How does bilateral trading differ from electricity pooling?

Abstract

Liberalisation in the energy sector opened opportunities for new market entrants leading to high competition in the market. As such, countries were forced to change their models of electricity trading in order to remain efficient and competitive in the market. The differences between bilateral and electricity pooling models are well described by the arrangements made. In this sense, the differences between bilateral and electricity pooling will be critically analyzed pointing out the differences between contracts for differences, power purchase agreements, differences in market structure, rules and procedures. The research in question is expected to reveal the inefficiencies that are associated with electricity pooling (centralized market system) and the reason why most countries are transferring to bilateral trading (decentralized market system). Equally important, a comparison of both models of trading to each other in a liberalised market will be carried to show that bilateral trading is a market oriented model and as such, the most efficient in a liberalized market.

Chapter 1

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Introduction

To begin with, electricity as a commodity has the capability to be sold, bought and traded altogether. At the most basic level, it is not easy to store electricity and as such, it has to be available on demand. Therefore, electricity has to go through a cycle of generation, transmission, distribution, supply and metering and as such, the supply should meet the demand. According to Crew, Schuh & the Centre for Research in Regulated Industries “electricity markets are defined by the physical realities of transmission systems along with the features of regulation and the institutions”. In the same line of deliberation, electricity marketing is based on various models and in this context, there will be an exploration of bilateral and electricity pooling models along with a comparison of both to each other in a liberalised market.

Background of Study

According to Bjornebye, electricity trading may take place bilaterally or at organized markets, where contracts for the sale and purchase of electricity under bilateral trading are entered into directly between the seller and the buyer. It can also be done by the help of trading institutions, brokers or basically out of the sole initiative of the parties in the contract. Fundamentally, such agreements or contracts are termed as over-counter contracts, abbreviated OTC. Currently, it has been noted that in many European electricity markets, bilateral trading has been playing a key role. On the other hand, electricity pooling is the mechanism through which electricity contracts involve predetermined multilateral contracts amongst participants in the market.

Importantly, bilateral trading is market-oriented in design as it encourages more interaction between sellers and the buyers. While this is the case, electricity pooling operates as a centralized trading model and as such, competition is exclusively on generators with nominal contribution from the buyers. A critical analysis of the two models in a liberalized market would make it easy to suggest which models work most efficiently.

Statement of the Research Problem

Having stated that electricity is a commodity that cannot be stored, it then becomes essential to determine the best model of trading that can efficiently be used in a liberalized market. Following this point, the statement of the research problem is how bilateral trading differs from electricity pooling detailing the major differences in terms of contract for differences and power purchase agreements, differences in Market Structure and the differences in Market Rules and Procedures. This will then shed light on which model works best in a liberalised market.

Objective of the Research

The main objective of the study is to show the main differences in terms of contract for differences in power purchase agreements, differences in Market Structure and the differences in Market Rules and Procedures for both bilateral and electricity pooling models of trading. Research Questions

The research in question is meant to answer the following questions:

1. How does bilateral trading differ from electricity pooling
2. What are the differences between contract for differences and power purchase agreement,
   differences in Market Structure and the differences in Market Rules and Procedures
3. Which is the most efficient model in a liberalized market

Significance

The study in question is of great importance to the electricity industry in the sense that the results obtained can be used to make recommendations on which model of trading is the most efficient; bilateral trading or electricity pooling. Again, stakeholders in the electricity market can use the information to make informed decisions.

Study Plan

Chapter 2

Liberalisation in the energy sector

In reference to Collier, European University Institute & Working Group on Environmental Studies, energy being an important commodity, should receive free movement. Outstandingly, government intervention in the energy sector has always been strong and as such, public regulation and ownership is what has controlled the sector. Recently, there has been much reform, and as such, a number of countries across the world have changed their focus from the traditional one to liberalisation made possible through international energy investment law.

It is actually through the liberalisation of the energy sector that markets have been opened to competitors. The rationale for liberalization is deemed to have been merely based on arguments of economists. This is to suggest that liberalisation is deemed to reduce barriers in the market along with the increased economic efficiency.

According to Geistberger[10], liberalization of the energy sector has been well received by some states while others have lagged behind. However, Geistberger, points out that through liberalisation prices are expected to be lower owing to more efficiency in both the allocation and the management of resources. In particular, Europe has lagged behind with a large percentage of the major gas utilities focusing on the domestic operations. However, if such companies exploited the liberalisation opportunity, then, Europe would benefit from more merger and acquisition opportunities also, Europe would benefit from better investment in the management and infrastructure along with the creation of opportunities for distribution companies.
Capacity short and Capacity sufficient countries

Capacity short and Capacity sufficient countries as far as energy is concerned, refer to countries whose demand response for energy is short and sufficient respectively (through capacity mechanism). In this sense, a capacity short country cannot supply enough energy and as such, cannot even try to engage in the cross border marketing or meet demand. On the other hand, a capacity sufficient country has the capability to supply energy sufficiently even at its peak loads. Such a country can then engage in cross border trading (liberalized market) without being constrained.

Brief Description of Pooling

Principally, electricity pooling operates in the market under arrangements of trading that are mandatory along with compulsory bidding and settlement procedures. The goal of electricity pooling is to maximise on the social welfare made possible through electricity production and consumption[14]. The main participants in an electricity pool are the generators, system operators, market operators and suppliers just to mention a few and as such, they are the ones who are obliged to sign the pooling agreements. For compulsory pools, generators are required to sell their output to the pool and as such the price is determined by the pool. Notably, electricity pools often allow member generators to place bids on the amount of electricity that they can generate given a certain price. It is clear in this case that the buyers input is not considered. Pools operate on an hourly basis whereby generators have to compete to meet demands of each hour.
Brief description of bilateral trading

Kirschen & Strbac asserts that bilateral trading involved two parties, namely the buyer and the seller. In this sense, the contracts entered in this case are without the interference or facilitation from a third party. Basically, the amount of time and the quantities of energy available for trading enable the sellers and buyers to choose different forms of bilateral trading. Such forms of bilateral trading take in customized long-term contracts which are used on small amounts of energy in over counter trading which are meant for large amounts of energy. Bilateral trading may also take the form of electronic trading which is commonly used in a computerized market place. Needless to say, prices in a bilateral trading are determined by parties involved.

Chapter 3

Comparison

Notably, both electricity pooling and bilateral trading models have both advantages and disadvantages but is worthy to note that bilateral trading gives opportunities for the parties involved to trade without restrictions to . On the other hand, electricity pooling allows generators to find a market for their electricity.
Comparison between contract for differences and power purchase agreement

Contract for differences (CFD) is a contract between two parties which takes in a buyer and a seller and in particular, it shows that the seller is to pay the buyer the difference realized between the current value of the particular asset and the value at the time of the contract. In other words it is an equity derivative that gives room for the parties involved to speculate on share movements without the need to own the underlying shares. In this sense, there is no connection between the CFD and the system operator; therefore there is no market operator in this case.

On the other hand, power purchase agreements refer to contracts that are entered into between two parties. In particular, it is a contract entered in by the seller (electricity generator) and the buyer (the one who seeks to purchase electricity). It is actually a take it or leave it contract and as such, the producer is obliged to finance, design, build, maintain, own and as such monitor the energy production asset of the host and then sell the power to the host at a rate that is negotiated at a predetermined moment in time.

Differences in Market Structure

Both the electricity pooling and the bilateral models of trading have abstract differences. For instance, electricity pooling assumes a centralized market accompanied with a central schedule and dispatch of generators. On the contrary, a bilateral model assumes a decentralised market with much dependence on self dispatch. Whereas, pools have their contracts based purely on finances and as such, contracts entered into are used to manage the fiscal risks. Quite the opposite can be said of the bilateral model that uses contracts as the main tools of trade.
Differences in Market Rules and Procedures

Market rules and procedures in both models of trading differ. While pools are not considered as markets owing to lack of involvement of buyers in price determination, bilateral models make a better market owing to the involvement of buyers and sellers in the process of trading. Notably, differences of prices due to demand fluctuations are common in pools and as a result, CFDs are commonly used in order to cope with the volatility of prices. There is less volatility in a bilateral model since there is room for negation between the buyer and the seller. Therefore, use of power purchase agreements is common with this model. Therefore, in pools the price is determined without input from the buyer while in a bilateral model; price determination is reached through a negotiation between the buyer and the seller.

Chapter 4

Country specific text and cases (E.g England and Wales Experience)

Noticeably, The England and Wales Experience have proved to be a good example owing to its use of the electricity pooling model in the 1990s. However, the new labour Government in power in the UK from May 1997 introduced new reviews of the systems of energy owing to the government’s concern over manipulation of the pool by large generators. Electricity trading arrangements were subsequently reviewed and the year 2001 witnessed a launch of new rules termed as New Electricity Trading Arrangements (NETA)[20]. This allowed electricity trading to be conducted outside a central power market (pool) and as such, the trading took place in a bilateral model of trading whereby sellers and buyers were afforded the opportunity to negotiate the prices of the electricity. This led to enhanced competition and price reductions along with the introduction of a balancing mechanism which ensured stability of the market system by either paying for the shortfalls or being paid for excesses.

Chapter 5

Conclusion

Basically, electricity pooling and bilateral trading present two models of trading with different ideas of operation. In actuality, electricity pooling is a centralized market system while the bilateral model of trading is decentralised. As such, the bilateral model of trading allows competition and the interaction between buyers and sellers and as a result, it is the most efficient method for use in a liberalized market. Thus a liberalised market allows suppliers to compete across the whole spectrum of the market and as such, just as bilateral trading, liberalization allows room for competition.

References

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3. Bjornebye, H 2010, Investing in Eu Energy Security: Exploring the Regulatory Approach to Tomorrow’s Electricity, Kluwer Law International, Netherlands.
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6. Collier, U, European University Institute & Working Group on Environmental Studies 1998, Deregulation in the European Union: Environmental Perspectives, Routledge, New York.
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10. Geistberger, M 2012, The Internationalization of Energy Firms: A Literature Review, GRIN Verlag, German.
11. Harris, C 2006, Electricity Markets: Pricing, Structures And Economics, John Wiley & Sons, New Jersey.
12. Kirschen, DS & Strbac, G 2004, Fundamentals of Power System Economics, John Wiley & Sons, New Jersey.
13. Organisation for Economic Co-Operation and Development 2004, Energy Policies of IEA Countries: The Netherlands 2004 Review, OECD Publishing, Paris, France.

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