How Energy Markets Work
The global energy markets are some of the most complex and volatile markets in the world and the UK electricity and gas markets are no exception. Understanding and following these markets is no mean feat but Good Energy believes it is important for generators to have a good grasp of these markets so that you know what determines current power price, where prices may be heading and if you are being offered a good price for your power.
In this section we give a basic introduction to the way the UK electricity market works and what influences their prices.
Supply and Demand for Electricity
Over every 30 minutes of every day Good Energy must attempt to match its supply (renewable generation) with its demand (domestic and business customers). If Good Energy is not perfectly in balance between supply and demand then it either pays a penalty if it is short of supply for its demand, or gets some money back if it oversupplies compared to its demand. It is normally more favourable to oversupply than undersupply but being perfectly in balance is normally best. The financial incentives on suppliers to balance supply and demand reflect the costs on National Grid in ensuring that at a national level total supply (all fossil fuel, nuclear and renewable generation) matches total demand (all domestic and business customers) over every minute of every day. In order to keep balance nationally the National Grid can call on a number of backup/reserve generators when the grid is forecast to be out of balance, and either instruct them to generate more supply, or turn off if there is too much supply for the demand (if this is the case, these generators can be paid not to generate). However both of these actions are expensive and so these costs are passed on to those suppliers which are out of balance, which is why it is normally most favourable to be perfectly balanced.
Forward power contracts
A forward power contract is an agreement between two parties to buy or sell a fixed amount of power for a specific period in the future. For instance it is possible to buy today 1MW of power for a whole year period (an Annual contract), but not starting until 5 months from the agreement date.
Why prices for renewable generators are discounted from the Wholesale power price
Wholesale forward market prices for power are usually based on a firm delivery for a set period of time. In contrast renewable generators typically output power only when the natural resource is available and, as the resource can be highly variable, so can the generation profile. For instance wind generators only generate power when the wind is blowing, and will generate differently in a storm compared to a mild breeze. Therefore most renewable generators do not provide a firm delivery as expected of a wholesale power contract and so power from renewable sources has to be discounted because of this. Good Energy discounts renewable generators differently depending on several factors including:
i. Generating technology
ii. Annual output from the generator
iii. Location of the generator
iv. On site demand
What the Wholesale market price is comprised of:
• the weighted cost of producing electricity from the various sources that
generate electricity (fossil fuels, renewables, nuclear) in the UK and to
some extent Europe (due to the interconnector)
• plus a margin for the electricity generators
• plus a margin for the electricity wholesalers
What the Generators price is comprised of:
• the wholesale market price for the contract period in question
• plus any benefits for distributed generation (see embedded benefits)
• less a discount for the variability/reliability of the generator
• less any allowance for risk of market price fluctuations over the contract period in question
• less any charges incurred by the Supplier for distributing and metering the electricity and administering the arrangement
What a typical electricity customer’s bill is comprised of:
• the weighted average cost of any ‘in-house’ generation, contracted
generation, and wholesale trades carried out by the electricity Supplier
• plus the cost for distributing power on the transmission and local
electricity networks
• plus the cost for balancing the customers demand to the Suppliers
supply
• plus the cost for metering the customer’s usage, administration,
customer care, green additionality etc
• plus a margin for the Supplier
This is why the price you pay for units of electricity that you use as a customer is higher than the price paid to Generators for the electricity they export.
Influences on electricity price and the interrelationship of fuels
In the UK several different fuel sources are used to provide electricity. The table below shows DBERRs figures on the fuel mix for the UK for the financial year 2008-2009. On the table ‘Other’ refers primarily to oil generated electricity and imported power that reaches the UK from Europe via the interconnector.
Energy Source %
Natural Gas 43.5
Coal 33.0
Nuclear 16.1
Renewables 5.5
Other 1.9
The prices of these fuels vary depending on the supply of and demand for each fuel, not just for electricity generation, but also for heating and industrial uses – construction, chemicals, manufactured products, etc. Speculation can also have an impact on prices for the various fuels as they are commodities that can be bought and sold on international markets without the buyer or seller actually needing to use the product.
So if the cost of the fuel source increases, then the cost of electricity supply from that fuel source will also increase. Once one type of fuel source changes price relative to the others then it becomes more economic to generate electricity from another fuel source, so that fuel source tends to increase in price too as ‘fuel switching’ occurs. This process repeated continuously means that fuel source prices tend to track each other to some extent.
In addition, the exploration and extraction of oil and gas are very closely linked because commonly, where you find one, you also find the other. As commodities that are explored, extracted, traded and transported in very similar ways, both oil and gas and their prices are subject to the same influences, and so gas prices are often indexed to oil prices. For example, in autumn 2005 Hurricane Katrina struck the Gulf of Mexico and the southern USA and knocked out oil production from a significant number of the oil rigs in the region. This reduced the amount of oil and gas that was entering the global market and with a reduction in supply, prices for oil then rose. This had a knock on effect on gas prices and then electricity prices, causing them to rise, as the cost of generating power from gas rose.