The RES-Induced Switching Effect Across Fossil Fuels: An Analysis of Day-Ahead and Balancing Prices.

• Author: Gianfireda, Angelica

1. INTRODUCTION

   In this paper we show how the increased electricity generation from Renewable Energy Sources (RES-E) has influenced the well known relationship linking the dynamic behavior of fuels and electricity prices. The evidence is obtained using Italian market data for day-ahead and, for the first time to our knowledge, balancing market prices. The analysis of real time sessions is particularly relevant in years when the high RES penetration has reshaped competitive conditions in the electricity markets. Balancing activity is extremely important for system security, given the intermittent and unpredictable nature of wind and solar sources. Moreover, balancing sessions have become a source of cost for Transmission System Operators (TSOs), that are the formal responsible of system security, grid stability and instantaneous balance between infows and outfows. (1)

   Day-ahead sessions are generally liquid markets where all production units are entitled to make offers. The resulting aggregated supply function is obtained as a merit order of bids which should reflect marginal generation costs of a large portfolio of technologies. On the contrary, balancing sessions are dominated by flexible thermal and hydro technologies. Hence, regulation services are supplied by units usually enjoying a degree of market power which is higher in balancing than in day-ahead sessions, because of the competition with a larger technology portfolio including RES-E units. It must be recognized that in the last years lower margins gained on the day-ahead market have changed the opportunity cost for thermal plants to participate to less competitive balancing sessions. Therefore, in this paper we look at both market sessions to gain a global view on how new market conditions have influenced electricity price dynamics.

   In this new scenario, we expect that electricity prices should be governed by new drivers with respect to the last decade. Indeed, we expect two distinct evolutionary dynamics of the fuels-electricity nexus induced by the significant growth of RES. On one hand, we expect a less pronounced relationship among day-ahead electricity prices and fuel prices (oil, gas and coal); on the other hand, we expect a stronger nexus between balancing and fuel prices. Indeed, prices in the latter sessions may be strongly affected by the increasing need of continuous balancing of demand and supply induced by new and intermittent RES-E generation. However, in these recent years we also witnessed other relevant facts which might have influenced market conditions, like decreasing gas and coal prices, demand contraction and increased market interconnections. All these events might influence the shape of the day-ahead market supply, but the sudden RES penetration is documented to be the main responsible of its displacement. We believe that the right shift of supply (also called "the merit order effect" of RES) is not only lowering electricity prices across the EU, but also changing the nexus between fuels and electricity prices. More specifically, we expect a change in the relative importance of fuels especially on balancing prices, given that the control or regulation power is mainly granted by gas-fired plants.

   We analyze these issues studying the most relevant portion of the Italian market as a reference case, but our findings can be easily generalized to other countries with similar market structures, pricing mechanisms and portfolio mix of balancing technologies. The Northern zone of Italy is historically characterized by high hydro shares and, in the last few years, by high solar photovoltaic (PV) penetration. It is connected with several foreign countries for which a market coupling has been implemented, and its zonal generation represents more than a half of national production. Hence, this zone is a good candidate (2) to analyze the influence of RES on relations between electricity and fossil fuels.

   We focus on a time span from 2006 to the end of 2015 during which we observed a progressive increment of RES generation from low or even absent to high penetration. However, on the same horizon, there were few important facts: relevant regulatory changes (regarding intra-day and balancing market sessions) have been introduced in the period 2009-2012, and also a financial crisis occurred, which affected the demand of electricity and it modified the intra-daily profile. (3) Therefore, we decided not to analyze this period because it is characterized by a transition towards a new market design and a new technology portfolio, and then we expect that the relationship among variables of interest to be unstable; this has been anticipated by Clo et al. (2015). Hence, we have divided the time series into two samples: the first one (2006-2008) representing a scenario with low RES penetration and low competition, whereas the second one (2013-2015) representsing a scenario with high RES penetration and high competition. Using dynamic econometric models, we study the relationship between fuels and electricity prices for both day-ahead and balancing market sessions across the two selected samples. The empirical analysis suggests that a switching effect has occurred in the day-ahead market, where RES penetration has decreased the role of fuels in explaining the dynamics of prices. Moreover, in the new competitive scenario, gas prices are found to be less relevant while coal prices become the main driving force of electricity price variability. The phenomenon is particularly evident at specific hours, like for example at sunset. We ascribe this result to the "merit order effect". Results related to the analysis of balancing prices are quite different. First, they are only mildly related to fuel prices in the long run. In the same manner, the switching effect exists but is limited and restricted to some hours only. Therefore, we decided to further investigate this nexus in balancing sessions taking into account accepted bids submitted from flexible thermal sources only. Looking at these prices, we find that fuels and electricity prices share common dynamics in real time market sessions in the second sample. We believe this is the evidence of a new role played by thermal units as supplier of flexibility and we interpret our results in terms of evolving market opportunities: thermal units are often excluded from the day-ahead market, being price-setter less frequently than in the past as consequence of a more competitive environment, and we believe that they try to recover profits in balancing sessions, where RES are not allowed to bid. However, balancing prices are not entirely cost-reflective and appear to be driven also by strategic considerations related to the high degree of market concentration, as we discuss later observing the price statistics of submitted offers to sell electricity. The paper is structured as follows: Section 2 reviews the main results obtained in the related literature, Section 3 provides a description of the structure of the Italian power market, whereas data, methodology employed and our empirical results are presented in Section 4. Finally, Section 5 concludes.

2. LITERATURE REVIEW

   Soon after the creation of wholesale electricity markets, the issue of price series dynamic behavior and forecasting became of paramount importance. The empirical analysis however concentrated on day-ahead market prices only and, until now, there is a lack of evidence about leading forces governing the dynamics of balancing prices. Starting from De Vany and Walls (1999), one stream of literature applies cointegration analysis to electricity price series and tests for integration of regional markets. Bosco et al. (2010) find strong evidence of a common long-term dynamics between electricity and gas prices for the major EU power exchanges. This long run common dynamics is one of the key factors explaining the almost strong integration among price series of the different power exchanges. Huisman and Kilic (2013) study the dynamic behavior of prices under normal and not-normal market conditions applying regime-switching models. They found evidence of convergence among EU markets due to increasing connectivity and improved liquidity. More recently, Weron (2014) discusses the main methods and results of applied papers on electricity prices forecasting. Other papers, like Nomikos and Andriosopoulos (2012), model energy spot price series extending the analysis to different market and including various energy products, like electricity, oil and gas. Several authors have studied the relationship between RES-E and electricity prices all around the world, as in Texas, Australia, Spain, Denmark, Norway, United Kingdom, The Netherlands and Germany. (4) Taking into account the Italian case, Gianfireda et al. (2016a) study the dynamic of day-ahead and balancing prices supporting the view that price spreads depend positively upon quantities generated by hydro, wind, solar and geothermal sources. At the same time, Gianfireda et al. (2016b) look at the relationship between day-ahead electricity prices, gas and coal prices in several EU countries, showing that the modified nexus has affected the creation of an internal energy market for Europe.

   The analysis contained in the present paper presents new interesting insights with respect to both Gianfireda et al. (2016a) and Gianfireda et al. (2016b). The former contribution investigates the dynamics of prices formed in different market sessions and the premium of readiness granted to flexible units. The analysis does not consider the relationship among electricity and fuel prices, which is the main goal of the present paper. In the latter one, the relationship among fuels and electricity prices is investigated but for day-ahead sessions only, without any reference to balancing sessions, which on the contrary are considered in this paper. Another important difference is related to the choice of hours which are...