The Price-Bid Margin in a Highly Competitive Market

This section seeks to explain the price-bid margins described above, in the context of a market with plenty of competition between generators in the wholesale market. In other words, we will attempt to explain why, at any given point in time (such as the bidding round represented in Figure 1), some units of electricity are paid more than their bid price. In the next section, we will discuss the case where the market is not always sufficiently competitive.

First consider the relevant definitions of revenue and cost. Total revenue for any firm is simply the market price multiplied by the number of units of electricity produced by that firm. Total cost for any firm is composed of two components: fixed costs and variable costs. Fixed costs are the costs associated with inputs that cannot be readily expanded without substantial amounts of time – typically plant and machinery. Variable costs are the costs associated with dispatching marginal units of production (usually fuel and some labour costs). We have already seen that, in a competitive market, a generator has incentive to reveal its marginal or variable costs in the form of its bid price. Now we can define “economic profits” as total revenue minus total costs.[6]

The upshot of these simple relationships is that the price-bid margin can be thought of as having two components: payments that cover fixed costs (often called “scarcity rents”) and economic profits. It is important to recognize that this does not mean that generators always earn a positive economic profit. Economic profits can also be negative(whenever fixed costs exceed the price-bid margin) or zero (whenever fixed costs just equal the price-bid margin).

Scarcity rents fluctuate with demand and help compensate firms for the fixed costs associated with seldom-used units of capacity. To see this, recall that some units of capacity have high marginal cost (which is the reasons for the rising “merit” ranking in figure 1). Consider again the firm Gen A, which owns a single generating plant. In the last section, we looked at how Gen A bids a single unit of capacity in its generating plant in a single period. Gen A makes several such bids (one for each unit of its capacity) every period. Most plants have increasing marginal costs, meaning that it becomes increasingly expensive for the plant to produce an additional unit of electricity as the plant nears capacity. In a period where Gen A is called on to operate near capacity – for example, an hour when demand is particularly high due to cold weather – then its low-priced units will each earn a large positive price-bid margin.[7] These margins allow the firm to recoup the fixed costs associated with a plant that is only intermittently required to run near full capacity.[8]

In a market with plenty of competition, scarcity rents and economic profits send incentive signals to new firms considering entry into the market. These signals are important in mobilising new investment and spurring innovation that ultimately benefit consumers. Over the long term, new generators should enter the market and “compete away” any positive economic profits. However, it is important to remember that planning and building new plants can take years, so the process can be slow. Economic profits that persist for long periods of time may raise questions regarding whether the economic profits might be better shared with consumers. There are two points that should be made in response. First, it is difficult to implement a policy that would “capture” economic profits, partly because it is difficult, in practice, to distinguish between economic profits and scarcity rents. Policies to capture economic profits could easily damage incentives for investment and innovation, harming consumers in the long run. Second, any economic profits are typically passed back into the economy in the form of new investment or dividends to shareholders (including government). In this sense, depending on the ownership of shares and the government’s role in society, it may sometimes be valid to say any economic profits are widely “shared”. [9]

It is worth noting that some government polices can affect marginal costs and thus bidding behaviour, the price-bid margin and economic profits. For example, hydro firms do not always bear the full economic cost of the water that they use. A reasonable policy might be to develop a system so that water prices take into account the value of water, particularly in circumstances where water is a productive input for competing uses (eg irrigation and hydro-generation). To the extent that this raises the firms marginal costs, it would force the firm to increase its bids and thus reduce the price-bid margin and economic profits.