MCCANN FITZGERALD:The single electricity market is set to establish a one-stop shop for all gas and electricity needs on this island, writes Valerie Lawlor

The Single Electricity Market (SEM) for the island of Ireland went live on November 1st, 2007. The establishment of the SEM is the first stage of an all island project establishing a single market for natural gas and electricity on the island of Ireland.

This project stemmed from a joint policy decision of the relevant government departments, North and South, namely the Department of Enterprise, Trade and Investment in Northern Ireland and the Department of Communications, Marine and Natural Resources in the Republic of Ireland, to create an-all island energy market.

The aim and expectation is that both jurisdictions will benefit from increased competition, reduced energy costs and improved reliability of supply.

Politically and legally, this project is entirely novel and required the establishment of a legislative framework to support the SEM. The all-island market has 2.5 million electricity customers, 1.8 million in Ireland and 700,000 in Northern Ireland

In design terms, the SEM is a gross mandatory pool market. This means that all electricity generated on or imported into the island of Ireland must be sold to, and all wholesale electricity for consumption on or export from the island of Ireland must be bought from, the pool.

A bilateral contracts market is expected to emerge around the pool to provide a financial instrument (a contract for differences in respect of price/volume) that can hedge pool participants against the risk of volatility in the pool price.

One of the principal differences between the SEM and the previous market arrangements is price - in the SEM, the price of electricity will be market driven and not administratively determined. Ensuring that the anticipated benefit of this difference is actually delivered to market participants and consumers is likely to be the principal challenge for the SEM.

In light of the market concentration in both jurisdictions, there is a risk that participants with market power could manipulate the price to their advantage.

All participants in the market operate under a single set of rules, the Trading and Settlement Code, regardless of their physical or geographic location on the island.

Generators "bid" their plant to the pool, setting out their pricing, so that the most cost efficient generators will be called upon to generate electricity first.

The System Marginal Price (SMP) is set for each half hour of trading by the bid of the last generator that must be despatched to meet demand in that settlement period.

All generators receive the SMP regardless of their bid. The cost of generation varies over the course of a day and by season, to reflect the marginal cost of generation at that time.

Generators bid in accordance with a bidding Code of Practice, the purpose of which is, in essence, to control market power and deliver greater transparency on pricing.

This requires generators to bid at their short run marginal cost, which is intended to ensure that generators with market power do not use it to influence SMP or to game constraint payments in cases of localised market power.

The SEM is regulated by the SEM Committee, decisions of which are in turn supported or implemented by the "Regulatory Authorities", being, jointly, the energy regulators in each jurisdiction - the Commission for Energy Regulation in Ireland and the Utility Regulator in Northern Ireland.

The SEM has a dedicated Market Monitoring Unit (MMU), the purpose of which is to monitor bidding in the pool to ensure that the bidding principles are adhered to.

The Regulatory Authorities have received formal complaints regarding the manner in which certain generators (principally owned by, or the output of which is sold to, ESB) are bidding their data into the pool.

This is, in turn, affecting the choices being made by the Market Operator as to which generation plants should be shut down and restarted during certain periods.

The MMU is currently conducting an inquiry into these complaints, the result of which will be closely watched by the industry.

One of the other principal aims of the SEM is to enhance the sustainability of the energy system on the island of Ireland through a program of reducing our dependence on fossil fuels and switching to renewable fuel sources. At present, the majority of renewable energy generated is wind power. Of approximately 6,000 megawatts (MW) of installed capacity on the Irish grid, 800 is wind powered.

It is anticipated that one of the benefits of the SEM and the SMP price arrangements is that clear price signals will be sent to the market, influencing the preferred location for new generation investment, as the need arises.

As a consequence it should improve the security and reliability of electricity supplies throughout the island.

It should also, over time, remove market distortions and minimise the cost of electricity to all customers. Again, this is a significant departure from the previous market structure - now market forces rather than central planners will deliver new capacity as and when needed.

A key design feature which incentivises new capacity across a mix of plants is the capacity payments mechanism - in addition to the SMP, payment generators are paid a capacity payment which is an administratively determined payment for each unit of generation capacity that is made available to the market, whether or not they are called upon to generate.

For 2008, €575 million has been allocated for these payments.

These payments, which are calculated on the basis of the costs of a conventional peaking plant, are intended to offset some of the fixed costs of generation thereby encouraging market participants to offer capacity.

As the share of renewables (principally wind) on the system rises, the efficient mix of plant should include a rising share of peaking and mid-merit plant relative to base load capacity and the SEM should operate in a manner that makes this structural outcome attractive from an investment perspective.

The SEM and Code make special arrangements for renewable generation at a couple of different levels.

Firstly, small scale (i.e. generators with fewer than 10MW) may elect to operate outside of the pool mechanism.

Secondly, generators who entered into long term offtake contracts pursuant to the government sponsored policy mechanism of the alternative energy requirements (AER) or renewable energy feed-in tariff (REFIT) programmes may also elect to be outside the scope of the pool through the use of intermediaries to interact with the SEM on their behalf.

Lastly, renewable generators may elect for "must run" status, meaning that they are (generally speaking) entitled to priority dispatch. This means that their electricity will be purchased at the price set by the market.

The set up of the SEM was a remarkable achievement for the many players involved.

However, this set up is just a beginning in terms of the establishment of a coherent all-island energy vision.

One of the highlights of 2008 in this field should be the publication by the Northern Irish and Irish Governments of the all-island grid study, following the consultation during 2007 on an "all island 2020" vision for renewable energy. This will analyse options for how infrastructure on the island could best be developed to allow for maximum penetration for renewable energy.

Valerie Lawlor is a partner in the corporate department of McCann FitzGerald with an expertise in law relating to energy and mergers and acquisitions.