms? And Will the new market structure, NETA, solve the problems that the Pool was believed to suffer from?2. The structure of the British electricity industryHowever, prior to discussing the wholesale market, it is necessary to identify the major structural changes to the industry since 1990. Many observers outside Britain probably still have a conception of the British structure, or more accurately, the structure for England & Wales as a de-integrated structure with two dominant fossil fuel companies, a transmission company and 12 distribution/retail supply companies. This vision is far from the truth as is shown in Tables 1-4. The Scottish system is now being absorbed into the England & Wales system and while the details of how the Scottish system will be integrated are not yet clear, Scotland will inevitably become part of the England & Wales market. The two privatised English generators are now far from dominant in the generation market, which should be highly competitive now. The retail supply industry is now completely integrated with the generation sector and consolidation is taking place into only a handful of companies. Only British Gas of the new entrants is making an impression in retail supply. The distribution sector is also increasingly separate from retail supply and is also consolidating into only a handful of separate groups.3.The Design of the Power Pool and NETA3.1The Power PoolThe basic design of the original British wholesale electricity market is well known. Demand is forecast for each 30-minute period 24 hours ahead by the System Operator and bids are received for plants that their owners wish to operate. Essentially, the bids are sorted by price and the highest successful bid needed to just meet demand in that 30-minute period sets the Pool Price This Pool Price is paid to all successful bidders. In addition, successful bidders are paid a capacity charge that only becomes significant if supply is only just sufficient to meet demand. Wholesale buyers (and any large consumers that choose to buy directly from the Pool) must buy all their output from the Pool and they pay the Pool Price including the capacity payment and charges for ancillary services. However, while all buying and selling must nominally go through the Pool, bilateral contracts are allowed which effectively bypass the pricing arrangements. In practice, power bought and sold that is covered by such contracts have accounted for more than 90 per cent of electricity consumption.3.2NETAAs with the Power Pool, NETA is settled every 30 minutes and buyers and sellers are allowed to sign bilateral contracts that remain entirely commercially confidential on any terms they choose. However, there the similarities end. At 24 hours before the period of demand in question, open-access Power Exchanges (PXs) are opened and buyers and sellers are able to place bids to buy or sell power to balance their needs. Deals are concluded bilaterally at the price posted. At four hours before the period of consumption, generators inform the System Operator of the plant they intend to operate and retail suppliers inform the System Operator of the amount of power they expect their consumers to consume. The System Operator then determines whether the supply and demand that the companies have forecast matches their (more accurate) demand forecast and it asks for bids from generators to supply additional power or reduce output in the so-called Balancing Market. The System Operator buys any difference between expected and actual sales by generators to wholesalers, and between wholesalers and their consumers for the companies in the Balancing Market. The system operator also deals with any congestion problems, and other ancillary services in this four-hour period and passes the cost on to retail suppliers.4.Why was it believed the Power Pool failed?Apart from the Norwegian Pool, which has, with some developments, been in operation for nearly 30 years and the Chilean market, which is now thought ripe for further reform, the British wholesale electricity market, centred on the Power Pool was in operation for much longer than any other competitive electricity market in the world. It is therefore important to analyse this experience in order to draw lessons not just for Britain, but also for all countries trying to develop a competitive wholesale electricity market.In important respects, the British wholesale electricity market, in the form it operated from 1990-2001, was highly successful. The supply of electricity was entirely secure over these 11 years and prices to consumers stable, albeit significantly too high. However, in 1997, the Power Pool, the spot market that was meant to be the centre point of the wholesale market, providing the market for significant proportion of power sales and price signals for the contract market, was judged by the Regulator and government to have failed and was replaced by NETA in March 2001. Wholesale electricity buyers do not appear to have had sufficient confidence in the Pool for them to trust it for their power purchases, nor did it provide price signals for the contract market. On those grounds, the Power Pool must indeed be regarded as a failure. However, it is far from clear why it has failed.There are a number of possible explanations for the failure of the Pool: Poor design of the Pool; High concentration in the generation market; Lack of consumer competition; Dominance in the wholesale market of transitional contracts, increased nuclear output and new gas-fired plants built by the retail supply companies; and Vertical integration of generation and retail supply.4.1Poor Design of the PoolThe origins of the Power Pool were not auspicious. An ambitious design featuring supply and demand side bids had to be abandoned only nine months before the new system was implemented. Perhaps significantly, the principles behind the abandoned design have not been revived in subsequent updates. In order to keep to the privatisation timetable, the only option then available was to adapt the software used by the old generation and transmission company, the Central Electricity Generating Board (CEGB). This was probably adequate for a monopoly company that could use the results with discretion to dispatch its own plant but hardly suitable for competitive market where rules had to be adhered to. Although the software itself was updated in 1995, the basic design could not be changed then.Two features have come under particular criticism. The first was the capacity payment mechanism based on estimates of Value of Lost Load (VOLL) and Loss of Load Probability (LOLP). This mechanism was seriously misconceived, because it rewarded shortage rather than rewarding new investment as it was meant to do. It was also vulnerable to gaming strategies by generators who could often manipulate the Pool price by withdrawing plant from the market at key times. The erratic price signals that this produced were a strong disincentive to buyers and sellers to trust the Pool for their sales or purchases throughout the 11 years the Power Pool was used.Another feature of the Pool that caused some criticism was the fact that all successful bidders were paid the marginal price whatever price they bid. This seemed likely to build in volatility to the Pool price because the cost of the marginal plant could vary by a large amount, for example, if the price is set by a plant that is almost on base-load it will be much lower than if it is set by a peaking gas turbine that only operates for a few hours a year. In response to concern about this, the Regulator carried out a study in 1995 and concluded that paying each individual successful bidder the price they had bid (pay-per-bid) would offer no advantage. This report also rejected the option of allowing trading outside the Pool, under which, generators with contracts for their output would not have been required to bid into the Pool in order for them to operate their plants. Offer (1994) Report on trading outside the Pool, Offer, Birmingham However, subsequently, he reversed his position on both these two issues. Trading outside the Pool and settling deals on a price bid basis are both important features of NETA.4.2Concentration of the marketMany outsiders have a vision of the British system as being dominated by only two large generation companies and from 1990-96 this was indeed the case. The actions of the Regulator and government in requiring National Power and Powergen to sell off generating plant in 1996 and again in 1999 to other companies to increase diversity in the market clearly show that they believed that a major problem with the Power Pool was concentration of the market. Clearly a market in which only two companies dominate is unlikely to function well. The way in which National Power and Powergen were able to deliver on the commitments under which they were required to bid their plants so that the annual average Pool price did not exceed a specified price demonstrated how strong their grip was on the Pool in 1994-96.However, even after 1998, when the generation market had been split up so that more than five companies operated price setting capacity, the Regulator still complained about abuses of Pool price setting. So, if the Regulator was correct in his analysis that Pool prices were still being rigged, concentration in the generation sector cannot have been the cause this time.4.3Lack of consumer competitionIt appears the Regulator also believed that the lack of retail competition for small consumers was an important factor in keeping Pool prices high. Because retail supply companies could pass through the full cost they had paid to the wholesale market for generation, the incentives to minimise purchase costs were not strong enough. In a cost benefit analysis of the decision to extend retail competition to all final consumers provided to the House of Commons Trade and Industry Select Committee in 1997, he attributed a saving of 300m per year from more economic wholesale purchasing by retail electricity suppliers (House of Commons Trade and Industry Committee, 1997). While at first sight this sounds plausible, closer examination casts some doubts on this. By 1997 half the retail market was open to competition and retail suppliers were under strong pressure in the market for medium and large consumers to minimise generation purchase costs in this sector of the market. It seems unlikely that companies would procure half their power needs competitively and the other half not competitively.In the supporting analysis, the Regulator cites as evidence the fact that captive consumers were paying significantly more for their generation than consumers in the competitive market. However, this appears to have been a matter of allocation and of weak regulation. The companies systematically allocated their cheapest power purchases to the competitive market. Had retail supply to small consumers remained a monopoly and the retail supply companies been required to average their power purchase costs over all markets, the companies would have still had a strong incentive to minimise wholesale power purchase cost. The existence of a monopoly for small consumers would also have allowed electricity retail suppliers to sign longer term contracts for some of their requirements perhaps reducing the cost of power purchase.4.4Dominance of transitional contracts, increased nuclear output and new gas-fired plants built by the retail supply companiesTransitional contracts clearly played an important role in minimising the scope for meaningful trading in the Pool for the period 1990-93 when coal still overwhelmingly dominated generation. The government had required the two large generators to continue to buy British coal at similar volumes to those that applied before privatisation and the retail supply companies were required to buy all the output produced using this coal. This accounted for about 65-70 per cent of their power needs for the period 1990-93. These contracts were renewed, but for about half the volume of coal for the period 1993-98. As well as protecting the British coal industry, the government also gave protection to the nuclear industry, requiring the retail e