Deepening of Power Market - Challenges Ahead

India's power sector is experiencing a major transformation, driven by policy reforms, technological advancements, and the pursuit of sustainable growth. The landscape of India's power sector is gradually shifting from traditional base-load and peak load patterns to flexible generation and flexible load. This transition is driven by the increasing integration of renewable energy (RE) sources into the grid and the growing demands from electric mobility and industrial decarbonization, which are imposing new requirements on the power grid.

In 2023-24, the country supplied a total of 1,617.04 billion units (BUs) of electricity. Of this, 86.96 BUs (5.3%) were transacted through bilateral trade, while 123.11 BUs (7.6%) were traded through the three power exchanges. The remaining 87% of power were transacted through Power Purchase Agreements (PPAs) by the discoms. However, there is a strong push to increase the share of power traded through exchanges to enhance efficiency, competitiveness, and transparency in the electricity market. Achieving this objective requires addressing several key challenges, including the need for a robust financing framework, the lack of long-term products in exchanges, and the evolving demands on the power grid.

Followings are some of the key issues & challenges which needs to be addressed for deepening of power market in India:

Legal and Regulatory Framework

Legal and regulatory barriers have been addressed with the Supreme Court's order clarifying the roles of the Central Electricity Regulatory Commission (CERC) and the Securities and Exchange Board of India (SEBI) as regulators for the forward market and derivatives, respectively. Furthermore, the Central Electricity Regulatory Commission (Connectivity and General Network Access to the inter-State transmission System) Regulations, 2022 ("GNA Regulations") and the Central Electricity Regulatory Commission (Indian Electricity Grid Code) Regulations, 2023 ("IEGC Regulations") have been implemented, which provide for short-term TGNA up to 11 months besides medium and long-term access.

Volatility in Spot Power Prices

Spot power prices exhibit significant volatility, especially during peak periods and seasons, resulting in a high standard deviation. Recent exchange prices have shown dips during solar hours and spikes hitting the price cap of Rs. 10 during non-solar peak hours. These trends highlight the need for the development and deepening of forward and derivatives markets. Introducing forward markets will help mitigate spot market volatility over the medium to long term, reducing price risks for participants.

The Current Financing Framework and Its Impediments

One of the main challenges to increasing the volume of electricity traded on power exchanges is the current financing framework. The power sector's normative debt-to-equity ratio of 70:30 is relatively high, making it difficult for projects to secure necessary funding. High debt-to-equity ratio means projects are heavily dependent on borrowed funds, increasing financial risk and leading to stringent conditions from lenders. Financial institutions, cautious of the associated long-term risks, often require significant comfort before extending debt. This comfort usually comes in the form of long-term Power Purchase Agreements (PPAs), which guarantee lenders that at least 85% of the generated power will be sold through long term PPAs, ensuring steady cash flows for debt servicing. The requirement for a long-term PPA as a precondition for financing creates a bottleneck for projects aiming to participate in power exchanges, where contracts are typically shorter-term and more flexible and even volatile.

Dependence on Long-Term PPAs

Long-term PPAs provide the financial stability that lenders seek, but they also lock in power producers into fixed contracts that may not be conducive to trading in power exchanges unless there is procurers event of default. This reliance on long-term agreements reduces the liquidity and flexibility of the market, as power producers are less able to respond to short-term price signals and market dynamics. Furthermore, the long terms PPA’s are available to the discoms on credit where as for the exchange traded power, upfront liquidity is required for settlement.

 Absence of Long-Term Products in forward market in Power Exchanges

Another significant challenge to increasing the market share of electricity traded on power exchanges is the absence of long-term or forward market products. In India, power exchanges primarily offer short-term contracts, ranging from day-ahead to a few months. This limited range restricts the ability of market participants to hedge against long-term price volatility and effectively manage their financial risks.  Electricity forward contracts involve a commitment to buy or sell a specified amount of electricity at a predetermined price, known as the forward price, at a future date (referred to as the maturity or expiration time). Essentially, these contracts are customized agreements between a buyer and a seller, where the buyer is obligated to receive the power and the seller is obligated to supply it.

Currently, forward contracts available on power exchanges are limited to three months, which falls short of meeting the diverse short-term power purchase requirements of distribution companies (Discoms). These needs range from day-ahead planning to a minimum of 1-3 years. Although the DEEP portal/OTC facilitates price discovery for such power procurements, the commercial terms and conditions of trades must be bilaterally settled between the involved parties over the counter.

Forward markets will also provide forward price signals, which can serve as benchmarks for evaluating investment decisions. Discoms and other buyers will be able to assess the reasonableness of their purchase agreements against these prices. Additionally, there is a need to study the impact of introducing forward products and their efficiency.

The phased introduction of forward market products for periods up to 11 months initially, with the durations increasing as the market matures, can significantly enhance market liquidity and participation. Forward market deepening will facilitate price discovery and enhance hedging opportunities, leading to price convergence among different market segments. In India, prices between the bilateral and spot markets continue to remain divergent; therefore, forward market deepening will be instrumental in bridging this gap.

Absence of Hedging & Speculation Opportunities (Futures & Options) in financial market

Without financial derivatives or futures and options products, power producers and consumers cannot effectively hedge against future price fluctuations. This inability to hedge complicates long-term financial planning and commitments in the financial market, leading to reduced participation in power exchanges. Furthermore, the absence of these financial instruments eliminates opportunities for speculators to participate in the power market, which would otherwise provide liquidity and contribute to better price discovery. Financial uncertainty is detrimental to both power producers and consumers. Producers are hesitant to sell a significant portion of their output on the exchange without price stability, while consumers are reluctant to rely on the exchange for their long-term energy needs due to potential price spikes.

Impact on Investment

The lack of long-term products also affects investment decisions in the power sector. Investors are more likely to support projects with stable and predictable revenue streams. The inability to secure long-term contracts through power exchanges makes it challenging to attract investment for new generation capacity, particularly from renewable sources that are crucial for India's energy transition.

Discoms' Preferences and Short-Term Contracts

At present, approximately 87% of the Discoms power requirements are secured through long-term PPAs. To address short-term needs, Discoms resort to sourcing power for up to three months from the Spot or Term Ahead Market (TAM) on power exchanges. For the period spanning three months to one year, they utilize the Discovery of Efficiency Electricity Price (DEEP) Portal, operating under the Short-Term Bidding Guidelines of the Ministry of Power, Government of India.

Discoms are displaying a preference for firm contracts limited to 1-3 years. This inclination towards shorter-term agreements provides greater flexibility to Discoms and eliminates the obligation to pay fixed charges under a contract for an extended duration. As a result, navigating this evolving energy landscape poses challenges, emphasizing the need for a more resilient and adaptive approach in addressing the dynamics of the power sector to absorb the URS power, merchant, and new capacities being added.

Absence of Capacity Market in the Power Sector

A capacity market is a mechanism designed to ensure the reliability of the electricity supply by providing financial incentives to power plants for being available to produce electricity during peak demand periods. In a capacity market, electricity generators are paid not just for the actual energy they produce, but for their available capacity to produce electricity when needed, regardless of whether they end up generating electricity. It ensures that there is enough generation capacity available to meet peak demand by Providing financial incentives to power plants to remain operational and available through market mechanism in which Capacity is typically auctioned off to the highest bidder, and those who clear the auction are paid a capacity payment.

Necessary Products for a Capacity Market are:

a) Capacity Certificates: Tradable certificates representing the commitment of a power plant to be available to generate electricity during peak demand periods.

b) Capacity Auctions: Mechanisms for procuring capacity from power producers through competitive bidding. Auctions can be designed for different timeframes, such as annual, seasonal, or monthly.

c) Capacity Contracts: Agreements between power producers and the market operator or regulatory authority, detailing the terms of capacity availability and payments

d) Demand Response Products: Programs incentivizing consumers to reduce their electricity usage during peak demand periods in exchange for financial rewards.

e) Ancillary Services: Services necessary to support the transmission of electricity and maintain grid stability, including frequency regulation, voltage support, and operating reserves.

Introducing a Capacity Market in India involves several steps and considerations like Regulatory Framework, Market Design & Develop the necessary technology and infrastructure to support the capacity market operations, including auction platforms and monitoring systems

 Conclusion

Increasing the market share of electricity traded in power exchanges in India requires a multifaceted approach that addresses the underlying financial challenges, the absence of long-term products, and the evolving demands on the power grid. By reforming the debt structure, introducing innovative financial instruments, strengthening the regulatory framework, promoting both short-term and long-term contracts, and improving market infrastructure, India can move towards a more efficient, competitive, and transparent electricity market. This transformation will not only benefit power producers and consumers but also contribute to the overall growth and sustainability of the power sector.