Benefits and Market Design Challenges of a More Internationally

Integrated Norwegian Electricity Market

In many respects the hydro-power system has an unique ability to carry out planned load- following and handle real-time balancing of the power load. The development towards a more internationally integrated electricity market implied a larger interface with thermally based systems with other characteristics. This section considers principle aspects of benefits from this integration and the implied challenges for market design.

4.1.1 The Benefits of More Internationally Integrated Power Systems

The initial opening of foreign trade that followed the general market reform, was based on market negotiated contracts. In this it represented a small, but clear step away from the former political restrictiveness of foreign trade. This was followed by further measures of opening trade, and subsequently thoroughly manifested in 1995 when Nordic energy ministers agreed to expand Nordic electric power co-operation. In 1996 the joint Norwegian-Swedish power exchange was started for trade in power contracts, and was later also to include Finland and Denmark.

A basic driving force of this development was the expected benefits of trade, following from the comparative advantages of the different energy systems. Here Norway was a purely hydro-based system, Sweden was a part hydro and part thermal system, and the other Nordic countries, as well as other close European countries to a large extent were thermal systems. The comparative advantages of hydro-power versus thermal systems are mainly related to issues of the supply of energy on one hand, and the value of power load capacity and ancillary services on the other hand:

- Energy supply in the hydro-power system is given by the nature-given precipitation, and is thus characterized by severe risks as to the available supply of energy. Energy generation in thermal systems is based on a variety of fuels which may be bought in markets. In principle, trade has thus the potential of offering a higher security of energy supply to the hydro-based system.

- Capacity for ancillary and load following services is necessary to ensure the momentary balance of the power flow and maintain the operating quality of the power system. In the thermal system, the ability and costs of providing different kinds of ancillary services, including load following, varies from plant type to plant type, but is in general relatively costly, with higher start/stop costs and higher variable costs. In the reservoir-based hydro- power system, the costs of supplying such services, as well as peak-load delivery, is in comparison relatively low. In this the hydro-power system offers cost advantages relative to the thermal system. This to a large extent follows from the underlying technology of the hydro-power system, where high investments in power load capacity to some extent are necessary to efficiently utilize the supply of water. Variable costs are also relatively low, with low start/stop costs, and low variable costs. For example, costs of momentary adjustments are largely related to the deviation from optimal turbine operation and the corresponding loss of water. Traditionally the Norwegian electricity system has thus had an abundant load capacity.

From a Norwegian point of view, the closer integration with other power systems offered the possibility of a better pay-off on the Norwegian power resources, especially with respect to peak-load supplies, load-following, and various ancillary services. The possibility to import energy also offered a higher security of supply, especially in the event of dry years in the hydro-power system. The realization of such benefits of integration, however, on one hand was contingent on the size of the actual cost differences in supplying power-load related services, and on the actual capacity of foreign trade, including the capacity of new investments in international cables. On the other hand, the realized benefit also was dependent on the extent to which the pricing systems of the market were able to reflect these values.

4.1.2 Challenges for Norwegian Market Design

In the anticipated closer integration with thermal systems, it was expected that the Norwegian market to a larger extent would face demand that represented a larger inherent willingness to pay for such services. This also implied a transition to a scenario of a greater relative scarcity

of such capacities, and as such an implied higher inherent market value of e.g. peak-load and load-following abilities, capacities for momentary balancing and other ancillary services. The concern was now whether the existing market systems would induce an efficient allocation and remuneration of these resources in the short, as well as in the long run. A basic insight is here that the actually resulting market prices, and thus the resulting remuneration, to some extent depends upon the chosen market design. Note that the commodity in this respect is a heterogeneous good, for example with different abilities for planned versus unplanned adjustments and load following, different response times, and different abilities with respect to a long range of other ancillary services.

The current pricing systems, developed in the initial stages of the market reform, did to some extent reflect different dimensions of the peak-load and momentary balancing attributes of the system80. The market reform had, however, taken place in a partly pure national market. The relatively isolated Norwegian power system in many ways represented a scenario of abundant capacity for the supply of balancing and ancillary services. From the abundance of capacity, it followed that the relative inherent market value of such services was low. Moreover, it seemed probable to assume that elaborate mechanisms in this scenario had not been needed to ensure an efficient allocation of these resources, and that this was reflected in the chosen design of the market system.

The question was now whether the market system, in a future state of a relatively larger scarcity of such capacity and services, would be able to bring forth market prices that would signal the real market value of different power load capacity and ancillary services. This has important implications for the short-run as well as long-run efficiency of the market. For example, the inherent value of specific services and capacity may be high, e.g. due to high demand and high willingness to pay for such services. However, if the inherent value is high, but the pay-off in market prices due to the explicit market design and price structure is low, the resulting incentives of the market system will result in inefficient resource allocation in the short-run, and may imply lower than optimal investments for the capacity in question. In this way the development of a more internationally integrated market also represented new challenges for market design in the Norwegian electricity system.

A further challenge of market design is related to the demand for such services, and for ancillary services in particular. For a large range of power generating capacity, there are in

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principle several competing uses, for example ranging from normal energy production to the provision of different forms of ancillary services. We have in our exposition already encountered such alternatives, i.e. where we argued that producers had the choice of offering their capacity in the spot market, or alternatively, in the regulation power market. In principle the optimal allocation of resources to different appliances is to follow from the decisions of the individual participants, on the supply side and on the demand side. In the presence of market imperfections, however, reliance on only individually based decisions will not necessarily induce optimality. In this respect we will argue that the system reliability in effect is a public good, in which special measures are required to ensure a sufficient level of system reliability in the power system.