The current trading arrangements
The original Revised Electricity Trading Arrangements (RETA) were proposed by Offer in July 1998, accepted by the Government in October 1998 and set out in Offer’s Framework Document of November 1998. They envisaged a Balancing Market for each trading period, with a single imbalance price based on the average cost to the System Operator (SO) of the trades that it needed to carry out in the Balancing Market. However, the precise operation of the Balancing Market, and the definition of the imbalance price, was not specified at this time.
In July 1999, Ofgem issued proposals for what had become the New Electricity Trading Arrangements (NETA). They referred to a Balancing Mechanism rather than a Balancing Market, and to cashout prices rather than imbalance prices. But there was more than a change of nomenclature. It was now proposed that there be dual cashout prices in each period, whereby those market participants who were short in any period would pay a higher price than would be received by those who were long Ofgem’s justification of dual cashout prices relied on three main propositions:
- That this was required in order to reflect the different costs and values of being short and long.
- That dual cashout would incentivise participants to self‐balance.
- That self‐balancing would minimise the role of the SO as ‘residual balancer’, which was said to be consistent with the then‐aims of policy.
The cash-out design is based on the concept of two – or dual– prices. The main price is the price for imbalance trades in the same direction of the system as a whole. It will be the system buy price (SBP) when the system is short and the system sell price (SSP) when the system is long. Accepted offers are arranged according to detailed rules to calculate the main cash-out price. The second price is the reverse price, that is for trades in the opposite direction, to the system as a whole. Both prices are usually notified to the market fifteen minutes after the relevant balancing period.
The SSP–SBP methodology is premised on a simple concept – the desire to encourage parties to balance their positions as an end in itself, although there is no regulatory requirement as such that parties should do so or that they should be fully contracted. This approach means that if a trading party is out-of balance against its contract nominations it will tend to see a price that is at a discount to the short-term energy market price if it is spilling (exporting) or that is at a premium to it if it is taking a top-up supply (importing) from the system. The cash-out prices that the trading party sees, and levied by the SO, are linked to actions taken by the SO that are treated as restoring the system to energy balance.
Ofgem’s 1999 argument for dual cashout as necessary to reflect costs was backed up by a further argument. If a generator expects the system to be short and the main‐direction cashout price to be high, it will have a strong incentive to avoid being caught in a short position as a result of under‐ generating. If, at the same time, the reverse direction price is lower than the main direction price then the generator will have a lower incentive to spill any excess generation onto the system via a long position as a result of over‐ generating. In this way, the generator is incentivised to balance its position.
Now consider the position of a supplier (retailer) who expects the system to be short but whose own demand is uncertain. It will have a similarly strong incentive to contract ahead to avoid being caught in a short position. But suppose, in the event, that its own demand turns out to be less than it has contracted for, and it finds itself in a long position. Then this surplus cover is worth less than it would have been with a single cashout price, by the amount of the difference between the main and reverse cashout price. In other words given the uncertain demand and the consequent risk of overcontracting, the dual cashout price seems to reduce, not increase, this supplier’s incentive to purchase enough cover to balance its position.
The belief that dual cashout provides additional incentive to balancing is still widespread today. But is it true? Does the use of a dual cashout price regime incentivise participants to balance their own positions by Gate Closure?
It is understandable that minimising the role of the SO might have been an informal objective of policy. Experience in the Pool had shown the limitations of an arrangement in which a central organisation used a set of rules to determine the system price. The thinking on cashout no doubt sought to avoid a return to such an arrangement, and to encourage the bilateral trading that was fundamental to NETA. However, the Offer July 1998 proposals make no suggestion that parties should be required or even urged to self‐balance before entering the balancing market. On the contrary, the balancing market was just one of several opportunities for the parties to buy or sell. It was for each market participants to decide whether, when and how far to contract, depending on the circumstances, preferences and economic situation of each participant. However the data does The data show a definite pattern of contracting without full regard to the shape of demand that is being balanced against. For vertically integrated participants, there is a strong probability that changes in forecast demand from settlement period to settlement period can be reasonably closely matched by changes in level of generation. Therefore suppliers operating without vertical integration are likely to show an even more marked tendency to contract without significant regard to demand shape.
Two become one
In August 2012, OFGEM launched the Electricity Balancing Significant Code Review (EBSCR) having expressed concerns that cash-out prices were not creating the correct signals for the market to balance, which, they argued, could increase the risks to future electricity security of supply and undermine balancing efficiency, in addition to increasing unnecessarily increasing costs.
They argued that the dual price cash-out mechanism “fundamentally fails to incentivise balance. This is because it delivers an asymmetric punishment for errors, with a significantly larger risk cost to a participant for going short rather than going long” and thus that the economic driver on consumption accounts is consequently to spill. The risks of going short in the market apply particularly to generator trips; Generator reaction has been to part load plant, which allows rapid response from alternative plant in the event of trip. The reserve consequently carried in the system by parties is way in excess of the reserve required by the transmission company and that the excess cost of this extra reserve feeds through to consumer cost.
In May 2014, they completed their review. Both in terms of the incentives on behaviour and the timing of implementation of changes, the EBSCR reforms have been designed to be complementary to the arrangements set out for the Electricity Market Reform (EMR) Capacity Market (CM). As a package, the Electricity Balancing Significant Code Review (EBSCR) policies have been designed to improve incentives on market participants to balance their positions by strengthening the price signal for cash-out.
In particular, EBSCR seeks to improve the extent to which the price that a party is exposed to for a given imbalance position captures the value of that imbalance to the System Operator (SO) in its role of taking actions to maintain a balanced Transmission System. More marginal cash-out prices, introducing costs for demand control actions and changes to how reserve actions are priced into cash-out will make the prices sharper for those parties whose imbalance has contributed to that of the Transmission System, particularly in times of system stress. In particular, three of the EBSCR reforms will sharpen the cash-out price. From winter 14/15 the imbalance price will be calculated based on a more concentrated weighted average volume of the most expensive actions. This volume weighting will reduce in a phased approach to winter 18/19 when the price will be set based on the marginal (most expensive) balancing action. Furthermore, changes to the way in which reserve actions taken by the SO are priced into cash-out and the introduction of an associated price for Demand Control actions ensures that the imbalance price has the potential to reach higher levels for parties who have short positions at times of system scarcity.
These reforms increase the potential level of prices faced by those market participants whose imbalance positions extend the imbalance of the Transmission System. The potential for higher prices increases the costs associated with imbalance, thereby incentivising market participants to take sufficient actions (e.g. dispatching additional units or buying in the spot market) prior to the closure of the market (gate closure) for each Settlement Period to mitigate their imbalance risks and ensure that contracted positions are as accurate as possible against their metered out-turn. This in turn should minimise the number of energy balancing actions that National Grid has to take post gate closure
Intended benefits of a single price cash-out model
|Incentive to balance||For generators – the opportunity cost of selling at a contract price that does not significantly reflect SBP will be greater once they have the potential option to spill at SBP as well as at SSP. Therefore spot prices will rise leading to raising the cost to suppliers of spilling. Suppliers will therefore go less long|
|Reduction in excess reserve||The risk cost of trip will be reduced and so less reserve will be held by parties against exposure to SBP. This reserve could be made available either in pre gate closure markets or offer prices for it in the balancing mechanism will be lower reflecting the same reduced cost of plant failure|
|Incentive to contract||With the size of the buy-sell spread in the two-price cash-outmechanism there are limited ways of mitigating imbalance risk.Consumption accounts can be consolidated or put into portfolios; production accounts can only effectively benefit from portfolio. Cutting this buy-sell spread will allow financial products to compete with portfolio as a means of managing risk. Generators are currently holding part-contracted plant as reserve. Reducing trip cost will improve incentives to contract out this capacity|
|Incentive to notify||By notifying fixed volume contracts suppliers can guarantee delivery on the contract; thereby reducing bilateral credit risk even where residual volumes may be on CfD contracts|
A perfect solution?
The conditions of the future electricity system will be different from those today in numerous respects – for example, less flexible renewable energy and more responsive demand side participation.Energy balancing and related pricing are likely to become increasingly important. This makes it all the more necessary to put the fundamentals of the cash-out on a more efficient economic basis. Assuming all costs are passed onto consumers and spread evenly across all units of consumption, the cost of balancing is expected to increase in the future, as the SO will need to take more actions to balance increasing levels of wind generation on the system. These radical changes will significantly shake up the electricity market. The sharper imbalance prices will mean parties will go to great lengths to avoid exposure to high imbalance prices that could in some periods be up to £3,000/MWh (£6,000/MWh following the introduction of the capacity market). But despite sharper, more volatile prices, there is nothing in the package about better forecasts or information, and there will need to be help for parties to better manage volume risk if price risk is to be deliberately amplified.