Electricity Market Clearing Prices: The Dance of Supply and Demand
The heartbeat of the electricity market is determined by what’s called the “Electricity Market Clearing Price.” This is the price at which supply in the market by electricity generators intersects the price of what consumers, also known as demand, are willing to pay. In this blog post, we’ll cover electricity market clearing prices in detail, the Merit Order Effect, power market basics, and renewable energy’s impact on electricity prices.
Understanding the Wholesale Electricity Market
Bulk purchasing and selling of electricity, as well as gas and steam, occurs in the wholesale electricity market. These are the basics of the power market and something you can think of as US Electricity Markets 101. Participants in this market primarily include energy producers (sellers) and energy retailers (buyers). Other market participants may include financial intermediaries, power traders, and large commercial and industrial consumers.
Deregulation and restructuring were the impetus for the creation of the wholesale electricity market construct in the 1990s. The idea was that competition in the market would drive down prices paid by consumers. Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) were created at this time to control, coordinate, and monitor the flow of electricity and settlement of buying and selling of electricity.
Setting the Power Price: The Merit Order Effect
Electricity market prices are set by ISOs and RTOs by The Merit Order Effect. Available power plants are stacked and organized in ascending order by the electricity price they bid into the wholesale electricity market. ISOs and RTOs match the supply coming from the power generators with the price at which consumers are willing to pay for the electricity.
Regulated markets have a similar structure where they organize their generating fleet by the lowest marginal cost to meet system demand. The highest marginal costs of power plants are at the far right of the economic dispatch curve, which means they’re called upon last to generate electricity. This structure is intended to minimize the cost of the production of electricity.
How Resources Are Selected and Prices Are Set
The price of electricity is set by a variety of factors primarily related to supply and demand. On the supply side, also known as generation, the price of electricity is driven by the price of fuel and its availability (i.e. coal, gas), construction costs (cost to build a power plant), and fixed costs (costs not impacted by change in supply and demand). The price of electricity on the demand side, also known as load, is affected by economic activity (businesses making widgets), weather (i.e. snow, heat waves), and efficiency of electricity consumption.
ISOs use what’s called Locational Marginal Pricing (LMP). Locational refers to the clearing price at any given point on a power grid. Marginal means the cost of delivering one additional unit of power, typically in megawatts (MW). LMP is the cost of delivering one additional unit of power at a particular location on the power grid. Supply, demand, and LMPs, as well as demand response, capacity markets, and ancillary services, play crucial roles in electricity market dynamics.
Impact of Renewable Energy on Electricity Prices
Renewable energy is making an impact on electricity prices, particularly in wholesale electricity markets. Non-fossil fuel generation has no fuel costs so it can create downward pressures on prices in the market. However, intermittency of resources like solar and wind can create volatility correlating to price increases because peaking generation needs to step in to fill a supply gap.
There’s still work to be done to allow independent power producers to sell output from their renewable energy projects to retail consumers nationwide. ISOs and RTOs make the buying and selling between IPPs and retail customers fairly easy. In regulated markets, the process of buying and selling renewable energy between an IPP and a non-utility customer is generally not that easy.
Benefits of a Low Electricity Market Clearing Price
The obvious answer is that consumers pay a lower price for the electricity they’re consuming. Who wouldn’t want that? Lower electricity prices generally point to a more efficient market where generators on the supply side can more efficiently generate power for the market and consumers to buy at a lower cost.
One downside to a low electricity market clearing price is its impact on the return on investment (ROI). Developers need to be incentivized to build generation to meet the current and future needs of the electricity market. As electricity market clearing prices creep downward, how does price creep impact the investment going into new resources to supply the electricity market?
Risks of a High Electricity Market Clearing Price
Electricity is a commodity that people need so high prices hit directly at consumer’s wallets. High prices are generally correlated with high price volatility, less efficient markets, and high electricity production costs. Volatility can be hedged in the Day Ahead Market or with battery energy storage systems but inefficient markets and supply chain disruptions are more challenging issues to resolve.
The pandemic showed renewable energy developers first-hand how impactful supply chains are to their projects. Whether it was transformers getting stuck in US ports, panels getting slapped with tariffs, or a shortage of raw materials like copper, outside of unique situations, most renewable energy project costs were negatively impacted translating to higher power purchase agreement prices. This negative impact may make its way into a higher electricity market clearing price in the future.
Conclusion
Electricity market clearing price is a concept market participants in wholesale electricity markets reference all the time. The Merit Order Effect is used to stack resources to be dispatched in ascending order. As resources in the supply stack are selected, the electricity prices start to be set. Renewable energy has no fuel costs so it’ll be interesting to see how electricity prices in the supply stack are impacted over time. A low electricity market clearing price, compared to a high electricity clearing price is generally viewed as positive but it may impact future investment in the power markets.
