How does the electricity market work?

Electricity markets have long been a topic of conversation, but they have taken on new urgency in recent years due to the energy price crisis. The electricity market is usually directly associated with the day-ahead market, where electricity is traded. However, this is only one of many markets where electricity is traded, and not even the most important one.

This is where the first insight comes in. There is no one “electricity market”, but a series of interconnected markets that ensure efficient use of resources. These act as a "machine" that transfers the cost of capital and raw materials used in electricity generation to end users.

Contrary to what it may seem, this machine works as intended. However, exceptional circumstances such as the current situation on the international gas market are causing electricity prices to rise significantly.

In order to understand how these complex markets work, let us examine the flow of energy, the management of associated risks, and the taxation of electricity.

How are electricity markets structured?

The "life cycle" of electricity is very simple. It is produced by different companies in their generation plants (thermal power plants, wind power plants, hydro power plants, solar power plants, etc.). It then passes through the transmission and distribution networks owned by regulated companies. And finally, it is delivered to end customers through retail supply companies.

Electricity is bought and sold through a series of markets with very different time horizons:

In the long term (months, even years), there are futures markets. For example, it is common for industrial companies to enter into contracts for the energy they intend to consume during a financial year in order to secure a price that will enable them to plan their activities.

At the other end of the scale, small private consumers also enter into contracts that are usually valid for one year but automatically renew and have an unlimited duration.

The day-ahead market is an auction called daily for the delivery of electricity in each of the 24 hours of the following day. Since it is a "unit price" auction, all agents charge and pay the same price for each hour.

The alternative to this model would be 'pay as bid' auctions, where each agent is paid or charged for their bid. However, this carries risks such as inefficient allocation if the agents' forecasts are not accurate.

There are also intraday markets as well as balancing markets, which are managed by the system operator. Their task is to ensure the balance between generation and demand that is necessary for the physics of electricity.

What each agent charges and pays is the result of the activity of these markets. And although their prices are related to those of the day-ahead market, they are very different. For example, if you are a customer with an annual contract, your price is the price you agreed to by contract and is not influenced by the price on the day-ahead market.

Although prices on both markets converge over time, this is not the case at all times. So, looking only at the day-ahead market price can give a distorted picture of the situation when there are major changes in costs and prices (like there are now).

Risk management in the electricity markets

Different players also have different risk aversion and therefore buy on different terms. For example, there are companies that enter into supply contracts with fixed prices from 1 January to 31 December in order to fix the cost of one of their production factors. On the supply side, some producers sell forward their production or part of it.

The part of production exposed to the day-ahead market price (or pool) is divided into two main groups:

• On the one hand, most natural gas and coal-fired generators, as well as part of the hydropower plants, which draw their revenues from the day-ahead and intraday market.
• On the other hand, there is the renewable generation, which benefits from the regulated scheme called RECORE. This type of generation receives payments for the energy sold on the day-ahead market and an additional regulated payment that is updated every three years.

As a result, RECORE generation receives an unusually high payment when the day-ahead market price is high, which is offset by a lower regulated payment in subsequent years.

There is generation that does not receive the pool price:

• Wind and solar, which are not covered by RECORE.
• Nuclear and hydropower.
• Gas with forward contracts.

Energy demand: Free market and regulated market

In terms of demand, most energy is contracted on the free market at a fixed price (77%) and the rest (23%) pays the daily market price. So these 23% are the ones that are affected by the price fluctuations on the day-ahead market.

Of this 23% of demand met on the day-ahead market, just under half is accounted for by household customers on the regulated tariff (PVPC). Although this amount seems small, it has a large social impact, as about 10 million household consumers use this tariff. The rest of the demand is accounted for by industrial customers who freely choose to be supplied from the pool.

Energy demand

The amount of energy bought forward is substantially higher than that sold forward. This is an imbalance in our market, mainly due to the volume of renewable generation subject to RECORE. The imbalance can be hedged using financial derivatives, such as those based on other countries' electricity markets or the price of gas. Alternatively, companies may choose to take open positions, buying at pool prices and selling at fixed prices.

When an energy company engages in both generation and retail sales.

In vertically integrated companies (Endesa and other large energy companies) there is an internal sale between generation and retail supply of the same company. This is one of the main ways in which these companies manage their risk and allows them to offer much more stable, fixed prices to their customers than the more volatile daily market prices.

In Endesa's case, when the contracts are signed with customers, the energy produced is allocated to the expected demand. We start with the expected generation from nuclear, hydro and renewables and continue to add electricity purchased on the futures markets, supplementing it with purchases on the short-term markets as needed.

We typically sell twice as much energy as we generate, so we often need to buy additional energy in short-term markets, such as the daily market. This means an unexpected price increase is generally unfavourable for the company.

Electricity taxes in Spain

The electricity tax structure in Spain is one of the most complex ever designed. There are several taxes on electricity:

Although the reduction of tax rates in crisis circumstances is a positive step, it is not proportional to the increase in prices. A more efficient and predictable tax system needs to be put in place.