The Electricity Market is like...... a Bus Service

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Dedication

This explanatory metaphor is dedicated with respect, admiration and affection to the people of the Independent Market Operator over the years, who made it all possible under the principal leadership of:

John Kelly – Chairman (2006 to 2015) & Member of the Electricity Reform Task Force 2001 to 2002

Allan Dawson – Chief Executive Officer (2007 to 2015)

The IMO at all times did its duty without fear or favour and everything it did was with reference to and in furtherance of the Wholesale Market Objectives with which it was charged and entrusted.

The Western Australian Wholesale Electricity Market comprises two independent and parallel markets; energy and capacity pdf 280KB. However, traditional retail tariffs mostly charge according to only energy consumption. While generating capacity is the machinery and infrastructure that enables the production of energy, it remains a strange abstraction to most people. The following metaphor explains how the electricity market works in simple everyday terms......

Capacity and energy

Consider a bus operator that runs a single return journey per day. Let's say that the bus takes folk to the beach. The bus has 50 seats. Most days there is an average of only 25 passengers, so the bus is 50% utilized. However on hot summer days, say, there is an average of 75 passengers, which means that 25 cannot travel. The operator decides to offer a guaranteed seat product at a premium price. He sells 50 guaranteed seats. Holders pay a fixed annual fee for the guarantee plus the normal fare whenever they use the seat. The normal fare is reduced a little because of the annual fee. 

Each day, seats are first allocated to the holders of guarantees and any seats left over are then offered on a queuing basis. Regular users of the bus spread the cost of the guarantee across many journeys, so the average price is uplifted only modestly by the guarantee premium. Similarly, occasional users pay a much higher average price.

It turns out that all 75 hot summer day users want guaranteed seats. As there are only 50 seats on the bus, the operator buys a second bus and uses the guarantee fees to fund it, supplemented by the profits from the occasional travel fees. In practice, both buses are run during hot summer days and only one bus is run during normal days, with the second bus on standby in case there is unexpectedly high(more than 50 passengers) demand one day.

The operator then notices that on the hottest day of the year, say, 105 people want to use the bus and all of them want a guaranteed seat. The operator therefore plans to buy a third bus. However, if he does so, the third bus would be used for only a few days per year and it would be run nearly empty (with only 5 passengers), so there would be no profit from the travel fees as they would be less than the costs of running the bus. The funds from the guarantee fees also wouldn't be enough to fund a third bus. However, the operator decides to offer 105 guaranteed seats, even though he knows he can service only 100. This is because he will have to serve the additional 5 for only one day per year. Although this is a risk, he has two options available to him:

  1. He can pay 5 passengers holding guaranteed travel rights not to travel on that day, and in effect give to them up to the entire annual guarantee fees and/or
  2. He can use the annual premiums to pay for much more expensive taxis for people that insist on travelling that day, still leaving him a profit.

This metaphor relates to the Wholesale Electricity Market as follows:

Bus

Electricity generator

Bus operator / driver

Electricity retailer

Bus regulator

Formerly the Independent Market Operator (IMO), recently replaced by the Australian Energy Market Operator (AEMO) and supervised in certain functions by the Economic Regulation Authority

Road

Electricity Network

Traffic Cop

System Management. Currently operated by Western Power and transferring to the AEMO

Bus capacity (50 seats)

Electrical generator capacity (MW)

Passenger journey

Delivered electrical energy (kWh)

Hot summer days

One of the four system peak daily maximum demands

Hottest day of the year

The day of maximum (peak) system demand

Guaranteed seat premium

Reserve Capacity Payment

Journey fare / travel fee

Energy cost (c/kWh)

Taxi

Peaking Generator

Payment for non-travel

Demand Side Management / load curtailment

Children

Residential customers

Demand forecasts

Estimate of the number of people travelling on the hottest day

The Bus Regulator (IMO) is responsible for forecasting the demand for travel and is required by the government to ensure that everyone who wishes to travel may do so; in effect, all seats are guaranteed. The IMO also ensures that all guarantees are honoured by the operators. It therefore carefully regulates the availability of bus seats and in particular the practice of hiring taxis (Peaking Generators) and the payment for non-travel (Demand side Management) in order to ensure that these services are available when needed. However, the IMO wishes to keep things simple for travellers and requires the operators to pay for the guarantee, which they fund by adding it as a levy to the travel fare without the passengers being expressly aware of it.

One important feature of the bus system is that only the State-owned bus operator (Synergy) is permitted to transport children. This guarantees Synergy a prominent position in the system, constituting around one quarter of the passenger journeys.

The energy price auction

Now that we've mastered the basics, let's assume that 1,000 people want to travel on the hottest day of the year (peak day) - meaning that 20 buses (or their equivalent in taxis and passengers paid-not-to-travel) are required to serve that peak day - while on an average day around 525 people travel, requiring only 11 buses to operate (50 x 11 = 550) with one being only half full.

The bus regulator (IMO) 'chooses' the buses that will run by holding a daily auction of fare prices on the basis of one fare per bus and then 'stacking' the available seats with the cheapest first. It adds up the corresponding number of seats until it reaches the forecast required number, and sets the travel price on all buses at the lowest price that will enable all passengers to travel. For example, if the offered prices are stacked at price units of 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12.... etc, and 11 buses are required, all journeys are priced at 11 units, being the price of the bus needed to carry passenger numbers 501 to 525 (with room for another 25). The passenger number (525) and the travel price (11 units) are known as the Balancing Point, and the bus that sets the price and runs partially loaded is called the Balancing Bus (Generator).

Now, suppose that the bus that bid 12 units and didn't run - let's call it "A" - has a fuel & driver cost of, say, 5 units per passenger assuming a full load - that is, a total journey cost of 250 units. It sees that it didn't run because it asked for 12 units as a travel fee, but if it had offered and been accepted at 11, it would have run and would have earned 6 units of profit per passenger (albeit only half full). If this bid is accepted and it runs half full, the income will be 11 x 25 = 275 units, which will earn 25 units profit for the journey.

Better yet, if it runs full at, say, 10 units, it will earn 500 units minus costs of 250 units = 250 units profit.

So, on the next day, to make sure it is selected to run full, it offers 9 units, so that the stack now runs 1, 2, 3, 4, 5, 6, 7, 8, 9, 9 10, 11, 12, etc. In this auction, bus A is selected and is paid the auction travel price of 10 units..... more than it offered, but less than yesterday's price because its eagerness to be selected caused a fall in the price paid to all buses.

The bus that was displaced by bus A - let's call it "B" - decides to cut its price too, because it sees bus A making 5 units of profit per passenger, and it is willing to accept a smaller profit. In this way, buses A and B bid down the price until they start undercutting the next bus in the stack - bus C. To ensure that it is chosen in an auction, a bus will usually bid 'zero', knowing that it will be paid the auction price (Clearing Price or Balancing Price). The end result is that the price drops until the most efficient buses run - and are paid the Balancing Price for the day, which drops to the level at which the highest priced bus is making only a little profit. In this way, the market gets the best travel price (energy price) every day and the efficient buses (lower in the stack) earn a good profit.

This metaphor relates to the Wholesale Electricity Market as follows:

Auction price stack

Balancing Merit Order

Auction travel price

Balancing Price (which is also similar to the STEM Price)

Travel price and passenger number

Balancing Point

Price component of the Balancing Point

Balancing Price

Balancing market

Let's imagine that the bus operators then complain that when they are the Balancing Bus and their bid sets the price, they are forced to run a half full bus - perhaps even a nearly empty bus, and make a loss on the journey. Returning to the example of bus A, its fuel & driver costs are 5 units per passenger, which for a 50 seat bus is 250 units. If it is carrying only 25 people, it needs a price of at least 10 units per passenger to break even. And the situation is far more severe if it is carrying only a few people - it can make a large loss. The IMO solves this issue by noting that on this much bigger system, the buses leave at different times, and it therefore holds the auction every 30 minutes instead of once per day. As part of this auction, the IMO also forecasts the price of the next auction, so that buses can be warned where they sit in the Balancing Merit Order. If a bus is close to the Balancing Point, and therefore at risk of running partially empty, it can either offer a much higher price - so that it is guaranteed not to run on the next batch of departures and can wait until later - or it can offer a much lower price so as to increase the chances of running full. It might even be willing to bid a loss making price because it makes less of a loss when full. In extreme situations, it may even pay passengers to travel on it (negative price).

Other market characteristics

In reality there are many nuances in both the capacity and energy markets that can be worked into the metaphor, albeit with some clumsiness. These nuances are managed by the traffic cops (System Management), which have extensive powers. [In a largely un-noticed moment of glory, during the Varanus Island gas curtailment in 2008 when generators were forced to switch to diesel fuel, System Management diverted a diesel tanker from Singapore, which arrived only a few hours before the power system ran out of diesel.]

Electrical power systems are characterised by the inability to store power on a utility scale and the consequent requirement to produce electricity at the precise time that it is needed (this is discussed in more detail in "How Customer Choice Works"). The balance of consumption and production manifests as the system frequency, which is designed to be 50.0 cycles per second (Hz) and is permitted to vary by up to +/- 0.2 Hz. The frequency falls when there is an excess of load, while an excess of generation causes it to increase. In terms of the metaphor, the system frequency is akin to buses running on time, and the excess time a passenger has to wait at a bus stop. This gives rise to several peculiarities (that become even more peculiar when carried into the metaphor.) These include:

  • Out-of merit operation of buses – sometimes there are disturbances on the roads that mean the normal price auction has to be over-ruled. These include bushfires, floods, congestion on normally functioning roads and roadworks causing temporary congestion. The traffic cops manage this by ordering buses to take different routes or park offroad and wait. They can also order otherwise idle buses to run and order passengers to change buses or to not travel at all – or even order them to travel when they didn’t intend to.

  • Wind generators have the right to take passengers only part of the way and stop in mid journey - and standard buses have to be on standby to transfer the passengers when the wind stops; in effect, travelling partly empty behind them. In the electricity market, this is called 'load following ancillary services' and, more accurately, is used to compensate for fluctuating system frequency in general and not just wind farms;

  • There is also another ancillary service called 'spinning reserve' which is akin to buses that run partially empty purposely so that they can in a timely fashion collect stranded passengers from any bus that breaks down in mid journey. Spinning Reserve buses are paid special payments to cover their fuel costs and compensate them for not being able to make money from carrying passengers. (The IMO is currently considering ways of integrating load following and spinning reserve as they are very similar);

  • There is yet another ancillary service called 'load rejection reserve' which is akin to special payments to buses when they are cancelled because passengers don't show up for the journey (frequency increases). A practical example is where a transmission line fails and customers suffer blackouts;

  • Sometimes buses (in reality coal-fired stations that take a long time to bring on line) have to run and find themselves competing with wind stations that are willing to run at a negative price equal to the amount of their subsidy from environmental legislation. In this case, the bus has to bid a negative price – which means that the bus has to pay passengers to travel on it;

  • Most buses contain differing numbers of seats. Often different buses have multiple seat prices and might run with only the economy seats filled;

  • Buses run on various fuels (say diesel and petrol in the metaphor, representing gas, coal, renewable (mainly wind & solar - free) and diesel in generators);

  • The forecasts of passenger numbers are often inaccurate (being based largely on weather,) resulting in a need for buses to be either cancelled or run unexpectedly, and often for only partial journeys. When there are more travellers than expected and a bus has to be run urgently, it is generally paid a very high price because that is what it offered in the auction in order to avoid being exposed to this 'nuisance' and cost.

The Electricity Market Review

The State Government is currently intervening in the metaphorical bus system. In terms of the metaphor, it is concerned that the bus system is run inefficiently and that the state-owned bus operator (Synergy) is disadvantaged. In particular, Synergy is making a substantial loss that is having to be funded by the Government. Further, through Synergy, the State has either directly funded or guaranteed the financing for three quarters of the entire bus fleet when only half is owned and operated by Synergy.

There are several dimensions to the review but from the perspective of the energy and capacity markets, the Government intends to both improve the efficiency of the bus system and attract to the market private sector bus operators that can themselves fund new buses and relieve the state of its financial burden.

The price of guaranteed seats (Capacity Market) is a key theme of the review and is focussed on two economic principles:

  1. when there are many more buses than are needed (excess capacity), the price of a guaranteed seat should fall, and substantially so when there is a lot of excess; and
  2. non-travellers (Demand Side Management) should perform equivalently to buses and be paid what they are worth, which is very little when there is excess capacity and a lot when there is a shortage;

The bus system currently hosts excess capacity which means that some buses are not needed but remain in the system. Traditionally, the bus regulator sets the price for guaranteed seats at the price required to buy a standard bus, and all participants – including non-travellers – are paid this price. This is very attractive to buses that are cheaper than this to buy, but which also have higher fuel costs and so don't run very often. Equally, the buses with the lowest fuel cost (high fuel efficiency) cost more to buy and need to earn profit by running frequently. Ideally, the market needs to attract a bus fleet that is a 'mix' of low cost - high price and high cost - low price buses, with the daily auction deciding which buses are run, and all buses are needed on the peak day. Non-travellers then participate as a genuine alternative to buying new buses.

This metaphor relates to the Wholesale Electricity Market as follows:

More buses than needed

Excess capacity

The Market Review is seeking to make various improvements as follows:

  • Improving the forecast of the number of people wishing to travel as recent forecasts have proved to be too high, leading to wasted assets and expense. Traditionally, everyone travelled by bus and travelled frequently, but passengers are now increasingly switching to personal cars (solar PV) and making fewer journeys (energy efficiency). The ‘firmness’ of the guaranteed right to travel is also being reviewed;
  • Reforming the payments made to non-travellers. These are very valuable in times of shortage of seats and virtually worthless in times of large excess. Fundamentally, the system can’t transport people by paying them not to travel (that is, Demand Side Management can’t boil a kettle.) In the ideal case, it would be recognised that non-travellers are capable of making an important contribution to the ancillary services markets (especially Spinning Reserve, but also Load Following) and ideally would be enabled to do so, which they currently can’t except in special cases;
  • Penalising the unreliable buses by withdrawing their guaranteed payments when they are unavailable, and especially so when the passenger load is high;
  • Reducing the guaranteed payments when there are more buses than are needed so as to encourage buses to leave the system and discourage new buses from coming to the system in those circumstances. Equally, when there are only just enough buses, the payments will increase;
  • Permitting private buses to transport children (called Full Retail Contestability);
  • Improving the integration of the System Manager (traffic cops) and the IMO;
  • Changing the charging structure for use of the roads and the rules for building new ones. In particular, passengers are increasingly starting to switch to private cars (disconnecting from the network).

This metaphor relates to the Wholesale Electricity Market as follows:

Private cars

Customers reducing their dependence on the grid through PV, energy efficiency and batteries