securing power during the transition

8/12/2019 Securing Power During the Transition

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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 [email protected].

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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OECD/IEA2012 SecuringPowerduringtheTransition

Page|1

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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SecuringPowerduringtheTransition OECD/IEA2012

Page|2

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


20/96


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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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Page|23

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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Page|24

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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Page|25

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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SecuringPowerduringtheTransition OE

securing power during the transition

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