Energy Explainer: Electricity Markets

Author: Dr Harry van der Weijde MEI, Chancellor's Fellow, School of Engineering, University of Edinburgh

Energy Explainer: Electricity Markets

1. In order to explain how the lights stay on, we first need to have a broad overview of how electrical networks work.

Electrical networks consist of three components: things that generate electricity, such as combustion engines, wind turbines or solar panels; things that consume electricity, such as lights, television sets or electric motors, and wires that transport electricity from generators to consumers. It is not generally possible to cheaply store large amounts of electricity, even for short periods of time. The energy generated in an electricity network therefore has to exactly match the electricity consumed, and it has to do so every fraction of a second. You can think about the electricity network as a moving car with an engine, connected to the wheels with a series of cogs. If, at any point in time, the engine produces more power than is necessary for the wheels to overcome the rolling resistance of the road and gravity, the car will start to speed up. If the engine produces too little energy, the car will start to slow down. Electricity networks work in a similar way. If more energy is used than is being produced, the system will slowly grind to halt. If more energy is being produced than is used, the system will start to speed up. Almost all electricity systems used in the world use something called alternating current, meaning that the electrical current flowing through wires alternates between a negative and positive value as many fifty or sixty times per second – we call this the frequency of the network. If the electricity system starts to speed up, this frequency will increase, combustion engines will speed up, as will electric motors, lights will burn brighter, and very soon, all of these things will stop working, because of overheating, failure of electronic components, or safety switches that have been put in to protect equipment. This will further increase the imbalance between electricity use and generation, sending the frequency to an even higher level. If the electricity system slows down, connected equipment will grind to a halt in much the same way. All of this can happen in a matter of seconds. It is therefore very important to make sure that electricity generation and consumption match all the time, even at very short intervals.

2. In the old days, when people first started using electricity, this was relatively simple.

Electricity was mostly used for lighting. Households would buy a number of electric lights from a supplier, who would come in, install the lights and the wires inside the house, connect the house up to its own electricity grid, and generate the electricity somewhere else in that grid using its own generators, probably fuelled by coal. These suppliers were vertically integrated – they owned and operated the entire system and sold directly to consumers. Electricity consumption, or load, in these networks was, of course, not entirely predictable, but the electricity supplier could monitor the system frequency and adjust its generation level as required. Equipment was also not too sensitive, and could withstand a bit of stress as a result of temporary imbalances between electricity supply and load. Each country would have a large number of these grids, each separate and owned by different electricity supplier. As electricity use grew, these smaller grids were joined up and consumers started to pay for electricity use, rather than the number of lights in their house, but suppliers mostly remained vertically integrated.

3. In the first half of the 20th century, things changed in some countries.

In a large part of Europe including the UK, governments decided that private firms could not be trusted to reliably provide electricity, which by this time had become absolutely essential for a wide range of uses. In these countries, the electricity sector was nationalised – the firms that provided electricity were now government-owned. This made it easier for governments to control what happened in the electricity system, which fuels were used and were they came from, which prices consumers and businesses were charged, and so on. However, government-owned firms are less driven to improve the system. This may have several reasons. Among others, government-owned firms generally do not themselves bear all consequences of their decisions; they may therefore, for instance, build too many power plants, since the government will pick up the tab even if these plants are not used. They may also spend too little money on developing innovative products, as they might not see the benefits of being able to do things in a cheaper way. In other parts of the world, including most of the US, nationalisation did not happen and things carried on as before, although governments did increasingly intervene to make sure electricity suppliers did not do things that were seen as undesirable, including charging high prices.

4. Nationalisation trends eventually reversed.

In most of the world, electricity is once again supplied by private firms. The firms that were previously owned by governments still exist – now privately owned – and continue to serve a large fraction of consumers. However, many countries have moved away from the vertically integrated suppliers that existed in the past, mostly as a result of new government regulation. The problem with vertically integrated electricity suppliers is that they can prevent rival generators from using their grids. It is very expensive to build new electricity grids alongside existing ones – so expensive that it is unlikely that firms will be able to do this profitably, given that they will probably only be able to steal part of the existing supplier’s customers away. Vertically integrated suppliers therefore enjoy a monopoly position: they can charge high prices because consumers have few alternatives.

5. Instead of a few firms with monopolies, governments therefore want a large number of firms that supply electricity.

At the same time, it would be extraordinarily wasteful to have a large number of parallel electricity grids. Modern electricity systems are therefore based on the idea that the physical grids should be owned by a separate organisation, which can sell the rights to use its network to a large number of electricity suppliers. There are various ways this can be organised, some of which we will look at below. This still leaves one problem. If there are many electricity suppliers, rather than just one, how can we make sure that electricity supply is equal to electricity use at any point in time? To do this, most countries have consumer electricity markets, wholesale markets and system operators. Vertically integrated suppliers survive in other parts of the world including most parts of southern US. They are usually heavily regulated by governments to make sure that they do not charge prices that are too high.

6. A market?

Markets can be physical places where buyers and sellers meet to exchange things. They can also be virtual places where buyers and sellers interact. With ‘electricity markets’ we generally mean the latter. There is no physical place you can go to buy electricity, like you would do if you wanted to buy bread or vegetables. Instead, firms that sell electricity and consumers that buy or are thinking about buying electricity communicate through ads, the internet, telephones and other means. All of these firms and consumers together form the ‘electricity market’. The costs of producing electricity depend on how much electricity is needed. Nuclear and renewable generators, though expensive to build, can generate electricity very cheaply once they are in place. If more electricity is needed, generators burning gas and coal, which burn fuel and therefore need more money per unit of electricity generated, can be switched on. If even more electricity is needed, we might need to turn on some old generators, which use even more fuel, or do other more expensive things. If markets function well, electricity will be bought and sold up to the point where cost of producing another unit is higher than buyers are willing to pay. The market price will be equal to the cost of the most expensive generator that is still needed. This makes intuitive sense – if the price was lower than the cost of the last unit generated, nobody would want to generate that last unit; if the price was higher, generators would be happy but consumers would not be willing to pay this price. This market price is called the equilibrium price – the amount of electricity sellers want to sell at this price is equal to the amount the buyers want to buy.

7. A consumer electricity market

In consumer electricity markets, electricity is sold to consumers and businesses. In most countries, consumers and businesses can buy electricity from a range of suppliers. These suppliers are often called ‘utilities’. Consumers and businesses usually agree to pay a price for electricity which is fixed or varies on a monthly or annual basis. In return, the utility agrees to supply however much electricity the consumer needs at each point in time.

8. A wholesale electricity market

Utilities, in turn, have to purchase the electricity they sold to consumers. They do this in wholesale electricity markets. In these markets, utilities and some large industrial firms buy power from firms that can generate electricity, the generators. Each country will have its own wholesale markets for electricity. Wholesale electricity markets are complicated because electricity cannot really be stored.  However, the amount of electricity used by consumers and businesses varies all the time, as people switch electric devices on and off. Modern wholesale electricity markets therefore consist of a large number of separate markets for each hour, half-hour or quarter of the day. One of these markets will be for electricity to be supplied between 7am and 7:30am next Saturday morning, another one for electricity to be supplied between 7:30 and 8am, and so on. Utilities have to predict how much electricity they will need to supply their customers at every point in time, and buy enough in each of these markets. Trading in these markets can begin a long time before the time that electricity is due to be delivered. Consumers do not generally participate in wholesale markets, because until recently is was hard to measure how much energy consumers used in real time, because it was presumed to be hard to organise a market with potentially millions of buyers and sellers, and because it was presumed that consumers did not have the knowledge and time decide how much energy to use, depending on prices, on short time intervals.

9. A system operator

Wholesale markets work pretty well, but in reality, electricity use varies every second of every day, not just every hour or even every quarter. Nevertheless, electricity generation has to exactly match electricity use all the time, even every fraction of a second – if this does not happen, blackouts are likely to occur. Moreover, utilities might get their predictions of energy use wrong, and consumers might need more or less electricity than their utilities have planned for. Electricity markets therefore have a system operator, which is responsible for making sure that blackouts do not happen. How does it do this? Sometime before electricity is due to be delivered (this might be an hour or as little as fifteen minutes), trading in wholesale energy markets stops and all generators and utilities tell the system operator what they are planning to do. The system operator checks that all of this is possible, and then keeps a close eye on electricity generation once it starts to be delivered, and on electricity use. If, at any point in time, electricity use exceeds generation, it asks some generators to supply more, or some large industrial consumers to use less. Similarly, if electricity is lower than generation, it can ask some generators to supply less or some industrial consumers to use more. Sometimes it does this by picking up the phone to instruct generators, but in the very short term, generators and large industrial consumers have equipment installed that can automatically respond to an excess or shortfall in generation. All of this is then repeated for the next half-hour or hour, and so on.

10. Apart from keeping generation and electricity use in balance, system operators usually have another task,

Which was already alluded to above: they have to take care of the wires that connect generators and consumers. Electricity wires are a bit like pipelines: they cannot transport unlimited amounts of electricity. Each wire will have a capacity: a maximum amount of electricity that it can carry at any point in time. If anyone would try to get more electricity through that wire, it would start to heat up, sag, and eventually break, touch the ground or a tree, or a similarly disastrous outcome. However, unlike pipelines, it is very hard to control how electricity flows through the network from a generator to a consumer. Flows can be somewhat controlled with very expensive bits of equipment, but generally follow the laws of physics: most electricity will take the easiest route through a network, using the shortest, biggest wires; a little bit will take harder routes, and so on. System operators have to make sure that none of these flows will break the wires that carry them. This is why when generators and utilities tell the system operator what they are planning to do fifteen minutes to an hour before delivery, the system operator checks that this is possible – that no wires will be overloaded. In order to check this, it will normally use a simulation of the entire network. If it finds that problems are likely to occur, it may have to ask generators in one place to reduce their planned generation levels, and generators in another location to produce more. This is costly. In many places, including large parts of the US and Australia, markets have been set up in such a way as to minimise these costs. In these places, a market operator collects all bids from electricity utilities and suppliers and figures out not one equilibrium price, but an equilibrium price at every single location in the grid, set such that demand and supply are equal overall, but also that local imbalances in each are not bigger than the capacities of the wires leading to and from that area. These locational prices reflect the cost of the last generator needed to supply local demand, which may be a local generator if the wires cannot bring more electricity in, or a cheaper generator further away if wires have not reached capacity.

11. So, consumers buy electricity from utilities, usually signing a long-term contract that agrees a price but allows consumers to use as much electricity as they would like at any point in time.

Utilities in turn buy electricity from generators in wholesale markets, trying to predict and match how much electricity will be used by consumers as well as they can, for every fifteen to sixty minute period.  A system operator makes sure that electricity supply matches electricity use exactly, on a second by second basis, and that the physical wires that transport the electricity are not overloaded.

12.   This system has generally been successful in keeping the lights on. However, electricity systems are changing rapidly.

First of all, in response to environmental problems, we use an increasing amount of electricity generation from renewable sources such as wind and solar energy. While traditional fossil fuel-burning generators were large and located in a few places, renewable generators are smaller and distributed all over the country, often including remote places. Grids were not designed for this, and are increasingly limiting how much renewable electricity can be used. Importantly, although renewable generators may be expensive to build, once built, they can produce electricity at near-zero cost. This means that wholesale electricity prices which, remember, where based on the cost of production of electricity, rather than the construction costs of generators, increasingly fail to reflect the cost of electricity and reward generators appropriately. Second, all of the above is based on the assumption that electricity cannot be stored cheaply. New technologies are being developed than can store electricity, which will alter how markets work. Finally, the assumption that consumers and businesses cannot participate in wholesale markets or more generally adjust their electricity use in real time in response to changing prices is being challenged through new technology, including meters that can monitor household electricity use at short intervals, programmable appliances which can respond to prices, and increased awareness of the need for flexibility to take advantage of renewable energy.