Restructuring Electricity Markets

The Indian power sector is gradually moving away from multi-decade generation contracts with limited despatch flexibility to short-term and spot electricity markets. This transition is mainly owing to a rapid decline in the cost of power from solar photovoltaic and wind projects, aggressive national renewable energy targets and renewable purchase obligations, greater flexibility in the allocation of coal to thermal power plants and ongoing efforts to improve the financial health of discoms. However, in order to facilitate the transition towards spot and short-term markets from the policy and regulatory standpoint, there is a need for proper contract regulation and spot market design, incentives for spot market participation, tools to hedge risks and maintaining competition in markets.

To address these issues and provide guidance to policymakers and regulators, a new report titled “Regulatory and Market Guidelines on Key Insights and Considerations of Priority Areas for Renewable Integration in India” was released by the United States Agency for International Development (USAID) under its Greening the Grid programme, in collaboration with the Ministry of Power. The report draws on two US case studies to offer key insights to Indian policymakers and regulators. Some of the key takeaways from the report are incentivising generators with bilateral contracts to participate in the spot electricity market, managing spot market risks with hedging tools, and maintaining consistent incentives in forward, real-time balancing and ancillary services markets to prevent gambling.

“India has already come out with regulations on real-time markets, which would become effective from April 1, 2020. Draft regulations on ancillary services will follow soon. Any such studies that apply to the Indian conditions are extremely useful for us in designing the market and providing information to all the stakeholders. This report from USAID is extremely useful and will help us in developing other products in the market,” said P.K. Pujari, chairperson, Central Electricity Regulatory Commission, at the launch of the report.

Background

The report examines the evolution of generation contracting in the US during different phases of electricity market development: from pre-market contracts, to the treatment of contracts during market transition, to the current use of contracts in organised markets. It focuses on two case studies, California and New York, which represent different industry structures and regulatory frameworks. In California, most of the power generation is non-utility owned however, the retail sector has historically been heavily regulated. In New York, all the power generation is non-utility owned and the state has a competitive retail market. Both California and New York had several enabling guidelines that facilitated the resolution of challenges associated with electricity contracting. These enabling guidelines included market-based fuel pricing, least-cost planning, economic despatch, and cost-based retail pricing. Adopting such enabling conditions will also be important for India’s transition to wholesale electricity markets.

Key insights for India

  • Long-term bilateral contracting can be compatible with merit order despatch, but enabling compatibility between them may require changes in markets and regulatory frameworks to reduce self-scheduling. Bilateral contracting continues to be an important part of the electricity markets in California and New York. Regulators have incentivised generators and load serving entities (LSEs) with bilateral contracts to participate in spot market merit order despatch through broadly three strategies. These are real-time balancing markets, mandatory spot market settlement for all supply and demand, and requirements for all generators to submit economic bids in spot markets.
  • Hedging tools are critical for managing electricity spot market risks, but the development of exchange-traded financial products for electricity will likely be demand driven and iterative. In California and New York, LSEs and generators hedge market risk through a mix of bilateral contracts and exchange-traded financial products. Financial products have evolved gradually and iteratively over time to adapt to industry demand, which has been shaped by utility regulation and contracting requirements for resource adequacy.
  • As reliance on spot markets increases, resource adequacy and fairly allocating fixed generation costs become more important. During periods when spot market prices are low, LSEs prefer not to sign long-term contracts, raising concerns over investment in new generation. To address this, California and New York have both developed resource adequacy programmes that require LSEs to demonstrate on a year-ahead or monthly basis that they have adequate resources under contract to meet forecasted demand plus a reserve margin.
  • Developing or expanding electricity markets does not reduce the cost of expensive legacy contracts, but it helps to improve future decision-making. The development of electricity markets in California and New York did not reduce the cost of expensive legacy contracts. However, a few expensive contracts were successfully renegotiated and paid in full.
  • In expanding retail competition and choice, it is important that lawmakers and regulators have a vision regarding the signing of long-term contracts to finance new generation. Competitive retail providers will generally try to avoid long-term contracts because of uncertainty in long-term demand. However, generators still typically require some amount of revenue certainty through longer-term contracts to obtain financing. Neither California nor New York has resolved this issue. In California, utilities sign long-term contracts on behalf of non-utility retail providers, but this approach is unsustainable. In New York, public agencies often sign long-term contracts on behalf of competitive retail providers and default service providers, but this was not the original vision for New York’s electricity market. The history of electricity market development in both states over the past two decades illustrates the importance of thinking through long-term contracting incentives.
  • There are multiple contractual arrangements through which electricity sellers and buyers with long-term bilateral contracts can participate in spot markets. California and New York illustrate the diversity of contractual arrangements through which generators and LSEs with long-term contracts can participate in spot markets. These include formal contracts for differences, tolling agreements that allow buyers to schedule and settle on behalf of sellers, and capacity contracts that pay only for net capacity costs. Under these contractual arrangements, generators and LSEs have the flexibility to respond to spot market prices. Based on contract terms and conditions, economic rents from spot markets are calculated and the risks of lower-than-expected capacity factors are allocated between parties.
  • There are no simple regulatory formulas for setting long-term contracting requirements for regulated utilities. In California, for instance, utilities have generally signed 10-year contracts with new generation resources. This 10-year contract duration was agreed to be the minimum duration required to secure bank loans for new projects. Meanwhile, in New York, regulated utilities were prevented from signing long-term contracts to limit their exposure to customer migration risk. However, this approach has been distortionary, and has pushed long-term contracting for new generation on to competitive retail providers. As a result, New York state agencies continue to have an active role in procurement.
  • Higher penetration of solar and wind power generation has increased the importance of a well-functioning spot market. In California, balancing needs and generator ramping have increased significantly with the growth in solar and wind penetration. Having a well-functioning balancing market that charges and pays renewable energy buyers and sellers a market price for imbalances, and pays conventional generators a market price for their increased ramping and cycling costs is critical to enable higher penetration of renewable energy at relatively low cost.
  • Although forward, real-time balancing and ancillary services markets are interactive in nature, the lack of consistent incentives across markets can create opportunities for gaming and reliability challenges. California’s experience during the electricity crisis illustrates the interactions among day-ahead, hour-ahead, real-time balancing, and ancillary services markets. If the design of one market is problematic, it can shape incentives and prices in other markets by creating opportunities for arbitrage. Although some amount of arbitrage may be desired, in California, unanticipated behaviour in different markets created opportunities for gaming and posed reliability challenges. Therefore, it is necessary to continually adjust market rules to ensure that incentives are aligned. Besides, it is also necessary to develop institutions for market monitoring.

To conclude, while it has become necessary to move towards shorter-term contracts and spot electricity markets, particularly, in view of the growing renewable energy capacity, it is essential to build a robust policy and regulatory framework in order to maintain a stable electricity grid and enable competitive market development.

Priyanka Kwatra

 

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