Energy markets 101
First pioneered in 1879 by a San Francisco-based power company that connected a coal-fired steam engine to two generators powering 20 light bulbs, the modern electricity grid has since then become fundamental to life as we know it. Effectively, our ability to generate, transport and use energy underlies much, if not all, of the crucial technological innovations since the industrial revolutions that have gradually built our economic and social wealth today. Accordingly, our usage of these resources and pieces of infrastructure has skyrocketed equally. Graphic 1 illustrates how electricity production has doubled over the last thirty years. However, this development is at yet another inflection point.
Graphic 1: Global electricity production by region: Production skyrocketed (2019–2022, TWh)
Over the last three decades, the grid has changed significantly in both magnitude and size, but also fundamentally remained the same in its basic governing principles and functioning. Yet, increasingly, the issues of this dichotomous reality become evident, as we realize the enormous impact that the grid has on climate change: 40% of energy-related CO2 emissions are directly attributable to the burning of fossil fuels for electricity generation. This of course highlights an urgent need to create a far more “green” energy grid, which will only be made possible by more renewable energy production and consumption.
In order to understand how and why these efforts change the basic functionings of the grid, we at Picus Capital will publish a series of articles outlining our view on the developments in the market and crucial opportunities that arise. To kick this off, the following article lays out some basics on the inner workings of the electricity grid.
The grid’s governing principle: Balance at all times
To start with the basics, an electrical grid is defined as the intricate system designed to provide electricity all the way from its point of generation (think solar panels or, more traditionally, coal fired power plants) to the customers like you and me that use it for our daily needs, from reading this article to cooking a meal or riding an elevator. Critical to understanding a lot of the challenges and complexity surrounding our modern electricity system is the grid’s fundamental governing principle: At all times, the (physical) grid has to balance — in other words, the exact amount of energy that is “taken” (consumed) from the grid on one end has to simultaneously be ”added” back (generated) on the other. For example,when a consumer flips a switch to power a 10 watt light bulb, at the same time 10 watts of power needs to be added back to the grid — at least in principle and particularly true for larger scale production and consumption. If this consumed capacity is not added in real time, the frequency of the grid drops, increasing the likelihood of a power outage. This concept of ”frequency” refers to the number of times the electric current (the actual flow of electrons) changes direction within the grid per second — and while the technical specifics are complicated, the key insight is that the frequency is impacted when electricity is consumed (you flipping a light switch) or generated (a solar panel getting a ray of sun) and this frequency needs to stay constant for the grid to not break down. In Europe and much of Asia, the grid’s standard frequency is 50 Hertz. In North America, it’s 60 Hertz. In either case, if the standard grid frequency at any time deviates by more than >1%, we experience a power outage.
To support this delicate balance, a multitude of market participants and intermediaries work together in the electricity market. They together govern the physical flow of electricity (as shown in Graphic 2) and control the commercial system behind the physical flow of electricity.
Graphic 2: Simplified value chain of electricity in the traditional system
The “traditional” electricity system and its players
In our traditional system, electricity flows mainly in one direction through the grid: Large power plants (powered by fossil fuels, nuclear, water, etc.) generate electricity that is then added to a high-voltage transmission system — think of voltage as the “pressure” with which electricity is pushed through the circuit). This system consists of cables called transmission lines that sit both above and below ground and are able to transport large amounts of electricity long distances to more localized (think neighborhood-level) distribution systems. In most countries, there is only one transmission system and multiple, more localized distribution systems that transport electricity to end consumers at lower voltages. Simplified, imagine the transmission system as one large high-speed (i.e. high voltages) highway and the distribution lines as “local roads’ that lead from this central highway to each neighborhood.
Within this system, different market actors have different responsibilities. Starting with electricity generation, usually large industrial power generation companies own and operate generation plants, such as RWE Group, Iberdrola and Engie in Europe or Duke Energy and Southern Company in the US. The electricity these companies produce is sold to energy retailers and then directly fed into the grid — these retailers are the known “faces” of the electricity industry as the majority of homeowners and other end consumers hold contracts with them, such as National Grid in the US or Enelin Europe).
The transmission grid itself is operated by the so-called transmission system operator (TSO), usually operating under a national/regional monopoly and often semi-state controlled. TSOs are essentially responsible for ensuring the stability and reliability of the (long-distance, major highway-style) grid. They oversee the physical distribution of electricity through this network, and work together with distribution system operators (DSOs), utilities, market makers, power generation companies and others (so-called demand response services) to manage the balancing of the grid. DSOs are the more local and smaller scale equivalents of TSOs within distribution systems and they function roughly the same. DSOs are responsible for transporting electricity to end consumers. Lastly, regulators are a critical participant in energy markets. Regulators mostly include governmental bodies and supranational agencies (such as the EU) that influence electricity markets across several instances. Examples include the setting of targets for renewable energy, cooperating with TSOs & DSOs to ensure grid stability, and influencing energy markets through subsidies and regulations such as the disaggregation of market roles. In the EU, directive 2009/72/EG laid down that transmission systems cannot be operated by vertically integrated operators across the energy value chain. The U.S.’s most notable regulatory actor, the Federal Energy Regulatory Commission (FERC), regulates the interstate transmission of electricity, natural gas, and oil, often reviewing M&A deals in the energy space and regulating interstate energy commerce. These bodies have gradually transformed the energy landscape, and initiated a gradual decrease in the market power of individual companies, although some oligopoly concerns for large players remain.
Illustration: major energy players applied to the German ecosystem
The EU electricity market
Behind this system that organizes the physical distribution of electricity there are multiple “facilitating mechanics”, including most notably the system that coordinates the commercial flow behind it. This electricity transaction infrastructure is powered by different markets that can be distinguished based on their time horizon. These gradually tap into one another to lead up to (close to) real time and serve to ensure the exact balancing of the grid at any-given time.
Graphic 3: Schematic overview of the different parts of the electricity trading markets
As schematically shown in Graphic 3, markets can be classified by their time horizon in advance of real-time. Forward markets include a long-width of time horizons before real time, and are driven by mechanisms down to which power plants are built (i.e. fundamental assumptions about energy usage in 10 years+). Mostly, these markets are, from a demand side, governed by fundamental demand assumptions that energy retailers build in forecasting models (aka. base load models). Practically, the majority of energy consumed by end customers is procured by suppliers on these long-term and far in advance markets. Closer to real-time, day-ahead markets are those in which energy that is to be delivered on the next day is sold. Market participants include energy retailers and speculative participants (mostly hedge funds and commodity traders — including commodity trading advisors and commodity pool operators). Within the intraday market, energy to be delivered on the same day is traded. Lastly, in the balancing market, so-called balancing service providers (BSPs) interact by putting in bids (i.e. a price to consume more or produce less electricity) and offers (a price to provide more electricity or consume less) up to 30 minutes before real-time (depending on the respective markets). Balancing service providers can be both generators (certain power plants that can flexibly turn their supply on and off), as well as demand-side operators of temporary storage (such as grid-scale batteries). Through an underlying algorithm, the bids and offers function in a way that TSOs will fall back on these offers by their attractiveness in real-time to balance the grid.
These market mechanisms are powered through largely centralized market makers. The most important ones are NordPool (which covers the trade of electricity in the Nordics), EPEX SPOT & EEX in DACH & France and ERCOT & PJM in the US. Market makers and TSOs/DSOs are connected through a so-called market management system (MMS) software to coordinate the commercial trade and physical flow of electricity in real time. The overall purpose of these mechanics loops back to the fundamental principle of ‘balance at all times’.
Energy markets: Europe vs. the U.S.
Unsurprisingly, energy market dynamics vary depending on their geographic location. While we will focus this perspective mainly on “established” energy markets, as in Europe and the U.S. it is important to note that such markets can look fundamentally different in regions with less developed and stable grids. Taking African energy markets as an example, the rise of solutions deploying micro- and off-grid solutions can be seen as a testament to the instability of the grid and the need for solutions that leapfrog some of the grid development challenges that were observable in established markets historically.
In the EU, 27 member states have adopted various directives through the years establishing common rules for market access, energy generation, transmission, and distribution and recognizing official regulatory authorities in each state. This market has had a tendency to integrate over the years with the creation of bodies like the European Network of Transmission System Operators for Electricity (ENTSO-E) and the European Network of Transmission System Operators for Gas (ENTSOG). With the advent of the 2022 energy crisis in Europe, fluctuating and unstable energy prices have prompted European governments to take back control of energy markets pricing.
The U.S., conversely, has remained relatively decentralized and fragmented along regional lines, moving in favor of market deregulation since the 90s. Regional grids grouping together geographies across state lines oversee the transmission of electricity and the stability of their grid. Two thirds of U.S. electricity demand is serviced by independent, deregulated utility providers. In contrast with regulated markets, deregulated ones allow electricity customers to select an electric supplier (known as customer choice) rather than being required to purchase electricity from their local electric utility.
Keep an eye out for a future article comparing the energy market structures in the United States and Europe!
Graphic 4: Regional Transmission Organization Map of the US
The challenges ahead
Renewable energy sources provide a massive opportunity to enhance the carbon footprint of the electricity grid. Yet, they also pose substantial challenges to the outlined basic functioning of the electricity grid and its surrounding infrastructure (both physical and intangible). As these resources can only produce when nature allows so, times of high production and high consumption do not (necessarily) coincide. Because of the need to balance, this causes substantial volatility in the market and requires flexibility from a grid that was never meant to be so flexible. Driven by political initiatives by the EU, the interconnectedness of the electricity grid across Europe amplifies the threat from partial outages in one region to affecting people across the continent even further. In addition, the trend of “electrifying everything” (especially in transport and heating) increases the load of the grid, further adding to the logistical and infrastructural challenges posed to the grid and its stability.
Ultimately, even in its original form, the electricity grid has been complex (and we hope we broke this complexity somewhat down for you). With the challenges from pushes for renewable energy, and general electrification, these become more critical. Indeed, while electricity generation has already skyrocketed over the past 100 years, we are yet at another inflection point. “Electrifying everything”, especially all other primary energy sources characterizes the direction we are heading for. Forcing fundamental change to the electricity system that was never meant to carry these loads at this flexibility, these challenges represent a threat but equally so an opportunity at the same time. The stakes are high, which is why we love looking into solutions at Picus which help manage the path ahead. In our view on the future of energy (tech) articles we have sketched out our perspective on the future lying in front of us, coupled with how we think about business models in that space. In the coming weeks, we will publish a series of further articles introducing our deeper view on the key co-developments of this fundamental transition and the resulting opportunities for the venture ecosystem. Stay tuned.
Are you a founder looking into Energy Tech topics or have you already started a venture in the space and are approaching Seed or Series A stage? If you are curious how we at Picus can help you with our approach as entrepreneurial sparring partners, please reach out to us on Linkedin or drop us an email at philipp.emig@picuscap.com, stephan.fuechtenhans@picuscap.com, pierre.bourdon@picuscap.com, grace.missakian@picuscap.com or melanie.schwendimann@picuscap.com
Picus Energy & Climate Squad 💚 (Flo, Sebastian, Philipp, Stephan, Grace, Pierre, Melanie)
