Spot and contract markets
How spot and contract markets work together to keep the lights on and prices stable
The national electricity market (NEM) covers South Australia, Tasmania, Victoria, New South Wales, ACT and Queensland.
The NEM wholesale market is where generators sell electricity and retailers buy electricity. Retailers then resell electricity to businesses and households. There are around 30 retailers and over 100 generation companies in the NEM wholesale market.
There are two ways to buy and sell electricity in the NEM wholesale market: through the spot market and the contract market.
How the spot market helps keep the lights on
The Australian Energy Market Operator (AEMO) manages the electricity system so power supply and demand is matched simultaneously. The physics of the power system means the electricity supplied by generators must exactly match how much electricity is being used by consumers, or blackouts can happen.
The spot market is the mechanism that AEMO uses to match the supply of electricity from power stations with real time consumption by households and businesses. All electricity in the spot market is bought and sold at the spot price.
The spot price tells generators how much electricity the market needs at any moment in time to keep the physical power system in balance.
When the spot price is increasing, generators ramp up their output or more expensive generators turn on to sell extra power to the market. For example, a gas peaker or pumped hydro plant may jump in, or a fast-response battery may discharge electricity.
When the spot price is decreasing, more expensive generators turn down or off.
Spot prices reflect how much electricity is being used
Spot prices are currently updated every thirty minutes but this will move to every five minutes in 2021. Prices are usually low in the early hours of the morning, before people wake up and businesses and factories start operating. Spot prices are usually higher in the mid afternoon or evenings, when people and businesses are generally using the most power.
There are different spot prices in each of the five NEM regions. Over the year to June 2018, spot prices averaged between $73 (Queensland) and $98 (South Australia) per megawatt hour (MWh), equal to 7.3c/kWh and 9.8c/kWh.
Example: NSW, midnight 17 September 2018 - midnight 18 September 2018
This graph shows demand on a typical Monday in New South Wales. Demand rises gradually from around 4pm until its peak at around 7pm. This three hour peak is when people return home from work and turn on electrical appliances, while most businesses are still open. As demand rises to its peak, so do spot prices. As demand falls in the evening and night, spot prices fall.
Do consumers pay the spot price?
No. Households and small businesses buy electricity from their retailer, not the wholesale market.
Retailers offer households and small businesses a retail contract or ‘plan’ for supplying electricity. The plan sets out how consumers will be charged for their energy over a fixed period of time.
Also, the cost of electricity supplied by generators is only part of an electricity bill. A typical bill comprises:
- Wholesale costs (30-40%): cost of generating electricity
- Network 'poles and wires' costs (40-50% of bill): cost of transporting electricity
- Environmental costs (5-15% of bill): direct costs of government schemes like the renewable energy target
- Retailer and residual costs (5-15% of bill): cost of retailer services and other residual costs.
Some large industrial users like zinc refineries enter directly into contracts with generators, or buy electricity directly from the spot market, or a combination of both, rather than buying through a retailer. Sometimes these large users are able to temporarily reduce their demand to avoid high spot prices.
How the contract market helps keep prices stable for customers
Retailers enter into contracts with generators to buy electricity at a fixed price
To manage their financial risks and have more certainty over wholesale energy costs, retailers enter into various wholesale hedging contracts.
These contracts fix the wholesale price retailers pay for electricity over the course of a year, or several years. This reduces retailers’ exposure to the highs and lows of the spot market - which can go as low as minus $1,000 per MWh, and as high as $14,500 per MWh - and smooths their costs.
It allows retailers to offer their customers stable retail prices, which typically change only once a year
Wholesale contracts also allow generators to finance their operations
Entering into wholesale hedging contracts increases the certainty of generators’ revenue streams, which allows them to get funding for their business operations from banks or other financial institutions. This is particularly important for generation companies seeking funding to build new power stations – which are generally expensive, long term investments.
Contracts give generators an incentive to supply electricity when it is needed by the power system
Generators must supply electricity to retailers as agreed in the contract or pay the retailer a financial penalty. The financial penalty relates to the difference between the contract price and the spot price. The higher the spot price, the higher the financial penalty.
Because of this penalty, generators typically hold a certain amount of generating capacity in reserve to make sure they can deliver their contract quantities. In this way, power should be available when demand is greater than expected.
The spot and contract markets work together
The spot and contract markets work together to deliver the required amount of power on a day-to-day basis and also over the longer term:
- Day-to-day power supply
Financial penalties in contracts between generators and retailers are linked to the spot price. The way generators get paid – and penalised – is therefore directly linked to the physical state of the power system via the spot price.
If a generator is contracted to supply power, it can incur very significant losses if its generation is unreliable because it will need to purchase electricity at up to the market price cap of $14,500 per MWh to make good its contractual obligations to its customers.
Conversely, a generator that is not available in a time of peak demand loses the opportunity of very high revenue – up to $14,500 per MWh.
- Power supply over the longer term
Wholesale contract prices are broadly based on expectations of average future spot prices. If demand and supply for electricity is expected to be tighter in the future, average spot prices are likely to rise and this will be signalled through rising contract prices – which flow through to retail prices.
Wholesale contract prices therefore provide important signals to the market about how much generation needs to be available, of what type, and where it needs to be located.
For example, following the closure of a large power station, there will be sustained high spot prices, which are then reflected in high contract prices. These high prices provide an incentive to build new generation or demand response capability that will fill the supply gap.
LINKING FINANCIAL INCENTIVES TO THE SYSTEM’S PHYSICAL NEEDS: EXAMPLE
Assume a generator sells a swap contract to a retailer that limits the price the retailer pays to $60 per MWh. This means that irrespective of the spot price, the generator will receive $60 per MWh from the retailer (for the quantity of electricity agreed in the contract) provided it is generating the quantity of the energy covered by the contract during the periods of time that the contract is in force.
During high price events where system reliability is stressed, for example during heatwaves, the penalty for not being reliable is extreme.
For example, during a market price cap event, when the spot price is at its maximum $14,500, a generator that is contracted at $60 per MWh will lose $14,440 per MW per hour that it is not available. For a 500 MW unit, this equates to a loss of $7.2 million an hour.
However, this link with the physical market only applies to financial derivative contracts (most commonly ‘swaps’ and ‘caps’) that are linked to spot prices, not Power Purchase Agreements.
When price signals can’t work properly
Price signals won’t work as well if factors outside the market are affecting investment.
For example, if a gas generation business thinks that governments will want to constrain carbon dioxide emissions in the future, but isn’t how they are going to do this, it will be harder to work out how much their investment will be affected, and how much profit it can make. This can make it difficult to get funding for a new power station.
Power Purchase Agreements: a broken link
The other main type of contract currently in the market is a Power Purchase Agreement.
A PPA is a long term ‘out of market’ agreement between a generator and a purchaser for the sale and supply of energy. PPAs are often used for wind and solar farms as they involve renewable energy certificates being provided to the purchaser at a fixed price.
Unlike financial derivative contracts, PPAs reward participants for producing power at any time, as opposed to producing power at the time that customers or the power system needs it. There is no incentive to generate at that particular point in time, or conversely, no penalty for not generating at that particular point in time.
PPAs break the link between financial incentives and the physical needs of the system.
Forms of contracting in the NEM
Contracts in the NEM are traded either on the ASX or bilaterally. Swaps and caps are two examples of core contract types.
Under a swap contract:
- A swap contract trades a given volume of energy during a fixed period for a fixed price (normally 1 MW for either a one month or three month period at the strike price).
- The variable wholesale market spot price is, in effect, swapped for the fixed strike price.
- The contract is settled through payment between the counterparties based on the difference between the spot price and the strike price.
Under a cap contract:
- A cap contract trades a fixed volume of energy for a fixed price when the spot price exceeds a specified price.
- It provides electricity purchasers with insurance against high prices.
- The standard contract traded in the market is a “$300 cap”. This means the seller of a cap is required to pay to the buyer the difference between the spot price and $300/MWh every time the spot price exceeds $300/MWh during the specified contract period.
- As a result of the one-sided payment obligations arising under a cap, caps are normally sold for a positive up-front premium.
- The current premium for cap contracts in 2017 range from $13 to $56/MWh.