Module 3

Electricity Markets
Notes by: Prof. Abhijit Abhyankar, IIT Delhi
 ELECTRICITY VIS-A-VIS OTHER COMMODITIES

The classification of market models based on contractual agreements discussed in the

previous section can be applied to most of the commodities that are traded in the
market, if we assume a certain level of abstraction by presenting only the buyers and
sellers. However, when it comes to ‘electricity' as a commodity, the same laws of
economics or commercial trade arrangements may not hold good. This is because,
electricity as a commodity bears different characteristics from other commodities, or
rather, electricity is physically different from other commodities. This fact complicates
the procedure of electricity trading. In other words, the trade is not as simple as an
interaction between two entities: buyer and seller. The interdependencies of actions
taken by various participants (primarily generators and loads), mandate somebody to
take over the control of real time activities. This somebody is the system operator, who
makes sure that the whole system runs reliably and thus kept in synchronism. Thus, it
is worthwhile to understand the distinguishing features of electricity as a commodity,
which are presented next.

Distinguishing Features of Electricity as a Commodity

There are three basic distinguishing features of electricity. These are associated with
electricity due to its physical nature. These three basic features effectively lead to one
distinguishing feature of this commodity, the one that has commercial implications. Let
us see these in details

Real Time Demand Supply Balance

Electricity cannot be stored in bulk. Other commodities can be manufactured and kept
in a warehouse until the demand for the same is sensed. A manufacturer of other
commodities gets sufficient flexibility in planning the manufacturing activity and
coordinating the dispatch. The same is not true for electricity. The demand for
electricity needs to be satisfied on real time basis.

The parties involved in electricity trade perhaps would like to do it through forward
contracts. These can be contracts for physical delivery or financial in nature. In many
power markets, bulk trade of electricity (> 80%) is done through forward contracts.
Forward contracts can be done years ahead. When a certain amount of electricity is
bought in the forward contract, it is the estimate of the buyer, how much it is likely to
consume during actual delivery time. However, in real time, the actual consumption
may not match the predicted consumption that had been forecasted at the time of
doing forward trade. This difference is called as imbalance. Knowledge about this
imbalance is exposed only during real time operation or slightly before that. In this
case, the system operator or some other market mechanism stands ready to make up
the imbalances (either on positive or negative side).

Due to storage limitation, the supply-demand matching decision needs to be done on

a competitive basis by letting supply and demand interact with each other. The
operator buys and sells these imbalances through some commercial mechanism. Due
to this feature of electricity, an issue related to the speed of operation pitches in. The
system operator, while making a provision for imbalances, has to take into
consideration various network interdependencies. The system operator always has to
communicate with the active participants to tell them which generators should increase
their output and which ones should decrease it. This activity is called scheduling in
advance and dispatch in real time. Since the system operator has to work with seconds
to spare, a delivery system to make up for imbalances has to be in place. In real time,
the only time available with system operator is what is allowed by the energy stored in
rotating masses of huge interconnected grid.

Thus, this exceptional feature of electricity leads to two issues related to power market
design: Imbalances and Scheduling and Dispatch. The question is how these difficult
tasks get reflected in the rules of marketplaces.

Power Flows Obey Laws of Physics

The electric power cannot be told as to where and how it should travel, once the
injection and take-off points are decided. The electric power flow over transmission
lines obey laws of physics. Effectively, electric power cannot be stopped from flowing
on a transmission line that is already hitting its power carrying capacity. The system
operator has to ensure that none of the lines get overloaded. To do this, only freedom
left with it is the selection of pattern of nodal injections (either generation or load).
Thus, any arbitrary set of forward contracts cannot be scheduled by the system
operator as this may lead to exceeding of limits of physical parameters of some of the
power system elements. Allowing only the practically feasible set of transactions
during scheduling and further making corrections while dispatching so as to keep line
loadings within limits is usually termed as congestion management.

The concept of network congestion is shown by a simple lossless system in Figure

3.6. In this, generator A is a cheaper generator than generator B and hence, it gets a
contract of satisfying the demand of load at bus 3 by generating 18 MW. The dispatch
would be as shown in Figure 3.6(A). The power flow over all lines would be dictated
by the reactance of parallel paths. In this case, let us assume that reactance of all
three lines are same. Thus, two parallel paths are provided so as to transfer power of
generator A to load at bus 3, with ratio of reactance 2:1. Obviously, the power will flow
in opposite ratio on these paths. The flows are shown in Figure 3.6(A). However, if the
physical properties of the line connecting nodes 1 and 2 state that it can carry only 3
MW, then the dispatch shown in Figure 3.6(A) left hand side is not practically feasible.
To correct it, generator B is asked to generate 4.5 MW and generator A is asked to
step down by 4.5 MW, leading to dispatch shown in Figure 3.6(B). This rearrangement
of nodal injections is one of the means of congestion management, which is peculiar
to electricity. We will discuss more about this in a separate module on congestion
management.
 Figure 3.6: Concept of network congestion

Generator Product Compatibility and Interactions

To ensure reliable delivery of electricity, only generation by generators at injection

points and take-off by loads at take-off points is not sufficient. The system operator
must make arrangements for provision of allied services necessary to do this. These
allied services are usually referred to as the ancillary services. Provision of reactive
power, operating reserves are some of the commonly required ancillary services.
Mostly, ancillary services are provided by generators. In this case, one is likely to
witness the interdependencies involved in providing these services. In other words,
the production of ancillary services is also dependent on production of energy. Then,
the same generator is said to be providing two different products: energy and ancillary
services.

This complicates the matter because the single generator can be simultaneously
needed to produce multiple outputs, or to produce ancillary service rather than energy.
This complication is shown in Figure 3.7, where, a generator's capacity is divided into
various products. The defining question is how much of capacity should be allocated
to each product? In centralized markets (explained later), the system operator does a
joint optimization, taking into account various technical and commercial parameters of
a generator to allocate it's full capacity to each of the products. module 6 is devoted to
ancillary service management where these issues will be discussed more elaborately.
 Figure 3.7: Generation capacity allocation to various products

Unusual Price Variation

The combined effect of various peculiarities of electricity is that it has large temporal
variation in its price. It is not prudent to run all generators throughout the day. Rather,
the most economical generators can be run throughout the day. Effectively, the price
of electricity will be low during low demand period. However, during peak demand
situation, the costly generators are brought on-line and the price of electricity goes
high. Thus, marginal cost of producing energy will vary throughout the day. Such rapid
cyclic variations in the price of a commodity are unusual, and arise due to peculiarities
associated with electricity, basically, the characteristic of matching supply and demand
on real time basis. It should be noted that this peculiarity of electricity has arrived
because of one of the basic physical properties associated with it.

Effects of Peculiarity: Four Pillars of Market Design

We have seen the characteristic features of electricity when compared with other
commodities. How do these affect the trading activities of this commodity? For
example, what if network congestion does not allow a set of transactions to be
feasible? Should the generator sell its generation capability in a single market that
makes provision for energy as well as reserves, or should there be different markets
for the same? Some subtle questions like these provide food for thought when
designing criteria of markets are to be determined.

Hunt in [1] has described the design issues arising out of characteristics of electricity
as pillars of market design. These are:

• Imbalance
• Scheduling and Dispatch
• Congestion Management
• Ancillary Services

Figure 3.8 shows four pillars of market design arising due to the basic characteristics
of electricity.
 Figure 3.8: Four Pillars of Market Design

The design of market revolves around the four pillars described above. It also depends
on how and where these issues are accommodated in the whole process of market
mechanism. Some of the pillars lead to creation of separate markets. Eventually, this
gives rise to the issue of market architecture, which is nothing but arrangement and
classification of these markets. Finally, these markets can be integrated into one
efficient market or there can be cascaded markets. The architectural aspects of market
design are discussed next.
 MARKET ARCHITECTURE

Stoft in [2] defines market architecture as a map of its component submarkets. This
map includes the type of each market and the linkage between them. Where does this
concept of multiple markets come from? The answer can be traced back to various
peculiarities associated with electricity. Four pillars of market design tend to cast the
same electric energy into various products, which are characterized by separate
individual markets. Moreover, there are various modes of energy contracts depending
upon when energy trades are done. This again gives rise to market mechanisms
based on timeline of trading. The submarkets of a power market include the wholesale
spot market, wholesale forward markets and markets for ancillary services.
Somewhere in between is embedded the market for transmission capacity. This can
be a separate market altogether or can be integrated with the energy market that takes
place near real time. Similar is the case with ancillary service market. The best way to
categorize alternative trading models is on the degree to which operational
arrangements and commercial arrangements for scheduling, imbalances, congestion
and ancillary services are integrated with spot markets. Two models are most
common: integrated or centralized and decentralized. In the rest of the module, we will
give more stress on how various markets for energy and other products are organized.
For the sake of understanding, we will not go into the intricacies involved in various
modes of arrangement and levels of competition discussed in Section 3.2. We will just
represent market by a set of sellers and buyers. For this, we do the abstraction of the
market as shown in Figure 3.9, indicating sellers and buyers with some interaction
facilitator. This abstraction gets rid of questions about ownership of transmission
network, power exchange, distribution network, as well as doesn't bother about whom
the buyer represents or buys for its own. The relevant details about the same will be
discussed at appropriate places. First, let us see how markets for energy are
arranged.

Timeline for Various Energy Markets

There are many ways depending on the time of hand-shaking, where buyers and
sellers can do the transaction. Figure 3.10 shows various modes of trading based on
the time-line. Following are the common modes in which the electric energy can be
traded:
 1. Bilateral contracts
2. Spot market

a. Day ahead markets (Power Exchange or through pool)

b. Real time market (through pool)

Figure 3.9: Abstraction of market concept

Trading for power delivered in any particular minute begins years in advance and
continues until real time, the actual time at which the power flows out of a generator
and into a load. This is accomplished by a sequence of overlapping markets. The
earliest amongst these are forward markets that trade non-standard, long term,
bilateral contracts. This generally represents energy trading between buyers and
sellers directly for the mutually agreed price. This type of trading stops about one day
prior to real time. At that point, the day-ahead market is held. The day-ahead market
is often followed by a real-time market. The term - spot market is used with different
interpretations associated with it. According to definitions in some of the systems, the
spot market includes day-ahead and real-time market, while in others; it just includes
the real-time market. Similarly, drawing line between spot and forward markets is not
clear. According to one definition, all the markets before the real-time market can be
classified as forward markets. This is because, in many forward markets, including
day-ahead market, traders need not own a generator to sell power. If power is not
delivered in real time, then the supplier must purchase replacement power at the real
time rate and fulfill the contract. A customer who buys power in a forward market will
receive either electricity delivered by the seller or a financial compensation. Any power
that is sold in the day-ahead market, but not delivered in real time, is deemed to be
purchased in real time at the real time price of energy. The combination of day-ahead
and real-time market is popularly known as multi-settlement market system in
USA. Another way to distinguish between forward and spot markets is by considering
day-ahead and real-time markets as spot markets, while all trades taking place before
that are termed as forward or bilateral trades. This segregation emerges because both,
the day-ahead as well as real-time markets provide a system price which holds for all
the market trades done through it. On the other hand, in bilateral or forward trades,
there is no single market price as such. In the rest of the module, we prefer to define
the spot market as defined just above. There is little doubt about what should be the
nature of settlements based on timeline. Much ahead of real time, i.e., more than a
week, month or years ahead, bilateral contracts provide the best manner of trading
power. One is very unlikely to have bilateral contracts near real time. The reason is
that the settlements of bilateral contracts take place very slowly. Near real time, it is
prudent to have a centrally organized market as the security and reliability issues can
be tackled centrally rather than bilaterally. Even, the day-ahead market can be
centrally organized. It can take the form of power exchange or the pool. In other words,
day-ahead market can be organized by a separate entity, or it can be integrated with
the system operator activities. If the latter is adopted, it is popularly known as a pool
structure. In general, real-time transactions require central coordination, while week-
ahead trades do not require the same. Somewhere in between are dividing lines that
describe the system operator's diminishing role in forward markets. Where to draw
those lines is the central controversy of power market design. A larger role for the
system operator implies a smaller role for private, profit-making entities.

Bilateral/Forward Contracts

Bilateral trading generally involves two parties interacting with each other: a buyer and
a seller. The characteristic of bilateral trades is that the price of a transaction is set
independently by the parties involved. There is no market clearing price as such.
Since, electricity cannot be stored, it creates a wide fluctuation in the spot price.
Forward contracts provide generators and loads with a means of hedging their
exposure to fluctuations in the spot price of electricity. The generators can negotiate
a price for their output prior to the moment of producing it. Similarly, properly structured
forward contracts provide buyers with the ability to lock in a fixed price for a fixed
quantity of electricity well in advance of delivery and consumption. Indeed, if a buyer's
actual energy usage matches its forward market purchases, it can achieve a benefit
of complete price certainty in the face of real time price volatility.

Figure 3.10: Seller buyer interaction based on timeline

Depending upon the quantity of power and time, the buyers and sellers resort to
different forms of trading:

• Long Term Contracts: This type of trade generally includes contract for a large
amount of power for a long time period. These types of contracts are negotiated
privately and the terms and conditions are such that they suit both the parties
involved in the transaction.
 • Trading Over The Counter: These transactions involve smaller amounts of
energy to be delivered. For example, the amount of energy to be delivered
during different periods of the hour, day, etc. This type of trading has much
lower transaction costs and is used by producers and consumers to refine their
positions before real time.
• Electronic Trading: In this, participants can enter offers to buy energy and bids
to sell energy directly in a computerized marketplace. The participants can
observe the quantities and offers/ bids submitted by all participants, but do not
know the party involved. The software in the exchange couples the matching
offers. It checks whether for a newly entered bid, if there is matching offer
whose price is greater than or equal to price of the bid. If no match is found, the
bid is added to the list of outstanding bids until a new offer matches it.
Otherwise, it lapses after the market is closed. The same process is repeated
after a new bid is entered. There is no market clearing price as such.

The Spot Market

As we have discussed in module 2, a market for any commodity provides an

environment for buyers and sellers to interact and agree on transactions, generally,
the quantity and price. These interactions progressively lead to an equilibrium point at
which the price clears the market, that is, the supply is equal to demand. If electrical
energy is to be traded according to a mechanism in which the buyers and sellers are
free to interact individually, the equilibrium between the production and the
consumption can be set through repetitive interaction. In this scheme of attaining
equilibrium, the consumers make an estimation of their consumption before entering
into a contract. The generators schedule the production of their units to deliver at the
agreed time the energy that they have agreed to sell. However, in practice, neither
party can meet its contractual obligation with perfect accuracy because, for example,
from a load's point of view, the actual demand of a group of customers is never exactly
equal to the value forecasted. Changes in weather and due to some other externalities,
the day ahead or before real time estimation of load consumption can have deviation
from that done few months or years back, while doing the contract. Also, unforeseen
problems may prevent generating units from delivering the contracted amount of
energy. It can be concluded that, while a large proportion of the electrical energy can
be traded through an unmanaged open market in terms of forward contracts, such a
market may not necessarily lead to an equilibrium that replicates real time scenario.
Thus, an intermediate stage is necessary, where a managed spot market can provide
a mechanism for balancing load and generation. This market should supersede the
open energy market as the time of delivery approaches. Its function is to match
residual load and generation by adjusting the production of flexible generators and
curtailing the demand of willing customers. In many real life markets, more than 80%
of the energy traded is through the forward or bilateral contracts. The rest is traded
through the spot market. In a multi-settlement market (typically practiced in some of
the markets in USA), the spot market is sometimes made of two markets: Day Ahead
(DA) market and a Real Time (RT) market. The DA market is run for each hour or half
hour of the next day. The RT market is always run by a system operator, while the
day-ahead market may or may not be run by the system operator. In both cases, the
general principle of market clearing is the same. This and other related issues are
discussed next.

Spot Market Clearing

For the sake of understanding, let us assume that the market is run by an entity called
Power Exchange (PX). The power exchange operates much like a stock exchange.
The buyers and sellers enter their needs into the power exchange. For example, a
buyer would say, “I need up to 20 MW between 1600 hours and1700 hours IST. I
would pay INR 3.5/ kWhr”, whereas, the seller would enter his demand as, “I have 100
MW and would like to sell it at INR 4/ kWhr”. When they transact with the power
exchange, buyers and sellers are really talking to the marketplace and not the
individual buyers and sellers. As in a stock exchange, the power exchange constantly
updates and posts a market clearing price (MCP), which is the current price at which
the transactions are being done. Note that when buyers and sellers communicate with
the power exchange, they don‘t know whom they are dealing with. The general step
by step process of settling this market is as follows:

1. Generating companies submit bids to supply a certain amount of electrical

energy at a certain price for the period under consideration. Usually, the period
is an hour or half an hour. The bids are ranked in order of increasing price.
From this, a curve that shows bid price as a function of bid quantity is built,
which is commonly known as supply curve. Supply curve is a plot with price on
y axis and quantity on x axis.
 2. Similarly, demand curve is established by asking consumers to submit offers
specifying quantity and price and ranking these offers in decreasing order of
price. If the load is willing to adjust its consumption with price, the load is said
to have demand elasticity. If the load is firm, the demand curve will take the
form of a vertical line with x axis intersection indicating total cumulative firm
demand.
3. The intersection of supply and demand curves represents the market
equilibrium. At this point, the supply matches the demand. This price is known
as Market Clearing Price (MCP) or System Marginal Price (SMP). All the bids
submitted at a price lower than or equal to the market clearing price are
accepted and the generators are scheduled for that much amount of power for
that particular time period under consideration. Similarly, all the offers submitted
at a price greater than or equal to the market clearing price are accepted.
4. As for settlement, the generators are paid this MCP for every MWh they are
scheduled for, while loads pay the MCP for every MWh they are cleared for.

Illustrative Example for PX Clearing

Suppose there is a central power exchange in which all players in the market send
bids and offers. Table 3.2 shows the offers and bids supplied to the central power
exchange for a particular hour of the next day, say 10:00 AM to 11:00 AM. Once the
buyers and sellers provide offers and bids, the power exchange forms an aggregate
supply curve and aggregate demand curve. The curves are plotted on the coordinates
of supply (and demand) and price as shown in the Figure 3.11. The point of
intersection of the two curves determines the market-clearing price (MCP). At this
point, the supply satisfies the demand. From the intersection of supply and demand
curves, the MCP would be set to 3200 INR/MWh and 450 MWh will be traded through
the central power exchange. The MCP is the price of electric energy that is paid by
consumers trading through the power exchange. The sellers are also paid at a price
equal to the MCP. MCP is the highest sell bid or lowest buy bid accepted in the auction.
The generator ‘S2' is called the marginal generator as its bid sets the MCP. Over and
above the forward contracts, the participants trade the residuals through the power
exchange. The objective of the power exchange clearing is to maximize the social
welfare as explained in the earlier module. It is the sum of generator surplus and the
load surplus.
 Quantity Price
Company
(MW) (INR)
S1 200 2400
S1 50 3000
S1 50 4000
Bids S2 150 3200
S2 50 3400
S3 100 2600
S3 50 3600
D1 50 2600
D1 100 4600
D2 50 2200
offers
D2 150 4400
D3 50 2000
D3 200 5000

Table 3.2: Bids and offers in the power exchange

Discriminatory or Non-discriminatory Pricing?

There are few questions which are likely to remain unanswered regarding the
settlement procedure adopted in the above market clearing process. One is likely to
get surprised to see all of the generators being paid the MCP, rather than at individual
bid. Except the marginal generator, all other generators are willing to produce power
for lesser price than the MCP. Then, why are they not paid their asking price? Paying
them their asking price would have reduced the average price of electricity. Paying
generators as per their asking price is known as pay-as-bid scheme. The main reason
why pay-as-bid scheme is not adopted is that it would discourage generators from
submitting bids that reflect their marginal cost of production. Basically, the notion that
the average price of electricity would decrease by adopting pay-as-bid scheme is
based on the assumption that the generators would continue to bid in the same way
as they do in the marginal pricing scheme. However, this is not true. All the generators
would instead try to guess what the MCP is likely to be and would bid at that level to
collect the maximum revenue. While doing so, some low cost generators would bid
too high. Then, in the market clearing process, these generators would not get
selected and be replaced by some other generators that have higher marginal cost of
production. The MCP would then be somewhat higher than it ought to be. Furthermore,
this substitution is economically inefficient because optimal use is not made of the
available resources. In addition, the generators are likely to increase their prices
slightly to compensate themselves for additional risk of losing revenue because of
uncertainty of MCP. An attempt to reduce the price of electricity would therefore result
in a price increase. On the other hand, in marginal pricing scheme, a seller is certain
that it will be paid no less than its cost of production if he bids at marginal cost, and
may be paid more. If a seller bids less than his marginal cost, it would lose money
because his bid may set the MCP. If it bids more than its marginal cost, it may bid
more than other sellers and fail to be selected in the auction. If the seller's bid sets the
MCP, then it would recover it's running cost and if the MCP is higher than it's marginal
cost, then it would earn profit or contribution to fixed cost. It is worthwhile to know that
the supply curve, being a derivative of cost function, does not consider the fixed costs.

Figure 3.11: Calculation of market clearing price (multiply price by 200)

Simple Bids or Complex Bids?

In the illustrative example provided above, the generators submitted simple bids
consisting of price-quantity pairs. In some system operator run markets, (typically
known as centralized model, explained later), generators submit complex bids for
each of their generating units. These bids are supposed to reflect the cost
characteristics of the unit (including the marginal, start-up and no-load costs) as well
as some technical parameters (minimum and maximum output, flexibility). Rather
than simply stacking the bids, the system operator then performs a central unit
commitment that determines the production schedule and the prices for an entire
day divided in periods of half an hour or an hour. For example, suppose a thermal
generator with low marginal cost and high start up cost is shut down temporarily. In
the centralized dispatch system, the generator submits a complex bid consisting of
all details mentioned above. While doing a central unit commitment, the system
operator will not only consider its marginal cost, but will also take into account its
start-up cost. On the other hand, if the market is not centrally dispatched, only the
marginal cost of the generator will be taken into account to decide its selection or
exclusion.

The advantage of complex bids is that they allow the system operator to take
account, the true characteristics of the generators and thus, potentially, do a more
efficient job of minimizing the cost. Setting the price becomes a disadvantage and
requires a complex optimization problem to be solved.This leads to higher cost of
computation & lower transparency.

Day-Ahead Market and Real Time Market

As mentioned earlier, imbalances arise due to deviation between the forward

contracted amounts and the actual or near real time estimation of consumption. The
spot markets are meant to provide a mechanism for handling these imbalances.
However, the energy trading must stop at some point before real time to give the
system operator to balance the system. How much time should elapse between this
gate closure and real time is a hotly debated issue.
Large coal based thermal plants take more than an hour to start up. Such generators
can not bid if the gate closure for spot market is lesser than one hour. Under these
circumstances, it is beneficial to have two energy markets: a Day Ahead (DA)
market in addition to Real Time (RT) market. A DA market, as its name implies,
operates a day in advance of the RT market. A day-ahead market becomes
beneficial as follows:

First, it can be beneficial if generators have high start up costs and start and stop
each day. In a centralized dispatch model (explained later), the system operator
integrates the start up costs of these generators so as to come out with the start/stop
decision in a longer term dispatch process. In other words, the time horizon for
optimizing dispatch decisions is a day, not an hour or less.

Second, it can be beneficial if generators would otherwise be able to game the

market to lift spot prices by withdrawing capacity at short notice - a form of market
power. This form of market power is explained with the help of Figure 3.12. Figure
3.12(A) shows competitive MCP denoted as MCP1. Now suppose, if this generator
company forms a coalition with Gen 7 and temporarily closes Gen 4 on the terms of
sharing the profit with Gen 7. Now, Gen 7 becomes the marginal generator and sets
the MCP (i.e., MCP2), which obviously is higher than the competitive MCP, as
shown in Figure 3.12(B). If the system operator needs to plan operations a few
hours ahead of time and relies on generator promises of availability, then under
such cases, withdrawing capacity of a generator just ahead of real time leads to
calling of an expensive generation. The day-ahead contracts can remove the
gaming incentive from generators because their prices are locked in day ahead, and
they can't play the same game in the day ahead market because more alternatives
are available day ahead than in real time.

The RT market provides volatile prices, in general. The DA market can promote
demand response. If the DA price is high, the loads can choose not to buy, and they
have a day to plan for alternative arrangements.
2

Figure 3.12: Change in MCP when capacity is withdrawn

MODELS FOR TRADING ARRANGEMENTS

As mentioned earlier, the decision about the market architecture is dominated by the
factor - how strongly the allied markets are integrated. The electrical energy takes
different forms in different markets. In other words, same electrical energy is valued
as different products in different markets. If the peculiarities associated with electricity
would not have been there, then the four pillars of market design would have been
absent and electricity as a commodity would have been treated at par with the other
commodities. Then, the players in the market would only bid or play for price and
quantity. However, due to peculiarities of electricity, apart from energy market (bilateral
or spot), other markets also come into picture in which electricity, as a product, takes
different forms. This fact strongly influences the decision about the dispatch
philosophies or in other words, the short-term trading arrangements. The dispatch
philosophies are based on the degree to which the operational and commercial
arrangements for scheduling, imbalances, congestion and ancillary services are
integrated with spot markets. Depending upon how various markets associated with
the four pillars are arranged, the market dispatch procedures take the form of
cascaded markets or integrated markets. Broadly speaking, the integrated markets
lead to economic efficiency at the cost of loss of transparency. On the other hand,
cascaded markets though inefficient, provide transparency. Keeping this in mind, the
dispatch philosophies or rather, the short-term trading arrangements can be classified
into two broad categories:
 1. Integrated or Centralized Dispatch
2. Decentralized Dispatch

As the name suggests, the integrated model is integrated with strong linkages
between various aspects stated above. On the other hand, decentralized markets
provide scattered efforts for various arrangements in a power market. One of the
essential differences between integrated and decentralized markets is whether or not
the system operator administers a spot market integrated with the pricing of energy
imbalances, congestion management and ancillary services. The integrated model
mandates the SO to run the spot market, integrated with imbalances, and the others.
On the other hand, the decentralized model attempts to keep the spot market separate
from the system operator, to be organized off-line by the traders. Integrated or
centralized markets are now being commonly employed in USA. In this, the system
operator schedules forward contracts at the request of traders, but also takes bids
from traders to modify scheduled contracts and to provide energy imbalances,
congestion management and ancillary services. The system operator runs the spot
market using large computer optimization program, and by doing so, the system
operator minimizes the overall cost of these services. The decentralized model was
employed in earlier Californian market (now it has moved towards integrated model)
and also in UK after adopting NETA3. In this model also, the system operator
schedules traders' contracts. However, the spot market is held separately and the
decisions of the same are conveyed to the system operator. The system operator has
to administer arrangements for imbalances. As far as possible, the traders run the spot
market and manage congestion, while separate arrangements are set up for ancillary
services. The decentralized model requires not only private markets for regular energy
to cater to imbalances of forward markets, but also markets for congestion energy and
markets for ancillary services. As mentioned in [1], in a liquid and efficient market, all
these separate products will be exchanged at the same price, time and place.
However, the decentralized model does not ensure that the prices of all these different
products converge. This may be looked upon as an inefficiency. The integrated model,
on the other hand, integrates energy of imbalances, congestion, reserves and spot
sales together and sells at the spot price determined by the system operator, achieving
economical efficiency in the dispatch process. In the following sections, we intend to
provide more details on the concepts of centralized and decentralized markets,
particularly comparing them on the following aspects:
 1. Imbalance energy
2. Congestion Management
3. Ancillary Services

Integrated or Centralized Model The schematic of centralized dispatch model is

presented in Figure 3.13. As shown, the joint optimization of all markets is done by the
system operator. It should be noted that the energy market refers to the short term
competitive market or the spot market, as defined in this module. As shown in the
figure, the buyers and sellers provide their bids and offers to the system operator. The
buyers in this model supply the complex bids. The system operator then performs the
central unit commitment, taking into account the complex bids. The system operator
accomplishes this by solving a complex optimization problem, typically known as
Security Constrained Economic Dispatch, in USA market context. The outcome of this
dispatch is the nodal prices, popularly known as Locational Marginal Prices (LMPs). If
the losses are neglected and the network constraints are non-binding, the outcome of
this dispatch and that shown in Figure 3.11 carry the same meaning. In other words,
all LMPs would come out to be the same which means nothing but common MCP to
all. However, this market clearing is influenced and altered if the network capacities
are congested and then the nodal LMPs would come out to be different. In other words,
the network congestion is implicit to this type of market clearing. Some of the important
features of this dispatch philosophy are next discussed.
Figure 3.13: Centralized Dispatch

Treatment of Imbalances

How contracts and imbalances are tackled in the integrated model? If the system
operator does the central unit commitment using a complex optimization process, how
are the forward contracts accommodated? These are a couple of questions which
need further explanation. In the integrated dispatch model, all differences between
contract positions and actual production, consumption, regardless of cause, are traded
at the market prices (spot prices) that come out of the system operator's central
optimization process and the forward contracts in the integrated model remain
financial in nature only. Whenever the traders make bilateral contracts in the integrated
structure, it is not necessary for the system operator to know anything about the
bilateral or forward contracts. This is because the system operator runs the least cost
dispatch optimization program to come out with locational spot prices and the
settlements are done based on these locational spot prices (LMPs). The effect of
central optimization for least cost dispatch is that every generator is scheduled by the
system operator irrespective of its forward contract obligation. Thus, it may so happen
that a generator has contractual obligation of 20 MW and the system operator in fact,
may schedule this generator to produce zero MW! The effect of getting into a forward
contract is then left only as a risk hedging tool by locking in to some earlier decided
prices. We will see more of this in the module on risk hedging. Sometimes due to
operational constraints, the generation units are required to be scheduled, rather than
shutting them down. In this case, the generators are said to do self scheduling. In other
words, the system operator, while running its least cost optimization program, must
schedule the MWs offered by this generator. This is also known as inflexible bidding.
The system operator, while running its optimization program, shows this generator as
a zero priced bid, so that it gets selected. Similarly, for load, it shows the self scheduled
load as an infinitely priced offer. What is the effect of offering either a flexible or
inflexible bid on revenues to generators? Let us see the generator's perspective in
case of flexible and inflexible bid submission in the spot market. Suppose, a generator
has a bilateral contract for 100 MW and its marginal price is INR 3000/MW. Now, there
are two choices for this generator.

1. Submit an inflexible bid. It can specify that, regardless of price, the system
operator should schedule this generator to inject 100 MW.
2. Submit a flexible bid. It can specify that anything up to its maximum capacity
can be dispatched by the system operator, as long as spot price exceeds its
marginal price, i.e., INR 3000/ MW.

The first option essentially replicates the decentralized model. In this, the operator is
meant to schedule the bilateral transactions physically. However, in case 2, if the spot
price falls below INR 3000/MW, the generator will not be dispatched by the system
operator, as per the least cost dispatch criteria. However, the requirement of load
involved in the bilateral contract will still be satisfied. It is equivalent to meeting the
generator's contract by purchasing electricity (i.e., imbalances) in the spot market at a
lower rate than its running cost. Alternatively, if the spot price rises above INR
3000/MW, the system operator will dispatch all MWs of this generator. It is easy to
conclude that in either of the circumstances, the generator is better off being flexible
than being inflexible. Indeed, in practice, in the integrated markets that are operating,
much of the generation is offered as flexibly as its production characteristics
allow. When all market participants are flexible, willing to modify operations from their
contracted levels if profitable, the system operator's dispatch is fully separate from
forward contracts. The forward contracts then become financial in nature only. The
system operator will only know about a contract if the traders involved have chosen to
be inflexible. In case of all generators opting for flexible bids, it is not relevant also for
the system operator to know about the contract schedules.

Congestion Management
The process of congestion management is implicit to market operation of the
integrated system. Congestion is solved as an integral part of the calculation of the
least cost dispatch, where cost is defined by generator bids. The system operator uses
the information regarding the bids and network condition to determine the most
economical way to operate the system within the physical constraints using
optimization software. Pricing for congestion (i.e., the price charged for transporting
electricity over scarce transmission) is also straightforward. Traders who schedule
contracts across valuable transmission lines are charged for transmission usage which
is equal to the energy price difference between the two ends of a transaction. As
mentioned earlier, the energy price at each node is calculated by the system operator
using central optimization process. Congestion management and its pricing are thus
integrated with energy pricing in the integrated model.

Ancillary Services
Though as good as 40 ancillary services can be listed, when it comes to classification
of market models based on ancillary services procurement, they essentially refer to
the capacity of generators to provide reserve. The reserves are not a separate service
from energy, they are options to buy energy if required. They should be priced as
options to call energy in the spot market. However, complicating factor is that the same
generating unit can provide energy in the spot market, as well as can act as a reserve.
Hence, the system operator's dilemma is about how much of it should be scheduled
in the spot market and how much should be kept idle as a reserve. In the integrated
or centralized markets, depending on various technical criteria, the system operator
does a joint optimization of energy and reserve market so that optimum scheduling is
done with minimum cost as well as appropriate amount is kept for reserve in the
optimal fashion. More details on this issue are provided in the module on ancillary
services management.

Decentralized Model
The decentralized and integrated models are most clearly distinguished by the
different roles of forward/bilateral contracts in the procedures used to schedule and
dispatch generation. While the integrated model treats the contracts essentially as
financial agreements, and dispatches generators to minimize overall costs, the
decentralized model requires the system operator to schedule the system explicitly
using the contracts. Thus, transaction is treated as a basic unit to be accommodated
in real time system operations. In all trading models, market participants can make
and trade contracts in diverse markets separate from the system operator. The
contracts could be one-to-one contracts or obtained through an organized trade. At
some predetermined moment prior to real time operations, however, the system
operator has to take over to deliver the contracts. The system operator is not intended
to facilitate a spot market - he simply schedules trades that have been arranged
elsewhere. While transferring transactions to the system operator for scheduling, the
condition that the amount bought should be equal to sold should be satisfied. Each
seller must have a buyer and each buyer a seller. The aim of decentralized model is
to leave as much of the trading as possible to the traders, whereas, in the integrated
model, on the day ahead and in real time, the system operator makes the trades by
following instructions incorporated in the traders' bids. The schematic of decentralized
dispatch model is presented in Figure 3.14. As shown, the energy market is not an
integral part of system operator's activity and essentially depends on an external
activity exclusive from the system operator.
 Figure 3.14: De-centralized Dispatch

Treatment of Imbalances

The participants of various forward trades wish to balance their positions near real
time. This is generally accomplished through a spot market. This provides a common
clearing price for imbalances, which is competitive in nature. If a decentralized system
has market based imbalance prices, then that price becomes the price at which the
system operator will buy or sell energy. The market based price of imbalances
provides a reference price for forward contracts. When participants sign contracts, the
contract prices are directly compared with the expected imbalances prices as
imbalance provides direct substitute for contract energy. The spot market for the
imbalance energy is generally run by a power exchange, where the participants submit
simple price-quantity bids rather than complex bids.

Congestion Management
Congestion management in decentralized model can occur in one of the following
ways:

1. Allocation of transmission rights on pro-rata basis

2. Allocation of transmission rights on first come first serve basis
3. Auction of available transmission capacity
4. Special case of zonal pricing with market splitting
5. Pro-rata curtailment in case of contingent situation

The first two approaches are not essentially the market-based solutions. They don't
reflect the willingness of a trader to pay for obtaining transmission rights. These
methods do not take into account the network element interdependencies. On the
other hand, the third option, i.e., of auctioning of capacity rights reflects traders'
willingness to pay. The fourth option, i.e., special case of zonal pricing, separates
markets across the transmission bottleneck and imposes a congestion fee for a
bilateral transaction taking place across the transmission bottleneck. The last
approach, i.e., curtailment, is more of congestion alleviation technique invoked in real
time. For all these methods, a different solution needs to be worked out to manage the
congestion in real time. In the decentralized model, the system operator will only
deviate from the final contract schedules in the dispatch if he needs to do so in order
to maintain security, and may not make efficient trades even if the traders ask him to
since there is no bidding mechanism for them to do so. It should be noted that
congestion management is not implicit with market clearing process. Transmission
capacity allocation needs to be done explicitly.

Ancillary Services
Unlike in the centralized model, the system operator procures all types of ancillary
services generally by making long term bilateral contracts with generator. It is obvious
that this is not the best possible way of obtaining reserves, though it gets rid of
complexities associated with joint optimization of energy and reserves market and lack
of transparency associated with it. There is a possibility that the reserves are procured
on market basis. However, in decentralized system, it takes the form of cascaded
markets. In other words, after passing through forward contracts and spot market, the
generators provide rest of their capacity to reserves markets, subject to technical
compatibility, with the needs. This arrangement can take the other form in the sense,
the generators get involved in long term contracts for reserves and after subtracting
for forward energy contracts, the rest is offered in the spot market for balancing. There
is no joint optimization as is done in the centralized dispatch market.

Comparison at a glance
The conclusion of the discussion on centralized dispatch and decentralized dispatch
is provided in Table 3.3 by comparing the various aspects of two models.

ISO MODEL OR TSO MODEL

In section 3.2, we have seen how various trading arrangements take different forms
depending on the interaction between various entities of the market. In all the four
models presented in section 3.2, the issue of ownership of transmission and
distribution network is not discussed. The restructured power system models across
the world can also be classified according to the ownership of transmission network.
Rather, more clear distinction would be based on whether the system operator itself
is owner of the transmission network or somebody else owns it. In ISO (Independent
System Operator) model, the owner of transmission network is different from the
system operator. In TSO (Transmission System Owner) model, system operator itself
owns the infrastructural investments. This arrangement is seen in most of the
developing countries.

ISO Model
ISO model is practiced in those countries in which transmission companies are also
providing the generation and distribution services in their area of operation. Further, in
these countries, sufficient number of equal sized transmission companies exists in the
market and it is not possible to club the system operation function with any of these
companies for commercial reasons. Therefore, separation of ownership of the
transmission assets from the system operation function is considered necessary to
avoid any preferential treatment for dispatching its own generation.
 Centralized Decentralized
No Attribute
Model Model
Unit
1 Central Individual
Commitment
Separate
Reserve
reserve
market
market or
2 Reserve integrated
obtained
with spot
through long
market
term contracts
Individual
Bids abd schedules
Basis for
3 offers of arising out of
scheduling
participants bilateral
transactions
Integrated Generally
4 Imbalances with spot through day-
market ahead market
Involvement
of system
5 operator in Yes No
day- ahead
market
Congestion
6 Implicit Explicit
Management
Significance
Risk Physical
7 of forward
hedging obligation
contracts
SMD
market in
NETA in UK
8 Example USA like
Nordic pool
PJM, ISO-
NE

Table 3.3: Comparison between centralized and decentralized dispatch models

TSO Model
In TSO model, operation and ownership of the grid are integrated into a single entity
which is responsible for development of transmission system and to provide non-
discriminatory open access to all eligible market participants. It is also responsible for
system operation functions. Neutrality is an important aspect of the TSO to ensure an
efficient market. This model is prevalent in the whole of the Europe.