Module 5 — How Electricity Markets Developed
Lesson 4 of 9
Market Design Philosophies: Pool, Bilateral and Hybrid Markets
Learning objectives
By the end of this lesson you should be able to:
- Understand that there is no single universal electricity market design.
- Explain the differences between pool markets, bilateral markets and hybrid markets.
- Recognise the advantages and disadvantages of each approach.
- Understand how different countries have adopted different market structures.
- Appreciate that electricity markets reflect institutional design choices rather than immutable engineering principles.
- Recognise why many modern electricity markets combine multiple approaches.
Introduction
In the previous lesson we introduced wholesale electricity markets as the mechanism through which electricity producers and buyers trade energy.
It is tempting to imagine that all wholesale markets operate in the same way.
They do not.
Different countries have adopted very different approaches to organising electricity markets.
Some rely heavily on centralised market operators.
Others allow companies to trade directly with one another.
Many combine elements of both.
These different approaches are known as market design philosophies.
Understanding these philosophies is important because many debates about electricity markets are not arguments about engineering—they are arguments about institutional design.
There is no single electricity market
Imagine asking:
"How does the internet work?"
The answer depends upon which country, internet provider and network architecture you are discussing.
Electricity markets are similar.
Although all electricity systems must satisfy the same physical laws, there are many different ways of organising the commercial arrangements.
Different countries have reached different conclusions about how electricity should be bought and sold.
The three broad philosophies
Most wholesale electricity markets can be placed into one of three broad categories.
- Pool markets
- Bilateral markets
- Hybrid markets
These are not completely separate systems.
Rather, they represent different approaches to coordinating electricity production and consumption.
Pool markets
In a pool market, electricity is bought and sold through a central market operated by an independent market operator.
Generators submit offers indicating:
- How much electricity they can generate.
- The price at which they are willing to generate.
Buyers submit bids indicating how much electricity they require.
The market operator matches supply and demand and determines:
- Which generators operate.
- Market prices.
- Financial settlements.
Every participant trades through the central pool.
How a pool market works
Imagine four generators.
Instead of negotiating separately with every retailer, each generator simply submits an offer to the market.
The market operator collects every offer and calculates the market outcome.
Retail suppliers then purchase electricity through the same market.
Rather than thousands of individual negotiations, the market provides one central mechanism for coordinating everyone simultaneously.
Advantages of pool markets
Pool markets offer several important benefits.
Transparency
All participants observe market prices generated using common rules.
Efficient coordination
The market operator can optimise generation across many participants simultaneously.
Liquidity
Because everyone trades through the same market, buyers and sellers are easier to match.
Clear price signals
The market produces transparent prices that reflect overall market conditions.
Challenges of pool markets
Pool markets also have limitations.
Complexity
Operating a central market requires sophisticated software, market rules and governance arrangements.
Centralisation
The market operator becomes responsible for coordinating a large number of participants.
Market power
Large generators may possess significant influence if competition is limited.
Bilateral markets
A bilateral market takes a different approach.
Instead of trading through one central marketplace, companies negotiate contracts directly with one another.
For example:
A retailer may agree directly with a wind farm to purchase electricity over the next five years.
No central market determines this agreement.
Instead, both parties negotiate terms privately.
Bilateral contracts
Bilateral contracts specify matters such as:
- Quantity.
- Price.
- Delivery period.
- Risk sharing.
- Performance obligations.
These contracts allow participants to tailor agreements to their individual requirements.
Many long-term renewable energy contracts operate in this way.
Advantages of bilateral markets
Bilateral trading offers several benefits.
Flexibility
Contracts can be customised.
Risk management
Long-term agreements reduce exposure to volatile market prices.
Investment certainty
Stable long-term revenues make financing new generation easier.
Commercial freedom
Participants negotiate arrangements that best suit their businesses.
Challenges of bilateral markets
However, bilateral markets also have disadvantages.
Limited transparency
Prices are often confidential.
Search costs
Finding suitable trading partners can require significant time and effort.
Liquidity
Small participants may struggle to find counterparties willing to trade.
Coordination
Because agreements are negotiated independently, achieving system-wide coordination becomes more difficult.
Hybrid markets
Most modern electricity markets are neither purely pool markets nor purely bilateral markets.
Instead they combine both approaches.
These are known as hybrid markets.
In hybrid markets:
- Companies negotiate long-term bilateral contracts.
- Electricity is also traded through organised exchanges.
- Short-term markets balance remaining supply and demand.
This allows participants to benefit from both long-term certainty and short-term flexibility.
An example
Imagine a retailer supplying one million households.
The retailer might purchase:
- 70% of its expected electricity using long-term bilateral contracts.
- 20% through organised wholesale exchanges.
- The remaining 10% through short-term markets as demand forecasts become more accurate.
The retailer therefore uses several market mechanisms simultaneously.
This is common in many liberalised electricity systems.
Different countries, different approaches
Countries have adopted different market designs depending upon their history and policy objectives.
For example:
Great Britain
Uses organised wholesale markets alongside extensive bilateral contracting and balancing arrangements.
Australia (National Electricity Market)
Operates a real-time spot market that determines dispatch every five minutes, while most participants also use financial contracts to manage price risk.
Nordic countries
Make extensive use of organised power exchanges alongside bilateral trading.
United States
Different regions operate under different market structures, with significant variation between states and system operators.
The important point is that there is no universal model.
Physical markets versus financial markets
It is also important to distinguish between physical and financial markets.
Physical markets determine:
- Which generators are expected to produce electricity.
Financial markets determine:
- How participants manage price risk.
Many electricity contracts never change how the power system operates physically.
Instead, they simply redistribute financial risk between market participants.
This distinction is fundamental to understanding modern electricity markets.
Why different philosophies exist
Different market designs prioritise different objectives.
Some emphasise:
- Competition.
- Transparency.
- Central optimisation.
Others prioritise:
- Commercial freedom.
- Long-term investment certainty.
- Risk management.
No market design performs perfectly against every objective.
Instead, countries choose designs that reflect their engineering requirements, political preferences and historical development.
Markets are institutional choices
Perhaps the most important lesson is that electricity markets are human institutions.
Unlike the laws of physics, market rules are designed by people.
They can therefore evolve.
Over the past thirty years many electricity markets have undergone repeated reform.
New technologies—including renewable generation, batteries, electric vehicles and flexible demand—continue to challenge existing market designs.
As electricity systems evolve, market institutions evolve alongside them.
A key insight
There is no single "correct" electricity market.
Pool markets, bilateral markets and hybrid markets all represent different ways of coordinating electricity production and consumption.
Each involves trade-offs between transparency, competition, flexibility, investment certainty and operational complexity.
The best market design depends upon the objectives society wishes to achieve.
Key takeaways
- Electricity markets around the world use different institutional designs.
- Pool markets coordinate trading through a central market operator.
- Bilateral markets allow participants to negotiate contracts directly.
- Hybrid markets combine organised exchanges with bilateral contracting.
- Most modern electricity systems use elements of all three approaches.
- Financial contracts help participants manage price risk without necessarily changing physical electricity flows.
- Different countries have adopted different market structures based on their history, policy objectives and engineering requirements.
- Electricity markets are institutional designs that continue to evolve as electricity systems change.
Looking ahead
Regardless of whether electricity is traded through pools, bilateral contracts or hybrid markets, transactions occur over different timescales.
Some electricity is traded years in advance, while other trades occur only minutes before delivery.
In the next lesson, we examine day-ahead, intraday, real-time and balancing markets, exploring how electricity markets coordinate decisions as real time approaches.