Misunderstandings About Electricity Markets

Eight Misconceptions Around the “Merit Order” Misconception 1: Marginal pricing is unique to electricity markets. It’s not. All commodities price on the margin. The “Merit Order” is what is conventionally called a short-term supply curve. Marginal costs determine prices of crude oil, natural gas, bananas, coffee beans, solar cells, cloud computing, etc. Misconception 2: The Merit Order Model is mandatory or prescriptive. It’s not. It describes how independent, profit-maximizing firms behave in free, competitive markets. Marginal pricing is not a rule or law – firms can bid any price they want. The Merit Order is not a policy; it is a description of how a free market works. The Merit Order Model is descriptive, not prescriptive. Misconception 3: Marginal pricing is an artificial and arbitrary rule. It’s not. Marginal pricing is not one among many sensible alternatives that we can pick and choose from. In fact, it is the only price that underpins a market equilibrium. Setting any other price requires rationing, i.e. excluding consumers from the market or forcing generators to produce. Misconception 4: Contribution margins are windfall profits. They are not. The difference between the electricity price and variable costs pays for investment. Misconception 5: Pay-as-bid would lead to different prices. It would not. If the pricing rule in an auction were changed – say, the EPEX SPOT day-ahead auction – market parties would adjust their bidding strategy immediately. Instead of bidding their own variable cost, they would estimate the variable cost of the marginal plant and bid just below. The resulting price would hardly change. Misconception 6: The Merit Order is a model of the day-ahead auction. It is not. It’s an equilibrium model of the entire short-term electricity market, not just one segment. Even if the pricing rule in a particular day-ahead auction (say, Nordpool Spot) were changed, the merit order would remain a valid model for predicting equilibrium power prices. Generators would simply adjust their bids or use different market platforms for trading. Misconception 7: The power price is coupled to the gas price by law. It’s not. It is economic mechanisms, not regulation, that make these prices move hand-in-hand. They do not always move in parallel — when gas plants are not needed to serve demand, gas prices have no impact on power prices. Misconception 8: It’s only about spot prices. It is not. Most consumers and producers hedge, i.e. they lock in prices months or years in advance of delivery by trading on forward markets. Hence spot price fluctuations do not immediately spill over to retail prices levels.

As I write this, the below is a snapshot of electricity prices in western Europe. Very prominently, the continental West has free electricity, while central Europe pays around €75/MWh. What is happening in the West is solar (and wind) saturating demand thus driving market clearing prices to zero. That's great for consumers, at least on the face of it. And that's where the crux is. We still think of the market clearing price as the cost of electricity, but that isn't correct and leads to misunderstandings. Sure, all the renewables are highly welcome, especially in a time of high gas prices. But if we use the market clearing prices as guides for energy cost, the results will be off. All the power generation during the zero priced hours still needs to be profitably remunerated, which is increasingly happening through long-term contracts (i.e. CfD, PPA, capacity or tolling contracts). These pre-agreed revenue streams above merchant revenues must ultimately be billed to the consumer or tax payer. So although electricity in Spain and France is available for free on the market right now, the tab for the actual cost is being picked up through taxes, fees or levies. There is nothing wrong with that, especially when a renewable energy supply is cheaper than the alternative would be. But if we start to talk about renewables as mostly free, we are creating false expectations. Just today I saw a LinkedIn post comparing power prices in Spain to the UK to advocate for linking the two markets by subsea cable. Good idea. But if we expect that Spain will pay the long term contracts so that the UK can take "free" surplus electricity, we're succumbing to that false cost evaluation. Yes, you would be able to import cheaper spanish solar energy, but expect to pay the levelized cost, not the daily market clearing price. Picture. electricity.maps

Your expensive generators often set market electricity prices This is something I think is misunderstood because people assume that if a generator is cheap to run, it automatically bids into the market at a low rate. It does not really work that way, because companies want to maximize profits. If power is not sold under a contract, it is offered into the day-ahead and real-time markets. The bid is not a guess of the market. It is what it costs to run, plus some margin. What is the least you would need to be paid to generate the next MW? Those bids are curves, especially for thermal units, because efficiency and emissions costs change with loading. As offers are accepted, the marginal MW, the last and most expensive MW needed to serve load, sets the clearing price for that interval. Renewables that are non-dispatchable often bid at zero or negative, so they clear first. This modified some for grid security reasons so that the grid can handle certain events. If electricity markets were a salad, the price is determined by the croutons put on top at the very end. Since the marginal unit sets the price, consumers only see cheap electricity when demand is low enough that the system does not need to call on high-cost units. If a state or municipal wants cheaper power, building more low-cost generation helps, but there is another lever. Reduce reliance on expensive-to-run units that show up during the tight hours. Those few units are what set the market rate during shortages. Peaker generation bids in high because it is expensive to run. It runs not many hours each year, so its fixed costs have to be recovered over a small number of MWh. In Texas, large crypto and data center load is being ramped down to resolve capacity issues rather than building as much new peaker generation. Selling their capacity back to the grid. This is beneficial in several ways. It reduces peaker units needed, and it can prevent the highest offer from becoming the marginal unit. It also shifts leverage. Instead of the marginal price being anchored to the minimum run cost of the last generator, a flexible load is effectively telling the market what that last MW is worth. My concern is the direction this takes us. It ties the marginal value of electricity to the value of what electricity can produce, cryptocurrency and AI, not just to the cost of producing the last dispatched MW plus margin. If AI leads to huge productivity gains and is highly valued, data centers have strong incentives to hold onto their capacity, not sell it back, even when the grid is stressed. That pushes scarcity hours up, and scarcity prices with them. Then regular consumers are not paying for electricity based on cost plus but on the demand for inelastic data center services. I think this is dangerous for the average customer. #utilities #elecricalengineer #renewables #datacenters #energystorage

After working on energy policy as both a Virginia legislator and Director of the Virginia Department of Energy, one thing I’ve learned is that electricity markets are often misunderstood. Wind and solar don’t have fuel costs. So why isn’t electricity dramatically cheaper? Because wholesale electricity markets don’t pay generators based on their individual costs. They pay based on the market-clearing price, which is usually set by a natural gas plant needed to meet demand. That means wind and solar generators often receive the same price per megawatt-hour (MWh) as natural gas generation, even though their operating costs are lower. I explain how this works, and why it matters for energy policy debates, in my latest column in the Virginian-Pilot. For those who may encounter the paywall, I’ve included the article here. The link to the Virginian Pilot is: https://lnkd.in/e9tBwaxm

I always considered myself relatively well-informed about energy issues, but I recently stumbled upon a shocking truth about how electricity markets function. It's called "marginal pricing," and it's a major reason why your electricity bill is so high, even with the increasing abundance of cheap renewable energy. Here's how this outdated system works: Imagine an auction where every power plant submits a bid to sell electricity. Renewables like solar and wind come in with incredibly low bids, often near zero, because their fuel (sunshine and wind) is free. Fossil fuel plants, burdened with the cost of coal and gas, submit much higher bids. Now, here's the kicker. The market operator doesn't simply buy the cheapest electricity first. Instead, they stack these bids from lowest to highest and then determine how much electricity is needed to meet demand at any given moment. The price of the most expensive power plant needed to meet that demand sets the price for all electricity sold. This means that even though we have vast amounts of cheap renewable energy available, we often end up paying inflated prices dictated by those dirty, old fossil fuel plants! This system, known as "marginal pricing," is a relic of the past designed for a time when fossil fuels were the dominant energy source. It's completely out of touch with today's energy reality, where renewables are increasingly cost-competitive, and it's costing us a fortune – both financially and environmentally. It's high time for a complete overhaul of our electricity markets! PS. I made covering the topic above and a lil bit more, let me know what you think, here's the Link https://lnkd.in/dnEbRPUS #EnergyCrisis #HiddenCosts #CleanEnergy #Sustainability #Innovation #RenewableEnergy #Sustainability #FutureOfEnergy #Renewables #MarginalPricing