Competitive Electricity Wholesale Markets and Uniform Pricing

The New Zealand wholesale electricity market is set up to achieve the welfare maximising benefits of competition. More specifically, the market is designed with the goal of achieving a market price equal to the industry’s marginal cost of electricity production. Around the world, all major electricity markets are based on the premise that the market price ought to reflect the marginal cost of production, including markets in Australia, North America, England and Wales, New Zealand and other markets with substantial hydro generation (such as Norway).

Figure 1 represents an exercise that is replayed many times each day in a competitive wholesale market with uniform pricing. Generators regularly provide “bids” to the market operator, indicating the minimum price for which they would agree to operate various units of capacity in a given period.[2] (In the New Zealand market, bids are submitted on an half-hourly basis.) Each individual generating firm makes a bid for each unit of capacity that it owns (ie, an individual plant bids multiple units). The market operator ranks these bids and sets the market price at the level needed to just satisfy demand.[3] All units that are bid below the market price are called on to operate and receive the market price for their production. This is why this system is referred to as “uniform pricing”: all generators supplying electricity are paid the same price per unit of electricity. Given a sufficient amount of competition, the market price determined by this system should equal the industry’s true marginal cost of production.

To understand this, note that each generator has incentive to bid a price that is equal to its marginal costs of production. Consider a firm, call it Gen A, which owns a unit of capacity that costs $30 to run.[4] When the market operator asks for bids, Gen A could bid the unit at $35, but it would run the risk of not being chosen for production at a profitable market price (eg, $32). Gen A could also bid $25, but might then be called on to produce at a market price of $28, in which case Gen A would lose money. So, it is in Gen A’s interest to bid $30, the marginal cost. If all generators follow this self-interest, then the ranking of bids should ensure that lower-cost units are dispatched first and that the market price equals the industry-wide marginal cost of production.[5]

As is apparent from Figure 1, in each period, low-bid units are paid more than their marginal cost of production – we’ll call this the price-bid margin. To some observers, this may appear inequitable. Why should a firm that signals its willingness to produce a unit of capacity at a relatively low price be rewarded with a higher market price? Isn’t this a bad deal for consumers? The short answer is that a competitive market with uniform pricing produces an efficient outcome that benefits consumers. In a competitive market, the difference between market price and a given unit’s bid price represents a legitimate scarcity rent or economic profit. However, as we will see later, if the market is not competitive, generators can earn excess or “monopoly” profits which are undoubtedly a bad deal for consumers, particularly if they reoccur frequently.

Figure 1: Determination of electricity market price under uniform pricing

Note: Based on Hunt (2002).