Wholesale cost reflectivity of GB andEuropean electricity pricesA project commissioned by OfgemSeptember 2018Dr Giorgio Castagneto GisseySenior Research Associate in Energy Economics and PolicyUCL Institute for Sustainable Resources · UCL Energy InstituteProfessor Michael GrubbProfessor of Energy and Climate PolicyUCL Institute for Sustainable ResourcesDr Iain StaffellSenior Lecturer in Sustainable EnergyImperial College London, Centre for Environmental PolicyDr Paolo AgnolucciSenior Lecturer in Environmental and Energy EconomicsUCL Institute for Sustainable ResourcesProfessor Paul Ekins OBEProfessor of Resources and Environmental PolicyUCL Institute for Sustainable Resources
Wholesale cost reflectivity of GB and European electricity pricesPrefaceThe Office of Gas and Electricity Markets (Ofgem) commissioned University College London(UCL) in February 2018 to conduct a study of the cost reflectivity of Great British (GB) andEuropean electricity wholesale prices, as part of the project ‘Assessment of wholesale Costpass-through and reflectivity in GB and major European electricity markets’ (ACE). Thisproject report derives from a collaboration led by UCL involving Imperial College Londonand was designed to inform Ofgem’s flagship report ‘State of the Energy Market’.Wholesale expenses are the largest component of electricity costs to GB consumers, consistingof nearly 40% of electricity bills. The largest five generators represent a combined share ofnearly 60%. The presence of market power (or the lack of competition) would likely lead tohigher electricity wholesale prices, hence more expensive electricity bills to consumers. It istherefore crucial to monitor the wholesale electricity market and ensure its competitiveness.One way is to inspect whether the electricity prices it yields are ‘cost-reflective’. This meansinvestigating how proportionately the costs borne by generators are internalised into prices.If it costs less for generators to produce electricity, then customers should pay proportionatelyless for that electricity.This report aims to understand the principal determinants of electricity wholesale prices inGB and a sample of major European markets; and to investigate the competitiveness of thesemarkets by studying how the major fuel costs borne by generators are reflected into electricityprices.The electricity markets considered are: GB, Germany, France, Italy, Spain, Netherlands, andNorway, during the period 2012–2017. The primary determinants of day-ahead electricitywholesale prices are inspected by quantifying the shares at the margin of the major fuelintensive technologies in each market. An econometric analysis is used to estimate the passthrough rate of fuel prices into the electricity wholesale price in each market.Our work also considers the influence of the largest five generators in GB on electricity prices,based on their internalisation of imbalance costs during the period 2014–2017. Imbalances aretypically unforeseen, so they cannot be factored into electricity prices in advance. We thereforeconsider whether previously incurred imbalance costs appear to be factored in. The impact ofthe studied input costs on the volatility of GB and European electricity prices is also examined.Finally, the presence of causality and asymmetric1 pass-through of fuel prices and bothnational and firm-level imbalance costs into electricity prices is considered. An additionalanalysis examines these questions on an annual basis.An ‘asymmetric’ response occurs when electricity prices rise more strongly, or quickly, following an increase inan input's cost, than they fall following a corresponding reduction in the input cost.1i
Wholesale cost reflectivity of GB and European electricity pricesExecutive SummaryFuel cost reflectivity of GB andEuropean electricity prices1. In 2017, the GB electricity price wasclose to a threshold consistent withvery strong cost reflectivity, with asubstantial increase compared to 2016.4. The 100% mean rate estimated for GBis consistent with some degree ofmarket power by GB gas generatorsduring 2012–2017. There is evidence oftemporary periods of market powerthroughout this timeframe.Based on movements in the cost of gas, the GB electricitywholesale market is more cost-reflective than a sample of five majorEuropean wholesale markets.2. Based on movements in the cost of gas,the GB electricity wholesale market ismore cost-reflective than a sample offive major European markets.3. The extent to which electricity pricesare cost-reflective of gas is not constant.Instead, it fits a cyclical pattern duringthe period 2012–2017, fluctuating by23% per year around a mean of 104%.5. During 2012–2017, Italian electricityprices increased much more thanjustified by the positive changes in gasprices, whereas Dutch electricity pricesexperienced the lowest proportionaterise of European markets.6. The GB electricity price respondedsymmetrically to changes in the gasprice, meaning prices rose and fellequally with gas price increments andii
Wholesale cost reflectivity of GB and European electricity pricesreductions. However, we foundasymmetric2 responses to changes in thecoal price, which coincided with aperiod of mostly falling coal prices.This means that coal generatorsincreased electricity prices in responseto increases in the coal price morestrongly than they decreased theelectricity price when the coal price fell.Internalisation of imbalance costs byGB generators7. Coal prices did not have a statisticallysignificant impact on mean GBelectricity prices during 2012–2017.Instead, they largely contributed to thevolatility of GB electricity prices. Thismay be due to GB no longer havingabundant coal capacity or annualoutput. The inflexibility of coal couldalso have had a role in determiningthese results. Yet we find that coal’sinfluence on the price increasedsubstantially, relative to its overall role inpower generation (which declined farmore).10. Imbalance prices have caused changesin GB electricity prices in 2016 and2017. Yet there is no evidence ofcausality running from imbalanceprices to electricity prices over longerperiods of time (2012–2017).8. Italy is the only electricity marketwhich displayed asymmetric responsesof the electricity price to changes in thegas price. In other words, electricityprices increased more in response tochanges in gas prices than theydecreased.An ‘asymmetric’ response occurs when electricityprices rise more strongly, or quickly, following anincrease in an input's cost, than they fall following acorresponding reduction in the input cost.29. Generators in GB are likely to havesomewhat internalised previouslyincurred imbalance costs intoelectricity prices between 2012 and2017.11. Imbalance costs do not have asubstantial impact on the GBelectricity price.12. The pass-through rate of imbalanceprices into the electricity wholesaleprice increased considerably in 2016.This could be due to the change in theimbalance price formula3 occurred in2015 or, more likely, due to thepresence of spiky imbalance prices.13. There appears to be a significantrelationship between EDF’s imbalancecosts and the electricity price relative toother firms, although EDF displayedrelatively small negative imbalancepositions. While this could beexplained by EDF being the largestgeneration company, the impact wasvery small in an absolute sense.The new pricing formula was designed to improvecost reflectivity by sharpening the imbalance price attimes of system stress.3iii
Wholesale cost reflectivity of GB and European electricity prices14. Both national imbalance costs andprices were associated withasymmetric responses in the GBelectricity price during the period2014-17.15. The largest firms are generally thecreditors of the imbalance marketwhereas the smallest ones are debtors.Determinants of wholesaleelectricity prices16. Gas, coal and oil are currentlyresponsible for setting the electricityprice 77% of the time. The remainderis almost entirely covered by imports(mostly from France and theNetherlands) and hydro (both run ofriver and pumped storage).17. In 2017, gas-fired power plants set thewholesale price of Britain’s electricitymore than any other technology. Theywere at the margin 65% of the time, an8% increase compared to 2016.18. Coal plants set the GB electricity pricein 2017 only 11% of the time, a 6%reduction relative to 2016. Oil-firedplants set the price 0.5% of the time.19. Gas-fired plants have never been soinfluential in setting the GBelectricity price as in 2017.20. From setting the price just under halfthe time in 2012, relative trends suggestthat gas has directly substituted forcoal to become by far the dominantprice-setter. The shares of coal and gasin setting prices were roughly stableover 2013-16. Overall, gas useincreased, displacing coal, but it wasused more at baseload.21. In 2017, gas was more influential insetting the price in GB than in othermajor European electricity markets(Germany, Italy, Spain, Netherlandsand Norway). The gas marginal sharein GB was 1.5 times greater than in theNetherlands, 2–2.5 times greater thanSpain and Italy, and nearly 5 timesgreater than Germany.22. Although the GB coal marginal sharehas decreased substantially it was stillsecond highest of the major Europeanmarkets in 2017, after Germany (24%),which has an especially coal-intensiveelectricity sector.23. GB wholesale electricity pricesincreased 18% in the year after the2016 EU referendum. The dominantfactor was input costs rising due to theexchange rate impact: Sterlingdepreciated by 15% against the USdollar and the Euro. The impact of thereferendum on exchange rates therebyappears to correspond almost exactlyto the increase of 5.7% in retailelectricity prices from 2016 to 2017.24. There were no other statisticallysignificant impacts on averageelectricity prices during the year afterthe referendum, except for an increasein electricity price volatility by 50%.iv
Wholesale cost reflectivity of GB and European electricity pricesThis report was requested by the Office of Gas and Electricity Markets (Ofgem). It is a collaboration ledby UCL involving Imperial College London and was designed to inform Ofgem’s State of the EnergyMarket report.AUTHORSGiorgio CASTAGNETO GISSEYMichael GRUBBIain STAFFELLPaolo AGNOLUCCIPaul EKINSABOUT UCLUniversity College London (UCL) is a public research university in London,England, and a constituent college of the federal University of London. The UCLInstitute for Sustainable Resources and the UCL Energy Institute deliver worldleading learning, research and policy support on the challenges of climate change,energy security, and energy affordability. We are part of the Bartlett: UCL's globalfaculty of the built environment. Our institutes bring together different perspectives,understandings and procedures in energy research, transcending the boundariesbetween academic disciplines. They coordinate multidisciplinary teams from acrossthe University, providing critical mass and capacity for ambitious projects.ABOUT OFGEMThe Office of Gas and Electricity Markets (Ofgem) is the independentenergy regulator for Great Britain. It is a non-ministerial governmentdepartment and an independent National Regulatory Authority,recognised by EU Directives. Ofgem’s principal objective when carryingout its functions is to protect the interests of existing and future electricityand gas consumers. Ofgem’s governing body is the Gas and ElectricityMarkets Authority (GEMA).We are happy to hear from you. The main contacts for this work are Giorgio Castagneto Gissey (UCL)and Wei Xiao (Ofgem), who may be reached via email respectively at: email@example.com firstname.lastname@example.org.Manuscript completed in July 2018.Copyright Office of Gas and Electricity Markets, 2018.Please cite this report as: Castagneto Gissey, G., Grubb, M., Staffell, I., Agnolucci, P., Ekins, P., 2018.Wholesale cost reflectivity of GB and European electricity prices. Ofgem: London.DISCLAIMERThe opinions expressed in this document are the sole responsibility of the lead author and do notnecessarily represent the views or official position of Ofgem or GEMA. Reproduction and translationfor non-commercial purposes are authorised, provided the source is acknowledged and the publisheris given prior notice and sent a copy. The authors, UCL, Imperial College London, Ofgem or GEMAwill not be liable in respect of any losses, including without limitation loss of or damage to profits,income, revenue, use, production, anticipated savings, business, contracts, commercial opportunitiesor goodwill. Any action you take upon the information in this report is strictly at your own risk.
Wholesale cost reflectivity of GB and European electricity pricesContentsPreface . iExecutive Summary . ii12Competition in GB and European electricity markets . 11.1Wider literature on competition and pass-through . 31.2Aims of this study . 5Results . 184.108.40.206Gas prices. 72.1.2Other fuel prices . 92.1.3National and firm-level imbalance costs . 102.1.4Asymmetric cost internalisation effects . 122.1.5Volatility of electricity prices . 132.23Determinants of electricity prices . 142.2.1Fuel shares at the margin . 142.2.2GB events – June 2016 . 17Discussion . 203.1Cost pass-through and reflectivity . 203.1.1Gas prices. 203.1.2Other fuel prices . 213.1.3National and firm-level imbalance costs . 233.1.4Asymmetric cost internalisation effects . 243.2Fuel shares at the margin . 253.2.1Great Britain . 253.2.2Great Britain vs European markets . 263.34Pass-through rates. 7Increased GB electricity price volatility in 2016 . 27Conclusions. 284.1GB is among the most cost-reflective of European electricity markets based onmovements in the price of gas . 284.2Gas has never been so influential in setting the GB electricity price . 29
Wholesale cost reflectivity of GB and European electricity prices4.3Coal not a key driver of average electricity prices in GB, but largely influenceselectricity price volatility. 2954.4Imbalance costs may be somewhat internalised into electricity prices . 304.5GB electricity price volatility largely increased after June 2016 . 30Methods . 315.1Data . 315.1.1Data used for marginal shares analysis . 315.1.2Time series data used in regression analyses . 325.1.3Electricity and fuel prices . 335.1.4National and firm-level imbalance costs . 385.1.5Control variables . 405.1.6Transformations . 415.1.7Periods under analysis . 415.2Fuel shares at the margin . 425.3Cost reflectivity: pass-through rates and asymmetric effects . 435.3.1Determinants of electricity prices . 435.3.2Generation mix by country . 455.3.3Modelling electricity prices . 485.3.4Calculation of cost reflectivity and pass-through rates . 525.3.5Asymmetric cost internalisation effects . 555.3.6Causal impacts of generation costs . 565.3.7Model parameter expectations . 576Acknowledgements . 597Author biographies . 608Appendix . 6398.1Data . 638.2Results. 678.2.1Average coal and gas shares at the margin 2012–2017 . 678.2.2Full period analysis . 688.2.3Annual analysis (GB) . 758.2.4Asymmetric cost internalisation analysis . 77References . 80
Wholesale cost reflectivity of GB and European electricity pricesWholesale cost reflectivity ofGB and European electricity prices1 Competition in GB and European electricity marketsMOST European electricity markets have a small number of firms producing large shares oftotal electricity generated (European Commission, 2015; Aurora, 2018). The six largestgenerators account for over 60% of national electricity generation in Great Britain (GB), andover 75% in Germany (BNetzA, 2016; Ofgem, 2017). This naturally leads to concerns relatingto the potential exercise of market power which could substantially reduce the affordabilityof electricity to consumers.The Gas and Electricity Markets Authority (GEMA) referred the GB electricity markets for aninvestigation by the Competition and Markets Authority (CMA). In contrast to the CMA’sfindings relating to the retail market, conclusions highlighted that competition in the GBwholesale market appears to be working reasonably well (CMA, 2016).Yet in recent years, wholesale electricity prices rose in GB to become amongst the highest inEurope during 2014-16 and remain well above the EU average (Grubb and Drummond, 2018).4As well as reflecting relative coal and gas prices, Ofgem (2017) attributes this to policy factorssuch as higher carbon taxes and the allocation of network charges, rather than weakcompetition. They found market concentration in GB to be low relative to EU electricitymarkets when looking at ownership of both overall and flexible capacity. As with 2014 and2015, they find the absolute level of hours of market power (‘pivotality’) to be very low.However, they suggest that it is possible for there to be greater scope for market power at asub-national level due to transmission constraints, a conclusion similarly reached by the CMAComparison is complicated by exchange rate effects, which for comparison to continental countries contributedto increase and subsequent decrease after the EU referendum; different industrial bands; and the fact that in theUK more environmental costs are added into the electricity price for which energy intensive users in the UK thenreceive direct compensation (which is not available to other industries), whereas continental systems tend to usemore direct exemption and less compensation.41
Wholesale cost reflectivity of GB and European electricity prices(2016). Recent analyses based on historic calculations of electricity wholesale price mark-upsover marginal costs for GB and Germany implied that competition in Britain is at least aseffective as in Germany in driving system costs down to the cost components (Aurora, 2018).The second liberalisation directives of the European Union (EU), adopted in 2003, have beentransposed into national law by Member States by 2004, with some provisions entering intoforce only in 2007. Consequently, more Member States are taking measures to secureelectricity supply, such as implementing capacity markets, which may impact competition inthe internal electricity market. The Commission has launched a Sector Inquiry, as well asestablished a Working Group with Member States and started individual assessments ofMember States' capacity aid schemes (EU Commission, 2018).An earlier Sector Inquiry – published in 2007 – showed that concentration in wholesaleelectricity markets was high in certain areas, especially in national markets (EU Commission,2007). The Inquiry found that only 8 out of 25 Member States had moderately concentratednational markets, 5 had highly- and 12 very highly-concentrated markets (Altmann et al.,2010). Generally, market concentration in national electricity markets remains substantial inGB as in many other European markets (Ofgem, 2017).Competition in wholesale markets varies over time (Ofgem, 2017) and must be periodicallymonitored to ensure the protection of consumer’s interests. Wholesale costs are the largestcomponent of electricity costs to GB consumers, consisting of nearly 40% of a typical GBelectricity bill (Ofgem, 2018), with similarly large shares also reported for other EU MemberStates (EU Commission, 2014a). The effectiveness of wholesale market competition cantherefore greatly affect consumer bills in GB and other EU countries.Market concentration and other measures such as market shares, or pivotality analysis, maybe useful indicators of market power in electricity markets, but they do not specificallyconsider how specific wholesale costs incurred by generators are passed through toconsumers. They cannot therefore be used to assess the extent by which components of theelectricity value chain are competitively internalised by generators. Cost reflectiveinternalisation of input costs is critical to the economical and sustainable delivery of electricityto customers and represents the main topic of this study. This report studies whether keywholesale costs are internalised cost-reflectively into electricity prices and investigates thepresence of market power in GB and other major European electricity markets.“A pass-through rate above 100%, under wide assumptions, isinconsistent with perfect competition, and so is strong evidencefor some degree of market power”– Ritz (2015)2
Wholesale cost reflectivity of GB and European electricity pricesFor these purposes, deriving the ‘pass-through’ rates of generation costs into electricity pricesis an important addition to the evidence base surrounding the competitiveness of generatorsin an electricity market. Pass-through rate analysis can be used to infer how competitivelymarkets tend to internalise specific generation costs, such as the cost of fuels, into electricitywholesale prices.A pass-through rate above 100% is, under wide assumptions, inconsistent with the notion ofperfect competition, and so is strong evidence for some degree of market power. On the other hand,a 100% pass-through is consistent with perfect competition – but it is also consistent with amonopoly or oligopoly, and so cannot constitute “proof” of any particular mode ofcompetition (Ritz, 2015).5By evaluating the pass-through rates of various fuel costs incurred for electricity generation,Castagneto Gissey (2014) determined that GB was among the most cost-reflective in a sampleof European electricity wholesale markets during the period 2008–2012. These results areconsistent with inference made by Ofgem (2015), which reported that the GB electricity marketappeared reasonably competitive and compared well with other European markets.Fuel costs account for most of electricity wholesale costs and over a third of final electricityprices (Ofgem, 2017). Natural gas generation is the leading form of flexibility in the GBwholesale electricity market. Wholesale electricity is widely traded in the day-ahead marketand gas takes the role of price-setter many of the times it is called upon, as based on ‘merit’,which is determined by the marginal cost of generation.Another component of wholesale electricity costs relates to energy imbalances. Elexon is theregulator of the energy imbalance market. It is responsible for comparing how muchelectricity generators and suppliers said they would produce or consume with actualvolumes, and transfers funds accordingly after gate closure of the wholesale market. Theimbalance market is responsible for electricity settlements equivalent to 1.5bn of electricitycustomers’ funds per year (Elexon, 2017). These costs are borne by generators and theiralteration could potentially affect electricity prices.The internalisation of fuel and imbalance costs into electricity prices can be quantified anddescribed by computing the associated pass-through rates using time series econometricanalysis, as these are the main generation wholesale costs which vary over time.1.1 Wider literature on competition and pass-throughCompetition in electricity markets has been assessed in several ways. Traditional measuresinclude market shares and market concentration.Market shares show how large a company is in relation to the rest of the market, while marketconcentration indicates the extent to which a market is dominated by one or more firms.Pivotality analysis is also widely used (Ofgem, 2017) and helps to assess how relevant eachSaying more about the precise degree of competition would require more detailed structural industrial-economicsmodelling of the underlying demand and supply market conditions.53
Wholesale cost reflectivity of GB and European electricity pricesfirm is in meeting electricity demand. Clearly, models falling in this category account for theimpact of individual firms.Most work considering pass-through rates are based on reduced-form economic models thatdo not make wide theoretical assumptions about the underlying information set andrelationships between variables. They derive an industry-wide measure of pass-through in ananalogous way to the present study. These studies have so far focussed on the cost passthrough of carbon emission allowances into electricity prices in the context of the EuropeanUnion Emission System (EU ETS). These studies include Jouvet and Solier (2013); Mirza andBergland (2012) and Zachmann and Von Hirschhausen (2008) and extend the work of Sijm etal. (2006), who use Sijm et al. (2006) equilibri
electricity prices between 2012 and 2017. 10. Imbalance prices have caused changes in GB electricity prices in 2016 and 2017. Yet there is no evidence of causality running from imbalance prices to electricity prices over longer periods of time (2012-2017). 11. Imbalance costs do not have a substantial impact on the GB electricity price. 12.
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EA 4-1 CHAPTER 4 JOB COSTING 4-1 Define cost pool, cost tracing, cost allocation, and cost-allocation base. Cost pool––a grouping of individual indirect cost items. Cost tracing––the assigning of direct costs to the chosen cost object. Cost allocation––the assigning of indirect costs to the chosen cost object. Cost-alloca