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Electricity cash out: how we got here

This article appeared in Viewpoint: Franck on 4 June 2007.

I have been thinking for some time about Ofgem's latest review of the cash out regime (imbalance settlement) in wholesale electricity trading in Great Britain.

One of my earliest tasks in economics consultancy was to understand how the Electricity Pool worked. I was subsequently part of the team developing and implementing NETA (although I did not agree with every aspect of the arrangements that were imposed by Ofgem/DTI at the time), and I have kept an interest in the topic (and some occasional paid work) ever since.

The current proposals for changes to the arrangements, P211 and P212, which were triggered by Ofgem's cash out review, did not originally inspire me greatly. Despite the overarching review, it all sounded like another layer of sticking plaster to be applied on arrangements that probably work (in the sense of keeping the lights on) as much thanks to the goodwill of the electrical engineers that run them as to their subtle incentive structures.

On further examination, I still dislike some aspects of P211 and P212, but I can now see some prospect for the current review to lead to something significantly better than the current arrangements. But I am not sure it quite works yet — my specific proposals will have to wait for time to check them and write them up.

So this is the first part of what might become a series about electricity cash out.

Enough background. This article is an overview of the current arrangements, and a review of the proposals that have been made so far for changing them, in particular P211 and P212. It is structured as follows:

The current GB regime (BETTA)

The current electricity settlement regime in Great Britain involves asymmetric treatment of imbalances in different directions, and relies on a concept of net imbalance volume to do so. The net imbalance volume is the aggregate imbalance across all participants. Each imbalance is defined as a difference between sold/bought and produced/consumed energy volumes.

Electrical losses are accounted for before these calculations are made, so the net sum of energy flows across the system is zero; and bilateral contract positions obviously sum to zero. But the net imbalance volume is non-zero because changes from notified generation or demand schedules that were instructed by the grid operator are excluded from the definition of imbalance (or covered by a contract with the grid operator).

A "main price" applies to imbalances which are in the same direction as the total net imbalance, and a "reverse price" applies to imbalances which tend to offset the total net imbalance volume.

For each settlement period, the reverse price is normally determined by reference to prices prevailing in bilateral trading before the settlement period. The main price is normally set as an average of prices that had been instructed by the grid operator in the direction that tends to satisfy the net imbalance volume, but only a subset of these prices is used. In particular a tranche of extreme prices are deemed to be instructed for "system" rather than "energy" reasons and excluded from the average. The complicated rules for selecting the subset are known as "tagging".

Introduction to worked example

A worked example is useful to understand what is going on. Let's have a hypothetical country with a North-South divide (lots of cheap power stations in the North, lots of people in the South, not a lot of transmission capacity between them). Let's assume that, in a particular settlement period (half hour):

Under the current rules:

Current proposals for change

Several proposals are being considered for changes to the wholesale electricity imbalance pricing arrangements. Leaving aside many important details, the April 2007 candidates seem to be as follows.

P211 would retain the asymmetry between main and reverse price, but replace the main price with an ex post unconstrained schedule calculation. This means that instead of using the prices for actions that were actually instructed, it would use a computer model to estimate what actions would have been instructed if there had been no locational or dynamic constraints, and use those prices.

The effect is to reduce the gap between main and reverse price as the pricing of the offers notionally accepted in a hypothetical unconstrained world is more generous that the offers actually accepted.

In the worked example above, it would mean reducing the main price to £40, based on the offer from Northern Hydro Power Generation that was not taken up, probably because of a transmission constraint.

P212 would also retain some asymmetry between main and reverse price, but only as a liquidated amount: the main price would be set as the reverse price plus or minus a small pre-set percentage. This would preserve some pressure on market participants to put effort into volume forecasting, and not to use imbalance settlement as an alternative to bilateral trading purely out of laziness.

So long as the percentage is low, the change would reduce the gap between main and reverse price, possible by more than P211 as it would remove from the main price the effect of unexpected changes in demand or supply immediately before or during the settlement period (after bilateral trading has stopped), as well as the constraint-related effects.

In the worked example above, this translate into a main price of £31.50/MWh using a 5 per cent margin.

There is also a Littlechild balancing market proposal (6 pages, PDF) which would use a single cash out price set as the market clearing price from an energy auction to be run shortly before each settlement period (half hour). I am not sure I understand how Littlechild's idea of using a National Grid forecast alongside participants of would work in practice, but I can see the aim of settling imbalances on the basis of a price that could reasonably have been voluntarily agreed immediately before the settlement period, based on the latest weather and plant availability information. Thus in the worked example above it seems likely that the main price from a balancing market would be close to £40/MWh.

Criteria for analysing proposals

One line of analysis for the proposals above is to go through their likely impacts on administrative costs, incentives to make and disclose accurate volume forecasts, the risks borne by various parties, any indirect discrimination between large and small operators, etc. This is what the BSC Panel and then Ofgem will presumably be doing.

This article does not attempt to shadow that work. Instead I want to take a step back and ask what is the set of arrangements that comes out of the simplest, most obvious purpose of the cash out regime.

The purpose of the cash out regime

To find out what is needed for cash out, one first needs to determine what cash out is trying to achieve. Stripped to the core, the answer to that must be that it is a system to ensure that all electricity consumed has been paid for.

So the first step in the design of cash out arrangements is:

Without any cash out, people could consume electricity without paying. That's not good. Let's set a price for uncontracted consumption and charge it to them.

P212 as the simplest way of meeting the purpose

Let us now consider what the price should be.

Clearly there is a constraint that the price must be a deterrent to deliberate or careless theft of power: people must be better off from contracting for their reasonable requirements than from just taking the power without telling anyone (subject to grid code requirements). That puts a lower limit on the price.

This would lead to a top-up price (charged for shortfalls) set at the level based on a bilateral market price, probably with a little additional margin; and a spill price (paid to people with excess power in their books) of zero. The additional margin is needed that nobody is tempted to hold back from contracting by the small risk that some of his demand will not materialise and he will end up with an unwanted excess of power priced at zero.

Someone might complain that the margin amounts to a disproportionate penalty on unauthorised consumption. Given that some deviations between planned and actual consumption will always happen due to the weather etc., they should not be punished any more than is strictly necessary to achieve the purpose.

So can something be done to reduce the margin? Yes, obviously. You could pay market price minus a little bit for spill, instead of zero. This would reduce the loss of overcontracting, and therefore reduce the amount of penalty on unauthorised consumption that is necessary to induce suppliers to make and contract for a realistic forecast of their consumption. So we could get away with a top-up price that has quite a small margin over the market price.

Give or take some details about the method of application of these margins and the use of net imbalance volume, we seem to have reached P212.

Conclusion: P212 is a simple way of meeting the basic requirement of discouraging unauthorised consumption, with no obvious disproportionate penalties or problems with it.

Why there might be a second article

The arguments in the above review appear to favour P212 (imbalance prices set on the basis of a forward market price).

This is despite my instinctive dislike of the administered percentage margin element in the P212 method.

So is this the end of the debate, with P212 waiting only for Panel and Ofgem ratification, and my irrational dislike of 5-10 per cent margins waiting to be overcome?

I don't think so. The step that is missing from the above analysis is the consideration of whether the arrangements comply with Article 81 (or if Article 81 is deemed not applicable because the trading arrangements were imposed by State action, whether they comply with the pro-competitive policy underpinning Article 81).

My initial analysis of these issues seems to lead away from P212, and towards a different solution which seems to be workable and sensible in every way.

But I have not had time to check the details, so this will have to wait for the second article in this series.

In short: can I come up with something better than P212? I think so, but I am not sure yet. More soon — or not so soon depending on when I get time to tidy my notes.

Contact me if you would like to discuss this article or the thoughts above about a possible forthcoming follow-up.

Links

Article added to Viewpoint: Franck by Franck Latrémolière on 4 June 2007. Full list of articles.

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Last changed by Franck at 5:17 PM on Saturday 23 June 2007.

Reference for this page:
Reckon Open "Electricity cash out: how we got here | viewpoint: Franck" 2007-06-23T17:17:54