Modelling Prices In Competitive Electricity Markets example essay topic

Since the early '90's, the electrical energy sector has undergone profound and dramatic changes. More and more countries moved towards the deregulation of their energy sectors, from a regulated and monopolistic industry to one were the market forces of supply and demand determine the unit price of electricity. The first case of energy sector deregulation in Europe was recorded when the United Kingdom with the Electricity Act of 1990 created the Electricity Pool for England and Wales. Norway soon followed suit (Norwegian Energy Act of 1991) and set up the Norwegian Pool in 1993, which eventually became the Nord Pool in 1996. At the same year, the European Union issued its Electricity Directive (Directive 96/92/EC) according to which the electricity markets of all EU countries should be open for competition by 2003, with the exceptions of Greece and Ireland which were granted a one year extension [13]. Deregulating a country's energy sector is a complicated and difficult task.

The typical power utility operation is divided into three main functions: electricity generation, its transmission over the power grid and finally the distribution to the end users. Deregulation stipulates that all three functions should be open to competition. In particular, new and existing power generation utilities / companies (Gen Coms) should be able to compete with each other at a wholesale level. For this to be possible though, the access to the power grid should be offered with the same terms to all players. The only way to avoid any bias or conflict of interest is hence to ensure that the generation, transmission and distribution of electricity are either run by different companies or under different management (un bundling). Furthermore, the electricity distribution sector may also be segmented for different geographical areas, (DisCo ms).

The actual trading of electricity, either the physical asset itself or financial products on it, is organized and takes place in a formal power exchange, or Pool [13]. The passage from a regulated to a deregulated power industry is seen in Figures 1 and 2. Deregulation of the energy sector is all the more challenging due to the particular characteristics of electricity that differentiate it from other traded commodities; namely limited stor ability and transportability. Electrical energy cannot be stored after it has been produced, except in the case of hydro plants where electricity is notionally stored indirectly in the form of the water kept in the reservoirs.

Even in this case though, high demand can be satisfied for a limited time only, while the use of larger in size and / or number reservoirs is either unfeasible or uneconomical. Hence, since electricity cannot be stored, localized supply and demand should always in balance in order to avoid compromising the integrity of the whole network. Thus, a deregulated energy sector involves three types of activities: generation, transmission and ancillary services [6]. In different markets, these three activities are implemented differently with the only common feature being the existence of an Independent System Operator (ISO) whose role is to oversee and maintain the system, (either under its full control or through bilateral contracts) [6].

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Bessembinder H. and Lemmon M.L., (2002): Equilibrium Pricing and Optimal Hedging in Electricity Forward Markets, The Journal of Finance, Vol. LVII, (3): 1347-1382.4. Burger M., Klar B., M"ulcer A. and Schindlmayr G., (2004): A Spot Market Model for Pricing Derivatives in Electricity Markets, Quantitative Finance 4: 109-122.5. Deng S., (2000): Pricing electricity Derivatives Under alternative Stochastic Spot Price Models, Proceedings of the 33rd Hawaii International Conference on System Sciences. 6. Ey deland A. and Wolyniec K., (2003): Energy and Power Risk Management: New developments in Modeling, Pricing, and Hedging, Willey Finance, John Willey & Sons, USA.