Day Ahead Markets

August 2008

Natural gas is growing in importance as a fuel for power generation in Ontario. In the last 3 years, contracts for over 5,000 MW of new generation let by the Ontario Power Authority have secured power from gas-fired generators ranging from small 2.5 MW district energy facilities to large 1,005 MW power plants.

And the latest OPA programs - the new Combined Heat and Power RFP and the Clean Energy Standard Offer Program - continue this trend.

The OPA contracts have a common theme. The OPA guarantees a revenue stream to the generator. To the extent the generator can earn some of the required revenue from selling power into the market, the OPA deducts that market revenue from its payment to the generator. In effect, the OPA makes up any shortfall if market revenues do not match the generator's revenue requirements.

The OPA does not look at the revenues the generator actually made from sales to the market. Instead, it assumes the amount of market revenues the generator earned by determining the hours in which the generator ought to have been operating, based on what the gas price was, what the power price was, and what the generator's efficiency and other operating costs are. Learn More »

The generator is at risk for lower revenues if it was not operating when the OPA deemed it to be operating, or if it operated in an hour that was uneconomic. In large part, this risk arises because of an asymmetry in information. The OPA determines the "deemed dispatch" after the fact, once gas prices and power prices for a period are known. The generator, however, must make the decision in advance, based on what it expects its gas price and its market revenues to be.

The challenge is made difficult because the generator must operate with one foot in each of two very different, very volatile and complex markets.

In the electricity markets, power prices for generators change every 5 minutes throughout the day, as changing demand requires instantaneous changes in supply. The Hourly Ontario Energy Price is determined after the hour is over, and is calculated as the average of the twelve 5-minute intervals in the hour.

By contrast, the natural gas market has evolved largely as a day ahead market. Buyers and sellers of gas schedule deliveries ahead of time. Natural gas deliveries have to be balanced to demand, but not instantaneously as in the power market. A difference between the rate of supply and the rate of consumption shows up as a rise or fall in pipeline pressure, and consumers generally have tolerances within which to maintain their imbalances.

Gas trading at the Dawn market area has become the gas price reference point for the OPA's contracts. The scheduling of gas deliveries for the next day is to be completed by 1:00 pm Eastern time in order for shippers to have guaranteed firm deliveries under their pipeline contracts.  Historically, buyers could not be guaranteed firm gas delivery if gas was bought for same day delivery. As a result, the buying and selling of gas is predominantly for next day delivery and is concentrated in the period from 10 am to about noon, with activity being greatest in the latter part of this window.

So generators are forced to buy gas today based on the expectation of what the power price will be tomorrow. If power prices end up lower, and the generator does not run, they may store or sell the gas they bought, perhaps at some loss.

If the generator chooses not to buy gas for tomorrow on the expectation that power prices will be too low to justify operation, and prices instead move higher, the generator may miss the chance to run and earn revenues because of a lack of gas supply.

This disconnect between the two markets undermines the efficiency of both marketplaces. Of course, efforts are being made to correct the problem.

On the gas industry side, pipelines and utilities are working to develop new transportation services that allow gas shippers to make more frequent changes to their gas delivery schedule, and to have those changes on a firm basis, regardless of when they are made. This will allow generators to operate their gas contracts more efficiently in the "same day" market. Also, gas storage operators are looking to enhance capacity and contract provisions so that generators can get access to additional gas, or can find a home for excess gas, without necessarily having to buy or sell it in the market. They could instead withdraw it or deposit it into storage.

Traditionally, the gas storage market in Ontario has been geared to a seasonal cycle of summer injection and winter withdrawal, whereas the needs of power generators are pushing the storage market to offer "high deliverability" services that enable large injections or withdrawals on any day, any time of the year.

Ontario Energy Board initiatives such as the Natural Gas - Electricity Interface Review (NGEIR) and the Storage and Transportation Access Rule (STAR) proceedings are laying the foundation for gas services that better suit the needs of power generators for short notice access to changes in firm deliveries. Changes to certain pipeline and utility services are already being implemented.

On the electricity industry side, the Independent Electricity System Operator has been developing a Day Ahead Market mechanism, and proposals for such a mechanism are expected this fall. The Day Ahead Market would allow generators to sell their power output at a known price for the next day, allowing them to lock in a gas cost and power revenue at the same time, reducing risk. The Day Ahead Market is also viewed by the IESO and the OPA as a means to reduce power price volatility and a foundation on which to build a more robust forward market. (Not all observers are convinced).

At present, the IESO operates a Day Ahead Commitment Process which enables generators to commit output for the next day and obtain guarantees that they will recover certain costs. The IESO also generates a Day Ahead Price Forecast, to give generators a sense of what the power price could be, by hour, for the next day. But the forecast has too wide a confidence band to be of much practical value.

Solving the problem of the disconnection between gas and power markets will significantly reduce risk for gas-fired power generators. Reducing the risk generators must manage should reduce their cost of producing power. At the same time, the development of new mechanisms in both the gas and power markets to help address this disconnection could have the spinoff benefit of making both markets more efficient, to the benefit of all energy consumers. The timing and effectiveness of these solutions is uncertain at this time.  For the immediate future, generators must understand the risks that result from this asymmetry and implement effective risk management strategies.  For additional information about this subject, contact John Voss at jvoss@aegent.ca.