Electricity Markets 101 - The Energy Academy (Series Two)

[MUSIC PLAYING] Hi everyone.

Welcome back to the Energy Academy by Modo.

I'm Neil Weaver.

And in this course, I'll be taking you through an introduction to the electricity market in Great Britain.

In the previous course, I explained how the physical aspects of the electricity system fit together, from generation to transmission to distribution to consumption, basically the journey electricity takes so that you can switch your light on.

If you haven't seen it already, I would strongly recommend going back and watching that course before you get started on this one.

Anyway, in this course, I'll be introducing the commercial aspect of Great Britain's electricity system, so the electricity market.

By the end of the course, you'll understand the conditions that go into determining or setting the price of electricity, the general evolution of electricity markets in Great Britain, from nationalization to privatization, how the wholesale market for electricity works in Great Britain at a very high level, a whole load of super important vocabulary, like short-run marginal cost,

CapEx, merit order, base load, and more, the main players involved in ensuring that the market runs smoothly, and how all those things fit together.

So in the next couple of episodes, I'll build my own mini electricity system.

I'll then use this to explain how electricity markets work, not just in Great Britain, but in open markets around the world.

Enjoy.

[MUSIC PLAYING] Hello again.

Welcome back to The Energy Academy.

In the next few episodes I'll be explaining exactly how the price of electricity is set.

This will be a very high-level explanation based on my own imaginary town full of generators and indicative pricing.

However, the principles behind it will mirror what happens in the real world.

Before we dive in, let's set out some basic rules.

All generators cost money to build, a lot of money.

And this cost has to be factored in when considering a project's viability.

The cost of building any infrastructure is called capital expenditure or CapEx.

When planning and building a generator of any type, the time it will take to pay back that CapEx and the amount of profit that can be made on top of that, need to be taken into account.

For example, one argument you'll often hear against nuclear is that the CapEx of building nuclear is prohibitively high.

However, while the cost of building a nuclear plant might be more initially than the cost of building a gas-turbine power station, the gas-turbine power station actually costs more money to run.

Which brings me on to my next basic rule.

That is, all generators cost money to run.

And that cost is called the short-run marginal cost.

This literally refers to the cost of any generator producing one more unit of electricity than it's currently producing.

The short-run marginal cost of some generators is higher than others due to stuff like fuel costs and carbon taxes.

For example, wind turbines have a lower short-run marginal cost than gas-fuel power stations because they don't need to source external fuel.

And they don't have to pay any carbon tax.

Therefore we say that the short-run marginal cost of wind is lower than that of gas turbines.

In the previous course I spoke lots about balancing supply and demand.

That's because this concept underpins the entire electricity system, not just physically but commercially, as well.

I also explained that there are countless sources of generation.

They come in all different shapes and sizes.

You've got traditional fuel-burning power plants, nuclear power plants, renewables like wind and solar, and all this generation forms the supply side of supply and demand.

Taken together, the generators represent what we call the generation stack.

So in the next episode, I'll build one.

See you there.

[MUSIC PLAYING] [MUSIC PLAYING] What's up, guys?

Welcome back to the Energy Academy.

And in this episode, I'll build a generation stack.

Basically, the generation stack opens up a whole new way of thinking about electricity markets.

It can help us visualize how we balance supply and demand.

It lets us weigh up the benefits and drawbacks of different technologies.

And perhaps most importantly, it helps to explain how demand impacts the price of electricity.

In essence, the idea of the generation stack is that the cheapest sources of generation are used first so that the end consumer ends up paying a fair price for electricity.

This idea of prioritizing the dispatch of cheaper generators first is called the merit order.

The best way to explain the generation stack is with an example here.

I'm going to create my own miniature electricity system.

But the concepts we discuss apply to Great Britain as a whole.

So in my example, I've got a small selection of generation units: 20 megawatts of wind, 50 megawatts of nuclear, 25 megawatts of gas turbines, and then five megawatts of gas peaking plants.

Gas peaking plant is simply a very quick but often very expensive way of meeting demand at peak times.

Each of these technologies has its own short run marginal cost.

I.e., the cost of producing one extra megawatt of electricity from these generators is based on things like carbon taxes, fuel costs, the cost of powering or ramping up and down, and more.

So the first thing we need to decide in my example is the short run marginal cost of each of those generators.

Wind is cheapest.

So let's say it costs one pound per megawatt hour.

Nuclear is next cheapest.

So let's say that's two pounds.

And gas turbines are net.

So we'll call that four pounds.

And then our gas peaking plant is most expensive.

So we'll give it a short run marginal cost of six pounds per megawatt hour.

So taken together, all these generators each with their own short run marginal cost make up our generation stack.

In the next episode, I'll explain how my new generation stack interacts with demand.

I'll see you there.

[MUSIC PLAYING] Hi, guys, [? Neal ?] again with another episode of The Energy Academy.

Picking up from where we left off, in this episode, I'll be explaining how my generation stack interacts with demand and subsequently impacts prices.

So let's return to that mini energy system that I built in part one.

If you remember, we've got wind, nuclear, gas turbines, and gas peaking plants that make up our generation stack.

To make things more interesting, we need a source of demand.

So let's imagine a small town.

The town is full of homes and businesses.

And it has a peak demand of 90 megawatts and a pretty simple demand profile.

Overnight, when people are asleep, demand is low.

As people wake up and businesses open, demand increases.

As people finish the working day, go home, stick the kettle on, stick the TV on, demand hits its peak of 90 megawatts.

At the end of the day, the townsfolk retire to bed, switch all the appliances off, and demand falls again.

And finally, to link our new demand to our generation stack, we'll need to build a little transmission system.

So now we're all set.

We've got generation, demand, and transmission.

So back to our generation stack, let's pick a point in the day and figure out how the stack interacts with demand at that time.

It's 2:00 PM.

And demand for the town is 50 megawatts, which means the town requires 50 megawatt hours between 2:00 and 3:00.

Also, let's assume it's a windy day and that our wind turbines are producing at full capacity.

In our generation stack, our wind turbines can produce 20 megawatts.

And our nuclear power can produce 50 megawatts.

This means that we can meet the town's demand just from wind and asking our nuclear power to provide 30 megawatt hours of electricity.

We could, of course, meet the entire demand with nuclear or by asking our gas [INAUDIBLE]..

However, that would cost more than meeting it through just wind and nuclear, as our gas has a higher short run marginal cost than the former.

And if you remember the merit order that I mentioned, the cheapest sources of electricity get used first.

So in this situation, what's the price of electricity?

In this instance, generating an extra megawatt hour would require asking our nuclear plants to turn up by one megawatt for an hour, which would cost us two pounds.

Therefore, the electricity price is two pounds per megawatt hour.

And we say that nuclear has set the price.

So now we understand how demand and our generation stack interact.

Let's repeat the process across the entire day.

As demand fluctuates, different generation is turned on and off, with different sites setting the price.

When demand is at its lowest, wind can satisfy the entirety of demand.

And it sets the price.

When demand is highest, our gas peaker has to turn up.

And the electricity price spikes.

This is how demand and generation interact.

And it's fundamentally how prices in the wholesale market for electricity are determined.

However, I've made loads of simplifications and assumptions in this process.

For example, in the real world, nuclear can't ramp from 0 to 100 instantly.

And what happens if it's not windy?

And where does battery energy storage come into the equation?

In reality, the balance of supply and demand is a whole lot more complicated.

Countless factors come into play.

And there are far more generators to balance supply and demand.

However, at its heart, my mini electricity system represents exactly what happens in wholesale markets around Great Britain and the world on a day-to-day basis.

Until next time, take it easy.

[MUSIC PLAYING] [MUSIC PLAYING] Hi guys.

Neal again with the Energy Academy by Motor.

Now we've had a look at how the price of electricity is set under current market conditions.

It's important to know the context.

In Great Britain, our electricity system is privatized.

This is vital.

Prior to the mid to late '80s, it was nationalized.

But what's the difference?

You still paid for the electricity use.

People still came round, and read your meters, and figured out what you had to be charged.

While some of the details and the names of the companies involved in this process have evolved and are still evolving, it's materially the same thing, right?

Well, not quite.

In the past, the electricity system in Great Britain was organized as a government-run monopoly.

The central electricity generating board, or CEGB, was responsible for the generation, transmission, distribution, and supply of electricity to homes around the country.

Major oversimplification incoming.

Before privatization, the government looked after and built generators, transmission lines, distribution lines via the CEGB.

The upkeep of all of this was then paid for through your bills and taxes.

The production of electricity wasn't primarily profit-driven.

So in theory, the sale of electricity had to just cover the costs of generation and transmission, et cetera.

But in the late 1980s and early 1990's, the government was involved in the process of privatization.

This included selling off the CEGB and other public-owned utilities to private investors.

In turn, this marked a shift in the way that the electricity market in Great Britain was organized.

So what are the main differences between pre-privatization and post-privatization electricity markets in Great Britain?

Well before privatization there was no competition in the electricity market.

Consumers had no choice of supplier and had to purchase their electricity from the CEGB at the price set by the government.

But after privatization, the market was opened up to competition.

And suddenly, consumers had a choice of who to buy their electricity from.

This led to a more market-driven approach with prices fluctuating based on supply and demand.

There's that concept again.

Secondly, before privatization, the CEGB was responsible for managing all aspects of the electricity system, from generation through to supply.

This made it much easier to coordinate the system.

After privatization, the market became much more complicated with dozens and hundreds of thousands of companies involved at different stages of the supply chain of electricity.

To find out more about what happens at each stage of that chain, make sure to go back and check out the first series of the Energy Academy.

So in today's world, we have a number of different electricity, markets, and mechanisms, and services all functioning at the same time, and sometimes carrying out wildly different purposes.

But it would be an oversimplification to suggest that the emergence of these multiple markets is strictly down to privatization.

It's not.

In the drive to cut down our carbon emissions, renewable technologies have emerged.

These technologies often have intermittent or unreliable generation patterns.

So this combination of new technologies and increased competition has made it more difficult to coordinate and manage the electricity system.

However, it also allows for more innovation and more competition.

Before privatization, the CEGB was able to make long term investments in our electricity infrastructure, power stations, transmission lines, and distribution networks.

But after privatization, private companies have taken on this role.

The level of investment in electricity infrastructure is now more focused on how profitable it is.

Overall, the privatization of the electricity industry has brought about huge changes to the system in Great Britain.

We've seen the introduction of competition, a more market-driven approach to pricing and investment, and a shift in the way that the whole system is coordinated and managed.

So now that you understand the context and the changes that have led to today's electricity market, it's time for you to understand how the electricity market works.

In the next episode, I'll be offering an introduction to the wholesale electricity market in Great Britain.

I'll see you there.

[MUSIC PLAYING] [MUSIC PLAYING] Hi guys.

Neil again.

Welcome back to The Energy Academy.

In Great Britain, the vast, vast majority of electricity is bought and sold by large generators and large suppliers.

And it's done so in the wholesale market.

In the wholesale market, suppliers by the electricity they need from generators to meet their customers' demand.

Generally, energy's agreed for delivery at a pre-agreed period at some point in the future at a given price per megawatt hour delivered.

Delivery can be agreed years ahead of schedule, right up to the point of delivery.

Generators and suppliers are actually pretty good at forecasting what electricity will be needed and when.

Therefore, they're able to buy and sell electricity for a specific time in advance and have managed to avoid there being too much of a surplus or deficit.

Buyers and sellers can either trade electricity directly via bilateral contracts, sometimes called over-the-counter trading, or on exchanges like those hosted by Nord Pool and EPEX.

A lot of over-the-counter trading is for baseload.

Baseload spans the course of an entire day with the same amount of electricity procured across the day.

Basically, it's the lowest amount of electricity someone will need to service an entire day.

It's traded months or years ahead of schedule.

And it covers a supplier's forecast of minimum demand across a period.

Because these forecasts are never perfect, suppliers then need to fine tune this or add shape.

This means they have to buy electricity on top of their baseload to correspond with more up-to-date dynamic forecasts of demand.

Adding shape is the purchase of electricity at a more granular level for shorter periods of time, like four hour or even half-hour blocks.

This electricity is procured much nearer the time of delivery, often day ahead or sometimes even within the same day.

But who runs the wholesale market?

Well, in truth, no one organization really runs it.

Once generators or suppliers have been awarded their generation or supply licenses by Ofgem, the independent regulator who looks after Great Britain's electricity markets.

They're free to buy and sell energy in the wholesale market.

To do this, they can either go through auction exchanges like Nord Pool and EPEX or enter into over-the-counter trading.

An example of an over-the-counter or bilateral trade might be generator A entering into a contract with supplier B. Generators

and suppliers then have to make their intended volumes known to National Grid ESO.

This is so that the ESO has visibility of planned supply and demand levels and can act accordingly to fix any imbalances that might occur.

That said, the ESO does not care who the deals were made between or the price that was paid.

As mentioned previously, regulatory bodies do exist, Ofgem, in our case, to ensure that all participants act within the law and the spirit of the market.

Anyway, in the final chapter of this series, I'll run through all the topics we've covered.

See you there.

[MUSIC PLAYING] Hi guys.

Neil here again with the final episode in series two of the Energy Academy.

In this episode, I'm just going to go through a short run through of all the topics I've covered in the previous six episodes.

First off, all generators cost money to build.

This cost is known as CapEx, short for Capital Expenditure.

And it has to be taken into account when trying to figure out the viability of a given project.

Second, all generators cost money to run.

This is called the short run marginal cost.

And it includes things like fuel prices, carbon emission taxes, the cost of powering up and ramping up, et cetera.

Wind, for example, has almost no short run marginal cost, as it requires no fuel, and it doesn't emit any carbon.

Coal and gas-powered generators, on the other hand, have a higher short run marginal cost because of the fuel and the carbon emissions.

In the electricity market, the cheapest forms of generation are used first, and the most expensive forms of generation are used last.

This is known as the merit order.

That's why, when it's super windy, the electricity price is lower.

That whole system is a relatively recent development brought about by the privatization of Great Britain's electricity system.

Pre-privatization, the system was less complex.

The Central Electricity Generating Board was responsible for every single aspect of the system.

However, privatization brought with it competitive pricing and innovations that have led to the system we've got today.

The central pillar of today's system is the wholesale market.

That's where the vast majority of electricity is bought by suppliers and utilities and where it's sold by generators.

Electricity can be traded on the wholesale market from years ahead of schedule right up to the point of delivery.

It can either be traded directly or bilaterally between two parties, sometimes known as over-the-counter trading.

Or it can be traded on exchanges, like Nordpool and EPEX.

In order to trade electricity, participants must gain the correct license from Ofgem, the independent regulator.

As we explained in series one, National Grid ESO is responsible for balancing supply and demand.

But in truth, no one really runs the wholesale market.

It just manages itself.

Anyway, thanks for watching this series of the Energy Academy.

In the next series, I'll outline the various markets, mechanisms, and services that come together to form Great Britain's overall electricity market.

I'll see you there.