28 January 2008
The single electricity market (SEM) for the island of Ireland went live on 1 November 2007, representing a significant milestone in the all-island project to establish a single natural gas and electricity market in Ireland.
This project has its origins in a joint policy decision of the Northern and Southern governments. The aim and expectation is that both jurisdictions will benefit from increased competition, reduced energy costs and improved reliability of supply.
Both politically and legally this project is entirely novel and required the establishment of a legislative framework in both the North and South to support the SEM.
The set-up of the SEM was a remarkable achievement for the host of players involved. However, this set-up is just the beginning in terms of the establishment of a coherent all-island energy vision.
Whether the SEM will deliver a more efficient and cost-effective electricity market and correctly incentivise new-generation investment will only become apparent in time, and will be contingent on how market participants respond to the incentives represented by the market.
The all-island market has 2.5 million electricity customers, 1.8 million in Ireland and 700,000 in Northern Ireland. It is a gross mandatory pool market, meaning that all electricity generated on or imported into the island must be sold to the pool, and all wholesale electricity for consumption on or export from the island must be purchased from the pool.
One of the principal differences between the SEM and the previous market arrangements is price. In the SEM the price of electricity will be set by the market and not administratively determined by way of a formula or agreed in bilateral negotiations.
All participants in the market operate under a single set of rules, the Trading and Settlement Code, regardless of their physical or geographic location on the island. Generators 'bid' their plant to the pool, setting out their pricing, so that the most cost-efficient generators will be called on to generate electricity first.
The system marginal price (SMP) is set for each half hour of trading by the bid of the last generator that must be dispatched to meet demand in that settlement period. All generators receive the SMP regardless of their bid. The cost of generation varies over the course of a day and by season, to reflect the marginal cost of generation at that time.
A key feature that incentivises new capacity across a mix of plant is the capacity payments mechanism. In addition to the SMP payment for physical electricity, generators are paid a capacity payment - an administratively determined payment for each unit of generation capacity that is made available to the market, whether or not they are called on to generate.
For 2008, e575m (£427.38m) has been allocated for capacity payments. These payments, which are calculated on the basis of the costs of a conventional peaking plant, are intended to offset some of the fixed costs of generation and increase certainty of revenue, encouraging market participants to offer capacity at times when capacity margins are tight.
A bilateral contracts market is expected to emerge around the pool to provide a financial instrument (a contract for differences in respect of price/volume) that can insulate pool participants against the risk of volatility in the pool price. To date, those players with market power (Electricity Supply Board (ESB) and Viridian) have been mandated by the regulators to enter into contracts for difference with suppliers for a specified volume at a price based on a pre-determined pricing formula.
The intention is that prescribed contracting will mitigate the incentives on these generators to profit from the use of market power. The use by the regulators of this tool, and their monitoring of its effect, will be critical to the success of the SEM and its credibility as a market.
Generators are required to bid in accordance with a bidding code of practice, in essence to control market power and deliver greater transparency on pricing. The code obliges generators to bid at their short run marginal cost, which is intended to ensure that generators with market power do not use it to influence the SMP or otherwise distort the market.
The SEM is regulated by the SEM Committee, whose decisions are in turn supported or implemented by the regulatory authorities - the Commission for Energy Regulation in Ireland and the Utility Regulator in Northern Ireland. The SEM has a dedicated Market Monitoring Unit (MMU) to ensure that the bidding principles are adhered to.
The regulatory authorities have already received formal complaints regarding the manner in which certain generators (principally owned by, or the output of which is sold to, ESB) are bidding their data into the pool which, in turn, affects the market operator's choices as to which generation plants should be shut down and restarted during certain periods.
The MMU is conducting an inquiry into these complaints, the result of which will be watched closely by the industry. This complaint is the first real test of the SEM arrangements.
New generation capacity
One of the other main aims of the SEM is to enhance the sustainability of the energy system on the island through a programme of reducing the dependence on fossil fuels and switching to renewable fuel sources.
At present, the majority of the electricity that is generated from renewable sources is wind-generated. Of approximately 6,000 megawatts of installed capacity on the Irish grid, 800 megawatts are wind-powered.
One of the highlights of 2008, particularly in relation to renewables, should be the publication by the Northern Irish and Irish governments of the all-island grid study, following the consultation during 2007 on an 'all-island 2020' vision for renewable energy. This study will analyse options for how infrastructure on the island could best develop to allow for maximum penetration for renewable energy.
Capacity location and type
It is anticipated that one of the benefits of the SEM and the SMP and capacity payment mechanisms is that clear price signals will be sent to the market, influencing the preferred location for new-generation investment as the need arises, improving the security and reliability of electricity supplies throughout the island.
It should also, over time, remove market distortions and minimise the cost of electricity to all customers. Again, this is a significant departure from the previous market structure: now market forces rather than government or regulators will deliver new capacity as and when needed.
As the share of renewables on the system rises, the efficient mix of plant should include a rising share of peaking and mid-merit plant relative to base load capacity and the SEM should operate in a manner that makes this structural outcome attractive from an investment perspective.
The performance of the SEM depends on how market participants respond to the incentives it provides. The SEM has the institutional arrangements that should, in theory, deliver on its aims. Whether or not it does so will be a function of the interplay of market participant behaviour and its oversight by the regulatory authorities.
Valerie Lawlor is a partner at McCann FitzGerald