Bilateral Markets - Sustainable Energy - TU Delft - YouTube

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Short-term electricity markets are necessary for matching supply and demand on a continuous

basis, but prices are difficult to predict and the recovery of fixed costs is uncertain.

Not all producers, nor all consumers, are willing to take these risks.

Long-term bilateral contracts are an important alternative to spot markets.

So now we will look at how these contracts are priced.

In many European countries, a majority of electricity is traded bilaterally between

producers and large energy consumers or retail companies.

These contracts reduce the investment risk for the generation companies and the risk

of electricity price changes for the consumers.

In European markets, most contracts don’t seem to last longer than 3 years, although

some contracts are as long as 10 years.

Because the contracts are private, there is no good overview of them.

Imagine you were a power producer.

How would you price your electricity in a long-term contract, say a three-year contract?

Let’s first have a look at your revenue stream throughout a year.

As the contract price is constant, your revenue is simply equal to the negotiated price … multiplied

by the volume of electricity that you sold.

As you can imagine, marginal cost pricing doesn’t make much sense here.

If you sold all your power at marginal cost for three years, you would not be recovering

any of your fixed costs during that time.

Such a long-term contract only makes sense to you if it covers all your costs, so also

your fixed costs.

This means that you need to make sure that the negotiated price per MWh is at least as

high as your average cost per MWh.

This way you ensure that your total revenues are at least as high as your total costs.

Is a consumer willing to pay this much?

The answer is yes, if he thinks that the negotiated price is equal to, or lower than, the average

electricity price that he would otherwise have to pay in the short-term market.

Similarly, you as a producer are willing to sell such a contract only if it pays as much

or more than what you would get in the spot market.

However, neither you nor the consumers can predict the electricity prices accurately.

Therefore, you may choose a long-term contract that is a bit lower than the average expected

spot price, as long as you recover all your costs.

This gives you the certainty that you will recover your costs as long as the contract

runs.

You may be willing to forgo some chance of higher revenues in exchange for this certainty.

Similarly, consumers may be willing to pay a bit MORE than the expected spot prices,

in order to reduce their risk of unforseen high prices.

As a result, there is some room for price negotiation.

Let‘s look at an example of a natural gas plant.

At which price would you sell a long-term bilateral contract?

Let's say that this plant has variable costs of 45 euro per megawatt-hour and annual fixed

costs of 25 million euros per year.

These fixed costs are capital costs - servicing debt payments - and the costs of personnel

etc.

The plant has a capacity of 500 megawatt and runs on average 2500 hours a year.

With this information we can determine the minimum price per megawatt-hour the producer

should ask for in order to cover all his costs.

We start with calculating the annual electrity production in MWh by multiplying the plant‘s

capacity with the operating hours.

On average, this plant produces 1,250,000 megawatt-hours a year.

Next, we determine the average fixed costs per megawatt-hour of electricity.

This can be done by dividing total annual fixed costs by total annual electricity production.

Total average costs are the sum of the variable costs and the average fixed costs.

So you would want to receive at least 65 euros per megawatt-hour in a bilateral long-term

contract.

We purposely used a fossil-fuel plant for this example.

Taking a wind farm would make it even more obvious: with almost all expenses being fixed

costs and very low operating costs, the owner would be silly to sell all its output at variable

costs - namely, for nearly nothing - for any duration.

So to summarize: In bilateral markets, long-term electricity contracts are useful for reducing

risks for both generation companies and consumers.

Generation companies try to sell their electricity for a price that is at least as high as their

total average costs.

Long-term bilateral contracts reduce investment risk for generation companies while consumers

avoid the uncertainty of short term price variations.