VPPs: Are buyers making a profit?
November 22nd, 2007 by Margaret Armstrong, Mines Paris/ParisTechVirtual power plants are one of the measures implemented by the EU to encourage competition in the energy sector. They were first implemented in France to allow outsiders access to the national market while still allowing the EDF to operate nuclear power stations. What has happened to those who purchased power through the French VPPs? Are they making a profit too or has winner’s curse struck again?
To remedy the risk of anticompetitive effects owing to its acquisition of EnBW, EDF proposed in 2001 to provide access to a part of its generation capacity located in France to competitors. It mainly took the form of drawing rights on virtual power plants (VPP, hereafter) while retaining the operational control of the plants. Those rights are auctioned under European Commission supervision. The initial agreement with the Commission which ran for 5 years was extended, with minor amendments, for a further 4 years. Up to now, more than 25 auctions have been held to sell the VPP. Two types of virtual power plants exist: baseload and peakload. The price for energy from baseload VPP is set to reflect the marginal cost of running a nuclear plant (initially it was 8 euros per MWh, and now it is 9 euros); similarly the price per MWh for peakload VPP reflects the marginal cost of peakload plants in France. Initially, it was set to 26 euros but has risen in line with fuel price to more than 50€.
In the auctions which are held every 3 months, interested parties can bid for VPP for periods of 3, 6, 12, 24 or 36 months. The VPP contracts are options; that is, the owner has the right to purchase electricity at the strike price (e.g. 8 or 9 euros for baseload) up to the capacity that they have paid for, but they are not obliged to do so. If they wish to exercise the contract they must notify the EDF of the required load curve by 12 noon on the previous day. On its website, EDF provides information on the bidding in the different rounds as well as the results of the auction, namely, the premium in thousands of euros per MW per month, and the capacity for the different contract lengths for both baseload and peakload. For instance, 5 MW were sold at baseload auction N°22 held on November 2006 for a 3 month period for delivery starting on 1 January 2007 with a premium of 39,400 €/MW.
The question that interests us is whether buyers of the VPP actually make a profit after having paid such significant premiums. Owners will exercise their right to draw power whenever the Powernext price exceeds the strike price (e.g. 8 or 9 euros for baseload VPP); otherwise they could simply buy at a lower price on Powernext. The figure below shows the revenue received at each 3 month auction in blue and the corresponding profit (or loss) in red, for baseload and peakload respectively. It clearly demonstrates that after paying the premium, owners sometimes lost money for the 3 month VPP. So why do bidders push the premium so high?
Is this just a case of winner’s curse? One knows that in auctions for oil leases, the classical case of winner’s curse, the “lucky” bidder is the most optimistic about the future reserves. But she does not discover the true reserves until years later when the oil field is put into production. The situation is quite different here as bidders in VPP auctions find out the true position relatively quickly, especially for auctions with 3 month delivery periods. Under those circumstances it seems strange for them to repeatedly bid up to (and past) the breakeven point. One reason is that the quantities made available via the VPP are large compared to those exchanged on Powernext. For example, in December 2002, the VPP capacity was about 5 times the total volume transacted on Powernext whereas in December 2006 (despite the tenfold increase in Powernext volumes), the VPP capacity would still have had a marked effect on the market clearing price. One advantage of VPP is that they are the only optional product that provides some security of supply by allowing them to diversity their sources of supply.
(If you want to know more about our VPP’s analysis donwload our recent working paper)
Margaret Armstrong, Alain Galli (Mines Paris-ParisTech) and Arun Kapoor (Indian Institute of Technology)
November 23rd, 2007 at 4:59 pm
I would like to ask a question to the authors and make a general comment on current VPP processes.
While comparing VPP and Powernext, did the authors take into account the G-factor of grid tariffs? and the financial effect of paying in advance the monthly option? Both issues represent an extra cost for VPP buyers.
VPP experience so far has been a flawed experiment because of its implicit design. VPP was simply planned to introduce liquidity to the market and disregarded incumbents’ availability to set the price in the power market. Actually, with VPP, incumbents have been provided with a practical tool to consolidate their price setting mechanisms. To reduce incumbents’ capability to set prices over the competitive reference, VPP should: 1) auction cost-based products with adequate indexation 2) extend delivery periods to longer terms (5 to 10y) in order to create an alternative sourcing to end users and limit the interest of simple arbitrage 3) accommodate demand and releasable offer before auctioning and 4) not use only-ascending auction rules.