What future for electricity markets?

This is the fourth installment of the Topic of the Month: Thirty years of electricity markets

The waves of innovation and disruption that are transforming the electricity industry around the world challenge the functioning of existing electricity markets, whose establishment occurred mostly in the 1990s and 2000s in a totally different technology and policy context. Recent crises in California (August 2020), Texas (February 2021), Europe, China and India (August-October 2021) confirm how critical the situation is and call for a reflection on how markets can or should adapt, transform or even disappear in the emerging new environment.

In this fourth episode of the Topic of the Month, we will address the implications that decarbonization, decentralization and digitalization have on the role and operation of electricity markets. We will also expand our focus beyond OECD countries and consider how other parts of the world are coping with the evolution of the electricity sector. Will Africa, South Asia and China follow the pathways of Europe and North America or adopt alternative models? How will they ensure access to secure and sustainable electricity to their citizens? Will they rely on open markets or not? If yes, how will they be designed?

The uptake of intermittent renewable energy sources (RES) such as solar photovoltaics (PV), wind energy and run-of-river hydro increases the variability of electricity generation. For any given level of demand, the penetration of intermittent RES is responsible for a surge in price volatility. Existing open wholesale markets are likely to be able to cope with currently evolving generation mixes over the short to the medium run, and accommodate increasing shares of intermittent RES. However, market players will have to adapt to a riskier environment and certain elements of current market designs will need to be adapted, too. Greater focus on short-term electricity markets and markets for ancillary services, stronger participation of the demand side, and the introduction of dedicated capacity remuneration mechanisms or long-term contracts look like important blocks of future “RES-proof” open markets. The deployment of storage and the expansion of transmission networks, incentivized by volatile prices, will play an essential complementary role and support the transition to a different electricity system operational paradigm, where demand is flexible and adjust to match variable supply (for more information on the new economics of electricity with high renewables, look at Chapter 15 by Richard Green in the new Handbook on Electricity Markets).

The current transformation is particularly profound when considering distribution grids and retail markets. The deployment of rooftop solar PV, domestic batteries, heat pumps and electric vehicles (EVs) affect the way medium and low voltage lines operate and the role played by smaller network users. Integrating this growing amount of distributed energy resources (DERs) into existing markets and system operation becomes a necessity to ensure an economical and secure supply of electricity. Two contrasting visions exist on how to adapt current markets, which were not developed with this necessity in mind. One of them expands the use of spot nodal prices to the distribution level, possibly up to the level of each individual generation and consumption device. The other vision builds on the idea of system operators signing long-term contracts with DER owners (or their intermediaries) for flexible control, in order to deal with voltage and congestion problems. Both visions present advantages and disadvantages. Some form of hybrid market design is likely to emerge over time, using both price signals and non-price-based rationing of available generation to loads in priority orders. The strong preference of most customers, regulators and policy-makers for relatively stable prices, simple tariff structures and a lack of discrimination might point in this direction (for more information on the future design of electricity markets, look at Chapter 16 by Michael Pollitt).

Outside OECD countries, the current situation and outlook of electricity markets are quite heterogeneous. In various parts of the world, open markets do not exist and in some cases even the electricity grid does not reach all potential customers. Access to good quality and reliable supply continues to be an important problem in Sub-Saharan Africa and in certain regions of Asia and Latin America. Centralized electrification programmes have often proven to be insufficient. More recently, improvements in RES-based distributed generation, storage and digital technologies have opened the door to new public and private sector driven electrification initiatives. Unfortunately, a lack of coordination between them and a lack of industry reform, especially regarding distribution, represent critical issues. In this context, the assignment of an obligation to supply over a certain area to a given entity, the provision of an adequate mechanism for cost recovery, and the selection of an appropriate mix of traditional grid expansion, mini-grids deployment and stand-alone electricity systems could constitute the best approach to achieve universal electricity access (for more information on how to achieve universal electricity access, look at Chapter 20 by Ignacio Pérez-Arriaga, Divyam Nagpal, Grégoire Jacquot and Robert Stoner)

China is one of the countries that were able to successfully ensure a reliable connection to basically all its citizens and firms. Over the past four decades, it modified several times the organization of its power industry, guaranteeing the enormous investment needed to support the massive expansion of its economy and the associated growth in energy consumption. However, for a variety of reasons, China failed to deliver cost-effective electricity, technological innovation and climate change mitigation. Elements of competition have been introduced since the 1980s, but control is still firmly in the hands of the Government. Politics, not markets, shape and constrain the development and reform of the sector. Competing visions of what should change, how specific changes should take place and whose interest should be protected have limited the choice and the ability of the Government to implement consistent policy measures. In recent years, however, Chinese electric firms have started to act beyond national borders. Their desire to be part of the future and compete on international markets represents, together with the enormous challenges posed by the commitment to decarbonize the economy over the next decades, a major driving force for electricity reforms towards a more market-based system. A driving force that the latest news from China suggest the Government seems to be willing to embrace (for more information on the reform of the Chinese electricity industry, look at Chapter 21 by Xu Yi-Chong).

Lack of industry reform is one of the main reasons behind the poor performance of electric utilities in Sub-Saharan Africa and the high share of the population still without access to electricity. Publicly-owned monopolies are frequently unable to recover their costs by charging their customers and often rely on government subsidies or international support. In turn, weak financial conditions impede an adequate expansion of the grid, the timely payment of independent power producers, and the delivery of reliable supply. Poor-quality service undermines the willingness of customers to pay their bills and of governments to enforce them, thereby closing a vicious circle. A massive inflow of Chinese investments has somewhat improved the situation in the past decade, but much remains to be done. However, the advances in RES-based generation technologies, both utility-scale and distributed, offer today new opportunities which can positively combine with new digital solutions. The experience of countries like Kenya suggests that low-cost RES plus innovative business models allow poorly served countries to avoid the need for expensive centralized grid expansion and spur electrification despite – or maybe because of – a lack of reforms (for more information on the evolution of electricity sectors in Africa, look at Chapter 22 by Vivien Foster, Anton Eberhard and Gabrielle Dyson).

Learn more

If you want to hear more on the current disruptions in the electricity sector and the future of electricity markets, or if you would like to pose questions to some of the contributors of the Handbook on Electricity Markets, join the second open-access webinar hosted by FSR and IAEE on 15 November 2021.

Watch more

Michael Pollitt on electricity markets: adapting to new technologies and policy priorities- YouTube

Welcoming new entrants in electricity markets – YouTube

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