How Wholesale Electricity Markets Work

Came and Dupuy (2005) give an overview of the economics of wholesale electricity markets. There are several points worth recapping here:

As a rule, markets work best when the market price is determined by the marginal cost of production. 

• As a rule, markets – not just for electricity – allocate resources efficiently because the market price is determined by the marginal cost of production. To understand why, consider a situation where price is higher than marginal cost: this is clearly inefficient because some producer could supply another unit and more than recoup all the costs associated with that unit (ie, the marginal cost). In other words, consumers are needlessly forgoing a unit of output which could feasibly be produced at a price they are willing to pay. Conversely, if price is lower than marginal cost, there is inefficiency because at least one unit is being produced that costs more than the going price.
• A well-functioning, highly competitive market tends to produce a market price that is equal to the industry’s marginal cost of production. That is, the market price equals the cost of bringing the last (marginal) unit of capacity into production in any given hour.[1] In this way, existing generation capacity is managed efficiently on an hour-by-hour basis. If a wholesale market is well-designed and sufficiently competitive, this works well: the available generating units with the lowest costs are called on first. High-cost units run infrequently – typically during periods of high (or “peak”) demand.

Figure 1: Wholesale Market Pricing

In uncompetitive markets, individual producers can exercise market power and raise the market price above marginal cost.

• 'Figure 1 is a stylised representation of a wholesale market during a typical hour (or half-hour) period. In each period, generators “bid” the price at which they would agree to operate various units of capacity.[2] The market operator ranks these bids and sets the market price at the level of the last bid needed to satisfy demand.[3] If the market is highly competitive, the bid ranking traces out an industry marginal cost curve,[4] and the market price is set by the intersection of demand and marginal cost. The difference between the market price and a given unit’s bid price reflect “scarcity rents” which allow firms to recover capital costs. These scarcity rents thus play an important role in providing incentive for new investment in the long term.
• However, in less competitive markets, individual producers can affect the market price. In this situation, it can be profitable for an individual firm to withhold output and thereby drive up the market price to earn “excess” profits on the remaining output. This is known as the exercise of market power.[5] It hurts consumers and is bad from an overall efficiency point of view.[6] International experience has shown that wholesale electricity markets can be susceptible to this problem – for reasons that will be explained below.

Figure 2: New Zealand Wholesale Market Spot Prices

Source: www.comitfree.co.nz

In practice, wholesale prices can be volatile. (Figure 2 shows average monthly spot prices in the New Zealand wholesale market. This averaging of course masks volatility at the hourly level.) As we will see, price spikes may sometimes be a result of market power, but in competitive markets price spikes provide important signals for investment.