4.10

SECONDARY ELECTRICITY MARKETS

Several secondary markets have sprung up around the electricity market. Some these markets (ancillary services, capacity markets, and PPAs) are all ways to help power grids reliably deliver power to consumers. Another market, the FTR market, has developed to help traders manage congestion risk. Finally, the REC market provides a way for power grids to incentivize construction of renewable energy in a deregulated electrical market.

These markets have all developed due to the complexity of delivering electricity to consumers. For example, one major issue with the electrical market is the uncertain nature of consumer demand for power. The demand for power during a summer heat wave or winter cold snap can be double or triple the demand for power at other times of the year. If enough generation units have been built to meet peak demand during an extreme event, many of them will lay idle for several years in a row. Someone needs to pay for these units to be built and maintained. One way to compensate the owners of these underutilized facilities is to allow power prices to skyrocket during peak demand. This allows these units to earn enough money during their brief period of operation to be profitable. However, this also tends to be unpopular with consumers who are hit with unusually high electricity bills. As a result, markets have developed other mechanisms to compensate generators for meeting uncertain consumer demand through the ancillary services, capacity, and PPA markets.

Two other markets created by many power grids are transmission markets (typically called FTR markets) and renewable energy markets. FTRs allow traders and other market participants a way to manage the risk of delivering to a specific point on a power grid. RECs provide an additional source of income to owners of renewable energy systems. REC markets also provide a way to track renewable contributions once power has been placed onto the power grid. This allows owners of renewable generation to sell the renewable attributes of their power to consumers.

Ancillary Services Markets

For a power grid to run properly, generation units must constantly modify their output to match changing consumer demand or variable generation from wind and solar units. For areas with a regulated utility, the utility will take on this responsibility. However, in deregulated markets, ancillary services markets compensate generators for their contributions to the power grid above and beyond selling electricity.

Failure to match generation to consumer demand can lead to power lines melting (blackouts) or voltage falling too low (brownouts). Because the power grid can’t control when consumers turn on or off a light switch or run a load of laundry, the power grid relies on generators to change how much power they produce. Often, this requires generators to rapidly ramp their output up or down. Since not all generators have the ability to increase or decrease production quickly, power grids will often pay additional fees to the ones that can respond.

Not all generation units can participate in an ancillary services markets. There are several types of ancillary services, each requiring a minimum level of performance. The four most common types of ancillary services are regulation up, regulation down, spinning reserve, and nonspinning reserve.

Regulation energy is used to maintain the frequency on a power grid at 60 hertz. Resources providing regulation services must usually be able to respond to automatic control signals that will increase or decrease the generator’s production depending upon the need. Note that the performance requirements for each class of service will vary by power grid.

•   Regulation Up (Reg Up). The generator needs to be able to respond to control signals to increase production. Units must typically be able to respond to signals in about a minute.

•   Regulation Down (Reg Down). The generator needs to be able to respond to control signals to decrease production. Units must typically be able to respond in about a minute.

Reserve generation is used to replenish the regulation pool. Reserve units will be activated to take over for the regulation resources. This will free up the regulation units so that they can continue to provide balancing services. Spinning reserve is standby capacity from generation units already connected or synchronized to the grid. Nonspinning reserve is capacity that can be synchronized to the grid and ramped to a specified load within a couple of minutes.

•   Spinning (Synchronized) Reserve. Spinning reserve is a type of ancillary service where the generator is operating but not feeding power into the power grid. A typical startup time for synchronized reserve units is to produce power within 10 minutes of activation.

•   Nonspinning Reserve. Nonspinning reserve is a type of ancillary service where the generation unit can quickly come on line (perhaps in 30 minutes to an hour).

Capacity Markets

Capacity markets help ensure that power grids will have sufficient resources to meet the future demand for electricity. A typical capacity market will hold an annual auction several years in advance of the operating period for which the power grid wants to ensure sufficient generation. Winning participants in the auction will commit themselves to stay operational through that period in exchange for payment (called a capacity payment).

Capacity markets serve as a stable revenue stream for resources that help meet peak demand but don’t run often the rest of the year. In addition to helping to maintain existing resources, a second goal for capacity markets is to help support the development of new resources. For example, capacity markets might incentivize investment in battery technology or efforts to reduce consumer load on demand.

Each power grid can have its own approach to ensuring sufficient resources for its customer base. As a result, there isn’t a single capacity market design, and some regions have no capacity market at all. Even so, for the regions that have capacity markets, many follow similar procedures.

•   Capacity. Many power grids pay capacity payments based on the average amount of power that the unit could produce if it was fully active.

•   Capacity Performance. Some capacity markets have special categories in capacity auctions for units that can guarantee their ability to produce power (usually by having their own fuel supply) or that can generate reliable power during periods of peak demand (like during summer afternoons or cold winter nights).

Auctions are typically used to determine the price in capacity markets. In these auctions, most power generation units are required to bid in their full generation capacity unless they plan to close down their generation units. The power grid will set an amount of generation capacity that it thinks it will be needed to meet consumer demand. Payment to generators will be based on whether the power grid has met its goal (whereupon no one gets paid) or there is a shortfall (where people will get paid because the power grid wants to incentivize new construction).

Capacity auctions of this type of auction tend to work well when there is consistently increasing consumer demand. However, capacity auctions often do not provide sufficient revenue to maintain existing units when demand is stable or falling. The reason is that incentivizing new construction is only part of the problem faced by power grids. The other problem is the need to compensate standby generation that will only operate intermittently—some units might only run once every 5 or 10 years.

Power Purchase Agreements

A PPA is a bilateral contract (one made directly between two parties) where one party wishes to generate and sell electricity (the seller) and the other party is looking to purchase electricity (the buyer). These agreements are typically used by regulated utilities to purchase power from renewable energy sources, like solar or wind farms. Along with electricity, these contracts typically purchase the renewable attributes of the generation and any capacity benefits provided by the generation.

PPAs are most commonly signed when a generation unit is first constructed. Guaranteeing the developer a steady income allows developers to obtain project financing at preferable rates. Prices are typically negotiated to give the developer a fixed return on its investment, allowing any savings to be passed on to consumers served by the utility. There is commonly a fixed price for power negotiated. This price is commonly determined using a levelized cost of new entry (LCOE) approach.

Financial Transmission Rights

FTRs are a hedge for congestion costs. They give market participants the ability to offset the cost of transmitting power over the power grid. FTRs are defined by their endpoints. When defining endpoints, the direction of transmission is important. The endpoints are called the source and sink. The starting point is called the source, and the ending point is called the sink. Energy is said to flow from the low-cost to the high-cost location. When the FTR flows energy in the same direction as the congested flow, it benefits the owner of the FTR. The FTR serves as a liability, or charge, to the holder when the FTR flows energy in the opposite direction as the congested flow.

FTRs are commonly acquired in auctions. Typically, the power grid coordinating the FTRs will hold an auction one to three years before the flow date associated with the FTR. Smaller monthly auctions will commonly allow market participants to post FTRs for sale or to purchase FTRs that were unpurchased in previous auctions.

From a trading perspective, many FTRs are extremely difficult to value because they are not limited to major points on the transmission grid. FTRs between two major hubs can be valued with a spread option model. However, many FTRs are not between major locations. For example, a power line running from a substation to an abandoned factory will still have locational marginal prices (LMPs) created at both the substation and the bus-bar. However, without power regularly being transferred over the power line, the price assigned to those locations might largely be a random number determined by flows in adjoining areas.

Because of this difficulty, many participants in the FTR market will mark-to-market their FTRs against the last reported auction price rather than using independent models. This provides a visible, independent source for data.

Renewable Energy Certificates

RECs are the most common way to trade renewable electricity. RECs allow their owners to claim that they have purchased renewable energy. They typically have value because regulators require certain market participants to purchase them or be faced with a penalty (sometimes called an alternative compliance payment). In other cases, there is a voluntary REC market, which allows consumers or businesses to claim that they are using renewable energy, usually for advertising purposes. REC markets primarily coexist with deregulated power markets. In regulated markets, the monopoly utility will typically meet its renewable requirements through PPAs with renewable generators.

In the United States, each REC represents proof that one megawatt-hour (MWH) of electricity was generated from an eligible renewable energy resource and fed into a power grid. After an REC is generated, it is traded and sold separately from electricity. RECs primarily exist as an electronic record. They are used because once electricity is placed on the power grid, it is impossible to differentiate renewable electricity from any other type of electricity.

RECs are largely created by government regulations. As a result, there are many different types of RECs—one for each type of regulation. For example, some RECs belong to a specific compliance program while others are voluntary. The name of the product, like a New Jersey solar renewable energy certificate (a NJ SREC), would indicate that this was a REC intended to meet solar energy requirements in New Jersey.

Environmental certificates and emissions allowance typically have no intrinsic value. They only have value because consumers want to purchase RECs. Consumers might wish to pay these costs directly through voluntary markets. Alternately, consumers can decide to indirectly purchase RECs by requiring that generators purchase them.

The dependence on regulation creates a great deal of uncertainty in the pricing of RECs. Typically, government regulations will specify a penalty payment if enough RECs are not purchased by a utility called an alternate compliance payment. When there is too little supply, prices quickly get bid up to the penalty price. As long as shortage conditions exist, prices will stay high. When there is too much supply, prices rapidly fall to zero. For example, if 10 million RECs have been created and utilities are only required to buy 2 million of them, the REC owners will bid prices close to zero to make a sale at any price.

Some features of RECs and similar environmental products are:

•   They have no inherent value.

•   Demand stems from a need to comply with regulations.

•   Prices are very sensitive to supply and demand.

•   They are only useful within a limited geographic area specific to the regulator.

In the United States, most RECs are the result of renewable portfolio standards that are adopted at the state level. Renewable portfolio standards, or RPSs, will typically define a certain amount of power that needs to come from renewable generation. They will also specify the conditions that generation facilities must meet to qualify as renewable power. Some common criteria used to define renewable power are location of the generator, technology for generation, and a generation date. For example, Ohio might establish a requirement that 10 percent of all consumer power be met from renewable power. It might further specify that at least half of that power needs to be from solar photovoltaic generation. It might also further require that half of that required generation—for both solar and nonsolar—come from facilities within the state. This will lead to four traded products: Ohio in-state solar REC, Ohio in-state nonsolar REC, Ohio out-of-state solar REC, and Ohio out-of-state nonsolar REC.

To produce RECs, generators need to register their production with a registry. When a renewable power is generated, a record of that generation is placed into the registry. The registry can cross-check with the power grid to audit that the generator has actually placed the correct quantity of power onto the power grid. When RECs are traded, transfer of ownership is accomplished by changing the owner of record electronically.

REC products are also quoted in terms of the year in which the REC was generated. This date, called a vintage, determines the window of time that an REC can be used to meet compliance requirements set out in the RPS. For example, an RPS may specify that RECs have to be used within three years of the date that they were generated.