Nov 4, 2012

Time for an electricity market reinvention?

The basis for the current industrialization is to rationalize work and improve productivity and competitiveness by using more cheap energy. The implications cannot be ignored in the long run. Fewer jobs and ever-increasing energy consumption has to be compensated by ever more artificially created jobs and increasingly artificially cheap energy. As a consequence, the effectiveness of society will decrease and it will become increasingly difficult to avoid contraction and decay. In addition, an industrialization based on cheap energy will eventually cause but not withstand a high price or the cost of keeping the price artificially low.

Electricity plays a crucial role and has since it's introduction been traded as "energy" between individual agents to make it artificially cheap. Hence, an important part of the solution would be to create a truly effective pricing and trading of electricity. It turns out to be easy.

Since electricity is instantly produced and consumed it simply must be traded collectively between all production and consumption connected to the grid. The potential to simplify and streamline the current market is obvious. Since electricity factually can not be traded between individual agents the market consists in reality only of a network and a price. Competition should thus be considered as a matter connecting supply and load to the grid as accurately as possible with respect to the spot price. As trade is collective the grid should take care of all the billing and crediting of consumption and production.

A highly simplified market and a reduced need to process information means that price formation can approach real time. To ensure correct pricing, mandatory bids should be collected for each individual and controllable production source. Along with real-time measurement of the current total load, losses and non controllable production these bids would form a basis for a centralized merit-order dispatch of controllable production and determination of spot prices at low load. At higher loads, the price would preferably be determined by an adaptive control algorithm optimized to minimize the total cost. In addition, and to secure a functioning market, the price must be effectively distributed to give the demand side the ability to adapt to its variations. This should of course be supplemented with a higher sampling rate of load measurement as a basis for billing.

The real big thing is be that a new market would correspond to reality. Consumers are buying instant capacity with the switch in a collective transaction to the same price. Moreover, their own incentives to adjust the load correspond to their collective incentive to reduce the price.

Among small consumers, there is hardly any need to manage price risk, other than by matching the load to the price when convenient or by automatic control. On the other hand ought users with large loads and especially if usage correspond with high prices have strong incentives to hedge their costs. Users of electric heating or air conditioning are obvious candidates. Meanwhile, producers who start up capacity when the price is high have a need for to cover fixed costs regardless of whether the plant is running or not. By designing price insurance contracts that gives users of capacity a financial compensation when the price exceeds a certain level, in return for payment of a premium, the risk can be exchanged between these parties. Conversely, there is also be a need for producers who might be forced to sell much capacity when the price is low to protect against low prices. And corresponding users who can connect large loads when the price is low and who want to hedge their fixed costs. Of course there is also a need for contracts for exchange of risk between producers and users who has capacity continuously connected to the grid. By standardizing and trading contracts them over an exchange, the transaction costs are minimized so that everything from small to the large agents can participate.

A new and drastically simplified electricity market has not only the ability to create short-term balance between supply and demand of capacity because both sides have mirrored incentives to respond to variations in price. It also has the ability to create long-term balance because users and producers have mirrored incentives to finance investment in supply and demand of capacity.

To summarize. Standardization is a classic method to reduce transaction costs and improve efficiency. On the electricity market, it can be used firstly to take advantage of the fact that electricity in itself is the most standardized commodity ever ("a network and a price") and secondly to create an effective mechanism for investments on that same market.

Time to reinvent?

Presentation delivered at the APEx2012 conference together with these slides.