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Unification approaches

Betta, scheduled for completion by April 2005, will integrate the Scottish, English and Welsh electricity markets. Richard Cockburn and Liz Bossley of CEAG consider the implications

UNDER EXISTING UK electricity-trading legislation, Scotland operates as a separate trading hub from England and Wales. Scottish trading arrangements operate under a duopoly, with two companies, Scottish Power, and Scottish and Southern Energy, formerly Scottish Hydro, operating and maintaining all elements of the supply chainfrom generation through to supply. Companies wishing to supply power to Scottish customers must enter a wholesale agreement with one of these two companies.

The UK energy regulator, Ofgem, sets the Scottish wholesale electricity price (SWP) by reference to an England and Wales (E&W) wholesale index minus 1.5%. The index is calculated using the average month-ahead weighted price from Heren, Argus, Platts and Spectron. This single number for baseload (a constant delivery of power over the duration of the contract) is broken down into a half-hour price matrix using the UKPX futures exchange's half-hourly index.

UKPX is the only index for a half-hourly market, but it has little liquidity in month-ahead trading and is, therefore, not a good source of month-ahead data. The index must be in half-hour form because E&W suppliers balance volumes in each half-hour and so must end up with a demand-weighted price rather than a simple time-weighted price. Hence the complexity of the formula.

Changes ahead

The 1.5% discount reflects the differing treatment of losses and transmission costs in Scotland compared with E&W. Some suppliers may have negotiated independent deals with the Scottish firms, but they are unlikely to be as competitive as a free wholesale market would be. The British Electricity Trading and Transmission Arrangements (Betta) will change thissuppliers will buy hedges in the UK-wide wholesale market, intra-day trading and balancing will apply across the whole of the UK, and the need for an indexed price will no longer exist.

E&W suppliers have been reluctant to enter the Scottish market under the duopoly terms, because the SWP is a difficult formula to hedge and, consequently, it is difficult to manage wholesale price exposure. E&W suppliers with an existing customer base south of the border indirectly determine the SWP through the operation of the UKPX-based formula, but the correlation between the SWP and E&W is imperfect, meaning there is an associated unmanageable basis risk.

Companies with limited capital prefer to deploy it in their own trading hub in E&W, where the risks are more easily managed, despite the opportunities presented by the Scottish market. With the Scottish market having a physical delivery of around 30 terawatt hours (TWh) and the E&W market around 330 TWh, it is no surprise that the E&W suppliers have, to date, seen it as small.

Says Marcello Romano, director of Foundation Energy, a power and gas trading company: 'Betta should help to add some liquidity, as it will remove one barrier to trade amongst the parties in the market. However, the market needs more speculative and trading interest so that when prices get out of line it is easier for traders to sell the over-priced elements and buy the under-priced elements to bring them back into line.'

Centrica has been the most successful E&W supplier north of the border, using its existing customer base in Scottish Gas.

Historically, the Scottish companies have negotiated supply prices (for example, the SWP) and distribution prices (such as distribution price reviews) with Ofgem, which has provided a cap on the market. These prices are kept low by a surplus of generating capacity in Scotland, which has discouraged new entrants. Power has traditionally flowed from north to south. Opportunities for E&W suppliers to move power north have been physically limited by interconnector capacity constraints, but, post-Betta, there will be a single trading hub and the total grid will benefit from the Scottish generation surplus.

Short-term power prices derived from the New Electricity Trading Arrangements (Neta) balancing mechanism in E&W have mostly been high enough for Scottish exports to be well rewarded. Scottish firms have been able to capitalise on a reasonably risk-free home-regulated market and still manage to exploit the E&W market by sending power south.

They have also responded to E&W competition by buying E&W power assets: Scottish companies have bought transmission and distribution networks (T&D) and generating capacity in E&W. Most recently, Scottish and Southern bought the Fiddlers Ferry and Ferrybridge plants for £136m ($253m), from American Electric Power.

Under Betta, the Scottish T&D networks will be regulated under the same terms as in E&W. The balancing of physical demand will be undertaken by National Grid Transco for the whole of the UK. Neta-system balancing prices will be UK-wide, managed and settled by Elexon as they are in the E&W market.

Hands untied

In Scotland, after April, there will be no interconnector hub constraints, there will be no regulated market prices and customers can demand a UK-wide price, as opposed to a duopolistic, regulated price. This unties the hands of the E&W suppliers to start attacking the Scottish market. Scottish customers can look forward to competitive and, potentially, even lower prices. But the E&W suppliers are unlikely to cut supply prices substantially to gain Scottish market share, because of the negative effect this would have on margins in the much larger E&W market.

The natural defence by existing Scottish suppliers to the opening of the hub would be to encourage their Scottish customers to sign up to long-term deals, preventing competitors from gaining a foothold in the market. But given the recent general increase in power prices and the promise of more competition, most customers are likely to wait and see.

The Scottish suppliers have another advantage: a large amount of generation from renewable sources, in the form of wind power and hydro-electric3% of E&W power comes from renewable sources compared with Scotland's 10%. The UK's Renewable Energy Obligation requires suppliers to source 4.9% of their power in 2004 and 2005 from renewable sources.

Accredited renewables generators are issued Renewable Obligation Certificates for each month's output, which can be traded separately from the power produced. The renewables-obligation target is set to rise linearly to 10.4% in 2010 and may rise to 20% by 2020, suggesting a continuing competitive advantage for Scottish renewable generators. Similar advantages will accrue to renewable generators under the EU Emissions Trading Scheme, which takes effect from 1 January.

There is still much detailed drafting required to complete Betta, but who will benefit mostnorth or southis still uncertain.

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