LONDON BUSINESS SCHOOL Energy Markets Group A Model-Based Comparison of Pool and Bilateral Market Mechanisms for Electricity Trading

The Revised Electricity Trading Arrangements (RETA), initiated by the Office of Electricity Regulation (OFFER) and Department of Trade and Industry (DTI), proposes that the England & Wales Electricity Pool be replaced by bilateral trading (“the bilateral model”). This will allow direct contracting between counterparties, paying generators what they bid, and introducing an optional balancing market. Underlying the proposed reforms is the strong belief that changing the trading arrangements will limit the potential for the exploitation of market power by generators, whilst still providing a favourable operating environment for flexible coal plant, and result in wholesale electricity prices falling by around 10%. Until now, there has been little quantitative analysis of the RETA proposals and they have progressed with a surprising degree consensus on both sides of the market. In this study, we have therefore developed a computer simulation model of the wholesale electricity market in England & Wales as a means of systematically testing the potential impact of alternative trading arrangements on market prices. Generating firms are represented as autonomous “adaptive agents”, which progressively learn to adopt profit maximising bidding behaviour. Unlike conventional simulation models, where agent behaviour is imposed exogenously by the modeller, elements of artificial intelligence are included to allow agents to independently develop their own trading strategies. Agents compete with each other in a repeated daily auction market setting where we test four different combinations of bidding and settlement rules. The results show that daily bidding with Pay SMP settlement, as in the current Pool day-ahead market, produces the lowest prices while hourly bidding with Pay Bid settlement, as proposed in the new bilateral model, produces the highest prices. This occurs, firstly, because hourly bidding allows generators to more effectively segment the market between on-peak and off-peak hours hence allowing more of the consumer surplus to be extracted and making tacit collusion easier. Secondly, it appears that Pay Bid increases the potential for overbidding by baseload generators, particularly independent power producers with small plant portfolios, reducing competitive pressure on generators with mid-merit plant. These results suggest that the bilateral model could amplify existing mid-merit generator market power and lead to relatively higher prices than the pool model, precisely the opposite of what OFFER, the DTI, and consumer groups are hoping for. However, OFFER is introducing RETA at the same time as forcing further divestment of plant by mid-merit generators. New entrants continue to add capacity, and full liberalisation of the retail market is beginning to increase competition among suppliers. It is therefore possible that market prices could still fall, despite RETA, but, in retrospect, it will be difficult to identify which changes have had a beneficial effect. Moreover, some aspects of the RETA proposal could even be beneficial, such as a firm day-ahead market, a balancing market that better allocates costs and risks, and the abolishment of capacity and availability payments. The virtue of using a modelling approach is that it has allowed us to focus on one set of changes, namely the reform of market clearing and settlement arrangements, while holding all else constant. It is on this basis that we argue that the bilateral model, as proposed, is likely to have a detrimental effect even though other reforms going on at the same time, particularly of the industry structure, could lead to the market as whole becoming more efficient.