RPS

Presented by

Dr.P. Somasundaram
Professor
Dept. of EEE, CEG
Anna University
UNIT I: INTRODUCTION
• Deregulation of power industry, unbundling of electric
utilities, Issues involved in deregulation – Fundamentals of
Economics: Consumer and suppliers behaviour, Total utility
and marginal utility, Law of diminishing marginal utility,
Elasticity of demand and supply curve, Market equilibrium,
Consumer and supplier surplus, Global welfare, Deadweight
loss - The Philosophy of Market Models: Monopoly model,
Single buyer model, Wholesale competition model, Retail
competition model, distinguishing features of electricity as a
commodity, pillars of market design- Market power.
• Reference:
https://nptel.ac.in/courses/108101005/
 Introduction
The vertically integrated utilities are being unbundled and
opened up for competition with private players. This enables
an end to the era of monopoly.
Control consisting of planning and operational tasks was
administered by a single entity or utility. The vertical
integration of all tasks gave rise to the term – vertically
integrated utility (Owns the Production, controls the
distribution, and is the retailer).
Operation of a single utility generating, transmitting and
distributing electrical energy in its area of operation -
monopoly utilities
The government would not let the private players enjoy the
monopoly and exploit the end consumer and hence
introduced regulation in the business. Thus, the power
industries of initial era became regulated monopoly utilities.
The structure of a conventional
vertically integrated utility is
shown in Figure. As evident
from the figure, there was only
a single utility with whom the
customer dealt with. Thus, only
two entities existed in the
power business: a monopolist
utility and the customer.
What does ‘regulation’ mean? The regulations are generally
imposed by the government or the government authority. These
essentially represent a set of rules or framework that the
government has imposed so as to run the system smoothly and
with discipline, without undue advantage to any particular entity
at the cost of end consumer.

Some of the characteristics of monopoly utility are:

•Single utility in one area of operation enjoying monopoly.
•Regulated Framework: The utility should work under the business
framework setup by the government.
•Universal Supply Obligation (USO): Utility should provide power to
all those customers who demand for it.
•Regulated Costs: The return on the utility's investments is
regulated by the government.

In a nutshell, regulation is about checking the prices of the

monopolist in the absence of private players and market forces.
 DE-REGULATION
• Vertically integrated – monopolized – not
efficient (service)
• Deregulation: Genco, Disco and Transco
• The main tasks of these three components will
remain the same as before, however, new
types of unbundling, coordination and rules are
to be established to guarantee competition and
non-discriminatory open access to all users.
 Electricity Deregulation
• Deregulation - “Process” of removing restrictions and
regulations to achieve competitive wholesale prices
without compromising capability, system reliability and
security

• Objective: To significantly reduce the cost of power charged

to consumers.

• Competition requires that no single firm or small group of

firms be able to dominate the market
 Reasons for restructuring
What is deregulation or restructuring?
Discontinuation of the framework provided by the
regulation.

Deregulation is about removing control over the prices with

introduction of market players in the sector.

‘Deregulation’ does not mean that the rules won’t exist.

The rules will still be there, however, a new framework
would be created to operate the power industry. That is
why the word ‘deregulation’ finds its substitutes like ‘re-
regulation’, ‘reforms’, ‘restructuring’, etc.
 DEREGULATION - Motivation
Reduce prices
Improve services
Promote innovation through competition
Increase efficiency
Foster customer choice
Promote transmission open access
Ensure competitiveness in generation
Monopoly status of the electric utilities did not provide any incentive for
its efficient operation.
Significant benefits of power industry deregulation would include:
•Electricity price will go down: It is a common understanding that the
competitive prices are lesser than the monopolist prices. The producer will
try to sell the power at its marginal cost, in a perfectly competitive
environment.
•Choice for customers: The customer will have choice for its retailer. The
retailers will compete not only on the price offered but also on the other
facilities provided to the customers. These could include better plans, better
reliability, better quality, etc.
•Customer-centric service: The retailers would provide better service than
what the monopolist would do.
•Innovation: The regulatory process and lack of competition gave electric
utilities no incentive to improve or to take risks on new ideas that might
increase the customer value. Under deregulated environment, the electric
utility will always try to innovate something for the betterment of service
and in turn save costs and maximize the profit.
Requirements: 100% Deregulation

Good operations, planning and market design

engineers

Sufficient supply and fuel diversity

Sufficient transmission infrastructure

Efficient demand side responsiveness and

management

Provision of right incentives and good price

signals
Requirements: 100% Deregulation [cont..]

Hedging (risk management) instruments

that enhance wholesale competitiveness

Environmental desires and electric power

needs trade-offs

Joint management
Understanding the restructuring process
 ENTITIES RESULTING FROM DE-REGULATION

SO

GENCO TRANSCO DISCO

SO is the Power System Operator and the Power Market Operator,

which may include other entities depending on the market
structure. SO, is independent of the other entities
 Various Entities Involved in Deregulation
Genco (Generating Company):
Genco is an owner-operator of one or more generators that
runs them and bids the power into the competitive
marketplace. Genco sells energy at its sites in the same
manner that a coal mining company might sell coal in bulk at
its mine.
Transco (Transmission Company): Transco moves power in
bulk quantities from where it is produced to where it is
consumed. The Transco owns and maintains the transmission
facilities, and may perform many of the management and
engineering functions required to ensure the smooth running
of the system. In some deregulated industries, the Transco
owns and maintains the transmission lines under the
monopoly, but does not operate them. That is done by
Independent System Operator (ISO). The Transco is paid for
the use of its lines.
Discom (Distribution Company): It is the owner-operator of
the local power delivery system, which delivers power to
individual businesses and homeowners. In some places, the
local distribution function is combined with retail function,
i.e. to buy wholesale electricity either through the spot
market or through direct contracts with Gencos and supply
electricity to the end use customers. In many other cases,
however, the Discom does not sell the power. It only owns
and operates the local distribution system, and obtains its
revenue by wheeling electric power through its network.

Resco (Retail Energy Service Company): It is the retailer of

electric power. Many of these will be the retail departments
of the former vertically integrated utilities. A Resco buys
power from Gencos and sells it directly to the consumers.
Resco does not own any electricity network physical assets.
Market Operator: Market operator provides a platform for
the buyers and sellers to sell and buy the electricity. It runs a
computer program that matches bids and offers of sellers and
buyers. The market settlement process is the responsibility of
the market operator. The market operator typically runs a
day-ahead market. The near-real-time market, if any, is
administered by the system operator.

Customers: A customer is an entity, consuming electricity. In

a completely deregulated market where retail sector is also
open for competition, the end customer has several options
for buying electricity. It may choose to buy electricity from
the spot market by bidding for purchase, or may buy directly
from a Genco or even from the local retailing service
company. On the other hand, in the markets where
competition exists only at the wholesale level, only the large
customers have privilege of choosing their supplier.
System Operator (SO): The SO is an entity entrusted
with the responsibility of ensuring the reliability and
security of the entire system. It is an independent
authority and does not participate in the electricity
market trades. It usually does not own generating
resources, except for some reserve capacity in certain
cases. In order to maintain the system security and
reliability, the SO procures various services such as
supply of emergency reserves, or reactive power from
other entities in the system. In some countries, SO also
owns the transmission network. The SO in these
systems is generally called as Transmission System
Operator (TSO). In the case of a SO being completely
neutral of every other activity except coordinate,
control and monitor the system, it is generally called as
Independent System Operator (ISO).
 Understanding the restructuring process

Electricity, as a commodity, can not be compared

with any other commodity traded in the market.

Two important features of electricity as a

commodity are: need for real time balance and
inability to wheel the commodity through desired
path (in bulk). Hence, a set of principles laid down
by standard micro-economic theory can not be
mapped directly to the electricity commodity
markets.
Tackling network congestion is one of the challenging issues of the
deregulated era. Transmission network provides the path through which
transactions are made in a power market. But each transmission network
has its own physical and operating limits like line flow limits, bus voltage
magnitude limits and more. The power injection and withdrawal
configuration should be such that no limit gets violated. If the network is
operated beyond these limits, it may, even, result in the entire system
blackout. This has given rise to a new problem under the restructured
power system environment, referred to as congestion management.

When some components in a power network appear to be overloaded due

to a trading arrangement, that particular arrangement is said to create
congestion on the network. The purpose of congestion management is to
make necessary corrections in order to relieve congestion. It can be easily
appreciated that under the vertically integrated structure, network
congestion, in fact, is not a challenging task. This is because all the
resources in the system are under the direct control of the monopolist.
Thus, this is the sole responsibility of the monopolist to maintain its
transmission network.
 Ancillary Services
Provision of ancillary services is another tough task carried out by the
system operator under the deregulated framework. Ancillary services are
defined as all those activities on the interconnected grid that are necessary
to support the transmission of power while maintaining reliable operation
and ensuring the required degree of quality and safety.

Under the deregulated power system environment, the system operator

acquires a central coordination role and carries out the important
responsibility of providing for system reliability and security. It manages
system operations like scheduling and operating the transmission related
services. The SO also has to ensure a required degree of quality and safety
and provide corrective measures under contingent conditions. In this
respect, certain services, such as scheduling and dispatch, frequency
regulation, voltage control, generation reserves, etc. are required by the
power system, apart from basic energy and power delivery services. Such
services are commonly referred to as ancillary services. In deregulated
power systems, transmission networks are available for third party access
to allow power wheeling. In such an environment, the ancillary services are
no longer treated as an integral part of the electric supply. They are
unbundled and priced separately and system operators may have to
purchase ancillary services from ancillary service providers.
Market design and market power - need regulatory
intervention.
Market design: choice made in the selection of dispatch
philosophies, choice of various pricing schemes, choice
between number of markets with multiple gate
closures, etc., from various alternatives. The market
architecture, which maps various markets on timeline,
is also an important sub-topic of market design process.
Market power: Deviation from the perfect competition.
In general, market power is referred to as ability of
market participants to profitably maintain the market
price above or below the competitive level for a
significant period of time. To tackle the situation, an
indirect regulatory intervention in the form of market
design rules is needed.
Deregulation of various power systems across the
world

Well developed, industrialized countries can expect

price to go down and these countries can treat the
change in the prices as betterment.

The developing countries need to make radical

changes in the policy and regulation such that
barrier to entry for private players is removed. The
effective betterment can be looked upon from this
perspective for developing countries.
 USA
Deregulation took place in developed countries by
pressure to reduce costs while simultaneously
increasing competitiveness in the market.

Existence of market power shows the signs of

deviation from the prefect competition. In general,
market power is referred to as ability of market
participants to profitably maintain the market price
above or below the competitive level for a
significant period of time.
• A regional transmission organization (RTO) in
the United States is an electric power transmission
system operator (TSO) that coordinates, controls, and
monitors a multi-state electric grid. The transfer of
electricity between states is considered interstate
commerce, and electric grids spanning multiple states
are therefore regulated by the Federal Energy
Regulatory Commission (FERC). The voluntary creation
of RTOs was initiated by FERC Order No. 2000, issued
on December 20, 1999. The purpose of the RTO is to
promote economic efficiency, reliability, and non-
discriminatory practices while reducing government
oversight.
• An independent system operator (ISO) is similarly an
organization formed at the recommendation of FERC. In
the areas where an ISO is established, it coordinates,
controls, and monitors the operation of the electrical
power system, usually within a single US state, but
sometimes encompassing multiple states. RTOs
typically perform the same functions as ISOs but cover
a larger geographic area.
There are currently seven ISOs within North America:
• CAISO - California ISO
• NYISO - New York ISO
• Electric Reliability Council of Texas (ERCOT); also a
Regional Reliability Council
• Midcontinent Independent System Operator -
Midcontinent ISO - one of the world's largest real-
time energy markets
• ISO-NE - ISO New England
• AESO - Alberta Electric System Operator
• Independent Electricity System Operator (IESO);
operates the Hydro One (electricity transmission and
distribution utility serving the Canadian province of Ontario)
transmission grid for Ontario, Canada
 Regional transmission organizations (RTOs)
• An entity that is independent from all generation and power
marketing interests and has exclusive responsibility for grid
operations, short-term reliability, and transmission service within a
region.
• Characteristics
1. Independence – an RTO should be independent from its market
participants in financial interests, decision-making, and tariff-
setting.
2. Scope and regional configuration – the region for an RTO should
be chosen to achieve the necessary regulatory, reliability,
operational, and competitive benefits.
3. Operational authority – an RTO must have the authority to
control its transmission facilities (e.g. switching elements in and out
of service, monitoring and controlling voltage) and must be the
security coordinator for its region.
 Characteristics [cont..]
4. Short-term reliability – an RTO must ensure the region meets the
NERC (North American Electric Reliability Corporation) reliability
standards or alert FERC (Federal Energy Regulatory Commission) if
it does not.

• Functions of RTO
1. Tariff administration and design – in order to ensure non-
discriminatory transmission service, an RTO must be the sole
provider of transmission service and sole administrator of its own
open access tariff.
2. Congestion management – an RTO must ensure the
development and operation of market mechanisms to manage
transmission congestion.
3. Parallel path flow – an RTO must develop and implement
procedures to address parallel path flow issues within its region
and with other regions.
Functions [cont..]
4. Ancillary services – an RTO must serve as the supplier of last
resort for all ancillary services and determine if the minimum
amount of ancillary services have been supplied according to
FERC Order.
5. OASIS and Total Transmission Capability (TTC) and Available
Transmission Capability (ATC) – an RTO must be the single OASIS
site administrator for all transmission facilities under its control
and independently calculate TTC and ATC.
6. Market monitoring – an RTO must monitor market behavior
and report market power abuses and market design flaws to
FERC.
7. Planning and expansion – an RTO must have ultimate
responsibility for both transmission planning and expansion
within its region that will enable it to provide efficient, reliable
and non-discriminatory service.
8. Interregional coordination – an RTO must coordinate its
activities with other regions.
 UK
The transformation of the British power sector proceeded along three paths in
1990. First, the traditional industry was unbundled both vertically and horizontally.
High-voltage transmission assets were transferred to a new National Grid Company
(NGC). Coal and oil fired units were divided among two companies National Power
and PowerGen. Nuclear Electric retained control of all nuclear units. At the outset,
National Power had 52 percent of total generating capacity, PowerGen had 33
percent, and Nuclear Power had the remaining 15 percent. The second set of
changes involved ownership. Both National Power and PowerGen became private
companies in 1991, whereas the difficulties associated with nuclear power resulted
in continued government ownership of all nuclear units. Approximately 30 percent
of shares in National Power and PowerGen were sold to the public, an equal
amount to foreign and institutional investors. The remaining 40 percent was held
by the government until 1995. The third set of changes sought to open the system
to competition, wherever possible, while continuing necessary regulations. Vertical
and horizontal restructuring of power generation was based on the assumption
that generation had become workably competitive and would become increasingly
so with new market entrants.

A report on reform process was floated by the regulator in 2001 which stated that
wholesale electricity prices had not fallen in line with reductions in generators’
input costs and that a lack of supply side pressure and demand side participation;
and inflexible governance arrangements had prevented reform of the
arrangements.
 The Nordic Pool – Norway, Sweden, Finland, and Denmark

The reforms in Nordic countries were inspired by the

electricity market reforms in England and Wales in 1989, as
well as by widely held beliefs that increased competition
would raise power industry efficiency to the benefit of
consumers. Norway was first amongst the Nordic countries to
liberalize its electricity market in 1991, but without
privatization. The Norwegian electricity sector remains almost
entirely in public hands. Rather than implement national
reforms, the other Nordic countries chose to reform by
merging with the existing Norwegian market, Sweden joining
the expanded Nordic pool in 1996, Finland in 1998 and
Denmark in 1999.
 The Developing Countries
The case of developing countries is different from that of
other countries. In these countries, the electricity supply is
treated as a social service rather than a market commodity.
The ownership of the power sector in these countries is
directly under the governments of respective countries. These
state owned-controlled systems have led to the promotion of
inefficient practices over a period. The power sectors of these
countries are marked by supply shortages. There has been an
inability to add to the generating capacity. The subsidies and
high transmission and distribution losses are the major
concerns before these systems. Another consequence of
state control over electric utilities was the high level of
overstaffing. The inability to raise funds for capacity addition
invited financial support from international financial
institutions like World Bank. These institutions mandated
opening of the power sector for private companies which
were contracted under build, own, operate and transfer
(BOOT) scheme.
 Fundamentals of Economics
The commodity market started with the barter system and eventually
developed to the era of electronic trading systems. In simple words, a
market is defined as a meeting place for buyers and sellers to strike a
deal. The technological advances have progressed to such an extent that
now-a-days, a deal for a commodity can be struck with a click of a
mouse. This is the concept of a virtual market place that has the potential
of eliminating a physical market place.

Microeconomics is the branch of economics that deals with how

households or firms make decisions and how they interact in the markets.
The restructured power systems treat electric energy as a commodity
rather than a service as in vertically integrated systems. As in the case of
any other commodity, the behavior of consumer and suppliers in
electricity markets are analyzed using the concepts of microeconomics.
• Modeling consumer behavior & Supplier behavior
• Establish equilibrium at the marketplace.
 Consumer Behaviour
It is a common practice to explain concepts of
microeconomics using common consumer goods as an
example. However, we will explain it by considering
number of units of electrical energy as a commodity.

Total utility and marginal utility

Consumer achieves some satisfaction from consuming
a product, electric energy in this case. If this satisfaction
is absent, the consumer would not demand it at all.
This term is called total utility. Similarly, marginal utility
is the utility obtained from the last unit consumed.
Let there be a square shaped room as shown in Figure.
Small circles in the figure represent incandescent lamps
located at the same height from the ground, as a source of
light for the whole room. Suppose there are nine lamps in
all, fitted in the room as per the plan shown in the figure.
Let us assume that all lamps are of the same rating and
illuminance.
Law of Diminishing Marginal Utility:

The above pattern of marginal utility provided by

sequence of putting bulbs on is called as law of
diminishing marginal utility. It states that after
consuming a certain amount of a good or service,
the marginal utility from it diminishes as more and
more is consumed. This law is quite natural and
should hold for most of the products one consumes.
Consumer Surplus
The net consumer surplus represents the extra
value that the person in the room is able to get
from being able to buy all the electric energy at INR
4, even though the value he attaches to electric
energy is higher than the price of electricity.
Consumer Equilibrium
The word equilibrium used in generic terms means
the position of balance. In the above example, the
person in the room will stop or rest or attain
equilibrium after lighting 6th or 7th lamp on. In
other words, the shaded area in Figure representing
net consumer surplus is maximized at equilibrium.
In general, we can then say that consumer's
equilibrium with respect to the purchase of one
good is attained when the difference between total
utility in terms of money and the total expenditure
on it is maximized.
Market Demand Curve
It is unlikely that all the persons entering the dark room will
feel the same marginal utility with each of the lamps. If we
aggregate the individual demand curves of sufficiently large
number of consumers, the discontinuities will be
smoothened and will give a market demand curve or the
demand function.
Demand Elasticity
The downward sloping demand curve can be seen from a
different perspective. It emphasizes that a small increase in
the price of a commodity will decrease its demand. The rate
of change of the demand curve with respect to price would
surely quantify the change. However, to make the changes
comparable, the percentage changes rather than absolute
changes are computed. Thus, the price elasticity of demand
becomes the ratio of relative change in demand to the
relative change in price.

Where ε depicts elasticity, π price and q, the quantity.

Various cases of demand elasticity
Supplier Behaviour
Law of Diminishing Marginal Product:
This law establishes the input-output relationship for the
producer in short-run.
Supply Function
Suppose, the total commodity output is called as y. Let
us assume that there is only one factor of production,
‘x'. Thus, the production function is given as
y = f(x)
For almost all goods and technologies, the production y
increases with x at the beginning. But as cheaper
resources start depleting, costlier resources are
employed for production and for the same quantity of
production, the cost starts increasing. In other words,
the rate of increase of y decreases as x gets larger.
The inverse of production function will be:
x = g(y)
This function indicates how much of the variable production factor is
required to produce a specified amount of commodity. If unit cost of
factor of production x is w, then, the cost function is given as:
cost (y)= w. g(y)
The convexity of the function is due to law of diminishing marginal
product.
Supply functions: Suppose there are many suppliers and they
make use of different technologies and fuels to produce electric
energy. Thereby, these producers will have different marginal costs
and will have different power producing quantities at different price
levels. If the amount supplied by a large number of producers is
aggregated, a smooth and upward sloping curve is obtained as shown
in Figure. This is typically known as supply curve.
 Suppliers' surplus
The supplier whose opportunity cost is equal to the market
price is called as marginal producer. The marginal producer
neither accrues any profit nor loss. The infra-marginal
producers accrue profit while the extra-marginal producers
would find it worthwhile to sell the commodity only in case
market price increases.
Supplier's Equilibrium:
At what level should the supplier stop producing that
commodity?
To answer this question, let us explain what is meant by
opportunity cost. The supplier has a threshold price in mind
below which it will not sell its commodity. There are two
reasons for deciding this threshold price. First of course is
that the total revenue will be less than total cost of producing
that commodity. Second and important reason could be that
the supplier could make use of same resources required to
produce the commodity under consideration to produce
some other commodity that would fetch more money. In that
case, the revenue from the sale of the commodity under
consideration will be less than the opportunity cost
associated with the production of the same. In other words,
the supplier will sell the commodity at a price at which the
opportunity cost of production is equal or lesser.
 Supply Elasticity:
An increase in the price of a commodity encourages
suppliers to make larger quantities of this commodity
available. The price elasticity of supply quantifies this
relation. The supply elasticity can be defined in a similar
fashion to the demand elasticity. Only difference is to
replace supply curve by demand curve.
 Market Equilibrium
A perfectly competitive market has many attributes,
the most important being that a single player is not
able to change the market price. Similarly, under
perfect competition case, all market buyers buy at
the same market clearing price. The market
equilibrium is achieved at a price called market
clearing price such that the quantity that the
suppliers are willing to sell is equal to quantity that
the consumers wish to obtain. In other words,
market equilibrium is a state of zero excess demand
and zero excess supply.
The equilibrium situation in a competitive market is said to
be Pareto efficient. An economic situation is Pareto efficient
if the benefit derived by any of the parties can be increased
only be decreasing benefit enjoyed by one of the other
parties.
Global Welfare: Global welfare is the sum of net consumer
surplus and net producer surplus. It is the quantification of
the overall benefit that arises from trading. Global welfare
is maximized when market is settled at the intersection of
supply and demand curves. The global welfare is also
termed as social welfare and social surplus.
Global welfare is explained with the help of Figure..
In this figure, sum of the areas DS1, DS2 and DW2
represents the consumer surplus while sum of areas
SS1, SS2 and DW1 represents the producer surplus.
The total area consisting of areas DS1, DS2, SS1,
SS2, DW1 and DW2 represents the global welfare. It
is clear from the figure that if the price is set to any
infra-marginal value rather than the equilibrium
price, there is a reduction in the global welfare.
Deadweight loss: What happens when the price is forcefully
set at some value other than the equilibrium price? It leads to
reduction in global welfare and creation of deadweight loss.
Suppose the price is set at π2 due to some intervention by
say, the government, as shown in Figure. In this case, the
consumers reduce their consumption from q* to q. The
consumer surplus then becomes equal to area DS1, while
producers' surplus is the sum of areas DS2, SS1 and SS2.
Similarly, if price is set at π1 , the suppliers reduce their
production to q from q*. The net consumer surplus is the sum
of areas DS1, DS2 and SS2, while producers' surplus is area
SS1. Thus, these interventions while setting price have
undesirable effect of reducing the global welfare by an
amount equal to the sum of areas DW1 and DW2. The
amount equivalent to this area is called as the deadweight
loss. In general, regulated tariff is the major source of
deadweight loss. From electric market point of view, the
network constraints can be a major source of creation of
deadweight loss.
 SHORT-RUN AND LONG-RUN COST
The output is a function of many factors of production
y=f(x1,x1..............xn)
However, all the production factors do not affect the output in
the same way. Some factors make immediate changes while
others take long time to be effective. In other words, some
factors affect the production in the short-run while the others
do so in the long-run. There is no clear-cut distinction about the
time horizon which divides the production factors between
short-run and long-run. In short-run, some of the production
factors are fixed. Long-run window provides the time span
sufficient enough for various factors to be adjusted. To provide
an analogy, a reactive power support by means of a capacitor
bank can be termed as a short-run factor as compared to the
construction of an entirely new parallel circuit for increasing
capacity of a heavily loaded transmission corridor.
In the short-run, the output often depends on a single
production factor while the rest of the factors are
considered to be fixed.
The short-run behavior of a commodity producing firm in a
perfectly competitive market can be explained as follows.
In this type of market, the only option left to the firm is to
maximize its profit is by adjusting its output, as it can not
influence the market price. This can be posed as follows:

Optimum will be achieved when

Thus, to maximize its profit, the firm will raise its
production up to that level at which the marginal
cost is equal to the market price.
In the long-run, the firm will have more degrees of
freedom to work with. Thus, defining a long-run
cost function is a complex task. It should be noted
that the long-run cost function (Cost LR) is the
solution of an optimization problem.

Such that
y = f(x1,x2,........xn)
wi is the unit cost of production of factor xi.
It is worthwhile to note that in general, the
decisions about power system operation are short-
run, while those associated with planning are the
long-run solutions. For example, optimal scheduling
of generation requires generation costs to be
known. These costs are short-run costs that assume
the plant size and the network capacity to be fixed.
 VARIOUS COSTS OF PRODUCTION
For a certain fixed maximum capacity of a plant, the
cost of land and associated machinery does not
depend on the output of the plant. On the other
hand, the quantity of fuel consumed by this plant
depends on the output. Thus, the cost of fuel is a
variable cost. The cost function for a generating
plant can be defined as function of level of MW
output. It can be given as follows:
The average cost is defined as the cost per MW
output of a plant. It is the sum of average fixed cost
and average variable cost. Thus, the average cost is
given as:
RELATIONSHIP BETWEEN LONG RUN AND SHORT
RUN AVERAGE COSTS
 PERFECTLY COMPETITIVE MARKET
A perfectly competitive market, in brief terms, can be explained as
a market form in which no consumer or producer can influence the
market price. Perfect competition has a market equilibrium which
is Pareto efficient. The defining characteristics of a perfectly
competitive market can be given as follows:
Atomicity : An atomic market is the one in which there are a large
number of small producers and consumers. They are so small that
individual actions have no significant impact on others. Firms
are price takers.
Complete information : All consumers and sellers know the prices
set by all firms.
Homogeneity : All firms sell an identical product.
Free entry : No firm has barrier for entry into or exit out of market.
Uniform price: Each firm charges the same price in the market.
In addition to this, there are obvious behavioral
assumptions such that the consumers try to
maximize utility while suppliers try to maximize
profit.

Markets for agricultural products with sufficiently

large number of suppliers and consumers can be
assumed to be a perfectly competitive market. On
the other hand, the electricity markets seldom
exhibit prefect competition due to less number of
dominant players.
 Philosophy of Market Models
Various market models for trading of
electricity and the need for designing the same
•What are the possible ways in which buyers and sellers can
trade electrical energy?
•Which section of consumers has a choice of selecting their
energy provider?
•What are the peculiarities of electricity that make market
arrangements of this commodity different from other
commodities? – already discussed
•What is the role and involvement of system operator in
the market decisions?
 MARKET MODELS BASED ON CONTRACTUAL ARRANGEMENTS

Unbundling of the conventional vertically integrated power system creates

groups of various commercial and technical activities. Since one of the major
aims of deregulation is introduction of competition, it is worthwhile to explore
every avenue where competition can be introduced. Eventually, competition
provides a choice for entities to choose another entity or a group of entities to
do a profitable transaction.

In electricity parlance, either the load or an entity representing a group of loads

gets a choice to select its energy provider, or there may exist some mechanism
which would cater to the electrical energy needs of these loads at a
competitive level. The former mechanism essentially requires bilateral
involvement of the entities who wish to get into a power buy and sell contract.
In this, the sellers and buyers mutually agree upon the terms and conditions,
including the price and time of delivery. A repetitive bilateral interaction
between buyers and sellers may lead to an equilibrium point where everyone is
happy. Alternatively, a similar result would be obtained if a common exchange
for the commodity is set up, where, buyers and sellers, instead of interacting
with each other, communicate their expectations to this marketplace. This
represents a simultaneous market clearing process and a common market price
of electrical commodity.
While moving from a vertically integrated structure to a competitive one,
various policy and structural issues crop up. One of the important concerns
is regarding the entity that should be allowed to take part in competitive
activity. Similarly, issue of rearrangement of various elements of power
system, when a new set of rules is introduced to buy and sell power, also
needs to be addressed. It is obvious that the commercial arrangements and
virtual boundaries between various functional entities can take many
shapes and forms. Consequently, various models can be classified according
to the levels at which the entities are given the choice of buying or selling
electricity. Various trading models can be proposed based on the above
discussion. The choice of choosing a model is a policy decision and is
dominated by various prevailing conditions. They need to be accounted for
before making structural changes.
Four basic models of industry structure are suggested. These are:
1. Monopoly model
2. Single buyer model
3. Wholesale competition model
4. Retail competition model
Every model needs different amount of structural change and
rearrangements of functions in the industry.
1. Monopoly model – Vertically integrated
 2. Single buyer model
Competition in the wholesale sector, i.e., generation.
Here, the single buyer agency buys power from Independent
Power Producers (IPPs) in addition to its own generation. The
power purchasing agency in turn sells it to state distribution
utilities or distribution companies in the service area. All
power generated by generating companies (Gencos) must be
sold only to a purchasing agency and not to any other agency.
Distribution companies (Discoms) are only able to purchase
from the single buyer agency. They do not have a choice of
choosing their power supplier. In this model, sales from
power pool to retailers take place at a pre-set tariff price. The
single buyer or the existing utility makes a long term contract
with IPPs. A contract is necessary because, without it, a
generator would be reluctant to invest large amounts of
capital in a generating plant. The contracts are generally of
life-of-plant type, indicating sale of all capacity of generating
units for its lifetime.
Figure shows another version of this model, which has further
evolved from the original single buyer model. In this model, the single
buyer does not own any generation and buys all the power from IPPs.
The distribution and retail activities are also disaggregated. This
model has an advantage of introducing some competition between
generators without the expense of setting up a competitive market.
The tariff set by the purchasing agency must be
regulated because it has monopoly over the Discos
while monopsony(single buyer) over the IPPs. The
single buyer model is looked upon as a way of
attracting private participation in the generation sector,
especially in the developing countries. In this model,
transmission and distribution network can be owned
and operated by State and Regional transmission
utilities. Inter-state tie line should be sufficient to
maintain a loose regional power pool.
Merits:
1. Private participation in power generation.
2. Introduction of some competition without expensive
set up for a competitive market.
Demerits:
•Long term contracts. Setting up a contract is
problematic.
•No true competition.
•Price is not decided by demand-supply interaction.
•End consumers' price is regulated .
3. Wholesale Competition Model
This model is one step closer towards competition.
There is an organized market in which the
generators can sell their energy at competitive
rates. The market may be organized either by a
separate entity or may be run by the system
operator itself. There is not much choice for the end
user. The end user is still affiliated to the Discom or
retailer working in that geographical area of
operation. The large customers or the bulk
customers, so to say, are privileged to choose their
energy provider. However, the definition of bulk
customer is a subjective matter and changes from
system to system.
This model, provides the choice of supplier to Discoms, along
with competition in generation. Implementation of this model
requires open access to the transmission network. Also, a
wholesale spot market needs to be developed. Since this
model permits open access to the transmission wires, it gives
the IPPs to choose an alternative buyer. Discoms can
purchase energy for their customers either from a wholesale
market or through long term contracts with generators. The
customers within a service area still have no choice of
supplier. They will be served by a Discom in their area. With
this model, the Discoms are under Universal Service
Obligation (USO), as they have monopoly over the customers.
They own and operate the distribution wires. The
transmission network is owned and maintained either by
government and/or private transmission companies. System
operators manage the centrally accomplished task of
operation and control.
This model provides a competitive environment for generators
because the wholesale price is determined by the interaction
between supply and demand. In contrast, the retail price of electrical
energy remains regulated because the small consumers still do not
have a choice for their supplier. The distribution companies are then
exposed to vagaries of the wholesale price of the commodity.

Merits:
•Choice of seller provided for Discoms and bulk consumers.
•The buyers and sellers can make forward contracts or buy from a
wholesale marketplace.
•The price is decided by interaction between demand and supply. Hence,
indicates truly competitive price.
Demerits:
•The end consumer still doesn't have a choice. It buys power from the
affiliated Discom.
•Rates for end consumers are regulated rather than competitive.
•Discoms face competition at wholesale level, while their returns are
regulated.
•Structural and institutional changes required at wholesale level.
 4. Retail Competition Model
In this model, all customers have access to competing
generators either directly or through their choice of retailer.
This would have complete separation of both generation and
retailing from the transport business at both transmission and
distribution levels. Both, transmission and distribution wires
provide open access in this model. There would also be free
entry for retailers. In this model, retailing is a function that
does not require the ownership of distribution wires,
although, the owner of distribution wires can also compete as
a retailer. This model is a multi-buyer, multi-seller model and
the power pool in this model acts like an auctioneer. It
behaves like a single transporter, moving power to facilitate
bilateral trading and this is achieved through an integrated
network of wires. In this pooling arrangement, there is a
provision for bidding into a spot market to facilitate merit
order dispatch. The pool matches the supply and demand and
determines the spot price for each hour of the day. It collects
money from purchasers and distributes it to producers.
The advantage of this model over monopoly utilities is that
competition is introduced in both wholesale and retail areas
of the system. This model is supposed to be a truly
deregulated power market model. The retail price is no
longer regulated because small consumers can change their
retailer for better price options. This model is economically
efficient as the price is set by interaction of demand and
supply. In wholesale competition model, with relatively few
customers, all of them regulated Discoms, a spot market can
be preferable but not essential. However, in retail
competition model, spot markets become essential, since
contractual arrangements between customers and producers
are carried out over a network owned by a third party. In
retail competition model, metering becomes a major
problem. If the number of customers are increasing and
metering capability for all the customers is not sufficient, it
may create logistical problem and provoke disputes.
Merits:
•Supposed to be 100% deregulated model.
•Every consumer has a choice of buying power.
•The price is decided by interaction of demand and
supply. Hence, it is truly competitive price.
•There is no regulation in energy pricing.
Demerits:
•Need constitutional and structural changes at both,
wholesale and retail level.
•Extremely complex settlement system due to large
number of participants.
•Requirement of additional infrastructural support.
Comparison of Various Market Mode
 ELECTRICITY VIS-A-VIS OTHER COMMODITIES
The classification of market models based on contractual
agreements can be applied to most of the commodities that are
traded in the market, if we assume a certain level of abstraction by
presenting only the buyers and sellers. However, when it comes to
‘electricity' as a commodity, the same laws of economics or
commercial trade arrangements may not hold good. This is
because, electricity as a commodity bears different characteristics
from other commodities, or rather, electricity is physically
different from other commodities. This fact complicates the
procedure of electricity trading. In other words, the trade is not as
simple as an interaction between two entities: buyer and seller.
The interdependencies of actions taken by various participants
(primarily generators and loads), mandate somebody to takeover
the control of real time activities. This somebody is the system
operator, who makes sure that the whole system runs reliably and
thus kept in synchronism. Thus, it is worthwhile to understand the
distinguishing features of electricity as a commodity.
Distinguishing Features of Electricity as a Commodity:
There are three basic distinguishing features of electricity: Imbalance, congestion
management & ancillary services. These are associated with electricity due to its
physical nature. These three basic features effectively lead to one distinguishing
feature of this commodity, the one that has commercial implications.

1. Real Time Demand Supply Balance: Electricity can not be stored in bulk.
Other commodities can be manufactured and kept in a warehouse until the demand for the
same is sensed. A manufacturer of other commodities gets sufficient flexibility in planning
the manufacturing activity and coordinating the dispatch. The same is not true for electricity.
The demand for electricity needs to be satisfied on real time basis. The parties involved in
electricity trade perhaps would like to do it through forward contracts. These can be
contracts for physical delivery or financial in nature. In many power markets, bulk trade of
electricity (> 80%) is done through forward contracts. Forward contracts can be done years
ahead. When a certain amount of electricity is bought in the forward contract, it is the
estimate of the buyer, how much it is likely to consume during actual delivery time.
However, in real time, the actual consumption may not match the predicted consumption
that had been forecasted at the time of doing forward trade. This difference is called as
imbalance. Knowledge about this imbalance is exposed only during real time operation or
slightly before that. In this case, the system operator or some other market mechanism
stands ready to make up the imbalances (either on positive or negative side).
Due to storage limitation, the supply-demand matching decision needs to be done
on a competitive basis by letting supply and demand interact with each other. The
operator buys and sells these imbalances through some commercial mechanism.
Due to this feature of electricity, an issue related to the speed of operation pitches
in. The system operator, while making a provision for imbalances, has to take into
consideration various network interdependencies. The system operator always has
to communicate with the active participants to tell them which generators should
increase their output and which ones should decrease it. This activity is called
scheduling in advance and dispatch in real time. Since the system operator has to
work with seconds to spare, a delivery system to make up for imbalances has to be
in place. In real time, the only time available with system operator is what is
allowed by the energy stored in rotating masses of huge interconnected grid.

Thus, this exceptional feature of electricity leads to two issues related to power
market design: Imbalances, and Scheduling and Dispatch. The question is how
these difficult tasks get reflected in the rules of marketplaces.
 2. Power Flows Obey Laws of Physics
The electric power can not be told as to where and how it
should travel, once the injection and take-off points are
decided. The electric power flow over transmission lines obey
laws of physics. Effectively, electric power can not be stopped
from flowing on a transmission line that is already hitting its
power carrying capacity. The system operator has to ensure
that none of the lines get overloaded. To do this, only
freedom left with it is the selection of pattern of nodal
injections (either generation or load). Thus, any arbitrary set
of forward contracts can not be scheduled by the system
operator as this may lead to exceeding of limits of physical
parameters of some of the power system elements. Allowing
only the practically feasible set of transactions during
scheduling and further making corrections while dispatching
so as to keep line loadings within limits is usually termed as
congestion management.
The concept of network congestion is shown by a simple
lossless system in Figure. In this, generator A is a cheaper
generator than generator B and hence, it gets a contract of
satisfying the demand of load at bus 3 by generating 18 MW.
The power flow over all lines would be dictated by the
reactance of parallel paths. In this case, let us assume that
reactance of all three lines are same. Thus, two parallel paths
are provided so as to transfer power of generator A to load at
bus 3, with ratio of reactance 2:1. Obviously, the power will
flow in opposite ratio on these paths.

However, if the physical properties of the line connecting

nodes 1 and 2 state that it can carry only 3 MW, then the
dispatch shown in left hand side is not practically feasible. To
correct it, generator B is asked to generate 4.5 MW and
generator A is asked to step down by 4.5 MW, leading to
dispatch shown in right hand side. This rearrangement of
nodal injections is one of the means of congestion
management, which is peculiar to electricity.
 3. Generator Product Compatibility and Interactions

To ensure reliable delivery of electricity, only generation by

generators at injection points and take-off by loads at take-
off points is not sufficient. The system operator must make
arrangements for provision of allied services necessary to
do this. These allied services are usually referred to as the
ancillary services. Provision of reactive power, operating
reserves are some of the commonly required ancillary
services. Mostly, ancillary services are provided by
generators. In this case, one is likely to witness the
interdependencies involved in providing these services. In
other words, the production of ancillary services is also
dependent on production of energy. Then, the same
generator is said to be providing two different products:
energy and ancillary services.
This complicates the matter because the single generator can be
simultaneously needed to produce multiple outputs, or to produce
ancillary service rather than energy. This complication is shown in
Figure, where, a generator's capacity is divided into various products.
The defining question is how much of capacity should be allocated to
each product? In centralized markets, the system operator does a
joint optimization, taking into account various technical and
commercial parameters of a generator to allocate it's full capacity to
each of the products.
 Unusual Price Variation
The combined effect of various peculiarities of electricity is that it has
large temporal variation in its price. It is not prudent to run all
generators throughout the day. Rather, the most economical generators
can be run throughout the day. Effectively, the price of electricity will be
low during low demand period. However, during peak demand situation,
the costly generators are brought on-line and the price of electricity
goes high. Thus, marginal cost of producing energy will vary throughout
the day. Such rapid cyclic variations in the price of a commodity are
unusual, and arise due to peculiarities associated with electricity,
basically, the characteristic of matching supply and demand on real time
basis. It should be noted that this peculiarity of electricity has arrived
because of one of the basic physical properties associated with it.
 Four Pillars of Market Design

Design issues arising out of characteristics of

electricity as pillars of market design. These are:
• Imbalance
• Scheduling and Dispatch
• Congestion Management
• Ancillary Services
Four pillars
 MARKET ARCHITECTURE
Market architecture: map of its component submarkets.

This map includes the type of each market and the linkage between them.
Where does this concept of multiple markets come from? The answer can
be traced back to various peculiarities associated with electricity. Four
pillars of market design tend to cast the same electric energy into various
products, which are characterized by separate individual markets.
Moreover, there are various modes of energy contracts depending upon
when energy trades are done. This again gives rise to market mechanisms
based on timeline of trading.
The submarkets of a power market include the wholesale spot market,
wholesale forward markets and markets for ancillary services. Somewhere
in between is embedded the market for transmission capacity. This can be a
separate market altogether or can be integrated with the energy market
that takes place near real time. Similar is the case with ancillary service
market. The best way to categorize alternative trading models is on the
degree to which operational arrangements and commercial arrangements
for scheduling, imbalances, congestion and ancillary services are integrated
with spot markets.

Two models are most common: integrated or centralized and decentralized.

 Timeline for Various Energy Markets
There are many ways
depending on the time
of hand-shaking, where
buyers and sellers can
do the transaction.
Figure shows various
modes of trading based
on the time-line.

Seller buyer interaction based on timeline

 Timeline for Various Energy Markets

Following are the common modes in which the

electric energy can be traded:

1. Bilateral contracts
2. Spot market
a. Day ahead markets (Power Exchange or
through pool)
b. Real time market (through pool)
Trading for power delivered in any particular minute
begins years in advance and continues until real
time, the actual time at which the power flows out
of a generator and into a load. This is accomplished
by a sequence of overlapping markets. The earliest
amongst these are forward markets that trade non-
standard, long term, bilateral contracts. This
generally represents energy trading between buyers
and sellers directly for the mutually agreed price.
This type of trading stops about one day prior to
real time. At that point, the day-ahead market is
held. The day-ahead market is often followed by a
real-time market.
Forward and spot markets is differentiated by considering day-ahead
and real-time markets as spot markets, while all trades taking place
before that are termed as forward or bilateral trades. This
segregation emerges because both, the day-ahead as well as real-
time markets provide a system price which holds for all the market
trades done through it. On the other hand, in bilateral or forward
trades, there is no single market price as such. In the rest of the
module, we prefer to define the spot market as defined just above.

In general, real time transactions require central coordination, while

week-ahead trades do not require the same. Somewhere in between
are dividing lines that describe the system operator's diminishing role
in forward markets. Where to draw those lines is the central
controversy of power market design. A larger role for the system
operator implies a smaller role for private, profit making entities.
 Bilateral/Forward Contracts

Bilateral trading generally involves two parties interacting

with each other: a buyer and a seller.
The characteristic of bilateral trades is that the price of a
transaction is set independently by the parties involved.
There is no market clearing price as such. Since, electricity can
not be stored, it creates a wide fluctuation in the spot price.
Forward contracts provide generators and loads with a means
of hedging their exposure to fluctuations in the spot price of
electricity. The generators can negotiate a price for their
output prior to the moment of producing it. Similarly,
properly structured forward contracts provide buyers with
the ability to lock in a fixed price for a fixed quantity of
electricity well in advance of delivery and consumption.
Indeed, if a buyer's actual energy usage matches its forward
market purchases, it can achieve a benefit of complete price
certainty in the face of real time price volatility.
Depending upon the quantity of power and time, the buyers
and sellers resort to different forms of trading:

Long Term Contracts: This type of trade generally includes

contract for a large amount of power for a long time period.
These types of contracts are negotiated privately and the terms
and conditions are such that they suit both the parties involved
in the transaction.

Trading Over The Counter: These transactions involve smaller

amounts of energy to be delivered. For example, the amount of
energy to be delivered during different periods of the hour, day,
etc. This type of trading has much lower transaction costs and is
used by producers and consumers to refine their positions
before real time.
Electronic Trading: In this, participants can enter
offers to buy energy and bids to sell energy directly
in a computerized marketplace. The participants can
observe the quantities and offers/ bids submitted by
all participants, but do not know the party involved.
The software in the exchange couples the matching
offers. It checks whether for a newly entered bid, if
there is matching offer whose price is greater than
or equal to price of the bid. If no match is found, the
bid is added to the list of outstanding bids until a
new offer matches it. Otherwise, it lapses after the
market is closed. The same process is repeated after
a new bid is entered. There is no market clearing
price as such.
 The Spot Market

A market for any commodity provides an environment for buyers and sellers
to interact and agree on transactions, generally, the quantity and price.
These interactions progressively lead to an equilibrium point at which the
price clears the market, that is, the supply is equal to demand. If electrical
energy is to be traded according to a mechanism in which the buyers and
sellers are free to interact individually, the equilibrium between the
production and the consumption can be set through repetitive interaction.
In this scheme of attaining equilibrium, the consumers make an estimation
of their consumption before entering into a contract. The generators
schedule the production of their units to deliver at the agreed time the
energy that they have agreed to sell. However, in practice, neither party can
meet its contractual obligation with perfect accuracy because, for example,
from a load's point of view, the actual demand of a group of customers is
never exactly equal to the value forecasted. Changes in weather and due to
some other externalities, the day ahead or before real time estimation of
load consumption can have deviation from that done few months or years
back, while doing the contract. Also, unforeseen problems may prevent
generating units from delivering the contracted amount of energy.
It can be concluded that, while a large proportion of the electrical energy
can be traded through an unmanaged open market in terms of forward
contracts, such a market may not necessarily lead to an equilibrium that
replicates real time scenario. Thus, an intermediate stage is necessary,
where a managed spot market can provide a mechanism for balancing load
and generation. This market should supersede the open energy market as
the time of delivery approaches. Its function is to match residual load and
generation by adjusting the production of flexible generators and curtailing
the demand of willing customers.

In many real life markets, more than 80% of the energy traded is through
the forward or bilateral contracts. The rest is traded through the spot
market. In a multi-settlement market (typically practiced in some of the
markets in USA), the spot market is sometimes made of two markets: Day
Ahead (DA) market and a Real Time (RT) market. The DA market is run for
each hour or half hour of the next day. The RT market is always run by a
system operator, while the day-ahead market may or may not be run by the
system operator. In both cases, the general principle of market clearing is
the same.
 Spot Market Clearing

For the sake of understanding, let us assume that the market is run by an
entity called Power Exchange (PX). The power exchange operates much like
a stock exchange. The buyers and sellers enter their needs into the power
exchange. For example, a buyer would say, “I need up to 20 MW between
1600 hours and1700 hours IST. I would pay INR 3.5/ kWhr”, whereas, the
seller would enter his demand as, “I have 100 MW and would like to sell it
at INR 4/ kWhr”.

When they transact with the power exchange, buyers and sellers are really
talking to the marketplace and not the individual buyers and sellers. As in a
stock exchange, the power exchange constantly updates and posts a market
clearing price (MCP), which is the current price at which the transactions are
being done. Note that when buyers and sellers communicate with the
power exchange, they don‘t know whom they are dealing with.
The general step by step process of settling this market is as follows:
1. Generating companies submit bids to supply a certain amount of electrical
energy at a certain price for the period under consideration. Usually, the period is
an hour or half an hour. The bids are ranked in order of increasing price. From this,
a curve that shows bid price as a function of bid quantity is built, which is
commonly known as supply curve. Supply curve is a plot with price on y axis and
quantity on x axis.
2. Similarly, demand curve is established by asking consumers to submit offers
specifying quantity and price and ranking these offers in decreasing order of price.
If the load is willing to adjust its consumption with price, the load is said to have
demand elasticity. If the load is firm, the demand curve will take the form of a
vertical line with x axis intersection indicating total cumulative firm demand.
3. The intersection of supply and demand curves represents the market
equilibrium. At this point, the supply matches the demand. This price is known as
Market Clearing Price (MCP) or System Marginal Price (SMP). All the bids submitted
at a price lower than or equal to the market clearing price are accepted and the
generators are scheduled for that much amount of power for that particular time
period under consideration. Similarly, all the offers submitted at a price greater
than or equal to the market clearing price are accepted.
4. As for settlement, the generators are paid this MCP for every MWh they are
scheduled for, while loads pay the MCP for every MWh they are cleared for.
The objective of the power exchange clearing is to
maximize the social welfare. It is the sum of generator
surplus and the load surplus.
Quantity
Company Price (INR)
(MW)

S1 200 2400
S1 50 3000
S1 50 4000
Bids
S2 150 3200
(Genco)
S2 50 3400
S3 100 2600
S3 50 3600
D1 50 2600
D1 100 4600
Offers D2 50 2200
(Disco) D2 150 4400
D3 50 2000
D3 200 5000
Paying generators as per their asking price is known as pay-as-bid
scheme. The main reason why pay-as-bid scheme is not adopted is
that it would discourage generators from submitting bids that
reflect their marginal cost of production. Basically, the notion that
the average price of electricity would decrease by adopting pay-as-
bid scheme is based on the assumption that the generators would
continue to bid in the same way as they do in the marginal pricing
scheme. However, this is not true. All the generators would
instead try to guess what the MCP is likely to be and would bid at
that level to collect the maximum revenue. While doing so, some
low cost generators would bid too high. Then, in the market
clearing process, these generators would not get selected and be
replaced by some other generators that have higher marginal cost
of production. The MCP would then be somewhat higher than it
ought to be. Furthermore, this substitution is economically
inefficient because optimal use is not made of the available
resources. In addition, the generators are likely to increase their
prices slightly to compensate themselves for additional risk of
losing revenue because of uncertainty of MCP. An attempt to
reduce the price of electricity would therefore result in a price
increase.
In marginal pricing scheme, a seller is certain that it
will be paid no less than its cost of production if he
bids at marginal cost, and may be paid more. If a
seller bids less than his marginal cost, it would lose
money because his bid may set the MCP. If it bids
more than its marginal cost, it may bid more than
other sellers and fail to be selected in the auction. If
the seller's bid sets the MCP, then it would recover
it's running cost and if the MCP is higher than it's
marginal cost, then it would earn profit or
contribution to fixed cost. It is worthwhile to know
that the supply curve, being a derivative of cost
function, does not consider the fixed costs.
Calculation of market clearing price
(multiple price by 200)
 MODELS FOR TRADING ARRANGEMENTS
The dispatch philosophies are based on the degree to which
the operational and commercial arrangements for scheduling,
imbalances, congestion and ancillary services are integrated
with spot markets. Depending upon how various markets
associated with the four pillars are arranged, the market
dispatch procedures take the form of cascaded markets or
integrated markets. Broadly speaking, the integrated markets
lead to economic efficiency at the cost of loss of
transparency. On the other hand, cascaded markets though
inefficient, provide transparency.
The dispatch philosophies or rather, the short-term trading
arrangements can be classified into two broad categories:
• Integrated or Centralized Dispatch
• Decentralized Dispatch
One of the essential difference between integrated
and decentralized markets is whether or not the
system operator administers a spot market
integrated with the pricing of energy imbalances,
congestion management and ancillary services. The
integrated model mandates the SO to run the spot
market, integrated with imbalances, and the others.
On the other hand, the decentralized model
attempts to keep the spot market separate from the
system operator, to be organized off-line by the
traders.
 Integrated or Centralized Model
The schematic of centralized dispatch model is shown in Figure.
 Integrated or Centralized Model [cont..]
The joint optimization of all markets is done by the system
operator. It should be noted that the energy market refers to the
short term competitive market or the spot market. The buyers and
sellers provide their bids and offers to the system operator. The
buyers in this model supply the complex bids. The system operator
then performs the central unit commitment, taking into account
the complex bids. The system operator accomplishes this by
solving a complex optimization problem, typically known as
Security Constrained Economic Dispatch, in USA market context.
The outcome of this dispatch is the nodal prices, popularly known
as Locational Marginal Prices (LMPs). If the losses are neglected
and the network constraints are non-binding, the outcome of this
dispatch same as that of MCP calculated earlier. In other words, all
LMPs would come out to be the same which means nothing but
common MCP to all. However, this market clearing is influenced
and altered if the network capacities are congested and then the
nodal LMPs would come out to be different. In other words, the
network congestion is implicit to this type of market clearing.
 Treatment of Imbalances
How contracts and imbalances are tackled in the integrated model?
If the system operator does the central unit commitment using a complex
optimization process, how are the forward contracts accommodated?

In the integrated dispatch model, all differences between contract positions and
actual production, consumption, regardless of cause, are traded at the market
prices (spot prices) that come out of the system operator's central optimization
process and the forward contracts in the integrated model remain financial in
nature only. Whenever the traders make bilateral contracts in the integrated
structure, it is not necessary for the system operator to know anything about the
bilateral or forward contracts. This is because the system operator runs the least
cost dispatch optimization program to come out with locational spot prices and the
settlements are done based on these locational spot prices (LMPs). The effect of
central optimization for least cost dispatch is that every generator is scheduled by
the system operator irrespective of its forward contract obligation. Thus, it may so
happen that a generator has contractual obligation of 20 MW and the system
operator in fact, may schedule this generator to produce zero MW! The effect of
getting into a forward contract is then left only as a risk hedging tool by locking in
to some earlier decided prices.

Risk hedging
Sometimes due to operational constraints, the generation
units are required to be scheduled, rather than shutting
them down. In this case, the generators are said to do self
scheduling. In other words, the system operator, while
running its least cost optimization program, must schedule
the MWs offered by this generator. This is also known as
inflexible bidding. The system operator, while running its
optimization program, shows this generator as a zero
priced bid, so that it gets selected. Similarly, for load, it
shows the self scheduled load as an infinitely priced offer.
What is the effect of offering either a flexible or inflexible
bid on revenues to generators? Let us see the generator's
perspective in case of flexible and inflexible bid submission
in the spot market. Suppose, a generator has a bilateral
contract for 100 MW and its marginal price is INR
3000/MW. Now, there are two choices for this generator.

•Submit an inflexible bid. It can specify that, regardless of

price, the system operator should schedule this generator
to inject 100 MW.
•Submit a flexible bid. It can specify that anything up to its
maximum capacity can be dispatched by the system
operator, as long as spot price exceeds its marginal price,
i.e., INR 3000/ MW.
When all market participants are flexible, willing to modify
operations from their contracted levels if profitable, the
system operator's dispatch is fully separate from forward
contracts. The forward contracts then become financial in
nature only. The system operator will only know about a
contract if the traders involved have chosen to be inflexible.
In case of all generators opting for flexible bids, it is not
relevant also for the system operator to know about the
contract schedules.
 Congestion Management

The process of congestion management is implicit to market

operation of the integrated system. Congestion is solved as an
integral part of the calculation of the least cost dispatch, where
cost is defined by generator bids. The system operator uses the
information regarding the bids and network condition to
determine the most economical way to operate the system within
the physical constraints using optimization software.

Pricing for congestion (i.e., the price charged for transporting

electricity over scarce transmission) is also straightforward.
Traders who schedule contracts across valuable transmission lines
are charged for transmission usage which is equal to the energy
price difference between the two ends of a transaction. As
mentioned earlier, the energy price at each node is calculated by
the system operator using central optimization process.
Congestion management and its pricing are thus integrated with
energy pricing in the integrated model.
 Ancillary Services

Though as good as 40 ancillary services can be listed, when it

comes to classification of market models based on ancillary
services procurement, they essentially refer to the capacity of
generators to provide reserve. The reserves are not a separate
service from energy, they are options to buy energy if required.
They should be priced as options to call energy in the spot market.
However, complicating factor is that the same generating unit can
provide energy in the spot market, as well as can act as a reserve.
Hence, the system operator's dilemma is about how much of it
should be scheduled in the spot market and how much should be
kept idle as a reserve.

In the integrated or centralized markets, depending on various

technical criteria, the system operator does a joint optimization of
energy and reserve market so that optimum scheduling is done
with minimum cost as well as appropriate amount is kept for
reserve in the optimal fashion.
 Decentralized Model

The decentralized and integrated models are most clearly

distinguished by the different roles of forward/bilateral contracts in
the procedures used to schedule and dispatch generation. While the
integrated model treats the contracts essentially as financial
agreements, and dispatches generators to minimize overall costs, the
decentralized model requires the system operator to schedule the
system explicitly using the contracts. Thus, transaction is treated as a
basic unit to be accommodated in real time system operations.
De-centralized Dispatch
 Treatment of Imbalances

The participants of various forward trades wish to balance

their positions near real time. This is generally accomplished
through a spot market. This provides a common clearing price
for imbalances, which is competitive in nature. If a
decentralized system has market based imbalance prices,
then that price becomes the price at which the system
operator will buy or sell energy. The market based price of
imbalances provides a reference price for forward contracts.
When participants sign contracts, the contract prices are
directly compared with the expected imbalances prices as
imbalance provides direct substitute for contract energy. The
spot market for the imbalance energy is generally run by a
power exchange, where the participants submit simple price-
quantity bids rather than complex bids.
 Congestion Management

Congestion management in decentralized model can occur in one of the

following ways:

•Allocation of transmission rights on pro-rata basis (in proportion)

•Allocation of transmission rights on first come first serve basis
•Auction of available transmission capacity
•Special case of zonal pricing with market splitting
•Pro-rata curtailment in case of contingent situation

The first two approaches are not essentially the market based solutions.
They don't reflect the willingness of a trader to pay for obtaining
transmission rights. These methods do not take into account the network
element interdependencies. On the other hand, the third option, i.e., of
auctioning of capacity rights reflects traders' willingness to pay. The fourth
option, i.e., special case of zonal pricing, separates markets across the
transmission bottleneck and imposes a congestion fee for a bilateral
transaction taking place across the transmission bottleneck. The last
approach, i.e., curtailment, is more of congestion alleviation technique
invoked in real time.
For all these methods, a different solution needs to be worked out to
manage the congestion in real time. In the decentralized model, the
system operator will only deviate from the final contract schedules in
the dispatch if he needs to do so in order to maintain security, and
may not make efficient trades even if the traders ask him to since
there is no bidding mechanism for them to do so. It should be noted
that congestion management is not implicit with market clearing
process. Transmission capacity allocation needs to be done explicitly.
 Ancillary Services

Unlike in the centralized model, the system operator procures

all types of ancillary services generally by making long term
bilateral contracts with generator. It is obvious that this is not
the best possible way of obtaining reserves, though it gets rid
of complexities associated with joint optimization of energy
and reserves market and lack of transparency associated with
it. There is a possibility that the reserves are procured on
market basis. However, in decentralized system, it takes the
form of cascaded markets. In other words, after passing
through forward contracts and spot market, the generators
provide rest of their capacity to reserves markets, subject to
technical compatibility, with the needs. This arrangement can
take the other form in the sense, the generators get involved
in long term contracts for reserves and after subtracting for
forward energy contracts, the rest is offered in the spot
market for balancing. There is no joint optimization as is done
in the centralized dispatch market.
No Atrribute Centralized Model Dcentralized Model

1 Unit Commitment Central Individual

Separate reserve market or

Reserve market integrated with
2 Reserve obtained through long term
spot market
contracts

Individual schedules arising

3 Basis for scheduling Bids and offers of participants
out of bilateral transactions

Generally through day-

4 Imbalances Integrated with spot market
ahead market
Involvement of
5 system operator in Yes No
day- ahead market
Congestion
6 Implicit Explicit
Management
Significance of
7 Risk hedging Physical obligation
forward contracts
SMD market in USA like PJM, NETA in UK & Nordic
8 Example
ISO-NE pool
 ISO (Independent System Operator) Model

ISO model is practiced in those countries in which

transmission companies are also providing the
generation and distribution services in their area of
operation. Further, in these countries, sufficient
number of equal sized transmission companies
exists in the market and it is not possible to club the
system operation function with any of these
companies for commercial reasons. Therefore,
separation of ownership of the transmission assets
from the system operation function is considered
necessary to avoid any preferential treatment for
dispatching its own generation.
 TSO (Transmission System Owner) Model

In TSO model, operation and ownership of the grid

are integrated into a single entity which is
responsible for development of transmission system
and to provide non-discriminatory open access to all
eligible market participants. It is also responsible for
system operation functions. Neutrality is an
important aspect of the TSO to ensure an efficient
market. This model is prevalent in the whole of the
Europe.
 MARKET POWER
• Significant influences on pricing or availability
of electricity
• It prevents both competition and customer
choice.
• Owning the ability by a seller, or a group of
sellers, to drive price over a competitive level,
control the total output or exclude competitors
from a relevant market for a significant period
of time
• Reduce competition in power production, service
quality and technological innovation.
• Exercised either intentionally or accidentally
• Two types:
i. Vertical Market Power
ii. Horizontal Market Power
• Vertical Market Power: control of transmission
and distribution facilities, to which, all retail
providers must have access, to the advantage of
its own generation and retail sales of electricity

• Horizontal Market Power: It is the ability of a

dominant firm or group of firms to control
production to restrict output and thereby raise
prices

• ISO may resolve vertical market power Problems

but not the HMP.
 Measuring Market Power
• Herfindahl-Hirschman Index (HHI)

• Measure concentration that also reflects the

number of participants (or firms) and the
inequality of their market shares

• HHI - Sum of the squares of market shares of all

participants.
• where N is number of participants and Si is i-th
participant’s market share in per unit or in %.
• Si is calculated by dividing the contribution of
the i participant by the total contribution of all
existing participants.
• Maximum value of HHI is 1.0 or 10,000.
• Market with two participants of equal size (Y)
Case 1: Power Market with I0 Power
Generation Participants
Case 2:
How is Market Power Exercised?
(i)With Large Market Share – no congestion
HHI
(ii). With Congested Transmission
System