EXPLAINING THE GRID PART THREE

Market Products

In order to understand electric markets, it is first necessary to review a few principles of grid operations.  First, and most important, electric systems have highly interconnected transmission networks.  The electricity delivered to the network instantly travels over all transmission lines in the network to serve the system’s customer loads.  As a result, an electric system works essentially works like a pool where all electricity delivered into the system serves all the loads.  Unlike a pool, however, electricity delivered into the system doesn’t just sit in the pool but must be instantly delivered to and consumed by customers.  As a result, the principal job of system operators is to ensure that the amount of electricity delivered into an electric system exactly matches the amount of electricity delivered to customers.  (this is a bit of a simplification, but it works to help conceptualize grid operations)

Because balancing generation and load is the paramount responsibility of grid operators, electric systems are officially referred-to in the electric industry as “balancing authority areas” and system operators as “balancing authority operators.”  The products sold in electric markets that we will discuss in my post today are the products used by system operators to ensure that they maintain the generation/load balance.  There are other esoteric energy-related products used primarily to hedge certain price risks, but they are bought and sold by traders and market participants and are not used by system operators.  As a result, I am not going to describe these products in this post.

Energy

The first product sold in electric markets is, not surprisingly, the electricity generators deliver into an electric system.  In the electric industry this product is called “energy.”  Energy is the fundamental, and most important, product sold in electric markets.  Most other products are simply contractual obligations used by system operators to ensure that there is always a balance between the mount of electricity delivered into an electric system with the system’s customer load.

In order to understand how energy markets work, it is important to review another important principle of grid operations affecting electric markets; namely that there is almost always more generation available in an electric system than is needed to serve the system’s customer load.  As I explained in my first post in this Explaining the Grid series, electric systems must have access to enough generation capacity to serve the peak load, which may occur only a few hours a year, plus a reserve margin to protect against unforeseen circumstances.  As a result, unless a system is operating under high stress conditions, such as extreme temperatures combined with a certain amount of generator outages, that system will not need to use all available generation at the same time to serve its customer load.

That being the case, how do system operators decide which generation facilities to run?  The basic method for doing this is to employ what is called a “stack.”  I am providing a graphic below to help to conceptualize this.  Remember that my expertise is in grid operations and not computer graphics, but I think that this does the job, even if only in a crude manner.

As this graphic shows, different generators are stacked by system operators, with the lowest cost units at the bottom, then next lowest cost, and so on, with the most expensive units at the top of the stack.  The stacks also include the capacity of each generator.  The generators chosen to operate at any particular point in time are chosen starting at the bottom of the stack up to the unit whose capacity, in combination with the capacity of the units below it in the stack, are equal to the customer load at that particular time.  In my graphic, there is 950 megawatts of load that is served by three generators, one of which has costs of $20, one with costs of $30, and one with costs of $50.  All of the capacity of the $20 and $30 units is produced, and 350 megawatts out of 400 megawatts of the $50 unit is produced.  (in real life, the system operator might need to select a somewhat different mix of generators for operational reasons, but use of the stack alone to select the generators is the preferred optimal method)

The benefits of the stack are apparent.  By selecting the lowest cost units to supply load, the system operator has “dispatched” (the term used to refer to units instructed to run) units that supply to customer load at the lowest possible cost. 

What costs are we talking about here?  Essentially it is the variable costs incurred by the generators to produce electricity.  For most types of units the most significant cost is the cost of fuel used by the unit.  This frequently means that many of the lowest cost units in the stack are large units, such as nuclear units, that cost the most to construct in the first place.  But, for those of you familiar with economics, know that the costs to construct existing units are sunk costs that do not change regardless of whether an existing unit is dispatched.  In the example shown in my graphic, it would make no sense to choose not to dispatch the $20 unit, if that unit was a nuclear unit, and to dispatch all of the $50 and $75 units instead.  The total variable costs incurred under this choice would be higher, and no costs would be saved by not dispatching the nuclear unit because the costs to construct the nuclear plant were already incurred, at the time the nuclear unit was constructed.

Capacity

The second-most important product—capacity—is not a physical product at all.  Instead, it consists of a contractual obligation by a generator to produce electricity when so required.  Some courts have referred to capacity as a kind of option contract, but I think of it as more like a contract between a professional sports team and a player.  The contract requires the player to show up at all games, and to play when so instructed by the coach.  The player earns the salary specified in the contract whether or not the coach puts the player into the game.  The point of the contract is that the team knows the player will be available to play and, if it has enough contracts with enough players, it knows that it will always be able to field a team for all of its games.

Similarly, a capacity contract obligates a generator to be prepared to supply a certain amount of energy whenever so ordered by the system operator.  The price paid to the generator for the sale of the energy is determined separately, and it paid only if only is actually produced.  But the price for the capacity is fixed, and is paid whether or not the system operator calls on the generator to produce energy, just as a professional athlete is paid whether or not the athlete ever plays in a game.

Both the system operator and the generator benefit from this arrangement.  The system operator knows that, if it has entered into sufficient capacity arrangements, it always will be able to call on generators to supply all of the energy needed to serve its customer load.  Generators are guaranteed a certain amount of revenues even if they are never called upon to produce any energy.    

Some system operators own their own generation capacity.  The payment they receive for this capacity varies depending on the circumstances, but the product is the same.  By owning the generation capacity, the system operator is able to operate it to produce energy when needed.

Other Products

There are other products, relatively less significant, but nevertheless important to ensure that energy and load are balanced.  These include the following:

Regulation.  We all are constantly changing the amount of electricity that we consume as we turn lights on and off, run the microwave to cook some popcorn, turn our thermostat up or down, etc.  Collectively, these changes cause total system load to rapidly fluctuate up and down in the course of the day, even if the general trend is up in the first half of the day and down the second half.  Further, not all generators produce a steady amount of electricity, and generator outputs can change as they are instructed to increase or decrease production.  Regulation is a product sold by generators that provides very quick deviations in the output of electric, both up an down, which system operators use to match these rapid deviations in load and generation to ensure that the total amount of electricity delivered to the system matches the total amount of load.  Only certain types of units (typically gas-fired turbines, but also hydroelectric dams and batteries), have the ability to change output quickly enough to provide regulation service.

Operating Reserves.  Operating Reserves consist of a contractual obligation for generators not producing energy to be ready to produce on short notice if needed to meet unexpected contingencies.  There are two types of operating reserves:  (1) Spinning reserves, which are generators that are on-line but not producing energy and, as a result, can be brought on-line quickly; and (2) Non-spinning reserves, which take onger to bring on-line, but still can supply energy relatively quickly.

Black Start.  Many generation facilities require the electric system to supply electricity to start up and commence operations.  This can create operational issues when a system goes down and electricity is not available from the grid.  Black start units are able to start without the need for electricity to be provided by the system, and therefore are able to supply the electricity needed to start up other units.

There are a few other products used by system operators as well, but the above covers the most important.  In my next post I will start to explain the markets for these products.

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