Efficiency trends in power trading market

I have blogged earlier about the anachronism in continuing the non-transparent OTC trade-based sytem of power sales when there were two functional power exchanges in the country.

The OTC trader-based system does not facilitate efficient price discovery, despite regulatory provisions on the profits that can be made, since the transactions takes place in private with little public disclosure of details. It is all the more unexceptionable given the with limited depth and breadth in the exchanges. Banning all OTC trades and bringing them into the fold of the exchanges would multiply its liquidity and optimize price discovery efficiency of the exchanges.

Currently, the two operational power exchanges in India, IEX and PXI, offer day-ahead and week-ahead contracts. The bilateral OTC trading term ahead contracts vary from hours to many years. Such traded power (less than an year contracts), including the unscheduled interchanges (UI), form about 10% of the power generated in the country.

A test of the logic behind this assumption is the trends in market share distribution between the OTC and exchange markets. If the exchanges were more transparent and efficient, it was natural to expect them to increase their market share at the expense of the traders. And, recent trends point to exactly this happening. The Businessline reports that cheap prices in the exchanges are driving consumers - industrial and distribution utilities - away from traders. It writes,

"In 2010-11, the value of deals on the PXs surged to Rs 5,389 crore, a 51 per cent growth (or Rs 1,826 crore in absolute terms) over the deal values clocked the previous fiscal. Volumes more than doubled on the bourses. Correspondingly, the bilateral trader market, or short-term deals executed through a power trader, was down by almost Rs 800 crore during the year even as volumes remained flat. One of the key reasons for the PXs gaining favour over the traders is the lower electricity prices discovered on the two operational bourses — IEX and PXIL.

At Rs 3.47/unit, the average price on the PXs was a good Rs 1.30 lower than the corresponding price of Rs 4.79/unit for deals involving traders in 2010-11. As a result, the gap between the volumes for deals involving traders and those transacted on the PXs has narrowed sharply last fiscal... Thanks to the surge in business on the bourses, cumulative deal value surged to Rs 18,657 crore in 2010-11."

One way to compare the relative efficiencies of the two markets is to compare their prices. The graphic below of prices in June 2011 reveals that even in case of contracts with duration less than a week, which are also offered in the exchanges, the prices were lower in the exchanges (even with the daily average) than with traders.



The differential in prices (between the exchanges and OTC traders) with contracts that are greater than a week too are disproportionately higher. The case for banning OTC trades could not have been more convincing.

Update 1 (11/9/2011)

In the corruption filled environment, it was only natural before skeletons came out from the cupboard of OTC trades executed by state utilities. Businessline reports that the Uttar Pradesh Power Corporation (UPPCL) signed a one-year deal with a private power generator in Gujarat, routed through a private power trader in the western State, to buy some 600 MW at around Rs 4.70 a unit. The price is well above the average of less than Rs 3 a unit on the power exchanges over the last two months.

In fact, the average electricity price discovered on the two operational bourses — IEX and PXIL – was Rs 3.47 a unit, well below the corresponding price of Rs 4.79 a unit for deals involving traders in 2010-11.

The coming coal crunch

It is now becoming increasingly apparent that fuel scarcity is arguably the biggest constraint facing Indian power sector. The situation is alarming in case of thermal power plants, where a large number of plants are scheduled to become operational over the coming 3-4 years.

The Coal Ministry has forecast coal shortfall to be 104-121 mt by end-2012 and 200 MT by 2016-17. This comes on the back of Planning Commission deciding to reduce the 11th Plan (2007-12) annual production estimates from 680 mt to 630 mt (486 mt from CIL, 81 from captive mines, and rest imports). However, this revised coal production target too appears difficult to achieve, with more realistic estimate being 592 mt.

The capacity addition expected based on coal linkage provided by Coal India Limited (CIL) itself is about 40 GW in the 2011-14 period. Assuming an 85% plant load factor (PLF), this would require about 200 mtpa of additional coal, whereas the incremental coal availability, assuming an 8% production growth, would be just around 73 mpta, leaving a whopping deficit or an average PLF of 40% for these new plants.

This leaves generators of all kinds with no option but to blend large quantities of imported coal. The inevitable cost escalation will adversely affect their profitability. Since NTPC has the largest exposure to CIL, it is naturally among those most likely to be affected by the coming deficits.

Since the contract agreement of standard PPAs, especially the tariff-based bids, excludes fuel supply from force majeure provisions, the entire cost escalation may have to be borne by the generator. Much the same would be the fate of private IPPs who won bids under Case I bids, whose tariffs are already determined. The profitability of merchant power plants, seen no long ago as an extremely profitable business opportunity, too will come under severe strain.

A significant number of generators who won Case I bids in recent years do not have firm coal tie-up for a major share of their coal and rely on spot purchases. This exposes them to severe risks on coal availability and coal pricing. Merchant power plants without coal tie-ups are even more vulnerable, being exposed to both fuel and price volatility.

Further, though the CIL issued Letter of Assurances to generators, many of them have not been converted into firm contractual Fuel Supply Agreements (FSAs). This means that while supplies of coal to these plants are on for now, in the absence of a firm FSA, CIL is not bound to maintain a minimum supply round the year. This has shaken up investors who face the risk of developers defaulting on their debt repayment commitments.

In light of all these developments, it is not surprising that, as the Businessline reports, investor interest in private generation is petering out. In any case, this reduction in investor interest was inevitable since the surge in power sector lending of recent years had left many banks with portfolios excessively exposed to the power sector. In order to re-align themselves to their regulatory commitments, they were already paring down lending to power sector.

All these problems comes even as CIL grapples with its failure to increase production capacity (it produces 80% of the country's coal production). Ading to the woes, the Ministry of Environment and Forests' (MoEF) refusal to accord clearances has left an estimated 203 blocks with combined reserves of 600 mtpa and potential generation capacity of 130 GW in limbo. The MoEF in 2009 had categorised these 203 coal blocks as "no go" mining zone. The Coal Ministry has been demanding permission to mine at least 90% of these 203 blocks to meet the ever widening demand-supply gap of the dry fuel.

None of these include the big risk posed by the worsening finances of State Electricity Boards, whose accumulated losses have crossed Rs 55000 Cr. These losses are certain to rise further when distribution losses are 25-30% and more than 20% of electricity is given free to farmers. Saddled with such huge debts, discoms are not likely to venture into spot market purchases, except when faced with an electoral season. This will add to the woes of an already volatile and deficient spot market.

In recent weeks, the government has also started cracking down on developers who though allocated coal blocks had not started developing them. A panel set up by the Coal Ministry has recommended issuing warnings to 29 coal and three lignite blocks allocatees, apart from the cancellation of 14 coal blocks and one lignite block to six PSUs, including NTPC and three private firms for failing to develop the mines.

Update 1 (26/1/2012)

The Economist writes,

"By the year to March 2017 domestic coal production will meet only 73% of demand, leaving a gap of some 230m tonnes, almost five times the level of 2012. Include other industries that use coal, such as steel, and some analysts calculate that India’s total imports by 2017 could reach some 300m tonnes. That is on a par with the current exports of Australia, or those of Indonesia, South Africa and Canada combined."

Electricity prices and elections

Summer time which coincides with elections is a sure-shot recipe for spot power prices in our power exchanges going over the roof. Two upward demand pressures on electricity consumption are at work - the seasonal cycle associated with higher consumption in summers and the pressure on governments facing elections to cut back on load reliefs.

This trend is playing out now, with Assembly elections due in many states. Businessline reports of day-ahead spot prices in the southern region zooming to over Rs 12 a unit in the last couple of days, over four times the price quotes for the rest of the country on the IEX — the country's largest power exchange (handles 80% of transactions). It writes,

"A key reason for spot electricity prices shooting through the roof in South India is the mad scramble among utilities in the region to arrange power to ensure zero power cuts before the polls in States such as Tamil Nadu, Kerala and Puducherry. Lack of adequate grid interconnection between the southern region and the rest of the country has compounded the problem."

The concern here is about the regulators staying away even in the face of such price volatility. There has been ample evidence of spot market prices inching upwards in anticipation of polls from January.



Being a regulated industry, it is natural that regulators step in whenever required to protect the interests of all stakeholders. It is therefore unfortunate that, depsite clear indications of surging prices and resultant profiteering at the expense of consumers, the regulators have stayed away.

It is all the more surprising since the the Central Electricity Regulatory Commission (CERC) had intervened to regulate prices before the Maharashtra Assembly elections in September-October 2009. The CERC invoked the proviso to Section 62 (1) (a)read with Section 66 of the Electricity Act of 2003 and imposed price ceiling on the purchase of electricity through bi-lateral agreements and power exchanges. In order to curb profiteering opportunities in response to a sudden surge in demand, the CERC announced a price band of 10 paise per unit to Rs 8 per unit to cover all inter-state day-ahead trades for a period of 45 days.

The argument that better grid inter-connectivity of the eastern region with the northern and western regions is responsible for the absence of similar price spikes in the NEW grid is a straw man. Neither Assam nor West Bengal are in the market making purchases similar in magnitude to Tamil Nadu. West Bengal is amongst those with the lowest deficits. In any case, as the example with Maharashtra in 2009 shows, when the bigger states enter the market, the demand pressures show up and forces prices upwards.

Power trading in India

Excellent graphic in Mint about the power trading market in India. It again baffles me as to why we persist with over the counter (OTC) traders when there are well-established exchanges in place.



Short-term power trading (for a period less than an year), which includes the UI transfers (40%) and trades done through traders (41%), exchanges (10%) and on bilateral basis (9%), formed around 8% of the total energy generated in 2009. In other words, this means that exchange traded power, whose price discovery is the most efficient and administration is the most transparent, forms just 10% of the total short-term traded power or a minuscule 0.8% of the total energy consumed.

Increasing transparency and improving efficiency of traded power is especially important since all the major buyers and sellers are governments themselves or government entities. States like Himachal Pradesh, Chhattisgarh, Gujarat and West Bengal, which had surplus power due to the availability of free/power purchase agreement-based power under contract from developers, were among the top sellers in the open market through traders/exchanges.

A policy framework that facilitates the transition from all OTC trades into exchange trades is surely beneficial for all stakeholders. It will improve the liquidity in the exchanges and facilitate more efficient price discovery and provide more reliable price signals for all market participants, including new generators. In fact, as the exchanges develop the requisite depth and breadth, it may be appropriate that even the frequency-based UI pricing be linked to the exchange prices.

As on April 2010, the total all-India capacity was 159,648MW with thermal power capacity of 102,704MW (64%), hydel power capacity of 36,863MW (23%), nuclear capacity of 4,560MW (3%) and renewable capacity of 15,521MW (10%).

Incentive distortions in financing power projects

Businessline reports of a new trend in financing power projects, wherein power equipment manufacturers, power trading companies, and O&M contractors have been "sweetening their pitch for contracts by offering to contribute equity stakes in upcoming projects". However, despite its obvious attractiveness for both developers and equity investors, this trend opens up several opportunities for conflicts of interest and incentive distortions.

Equity participation becomes attractive for cash-strapped promoters, especially state generation companies (from Maharashtra, Tamil Nadu, and Karnataka), in achieving financial closure. Manufacturers, traders and contractors see equity participation as a backdoor to bagging contracts.

Assuming that promoters' investment decisions, on both capital and technology, are always driven by profit and efficiency maximization, the aforementioned model creates possibilities for incentive distortions that goes against these objectives. Here are three possible such conflicts of interest

1. Equity contributions by manufacturers have the potential to distort equipment and technology specifications (as the equity investing manufacturer tries to influence the bidding process to his advantage), and in the process result in sub-optimal investment decisions. Given the 80:20 debt-to-equity ratios in power projects, manufacturers see a small equity stake as a cheap way to bag massive contracts.

2. Power traders with investments in generators have an incentive to selectively restrict generation/supplies and thereby create artificial shortages, so as to inflate prices.

3. O&M contractors with equity investments have an incentive to get contract provisions incorporated that are not necessarily in the interest of the project.

It is therefore imperative that the Central and State regulatory commissions take appropriate measures to curb such conflicts of interests. But, whatever the precautions incoporated into contract provisions, through regulatory directions, to pre-empt these perverse incentives, it is impossible to fully eliminate them.

Ban OTC trades in electricity markets

Though exchange based trading of power has been in vogue in India for slightly more than a year, they constitute just 0.3% of the total consumed power in the country. Two power trading exchanges - Indian Energy Exchange (IEX) and Power Exchange of India (PXI) - are presently operational. Further, of the total short term power trade, exchanges (which trade only day-ahead contracts) form just 9%, while bilateral forward contracts (upto one year) form 50% and Unscheduled Interchange (UI) (spot market with frequency-based pricing to settle real time inter-state unscheduled imbalances) forms 41% (figures from April, 2009).

Currently, of the total power traded, exchanges form just 9%, while bilateral trades form 50% and Unscheduled Interchanges (UI) forms 41% (figures from April, 2009). This multiplicity of platforms for traded power has resulted in the fragmentation of the nascent power trading market, and rendered all of them inefficient and distorted. The bilateral trades are conducted Over the Counter (OTC) by registered traders who sell day-ahead and longer term contracts to mainly state utilities at negotiated prices. Sensing the importance of increasing liquidity in the exchanges, the Government have also taken several steps including obligating all new generators to sell a part of their produce through the exchanges, and a proposal to slowly shift UI trades into the power exchanges.

Markets in electricity trading are qualitatively different from those in other products, including commodities. Since electricity is not storable and transportation a major constraint, the markets trading in electricity contracts are inherently inefficient, liquidity strapped and have limited fungibility. The constraints in transmission capacity means that prices for delivery at one place at any time will have no relation to that for delivery at another place at the same time. This limits the forward market for each time and place to only a few buyers and sellers. In other words, the absence of a country-wide market in forward contracts seriously limits the market liquidity and efficiency. It is therefore important to have markets that trade the full spectrum of products - spot, forwards and futures; have considerable liquidity; and have enough transmission capacity to increase the fungibility of contracts.

In the context of a market with substantial power deficit, limited number of sellers, and relatively inelastic demand (buyers cannot afford not to meet the demand due to political compulsions), sellers will always be the market makers. All the aforementioned conditions are likely to persist for some time to come. This market power of the seller's gets amplified in inverse proportion to the volumes traded in the exchange. In the circumstances, it is imperative to take all possible measures to increase trading liquidity in the exchanges so as to mitigate market conditions favoring the sellers.

In the circumstances, it would appear natural for the government to encourage the shifting of OTC trades into the transparent of platform of power exchanges. It will do more than any other intervention to considerably enhance the market liquidity and promote efficient price discovery in exchange transactions. This assumes importance especially in view of the proposal by both IEX and PXI to introduce term ahead contracts in its portfolio of offerings. Contracts not covered by the exchanges can continue through OTC route, while those offered by the exchanges can be immediately brought under the exchanges.

The presence of OTC traders inhibits the development of efficient power exchanges in the country. The non-transparent nature of its price discovery and the demand-supply imbalances makes OTC trades attractive for traders who enjoy a superior bargaining power. These bilateral contracts "crowds in" all types of trades and drains liquidity from the exchanges. Despite its high prices, desperate state utilities too prefer the longer term bilateral contracts which lowers the uncertainty associated with procuring power in an illiquid and deficit market. In the final analysis, the day-ahead and term-ahead markets should converge towards the same efficiency and transparency that has been the mark of the CERC managed UI market.

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The State and Regional Load Despatch Centers consolidate the requirements of each utility on a day-ahead basis and then schedules the transmission corridors to match the generating station and the purchasing utility or open access customer. Any demand by a utility, over and above that scheduled is called unscheduled inerchange (UI) demand. The UI rates are fixed based on the marginal cost of production of the costliest scheduled generator supplying at that point in time and is capped by a ceiling rate. Since the UI rate are known in advance, these trades are done without any contracts and involve real time balancing and settlement.

Price ceilings in power exchanges

In a landmark decision, the Central Electricity Regulatory Commission (CERC) has finally imposed a price band on electricity sales in power exchanges and bilateral markets, in an effort to curb the runaway price increases and volatility in a massively deficient electricity market (peak shortage estimate of 18.1% for 2009-10). The price band from 10 paise per unit to Rs 8 per unit would cover all inter-state day ahead trades for a period of 45 days.

Generators and traders had opposed any price ceilings on the grounds that it would deprive the market of generation capcity. However, by fixing the price ceiling by taking into account the prevailing market price of the high cost liquid fuels, the CERC has ensured that there is no economic incentive for generators to keep their plants idle.

The CERC points to the increase in prices of electricity traded in the Indian Energy Exchange (IEX) between 6 and 7 PM from Rs 5 per unit to Rs 14.5 per unit in the period from 3.08.2009 to 13.08.2009. Given the fairly stable global fuel prices, cost considerations cannot explain this steep 2.89 times rise in the 10 day period. Let us model the market by assuming Rs 5 per unit as the equilibrium market value based on the actual cost of production and Rs 14.5 as the equilibrium traded price in the exchanges.



The quantities demanded at exchange equilibrium price of Rs 14.5 is Qe, at the ceiling price of Rs 8 is Qc, and at the initial market price of Rs 5 is Qm. At a market price of Rs 8, from the generators original supply curve (based on their cost of production) it is clear that they would be willing to supply a quantity of Qc(sup). Since Qc > Qe, the quantity of electricity generated and consumed increases with the price ceiling, thereby lowering the deadweight loss.

A price ceiling that is fixed at the marginal cost of the highest cost fuel is the most efficient rationing price. At this price, all the available generators will be able to get back atleast their marginal cost of production. The CERC has accordingly placed the ceiling price at Rs 8, equivalent to the marginal cost of production of high cost liquid fuel generators. At a lower price ceiling, there will be idle generation capacity.

Illiquid electricity exchanges

I have blogged earlier here, here and here about how illiquidity amplifies distortions in a tight electricity market.

In a deficit market, the demand curve shifts to the right due to the effect of both the increased demand and anticipation of larger deficits (which in an effect similar to Ricardian equivalence, increases the prices buyers are willing to pay for procurements at the margin). In the short to medium term (especially in the present Indian electricity generation context), supply remains more or less stagnant. The result is an increase in the prices of the power traded in the exchanges.



Further, in a market with limited reserve capacity, even small disruptions in generation (due to breakdowns or repair shutdowns in base-load plants or fall in hydel capacity due to failure of rains) or sudden spikes in demand (due to a very hot summer or peak agriculture load) can drive up prices of exchange traded power. The magnitude of the price wedge will depend on the market liquidity. Smaller the exchange liquidity, larger will be the price increase due to sudden shortages.

Electricity market trading strategies

The proposals by the two functioning power exchanges in India to offer term-ahead electricity contracts offers interesting possibilities. However, I am inclined to a model that combines features from both proposals. Designing a market by accounting for the reactions and counter-reactions of the various market participants being an extremely complicated task, this may be treated as an amateur attempt. So comments and counter-proposals are welcome.

Though exchange based trading of power has been in vogue in India for slightly more than a year, they constitute just 0.3% of the total consumed power in the country. Two power trading exchanges - Indian Energy Exchange (IEX) and Power Exchange of India (PXI) - are presently operational, and they trade only day-ahead contracts (for delivery next day). Further, of the total short term power trade, exchanges form just 9%, while bilateral trades (for terms upto one year) form 50% and Unscheduled Interchange (UI) (settlement of real time grid imbalances by frequency-based pricing mechanism) forms 41% (figures from April, 2009).

The fundamental requirements for the success of power trading exchanges, like that of any other trading exchanges, are
1. Adequate quantity of power to be traded (or liquidity)
2. Large enough number of sellers and buyers (so as to ensure competition)
3. Availability of transmission facilities so as to materialize the trades

Unfortunately, the Indian market suffers on all the three counts, with the liquidity problem being the most excruciating. The net result has been a marketplace which is illiquid, inefficient, and vulnerable to anti-competitive practices. Hitherto exchanges have been trading only day-ahead contracts, while the longer term contracts are executed over the counter through licenced traders. In order to improve liquidity in the market and increase its depth, both the power exchanges have put forward proposals for term-ahead forward contracts.

The proposals for price discovery for the Term Ahead Markets (TAM) being proposed by the two power exchanges are as follows

IEX
Proposes a two part trading - a double-sided, sealed bid auction followed by continuous matching trades. Every day, both buyers and sellers would simultaneously submit bids in closed covers during specified time period. The bids are then matched to calculate a uniform equilibrium price, which is the price of the last accepted bid. This is a form of Dutch auction. The uniform price nature of the auction would tend to encourage sellers to bid close to their marginal cost of production, and thereby facilitates more efficient price discovery. Once the market is cleared, all the remaining sellers and buyers are pitted in a continuous matching trade where the highest buy order is matched with the lowest sell order.

In the context of a deficit power environment and state utilities faced with demand that cannot be refused (due to political compulsions to provide assured supply), this market design does favor the seller in so far as it leaves the buyer with limited information to base his bid. Any high bid by a desperate buyer will profit the seller and create a "winners curse" for the buyer.

The continuous matching bid process, where price discovery is likely to be more efficient, is a welcome feature. However, this can also encourage both sellers and buyers to hold out during the double-sided closed-bid auction, in the hope of getting a better deal during the continuous matching. Safe in the assurance that they will have another opportunity, sellers will have no incentive to quote close to their marginal cost. Similarly, in their desperation to close their deficit and the uncertainty surrounding the availability of power after the first round auction, buyers may end up being forced into quoting higher prices to grab as much as they can.

PXI
Proposes to have separate sell and buy sessions. First, the sellers simultaneously place their closed bids during a specified time period. Then the sell orders are opened and disclosed and the buyers use this information to simultaneously place their bids in closed covers. The sell bids are then opened and the lowest priced sellers are matched with the highest priced buyers and the seller is paid the price bid by the buyer.

In regular pay-as-bid auctions, the lowest bidding seller is matched to the lowest bidding buyer at the market clearing price, and so-on. This incentivizes sellers to bid as close to the market clearing price as possible, irrespective of their marginal cost of production. The variation of price matching proposed by the IEX seeks to minimize this incentive distortion by reducing the incentive for sellers to guess the market clearing price and thereby bid accordingly (as in the regular pay-as-bid auctions). This cycle is then repeated in a second matching run where first the sellers and then the buyers modify their original bid prices.

This market design is more favorable for the buyers, in so far as they now have some information to base their bids. Sellers also have an incentive to quote close to their marginal cost given the fact that buyers can see all sale offer prices before making their own bids. This in turn dis-incentivizes competing sellers from pricing themselves out with very high bids and also encourages them to bid closer to their marginal cost to maximize their chances of winning the bid.

The biggest fault with this market design is that the entire market surplus is cornered by the sellers/producers. As can be seen from Figure 1, in a uniform, marginal pricing arrangement (as done by the auction in IEX), both the buyers (who were willing to pay higher than the market clearing price) and the sellers (who were willing to supply at lower than market clearing price) enjoy their respective surpluses as indicated in the graphic.
Figure 1

However, in the IEX model in Figure 2, by paying the lowest bidding seller the price agreed by the highest bidding buyer, the entire surplus gets transferred to the seller, and so on. In other words, the buyer/consumer surplus will also accrue to the sellers.
Figure 2


The two critical issues are the auction design which facilitates price discovery and the actual price fixation. So how about a market design that takes in the first from PXI and the second from the proposal of IEX? In other words, separate closed bid sell and buy sessions and the price being fixed at a uniform market clearing price. A continuous matching process may be a better alternative to clear the residual that does not get cleared in the first round of auction.

It however remains to be seen as to the extent of impact the deficits and the needs of the state utilities exerts on the market participants. If the market is illiquid and sellers perceive desperation on the part of buyers to get power at any cost to meet their local political compulsions, then any market design will always be vulnerable to being gamed. Such signals sent by the buyers and received by the sellers can have a feedback effect that amplifies the signals and leaves the market even more distorted in favor of sellers. Incidentally, given this eventuality, a simple uniform price bid with continuous matching trade to clear the residual is the best alternative.

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Unschedule Interchange (UI) is a frequency-linked real-time pricing mechanism to operate and settle the electricity demand-supply imbalances in the grid at any point in time. The grid imbalances at any time are transacted as effective spot transactions for immediate delivery, with the prices determined by the grid frequency. This arrangement has been in successful operation for sometime now to settle the imbalances in the Central Generating Stations (CGS) pool. The frequency-linked rates are determined by the CERC.