Risk Management Issues for Distributed

Generation
C McClay and P Litchev

Abstract - This paper discusses

the risk managementissuesfor solutions and the degreeto which eachreducesthe exposureto
distributed generation in two different electricity markets. The price spikes.
first of these is the NETA market in England and Wales, which
has introduced significant new risks for distributed generation. II. DISTRIBUTED GENERATION UNDER NETA
This is contrasted with the situation in the Midwest where
distributed generation has been successfully used by utilities to A. Overview of NETA
reduce exposure to electricity price spikes in the short-term
markets.
The introduction of NETA in England and Wales in March
Index terms - distributed generation, electricity 2001 replaced the centralized Pool mechanismwith a number
risk
management of bilateral markets and power exchangesfor the trading of
electricity. These markets allow participants to trade in a
I. INTRODUCTION range of time frames from several years ahead down to
individual half-hours for on-the-day delivery. At gate-closure,
The risk managementissues for distributed generation are which is currently 3.5 hours ahead of the delivery period,
largely dependent upon the electricity market structure and trading in the markets ceasesfor that period and participants
regulatory environment in which the generation is sited. The must notify central systems of their contract position and
United Kingdom has recently undergone a dramatic intended generationor demand. The systemoperator manages
restructuring of the electricity market with the introduction of energy balancing in real time via a balancing mechanismin
NETA in March 2001. The structure of NETA, and in which offers to increase generation or bids to reduce
particular the dual cash-out prices in the Balancing generation are acceptedfrom market participants. At the end
Mechanism, has introduced a number of risk management of the delivery period, the market enters the settlementstage.
issues for distributed generation, which is now exposed to Contract positions are compared to metered generation or
significantly different risks from those experienced under the demandand any imbalanceis chargedfor accordingly.
Pool. In order to operate successfully under NBTA it is
important that participants understandthe risks to which they B. Imbalance Risk
are now exposed and implement strategies to manage these
risks effectively. The key element of NBTA that introduces significant risks for
distributed generation is the penal dual cash out prices of the
The situation for distributed generationin an electricity market balancing mechanism (BM). If a generator delivers less
such as that found in the Midwest is significantly different energy than it has contracted for in a settlementperiod then it
from that experiencedrecently in the UK. A regular feature of must pay the systembuy price (SBP) for the shortfall. This is
the Midwest market is the occurrence of price spikes during the weighted-averageof offers acceptedin the period. If it
the summermonths when the load from air-conditioning units over generatesin a period then it receivesthe, normally lower,
is particularly high. During these price spikes, there is system sell price (SSP) for the excess.This is the weighted-
insufficient plant margin available due to a lack of available
average of bids acceptedin the period. The mechanismwas
capacity on the system together with constraints on the designed to encouragemarket participants to contract in the
transmissionnetwork that prevent the transfer of power to the long-term markets and power exchanges ahead of gate-
regions where it is required. The utilities in the Midwest have closure. In the first few months of NETA, SBP has been
responded to this situation by using distributed diesel extremely volatile and so the earnings risk if a generatordoes
generation at peak times in order to decreasethe demand not deliver its contract position is high. Effective risk
exposed to these price spikes. Alternative solutions to the managementstrategiesare therefore important for all market
problem would be to build more gas turbines or to reinforce participants, including distributed generation.
the transmission network to reduce the constraints on the
system. In order to select the most appropriate solution, the It has been said that NBTA rewards reliable plant. However it
utility company needsto determinethe costs of the alternative would be more accurateto say that NETA rewardspredictable
plant, as the contract position for the generator must be
C McClay is with Edison Mission Energy, UK (email
submitted at gate closure, which is currently 3.5 hours ahead
cmcclay@cdisonmission.com) of the delivery period. A large number of the distributed
P Litchev is with Edison Mission Energy, California (email generators in the UK are CCGTs, which have a relatively
plitchev@edisomnission.com) predictable output. It might therefore be expected that the
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earnings risk for these generators due to imbalance will be
low. However, the volatility of SBP is such that a forced
outage occurring during a price spike could have a
catastrophic effect on the earnings of an independent
generator.
As environmental concerns become more important, there is
an increasing drive to encouragemore renewablegenerationto
connect to the distribution networks. The latest measureis an
obligation on supply companies to purchase a proportion of
their power from renewable sources. A large proportion of
this renewable generation will consist of wind turbines, which
inherently have an unpredictable output. It is therefore not
possible to reliably match the contract position that is
submitted at gate closure to the delivered energy and there will
be significant imbalance risk. It is particularly important to
find effective risk management solutions for renewable
generators‘under NETA, if the UK government targets for
generationfrom renewalblesourcesare to be met.
C. Possible Risk Management Solutions
There are a number of choices that a distributed generatorcan
make under current market rules to manage imbalance risk.
The method adopted will depend upon the risk appetite of the
generator and the degree to which it wishes to participate in
the NETA markets.Eaclhof thesewill be discussedin turn.
1) Licensed Supplier
At present, generators commonly trade through a licensed
supplier. The generator effectively sells its output to the
supply company as negative demand, which is netted off the
supplier’s energyrequirementsprior to gateclosure.
By selling to a licensed supplier, a generator avoids the need
to invest in expensive trading systemsand, depending upon
the structure of the contract, can have zero or limited exposure
to imbalance prices. In addition, the generatorcan capture all
embedded benefits. However, by choosing this route to
market, the generator limits its ability to participate in the
balancing mechanismor to offer ancillary services. This may
be an important considerationfor flexible plant.
This approachto imbalancerisk managementwill be attractive
if the supply company c:anmanagethe risk more cheaply than
the generator. This will almost certainly be the casewhen the
supply company has a large demand that is not strongly
correlated to the generator output, as the increasedimbalance
risk for the supply company due to unpredictable generation
should be small. However, if the demand is not significantly
greater than the generator output, the effect of the
unpredictable generationon the total imbalancecould be large.
Under these circumstances,the supplier will not be able to
manage the risk more cheaply than the generator and will
likely charge a high priemium to the generator for accepting
the risk.
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A further consideration for participants is that this approachis
only possible if there is enough demandat grid supply point to
offset the generation. This may become a significant problem
in the future, as there are currently a large number of
proposals for new wind farms, which are required to meet the
government targets for renewable energy. Wind farms are
generally sited in rural areas, where there is normally less
demand. At present, there is sufficient demandat grid supply
points to offset the generation of wind farms. However, the
trend is to build schemesinvolving a larger number of bigger
turbines, such as the numerous offshore wind projects
currently being considered. In addition, there is a
geographical clustering of these projects in sites with
favourable wind conditions. Both of these factors may result
in a number of grid supply points where there is not sufficient
demand to offset all of the generation, thereby limiting the
volume of energy that the generator can sell to the licensed
supplier.
2) Aggregation Agent
An alternative to selling to a licensed supplier is to employ the
services of an aggregation agent. The aggregator can trade
fully on behalf of the generator or alternatively, may simply
manage imbalance risk by aggregating the output with other
generatorsor supply. Although this was seenas an attractive
option for distributed generation at the inception of NETA,
there are currently few establishedaggregationagents.
This approach shares many of the benefits of selling to a
licensed supplier. The generator does not need to invest in
expensive trading systemsand depending on the structure of
the contract, the generator can have zero or limited exposure
to imbalance prices. The generator can receive embedded
benefits or alternatively may choose to accessthe BM via the
aggregator.
This approach depends upon the aggregator managing the
imbalance risk more cheaply than the generator,which should
be the case if the aggregator has a wide portfolio of
generation. The degree to which the aggregatorcan manage
exposureto imbalancerisk dependsupon the correlation of the
outputs from the individual generators. As the amount of
unpredictable wind generation installed on the system
increases, it may be difficult to reduce the imbalance risk
sufficiently through aggregation. This may lead to
aggregators charging high premiums for accepting the risk.
Another important consideration for an aggregationagentis to
ensure that all participants pay a fair share of the imbalance
costs. This fair sharewill changeas new membersjoin and so
the type of contract needsto be structured carefully.
In addition to offering a service to manage imbalance risk,
aggregatorsmay also trade on behalf of individual generators.
If a generator choosesthis route to market, it is vital that the
contract is structured so that the aggregator receives the
correct incentives to extract maximum value for the project
through trading. A further consideration for the generator is
that this approach to trading the generation assetswill almost
 certainly result in a reduced market profile, which may not be calculations which are intended to dampen the volatility of
desirable. SBP in the future.

3) Independent Trading A modification to the market rules that is currently being

discussedis the reduction of gate closure to 1 hour from the
An alternative to the two mechanismsdescribed above is for current 3.5 hours. This modification would reduce the time
the generator to participate fully in the NETA markets as a that a plant on forced outage needs to remain exposed to
balancing mechanism unit. This approach may be more imbalance prices before trading out of the contract position.
attractive for distributed generation that is part of a larger The earnings risk due to a plant breakdown is therefore
portfolio with which it can be aggregated. reduced. This modification may be of particular benefit to
wind generators, as lead lead-time for forecasting the wind
If the generator is part of a larger portfolio it gains all of the speed is significantly reduced. This should allow more
advantagesof trading through an aggregationagentand retains accurate forecasting of the output, thereby reducing the
full control of contracting, ancillary servicesand participation imbalancerisk due to forecasting errors.
in the BM. However, this approach requires extensive
investmentin trading systemsand staff and if the generator is
E. Transmission Access Risks
not part of a large, diverse portfolio it can be exposed to
extremely high imbalance risks. In addition, the generator
limits its ability to receive embeddedbenefits. It has been repeatedly emphasized in this discussion, that
NETA rewards reliable generation. If a generator contracts
4) Combining withflexible generation output in the energy market, it is important that they have the
right to accessthe transmission systemso that the energy can
All the methodsdescribed above attemptto manageimbalance be delivered. At present under NETA, generators are not
risk by aggregating with other sources in a passive manner. required to purchase access rights and any transmission
An alternative to this approachis to combine the unpredictable constraints are managedthrough the balancing mechanism. It
source with flexible generation, which can actively was intended that a new access rights market would be
compensatefor any variation in the generation. This could be implementedin the UK to accompanyNETA. However, this
achieved under the current market rules by installing the market is still at the proposal stage and there is currently a
flexible generationat the samegrid supply point and operating great deal of resistance to its introduction from market
as a single trading unit. At present the only viable method for participants. Distributed generators that sell to a licensed
distributed generation is to install fuel cells, which may be supplier should be unaffected by accessright issues and at
prohibitively expensive. present it is not certain whether any proposals would affect
other distributed generators. However, if distributed
An alternative to this on site flexible generation might be to generation is required to participate in the access rights
compensatefor the variation in a single generator,or group of market, there are a number issuesthat may be of concern.
generators using a large flexible sonrce such as a pumped
storageunit. This has the advantagethat it can use flexible In the access rights proposals, it is not clear what
plant that already exists ‘on the system and so should be less compensationwill be available to generatorsif a failure of the
costly than the on-site solution. However, this approachis not transmissionsystemprevents delivery of the contract position.
possible within current systemrules, as the active management One suggestionis that the generator is only compensatedfor
of imbalancerequires the pumped storageunit to deviate from the periods after gate closure, a maximum of 3.5 hours.
its FJPN,which presently violates the Grid Code. Beyond this time, the generator is expectedto trade out of the
position. This is clearly an undesirable situation as the short-
term marketsare not particularly liquid and the generatorwill
D. Market Changes be a distressedbuyer. This may be a greater problem for a
distributed generator as it is exposed to faults on both the
It has been suggestedthat the penal imbalance mechanismof distribution network and the transmission network. Indeed at
NETA should not apply to all distributed generation and in present, distributed generators are not compensatedfor any
particular to renewable generation. The penal imbalance loss of accessto the transmission systemdue to faults on the
prices were intended to encouragecontracting in advance of distribution network.
gate closure and investment in plant to maintain reliability.
The imbalance from wind generatorsdue to forecasting errors A further area of concern in the accessrights proposalsis the
and from CHPs due to changes in load, are inherent in the suggestion that the access rights market might be a penal
technology rather than deliberate. It has therefore be argued market. Under this scheme,participants would be required to
that if these technologies are to be encouraged for buy access rights to match their energy delivery and any
environmental reasons, they should not be subject to penal imbalance would be exposed to imbalance prices. This will
imbalance prices. However, it seemsunlikely that there will clearly affect unpredictable generation such as wind farms in
be any exemption granted in the near future and so distributed the sameway as the energy imbalance market. Any attemptto
generatorsmust continue to managetheir risk. The task may introduce a penal system therefore needs to be vigorously
be simplified a number of changes to the imbalance price

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 opposed by distributed generationsuch as wind generatorsand
CHPS. In addition to investing in new transmission lines, the utility
companies have managedprice risk exposure by investing in
It is clear that there is currently a great deal of uncertainty distributed generation. For example, since 1997 CornEd has
surrounding the access rights market in the UK. This installed a number of diesel generatorsto provide local peak
uncertainty exposesmarket participants to regulatory risk and lopping during the summer months. These generators are
it is important for distributed generatorsto participate fully in rented for the peak months of June to August and installed at
the consultation process to limit the negative impact of any points on the network where the extra energy will be most
proposalson their earningsrisk profile. effective. By introducing distributed generation at specific
points on the network, the utility effectively reduces the
III. DISTRIBUTED GENERATION FOR RISK demand over the peak. In addition, if the sites for the
MANAGEMENT IN THE MIDWEST distributed generation are chosen carefully, the utility should
avoid increasing the constraints on the transmission network
The environment for distributed generation in the Midwest is and may even help to alleviate them.
significantly different from that experienced in the UK. In
June 1998, the electricity market in the Midwest experienced The degree to which distributed generation has been
severeprice spikes of up to $7,OOO/MWhthat resulted from a successfully used as a risk managementtool by utilities in the
severe shortage of power available in the markets. This Midwest is in large part due to the structure of the industry. In
shortage occurred due to a combination of factors: the Midwest, the utility companies own both the distribution
unseasonably high temperatures; a high level of plant on business and the supply company. This contrasts with the
routine maintenance;storm damageto plant and transmission situation in the UK, where the ownership of the distribution
lines; a curtailment of power exports from other transmission network is separatefrom the supply company. In the UK, the
networks due to unstable power flows on the system. In distribution owner tends to consider only the problems caused
addition, some companies defaulted on power-supply by connection of generation to their network as it is the supply
contracts that had originally been purchased by utilities to company that accrues the benefits of the distributed
manageexposureto price spikesin the short-term markets. generation. In the same way, the supply company does not
normally consider where the distributed generation would be
Although the price levels of June 1998 have not been repeated best placed to minimize systemproblems that may result from
in the Midwest, summer price spikes are a regular feature of its introduction on the network. The placementof distributed
the market. Utilities can manage their electricity purchase generation at points where it will benefit the distribution
costs by reducing the magnitude of the price spikes occurring company can only be encouragedthrough financial incentives
in the short-term markets, or by reducing the volume of or penalties and so the situation in the UK will probably not
demandthat is exposedto theseprice spikes. result in the optimum placementand use of distribution on the
network.
The purchaseof longer-term power contracts can be used to
manage earnings risk by reducing the volume of demand The electricity industry structure in the Midwest encouragesa
exposedto price spikes in the short-term markets. The prices more integrated approach to the placement of distributed
in the long-term market will of course reflect the expectation generation. By introducing distributed generation, the utility
of prices in the short-term,with higher prices occurring for the reduces demand at peak times. In addition, the utility can
summermonths.However, the prices should be less volatile in choose to place the generation where it most benefits the
this market, as the price spikes are caused by short-term management of the distribution network. The distributed
effects that cannot be predicted months or even weeks in generationtherefore fulfils two roles simultaneously.
advance.

Although purchasing long-term power contracts does reduce
the exposure of the utility to short-term price spikes, this
approach does not remove the underlying cause of the price
spikes,that is, the shortageof generatingcapacity available on
the system at peak demand. This shortage can in part be
reduced by the introduction of more peaking plant such as
OCGTs on the system. Energy companies will consider
building new plant if the returns on the projects are sufficient.
However, the shortageof power at peak demand will not be
solved simply by building more plant, as the power must be
available where it is required. This may not possible if there
are constraints on the system,which was certainly the casein
June 1998. Utilities in the Midwest have therefore invested
significantly in the transmission networks in the past two
years.
IV. TYPES OF DISTRIBUTED GENERATION IN THE
UK AND THE MIDWEST
In the UK, the drive is towards installing more renewable
generation such as wind turbines because of environmental
considerations. As previously discussed,wind turbines have
an unpredictable output and so under NETA, the major
consideration for distributed generation is how to manage
imbalance risk effectively. This contrastswith the situation in
the Midwest, where distributed generation can be used to
reduce demand at the time of price spikes. This requirement
for peak lopping influences the type of distributed generation
that is introduced on the system;clearly wind turbines are not
suitable for risk managementin the Midwest market. Instead,
the
-. requirement
_ is for flexible peaking plant. At present,
diesel generatorsare commonly used in the Midwest for peak

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lopping however GCGTs provide an alternative.
Considerationsfor the utility when choosing which technology
to adopt include cost, reliability and environmental factors.

V. SUMMARY

This discussion has presentedtwo electricity markets in which

the risk management issues for distributed generation are
distinctly different. The penal cash out prices of the balancing
mechanism under NETA have introduced significant risk
management issues for distributed generators, especially
renewable generation such as wind turbines. This contrasts
with the situation in the Midwest, where distributed generation
has been successfully used to managethe exposure of utilities
to the volatile marketprices that occur during the stmnner.

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