Electricity markets reimagined: Flexible by design

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Distributed generation, including domestic solar panels, offer consumers the chance to export energy to the grid. [h080/Flickr]

In just over a decade, we will be able to build a new electricity system around renewable energy that is cleaner, produces almost no carbon emissions, costs less than a system built around natural gas, and is just as reliable, writes David Nelson.

David Nelson is executive director of Climate Policy Initiative Energy Finance.

This tantalizing vision of the future is based on the dramatic cost declines we have seen in wind and solar.

In our report, Flexibility: the path to low-carbon, low-cost electricity grids, we forecast that from 2030, a system based on wind and solar would cost $70/MWh versus $73/MWh for a system based on gas.

If we can harness flexibility existing sources, including managing how and when consumers use electricity and including existing power plants for backup, the cost of the renewable-based system could fall much further. Even today, there is more flexibility on electricity systems than you might think. We found that most regions could easily reach 30% variable renewable energy by using flexibility that is already available in the system, while those with access to large reservoirs of hydroelectric power could achieve far higher levels. With better markets and price signals, all markets can go much further.

However, a future of widespread electricity grids powered by the sun and wind is not guaranteed unless market models are reimagined to encourage different types of flexibility in storage, delivery and consumption of energy. We cannot expect an electricity market designed around the price and market risks of fossil fuels to shift the required trillions of dollars of investment from fossil fuels to renewable energy and flexibility support.

Electricity markets were designed to encourage generators to build and produce electricity cost-effectively. Since gas was the cheapest source of new generation in many markets, electricity prices became closely linked to the price of natural gas.

But what happens when all energy needed in an hour is produced by renewables? What we need is a market that incentivises someone to shift that excess energy to a time when it is needed. As increasing renewable energy supply pushes electricity prices to zero for more and more hours, average annual wholesale electricity prices will fall. Generators dependent on those prices, including gas and coal fired power plants, could go bust. Even renewable energy generators with fixed price contracts will feel the pain. Under current market models, as renewable energy prices fall and more renewable energy gets built, wholesale prices could fall faster. Thus, as renewable energy prices fall, the apparent subsidy – and the risk investors perceive – could actually rise. In other words, the existing market structure would be broken.

We need to do three big things, and several smaller things, to fix our electricity markets and develop the new flexibility resources cost effectively.

First, benchmarking commodity wholesale energy prices on hourly, gas-based prices, no longer makes sense. Commodity electricity market prices should be based on what is now the likely least cost source of new energy – renewable energy. Since variable costs are low and output is predictable, investment in a new wind turbine is essentially an upfront payment for a fixed supply of energy produced over a period of 20 years or so. If we know the financing costs, we know the cost of each of those kWhs. So rather than having an energy price that fluctuates each hour, we should have a price that is based on that cost of electricity. Annual auctions for 20-year energy supply contracts would produce such a price that could then be used as a wholesale benchmark. Such electricity markets already exist, like the hydro-based market in Brazil.

Second, existing electricity market designs continue to have a role in pricing the delivery cost of energy, based on time and location. Flexibility markets designed to charge consumers a delivery price (or an incentive to take more energy when there is excess supply) provide incentives to shift demand, charge batteries, or even use gas turbines to meet peak demand, addressing the second important market need.
In addition, separate markets or mechanisms will be needed to provide additional support services, such as very short term reserve, that these two markets will find it hard to address. Most of these services are already reasonably well covered by existing system operators.

Third, these markets will need to incorporate a wider range of players. In the not-too-distant future, we can imagine a market where consumers can also be participants. Distributed generation, battery storage, automated systems and electric vehicle charging all offer consumers the enticing prospect of exporting to the grid in more sophisticated ways.

A delivery market would pay to deliver energy to a specific time and place. Consumers would be able to contract with the energy producer to buy energy, contract with an aggregator or pay a delivery charge to a market operator. Locational marginal pricing will play a critical role in sending the right price signals in delivery markets.

If the market participants in the future market change, what technologies will drive this change? There are many options for each of the different flexibility needs. The least cost flexibility options – as shown in this chart from our work for the Energy Transitions Commission – will change over time as technologies evolve. In today’s market, existing generation and demand side resources are the most cost-effective. Demand-side resources, when they can be harnessed, are almost always cost effective. If battery costs fall as predicted, they will become cost competitive across several flexibility needs. New gas turbines are cost effective today, but may be less so in the future as lower cost options evolve.

Growing electrification will create more opportunities for using demand management, as the new electricity demands are more flexible.

But we cannot rely on rock-bottom prices for solar and wind to drive the energy transition. Otherwise the mismatch between a market designed around fossil fuels and variable renewable generation could distort the market even further, creating an almost insurmountable barrier to low-cost, low-carbon electricity grids. Under that scenario neither the supply nor the demand side wins.