Table of Contents

Acknowledgements xxi

Introduction 1

1 The Basics 7

1.1 How electricity works 7

1.2 Early development of the Electricity Supply Industry (ESI) 10

1.3 The lifecycle of electric power 12

1.4 Development, structure, coordination, legislation of the ESI 14

1.5 New ownership structure 15

1.6 Selected country examples 16

1.6.1 Europe 16

1.6.2 Development in the Americas 18

1.6.3 Australasia 19

1.6.4 Asia 20

1.6.5 Africa and the Middle East 20

2 Structure, Operation and Management of the Electricity Supply Chain 21

2.1 Energy sources 21

2.1.1 Fossil fuel 22

2.1.2 Nuclear 26

2.1.3 Renewable combustible matter 26

2.1.4 ‘Hot’ natural energy 26

2.1.5 ‘Cold’ natural energy 27

2.1.6 Hydrogen 27

2.1.7 Stored 27

2.1.8 Consumables 28

2.1.9 Integration of energy sourcing and power generation 28

2.2 Power generation 29

2.2.1 Turbine generation 30

2.2.2 Open cycle 31

2.2.3 Conventional thermal generation 31

2.2.4 Combined cycle 34

2.2.5 Combined heat and power (CHP) 34

2.2.6 Turbines driven by water 34

2.2.7 Wind 36

2.2.8 Non turbine generation 36

2.2.9 Distributed power generation 36

2.2.10 The production of environmental and amenity impact factors 37

2.2.11 Abating the production of environmental impact factors 40

2.2.12 Constructing the emission abatement stacks 44

2.2.13 Stock management 49

2.2.14 Flexibility 50

2.2.15 Reliability and availability 55

2.2.16 Reactive power 55

2.2.17 Three phase 55

2.2.18 Efficiency 56

2.2.19 Cost 58

2.2.20 Generation mix 59

2.2.21 Requirements for ancillary services 60

2.2.22 Plant dynamics 60

2.2.23 The relative value of the different forms of plant service 60

2.2.24 Generator hedging 61

2.3 High voltage transmission, network operation, system operation 62

2.3.1 Electrical networks 62

2.3.2 Functions associated with network operation 72

2.3.3 Coordinated planning of generation and transmission build 74

2.3.4 Signals to build 76

2.3.5 Interconnection 78

2.3.6 Charging mechanisms available to the grid and system operators 79

2.4 Distribution 81

2.4.1 The roles of the distribution network operator 82

2.4.2 Entry connection cost 83

2.5 Metering 84

2.5.1 Metering and the consumer experience 85

2.5.2 The metering lifecycle 85

2.5.3 Meter types 86

2.6 Supply 87

2.6.1 Billing 88

2.6.2 Consumer segmentation 89

2.6.3 Regulatory requirements 89

2.6.4 Consumer agreements 90

2.6.5 Supplier profit and loss profile in relation to wholesale price 93

2.6.6 Retail pricing 93

2.6.7 Hedging 95

2.6.8 Supplier risk and supplier charges 101

2.6.9 Swing in industrial and commercial contracts 102

2.6.10 Demand side management 102

3 Policy – Issues, Priorities, Stakeholders, Influencers 105

3.1 Agendas and policy formation 106

3.2 Policy issues and drivers 107

3.3 Policy outcomes and instruments 110

3.4 Energy policies 112

3.4.1 Policy trends 112

3.4.2 Formation of policy 115

3.5 Framework 116

3.6 Domestic institutional players 117

3.7 The role and influence of international players 118

4 Liberalisation, Deregulation and Regulation 121

4.1 The liberalisation paradigm 122

4.2 Steps 122

4.2.1 Unbundling (and de-integration) 123

4.2.2 Corporatisation 125

4.2.3 Ring fence some activities under state control 126

4.2.4 Forced divestment and fragmentation of the incumbents 127

4.2.5 Privatisation 127

4.2.6 Deregulation 127

4.2.7 Reregulation 128

4.2.8 Further fragmentation 128

4.2.9 Cross industry horizontal integration 128

4.2.10 Re-consolidation 128

4.2.11 Entry of financial institutions 128

4.2.12 Pressure on retail deregulation 128

4.2.13 Further deregulation of networks and metering 129

4.2.14 Revise model 129

4.3 Conditions for reform 129

4.4 The role of the state 130

4.4.1 The national macroeconomy 131

4.4.2 Mechanisms of government influence 131

4.5 Measures of liberalisation and deregulation 132

4.6 Regulation 134

4.6.1 Quid pro quo model for regulatory change 135

4.6.2 Prescriptive model for regulation 135

4.6.3 Regulatory engagement 137

4.6.4 Economic regulation 137

4.7 Regulators 137

4.7.1 Regulatory indicators 139

4.7.2 Market monitoring by the regulator 139

4.7.3 Price regulation 139

4.7.4 Rate of return regulation 140

4.8 Industry key performance indicators 140

5 Market Structures for Electricity 141

5.1 The basics of plant dispatch 143

5.1.1 Acquiring the information on demand 143

5.1.2 Management of variation in demand in the centrally managed system 145

5.1.3 Acquiring the basic information on generation capability 146

5.1.4 Construction of the first trial schedule 149

5.1.5 Schedule feasibility and adjustment 150

5.1.6 Ancillary services 158

5.1.7 Profiles within commitment periods 158

5.1.8 Generator failure 159

5.2 The centrally managed model 160

5.2.1 Information and behaviour in centrally managed systems 160

5.2.2 Introduction of Independent Power Producers (IPP’s) 163

5.2.3 Consumers in the centrally managed system 164

5.3 The single buyer 164

5.4 The pool model 165

5.4.1 The trial schedule in the pool 166

5.4.2 Subsequent trial schedules and final initial schedule 167

5.4.3 Demand 168

5.4.4 Power capacity 168

5.4.5 Penalty for failure 169

5.4.6 Pool index 169

5.4.7 Contracts for difference 169

5.4.8 Supplier price 170

5.4.9 Fixed cost recovery in the pool 171

5.4.10 Price caps in static schedule 171

5.4.11 Market power in the pool 171

5.4.12 Information and communication in the pool 172

5.4.13 Renewable and other generation with special treatment 172

5.4.14 Offering and contracting strategy for generation plant in the pool 172

5.4.15 Interpool relationships 175

5.5 The bilateral model 176

5.5.1 Contracting in the bilateral system 176

5.5.2 Physical notification in the bilateral system 176

5.5.3 The market operator in the bilateral market 177

5.5.4 Operational strategy for contracted plant in the bilateral market 177

5.5.5 Hybrid pool/bilateral markets 178

5.6 Imbalance and balancing 178

5.6.1 Market structure for balancing and imbalance 178

5.6.2 Imbalance charging 179

5.6.3 Provision of balancing 179

5.6.4 Transmission effects in balancing 180

5.6.5 Profile effects within the balancing period 180

5.6.6 Transaction strategy 181

5.6.7 Transaction cost minimisation 181

5.6.8 Imbalance revenue distribution 181

5.6.9 Auction choices 181

5.6.10 Issues with balancing mechanisms 182

5.7 Reserve contracts 182

5.8 Wholesale markets 183

5.9 Power exchanges 184

5.9.1 The journey to power exchanges 184

5.9.2 Specifics of power exchanges 187

5.10 Advanced pool markets 189

6 Power Capacity 191

6.1 The definition of capacity 191

6.2 Requirements for Capacity 193

6.2.1 Generator failure 193

6.2.2 Demand variation 196

6.2.3 Network failure 196

6.3 The basic economics of provision of capacity and reserve by generators 197

6.3.1 Representation of generation capacity on the power stack 197

6.3.2 Provision of capacity by a unit 197

6.4 Modelling the capability of generation capacity 200

6.4.1 Capacity effect of take or pay fuel supply contracts 200

6.4.2 Capacity effect of annual emission limits 202

6.4.3 Capacity effect of port and other infrastructure contracts 203

6.4.4 Capacity effect of coal stocking 203

6.4.5 Capacity effect of plant life usage optimisation 204

6.4.6 The role of outage management in capacity 205

6.4.7 Generation above normal maximum capacity 205

6.4.8 Long term capacity 206

6.4.9 Hydro 207

6.4.10 Pumped storage 207

6.5 Modelling capacity capability from the consumer side 208

6.5.1 Modelling value of lost load as a capacity capability 209

6.6 Commercial mechanisms – the generator perspective 209

6.6.1 Day ahead capacity payments in pool markets 210

6.6.2 Fixed cost subsidy, marginal cost energy provision 214

6.6.3 Traded options and capacity contracts 214

6.6.4 Self insurance for generator shortfall 217

6.6.5 Mutual insurance 218

6.6.6 Value from rare but highly priced energy contracts 219

6.6.7 Reserve contracts 220

6.7 Capacity provision – the supplier’s perspective 220

6.7.1 Requirements to secure capacity by load serving entities 220

6.8 Capacity provision – the network operator’s perspective 223

6.9 The system operator’s perspective 224

6.9.1 Cost to consumers 224

6.9.2 Placing capacity obligation with the system operator 226

6.9.3 Placing the capacity obligation with the regulator or ministry 226

6.10 Capacity facilitation – contractual instruments 226

6.10.1 Generator cover 227

6.10.2 Insurance and reinsurance 227

6.10.3 Traded options 235

6.11 Use of options to convey probability information 235

6.12 Effect of price caps on capacity and prices 237

7 Location 239

7.1 Infrastructure costs to be recovered 240

7.1.1 Build and maintain 240

7.1.2 Losses 241

7.1.3 Reactive power 241

7.1.4 Redundancy and security 241

7.1.5 Cost of constraint 242

7.1.6 Commercial losses 242

7.1.7 Wheeling and interconnection 242

7.2 Counterparties for payment and receipt 242

7.3 Basic charging elements for location related charging 243

7.3.1 Connection charges 243

7.3.2 Use of system charges 243

7.3.3 Calculation of capacity cost in relation to system capacity need 245

7.3.4 Losses 245

7.3.5 Locational element of balancing 247

7.3.6 Locational element of reserve and security 247

7.3.7 Regional structure for cross subsidy 247

7.3.8 Constraints 248

7.3.9 Reactive power 248

7.4 Models for designation of electrical location 249

7.4.1 Postage stamp 249

7.4.2 Zonal 250

7.4.3 Postage stamp with market splitting 250

7.4.4 Nodal 251

7.4.5 Implicit locational differentials 253

7.4.6 Control area 253

7.4.7 Position in voltage hierarchy 253

7.5 Nodal energy prices, virtual transmission and nodal market contracts 254

7.5.1 Market models 254

7.5.2 Transmission allocation at system borders 258

7.5.3 Connection allocation 260

7.5.4 Integration of location based charging elements 260

7.6 The energy complex 260

7.6.1 Case examples 260

7.6.2 Global opinion 262

7.7 Environmental borders 263

8 Environment, Amenity, Corporate Responsibility 265

8.1 Environmental pressure 265

8.2 Definitions 266

8.2.1 Definition of production of potential impact factors 268

8.2.2 Definition of impact 269

8.2.3 Definition of sensitivity of impact factors once produced 272

8.3 The policy debate 273

8.4 Regulation and incentive for restricting emissions and other impacts 274

8.4.1 Continuous limits 274

8.4.2 Non instantaneous limits 275

8.4.3 Environmental tolerance limits and translators 276

8.4.4 Technology prescription or limits 276

8.4.5 Self regulation 277

8.4.6 Annual limits (caps) 277

8.4.7 Cap and trade 279

8.4.8 Emission allowance auctions 283

8.4.9 Trade no Cap 283

8.4.10 Taxes 283

8.4.11 Cap and tax 284

8.5 Other policy tools for environmental enhancement 285

8.5.1 Feed in renewable generation 285

8.5.2 Renewable obligation 285

8.6 Fuel labelling and power content labelling 286

8.6.1 Physical power labeling 292

8.7 The cost of environmental enhancement 292

8.8 Valuation of environmental factors 292

8.9 Corporate responsibility 293

8.10 The environmental impact of consumption 294

9 Price and Derivatives Modelling 295

9.1 Price processes and distributions 296

9.1.1 Price processes 296

9.1.2 Random walk 296

9.1.3 Terminal distributions and price returns 298

9.1.4 Transformation of process and Ito’s Lemma 298

9.1.5 Normal and lognormal distributions 299

9.1.6 Skewness 301

9.1.7 The Poisson process 301

9.1.8 Jump diffusion 302

9.1.9 Central limit theory 303

9.1.10 Extreme value theory 303

9.1.11 Mean reversion 304

9.1.12 Mean reversion with jump diffusion 306

9.1.13 Regime switching 307

9.1.14 Markov processes 309

9.1.15 Spot and Forward price processes 310

9.1.16 The choice between spot and forward price processes 317

9.1.17 n factor processes 318

9.1.18 Correlation 318

9.1.19 Co-integration 321

9.1.20 Conditional expectations 321

9.1.21 The denominator 325

9.1.22 Cost of risk 325

9.1.23 Transaction cost 327

9.2 Volatility modelling 328

9.2.1 Term structure of volatility – TSOV 328

9.2.2 Smile and skew 335

9.3 Correlation modelling 337

9.3.1 Cross commodity correlation modelling 337

9.3.2 Commodity spread modelling 338

9.3.3 Correlation between long and short duration contracts 339

9.3.4 Correlation measurement using historic data 340

9.3.5 Correlation models 341

9.3.6 Principal components 344

9.4 Pricing electricity derivatives 346

9.4.1 Average rate contracts 347

9.4.2 European options 347

9.4.3 American options 348

9.4.4 Swing options 349

9.4.5 Monte Carlo Simulation 349

9.4.6 Modelling with trees 350

9.4.7 Modelling swing contracts using semi-analytic methods 357

9.4.8 Volume options 357

9.4.9 Imbalance pricing 358

9.5 Establishing fundamental relationships 359

9.5.1 The exogenous and endogenous worlds 361

9.5.2 Price Growth 364

9.5.3 Weather, climate, daylight 365

9.5.4 Consumer contracts 370

9.5.5 Valuation of physical assets and risks 372

9.5.6 Pricing using world views 375

9.6 Market completeness 376

9.6.1 The completeness of markets with options 377

9.7 Emission permit prices 378

9.7.1 Forward price profile 378

9.7.2 Banking and borrowing 378

9.7.3 Volatility of permit prices 379

9.8 Network price volatility 379

10 Economic Principles in Relation to the ESI 381

10.1 Basic economic principles in an ESI context 381

10.1.1 Microeconomics and macroeconomics 381

10.1.2 Classical economics 382

10.1.3 Neoclassical economics 383

10.1.4 The economics of the margin 385

10.1.5 The demand function 387

10.1.6 The production function 391

10.1.7 Surplus 392

10.1.8 Pareto optimisation 393

10.1.9 Utility 396

10.1.10 Welfare 401

10.1.11 Preference 402

10.1.12 Contingent valuation 406

10.1.13 Valuation approaches to mortality and morbidity 407

10.1.14 Policy 407

10.1.15 Discriminatory pricing 408

10.1.16 Problems with cross subsidy and redistribution of wealth 411

10.1.17 Public goods and private goods 413

10.1.18 Existence value 414

10.1.19 Goods and bads 414

10.1.20 Externalities 414

10.1.21 Equilibrium 415

10.1.22 Trade 416

10.1.23 Fixed and marginal costs 419

10.1.24 Cost of capital 420

10.1.25 Fundamental measures 422

10.1.26 Hedonic and shadow prices 423

10.1.27 Price growth 423

10.2 Optimal pricing by asset owners 424

10.2.1 The privately owned monopoly operator 424

10.2.2 Forward hedging – timing effects 425

10.2.3 Fixed cost recovery 425

10.3 Regulated prices 433

10.4 Taxes and subsidies 434

10.4.1 Deadweight loss of taxes 435

10.4.2 The role of the ESI in the fiscal structure of the macroeconomy 435

10.5 Games, interaction and behaviour 436

10.5.1 Use of information without interaction 437

10.5.2 Local consolidation 438

10.5.3 Collaboration 438

10.5.4 Repeated games 439

10.5.5 Interactive behaviour of mid merit plant 439

10.5.6 Interactive behaviour of low merit plant 440

10.5.7 Reaction curves 440

10.5.8 Sequential quantity response – Stackelberg game 441

10.5.9 Simultaneous volume response – Cournot game 442

10.5.10 Comparison of Stackelberg and Cournot outcomes 443

10.5.11 Price leadership – Bertrand game 443

10.5.12 Gaming and payoff matrices 444

10.5.13 Nash equilibria 445

10.5.14 Repeated games and cooperative games 448

10.5.15 New entrance – pre-emption and optionality 449

10.5.16 Gaming by institutions 450

10.5.17 Auctions 451

10.5.18 Focal points 452

10.5.19 Supply function equilibria 452

10.6 Environmental economics 455

10.6.1 Valuation 455

10.6.2 Environmental taxes 456

10.6.3 Property rights 459

10.7 Market failure 461

10.8 Shocks 462

10.9 The political economics of liberalisation 464

11 Financial Modelling of Power Plant 467

11.1 Power plant financial model 467

11.2 The baseload contract 469

11.2.1 Contracts on failure 470

11.3 The planned flexibility contract 470

11.4 The vanilla option contract 470

11.4.1 Cost of the reliability contract on the option contract 471

11.5 Extra flexibility 471

11.6 Finance and hedging 472

11.6.1 Plant failure as a limiting factor in growth and return 472

11.6.2 Cost of risk 474

11.6.3 Value at Risk – VAR 475

11.6.4 Corporate financial measures 475

11.7 Accounting 476

12 Security of Supply 477

12.1 Supply chain 477

12.1.1 Sources 478

12.1.2 Power generation capacity 479

12.1.3 Transmission 480

12.1.4 Distribution 480

12.1.5 Suppliers 480

12.1.6 Consumers 481

12.2 Reserve margin 481

12.2.1 Scenario approach concept of reserve margin 481

12.2.2 Probability approach to reserve margin 482

12.2.3 The effect of import, export and transit 483

12.3 The responsibility for security of supply 484

Appendix 485

A.1 Plant life usage 485

A.2 Power plant failure and physical risk 487

A.2.1 Causes of failure 487

A.2.2 Combinatorial analysis 487

A.2.3 Monte Carlo modelling 488

A.2.4 Cost of failure 488

A.2.5 Hedging return to service 488

A.2.6 State space modelling of power plant 489

A.3 Reactive power 491

A.4 Direct current load flow modelling 493

A.4.1 Calculating transmission charges from DC load flow 495

A.4.2 Calculation of losses 495

References 497

Index 507