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Introduction

1.1 Why Study Power System Economics?

If kilowatt-hours could be stacked on a shelf - like kilograms of flour or television sets - ready to be used as soon as the consumer flips the switch or starts the industrial process, electricity would be a simple commodity, and there would be no need for this book. Despite recent advances in electricity storage, distributed generation, and demand-side flexibility, most electrical energy is still produced by large power plants and delivered to consumers through vast transmission and distribution networks. Any commercial transaction between a buyer and a seller of electrical energy thus has an impact on the state of the power system. Since consumers have high expectations regarding the reliability of their electricity supply, commercial transactions that could endanger the stability of the system cannot be allowed. Trading in electrical energy thus requires closer supervision than markets for traditional commodities. Power system economics is thus closely linked to power system operation.

Building the infrastructure required to generate electrical energy and delivering it to consumers requires enormous amounts of capital. Decisions about what facilities should be built must therefore balance the investment expenses against the benefits that they will provide in terms of reducing the cost to consumers, improving reliability and resilience, as well as meeting environmental objectives. The assessment of an investment project must therefore consider not solely its profitability but also how it would affect the operation of the entire system.

The drive to decarbonize our economies to mitigate climate change affects both the short-term operational economics and the development of the infrastructure. Conventional fossil-fired generating plants are rapidly being replaced by wind and solar generation that have very different economic and operational characteristics. At the same time, the electrification of transport, heating, and industrial processes increases the demand for electrical energy and hence the need for large infrastructure investments. Developing market frameworks that align profitability, reliability, and sustainability objectives is thus a challenging and critical task.

Development of smart control paradigm will support cost effective transition to low carbon energy future.

1.2 Industry Structure

This section discusses the common types of electricity supply industry structures and how a particular structure determines the responsibilities different entities have in the electricity markets.

1.2.1 Vertically Integrated Monopoly Utility

A vertically integrated monopoly utility generates electrical energy, transmits it from the power plants to the load centers, and distributes it to individual consumers. It has a monopoly on the supply of electricity in a given geographical area, which means that consumers have no choice: if they want to purchase electricity from the grid, they must buy it from their local utility. This industry structure was universal for most of the twentieth century, and it remains the model in many parts of the world. Some of these utilities are regulated investor-owned companies, while others are government agencies or government-owned companies.

Electric utilities operating under this model made truly remarkable contributions to economic activity and quality of life. Most people living in the industrialized world have access to an electricity distribution network. For several decades, the amount of energy delivered by these networks doubled about every eight years. At the same time, advances in engineering improved the reliability of the electricity supply to the point that in many industrialized countries, the average consumer is deprived of electricity for less than two minutes per year. These achievements were made possible by ceaseless technological advances. Among these, let us mention only the development and erection of transmission lines operating at over 1,000,000 V and spanning thousands of kilometers, the construction of power plants capable of generating more than 1,000 MW, and the online control of the networks connecting these plants to the consumers.

Figure 1.1 illustrates this traditional industry structure. Commercial activity is limited to consumers purchasing electricity from their local electric utility. This utility makes all the operational decisions (e.g., how much power each of its plants should produce to supply the load) and investment decisions (e.g., what type of power plants should be built and where they should be located).

Because monopolies could take advantage of the fact that their customers don't have a choice to charge them extortionate prices, they must either be government entities or be subject to oversight by a government department called the regulator. This regulator enforces the regulatory compact, which is an agreement that gives the utility a monopoly on the supply of electricity over a given geographical area. In exchange, the utility agrees that its prices will be set by the regulator, that it will supply all the consumers in that area, and that it will maintain a certain quality of service.

This vertically integrated monopoly model does not preclude bilateral energy trades between utilities that have a monopoly over different geographical areas. Such trades take place at the wholesale level, i.e., through interconnections between transmission networks.

Figure 1.1 Flows of electrical energy in a monopoly vertically integrated industry structure.

Figure 1.2 Flows of electrical energy in the variant of the monopoly vertically integrated industry structure.

An increasing number of consumers have installed photovoltaic (PV) panels or other forms of distributed generation on their premises. Such a consumer becomes a producer when the power output of its generator is larger than its load. This excess power then flows back into the distribution network, and the utility has to buy it from these prosumers.

Figure 1.2 shows a fairly common variant of the vertically integrated monopoly model. In this variant, one organization has a monopoly over the generation and transmission over a fairly wide area and sells electrical energy to several distribution companies (Discos), each of which has a local monopoly over the sale of electricity to consumers.

1.2.2 The Dawn of Competition

In the 1980s, some economists started arguing that the vertically integrated monopoly utility model had run its course. They said that the monopoly status of the electric utilities removed the incentive to operate efficiently and encouraged unnecessary investments. They also argued that the cost of the mistakes that investor-owned utilities made should not be passed on to the consumers. Closer supervision by the regulator would not be effective because the operations of the utilities were rather opaque, making it difficult for regulators to assess where improvements could be made. On the other hand, publicly owned utilities were often too closely linked to the government. Politics could then interfere with good economics. For example, the revenues from some public utilities were used to support other government expenditures, while others were prevented from setting rates at a level that reflected costs or were deprived of the capital that they needed for essential investments.

These economists suggested that prices would be lower and the overall economy more efficient if the supply of electricity were subjected to the discipline of a competitive market rather than monopoly regulation or government policy. This proposal was made in the context of the general deregulation of Western economies that started in the late 1970s. Before attention turned toward electricity, this movement had already affected airlines, transportation, and the supply of natural gas. In electricity and these other sectors, regulated markets or monopolies had previously been deemed the most efficient way of delivering the "products" to the consumers. It was felt that their special characteristics made them unsuitable for trading on free markets. Advocates of deregulation argued that the special characteristics of these products were not insurmountable obstacles and that they could and should be treated like all other commodities. If companies were allowed to compete freely for the provision of electricity, the efficiency gains arising from competition would ultimately benefit the consumers. In addition, competing companies would probably choose different technologies. It was therefore less likely that the consumers would be saddled with the consequences of unwise investments.

Figure 1.3 Incumbent vertically integrated utility with independent power producers (IPPs).

Since then, many jurisdictions around the world have implemented one of the levels of competitive electricity markets described in the following sections. In other areas, the vertically integrated monopoly model persists, either for political reasons or because the small size and isolated nature of the power system mean that the cost of implementing a market would be higher than the potential benefits.

1.2.3 Introducing Independent Power Producers

A first step toward a more competitive industry structure consists of...