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How will the electricity market of the future work?

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Authors: Kieran McNamara, Valentina Ferlito and Alberto Toril

Our energy destinies rest in the hands of governments – and this is particularly true in power markets. More than 70% of future investments in global energy supply will be made by state-directed entities or respond to regulatory incentives. If we narrow this view to the power sector, more than 95% of global investment will be made in sectors that are fully regulated or affected by mechanisms to manage the risk associated with variable prices on competitive wholesale markets.

Traditionally, electricity markets developed and operated within strictly regulated frameworks, in which vertically integrated utilities handled all or most activities from generation to transmission to retail. Over the past 35 years, however, many parts of the world have gradually moved towards competitive markets as a means to generate and procure electricity alongside many of the support services required to operate a power system.

Today, countries that rely on competitive markets to maintain efficient operations in the short term, either through bilateral physical contracts, power exchanges, or co-ordinated spot markets, account for 54% of the world’s electricity consumption. Once China completes implementation of its power sector reform, this share will increase to almost 80%.

Despite their imperfections, markets have largely succeeded in the goal of providing reliable electricity at least cost to consumers. Nonetheless, some regional markets have come under strain. Without policy measures to address this shortfall, there is a risk to future security of supply. This is a topic that is examined in much greater detail in the electricity focus of the World Energy Outlook-2018.

Since 2010, some electricity markets have experienced a decline in wholesale energy prices brought about by stagnant demand, low natural gas prices and higher output of generation with low marginal costs. This situation is not unique to Europe, for example, our analysis points to similar outcomes emerging in regions such as the United States and Australia.

Ensuring sufficient investment in competitive electricity markets

The decline in market revenues experienced in many markets raises some questions about the ability of competitive markets to provide adequate returns to sustain the existing fleet and to provide adequate signals for timely and efficient investment. The problem arises from the low wholesale market prices that have occurred in many markets, as a result of rapid deployment of variable renewables, the requirement for high levels of reliability (through healthy capacity margins), and, in some cases, low natural gas prices.

While periods of reduced profitability are a natural part of competitive markets, declining revenue in lean systems where investment is needed – which we see in some markets today – may signal a need to re-evaluate market design and its ability to deliver investment and electricity security, especially since the main conditions that have depressed wholesale prices are likely to continue at least in the near term. With new sources of capacity and flexibility in power systems becoming more widely available and cost-competitive, future regulatory frameworks or market reforms should strive to ensure a level playing field for all system resources, including power plants, energy storage systems and demand-side response.

Furthermore, wholesale markets are responsible for non-energy revenues that come from providing a variety of products commonly referred to as system or ancillary services. These products safeguard against unforeseen changes in demand or available supply (primary and secondary reserves), as well as products that support the quality of power (reactive power, frequency regulation and inertia). They provide revenues to sources that, even if not essential for the adequacy of the system, support the reliability of supply and quality of power delivered.

Recent trends suggest that some markets may be unable to deliver investment signals that guarantee resource adequacy. For example, in markets in the European Union, the share of total production costs covered by electricity sales fell from 77% in 2010 to about 60% in 2017, and looks set to continue declining. Such unsatisfactory market signals led many European utilities to broaden their exposure to global markets by means of deep business restructuring and reorganisation, in addition to giving large space for capex optimisation and high investments in operational efficiency, renewables and digitalization. In fact, even if in 2017 the missing money gap narrowed, as wholesale electricity prices and total electricity sales increased by about 20%. This relief was temporal, however, mainly a result of a rebound in natural gas prices, lower contribution than usual of hydropower to the generation mix and extended nuclear plants outages. Unfortunately none of these underlying causes of partial remuneration recovery is likely to continue.

In the United States, the share of total generation costs covered by wholesale electricity sales is also declining. Stagnant demand and the rising share of variable renewables, led by wind power, have added to the downward pressure on wholesale electricity prices in several US electricity markets. Electricity sales may continue to recoup less than the total cost of generation, owing to an expected growth from solar PV and wind generation and a persistence of low gas prices, despite the possibility of a return to growth for electricity demand spurred by space cooling and the electrification of heat and transport.

In Australia, the recent experiences have been quite different; mostly due to scarcity pricing – which also constitutes a key signal for new investment required – that has more than offset an increasing share of renewables during the last seven years and has covered a rising portion of total costs in generation.

Where do we go from here?

The experience of established competitive markets provide useful examples of potential concerns and solutions for countries looking to transition to competitive markets. For example, Japan is pursuing electricity market reforms that establish a set of markets for baseload, transmission usage, capacity, balancing and zero emission credits, which will provide a basket of complementary revenue streams. Mexico is also pursuing market reforms that aim to transition away from regulated to competitive markets and that take account of the experience of other countries.

These points lead to the obvious question: how will the electricity market of the future work? It is very likely that over the medium to long term, many markets will continue to experience further downward pressure on wholesale energy prices as more zero-cost power generation enters the market alongside new energy service providers and innovative technological solutions. Policy makers, regulators and energy sector stakeholders need to understand the changes underway and seek new solutions and market designs that can support the transition towards low-carbon electricity markets while at the same time ensuring the security and adequacy of power systems.

*Valentina Ferlito IEA consultant and Alberto Toril IEA consultant

IEA

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A review on govt. plan to barter oil for dues to private sector

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The regulatory body of the government has been recently preparing the draft for a bartering system which is set to settle the government dues to the private power plant owners and electricity contractors.

Based on this draft, nearly 400 trillion rials (about $9.52 billion) worth of oil is going to be given to the private companies in return for the electricity that they have provided for the national network, or for the services that the contractors provided for the energy ministry.

According to the energy ministry, big companies and well-established contractors have given green light to such a mechanism in order to settle their dues.

Although this mechanism has been mentioned and foreseen in the budget law, and the government’s efforts for paying its dues to the private sector, in itself, is a positive act which must be appreciated, but there is still uncertainty about the practicality of this approach. 

Is this method really suitable for solving the financial problems that the government is facing regarding the private sector and the electricity industry? And if yes, what would the scale of such bartering system be? Would it cover small amounts as well?

Govt. payment mechanisms

So far, the Iranian government have tried numerous approaches and mechanisms for settling its debts to the private sector, in times that the financial conditions are not right for clearing payments with money (like during sanctions and recession).

Bartering the dues for “treasury bills” was one of the first approaches that the government used in order to pay its dues to the electricity contractors and private power plant owners. In this method, the energy ministry would pay it dues in the form of a treasury bill which can be traded for raw materials like aluminum ingots, steel and etc. needed by the companies and contractors.

Another mechanism was using “clearing bills”, in this method the government would offset its debts to the companies and contactors with the taxes and legal bills which they were supposed to pay to the government in order to operate.

Many experts and analysts believe that such approaches are suffering from significant shortcomings and loopholes. For instance, in many cases, the value of the government’s treasury bills could decrease drastically at the time that the company or contractor wants to use them, or the manufacturers and companies doesn’t supply the items covered in the bills, so many of the owners of such bills will be forced to sell them to middlemen in the market for lower prices in order to use the money with more flexibility.

The new approach

Analysts and experts in the country’s power industry believe that, like many other methods which have been implemented so far, the oil-for-due mechanism has its own shortcomings and drawbacks.

They argue that this mechanism only good for big companies and contractors with large amounts of due payments, and the small and medium-sized companies and enterprises would not benefit much from such bartering system.

The ministry of energy has said that this method is intended to settle state debts to large contractors. This means that the government itself believes that the developed method works only for large contractors or large companies. But, it should be noted that the number of big contractors which have the means to receive, transport and sell oil in or outside the country is not that much and many of the companies, active in the energy industry are small and medium-sized companies.

This suggests that the target population which the government has considered for this mechanism is not that rational and the statistical pool considered for this method is very limited and small.

It is also said that since this new mechanism requires the coordination between two different miniseries, namely energy ministry and the oil ministry, inevitability some unforeseen issues might emerge in the process.

Final thoughts

Many of the experts and scholars in the country’s energy industry believe that if the energy ministry wants to take measures to address its debts to the private sector, it should find a comprehensive and inclusive solution, one that covers the whole industry, since as I mentioned before only a limited number of companies in the country have the ability or means to use oil as a payment method.

The best way to address the financial issues which the energy ministry is facing is to remove the subsidies which is applied for the electricity bills for households and commercial consumers.

There is a huge gap between the real value of electricity and the price with which it is provided to the consumers in Iran. Closing this gap (only if partially) would solve many of the financial problems that this industry is currently facing.

Emending the power industry’s economy requires emendation in the country’s economic structure at a macro level, but unfortunately there doesn’t seem to be any will for going in that direction anytime soon.

From our partner Tehran Times

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Iran’s ‘oil for execution’ plan: Old ideas in a new wrapping

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This week Iranian Oil Ministry is going to officially start a new plan that is aimed to be a new way for selling oil and tackling the pressures imposed by U.S. sanctions on the country’s oil industry.

The plan is to execute a barter system which allows domestic and foreign companies, investors and contractors to carry out projects in Iran in exchange for oil (I would like to call it “oil for execution”).

In this regard, as the official inauguration of this new program, a business contract will be signed within the next few days, under which a domestic company is going to receive crude oil in exchange for funding a project to renovate a power plant in Rey county, near the capital Tehran.

At the first glance, the idea of offering oil in exchange for execution of industrial projects seems quite a new idea, however unfortunately it is no more than the same old structure under a new façade.

U.S. sanctions and Iran’s coping tactics

Since the U.S.’s withdrew from Iran’s nuclear pact in May 2018, vowing to drive Iran’s oil exports down to zero, the Islamic Republic has been taking various measures to counter U.S. actions and to keep its oil exports levels as high as possible.

The country has repeatedly announced that it is mobilizing all its resources to sell its oil, and it has done so to some extent. However, considering the U.S.’s harsher stand in the new round of sanctions, the situation seems more complicated for the Iranian government which is finding it harder to get its oil into the market like the previous rounds of sanctions.

Selling in the gray market, offering oil in stock exchange, offering oil futures for certain countries, bartering oil for basic goods and finally bartering oil in exchange for executing industrial projects are some of the approaches Iran has taken to maintain its oil exports.

A simple comparison between the above mentioned strategies would reveal that they are mostly the same in nature, and there are just small differences in their presentation and implementation.

For instance, let’s take a look at the “offering oil in stock market” strategy, and to see how it is different from the new idea of “offering oil in exchange for development projects”.

Oil at IRENEX vs. oil for execution 

As I mentioned earlier, one of the main strategies that Iran followed in order to help its oil exports afloat has been trying new ways to diversify the mechanisms of oil sales, one of which was offering oil at the country’s energy stock market (known as IRENEX).

In simple words, the idea behind this strategy was that companies would buy the oil which is offered at IRENEX and then they would export it to destination markets using whatever means necessary.

Since the first offering of crude oil at Iran Energy Exchange (IRENEX) in October 2018, the plan has not been very successful in attracting traders, and during its total 15 rounds of oil (including heavy and light crude) offerings only 1.1 million barrels were sold, while seven offerings of gas condensate have also been concluded with no sales. This has made some energy experts to believe that this whole strategy is doomed to fail.

The most important challenge that Iran has been faced in executing this approach is the impact of U.S. sanctions on the country’s banking system and its shipping lines, since the purchased oil, ultimately has to be transported from the agreed oil terminals via oil tankers to different destination across the world. 

With the previous strategies coming short, nearly six months after the first offering of oil at IRENEX, in early May, Masoud Karbasian, the head of National Iranian Oil Company (NIOC) announced that the company plans to barter oil for goods and in exchange for executing development projects.

However, the “oil for execution” part wasn’t implemented until this weekend when Head of Thermal Power Plants Holding Company (TPPH) of Iran, Mohsen Tarztalab announced that the company is going to sign a €500 million contract under the new “oil for execution” framework for renovation of Rey power plant near Tehran.

According to Tarztalab, the TPPH decided to go for the deal after the sanctions prevented Japan from financing the renovation of Rey power plan.

Based on this deal, TPPH is going to renovate the power plant and in return NIOC will pay for the services in the form of crude oil. Clearly, TPPH is then in charge of the received oil and it’s their concern weather to export it or sell it inside the country.

A closer look at this deal, reveals how similar it is to other approaches that NIOC has been taking. Just like the oil offered at IRENEX, in this model, too, a company is left with an oil cargo which is banned from entering global markets. The buyers are once again facing financial barriers and shipping difficulties.

Although, like the first oil offering in which a few companies risked buying some oil, this time, too, TPPH, is making a significant gamble in signing this deal, but, just like the IRENEX experience, it seems really improbable for more companies to follow the state-owned TPPH’s footsteps.

Final thoughts

The need for taking all necessary measures for withstanding the economic pressures of the U.S. sanctions is an obvious fact, however the ways of doing so should be chosen more carefully.

It seems that the government has been only wrestling with the “problem” here rather than attempting to find practical “solutions”.

Fortunately, in the past few months, the government seems to have seen the fact that the best way to withstand any economic pressure is the transition from an oil-dependent economy to an active, self-sufficient and independent economy which is more invested in its potentials for trade with neighbors rather than the oil market. 

Solutions like offering oil in the energy exchange or oil for execution might be some kind of transition from traditional oil sales to new approaches, but they are not ultimate solutions in the face of sanctions.

To overcome the current economic conditions, the government has realized that it should have medium- and long-term planning and policy making. 

Active diplomacy and attention to the energy needs and capacities of the neighboring countries and offering discounts for oil products, although are more time-consuming ways to increase oil sales, but will be more successful than the ways we discussed, and will yield greater benefits for the country.

From our partner Tehran Times

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The who and how of power system flexibility

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All around the world, power systems are changing fast. For example last year Denmark supplied 63% of its power demand from variable renewables (wind and solar PV) while last June Great Britain went a full 18 days without burning coal for power generation.

Yet despite such examples of progress, change has not been fast enough to meet the objectives of the Paris Agreement. In fact, power sector emissions have been on the rise over the past two years and investments in variable renewable power capacity appear to have stalled for the first time in two decades. Meanwhile electrification continues in sectors such as transport – and without accelerated decarbonisation, much of the growth in power demand will be met by fossil fuels.

But having more low-carbon electricity on the grid is not enough; we need to make better use of that low-carbon electricity. That means coordinated action on the transformation of power systems.

Power system flexibility – the ability to respond in a timely manner to variations in electricity supply and demand – stands at the core of this transformation. Luckily, policy makers and industry leaders across the globe are increasingly aware of the importance of flexibility and are taking action. Over the last two years, two Clean Energy Ministerial Campaigns have contributed to developing an understanding of what technical solutions for flexibility are available – in power plants, grids, storage and on the demand side.

That’s the ‘what’ of power system flexibility. But the more difficult questions are ‘how do we implement this flexibility?’ and ‘who should be involved?’.

The answer is: it depends. More precisely, introducing the appropriate measures to deploy power system flexibility requires a deep, thoughtful look at each country’s institutional framework. One key finding from the various workshops and forums organised by the CEM Power System Flexibility Campaign is that the changes necessary to activate innovative flexibility solutions inevitably deal with regulatory decisions.

One key myth that these same events are contributing to dismantle is that power sector regulation is far too complex and far too country-specific to profit from international sharing of best practices. In fact, it may be the contrary. This sharing of best practices is one of the main contributions of the joint IEA and 21st Century Power Partnership report Status of Power System Transformation 2019, which explores the various points of intervention, along with the relevant stakeholders for flexibility deployment.

The report describes how it is possible for policy makers to easily identify areas where they can directly enable change and areas where more targeted interventions may need wider stakeholder engagement.

It starts by looking at energy strategies, legal frameworks, and policies and programmes. These high-level instruments are usually what is thought of when looking at renewable energy policy support. While relatively far away from implementation, this level is particularly important as it sets the overall course for power system development.

Energy strategies typically lay out broad targets, such as China’s target of flexibility retrofits for 220 GW of coal-fired power plants in its 13th Five-Year Plan or Switzerland’s ‘Energy Strategy 2050’. Legal frameworks go one step closer to implementation by defining electricity industry structure along with the foundations of who does what, such as the UK’s recent bill for electric mobility or the distribution sector and flexibility reforms in Chile. Lastly, policies and programmes can be useful tools to test specific technology approaches or focus on specific aspects of the energy transition, for example Italy’s feasibility study on ‘Virtual Storage Systems’ or the creation of a working group for the modernisation of Brazil’s power sector.

While these high-level solutions are necessary and can be very effective, accelerating the energy transition for increasingly complex and decentralised power systems will increasingly require detailed fine-tuning of institutional frameworks. This is where we come to regulation, market rules and technical standards. By allocating costs and risk, regulation essentially determines who can do what, and how. Similarly, market rules and technical standards play a key role in shaping the interactions of different stakeholders in the power system.

In many cases, it may be necessary to update regulatory frameworks to recognise the new capabilities of new technologies in the power system. This might be the responsibility of the regulator in the case of vertically integrated utilities or spread across regulatory decisions, market rules and technical standards in the case of more unbundled power systems.

For example, if modern wind and solar power plants are technically able to provide frequency regulation, the recognition of their contribution to system reliability may require a regulatory decision to assess and validate their capabilities. It might also require modifying the system operator’s market rules to allow access to ancillary services, as was done in Spain.

Similarly, if digitalisation and decentralisation of the power system offer the potential of greater demand-side participation, it will be regulation that enables smaller system resources to participate in energy, capacity and ancillary service markets. How this is implemented would vary across jurisdictions, for example updating prequalification requirements may be necessary to enable aggregation, as in the EU, simply recognising independent aggregators as market players, as in Australia, or reforming retail tariffs as in Singapore.

But to know what changes should be implemented, and by who, it is critically important to understand the specific point of intervention and engage the right stakeholders. More broadly, it is important to start a conversation with a comprehensive set of stakeholders, to get an idea of what is possible and what is needed, and to compare experiences within and across countries.

Over the coming year, the IEA and PSF Campaign will continue working on this global dialogue to improve the understanding of regulatory and market design options for the deployment of system flexibility, supported by the Campaign’s co-leads – China, Denmark, Germany and Sweden. The PSF campaign is preparing initial steps to collaborate with CEM’s 21st Century Power Partnership, the Electric Vehicle Initiative and the International Smart Grid Action Network to look at the linkage between power system flexibility and transport electrification, an important conversation given the trend towards decentralisation driven by adoption of electric vehicles.

This work all aims to drive home one key-message: we need creative policy making if we are serious about accelerating the energy transition, and regulatory innovation and international cooperation are a good place to start.

IEA

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