Electricity markets are being developed as a result of the deregulation of electricity utilities around the world. The process began in 1990 when the UK Government under Margaret Thatcher privatisedd the UK Electricity Supply Industry in England and Wales. The process followed by the British has been followed in other countries. The institutions and market designs may differ but the underlying concepts are the same. These are: separate the contestable functions of generation and retail from the natural monopoly functions of transmission and distribution; and establish a wholesale electricity market for electricity generation and a retail electricity market for electricity retailing.

Table of contents
1 Wholesale electricity market
2 Retail Electricity Market
3 Electricity market experience
4 See also
5 Further reading

Wholesale electricity market

A wholesale electricity market exists when competing generators offer their electricity output to retailers.

Electricity is by its nature difficult to store and has to be available on demand. Consequently, unlike for other products, it is not possible, under normal operating conditions, to keep it in stock, ration it or have customers queue for it. Demand and supply vary continuously. There is therefore a physical requirement for a controlling agency, the system operator, to coordinate the dispatch of generating units to meet the expected demand of the system across the transmission grid. If there is a mismatch between supply and demand the generators speed up or slow down causing the system frequency (either 50 or 60 Hertz) to increase or decrease. If the frequency falls outside a predetermined range the system operator will act to remove either generation or load.

In addition, the laws of physics determine how electricity flows through an electricity network. Hence the extent of electricity lost in transmission and the level of congestion on any particular branch of the network will influence the economic dispatch of the generation units.

For an economically efficient electricity wholesale market to flourish it is essential that a number of criteria are met. Professor William Hogan of Harvard University has identified these. Central to his criteria is a coordinated spot market that has "bid-based, security-constrained, economic dispatch with nodal prices". Other academics such as Professors Pablo Spiller and Shmuel Orem of the University of California, Berkeley have developed other criteria. Professor Hogan's model has largely been adopted in New Zealand and supported by the US Federal Energy Regulatory Commission in its proposed Standard Market Design.

Bid-based, security-constrained, economic dispatch with nodal prices

The price of electricity at each node on the network is an aggregation of the marginal electricity generator's offer price and the marginal cost of losses and congestion on the network. This is known as "locational marginal pricing" (LMP) or "nodal pricing". Where congestion exists on a transmission network, there is a need for load to be shed or more expensive generation to be dispatched on the downstream side of the constraint. Prices on either side of the constraint separate giving rise to congestion pricing and constraint rentals.

A constraint can be caused when a particular branch of a network reaches its thermal limit or when a potential overload will occur due to a contingent event on another part of the network. The latter is referred to as a security constraint. In essence, transmission systems are operated to allow for continuity of supply even if a contingent event, like the loss of a line, generator or transformer, were to occur. This is known as a security constrained system.

The marginal generator is determined by matching offers from generators to bids from retailers at each node to develop a classic supply and demand equilibrium price. This process is carried out for each 5-minute, half-hour or hour (depending on the market) interval at each input and exit node on the transmission grid. The prices take into account the losses and constraints in the system and generators are dispatched by the system operator, not only in ascending order of offers (or descending order of bids), but in accordance with the required security of the system. This results in a spot market with "bid-based, security-constrained, economic dispatch with nodal prices".

Risk management

A consequence of the complexity of a wholesale electricity market is the price volatility at times of peak demand and supply shortages. This is manifest by price "spikes" which are hard to predict and price "steps" when the underlying fuel or plant position changes for long periods .

Electricity retailers, who buy from the wholesale market, and generators who sell to the wholesale market, are exposed the these price effects and to protect themselves from volatility, they will enter into "hedge contracts" with each other. These contracts are generally contracts for differences where the parties agree a strike price for defined time periods. If the actual wholesale price in any time period is higher than the "strike" price, the generator will refund the difference berween the "strike" price and the actual price for that period. Similarly a retailer will refund the difference to the generator when the actual price is less than the "strike price". The actual price is sometimes referred to as the "spot" or "pool" price, depending on the market.

Other hedging arrangements, such as Financial Transmission Rights, call options and put options are traded in sophisticated electricity markets.

Retail Electricity Market

A retail electricity market exists when end-use customers can chose their supplier from competing electricity retailers.

Generally, electricity retail reform follows from electricity wholesale reform. However, it is possible to have a single electricity generation company and still have retail competition. If a wholesale price can be established at a node on the transmission grid and the electricity quantities at that node can be reconciled, competition for retail customers within the distribution system beyond the node is possible.

Although market structures vary, there are some common functions that an electricity retailer has to be able to perform, or enter into a contract for, in order to compete effectively. Failure or incompetence in the execution of one or more of the following has led to some dramatic financial disasters:

Meter Reading
Meter Rental
Credit control
Customer management via an efficient call centre
Distribution Use of System Contract
Reconciliation Agreement
"Pool" or "Spot Market" Purchase Agreement
Hedge Contracts - contracts for differences to manage "spot price" risk

The two main areas of weakness have been risk management and billing. In the USA in 2001, California's flawed regulation of retail competition led to the California electricity crisis and left incumbent retailers subject to high spot prices but without the ability to hedge against these (see Manifesto on The Californian Electricity Crisis). In the UK a retailer, Independent Energy, with a large customer base went bust when it could not collect the money due from customers.

Electricity market experience

In the main, experience in the introduction of retail competition has been mixed. The UK, Australia and New Zealand have achieved some success. Among the countries in the world that have developed successful wholesale electricity markets are:
Australia - see NEMMCO the Australian Market Administrator
New Zealand - see New Zealand Electricity Market
Denmark, Finland, Sweden and Norway - see Nordpool, the Nordic Power Exhange
England and Wales see the Balancing and Settlement arrangements at Elexon
USA - see PJM Marketand New York Market

See also

Further reading