Authors: Valeria di Cosmo and Muireann Á Lynch
In the electricity sector, there are two different markets: the wholesale (or spot) market, in which electricity generators generate and sell electricity at a new price every half hour, and the retail market, in which electricity supply companies sell electricity to the final consumers.
Supply companies tend not to change the price they charge their consumers very frequently, and so these companies typically enter into longer-term contracts for electricity with generators to avoid the risks they would face if they bought at a new price every half hour. Internationally, many electricity markets also include a specific capacity payment mechanism, which ensures generators receive sufficient revenue to cover their fixed costs, thereby incentivising investment.
The Single Electricity Market (SEM) of the island of Ireland has been in place since 2007. The market takes the form of a centrally-traded pool where all electricity is bought and sold. In 2014, the payments made to generators for the electricity they provided came to €2.2 billion and capacity payments came to €556 million. Since the SEM was launched, wholesale electricity prices have tracked input fuel prices closely and the costs and bids of generators have been open and transparent.
The European Union is working to harmonise electricity markets in its Member States by specifying a Target Model for electricity markets across Europe. The SEM has some technical features that render it incompatible with the European Target Model and so a number of changes to the market are necessary. The SEM will therefore be replaced by a new Integrated Single Electricity Market (I-SEM), which will be Target-Model compatible, by 2017.
The new market will affect the spot and retail markets and the mechanisms through which supply companies buy electricity in advance to manage their risks. We have concerns about some possible undesired consequences of the new market design for the I-SEM, relating to both spot and retail markets. There are also proposed changes to the capacity payment mechanism which are of concern.
Traditionally, electricity was generated and supplied to final consumers by State-owned monopolies. In the past two decades, electricity markets worldwide have been liberalised, with many players competing in both generation and retail markets. Often, however, the legacy monopolist retains a large market share in generation and retail markets. The SEM is no exception.
The legacy monopolist in the SEM has both a generation and a retail arm. Thus, one firm owns a large amount of the generation units on the system, provides a large proportion of total power generated and has the largest number of retail consumers. This allows the firm, in theory, to hide the true costs in each market by passing costs between its retail and generation arms. The legacy monopolist therefore has the potential to influence prices in both wholesale and retail markets. Any redesign of the SEM should take these structural issues, namely a low number of players and a dominant firm, into account.
The paper is structured as follows: Section 2 (Market power in spot and retail markets) analyses the challenges facing the new I-SEM in spot and retail markets. Section 3 (New capacity payment mechanism) analyses the risks associated with the new capacity mechanism and Section 4 concludes.