Module1: Introduction

The power industry across the globe is experiencing a radical change in its business as
well as in an operational model where, the vertically integrated utilities are being
unbundled and opened up for competition with private players. This enables an end to
the era of monopoly. Right from its inception, running the power system was supposed
to be a task of esoteric quality. The electric power was then looked upon as a service.
Control consisting of planning and operational tasks was administered by a single entity
or utility. The vertical integration of all tasks gave rise to the term vertically integrated
utility. The arrangement of the earlier setup of the power sector was characterized by
operation of a single utility generating, transmitting and distributing electrical energy
in its area of operation. Thus, these utilities enjoyed monopoly in their area of
operation. They were often termed as monopoly utilities.
Why were earlier utilities the monopolies'? The reason for monopoly can be traced
right back to the early days when electricity was comparatively a new technology. The
skeptical attitude of the government towards electricity led to investment by private
players into the power sector, who in turn, demanded for the monopoly in their area
of operation. This created a win-win situation for both- government and the electrical
technology promoters. However, the government would not let the private players
enjoy the monopoly and exploit the end consumer and hence introduced regulation in
the business. Thus, the power industries of initial era became regulated monopoly
utilities . The structure of a conventional vertically integrated utility is shown in Figure
1.1. As evident from the figure, there was only a single utility with whom the customer
dealt with. Thus, only two entities existed in the power business: a monopolist utility
and the customer.

Fig 1.1
What does regulation mean? The regulations are generally imposed by the
government or the government authority. These essentially represent a set of rules or
framework that the government has imposed so as to run the system smoothly and
with discipline, without undue advantage to any particular entity at the cost of end
consumer. All practical power systems of earlier days used to be regulated by the
government. This was obviously so. The old era power industries were vertically
integrated utilities and enjoyed monopoly in their area of operation. Whenever a
monopoly is sensed in any sector, it is natural for the government to step in and set up
a framework of way of doing business, in order to protect end consumer interests.
Some of the characteristics of monopoly utility are:
1. Single utility in one area of operation enjoying monopoly.
2. Regulated Framework: The utility should work under the business framework
setup by the government.
3. Universal Supply Obligation (USO): Utility should provide power to all those
customers who demand for it.
4. Regulated Costs: The return on the utility's investments is regulated by the
government.

In a nutshell, regulation is about checking the prices of the monopolist in the absence
of private players and market forces.

Reasons for restructuring / deregulation of power industry

The next obvious question is, what is deregulation or restructuring of an industry?
From the name, one can sense discontinuation of the framework provided by the
regulation. In other words, deregulation is about removing control over the prices with
introduction of market players in the sector. However, this is not correct in a strict
sense. An overnight change in the power business framework with provision of entry
to competing suppliers and subjecting prices to market interaction, would not work
successfully. There are certain conditions that create a conducive environment for the
competition to work. These conditions need to be satisfied while deregulating or
restructuring a system. Sometimes, the word deregulation may sound a misnomer.
Deregulation does not mean that the rules wont exist. The rules will still be there,
however, a new framework would be created to operate the power industry. That is
why the word deregulation finds its substitutes like re-regulation, reforms,
restructuring, etc. The commonly used word in Europe is liberalization of power
industry; deregulation is a more popular phrase in US.
If the power industries worked successfully with the regulated monopoly framework
for over 100 years, what was the need for deregulating or changing the business
framework of the system? There are many reasons that fuelled the concept of
deregulation of the power industry. One major thought that prevailed during the early
nineties raised questions about the performance of monopoly utilities. The takers of
this thought advocated that monopoly status of the electric utilities did not provide any
incentive for its efficient operation. In privately owned utilities, the costs incurred by
the utility were directly imposed upon the consumers. In government linked public
utilities, factors other than the economics, for example, treatment of all public utilities
at par, overstaffing, etc. resulted in a sluggish performance of these utilities. The
economists started promoting introduction of a competitive market for electrical
energy as a means of benefit for the overall powerector. This argument was supported
by the successful reform experiences of other sectors such as airlines, gas, telephone,
etc.
Another impetus for deregulation of power industry was provided by the change in
power generation technology. In the earlier days, cost-effective power generation was
possible only with the help of mammoth thermal (coal/nuclear) plants. However,
during the mid eighties, the gas turbines started generating cost effective power with
smaller plant size. It was then possible to build the power plants near the load centers
and also, an opportunity was created for private players to generate power and sell the
same to the existing utility. This technology change, supposed to have provided

acceleration to the concept of independent power producers, supported the concept

of deregulation further. This technology change is supposed to have provided
acceleration to the concept of independent power producers. This further supported
concept of deregulation. This was specifically true where the financial losses were
apparently high which was prevalent in some of the developing countries.
It should be noted that these are the indicative or major reasons for introducing the
concept of deregulation in power industry. There are many other reasons as well. One
of the important reasons is the condition under which power systems were regulated,
did not exist any more. There was no wind of skepticism about the electrical technology
and all the initial investments in infrastructure were already paid back. Further, the
deregulation aims at introducing competition at various levels of power industry. The
competition is likely to bring down the cost of electricity. Then, the activities of the
power industry would become customer centric.
The competitive environment offers a good range of benefits for the customers as well
as the private entities. It is claimed that some of the significant benefits of power
industry deregulation would include:
1. Electricity price will go down: It is a common understanding that the competitive
prices are lesser than the monopolist prices. The producer will try to sell the
power at its marginal cost, in a perfectly competitive environment.
2. Choice for customers: The customer will have choice for its retailer. The retailers
will compete not only on the price offered but also on the other facilities
provided to the customers. These could include better plans, better reliability,
better quality, etc.
3. Customer-centric service: The retailers would provide better service than what
the monopolist would do.
4. Innovation: The regulatory process and lack of competition gave electric utilities
no incentive to improve or to take risks on new ideas that might increase the
customer value. Under deregulated environment, the electric utility will always
try to innovate something for the betterment of service and in turn save costs
and maximize the profit.

The deregulation of the industry has provided electrical energy with a new dimension
where it is being considered as a commodity. The commodity status given to electrical
power has attracted entry of private players in the sector. The private players make the
whole business challenging from the system operators point of view, as it now starts
dealing with many players which are not under its direct control. This calls for
introduction of fair and transparent set of rules for running the power business. The
market design structure plays an important role in successful deregulation of power
industry

Understanding the restructuring process

The process of deregulation has taken different formats in different parts of the world.
Also, the reasons for power sector to adopt the reforms vary from country to country.
For the developed countries, introduction of competition to achieve social welfare was
probably the most important reason. On the other hand, the developing countries
mainly banked on the capacity addition through entry of private players. It is observed
that neither, there is lone reson for driving deregulation of power industry nor is there
a single objective of the same.
The restructuring process starts with the unbundling of the originally vertically
integrated utility. This essentially leads to separate the activities involved in an
integrated power system leading to creation of functional partition amongst them. For
example, the unbundling of power industry involves separating transmission activity
from the generation activity. Further, distribution can be separated from transmission.
Thus, these three mutually exclusive functions are created and there are separate
entities or companies that control these functions. Then, the competition can be
introduced in the generation activity by allowing other private participants in this
segment. In contrast to the vertically integrated case where all the generation is owned
by the same utility, there is a scope for private players to sell their generation at
competitive prices. The generators owned by the earlier vertically integrated utility will
then compete with these private generators. The transmission sector being a natural
monopoly is most unlikely to have competing players in the sector. This is because for
natural monopolies like transmission companies, the business becomes profitable only
when output is large enough. Figure 1.2 shows the representative structure of
deregulated power system. In contrast to the vertically integrated utility structure, it
can be seen that there are many alternative paths along which the money flows. It is
evident that there are many more other entities present, apart from the vertically
integrated utility and the customers. It should be noted that there can be many more
versions of deregulated structure.

Various Entities Involved in Deregulation:

The introduction of deregulation has introduced several new entities in the electricity
market place and has simultaneously redefined the scope of activities of many of the
existing players. Variations exist across market structures over how each entity is
particularly defined and over what role it plays in the system. However, on a broad
level, the following entities can be identified:
1. Genco (Generating Company): Genco is an owner-operator of one or more
generators that runs them and bids the power into the competitive
marketplace. Genco sells energy at its sites in the same manner that a coal
mining company might sell coal in bulk at its mine.
2. Transco (Transmission Company): Transco moves power in bulk quantities from
where it is produced to where it is consumed. The Transco owns and maintains
the transmission facilities, and may perform many of the management and
engineering functions required to ensure the smooth running of the system. In
some deregulated industries, the Transco owns and maintains the transmission
lines under the monopoly, but does not operate them. That is done by
Independent System Operator (ISO). The Transco is paid for the use of its lines.
3. Discom (Distribution Company): It is the owner-operator of the local power
delivery system, which delivers power to individual businesses and
homeowners. In some places, the local distribution function is combined with
retail function, i.e. to buy wholesale electricity either through the spot market
or through direct contracts with Gencos and supply electricity to the end use

4.

5.

6.

7.

customers. In many other cases, however, the Discom does not sell the power.
It only owns and operates the local distribution system, and obtains its revenue
by wheeling electric power through its network.
Resco (Retail Energy Service Company): It is the retailer of electric power. Many
of these will be the retail departments of the former vertically integrated
utilities. A Resco buys power from Gencos and sells it directly to the consumers.
Resco does not own any electricity network physical assets.
Market Operator: Market operator provides a platform for the buyers and
sellers to sell and buy the electricity. It runs a computer program that matches
bids and offers of sellers and buyers. The market settlement process is the
responsibility of the market operator. The market operator typically runs a dayahead market. The near-real-time market, if any, is administered by the system
operator.
System Operator (SO): The SO is an entity entrusted with the responsibility of
ensuring the reliability and security of the entire system. It is an independent
authority and does not participate in the electricity market trades. It usually
does not own generating resources, except for some reserve capacity in certain
cases. In order to maintain the system security and reliability, the SO procures
various services such as supply of emergency reserves, or reactive power from
other entities in the system. In some countries, SO also owns the transmission
network. The SO in these systems is generally called as Transmission System
Operator (TSO). In the case of a SO being completely neutral of every other
activity except coordinate, control and monitor the system, it is generally called
as Independent System Operator (ISO).
Customers: A customer is an entity, consuming electricity. In a completely
deregulated market where retail sector is also open for competition, the end
customer has several options for buying electricity. It may choose to buy
electricity from the spot market by bidding for purchase, or may buy directly
from a Genco or even from the local retailing service company. On the other
hand, in the markets where competition exists only at the wholesale level, only
the large customers have privilege of choosing their supplier.

Understanding the restructuring process

Electricity, as a commodity, can not be compared with any other commodity traded in
the market. This is because it has some distinguishing characteristics of its own, which
demand satisfaction of technical constraints before accomplishing the commercial
trades. Two important features of electricity as a commodity are: need for real time
balance and inability to wheel the commodity through desired path (in bulk). Hence, a
set of principles laid down by standard micro-economic theory can not be mapped
directly to the electricity commodity markets.

Tackling network congestion is one of the challenging issues of the de-regulated era.
Transmission network provides the path through which transactions are made in a
power market. But each transmission network has its own physical and operating limits
like line flow limits, bus voltage magnitude limits and more. The power injection and
withdrawal configuration should be such that no limit gets violated. If the network is
operated beyond these limits, it may, even, result in the entire system blackout.
Therefore, any arbitrary set of transactions cant be organized on the power network.
This has given rise to a new problem under the restructured power system
environment, referred to as congestion management. There are many ways in which
congestion is formally defined but to explain in simple words, when some components
in a power network appear to be overloaded due to a trading arrangement, that
particular arrangement is said to create congestion on the network. The purpose of
congestion management is to make necessary corrections in order to relieve
congestion. It can be easily appreciated that under the vertically integrated structure,
network congestion, in fact, is not a challenging task. This is because all the resources
in the system are under the direct control of the monopolist. Thus, this is the sole
responsibility of the monopolist to maintain its transmission network.
Provision of ancillary services is another tough task carried out by the system operator
under the deregulated framework. Ancillary services are defined as all those activities
on the interconnected grid that are necessary to support the transmission of power
while maintaining reliable operation and ensuring the required degree of quality and
safety. Under the deregulated power system environment, the system operator
acquires a central coordination role and carries out the important responsibility of
providing for system reliability and security. It manages system operations like
scheduling and operating the transmission related services. The SO also has to ensure
a required degree of quality and safety and provide corrective measures under
contingent conditions. In this respect, certain services, such as scheduling and dispatch,
frequency regulation, voltage control, generation reserves, etc. are required by the
power system, apart from basic energy and power delivery services. Such services are
commonly referred to as ancillary services. In deregulated power systems, transmission
networks are available for third party access to allow power wheeling. In such an
environment, the ancillary services are no longer treated as an integral part of the
electric supply. They are unbundled and priced separately and system operators may
have to purchase ancillary services from ancillary service providers.
Then, there are certain issues like market design and market power which need
regulatory intervention. Issues pertaining to market design revolve around choice made
in the selection of dispatch philosophies, choice of various pricing schemes, choice
between number of markets with multiple gate closures, etc., from various alternatives.
The market architecture, which maps various markets on timeline, is also an important
sub-topic of market design process.

Existence of market power shows the signs of deviation from the prefect competition.
In general, market power is referred to as ability of market participants to profitably
maintain the market price above or below the competitive level for a significant period
of time. To tackle the situation, an indirect regulatory intervention in the form of
market design rules is needed. Thus, as mentioned earlier, deregulation does not mean
ceasing to have rules. It is the restructuring of the power business framework. More
rigorous treatment to these issues is given in further chapters.

Reasons and objectives of deregulation of various power systems across the world
Restructuring or deregulation is a broad term and can have different meanings in
different countries. This is because the changes essential for betterment of power
sector depend on the prevailing conditions in the power sector of respective countries.
Further, the word betterment can be looked upon subjectively. For example, well
developed, industrialized countries can expect price to go down and these countries
can treat the change in the prices as betterment. On the other hand, the developing
countries need to make radical changes in the policy and regulation such that barrier
to entry for private players is removed. The effective betterment can be looked upon
from this perspective for developing countries.
In this section we will see, in brief, the issues that led to restructuring of the power
industry for following regions / countries: US , UK , Nordic Pool and developing
countries.
The US
The US electric utilities, from the very beginning were privately owned and worked in a
vertically integrated fashion. The developed countries like US had well functioning and
efficient electricity systems. However for some systems, so long as consumers were
concerned, they were not satisfied with the rising costs of electricity. For some other
systems, utility management found that running the system was not viable due to low
tariff. In some systems, pressure from smaller players to open up the business for
competition played a major role. By and large, deregulation took place in developed
countries by pressure to reduce costs while simultaneously increasing competitiveness
in the market.
Existence of market power shows the signs of deviation from the prefect competition.
In general, market power is referred to as ability of market participants to profitably
maintain the market price above or below the competitive level for a significant period
of time. To tackle the situation, an the indirect regulatory intervention in the form of
market design rules is needed. Thus, as mentioned earlier, deregulation does not mean

ceasing to have rules. It is the restructuring of the power business framework. More
rigorous treatment to these issues is given in further chapters.
The UK
The transformation of the British power sector proceeded along three paths in 1990.
First, the traditional industry was unbundled both vertically and horizontally. Highvoltage transmission assets were transferred to a new National Grid Company (NGC).
Coal and oil fired units were divided among two companies National Power and
PowerGen. Nuclear Electric retained control of all nuclear units. At the outset, National
Power had 52 percent of total generating capacity, PowerGen had 33 percent, and
Nuclear Power had the remaining 15 percent. The second set of changes involved
ownership. Both National Power and PowerGen became private companies in 1991,
whereas the difficulties associated with nuclear power resulted in continued
government ownership of all nuclear units. Approximately 30 percent of shares in
National Power and PowerGen were sold to the public,an equal amount to foreign and
institutional investors. The remaining 40 percent was held by the government until
1995. The third set of changes sought to open the system to competition, wherever
possible, while continuing necessary regulations. Vertical and horizontal restructuring
of power generation was based on the assumption that generation had become
workably competitive and would become increasingly so with new market entrants.
A report on reform process was floated by the regulator in 2001 which stated that
wholesale electricity prices had not fallen in line with reductions in generators input
costs and that a lack of supply side pressure and demand side participation; and
inflexible governance arrangements had prevented reform of the arrangements.
The Nordic Pool
The reforms in Nordic countries were inspired by the electricity market reforms in
England and Wales in 1989, as well as by widely held beliefs that increased competition
would raise power industry efficiency to the benefit of consumers. Norway was first
amongst the Nordic countries to liberalize its electricity market in 1991, but without
privatization. The Norwegian electricity sector remains almost entirely in public hands.
Rather than implement national reforms, the other Nordic countries chose to reform
by merging with the existing Norwegian market, Sweden joining the expanded Nordic
pool in 1996, Finland in 1998 and Denmark in 1999.
The Developing Countries
The case of developing countries is different from that of other countries. In these
countries, the electricity supply is treated as a social service rather than a market
commodity. The ownership of the power sector in these countries is directly under the
governments of respective countries. These state owned-controlled systems have led

to the promotion of inefficient practices over a period. The power sectors of these
countries are marked by supply shortages. There has been an inability to add to the
generating capacity. The subsidies and high transmission and distribution losses are the
major concerns before these systems. Another consequence of state control over
electric utilities was the high level of overstaffing.
The inability to raise funds for capacity addition invited financial support from
international financial institutions like World Bank. These institutions mandated
opening of the power sector for private companies which were contracted under build,
own, operate and transfer (BOOT) scheme.

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 takeover 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 can not 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 can not 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 can not 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 can not 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 MODELS BASED ON CONTRACTUAL ARRANGEMENTS

As mentioned earlier, unbundling of the conventional vertically integrated power system
creates groups of various commercial and technical activities. Since one of the major aims of
deregulation is introduction of competition, it is worthwhile to explore every avenue where
competition can be introduced. Eventually, competition provides a choice for entities to choose
another entity or a group of entities to do a profitable transaction. In electricity parlance, either
the load or an entity representing a group of loads gets a choice to select its energy provider, or
there may exist some mechanism which would cater to the electrical energy needs of these
loads at a competitive level.
The former mechanism essentially requires bilateral involvement of the entities who wish to
get into a power buy and sell contract. In this, the sellers and buyers mutually agree upon the
terms and conditions, including the price and time of delivery. A repetitive bilateral interaction
between buyers and sellers may lead to an equilibrium point where everyone is happy.
Alternatively, a similar result would be obtained if a common exchange for the commodity is set
up, where, buyers and sellers, instead of interacting with each other, communicate their
expectations to this marketplace. This represents a simultaneous market clearing process and a
common market price of electrical commodity.
While moving from a vertically integrated structure to a competitive one, various policy and
structural issues crop up. One of the important concerns is regarding the entity that should be
allowed to take part in competitive activity. Similarly, issue of rearrangement of various
elements of power system, when a new set of rules is introduced to buy and sell power, also
needs to be addressed. It is obvious that the commercial arrangements and virtual boundaries
between various functional entities can take many shapes and forms. Consequently, various
models can be classified according to the levels at which the entities are given the choice of
buying or selling electricity.
Various trading models can be proposed based on the above discussion. The choice of choosing
a model is a policy decision and is dominated by various prevailing conditions. They need to be
accounted for before making structural changes. In [1], four basic models of industry structure
are suggested. These are:
1.
2.
3.
4.

Monopoly model
Single buyer mode
Wholesale competition model
Retail competition model

Every model needs different amount of structural change and rearrangements of functions in
the industry. These models are discussed next.
Monopoly Model
In this model, a single entity takes care of all the businesses such as generation, transmission
and distribution of electric power to the end users. One of the versions of this model is shown
in Figure 3.1(A). In this, a single utility integrates the generation, transmission and distribution
of electricity. Usually (but not necessarily), in this kind of model, the monopoly lies with the
Government. It is quite natural that this kind of model should have strict regulation in order to
protect end consumers against monopoly. Most of the electric power systems followed this
model prior to deregulation.
Another version of the monopoly model is shown in Figure 3.1(B). In this model, generation and
transmission are integrated and operated by a single utility and it sells the energy to local
distribution companies, which themselves represent local monopolies.

Figure 3.1: Two different versions of monopoly model

Single Buyer Model

In this model, as shown in Figure 3.2, there is competition in the wholesale sector, i.e.,
generation. Here, the single buyer agency buys power from Independent Power Producers
(IPPs) in addition to its own generation. The power purchasing agency in turn sells it to state
distribution utilities or distribution companies in the service area. All power generated by
generating companies (Gencos) must be sold only to a purchasing agency and not to any other
agency. Distribution companies (Discoms) are only able to purchase from the single buyer
agency. They do not have a choice of choosing their power supplier.
In this model, sales from power pool to retailers take place at a pre-set tariff price. The single
buyer or the existing utility makes a long term contract with IPPs. A contract is necessary
because, without it, a generator would be reluctant to invest large amounts of capital in a
generating plant. The contracts are generally of life-of-plant type, indicating sale of all capacity
of generating units for its lifetime.
Figure 3.3 shows another version of this model, which has further evolved from the original
single buyer model. In this model, the single buyer does not own any generation and buys all
the power from IPPs. The distribution and retail activities are also disaggregated. This model
has an advantage of introducing some competition between generators without the expense of
setting up a competitive market. The tariff set by the purchasing agency must be regulated
because it has monopoly over the Discos while monopsony over the IPPs. The single buyer
model is looked upon as a way of attracting private participation in the generation sector,
especially in the developing countries.
In this model, transmission and distribution network can be owned and operated by State and
Regional transmission utilities. Inter-state tie line should be sufficient to maintain a loose
regional power pool. Merits and demerits of this model are as follows:
Merits:

Private participation in power generation

Introduction of some competition without expensive set up for a competitive market.

Figure 3.2: Single buyer model

Demerits:

Long term contracts. Setting up a contract is problematic.

No true competition.
Price is not decided by demand-supply interaction.
End consumers' price is regulated .

Wholesale Competition Model

This model is one step closer towards competition. There is an organized market in which the
generators can sell their energy at competitive rates. The market may be organized either by a
separate entity or may be run by the system operator itself. There is not much choice for the
end user. The end user is still affiliated to the Discom or retailer working in that geographical
area of operation. The large customers or the bulk customers, so to say, are privileged to
choose their energy provider. However, the definition of bulk customer is a subjective matter
and changes from system to system.

Figure 3.3: Single buyer model with only IPPs

This model, as shown in Figure 3.4, provides the choice of supplier to Discoms, along with
competition in generation. Implementation of this model requires open access to the
transmission network. Also, a wholesale spot market needs to be developed. Since this model
permits open access to the transmission wires, it gives the IPPs to choose an alternative buyer.
Discoms can purchase energy for their customers either from a wholesale market or through
long term contracts with generators.
The customers within a service area still have no choice of supplier. They will be served by a
Discom in their area. With this model, the Discoms are under Universal Service Obligation
(USO), as they have monopoly over the customers. They own and operate the distribution
wires. The transmission network is owned and maintained either by government and/or private
transmission companies. System operators manage the centrally accomplished task of
operation and control.

Figure 3.4: Wholesale Competition Model

The model provides a competitive environment for generators because the wholesale price is
determined by the interaction between supply and demand. In contrast, the retail price of
electrical energy remains regulated because the small consumers still do not have a choice for
their supplier. The distribution companies are then exposed to vagaries of the wholesale price
of the commodity. The merits and demerits of this model are as follows:
Merits:

Choice of seller provided for Discoms and bulk consumers.

The buyers and sellers can make forward contracts or buy from a wholesale marketplace.
The price is decided by interaction between demand and supply. Hence, indicates truly
competitive price.

Demerits:

The end consumer still doesn't have a choice. It buys power from the affiliated Discom.
Rates for end consumers are regulated rather than competitive.
Discoms face competition at wholesale level, while their returns are regulated.
Structural and institutional changes required at wholesale level.

Retail Competition Model

In this model, as shown in Figure 3.5, all customers have access to competing generators either
directly or through their choice of retailer. This would have complete separation of both
generation and retailing from the transport business at both transmission and distribution
levels. Both, transmission and distribution wires provide open access in this model. There
would also be free entry for retailers. In this model, retailing is a function that does not require
the ownership of distribution wires, although, the owner of distribution wires can also compete
as a retailer.
This model is a multi-buyer, multi-seller model and the power pool in this model acts like an
auctioneer. It behaves like a single transporter, moving power to facilitate bilateral trading and
this is achieved through an integrated network of wires. In this pooling arrangement, there is a
provision for bidding into a spot market to facilitate merit order dispatch. The pool matches the
supply and demand and determines the spot price for each hour of the day. It collects money
from purchasers and distributes it to producers.
The advantage of this model over monopoly utilities is that competition is introduced in both
wholesale and retail areas of the system. This model is supposed to be a truly deregulated
power market model. The retail price is no longer regulated because small consumers can
change their retailer for better price options. This model is economically efficient as the price is
set by interaction of demand and supply. In wholesale competition model, with relatively few
customers, all of them regulated Discoms, a spot market can be preferable but not essential.
However, in retail competition model, spot markets become essential, since contractual
arrangements between customers and producers are carried out over a network owned by a
third party. In retail competition model, metering becomes a major problem. If the number of
customers are increasing and metering capability for all the customers is not sufficient, it may
create logistical problem and provoke disputes.

Figure 3.5: Retail Competition Model

Merits:

Supposed to be 100% deregulated model.

Every consumer has a choice of buying power.
The price is decided by interaction of demand and supply. Hence, it is truly competitive
price.
There is no regulation in energy pricing.

Demerits:
Need constitutional and structural changes at both, wholesale and retail level.
Extremely complex settlement system due to large number of participants.
Requirement of additional infrastructural support.

Comparison of Various Market Model

A comparison between the four models discussed above is provided in Table 3.1. The attributes
for comparison are chosen in such a manner that the difference between two truly competitive

models - wholesale competition and retail competition gets significance. It is then obvious that
the monopoly and single buyer models will emerge to be similar models when compared on the
chosen attributes.

Monopoly

Single
Buyer

Degree of
deregulation*

Number of
buyers

Many

Many

Number of
seller

Many

Many

Many
Everbody
including
small
consumers

Attribute

Wholesale
Retail
Competition Competition

Choice
available

No

No

Discoms and
big customers

Requirement
of spot
market

No

No

Preferable,
but not
essential

Essential

NA

NA

Transmission
network

Transmission
as well as
distribution
network

Everbody

Everbody

Small
consumers

None

Open access

Regulated
price to be
paid by

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 nonstandard, 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 realtime 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 can not 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 dont
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 marketclearing 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.

Bids

Company

Quantity
(MW)

Price
(INR)

S1

200

2400

S1

50

3000

S1

50

4000

S2

150

3200

S2

50

3400

S3

100

2600

S3

50

3600

D1

50

2600

D1

100

4600

D2

50

2200

D2

150

4400

D3

50

2000

D3

200

5000

offers

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 payas-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 (multiple price by 200)

Simple Bids or Complex Bids?
In the illustrative example provided above, the generators submitted simple bids consisting of pricequantity 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.

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 discussed next.

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.
2.
3.
4.
5.

Allocation of transmission rights on pro-rata basis

Allocation of transmission rights on first come first serve basis
Auction of available transmission capacity
Special case of zonal pricing with market splitting
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
Model

Dcentralized
Model

Central

Individual

Reservw
market
integrated
with spot
market

Separate
reserve
market or
obtained
through long
term
contracts

Basis for
scheduling

Bids abd
offers of
participants

Individual
schedules
arising out
of bilateral
transactions

Imbalances

Integrated
with spot
market

Generally
through dayahead
market

Involvement
of system
operator in Yes
day- ahead
market

Congestion
Implicit
Management

Significance
of forward
contracts

No

Atrribute

Unit
Commitment

Reserve

Risk hedging

No

Explicit
Physical
obligation

Example

SMD market
in USA like
PJM, ISONE

NETA in
UK Nordic
pool

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.