A Crash Course in Locational Marginal Pricing
Deregulated electricity markets in the US determine the price of electricity by what’s called Location Marginal Pricing (LMP). ISOs use different methods to determine LMPs so for this blog post we’ll assume all ISOs use the same method for price formation for simplicity. Locational Marginal Price is one of the most important concepts in electricity markets for market participants. In this blog post, we’ll explain Locational Marginal Price, the benefits of LMP for price discovery, and the potential drawbacks of the LMP model.
What is Locational Marginal Pricing?
The Locational Marginal Price (LMP) is made up of two parts, Locational and Marginal. Locational is the price electricity clears at a specific location on the electricity grid. Marginal is the price set by delivering one more unit of power to the electricity grid, typically in megawatts (MW). In other words, LMP is the cost to provide one more unit of power at a specific location on the electricity grid.
Three components make up the LMP - energy cost, congestion, and losses. Energy is the amount paid to a power plant to generate one more unit of power at their plant. Congestion happens when low-priced electricity is unable to freely flow to a specific location on the electricity grid due to transmission line capacity limits. Power lines have a limit to the amount of electricity they can move without failing or overheating. Losses occur when electricity moving through the transmission lines heats the lines instead of transiting through them.
LMP Benefits
One of the principal benefits of Locational Marginal Pricing is that it provides the market with a transparent way to allocate and price for the usage of the transmission system. This transparency sends price signals to market participants for where to invest in new resources on the electricity grid and the implementation of demand response.
LMP also shows grid operators where congestion is occurring along with losses on the system. Too much congestion or losses may indicate an area to invest in new generating resources, the addition of new transmission lines, or the repair of existing transmission lines with consistent higher-than-expected losses. Energy costs, congestion, and losses drive Locational Marginal Prices higher impacting buyers of electricity.
LMP Drawbacks
Two drawbacks come to mind when a market implements Locational Marginal Pricing. The first is complexity for customers. Average customers may find it challenging to understand how the confluence of the energy cost plus congestion and losses equals the LMP. Customers in regulated markets may prefer a structure where the incumbent regulated utility sets pricing based on how it chooses to operate the generation assets in its service territory.
A lack of transparency from the grid operator on how it dispatches the lowest-cost resources on the grid has been another noted concern. However, this may fall into the “would you rather” camp where a regulated market provides customers little-to-know price transparency and dispatch decisions relative to independent system operators and regional transmission organizations being held accountable by stakeholder groups.
LMP vs. Traditional Pricing
Electric utilities in regulated states are overseen by state regulators who help these utilities set electricity prices. One of the goals of a state’s public utility commission or public service commission is to prevent utilities from overcharging customers for electricity. Retail electricity prices are set by state regulators based on the utility recovering its investment and operating costs along with a fair or reasonable rate of return for its investments. The state you’re located in determines if regulators fully regulate electricity prices or have unregulated prices for power generators and regulated prices for the cost of transmission and distribution.
Deregulated electricity markets are structured such that power generators sell their output to retail electricity providers who set prices for consumers they’re selling to. Independent system operators or regional transmission organizations dispatch generating resources by the least cost the generating resource bid into the market. Electric utilities can own the generation, transmission, and distribution, or only the distribution but are not the entities setting the price of electricity.
LMP and Renewable Energy
Renewable energy projects have no fuel costs so many of these units offer their electricity into the market at $0/MWh to ensure the market operator dispatches their generation at full capacity. Absent incentives, if the Locational Marginal Price dips below zero, renewable energy projects will not deliver their electricity to avoid paying to use the electricity grid. Nuclear generation can be different than solar and wind generation resources in that it’s challenging operationally to throttle its electricity output as nuclear plants want to be dispatched at their most efficient output (typically in the 90%+ range).
Locational Marginal Price (LMP) can play two important roles concerning the development of renewable energy projects. First, LMPs provide price signals to developers to show where on the electricity grid it makes the most sense to develop renewable energy projects. If an LMP is high in a particular area, this may signal to developers that this area is potentially an ideal area to develop a project. Second, the price signals provided by the LMP can show how to more efficiently manage their electricity output and avoid expensive upgrades to the transmission system.
LMP in Other Regions
The US electricity grid is comprised of three regions - Western Interconnection, Eastern Interconnection, and Electricity Reliability Council of Texas (ERCOT). With these three regions, seven grid operators manage all aspects of their respective electricity grid. These operators are ISO New England (ISO-NE), Midcontinent Independent System Operator (MISO), PJM Interconnection (PJM), Southwest Power Pool (SPP), California Independent System Operator (California ISO), New York Independent System Operator (NYISO), and ERCOT.
Each of these grid operators utilizes some form of Locational Marginal Pricing. Market participants can use this pricing as a signal on how to operate their generating portfolio and where to invest in developing new generation resources. For example, an asset owner may not want to generate electricity if congestion is high or a developer may choose to develop a new solar or wind project in a location where the LMP is high. Price signals can be valuable for both of these participants in the market.
LMP and Grid Modernization
A modern electricity grid is aided by Locational Marginal Pricing (LMP) in that pricing signals where the grid is congested as well as where it may make sense to add new generating resources. LMPs can drive both the deployment of new generating resources like solar and wind but also assist in the operation of existing resources on the grid. Managing the electricity grid in an economically efficient way benefits market participants along with end-use customers like you and me.
As a developer, smarter grids incorporating data like Locational Marginal Pricing are exciting because of the pricing signal LMPs provide. Higher LMPs can translate to higher project revenues that drive higher returns for operating projects. In addition, LMPs indicate where it may make sense for developers to develop new projects.
Conclusion
Locational Marginal Pricing (LMP) is the price to deliver one additional MW of electricity to a specific location on the electricity grid. The energy cost, congestion, and losses make up the LMP. Losses are typically consistent while higher energy costs and congestion increase the LMP and vice versa. Benefits of LMP include pricing signals on where congestion is occurring as well as where to locate new generating resources. Drawbacks can include the complexity for customers in understanding how the LMP is calculated and how grid operators dispatch resources. All in all, markets incorporating locational marginal pricing provide signals to participants on how to manage their generating resources and where to potentially place new resources.
