1
(1)
Dept. of Accounting and Commercial Law, Hanken School of Economics, Vaasa, Finland
The basis of wholesale electricity markets is electricity trade at transmission grid level. The generation business is at the heart of wholesale electricity markets. There is no physical electricity to be supplied, consumed, transmitted, or traded, unless it is generated. Obviously, electricity producers matter.1
Electricity generation is one of the riskiest of industrial activities. It is capital intensive and requires large long-term investments in generation installations that tend to have no alternative uses (asset specificity).2
Investments in generation assets are influenced by wholesale electricity prices and electricity producers’ risk exposure. Wholesale electricity prices are determined on electricity exchanges. They will play an increasingly important role in the future as more products will be exchange-traded because of market regulation.3 If wholesale prices are distorted, investment in generation will be distorted as well.4
Electricity Producers
Similar to all other firms and electricity market participants, electricity producers have their own interests. They are not identical with the interests of system operators5 or with regulators’ interests. For example, a firm is not in the business of electricity production just to increase general welfare or consumer benefits,6 but the invisible hand of competition between electricity producers can increase production efficiency and even benefit consumers in the long run. Neither is a firm in the business of electricity supply or distribution to sell at the lowest prices,7 but prices can reflect the level of competition in the long run.
This book focuses on the legal tools and practices, which electricity producers use to reach their commercial objectives in the Nordic and Western Central European wholesale markets that are the core of the NWE area.
The topic is interesting from a wider perspective. Electricity markets are in the process of being liberalised.8 European wholesale markets have been undergoing a major change because of ambitious EU-wide policy objectives. In February 2011, the European Council set the target of 2014 for the completion of the internal electricity market. The European Council summed up the required measures as follows: “This requires in particular that in cooperation with ACER national regulators and transmission systems operators step up their work on market coupling and guidelines and on network codes applicable across European networks”.9 To illustrate, EU electricity law now requires the use of market-based mechanisms, that is, implicit or explicit auctions for the allocation of cross-border or cross-zonal transmission capacity with continuous trading as an option for intraday trade.10 EU electricity law also requires the preferential treatment of electricity generated from renewable sources (RES-E).
Whether the broad policy objectives will be reached depends on how market regulation affects electricity producers in the wholesale market.11
Physical and Financial Contracts
The starting point in this book is the contract for the physical supply of electricity. It is the most important contract type for electricity producers and end consumers in electricity wholesale markets.12 Other contracts, tools, and practices either facilitate the conclusion and performance of electricity supply contracts or are designed to complement them.
Physical electricity can be traded in various ways. Standardised contracts can be traded on an exchange. The majority of electricity trading occurs in the OTC market where trading is bilateral and contracts are not standardised. Structured contracts are bilateral and usually long-term contracts between an electricity producer and an end consumer or distributor.13 Electricity producers use financial contracts to manage price risk and volumetric risk.
Objectives, Legal Tools and Practices
The “liberalisation” of electricity markets has increased the number and diversity of market participants. Obviously, each participant has its own particular commercial objectives in the electricity market, and each participant uses its own combination of legal tools and practices to reach them.
However, there are patterns of behaviour shared by all market participants, which belong to the same class. These patterns of behaviour can be explained by the participants’ similar high-level objectives and the particular characteristics of electricity and the electricity trade.
The behaviour of electricity producers as electricity market participants is studied here by studying their legal tools and practices. It should be possible to describe how electricity markets work and predict patterns of behaviour by using legal concepts rather than economic concepts or concepts borrowed from other social sciences.14
All Transactions
At a higher level of generality, all firms work in similar ways. It is this general assumption that underlies management science and economics. For the purposes of commercial law, one could say that all firms share the same objectives in all transactions at a high level of generality.15
One may assume that there are firms—organisations—which try to survive in the long term. For this purpose, these firms manage: cash-flow and the exchange of goods and services; risk; principal-agency relationships; and information.
Moreover, all firms use a combination of five generic types of legal tools and practices, which are present in all transactions. They include: the choice of a business form; contracts, regulatory compliance and organisational measures; generic ways to manage principal-agency relationships; and generic ways to manage information.
Context
Depending on the commercial context, firms customarily manage particular characteristic issues in addition to the general issues managed in all transactions. For example, firms manage risks in all transactions, but they tend to manage particular risks depending on the context.
Electricity Trade
In the context of electricity trade, parties must address particular issues because of physical laws and efficiency constraints (Sect. 2.5). The electricity producer thus manages not only generic issues such as cash flow and risk but even these particular issues. They include: (a) grid access, delivery point, and voltage level; (b) volume; (c) transmission and distribution capacity; (d) balance; (e) measurement; (f) separation of physical rights, service rights, and financial rights; and (g) price volatility. Distinguishing between general and particular issues helps to understand what is characteristic of electricity markets.
This distinction between general and particular issues has not been made in the past. For example, the risks that electricity market participants are exposed to have been classified in various ways: (a) According to Hunt S and Shuttleworth G (1996), an electricity producer is subject to: market price risk (market price may be higher or lower than expected); sales quantity risk (market conditions influence output); fuel price risk (fuel prices may rise and fall); and availability risk (a power plant may not always be available to run)16; (b) In addition to various kinds of market operation risks, an electricity producer is exposed to regulatory risks,17 weather risks, and uncertainty according to Perrels A and Kemppi H (2003)18; (c) According to Spicker J (2010), the risks that an electricity market participant is exposed to in OTC trade include: price risks, volumetric risks, currency risks, open positions, estimation risks, transformation risks (relating to merchantability as wholesale products should be transformed into retail products), organisational risks, and credit risks.19
Some of these risks—such as credit risk and various forms of counterparty risk, including legal and regulatory risk—are general and managed in all transactions. Other risks may be particular risks managed in electricity transactions.
Business Models
Each market participant uses a business model. Large industrial consumers, retail distributors, portfolio managers, brokers, electricity wholesalers, and electricity producers use different business models. This book focuses on the business models of the electricity producer. They include both generation and supply and trading.
Regulation, No Liberalisation of the Wholesale Market for Electricity Producers
From a regulatory perspective, the key to achieving the benefits of competition is to introduce competition in as many parts of the value chain as possible—from generation to consumption.20
At the same time, electricity markets must be highly regulated for operational reasons. To illustrate, electricity producers would not gain access to electricity markets without a large regulatory framework.21 Another example is the use of marginal pricing. According to this pricing and trading principle facilitated by market regulation, the last accepted bid sets the price for the whole market.22
The level of regulation depends on the choice of perspective. There is more central planning and more regulation where market regulation is designed to foster economic efficiency by maximising the global surplus of market agents.23 There is less regulation where each market participant has discretion to act according to its own interests without any third party trying to estimate what the maximum global surplus should be.