Why does wholesale pricing matter to retail buyers?
If you are a retail energy buyer, why should you care about wholesale markets? Retail electricity pricing depends heavily on what takes place in wholesale markets. Understanding how wholesale pricing and markets work will give you a much clearer understanding of what drives both short- and long-term price movements and to adapt your purchasing strategy accordingly.
This article aims to give you an overview of how wholesale prices are determined and the individual cost components. It also provides an overview of some of the major differences in market structure and rules among states and ISO regions. We close with takeaways intended to help you think through price movements in your market and how this can help you optimize your energy management strategy.
Energy Cost Components
In most markets, there are four main components to a wholesale electricity price in a competitive market:
- Energy – the actual commodity consumed by customers
- Capacity (“reliability”) – the service of making a resource available for dispatch, if needed
- Ancillary services – additional services to ensure the grid runs properly
- Transmission congestion & losses – the cost associated with (1) delivering power across congested transmission lines with insufficient capacity and (2) losses from transmitting power over a distance
Different ISOs use different terminology and cost systems to account for these components, but they all factor these four components into the price somehow. Typically, energy comprises the majority of the price, followed by capacity, but other components can add considerable costs in certain situations.
Locational Marginal Price
The ultimate price of a unit of electricity (MWh) is typically referred to as a “locational marginal price” (LMP). It is locational because there are costs associated with transmitting the electricity from the generation source to the location (“node”) where it is consumed. “Marginal” refers to the fact that the cost of all the electricity consumed at a given time and place is determined by the most expensive (“marginal”) resource in the mix.
Forward, Real-Time, and Contracted Pricing
Wholesale pricing is determined through a combination of:
- Auction-based market pricing – forward pricing determined through an auction with a “uniform clearing price;” forward pricing auctions take place a day, week, month, year, or multiple years in the future.
- Real-time (“spot market”) pricing – reflects price adjustments based on market conditions when the power is consumed (fuel prices, congestion costs, etc.)
- Bilateral contracts – contracts between a supplier and a buyer without ISO oversight of the pricing agreement. The supplier is typically either a generation facility or a retail supplier, while the buyer is a retail supplier, utility, or end-user.
Retail energy purchases are made under bilateral agreements. However, this article focuses on forward pricing (for energy and capacity), which is instrumental in determining the price charged for retail energy.
The Auction Process
The auction process is designed to match electricity supply to demand at the lowest possible price point. The ISO, which oversees the process, predicts the hourly demand. Each generator offers a specific amount of generation capacity (supply) into the market at specific prices. In theory, the offer prices are based on the cost to operate the facility.
Once the offers are made, the ISO sorts them in ascending order to determine how much supply is available at different price points. It then selects the “winning” bids – the lowest-priced combination of offers required to meet demand – which will be dispatched at the hour dictated by the auction. The clearing price is set based on the marginal (most expensive) unit of generation required to meet demand.
To illustrate, the following table shows a hypothetical auction involving seven capacity offers at different price points. Note that demand response is bid along with the generation resources.
In this example, let’s say demand is 2,000 MW at a particular time of day. That means the cheapest 2,000 MW will be dispatched and awarded the market clearing price. The chart below shows the supply available at each price point. The line represents demand. Any offer below that level of demand will be accepted; any offer above will not. Gas plant #1 represents the marginal resource, at $50 per MWh, which means every generator receives $50 per MW that hour, as can be seen in this chart.
Let’s extend this example throughout the day. Now, hourly demand varies from 2,000 MW in the middle of the night to a peak of 3,400 MW at 5 pm. Let’s also assume that all the same set of resources and pricing is available throughout the day – Under those assumptions, you get the following hourly pricing:
This is a simplification, of course. In reality the supply curve is never constant throughout the day; wind generation varies, transmission congestion affects plants differently based on their relative locations, gas-fired generation varies if gas supplies are constrained, resources may go offline or be bid into other markets throughout the day, etc.
A discussion on Michigan.gov describes four retail electric market structures: auction/RFP (PJM and New England), no default service (ERCOT), market pass-through (New York), hybrid/limited competition (Michigan, Ohio, California). The links below provide detailed overviews of each ISO’s market structure:
Note: California, states participating in the Southwest Power Pool, as well as three Canadian provinces operate wholesale power markets governed by ISOs. This article focuses on US markets offering retail electric competition.
Understanding wholesale electricity prices and specific rules in your ISO region can help you understand the factors that affect local electricity pricing. It helps you to understand the importance of factors like time-of-use pricing and the value of services like demand response. And it helps you understand the trends shaping your local market, such as constrained gas supplies or transmission constraints, which enables you to decide whether to lock in a long-term price to defend against future increases or select a variable rate that can take advantage of falling electricity prices. Armed with this knowledge, you will be able to negotiate the best possible pricing and contract terms and determine which other measures can help you optimize your electricity use and management practices.