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The views expressed in this IEA Insights paper do not necessarily reflect the views or policy of the International Energy Agency (IEA)
Secretariat or of its individual member countries. This paper is a work in progress and/or is produced in parallel with or
contributing to other IEA work or formal publication; comments are welcome, directed to manuel.baritaud@iea.org.
OECD/IEA,2012
OECD
IEA
2012
SecuringPower
duringtheTransition
GenerationInvestmentandOperationIssuesinElectricityMarketswithLowCarbonPolicies
ManuelBaritaud
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INTERNATIONAL ENERGY AGENCY
The International Energy Agency (IEA), an autonomous agency, was established in November 1974.Its primary mandate was and is two-fold: to promote energy security amongst its membercountries through collective response to physical disruptions in oil supply, and provide authoritative
research and analysis on ways to ensure reliable, affordable and clean energy for its 28 membercountries and beyond. The IEA carries out a comprehensive programme of energy co-operation amongits member countries, each of which is obliged to hold oil stocks equivalent to 90 days of its net imports.The Agencys aims include the following objectives:
n Secure member countries access to reliable and ample supplies of all forms of energy; in particular,through maintaining effective emergency response capabilities in case of oil supply disruptions.
n Promote sustainable energy policies that spur economic growth and environmental protectionin a global context particularly in terms of reducing greenhouse-gas emissions that contributeto climate change.
n Improve transparency of international markets through collection and analysis ofenergy data.
n Support global collaboration on energy technology to secure future energy supplies
and mitigate their environmental impact, including through improved energyefficiency and development and deployment of low-carbon technologies.
n Find solutions to global energy challenges through engagement anddialogue with non-member countries, industry, international
organisations and other stakeholders.IEA member countries:
Australia
Austria
Belgium
Canada
Czech Republic
Denmark
Finland
France
Germany
Greece
Hungary
Ireland
Italy
Japan
Korea (Republic of)
Luxembourg
NetherlandsNew Zealand
Norway
Poland
Portugal
Slovak Republic
Spain
Sweden
Switzerland
Turkey
United Kingdom
United States
The European Commission
also participates in
the work of the IEA.
OECD/IEA, 2012
International Energy Agency9 rue de la Fdration
75739 Paris Cedex 15, France
www.iea.org
Please note that this publicationis subject to specific restrictionsthat limit its use and distribution.
The terms and conditions are available online athttp://www.iea.org/termsandconditionsuseandcopyright/
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Foreword
At the October 2011 Governing Board Meeting at Ministerial Level, IEA member countries
endorsed the IEAElectricitySecurityActionPlan (ESAP).Theproposedelectricity securitywork
program
reflects
the
challenge
of
maintaining
electricity
security
while
also
seeking
to
rapidly
reducecarbondioxideemissionsofthepowersystems.Inparticular,thelargescaledeployment
of renewablesneeded tomeet lowcarbongoals is technically feasible.However, itwill lead to
morevolatile,realtimepowerflows,whichwillcreatenewchallengesformaintainingelectricity
security.
Wellfunctioningelectricitymarketswillbeneededtostimulatethesufficient,timelyinvestment
needed to achieve low carbon and electricity security goalsat least cost. Governments have a
crucial role to play. Better integrated and more effective policies, regulation and support
programswillbeneededtocomplementandreinforce incentivesformarketbasedflexibilityto
helpdelivercosteffectiveelectricitysecurityanddecarbonisation.
TheElectricity
Security
Action
Plan
consists
of
five
work
streams:
1. Generation Operation and Investment. This work stream examines the operational and
investmentchallengesfacingelectricitygenerationinthecontextofdecarbonisation.
2. Network Operation and Investment. This work stream examines the operational and
investment challenges affecting electricity transmission and distribution networks as they
respondtothenewandmoredynamicrealtimedemandscreatedbyliberalisationandlarge
scaledeploymentofvariablerenewablegeneration.
3. Market Integration. This work stream identifies and examines the key issues affecting
electricity market integration, including policy/legal, regulatory, system operation/security,
spot/financialmarketandupstream fuelmarket dimensions. Itdraws from theotherwork
streams as appropriate, and from regional market development experience in member
countries.
4. Demand Response. This work stream examines key issues and challenges associated with
increasingdemandresponse,reflectingitsconsiderablepotentialtoimproveelectricitysector
efficiency,flexibilityandreliability.
5. EmergencyPreparedness.Thisworkstreamdevelopsa framework for integratingelectricity
securityassessmentintotheIEAskeypeerreviewprogramsEmergencyResponseReviews
andIndepthReviewstoimproveknowledgeandinformationsharingonelectricitysecurity
matters among IEA member countries, with a view to helping strengthen power system
securityandemergencypreparedness.
SecuringPowerduringtheTransitionisanissuepaperongenerationoperationandinvestment
in liberalised electricity markets with low carbon policies. After a brief overview of thefundamentalsofliberalisedelectricitymarkets,itpresentsthepolicycontextofthetransitiontoa
lowcarbon economy and reviews the current and foreseen operating challenges and the
investment issues. It considers ways to strengthen policy and regulatory arrangements to
encouragemoreflexibleandresponsiveoperationandmoretimelyandefficientinvestment.Itis
partofaseriesonelectricitypublished inconjunctionwiththeoverallElectricitySecurityAction
Plan.
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TableofContents
Foreword.......................................................................................................................................1
Acknowledgements......................................................................................................................7
Executivesummary.......................................................................................................................8
Willelectricitymarketsdeliverelectricitysecurityduringthetransitiontoalowcarbon
economy?..................................................................................................................................8
Keyfindings...............................................................................................................................9
Competitiveelectricitymarketsmustbesupportedbytoughregulation...............................9
Uncertaintyaboutclimateandrenewablespoliciesimpactsfutureinvestmentneeds........10
Thegrowingchallengesofdesigningastableregulatoryframeworkandwellfunctioning
markets...................................................................................................................................10
Variablerenewableswillneedtoprovideflexibilityservicesinordertosecuresystem
operations...............................................................................................................................11
Capacityarrangementscancreateasafetynettocopewithuncertainties..........................12
Searchingforatargetmodeloflowcarboninvestments......................................................13
1.Thegeneralframeworkforefficientelectricitymarkets......................................................14
Electricity:aservicewithuniquecharacteristics....................................................................14
Realtimesupply.................................................................................................................14
Networkswithmonopolycharacteristics...........................................................................14
Alackofdemandresponse................................................................................................15
Twoapproachesforprovidingelectricity...............................................................................15
Verticallyintegratedregulatedmonopolies.......................................................................15
Competitivemodel.............................................................................................................17
Reliability,carbonemissionsandtechnologyspillovers.........................................................18
Reliability............................................................................................................................18
Reducingcarbon
emissions
in
acompetitive
framework
...................................................
21
Promotingtheinceptionoflowcarbontechnologies........................................................22
2.Policycontext:transitiontowardsalowcarbonelectricitygeneration..............................25
Levelplayingfieldsforlowcarbongenerationinvestments..................................................26
Globalclimatepolicywillremainuncertain.......................................................................26
Regionalcarbonmarketsarefailingtotriggerlowcarboninvestments...........................27
Powersectoremissionsorcarbonintensitytargets..........................................................28
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Policiestosupplementacarbonpricearetechnologyspecific..............................................29
Renewablesupportpolicieshavebeeneffective...............................................................30
Nuclear................................................................................................................................31
Energyefficiencypolicies...................................................................................................32
Carboncaptureandstorageprogress................................................................................33
Howdoesthetransitionaffectsecurityofelectricitysupply?...............................................34
3.Operatingchallenges..............................................................................................................36
Peakloadgenerationadequacy..............................................................................................36
Minimumloadbalancing........................................................................................................37
Rampsandstartups...............................................................................................................41
Predictability...........................................................................................................................
43
4.Investmentissues...................................................................................................................45
Theimpactofthefinancialandeconomiccrisis.....................................................................47
Localacceptabilityissues........................................................................................................48
Cashflowvolatilityandvariability..........................................................................................48
Uncertainrevenuesforpeakingunits................................................................................48
Dogasplantsbenefitfromanaturalhedgeonelectricitymarkets?.................................49
ImpactofVREonrevenuesofmidmeritplants................................................................50
Longtermcontractsandverticalintegration.....................................................................50
Lowcarboninvestments....................................................................................................50
Loadfactorrisk........................................................................................................................51
Peakpricingrestrictions..........................................................................................................54
Systemoperationsduringscarcityconditions....................................................................55
Marketpower.....................................................................................................................55
Politicalinterventions.........................................................................................................56
Missingorincompleteflexibilitymarkets...............................................................................56
Energypolicyandregulatoryrisks......................................................................................57
5.Policyoptions..........................................................................................................................61
Improvingclimateandlowcarbonenergypoliciesinstruments...........................................62
Definitionofenergyandclimatepolicies...........................................................................62
Carbonpricingpolicies.......................................................................................................63
EnergyEfficiencyPolicies....................................................................................................64
Technologypolicies............................................................................................................64
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Designofrenewablesupportinstruments.........................................................................65
EnergyMarketDesignImprovements:anoregretsolution..................................................68
Removerestrictiononelectricityprices.............................................................................68
Electricityproductdefinition..............................................................................................70
Locationalmarginalpricing................................................................................................73
Consistentandintegrateddayahead,intraday,balancingandreservemarkets............74
StandardsandProcedures:avaluablecontribution...............................................................74
Reliabilitycriteria................................................................................................................74
Adequacyforecasts............................................................................................................75
Technicalflexibilityandcontrollabilityrequirements........................................................75
TargetedReliability
Contracts:
atemporary
fix
......................................................................
75
Contracttopreventmothballingandhandletransmissionconstraints............................76
Contractstobringinnewinvestmentinpowerplants......................................................78
Contractstodevelopdemandresponse............................................................................78
Marketwidecapacitymechanism:asafetynet.....................................................................78
Capacitypayments.............................................................................................................79
Capacitymarkets................................................................................................................80
Annex:Evaluatingthepolicyoptions........................................................................................85
Proportionality........................................................................................................................86
Effectiveness...........................................................................................................................86
Leadtime................................................................................................................................86
Simplicity.................................................................................................................................87
Directcost...............................................................................................................................88
Indirectcost............................................................................................................................88
Adaptability.............................................................................................................................88
Acronyms,abbreviationsandunitsofmeasure........................................................................89
References..................................................................................................................................90
ListofFigures
Figure1 SouthAustralianpricedurationcurve,variousyears(logarithmicscale).................20
Figure2 Australianelectricitymarketpeakdemandandgenerationcapacity,1998/99
2010/11.....................................................................................................................21
Figure3 SolarPVsystemcostsandfeedintariffs,mediumscalesystems.Germany
200612(upto100kW)............................................................................................23
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Figure4 ReductioninworldenergyrelatedCO2emissionsinthe450Scenariocompared
withtheNewPoliciesScenarioandscopeofdifferentregulatoryinstruments .....25
Figure5 Timelineofglobalclimatenegotiationsandevolutionofcarbonemissions,
19922020..................................................................................................................26
Figure6 Europeancarbonprices(EUallowances),20052012..............................................27
Figure7
Breakdownoflevelisedcostofelectricityofpowergenerationtechnologies .......30
Figure8 InstalledcapacityofsolarPVandonshorewindworldwide,GW(19922020).......30
Figure9 InvestmentintheUnitedStatesbytechnologygroup,20022009.........................34
Figure10InvestmentinEuropebytechnologygroup,20002011Europe.............................34
Figure11Theimpactofenergypoliciesonthefunctioningofelectricitymarkets.................35
Figure12Peakloadadequacyandminimumloadbalancing..................................................37
Figure13Marginalfuelfrequency,ERCOT,WestZone...........................................................38
Figure14Unusedwindgeneration(MWh)JanNov2010.......................................................38
Figure15NegativepricesinGermany(2012)..........................................................................39
Figure16Illustrativeresidualloaddurationcurveandrenewablecurtailments....................40
Figure17ElectricityconsumptioninFranceon22March2012..............................................41
Figure18Hourlyvariabilityofresidualloadwithhighsharesofrenewables(United
Kingdom
with80%ofrenewables)........................................................................................42
Figure19Theevolutionofwindforecastuncertainty24hoursbeforerealtime...................44
Figure20Overviewofinvestmentissues................................................................................46
Figure21CostandrevenuesofnotionalpeakinggasfiredgeneratorsintheSouth
AustralianwholesaleMarket,20062011...............................................................49
Figure22Cleansparkspread,baseloadmonthahead,Germany .........................................50
Figure23ElectricitysuppliedinEurope,OECDEurope ..........................................................51
Figure24Schematicillustrationoftheimpactofrenewablesonloadfactors,capacity
andprices................................................................................................................53
Figure25Twentyfiveyearlevelised,fixedcostandeconomicdispatchnetrevenues,
19992010...............................................................................................................54
Figure26Peakpricingrestrictions...........................................................................................55
Figure27Missingmarkets.......................................................................................................57
Figure28Evolutionofelectricityconsumptionandnonrenewableconsumptionin
Spain.......................................................................................................................58
Figure29Possibleimpactofpolicyuncertaintyonadequacyforecasts ................................59
Figure30Policymeasures........................................................................................................61
Figure31Illustrationofthecarbonpricesupportmechanism...............................................63
Figure32PricedurationcurveforPJMrealtimemarketduringhoursabovethe95th
percentile,20062010.............................................................................................69
Figure33Exampleofa reliabilitycontract..............................................................................71
Figure34Averagenodalprices,realtime,Q32005(ISONewEngland).................................73
Figure35Capacitypayment(EUR/MW/yr)asafunctionofreservemarginindexin
Spain.......................................................................................................................80
Figure36Capacitysupplyanddemandcurve2010201.........................................................81
Figure37Comparisonofnetrevenuesofgasfiredgenerationbetweenmarkets.................82
Figure38Qualitativeassessmentofdifferentpolicyoptionstoensuresecurityof
electricitysupplyduringthetransition...................................................................85
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ListofTables
Table1Examplesofreliabilitythresholdsinwholesaleelectricitymarkets...............................19
Table2Globalmarginalabatementcostsandexamplemarginalabatementoptionsinthe
2degree
scenario
...........................................................................................................
22
Table3StatusofnuclearprojectsinOECDcountriesandtypeofregulatoryintervention........32
Table4Overviewofoperatingchallengesofrenewableintegration..........................................36
Table5Differenttypesofcapacitymarkets................................................................................81
ListofBoxes
Box1Thecostofensuringsecurityofsupply...............................................................................19
Box2IncentivesforinvestmentinsparecapacityinAustralia....................................................20
Box3ProposalforaUnitedStatesCleanEnergyStandardAct....................................................29
Box4MarketpremiumpaymentsinGermany.............................................................................67
Box5ISONewEnglandForwardReserveMarket........................................................................72
Box6ThestrategicreserveinSwedenandFinland......................................................................77
Box7CapacitypaymentsinSpain.................................................................................................80
Box8Designdetailsofcapacitymarkets......................................................................................82
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Acknowledgements
TheprincipalauthorofthispaperisManuelBaritaudoftheGas,CoalandPowerMarketsDivision,
workingunderthedirectionofLaszloVarro,HeadofDivision.
ThispaperhasbenefitedgreatlyfromsuggestionsandcommentsbyDougCooke,fromthe IEA.SteveMacmillan,secondedfromOriginEnergy(Australia)isthemainauthorofthefirstchapter.
Theauthorwantstothank fortheircontributionsthe followingstaff fromthe IEA:DennisVolk,
Christina Hood, Simon Mueller, Alexander Antonyuk, Grayson Heffner, Justine Garett, Andr
Aasrud,CedricPhilibertandJohannesTruby.
In addition, the International Energy Agency and the author are grateful to the following IEA
membercountryadministrationsfortheirparticipationintheconsultationprocesswhichwaspart
oftheresearchforthisstudy:
Australia,DepartmentofResources,EnergyandTourism
Denmark,MinistryofClimate,EnergyandBuilding
EuropeanCommission,DirectorateGeneralforEnergy
Germany,FederalMinistryofEconomyandTechnology
Ireland,DepartmentofCommunications,EnergyandNaturalResources
Netherlands,MinistryofEconomicAffairs,AgricultureandInnovation
Spain,MinistryofIndustry,EnergyandTourismStateSecretariatforEnergy
UnitedKingdom,DepartmentofEnergyandClimateChange
UnitedStates,DepartmentofEnergy
ThisworkalsobenefitedfromconversationswithMarcoCometto,MikeHogan,JacquesdeJong,
Jan Horst Keppler, ThomasOlivier Lautier, Christoph Reichmann, Fabien Roques, Marcello
Saguan,UlrikStridbk,MigueldelaTorreRodriguez,PhilippeVassilopoulos,StephenWoodhouse
andmanyotherpeoplemetatEurelectric.
JanetPapeprovidedessentialsupportintermsofeditinganddesignofthispaper.
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Executivesummary
Willelectricitymarketsdeliverelectricitysecurityduringthe
transitionto
alow
carbon
economy?
Electricitysecurityhasbeenapriorityofenergypolicy fordecadesdue to thedependenceof
modern societyon reliableelectricity supply.Onlya fewyearsago therewasconfidence that
liberalised electricity markets in IEA member countries could also deliver sufficient and timely
generation investments needed to ensure security of supply. Most of the liberalised power
marketsexperiencedsignificantinvestmentsinnewefficientcombinedcyclegaspowerplantson
amerchantbasis.LessonsLearnedfromLiberalizedElectricityMarkets(IEA,2005)concludedthatelectricity market liberalisation has delivered considerable economic benefits and that
minimising regulatory uncertainty is key to creating a framework for timely and adequateinvestment.
However,policies todecarboniseelectricity systemshave served tomagnify investment riskand uncertainty at a time when the capital stock is ageing and slowing demand growth is
discouraginginvestmentinmanyIEApowermarkets.Somenewlowcarbonsources(mainlywind
and solar photovoltaics) have unique technical characteristics that accentuate realtime power
systemvolatility,creatingadditionalchallengesforsystemoperations.Thecombinationofthese
developments is increasinglyperceivedtoposeachallengetomaintainingelectricitysecurity in
manyIEApowersystems.
Ensuringsecurityofelectricitysupplyisnotjustaboutavoidingblackoutsatanycost;itisalso
aboutthefunctioningofelectricitymarkets.Clearly,abasicrequirementofanyeffectivemarket
and regulatory framework is to ensure a reliable and secure supply of electricity. An efficient
regulatoryand
market
framework
would
also
seek
to
deliver
reliable
electricity
services
that
meet
enduserequirementsat leastcost.Ultimatelythiscanonlybeachievedovertime ifthemarket
stimulatesadequate investment innewgenerationcapacityattherighttime, intherightplace,
andusingthemostcosteffectivetechnologies.
InseveralOECDcountriesmostincrementalpowerproductionisdrivenbygovernmentpolicies
rather thanmarketsbasedon feedin tariffsorquota systems.Newnuclear investmentalso
extensively relies on public policy support. This has led to a situation where some pioneers in
electricity market reform are beginning to express concern about the capacity of energyonly
wholesalemarketstoprovidesufficient incentivestodeliverthe investmentneededtofacilitate
decarbonisationwhilecontinuingtodeliverreliablesupplyofelectricity.
Securing
Power
during
the
Transition
assesses
the
threats
and
identifies
options
for
competitiveelectricitymarketsembarkingonthetransitiontowardsa lowcarbongeneration.
Theanalysisprovidesanintegratedanalysisofissues,coveringtheimpactoftheglobaleconomic
andfinancialsituation,energypolicycontextandtheimplicationsforelectricitymarketdesign.Its
objective is to identify opportunities to improve regulatory and market designs to create a
frameworkfortimelyandadequateinvestments,inparticularinconventionalpowerplants.
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Keyfindings
Energymarketshave thepotential toensureelectricityof supplyprovided thatanumberof
policymeasuresarepursued.Thesemeasuresconstituteabasicpackagethatwillbringbenefits,
notonlyintermsofsecurityofsupply,butalsointermsofoverallefficiencyduringthetransition
toalowcarboneconomy.Theyinclude:
providingmorecertaintyconcerningclimatepolicies;
enhancing lowcarbonsupport instruments inorder toensuremoreeffective integrationof
variable renewable generation into electricity markets, in particular, the participation of
variablerenewablestoensuresystemsecurity;
incrementallyimprovingwholesaleenergymarketdesigninordertoaccommodateincreasing
sharesofvariablerenewablesatleastcost;and
enhancingtechnicalstandardsandprocedures,tomoreclearlydefineandenforcereliability
criteria,adequacyforecastsandcontrollabilityrequirementsofrenewablegenerators.
Nonetheless,severalreasonsmayexplainwhygovernmentshaveintroducedorareconsidering
the introduction of capacitymechanisms. First the degree of uncertainty concerning climate
policies and the pace of deployment of renewables may magnify risk to such an extent that
markets alone are unlikely to deliver efficient and timely investment responses. Second,
regulations thatrestrictefficientelectricitypriceformation,suchasunduly lowpricescaps,can
undermine marketbased signals for efficiently timed and located investment responses.Third,
the reduction in spotpricesand lowerand lesspredictableperiodsofoperation resulting from
increasing volumes of variable renewable generation, increases cash flow uncertainty for
conventional generation, with the potential to encourage the closure of existing conventional
capacityanddiscouragetimelyinvestmentinnewcapacity.Wheretheserisksarematerial,there
maybe
acase
for,
capacity
arrangements
that
can
create
asafety
net
in
order
to
ensure
sufficient
andtimelyinvestments.Possiblecapacitymechanismsinclude:
Targeted contracting of capacity, which can provide a temporary fix but may introduce
distortionsbetweentechnologies.
Marketwidecapacitymechanismscanbeeffectivetocreateasafetynetifwelldesignedbut
tendtobecostlyandcomplexandcanintroduceotherformsofmarketdistortion,suchasthe
riskofoverinvestmentorunderinvestmentandmarketmanipulation.
Capacitymechanismswould constitutea shift towardheavyhanded regulatory intervention, in
whichacentralentitynotthemarkethastoplanhowmuchgenerationcapacity isneeded.
Added to thepolicydrivendeploymentof renewables, suchmechanismshave thepotential to
jeopardisethecompetitionbenefitsfromelectricitymarketliberalisation.
Competitiveelectricitymarketsmustbesupportedbytough
regulation
Even ifcompetitiveelectricitymarketsare still relatively recent, there isclearempiricalevidence
thatwelldesignedcompetitivemarketsdoesworkandcanbringeconomicbenefits.Thathasnot
beenaneasyconclusion;giventheuniquefeaturesofelectricityintermsofrealtimebalancingneeds
andlackofdemandresponsetoprices,marketrulesmustbewelldesignedtoensurereliablesupply.
TheexperienceofseveralIEAmembercountriesovermorethantenyearsdemonstrateshowithas
workedinpractice.
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Parallel to the process of developing competition,many OECD governments have adopted
policies in order to decarbonise electricity generation in the coming decades. To meet the
greenhouse gas reduction objectives and mitigate global warming, governments are actively
pursuinglowcarbonpolicies.Defininghighlevelprinciplesfortheelectricitymarketissimple:set
a high carbon price, add some technologyspecific support and create a competitive market
platformtobringinnewtechnologiesandinnovativesolutions.Thiswillcreatethefoundationfor
decarbonising theelectricitysectorat leastcostanddeliveringadequategenerationcapacityto
maintainelectricitysecurityofsupply.Thisbeingsaid,existingcarbonpricingmechanismssuchas
theEuropeanEmissionsTradingScheme(ETS)seemsufficientto influencedispatchingdecisions
and investmentchoicesbetweenreadilyavailabletechnologiessuchascoalandgas,butdonot
create sufficient incentive for the largescale commercial deployment of new lowcarbon
technologies.
Uncertaintyaboutclimateandrenewablespoliciesimpactsfuture
investmentneeds
Policieshavebeenintroducedorarebeingconsideredtoreducegreenhousegasemissions.But
defining appropriate policies during the transition is necessarily an incremental development
process.Theglobalclimatenegotiationshaveprovedtobechallengingandmoststakeholdersdo
not expect a new global agreement to enter into force before 2020 at the earliest. Regional
carbonmarketsintroducedtodatehaveresultedinpricesthataretotoolowandtoouncertain
totriggerlowcarboninvestments.Giventhatanycarbonmarketisdrivenbypolicydecisionsand
issubjecttouncertaineconomicandtechnologicaldevelopments,carbonpricevolatility istobe
expected.Facingthissituation,somecountrieshaveintroducedacarbonpricefloor(s)(theUnited
Kingdom) while others are considering introducing sectoral measures restricted to electricity
generation(theUnitedStates)ratherthaneconomywidecarbonmarkets.
Renewables support schemes have proven effective at facilitating deployment. They pursue
multipleobjectives, includingpromoting longterm industrialpolicies,andeconomicstimulation.
They have delivered substantial and sometimes unanticipated levels of deployment of some
technologies.Butmostofthesetechnologiesarepromisingbutnotyetfullycostcompetitiveand
renewabledeploymenthascomewithacost.Inmanycases,theyposean increasingburdenon
thepriceofelectricity fordomesticand, incertaincountries, industrialconsumers.Thepaceof
theirdeployment isdependenton the levelofgovernment subsidyand recentpolicydecisions
haveservedtoraisethedegreeofuncertaintyassociatedwiththepaceoftheirdeployment.
Thegrowingchallengesofdesigningastableregulatory
frameworkand
well
functioning
markets
Stableandpredictable climate and lowcarbonpolicieswouldhave thepotential tomitigate
someoftheproblemsassociatedwithinvestmentincentives.Examplesofsuchpoliciesinclude
providing more certainty for carbon pricing, defining attainable policy goals, developing
predictablepoliciesforrenewablesandenergyefficiency,andavoidingsuddendecisionsthatcan
erodecertaintyandconfidenceamongmarketparticipants.Governmentsshouldaimtoprovide
as much certainty and predictability as possible, recognizing that the uncertain economic
environmentandtechnologicaldevelopmentswilldemandadegreeofflexibility.
Delivering costeffectiveenergyefficiency improvements isa criticalcomponentofelectricity
security.Ifthispotential is leftuntapped,greater investmentwillbeneeded innewgeneration.Wellfunctioning markets create incentives to deliver innovative and costeffective demand
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response and energy efficiency. Policies should seek to complement and build on these
incentives. However it is important that there is as much certainty as possiblethat energy
efficiencypolicieswilldelivertheirtargets,bothtoensurethatcostsareminimisedandsothat
theydonotintroduceundueuncertaintyindemandtrendsthatwouldmakeinvestmentinsupply
morechallenging.
Increasingsharesofvariablerenewablesexacerbatetheissueswithinvestmentsinpeakpower
plants.Thevariabilityofelectricitydemandandtheneedtomeetpeakdemandhasalwaysbeen
a concern for system operators. During a few hours of peak demand, efficient electricity
wholesale hourly prices are volatile and much higher than the yearly average wholesale price:
efficient peak prices reflect the costs of the plants needed to meet peak demand. With high
sharesofwindandsolarpower,newinvestmentincapacity,includinggenerationplants,demand
response,storagecapacitywillbeneeded.However,attractingsufficientandtimelyinvestmentin
peakcapacityand incentivizingdemandresponsehasproventobeaproblemforseveralOECD
electricitymarkets.
Removing restrictions on wholesale peak prices during scarcity conditions is important to
ensurewell
functioning
electricity
markets.Wholesalepeakpricesduringscarcityconditionsare
not intrinsicallybad,since inperiodsofscarcity,highpricesactto incentivisedemandresponse.
Moresophisticatedstructuralandbehaviouralremediesshouldbepursuedtoaddressconcerns
about market power, rather than poorly targeted price controls. Ultimately a more flexible
demandsidewouldcontributetomitigatingmarketpowerandpricevolatility,andoughttobe
pursuedtoenhancemarketefficiencyandflexibility.
Increasingsharesofvariablerenewableswilldecreaseloadfactorsofbaseloadplantsandmid
meritplants,addtothevariabilityofrevenuesandcanleadtoverylowwholesalepricesduring
hours of high renewable generation with zero fuel cost. Variable renewable resources will
reduceconventionalbaseloadcapacityneedsovertime.Yearlyvariabilityofweatherconditions
mayfurther increasethevariabilityofrevenues.Compoundedwithuncertaincarbonprices,this
will further deter marketbased investment in lowcarbon baseload technologies. Attracting
financing with more volatile and variable cash flows will become an increasing challenge,
exacerbatedbythecurrentfinancialcontext.
Variablerenewableswillneedtoprovideflexibilityservicesin
ordertosecuresystemoperations
At significant penetration levels, generation using variable renewable energymagnifies the
volatility of realtime electricity balancing, increasing the challenge tomaintain reliable and
securepowersystemoperations. Challengesinclude:
the low contribution of variable renewables to meet peak demand with a reasonably high
probability,
longerandsteeperrampratesofresidualdemand,and
the limited predictability of renewables and higher balancing needs during hours of high
renewablegeneration.
The flexibility of the electricity system can be increased by flexible conventional generation,
interconnections,storageanddemandresponse.Butvariablerenewablessuchaswindandsolar
photovoltaic (PV) can and should have a role to play, which necessitate that their output be
controllable.
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With high shares of variable renewable resources, thesewill also have to contribute to the
balancing of the system. The experience in many countries to date indicates that beyond a
certain level (20 to 30% of energy, depending on the features of the electricity systems), the
variablerenewableoutputmustbecontrolledduringperiodsofexceptionallyhighoutputinorder
toensuresecureandreliablesystemoperations.Thismeansthatinpractice,somewindturbines
or solar power plants must be curtailed, as is already the case in Spain, Texas and Ireland.
Investmentinotherflexibilityoptionshelpsmitigatecurtailmentforsecurityreasons.
Efficient participation of renewables in the markets requires both renewable support and
adaptationofthedesignofmarkets.Somerenewabletechnologies includinghydro,biogasand
concentrated solar power with heat storage are already capable of flexible operations and a
provisionofsystemservices.Otherlargescalevariablerenewablefacilitiescouldalsoparticipate
intheenergymarketbyprovidingadollarperMWhbid,belowwhichtheyarenolongerwillingto
generate.Thisimpliesanadaptationofthedesignofrenewablesupportinstruments.
Amarketplatformforflexibleservicescanbebasedonexistingbalancingandreservemarkets
andcreatesalevelplayingfieldforalltechnologies.Definingflexibilityproductssuchasramping
upanddown, fast response ramping,minimum loadbalancing,etc.can revealaprice foreachflexibility service. These services are being supplied by the same assets, and their availability
dependsonshorttermarbitragesbetweendifferentmarkets.Alltechnologiesshouldbeableto
participateinthesemarkets, includingvariablerenewableandconventionalgeneration,demand
responseandstorage.Participationofrenewablesinbalancingmarketswouldorientinvestment
withinrenewablestowardsamoreflexibleportfolioandprovide longertermsignalsto invest in
capacitywiththerightcapabilities.
Capacityarrangementscancreateasafetynettocopewith
uncertainties
While in theory, well designed, energyonly electricity markets could ensure adequate
investments, this isbecoming increasingly challengingunderpolicies thatpromote rapidand
largescaledecarbonisation.Ouranalysisalso indicates that currentpolicy and regulatory risks
mayactasadeterrent for the investments ingenerationneeded toensure securityof supply.
Existing or foreseen restrictions on power peak prices, lack of credibility of carbon policy, the
uncertain pace of development of renewable and nuclear policies, as wellas energy efficiency
policytargets,all induceadegreeofpolicyrisk. Private investorsarenotinthebestpositionto
handlethesekindsofrisk.
Improved climate, energy and renewable policies and better energymarkets are needed to
address these challenges. Following the economic crisis, many OECD countries are currently
experiencingasituationofexcesscapacity,andthushaveawindowofopportunity inwhich to
addresstheseissuesbeforeconsideringothermoreinterventionistarrangements.Thisshouldbe
apriorityas theywilldelivereconomicbenefits in termsof lowerdispatchingcostsandbetter
pricesignalsandhavethepotentialtosubstantiallyreducethetransitionalcostsassociatedwith
of decarbonisation. This includes improving renewable policies, removing restrictions on peak
prices, creating more transparent and efficient market platforms for flexibility services,
developingefficient locationalpricingand integrationofthedayahead, intraday,balancingand
reservemarkets.Obviously,thisiseasiersaidthandoneandinparticularimprovingclimatepolicy
depends on a range of wider issues including progresswith internationalnegotiations andwill
take time. If a situation of excessive uncertainty persists, there may be a material risk that
competitive electricity markets may not provide timely and sufficient investment to maintain
securityofsupply.
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Capacitymechanisms,includingtargetedcontractsandmarketwidecapacityarrangements,are
asecondbestsolutiontoensuresecurityofsupplyandgenerationadequacy.Theobjectiveof
suchmechanismsshouldbenottoincreasetheprofitabilityofexistingassetshitbytheeconomic
crisis, but rather to provide certainty that there will be enough capacity available, either with
existingoldplantsornewassetsifneeded.
Targetedcontractscanhelpcountries facingshorttermand transitoryadequacyor reliability
issues during the transition period. Such contracts are quick to implement and unwind once
policy and regulatory uncertainty has been reduced and market design improved. Therefore,
targeted contracts have the potential to promote security of supply without necessarily
jeopardizing thetheeconomicbenefitsfromwellfunctioningenergyonlymarkets in the longer
run.However,expectationsofsuchcontractscandistortmarketpricesandmightleadtostrategic
behavior as companies withhold investment and wait for their introduction. Moreover,
experienceincertaincountriesindicatesthatitcouldbedifficulttostopthem.
Marketwidecapacitymechanismscanbeeffectivetoensuregenerationadequacybuttendto
becomplex,costlyandsubjecttoregulatoryrisk.Bycreatinganexplicitmarketforcapacity,they
canbeeffectivetoensureadequatecapacity.Theycanbeusedtopromoteflexibility,investmentin capacity and in particular, demand response. They also have the potential to address the
growingdiscrepancybetweentheongoingneedforflexibleconventionalgenerationcapacityand
itsdecliningutilisation,whichisasalientfeatureofsystemswithhighvariablerenewableshares.
Theyhavethepotentialtoencouragecompetitionbetweendifferenttechnologies,whilereducing
theriskofoverinvestinginparticulartechnologiesassociatedwithtargetedcontracts.
However,capacitymarketstendtohavehightransactioncostsandputaburdenonregulatory
institutions.Theymighthaveunintendedconsequencesinintroducingsecondaryincentivesand,
depending on their design, may create excess capacity and lower demand response during
scarcityconditions. Inaddition,while regional integrationofelectricitymarkets isan important
source of flexibility and efficiency gains, national capacity markets tend to reinforce national
rather than marketwide assessments of generation adequacy, thereby introducing distortions
between different countries or jurisdictions. Before introducing capacity mechanisms,
governmentsshouldcarefullyconsiderthetimingoftheirintroduction,theirimpactonincentives
anddefinecommonrulesforregionalmarketsspanningmultiplejurisdictions.
Searchingforatargetmodeloflowcarboninvestments
Thisworkmainlyfocusesonissuesregardingtimelyandefficientinvestmentsinconventionalpower
plantsduringthetransitiontowardsalowcarboneconomy.Duringthetransition,governmentswill
probably continue to incentivise most nonhydro renewable and other lowcarbon investments.
Lookingforward,amajorchallengefacingelectricitymarketswillbetodeliverinvestmentsinlow
carbontechnologies,whichshouldrepresentthebulkofnew investment ifdecarbonisationofthe
powersectoristobeachievedinthemediumterm.Whatwillthemarketwholesalepowerprices
be with high variable renewables? What share of lowcarbon electricity can be expected from
marketbasedinvestmentsinelectricitymarketswithahighpriceofcarbon?Willthisbeenoughto
achievethedecarbonisationobjectiveswhilemaintainingsecurityofelectricitysupply?Designinga
wholesaleelectricitymarket to reach the leastcostdispatchanddeliver thedesired levelof low
carbon investment is a challenge that will require further research. Ifa revised market design is
needed inthenextdecadetohelpcosteffectivelyandefficientlymanageveryhighsharesoflow
carbongeneration,workonthismodelshouldbeginnow.Theprospectofanotherchangeinmarket
settingscouldcausefurtherinvestmentuncertaintyandleadtodelayedinvestment,sothesooner
thereisclarityaroundthislongtermdirectionthebetter.
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1.Thegeneralframeworkforefficientelectricity
markets1
An
effective
electricity
sector
has
to
deliver
lowcost,
secure
and
sustainable
energy.
In
many
economiescompetitiveforcesareseenasthemostefficientmeanstoachievethisoutcome.But
markets do not design themselves and in virtually all markets for goods and services,
governmentsusepoliciestocorrect forsome levelofmarket failure,and inthisrespect,power
markets are no exception. Effective policy in the electricity sector should allow consumers to
capture thebulkof thebenefits that flow from competition,whilstalsodelivering solutions to
pressingenvironmentalchallenges.
This chapter seeks to introduce the roleof competitivemarkets inelectricitygeneration. First,
severaluniquefeaturesofelectricityareidentifiedthatarerelevanttotheroleofcompetitionin
power markets. Second, two approaches of electricity provision are presented, one based on
monopolyprovisionandtheotheroncompetition.Somebenefitsandshortcomingsofthesetwo
approachesareoutlined.Lastly,threeareasarepresentedwhereregulatorsintervenetoaddressproblemsofmarket failure,whilemaintaining thebenefitsofcompetitiveactivity in thepower
sector. These areas are supply reliability, reductions in carbon emissions and technology
spillovers.Thesectionconcludeswithabriefdiscussionofthecapacityofelectricitymarketsto
deliverthelongtermdecarbonisationobjectives.
Electricity:aservicewithuniquecharacteristics
Electricity has a number of characteristics that affect the way competitive forces are used in
electricityproductionandsupply.Threeareoutlinedbelow.
Realtime
supply
Sinceelectricitycannotbestoredcosteffectivelyinbulkquantities,supplyanddemandmustbe
balanced inrealtime,usingcomplexsystemsofdispatchamongmultipleproviders.Supplyand
demand imbalances inone locationonanelectricalsupplynetworkhavethepotentialtoupset
thebalanceacross theentire interconnectednetwork.Assuch,asystemoperatormustensure
that demand is balanced across the network at all times so as to maintain frequency for all
networkusers.Aplatformisusedtoallowallthoseprovidingelectricitysuppliestocommunicate
in real time with the systemoperator. Ina competitiveelectricitymarket this centralplatform
mustalsobeamarket platform, toallow for thematchingof demandand supply, so that the
cheapestenergybidscanbeidentifiedanddispatchedtomeetdemand.
Networkswithmonopolycharacteristics
Electricityisdistributedthroughanetworkofgenerators,loadsandwires.Inagivengeographical
areaitiseconomicaltobuildonlyonenetwork,andasinglenetworkismostcheaplyprovidedby
a single supplier. When one supplier is best placed to provide a service, this is a service with
natural monopoly characteristics, meaning competition between multiple providers cannot
operate to reducecostsof supply.Asa result,networks servicesareprovidedcommerciallyby
singlepartiesand the revenues from these servicesmustbe regulated, toensure theprovider
doesnotabuse theirmonopolyposition. Ineconomieswith competitivemarkets forelectricity
1TheprincipalauthorofthissectionisSteveMacmillan.
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supply,networkactivitiesaresplitfromcompetitiveactivitiesinthegenerationandmarketingof
electricity.
Alackofdemandresponse
Consumershavetraditionallyhad limitedopportunitiestorespondtoshorttermchanges inthecostofpowersupply,astheirratesdonotreacttoshorttermchanges inoveralldemand.This
means that the retail price and end customer pays for electricity does not increase when the
wholesale price for electricity is highest, even though the cost of that electricity may change
substantially.Thedifferences in thecostofsupplyaregenerallyaveragedandspreadacrossall
users, so price signals do not communicate information about the scarcity of electricity at
particulartimes.Asaresult,customersareunabletorationsupplyinresponsetothevaluethey
placeonitandwillcontinuetodemandelectricityevenwhenitsunderlyingcostisatpeaklevels.
Technological developments are addressing this lack of demand response, by measuring when
customersusetheirelectricityandusingthis informationtodevelopmorecostreflectivetariffs.
However, in themedium term the lackofdemand response inelectricitymarketscontinues to
haveimportantimplicationsforpoliciesdesignedtoinfluenceconsumerbehaviour.
Twoapproachesforprovidingelectricity
Two approaches exist for providing electricity in modern economies. The first is an integrated
monopolyproviderandthesecondisacompetitivemarket.Inpractice,amultitudeofvariations
existthatintegrateelementsofbothapproaches.
Invirtuallyallenergymarketsworldwide,provisionviaamonopolywas theprimarymodel for
industrialorganisation.Underthisscheme,asingleagencyorcompany istaskedwithmanaging
the entire energy supply chain for customers in a defined area. Typically, these utilities were
governmentownedandfullyverticallyintegrated,meaningtheyownedalltheassetsrequiredtogenerate,distributeandretailelectricity.
Ina competitivemarket approach, competition is introduced to segmentsofelectricity supply.
While approaches differ widely, competition is most frequently introduced in generation and
marketing (alsoknownas retail).Competition indistribution is limited for the reasonsoutlined
above.
Verticallyintegratedregulatedmonopolies
Underamodelofmonopolyprovisiontheverticallyintegratedutilityenjoysanexclusivemandate
over the demand of customers in a given area, meaning it does not have to compete for
customersbasedonpriceorthequalityof itsservice.Assuch,governmentagenciesaretaskedwithensuringthatthequalitymeetscommunityexpectationsandpricesarekeptatacceptable
levels.
Wherea singleentityprovidesallelectricity forcustomers inadefinedarea,governmentsand
regulatorshavearoleindeterminingtheappropriatelevelofinvestmentinsupply.Ifinvestment
isinadequatetomeetdemandthencustomerswillexperienceelectricityshortageandrationing
ofelectricity.Conversely, if investment is inexcessof levelsrequiredtomeetdemandthenthe
costofelectricitymusteventually rise significantly to fund investments in infrastructure that is
rarelyused.Whenaregulatorapprovesaninvestmentunderamonopolymodel,theutilitypasses
on the cost of this investment to all its customers. Since no customer will willingly forego
electricityaltogether,theregulatorsdecisioneffectivelyensuresthatendcustomerswillfundany
investmentthathasbeenapproved.
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Publiclyownedutilitiesaresometimesalsotaskedwithmeetingabroaderrangeofpublicpolicy
goalsthanmerelytheefficientandeffectiveprovisionofelectricity.Thesecouldincludekeeping
the price of retail energy at lower levels that do not reflect cost (for example, through cross
subsidies),maintainingemployment,orpreferringacertaingeneratingfuel.
Benefits
The benefits of monopoly provision are generally considered to be simplicity and certainty. A
single integratedutilitydoesnot requirecomplexsystemstodispatchmultipleprovidersat the
wholesale level, or retail market platforms that allow for switching of customers between
different retail providers, or an elaborate access regime to ensure multiple parties can access
monopolynetworkinfrastructureonequalterms.
A single provider can theoretically integrate all the information it has on customer usage into
nuancedviewofdevelopmentsindemand.Wherefreshinvestmentisrequiredtomeetdemand,
agovernmentcandirectautilityto investatagiventimeandthisensuresthatcapacitywillbe
adequatetomeetreliabilitystandards.
Moreover,regulatedmonopolieshavealsobeenabletodeliver investments incapital intensive
and innovative technologies.For instance, this renderedpossible the largescaledeploymentof
nuclearfleetsinFrancefromthe1970sto1980s,contributingtocontrollingcostsandmitigating
risks.
Drawbacks
Thedrawbacksofthemonopolymodelarethattheutilityarguablyhasweakincentivestoreduce
costs, to improve its service offerings, innovate in new services or invest in new generation
technologies.Oncea regulatorhasapprovedagiven levelof investment, theutility isvirtually
guaranteed to collect the approved revenues, regardless of how it performs. In practice,
regulators of monopoly providers frequently seek to introduce incentives similar to thoseassociatedwithcompetitivemarkets,topromoteefficientoutcomesthatmeetacceptablelevels
ofservice.
Afurtherdrawbackisthatlikeanyobservertheregulatorwillfacelimitationsinitsunderstanding
ofthedynamicsofsupplyanddemand.Even iftheregulatormakesforecastsbasedonthebest
informationathand,thesedecisionswillsometimesleadtoconditionsofunderoroversupply.In
theseconditionstheriskassociatedwiththeseforecastingerrorsarecarriedentirelybytheend
customer,whohasnochoicebuttofundallapprovedinvestments.
In addition to limitations in knowledge, the regulator can also generally intervene reasonably
easily in key decisionsof the utility,which makes iteasier to pursue other public policy goals.
Regulators are also susceptible to influence or pressure from groups that stand to benefit orsuffer losesbasedontheirdecisions,evenwhentheoreticallyregulatorsare independent.Also,
when regulating monopolies, regulators frequently know less about features of demand and
supplythanthecompaniestheyregulate,whichcreatesfurtheropportunitiesfortheirdecisions
tobeinfluencedtobenefitonesectionofsocietyinsteadofconsumersasawhole.
Lastly,inamarketwhereoneentityisdirectedtodeliveraservice,incentivesforinnovationare
generallyconsideredtobeweak,unlessgovernmentsareparticularlyandeffectively involved in
supportingcomplementaryresearchanddevelopmentactivities.
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Competitivemodel
Introducingcompetitioningenerationandmarketingmeansallowingmultiplepartiestocompete
to provideelectricity to customers in a given area. A wholesale market platform, organised or
overthecounter, isestablishedwherebygeneratorscanoffertheirsupplyatagivenprice.The
cheapestpower isprocuredfirstandthisallowsforapricetobesetreflectingtheconditionsofsupplyanddemandatthattime.Theelectricitymarketpricesallowinvestorsinsupplytoassess
theprofitabilityofinvestingininfrastructurerequiredtosupplycustomerswithpower.Although
manymayinvest,noneisguaranteedthatitwillbecalledupontogenerate.
Whena party decides to invest in generation infrastructure, it makesprojections about future
demandsimilartothoseoftheregulatorinthemonopolymodel.However,theinvestorisunable
topassalltheriskofinappropriateprojectionsontothecustomerinthesameway.
In addition to parties that own infrastructure, there are other parties that enter the market
merely as marketers of electricity. This involves procuring electricity on wholesale markets,
bundlingunderlyingelectricitywithnetwork services,andbillingend customers. (Someparties
bothgenerate
and
market
electricity.)
Marketers
seek
to
acquire
more
customers
based
on
lower
pricesandsuperiorlevelsofservice.
Becausesupplyanddemandmustbeconstantlymatchedinrealtimeandcustomershaveforthe
timebeingvery littleopportunity to ration theirusewhenwholesalepricesarehigh,priceson
wholesale markets can increase rapidly when supply is short. In response to this volatility in
prices,acomplexarrayof financial instrumentshasdeveloped incompetitivemarkets toallow
marketerstoreducetheirexposuretovolatilemovementsinwholesaleprices.
Benefits
The benefits of a competitive market are generally considered to be that it addresses the
shortcomingsof
the
monopoly
model
in
terms
of
poor
efficiency,
lack
of
innovation
and
too
high
prices.
Whereprovidersmustcompetetoprovidegenerationandmarketingservicestheycarrytherisk
that their investmentswillbe illconceivedorthattheywill run theirassets inefficiently. Inthis
instance, they have strong incentives to make investments that anticipate the future needs of
consumers,aswellastominimisecosts,asthisapproachoffersthebestchanceofacommercial
return.Inthiscontext,customerchoicecanhelptorevealtheleastcostalternative,aswellasto
deliveranevolutioninproductsandservices.
As a result of competition between multiple providers, customers generally see a more
responsive service as well as a less costly means of supply. It is important to note in these
circumstances
that
introducing
competition
does
not
automatically
mean
that
prices
for
electricitywill fall, forarangeof reasons.Butwemustconsider thebaseline forenergyprices,
whichmaybe increasing, forexamplebecausethecostof inputs(suchasfuel) is increasing. In
thisinstance,pricesforelectricityarelikelytogrowregardlessofthesupplymodeladopted,and
mayriselessunderacompetitivemodelthantheywouldhaveunderaregulatedmodel.
Challenges
Thechallengesassociatedwithdesigningcompetitivewholesaleelectricitymarketsaregenerally
associatedwithsome typeof market failure,oran instancewherecompetitivemarkets failto
provide efficiently for the supply of a good or service, or are unable to fully value the cost of
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goodsandservices.Marketfailuresarefrequentlydefined intermsofpublicgoods2ornegative
externalities3andnaturalmonopolies.
Amongthevarioustypesofmarketfailurethatexistinrelationtocompetitiveelectricitymarkets,
some are long established, while others relate to more recent environmental challenges. In
addition
to
market
failure
arising
in
relation
to
electricity
networks,
which
are
assets
with
monopolycharacteristics,marketfailuresassociatedwithpowergeneration includeairpollution
and carbon emissions flowing from, and technological innovation where the market does not
adequately promote the development and diffusion of energy technologies such as renewable
energy.
Approaches to internalising the cost of pollution long predate concerns about anthropogenic
climatechange.Theseapproachesgenerally involvevarious formsof tax that look to introduce
thecostofenvironmentaldamagetothecostofgoodsandservices(Pigou,1952).Estimatingthe
costofanegativeexternalityand intervening inmarketframeworkscanbedone inavarietyof
ways.
Reliability,carbonemissionsandtechnologyspillovers
Reliability
Inthecategoryofmarketfailureswhichhave longbeencommontocompetitivepowermarkets
the question of reliability4 is a pertinent example. The system frequency is common for all
networkusersoverasynchronousarea(50Hertzor60Hertz)andactionstakenbyoneusercan
affectthefrequencyandthereforethequalityofpowersupplyforalltheothers.Becauseenergy
cannotbestoredmassivelyatlowcost,thegeneratorusedtoprovidesupplyinraremomentsof
peakdemandwillonlyrarelyoperate.Customersvaluereliabilitydifferentlydependingontheir
circumstances.Butunlikewithmarketsfortraditionalgoods,thereare limitedmeanstocharge
accordingtoeachcustomerswillingnesstopayforreliability(orwillingnesstorationtheiruseof
powerattimesofpeakdemand).Consequently,allpartiesbenefitsomewhatfromasystemwith
adequatesupply,butitisdifficulttodeterminethevaluethatthecommunityasawholeputson
uninterruptedelectricalsupply.
In principle, a price level should exist above which a limited outage becomes an acceptable
alternative to theaverageuser.However,thisprice level is likely tovaryasa functionofmany
variables, such as the duration and timing of interruption, whether customers are generally
prepared for interruptions, whether customers are notified inadvance notice, and the type of
customer.
2Apurepublicgoodcanbedefinedasgoodsandserviceswhichoncemadeavailabletoonepartyarethenavailable
toallparties.Oneexampleistheatmosphere,whichisusedbyallbuttraditionallywasmaintainedbynone.Problems
ariseinrelationtopublicgoodsbecauseitisdifficulttoexcludepartiesfromthebenefitsofthegoodorservice,andso
itcanbedifficulttoapportionthecostsofprovidingthegoodorservicetoallpartiesthatbenefit.
3Anegativeexternalityariseswhentheactionsofanindividualnegativelyaffecttheutilityofanotherindividual,but
thefullcostofthisisnotcapturedinthecostsofthefirstindividual.AnexampleisacoalpowerstationthatemitsCO2
intotheatmosphere,whilethenegativecostofthispollutionontheatmosphereisnotfactoredintothecostsofthe
powerstation.Theproblemofcarbonemissionsrepresentsaclassicproblemofnegativeexternality.
4Reliabilityherereferstoreliabilityofsupplyratherthannetworkreliability.Networkreliabilitytypicallyalsopresents
challengesassociatedwithpublicgoods,sinceallpartiesusingthenetworkrelyonnetworkstabilitybuthaveastrongprivateincentivetominimisetheircontributiontomaintainingit.
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Box1Thecostofensuringsecurityofsupply
Anumberofdifferent indicatorsareusedbygovernmentsorregulatorstodefineanacceptable
levelof reliability inenergymarkets (Table1).These includemeasures that targetanumberof
hoursinayearwheredemandwillnotbefullymet,andathresholdvolumeofunservedenergy
thatshould
not
be
breached.
These
mechanisms
all
relate
in
some
way
to
the
cost
of
marginal
supply,andindirectlytothevaluethatcustomersplaceonreliability.Inthisway,considerations
aboutthevalueoflostloadareinherentinfeaturesofmarketdesignsuchasmarketpricecaps.
Table1Examplesofreliabilitythresholdsinwholesaleelectricitymarkets6
Mechanism Market Implications for wholesale prices
Time-based
No more than 30 hours ofexpected curtailment durationover 10 years
FranceImplies that a marginal generator with fixed costs of USD 60/kW needsto earn USD 20 000/MWh for three hours on average in order to remainprofitable.
Time based
1 day in ten years whencapacity is insufficient
PJM
(Northeast USA)
Translate to approximately 15 to 20 percent planning reserve marginsabove expected peak demand. PJM relies on a capacity market toensure adequate capacity targets are met.
Volume based
No more than 0.002% ofenergy unserved per year
Australia(eastern)
Price cap of AUD 12 900/MWh is designed not based on estimate ofvalue customer ascribes to reliability, but to provide for generation thatmeets threshold of 0.002%.
Time and volume based
8 hours in a year or34.5 energy units per millionunserved
IrelandValue of lost load calculated at EUR 10 520, based on average cost ofa best new entrant peaking plant running for 8 hours in a year only.
Note:Unlessotherwisecited,allmaterialforfiguresandtablesderivesfromIEAdataandanalysis.
Despitethecomplexityinherentininterveninginthepowermarkettoestimateanappropriatelevelof
reliability,itshouldnotbeconcludedthatthisisnotfeasible.Anumberofwholesalepowermarkets
havesetpricecapsathigh levels,andthesemarketshaveconsistentlydeliveredadequate(butnot
excessive) spare capacity, in the absence of other market interventions. Examples include the
Australian National Electricity Market (NEM) and the Texas electricity market (run by the Electric
ReliabilityCouncilofTexas,ERCOT);foranoutlineoftheAustraliansituation,seeBox2.
5Itisdurationd*suchas60000+d*100=20000d*whichyieldsd*=3.015hours.
6ForFrance,seeDcret20061170du20septembre2006relatifauxbilansprvisionnelspluriannuelsd'quilibreentrel'offreet lademanded'lectricit; forPJM,seeFERCorder747 (www.ferc.gov/whatsnew/commmeet/2011/031711/E7.pdf)andNorthAmericanElectricReliabilityCorporationReliabilityFirstCorporationStandardBAL502RFC02;forNewZealand,Single
Electricity Market Committee Policy parameters 2012 Decision paper, SEM11073; for Australia: standard set by AEMC
ReliabilityPanel.
Foragivenconstructioncost, it ispossibletocalculate theassociatedreliabilitycriteria in termsof
expected lost load duration, a metric that governments often use in order to set the reliability
criteria. To take a simplified numerical example, the annual cost of a peak power plant is
60000USD/MW/yr,withavariablecostof100USD/MWh.BuildingoneMWofcapacitytooperateit
onlyonehourwouldcost60100USD/MWh,whichishigherthanthevalueoflostload(20000inthis
example).ThereforeitislesscostlynottoservethisMWhandrelyonloadcurtailment.For2hours,
thecostwouldbe (60000+2*100)/2=30100USD/MWh,which isagain toocostly.Withavalueof
lost load equals to 20000 USD/MWh, the optimal expected curtailment duration would be
c.3hours.5
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Whileregulatorscantheoreticallyallowpricesforwholesaleenergytobebidupwithoutlimit,yet
inpracticetheyrarelydoso.Thisisbecausecustomersarepoorlyplacedtoresponddynamically
tochangesinprices,soitisunclearwhetherextremepricespaidinpeakperiodsgenuinelyreflect
thevaluecustomersplaceon reliability.A furthercomplication is thatwhensupply is tightand
ownership in peak generation is limited to small number of parties, these parties can enjoy
marketpower
whereby
they
can
increase
the
price
beyond
competitive
levels.
As
aresult,
system
operators attempt to estimate the value of reliable supply to the community as a whole and
frequently intervene to reduce consumption when pricesexceed that level. The implications of
suchinterventionsarediscussedinmoredetailinChapter4.
Box2IncentivesforinvestmentinsparecapacityinAustraliaTheAustralianNationalElectricityMarket(NEM) isawholesalemarketthroughwhichgeneratorssell
electricity in eastern and southern Australia. The main customers are energy retailers, which bundle
electricity with regulated network services for sale to residential, commercial and industrial energy
users.
Electricityproduced
by
large
electricity
generators
in
the
NEM
jurisdictions
is
sold
through
acentral
dispatchprocessthattheAustralianEnergyMarketOperator(AEMO)manages.TheAustralianNEMis
an energy only design. This means that all capacity in the market is remunerated through market
clearingprices.Nootherpaymentsaremadeinthespotmarketexceptthosearisingfromspecifically
designed reliability safety nets and specific purpose ancillary services. (Financial hedges also occur
outsidethemarketbetweenmarketparticipants.)
The dispatch price for a 5minute interval is the offer price of the highest (marginal) priced energy
sourcethatmustbedispatchedtomeetdemand.Awholesalespotprice isthendeterminedforeach
halfhour(tradinginterval)fromtheaverageofthe5minutedispatchprices.Thepoolpriceistheprice
thatallgeneratorsreceivefortheirsupplyduringthehalfhour,andthepricethatwholesalecustomers
pay for the electricity they use in that period. Spot prices may not exceed a cap ofAUD12900 per
MWh.
Figure1belowshowsapricedurationcurveforoneoftheAustralianzones.Ascanbeseen,veryhigh
pricesarerare,withpricessittingwithintherangeofAUD040foraround90%ofthetime.
AsshowninFigure2,theNEMhasconsistently deliveredcapacityadditionsaheadofdemand.
1
10
100
1000
10000
100000
0 20 40 60 80 100
Po
olprice($/MWh)
Portionofyear
2005
2006
2007
2008
2009
2010
Figure1SouthAustralianpricedurationcurve,variousyears(logarithmicscale)
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The Australian example illustrates adequate capacity in a robust competitive energyonly market.
However,viewsdifferontheadequacyofhighbutcappedwholesalespricesasasufficientincentiveto
investinmarginalsupply.
Reducingcarbonemissionsinacompetitiveframework
Incontrasttotraditionalquestionsaboutmarketfailureinrelationtoenergymarkets,thethreat
of anthropogenic climate change has created a new set of externalities. Reducing carbon
emissionsassociatedwithpowergenerationisacentralchallengeintheprojecttoreduceoverall
emissions from human activity. This is the case not only because stationary energy currently
accounts for 40% of global energyrelated CO2 emissions, but also because reducing emissions
fromsourcessuchasthetransportsectorwill involvefurtherelectrificationsincemanyofthe
mostpromisinglowcarbonenergytechnologiesarethosethatproduceelectricity(windandsolar
beingtwoexamples).
Different
analysis
sought
to
estimate
the
value
for
carbon
that
would
deliver
the
required
reduction in emissions According to the IEA Energy Technology Perspectives scenarios (IEA,
2012a), marginal abatement costs represent the cost of the last tone of CO2 eliminated via
abatement measures. They are often used as a reference for what carbon price is needed to
triggerthisabatement.IntheTwoDegreesscenarioprovidedbytheIEAsETP,thecarbonprice
shouldincreasefrom3050USD/tCO2(inreal2010USD)by2020to80100by2030and130160
by2050.
0
10000
20000
30000
40000
50000
Megawatts
Marketcapacity Marketpeakdemand Marketforecastdemand
Figure2Australianelectricitymarketpeakdemandandgenerationcapacity,1998/992010/11
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Table2Globalmarginalabatementcostsandexamplemarginalabatementoptionsinthe2degree
scenario
2020 2030 2040 2050
Marginal cost(USD/tCO2)
30-50 80-100 110-130 130-160
Energyconversion
Onshore wind
Rooftop PV
Coal with CCS
Utility scale PV
Offshore wind
Solar CSP
Natural gas w CCS
Enhanced geothermalsystems
Same as for 2030, butscaled up deploymentin broader markets
Biomass with CCS
Ocean energy
Industry
Application of BAT in allsectors
Top-gas recycling blastfurnace
Improve catalytic processperformance
CCS in ammonia and HVC
Bio-based chemicals andplastics
Black liquor gasification
Novel membraneseparationtechnologies
Inert anodes andcarbothermicreduction
CCS in cement
Hydrogen smeltingand molten oxideelectrolysis in ironand steel
New cement types
CCS in aluminium
Transport
Diesel ICE
HEV
PHEV
HEV
PHEV
BEV
Advanced biofuels
Same as for 2030, butwider deployment andto all modes
FCEV
New aircraft concepts
Buildings
Solar thermal space andwater heating
Improved building shells
Stability of organic LED
System integration andoptimisation withgeothermal heat-pumps
Solar thermal spacecooling
Novel buildingsmaterials;development of"smart buildings"
Fuel cells co-generation
Source:IEA,EnergyTechnologyPerspectives,2012.
Inthecaseofcarbonemissions,afurthercomplicationarises, inthatno lowcostalternativeor
setofalternativescurrentlyexisttoreplacefossilfuelsentirely.Asaresult,markets(andmarketinterventionssuchaspermitsystems)mustdelivertechnologicalsolutionsaswellasallowingfor
theleastcostadoptionofthese.Furthermore,thismeansthatmandatingadramaticreductionof
emissionsintheshorttermcanimplyveryhigh(andinsomecasesnotwellknown)costs.
Estimatingthecostofanegativeexternalityandinterveninginmarketframeworkstocorrectfor
marketfailurecanbedoneinavarietyofways.
Tradingsystems incarbonpermitshavebeenestablished innumberofeconomies intheworld,
notablyintheEuropeanUnion,andrecentlyinAustralia.Permittradingsystemsaredesignedto
bringthecostofcarbonemissionsintothecostofproducinggoodsandservices,andtherebyto
improve efficiency in the economy by reducing investment in more carbon intensiveactivities.
Trading
systems
are
likely
to
be
most
efficient
when
there
is
significant
variation
in
costs
of
reducingpollutionamongdifferentpartiesandsectors,sothattradingofsurpluspermitscantake
placeandtheleastcostsolutionscanbeadopted.
Awidevarietyofanalyseshavebeencarriedouttoassessthecostsoflimitingcarbonemissions
through permit systems. The European Emissions Trading System demonstrates some of the
complexityinvolvedinestimatingthecorrectnumberofpermitsthatshouldbemadeavailablein
ordertocreatesufficientscarcitysuchthatpermitpriceswillbehighenough.
Promotingtheinceptionoflowcarbontechnologies
Since the Industrial Revolution competitive markets have played a crucial role in delivering
technological
outcomes,
comparable
to
that
of
the
contribution
from
pure
scientific
research.
Where a technological solution to a pressing environmental concern is not yet available, or is
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availableonlyathighcost,governments lookto intervene inmarketstopromotethisoutcome.
The objective is not only to incentivise economic actors to address the problem to the extent
possible,givenexistingtechnologies,butalsotopromotefurthertechnologicaldevelopment.
Economic theory suggests that significant cost reductions can accrue when commercial parties
applytechnologies
that
are
still
in
their
inception
phase.
These
effects
are
sometimes
referred
to
aslearningbydoing,andspillovereffects.7Considerableevidencesuggeststhatsuchbenefits
genuinely occur (IEA, 2003). The extent of this externality relates primarily to the appropriate
level of public subsidy that should be directed towards a technology, since public funds are
justifiedtotheextentthatsocietyasawholewillbenefit.
In the caseof climate change,mechanismsused topromote technologicaldevelopment in the
market include subsidies and quotas for renewable energy both mechanisms that direct
expendituretowardsemergingtechnologies.Theobjectiveoftheseprogrammesisnotsimplyto
foster theadoptionof the technologies inquestion,butalso topromotedevelopment thatwill
lowertheircost,asotherscopythetechnologicaladvancesachieved.Anexamplecanbedrawn
from the cost of solar PV systems in Germany, which has fallen considerably. In response,
subsidiesforsolarPVinGermanyhavebeenconsistentlyreduced(Figure3).
Figure3SolarPVsystemcostandfeedintariff,mediumscalesystems(upto100kW),Germany
200612
EUR/MWh EUR/kW
Setting subsidies to support technological development presents challenges, particularly in
estimating theappropriatevalue foragiven technology inagivencontext. If subsidiesare too
generous,
investment
will
exceed
optimal
levels.
Eventually,
the
benefits
from
subsidising
the
productionofaparticular technologywillpresentdeclining returns to scale,as the technology
maturesandproductionisadoptedmorebroadly.
Canelectricitymarketsdeliverthecarbonemissiontargetsby2050?
Ifthe levelsofreductions inemissionstargeted inanumberof IEAmembercountriesaretobe
realisedthis impliessignificantgrowth in lowcarbonenergygenerationsuchasCCS,renewable
energyandnuclear.Electricitymarketshavebeen introduced insystemswith largeconsolidated
sources of energy such as gas, coal and nuclear, with relatively high marginal costs and few
7Spilloverscanbeconsideredamarket failuredrivenbyapositiveexternality:thepartythatcarriesoutthe initial
researchdoesnotcapturethebenefitsoftechnologicaldiffusion,yetsocietyasawholestandstobenefitifspillovers
occur.SeeIEA(2008b)andIEA(2011a)foradiscussion.
0
1000
2000
3000
4000
5000
6000
100
200
300
400
500
600
Apr
Jun
Aug
Oct
Dec
Feb
Apr
Jun
Aug
Oct
Dec
Feb
Apr
Jun
Aug
Oct
Dec
Feb
Apr
Jun
Aug
Oct
Dec
Feb
Apr
Jun
Aug
Oct
Dec
Feb
Apr
Jun
Aug
Oct
Dec
Feb
2007 2008 2009 2010 2011 2012
FIT[ /MWh ] S ystemcost[EUR/kW]
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networkconstraints.Asaresult,theambitioustargetsby2050forlowcarbonenergyingeneral,
and renewable energy on a large scale, have considerable implications for competitive energy
markets.
Whenvariable renewableenergymakeup less than fivepercentofoutput, it is treatedwithin
existingmarket
frameworks.
When
penetration
of
renewable
resources
moves
to
between
20
and
40% of output, these electricity market frameworks need to be modified to allow a greater
coherence in theoperationofconventionaland renewableenergy sources.Theoptimalmixof
conventionalgenerationtosupportincreasedvariablerenewablegenerationandensuresecurity
of electricity supply will be different from the most economic mix prior to the introduction of
largeamountsofvariableenergyresources.
Inthe long term,marketdesignshouldnotonlyensureadequate investmentbut itshouldalso
incentivise investments in lowcarbongeneration.As renewableenergy targetsaresethigher
and even as direct economic support for these sources is reduced many questions arise
concerning the functioning of electricity markets: what would be the level of lowcarbon,
including renewablegeneration,nuclearandCCS,withanelectricitymarketwithahighcarbon
price? Would thisbe enough to deliver the almost complete decarbonisation of the electricitysectorby2050?Ifnot,howtodesignelectricitymarkets?
Further work is required to fully understand how to design wholesale electricity markets and
carbon dioxide regulations capable to deliver the policy targets in terms of carbon dioxide
emissionreduction.
Thefollowingchaptersexaminethesuiteofmethodsandapproachesavailabletopolicymakers
to intervene incompetitivepowermarketsduringthenext10to20yearsofthetransitiontoa
lowcarbonelectricitysector,wherethepenetrationofvariablerenewablesmovesto,say,above
20to40%ofoutput.
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2.Policycontext:transitiontowardsalowcarbon
electricitygeneration
Ifgovernments
want
to
achieve
the
global
goal
of
limiting
temperature
rise
to
2C,
they
will
have
to introduce policies that will have the effect to reduce power demand, increase energy
efficiency, promote investments in renewable technologies, nuclear and carbon capture and
storage.ComparedtotheWorldEnergyOutlooks(IEA,2011c)NewPoliciesScenario,which isacentral case, reaching the 2degree scenario would require reducing energyrelated carbon
emissionsby15GtCO2perannumin2035,outofwhich,twothirdswouldbefromelectricity,or
10GtCO2/year.Outofthistotal,lowerelectricitydemandwouldcontributetoareductionof3Gt,
renewableenergy,3Gt,andnuclearandCCSabout2Gteach(Figure4).
Tomakethishappen,OECDcountrieswillhavetoleadthewayandtheirrelativecontributionto
the decarbonisation effort will need to be even greater. The 2degree objective will require
decarbonising the power sector almost entirely by 2050. Obviously, the current shortterm
macroeconomic issues do not help and longterm climate policies tend to shift away fromgovernments agendas. This uncertain commitment to climate policies is a major deterrent to
investment.
What instrumentsareused todeliver lowcarbonelectricityandwhat is their influenceon the
functioningofelectricitymarkets?
Thepreviouschapterdescribedthehighlevelobjectivesofwhatwecancallthetargetelectricity
market arrangement, where a proper carbon price is the cornerstone of climate policy.
Notwithstanding,currentclimatepoliciesarefrommanyaspectsatrialanderrorprocessand in
practice,governmentsuseabroadrangeofpoliciestocomplementacarbonprice(IEA,2011b).
This section reviews the existing or foreseen regulatory instruments which contribute to
promotinglow
carbon
electricity
and
discusses
their
merits
and
impacts
from
the
perspective
of
electricitymarketsandinvestmentdecisions.
Figure4ReductioninworldenergyrelatedCO2emissionsinthe450ScenariocomparedwiththeNew
PoliciesScenarioandscopeofdifferentregulatoryinstruments(GtCO2)
Source:IEA(2011c).
CCS(2Gt)
Nuclear(2Gt)
Renewables(3Gt)
Energyefficiency(3Gt)
Othersectors(5Gt)
Economywide
carbonprice
Powersector
emissionstargets
Electricitycarbon
intensitytargets
Technologyspecific
targets
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