I’ve been thinking a lot recently about how to design electricity markets that allow participants to receive and act on the appropriate signals. At the moment most of our electricity markets take one of two type, each with advantages and disadvantages. I’m keen to understand the best type for different situations, or if there are even better types than these. I should note that I’m not familiar with the literature, so if people have suggestions of papers to read (either specific to electricity or more general) please do let me know.
I start off with describing the two types of market that we currently see.
The most intuitive kind of market allows participants to buy and sell whenever they want. Usually one party advertises that they are willing to buy or sell a given product/volume at a given price, and the other party accepts. (Interestingly, in most shops, the price tag isn’t technically an offer to sell, but merely an indication that they are likely to accept if you bid to buy the item for that price.) Continuous electricity markets are common, often aided by brokers and online platforms.
The primary challenge with continuous markets is to encourage enough participants to list bids and offers. There is a downside in listing a bid or an offer: you are giving away information, and potentially reducing your profit compared with what you might otherwise get. Yet if everyone waits for someone else to list a bid or offer, or only lists bids so low or offers so high that they’re unlikely to be accepted, the market will fail through lack of liquidity.
Other challenges with continuous markets involve information discovery and fairness. Supposing one seller offers 1MWh of electricity for £30/MWh, and a buyer accepts. We know that they were happy to trade at that price, but they might have both been happy to trade at higher or lower prices, so in what sense was this the right price? If does not tell us what price buyers or sellers should be willing to transact further quantities. Secondly, participants must trust that their bids and offers and orders are treated fairly. For example, if as soon as a buyer accepts an offer, the seller raises the price, that would undermine confidence in the platform.
Auction markets function by limiting the possibility for trade in order to create a more level playing field, with the aim of increasing the likelihood that participants will provide more accurate indications of their willingness to buy or sell. In the case of electricity auction markets, the market operator typically collects bids and offers from each party, and then determines the clearing price at which bids and offers match. All transactions occur at the clearing price, eliminating the downside of submitting a genuine best bid or offer.
If we can rely on participants to submit their best bids and offers, then the auction results provide useful information. In some cases the auction operator may publish a full listing of all bids and offers, which provides further useful information and generates trust that the auction has functioned correctly, however this may reduce participants willingness to provide their best bids and offers, especially if there are alternate trading mechanisms.
The biggest challenge with auction markets is their one-time nature. Participants cannot choose to trade at the clearing price once it is known. Some markets offer multiple auctions, with the result that participants can base their bids and offers in the second auction on the first auction results, however the second auction may produce a significantly different clearing price. Finally, if not enough participants take part and submit their best bids and offers, auction markets can provide misleading signals, in some cases even being manipulated.
A best of both worlds?
Wholesale electricity markets in Great Britain currently operate on a combination of continuous and auctions. There are continuous markets, on exchanges and between counterparties, right up until the start of the hour in question. However, for these continuous markets, only certain products have any liquidity (individual half hours only have any liquidity from the day ahead). There is a day ahead hourly auction at 11am UK time, and then three half hourly auctions, one at 3:30pm day ahead, one at 5:30pm day ahead, and one at 8am on the day. The day ahead hourly auction has considerable liquidity, while the half hourly auctions have relatively lower liquidity. Finally, there is a balancing market in which participants can provide bids and offers which the system operator can accept.
It isn’t clear to me that this mix of markets provides the optimal mix. I have a preference for continuous markets, allowing participants to trade freely and for preferences to be communicated in real time. I worry also that auction results are being used in ways they shouldn’t, for example, for setting a price for future transactions, potentially destabilising the market. (For example, my retail electricity prices, which determine when and how much I consume, is set based on the previous day’s auction results.) However, I recognise that electricity markets may not be liquid enough for customers to trust the best available price in a continuous market.
Given that both continuous markets and auctions depend on liquidity, there is inertia in these markets. On the other hand, with changes to participation, including batteries, demand side flexibility, and intermittent generation, perhaps there will be changes to preferences, and the share of liquidity in these markets will alter. Either way, it will be interesting to observe, both how participants change their behaviour and how market designers/regulators change the market structure.