An argument for Pay-as-Bid v. Pay-as-Cleared

At the excellent Energy Storage Networks Annual Conference last week in London, energy minister Michael Shanks spoke very well about the recently issued NESO document: Clean Power 30.

When asked whether the vision he had set out of CP 30 would break the price link for gas with power he didn’t answer that particular question, but did say some gas would still be needed. Indeed, the NESO CEO Fintan Slye claims in his introduction that we will have “home-grown energy that breaks the link between volatile international gas prices”

This is borne out at the top of page 7 of that CP 30 report: ‘A clean power system is one where demand is met by clean sources (mainly renewables), with gas-fired generation used only rarely to ensure security of supply, primarily during sustained periods of low wind’.

Now, imagine we still have the same market structure in 2030 as we do now i.e. pay as clear.

Do we think this gas plant is going to be happy sitting around twiddling its thumbs and waiting for its moment in the sun? Because by 2030 the load factor it’s running at, if it’s just confined to these low renewables moments, will be very low – 10%? 20%? Therefore in the moments when gas plant does get to run, it needs to make hay to justify being kept on-line. Meaning it will extract as much scarcity value as it can, so that when it gets called, it will need to charge very high prices to justify being kept online. And as we know under pay as clear, all generation then gets that price.

So the gas price-power price link will NOT be cut, as the NESO report asserts – without market reform. Let’s look at this.

The day ahead (DA) and on the day power(M7) markets are run by exchanges. A significant amount of power is traded DA, with a lot of the activity in M7 being adjustment trades (as forecasts change), or pure speculative trading by trading houses.

The DA market currently gets its price for each half-hour (HH) via the pay as cleared mechanism. This means all bids and offers (buy orders and sell orders) are submitted until the TSO, in conjunction with the exchange, has matched up enough bids and offers to meet the forecast demand for a particular half-hour. The last MW of power offered in to meet the demand sets the price for all the power offered in to meet the demand. Pay as cleared results in the plant at the margin being the price setter for the whole HH – and this mechanism thereby creates super-profits for plants with a low marginal cost, such as nuclear and renewables. These low marginal cost generators will always offer into the market power at low prices to ensure they get called in the generation stack, knowing they will get a higher price.

This is illustrated below:

The UK within day market, M7 however, is a ‘pay as bid’ (PAB) market’ – which means a generator needing to sell has to be offering at a price that is likely to trade – if it gets too greedy it may be undercut by other plant and fail to sell (and therefore generate). Similarly a buyer needs to put in realistic buy prices in order to trade – or risk paying imbalance costs (with all that attendant uncertainty).

Having a market which is predominantly pay as cleared results, as can be seen in the box above, in a material transfer of value from consumer to generator. When we get to the situation where there are only a very few gas generators left, and they only run intermittently (rather than baseload) they will be sure to extract maximum scarcity value at times of system tightness – which will result in some fairly eye-watering prices if the continent is tight also, and the ageing French nuclear fleet is running below par.

This is of course why an island like the UK needs as many interconnectors to different parts of the continent as possible – the ultimate flexibility.

The risk of these sort of spike highs could be alleviated at a stroke were the DA market changed from pay as clear to pay as bid, and this does mean that both buyers and sellers have to become more precise in their pricing, rather than just lazily offering in and getting best price whatever. Note that the BM is also a pay as bid market which, given the added locational element of BM, uncertain run times, and skip rates makes the pricing precision even more challenging.

In conclusion, pay as bid would involve a substantial change to the way we trade energy in the UK – but logically, it’s the only way to break the power price link to the gas price in our system.

Octopus recently announced their new battery lease agreement (also called a tolling agreement) with Gresham House, whereby they will manage 900 MWh of Gresham House’s portfolio. This news got me thinking about the nature of commercial agreements offered to battery owners by route-to-market providers, or aggregators for short.

TOLLING AGREEMENTS

Let’s start with the tolling agreement – it’s essentially a rental agreement for the renter to do what they like with the battery, within warranty confines. My first question is about the motives of the battery owner. We invest in batteries either to profit from market price volatility, or to mitigate volatility, so Gresham, by investing in batteries, are buying volatility and value their portfolio according to the financial modelling that reflects that. To give up all the upside that granting a tolling agreement does, means that either a) the tolling value is considerably above the valuation of those assets that they have in their books, or b) they think there is a significant risk that volatility is going to decrease over the tolling term. And, of course, the opposite is the case for Octopus.

Tolling agreements therefore aren’t that prevalent because typically the buyer doesn’t want to risk a monthly committed payment at the level the toller wants or needs, which is unsurprising given how variable battery incomes are month to month. However, there is probably more scope for specific tolling agreements – for example, we would consider offering a call option through the winter at a strike price on a particular block – say block 5, for example. This is useful to some market players, like suppliers, and involves a far lower level of financial commitment.

THE FLOOR

The next level of commitment, and a greater level of risk sharing, is the floor. With a floor, the battery owner is guaranteed a minimum monthly revenue and a proportionate share of anything made above that level in the month. This means the storage owner is in a position to benefit from any upside should the month prove volatile, and the offtaker (the one buying the resources) is taking less risk in terms of guaranteeing payment, as payments will be less than under tolling agreements. Let’s not forget that in the purely merchant market that battery storage operates in, these guaranteed payments have material cashflow implications for the aggregator, a fact that asset owners need to think about when choosing a counterpart. So, the ratio of risk and reward changes here, tilting slightly from the aggregator to the owner.

CAP AND FLOOR

A variation to this arrangement is the cap and floor, where the owner gets the first portion of the month’s income, the aggregator the next, and then above a certain level (the cap), the two parties share the upside on a proportional basis.

MERCHANT REVENUE SHARING

The last type of agreement in common use is the pure merchant revenue sharing arrangement. In this case, the owner stays completely exposed to market upside – and downside – possibilities, and relies on the aggregator to deliver the maximum revenue possible, for which they will earn a share of the rewards. Thus, there is considerable risk for the owner in the choice of aggregator, and whether said aggregator can deliver on their promises – whilst for the aggregator, this arrangement is in the nature of a free option, barring their operational costs specific to the asset. In this arrangement, the aggregator only earns a small percentage of the net revenues.

As more and more batteries come online, owners will weigh up the size of the opportunity against the risk in the various arrangements, and the beauty of them is that the levels and revenue share proportions can be played with and adjusted until a mutually acceptable arrangement is reached. The only real limitations are a) on the aggregator side, the arrangement has to be sufficient to meet the costs of integration (not inconsiderable) and operation, and b) on the owner side, the requirement for a minimum investment return.

Hello and welcome to Ecotricity Smart Grid’s newest product launch - Ecolibrium.

Ecolibrium is, essentially, our Virtual Power Plant (VPP). We developed it to enable the batteries we’re developing to have a route to market. We didn’t want to use existing aggregators because – to be honest – we looked at what was on offer and didn’t think it was very good, in terms of contracts, transparency, risk-reward balance - but most importantly, in terms of ‘good’ optimisation.

What do I mean by ‘good’? I mean an optimiser that can assess all the revenue possibilities and consistently make decisions that create the best possible revenue outcomes alongside sympathetic battery utilisation.

We quickly realised that the models and platforms we were building had broader applications than just batteries – they could also be used to opportunistically turn down generating assets against revenue opportunities from the Balancing Mechanism or system imbalance price. And we have done this very successfully, as well as partaking in the Grid’s ‘pandemic scheme’, the Optional Downward Flexibility Mechanism, when demand crashed.

So here we are – with architecture and a platform suitable for not only our assets, but for anybody’s asset or battery. Indeed we’ve been running a co-located solar-battery site in South Wales for the last 2 years as we’ve been developing our models and platform.

I’m genuinely excited by this development, which has been painstakingly created over the last 4 years. We have some really smart and engaged people who understand the energy and tech space, we have an insightful revenue estimation model where clients can get a realistic revenue estimation for their assets. And last but not least, we are very transparent – so our clients always know exactly what’s going on with their assets and why, through their portal account on our website.