Electricity market

An electricity market is a system that enables the exchange of electrical energy through an electrical grid. Historically, electricity has been primarily sold by companies that operate electric generators, purchased by electricity retailers, and sold to customers.
The electric power industry began in the late 19th and early 20th centuries in the United States and United Kingdom. Throughout the 20th century, and up to the present, many countries have made changes to their system of supplying and/or purchasing electricity. Change has been driven by many factors, ranging from technological advances to politics and ideology.
Around the turn of the 21st century, several countries restructured their electric power industries, replacing the vertically integrated and tightly regulated "traditional" electricity market with market mechanisms for electricity generation, transmission, distribution, and/or retailing. The traditional and competitive market approaches loosely correspond to two visions of industry: the deregulation was transforming electricity from a public service into a tradable good. As of the 2020s, the traditional markets are still common in some regions, including large parts of the United States and Canada.
In recent years, governments have reformed electricity markets to improve management of variable renewable energy and reduce greenhouse gas emissions.

History

When electric power was first produced and sold to customers, it was not regulated by government. Customers would buy electricity from a producer, who would distribute it through their own network. However, the industry began to be regulated by a variety of government bodies.

Traditional industries

By the 1950s, a wide variety of arrangements had evolved with substantial differences between countries and even at the regional level, for example:

France, Italy, the Republic of Ireland and Greece had a nationwide government-owned vertically integrated company;
The United Kingdom had a government-owned generation and transmission, but the distribution was decentralized in 14 electricity boards;
Germany combined a small number of regional integrated generation and transmission companies with municipal distribution;
Japan had 10 regional vertically integrated monopolies;
Norway's electricity supply was mostly at the level of municipalities;
In the US, a complex mix of companies, owned either privately or by varying levels of government, evolved, while the regulation favored municipal-level and co-op ownership. For example, Hawaii had only privately owned utilities, Nebraska only publicly owned ones, the Tennessee Valley Authority is federally owned, and the Los Angeles Department of Water and Power is city-owned.

These diverse structures had a few unifying features: very little reliance on competitive markets, no formal wholesale markets, and customers unable to choose their suppliers.
The diversity and sheer size of the US market made the potential trade gains large enough to justify some wholesale transactions:

large utilities were providing electricity to smaller ones under bilateral requirements contracts;
coordination sales were made between the vertically integrated companies to reduce the costs, sometimes through power pools.

On the retail side, customers were charged fixed regulated prices that did not change with marginal costs, retail tariffs almost entirely relied on volumetric pricing, and fixed cost recovery was included into the per-kWh price.
The traditional market arrangement was designed for the state of the electric industry common pre-restructuring. Richard L. Schmalensee calls this state historical. In the historical regime almost all generation sources can be considered dispatchable.

Evolution of deregulated markets

Chile had become a pioneer in deregulation in the early 1980s. Only few years later the new market approach to electricity was formulated in the US, popularized in the influential work by Joskow and Schmalensee, "Markets for Power: An Analysis of Electrical Utility Deregulation". At the same time in the UK, Energy Act of 1983 made provisions for common carriage in the electricity networks, enabling a choice of supplier for electricity boards and very large customers.
The incorporation of distributed energy resources has inspired innovative electricity markets that emerge from a hierarchical deregulated market structure, such as local flexibility markets, with upstream aggregating entities representing multiple DERs. Flexibility Markets refer to the markets in which Distribution System Operators procure services from assets linked to their distribution system, aiming to guarantee the operational safety of the distribution network. This concept is relatively new, and its design is currently a subject of active research. In this sense, different entities can act as aggregators, e.g. demand response aggregators, community managers, electricity service providers, and more, depending on the characteristics of the set of assets being represented.

Services

The structure of an electricity market is quite complex. Markets often include mechanisms to manage a variety of relevant services alongside energy. Services may include:

on the supply side, a wholesale energy market
on the demand side, a retail energy market

A simple "energy-only" wholesale electricity market would only facilitate the sale of energy, without regard for other services that may support the system, and experienced problems once implemented alone. To account for this, the electricity market structure typically includes:

ancillary services not directly related to producing electricity. These would not generate income in the "energy-only" model, but are essential for overall operation of the system
capacity market or some other mechanism providing an income stream necessary to build and maintain additional generation units for the worst-case scenario. On a typical day, these units are never called upon and thus would not produce revenue in an "energy only" market.
[|cost-based market] with audited costs replacing producers' bids in places where the local market power is a concern. Due to a lack of competition, electricity networks are subject to price regulation in Australia.

The competitive retail electricity markets were able to maintain their simple structure.
In addition, for most major operators, there are markets for transmission rights and electricity derivatives such as electricity futures and options, which are actively traded.
The market externality of greenhouse gas emissions is sometimes dealt with by carbon pricing.

Economic theory

Electricity market is characterized by unique features that are atypical in the markets for commodities or consumption goods.
Although few somewhat similar markets exist, the magnitude of peak pricing sets the electricity market apart, the hotel/airline markets can also use retail price discrimination, unavailable in the wholesale electricity market. The peculiarities of the electricity market make it fundamentally incomplete.

Generation

Electricity is typically available on demand. In order to achieve this, the supply must match the demand very closely at any time despite the continuous variations of both. Frequently, the only safety margins are the ones provided by the kinetic energy of the physically rotating machinery. If there is a mismatch between supply and demand the generators absorb extra energy by speeding up or produce more power by slowing down causing the utility frequency to increase or decrease. However, the frequency cannot deviate too much from the target: many units of the electrical equipment can be destroyed by the out-of-bounds frequency and thus will automatically disconnect from the grid to protect themselves, potentially triggering a blackout.
There are many other physical and economic constraints affecting the electricity network and the market, with some creating non-convexity:

a typical consumer is not aware of the current system frequency and pays a fixed price for a unit of energy that does not depend on the balance between supply and demand, and thus can suddenly increase or decrease the consumption;
variable renewable energy sources are intermittent due to the reliance on the weather and can ramp up or down literally from one minute to another;
the fossil-fuel and nuclear plants have restrictions on the ramping speed: from 5–30 minutes in the gas-fired plants to hours in the coal-fired generation, and even longer for the nuclear ones;
many fossil-fuel plants cannot be ramped down below 20–60% of the nameplate capacity;
due to high cost of the start-up, the production cost of electricity might differ from the marginal cost in some time intervals thus forcing the providers to bid above the marginal cost.
Networks

Electricity networks are natural monopolies, because it is not feasible to build multiple networks competing against one another. In order to address this, many electricity networks are regulated to address the risk of price gouging. The two main types of network price regulation are:

Cost of service regulation: prices are based on the actual cost of operating the network
Incentive regulation: prices are capped based on a prior estimate of costs. The difference between the actual and estimated costs deliver a return or loss to the network operator.

The design of transmission network limits the amount of electricity that can be transmitted from one tightly coupled area to another, so a generator in one node might be unable to service a load in another node, potentially creating fragments of the market that have to be served with local generation.

Wholesale electricity market

A wholesale electricity market, also power exchange or PX, is a system enabling purchases, through bids to buy; sales, through offers to sell. Bids and offers use supply and demand principles to set the price. Long-term contracts are similar to power purchase agreements and generally considered private bi-lateral transactions between counterparties.
A wholesale electricity market exists when competing generators offer their electricity output to retailers. The retailers then re-price the electricity and take it to market. While wholesale pricing used to be the exclusive domain of large retail suppliers, increasingly markets like New England are beginning to open up to end-users. Large end-users seeking to cut out unnecessary overhead in their energy costs are beginning to recognize the advantages inherent in such a purchasing move. Consumers buying electricity directly from generators is a relatively recent phenomenon.
Buying wholesale electricity is not without its drawbacks, however, the larger the end user's electrical load, the greater the benefit and incentive to make the switch.
For an economically efficient electricity wholesale market to flourish it is essential that a number of criteria are met, namely the existence of a coordinated spot market that has "bid-based, security-constrained, economic dispatch with nodal prices". These criteria have been largely adopted in the US, Australia, New Zealand and Singapore.
Markets for power-related commodities required and managed by market operators to ensure reliability, are considered ancillary services and include such names as spinning reserve, non-spinning reserve, operating reserves, responsive reserve, regulation up, regulation down, and installed capacity.