Sometimes an idea can be so entrenched in “common sense” that only a few question if it still makes sense. The marginal cost model in the energy markets is one such idea.
One way to validate your ideas is to apply them to similar markets. Let’s take the market for apples as an example.
In your street are two stores selling them: Paula’s Fruits and Peter’s Healthy Snacks. Paula is selling her apples for £1 each. Peter is selling his for £5 each.
Would you go to Paula, buy her apples but pay £5 for each of them, just because that’s what Peter is asking for?
That is exactly what happens in the wholesale electricity markets in most Western countries.
In Europe, solar and find farms can operate profitably if they earn between €30 to €60/ MWh (MWh = Mega Watt hour = a unit of electricity). Yet we pay solar and wind farm operators often more than £200/MWh at the moment because that is what the gas plant operators are asking for.
What is the marginal cost model?
The electricity market where buyers and sellers make deals is called the wholesale market. It is usually organised on larger platforms like Nord Pool or EEX in Europe.
Most electricity is sold on the day-ahead market, i.e. buyers and sellers agree on prices and electricity amounts one day in advance.
Buyers have until a fixed cut-off time to report how much electricity they will need in any given time interval and how much they are willing to pay for it.
Generators have until the same hour to report how much electricity they can supply in each time interval and how much they want for the electricity.
A computer algorithm will then match buyers and sellers by looking at the maximum amount buyers are willing to pay and comparing that with the number of generators ready to sell their electricity for that price.
Let me explain this with two examples:
Example 1:
Buyer 1 needs 100 MWh and is willing to pay up to EUR 50 per MWh.
Buyer 2 needs 20 MWh and is willing to pay up to EUR 30 per MWh
Generator 1 can supply up to 80MWh and wants at least EUR 30 per MWh.
Generator 2. can supply 200MW and wants at least EUR 20 per MWh Demand: 120MWh < Supply: 280MWh => Buyers set the price!
Generator 2 asks for at least EUR 20 per MWh and can supply the entire demand.
As a consequence, Generator 2 can sell 120MWh at EUR 20 per MWh to Buyers 1 and 2. At the same time, Generator 1 can’t sell any electricity as the price they are asking for the electricity is too high.
Example 2:
Buyer 1 needs 100 MWh and is willing to pay up to EUR 50 per MWh.
Buyer 2 needs 200 MWh and is willing to pay up to EUR 30 per MWh.
Generator 1 can supply up to 80MWh and wants at least EUR 30 per MWh.
Generator 2 can supply 200MW and wants at least EUR 20 per MWh.
Demand: 300MWh > Supply: 280MWh => Generators set the price!
Generator 2 sells all of its production, and Generator 1 can sell 80MWh. Because Generator 2 wants at least EUR 30 per MWh, all buyers now have to pay EUR 30 per MWh for their electricity.
Where does the marginal cost model come from?
Marginal Cost = the cost of producing 1 MWh of electricity taking into account only the fuel costs.
In the past, electricity was produced mainly from coal, oil, and gas-fired power plants. The main difference between those generators was the price of the fossil fuel they burned (coal, gas, or oil). All had similar construction costs, and all had high operating costs.
It made sense to design the electricity market so that you paid power generators based on how much it did cost to produce each additional MWh of electricity (i.e. the marginal cost).
Why it is not fit for a future with high penetration of renewable generation?
Renewable power plants are different in that they require higher construction costs (on a per MW basis) than fossil fuel generators. But they have very low operating costs (fewer people are needed, and you have less wear and tear) and no fuel costs (the sun, wind or water are free). And they often can produce electricity significantly cheaper than fossil fuel power plants today.
But we still need gas power plants to supply electricity when there is not enough wind or sunshine. This brings two problems with it:
Gas and coal power plants need to ask for higher prices for each sold MWh, as they run fewer hours but still have to pay their full operating costs, like wages and salaries.
Solar and wind have almost no marginal cost since they don’t have to pay anything for fuel. Therefore the marketplace values green electricity at €0/MWh.
The current electricity markets no longer work in a world with an ever-higher number of renewable energy generators. Today natural gas sets the electricity price most of the time if there is not enough renewable energy production. If the gas prices are too low, solar and wind projects can’t earn enough to pay for their upfront construction costs. If gas prices are high (as of now), consumers have to pay renewable energy generators more than they need.
What is the purpose of the electricity market?
What are electricity markets supposed to achieve?
1. Matching supply and demand
Consumers need a fixed amount of electricity (MWh) at a specified time (i.e. 14:00 hours).
And generators want to sell a fixed amount of electricity when they produce it, as electricity can’t be stored over long periods (yet).
2. Finding the right price
Consumers of electricity want to pay the lowest price per MWh. That’s why we ended up with auctions where generators compete with each other.
And generators need to earn enough to cover their generation costs and the costs of building the plant, plus a profit margin.
What could be an alternative price model?
Pay generators based on their levelised cost of electricity (LCOE, i.e. taking into account the construction and operating costs of the generator).
As you can see from the two points mentioned above, the current markets fulfil the first point (matching supply and demand) very efficiently.
It is the second point (finding an acceptable price) where the problem lies, as the marginal cost model is not fit for a world with a significant market share of renewable energy generators.
Generators already provide information on how much money they want for their electricity when they bid on the auctions in the electricity market. We can keep that part of the current system as well.
Buyers keep bidding for electricity based on how much they can afford to pay for electricity.
The organisers of the marketplace only have to adjust the process through which they match supply and demand in a slightly different way by calculating average electricity prices for consumers based on the different generation costs.
Let me explain it using one of the earlier examples:
Example 1: (unchanged)
Buyer 1 needs 100 MWh and is willing to pay up to EUR 50 per MWh.
Buyer 2 needs 20 MWh and is willing to pay up to EUR 30 per MWh.
Generator 1 can supply up to 80MWh and wants at least EUR 30 per MWh.
Generator 2 can supply 200MW and wants at least EUR 20 per MWh.
Demand: 120MWh < Supply: 280MWh => Buyers set the price!
Generator 2 asks for at least EUR 20 per MWh and can supply the entire demand.
As a consequence, Generator 2 can sell 120MWh at EUR 20 per MWh to Buyers 1 and 2, while Generator 1 can’t sell any electricity as the price they are asking for is too high.
Example 2: (average generation cost)
Buyer 1 needs 100 MWh and is willing to pay up to EUR 50 per MWh.
Buyer 2 needs 200 MWh and is willing to pay up to EUR 30 per MWh.
Generator 1 can supply up to 80MWh and wants at least EUR 30 per MWh.
Generator 2 can supply 200MWh and wants at least EUR 20 per MWh.
Demand: 300MWh > Supply: 280MWh => Generators set the price!
Generator 1: 80MWh x EUR 30 = EUR 2,400
Generator 2: 200MWh x EUR 20 = EUR 8,000
Total Generation: 280MWh
Total Cost: EUR 8,000
Average price: EUR 8,000 / 280MWh = EUR 28.57 per MWh vs EUR 30 per MWh with the marginal cost approach.
Buyers 1 and 2 pay EUR 28.57 for each MWh they consume. Generator 1 gets paid EUR 30 for each MWh it sells Generator 2 gets paid EUR 20 for each MWh it sells.
This system allows us to utilise the cost benefits of renewable generators while incentivising consumers to conserve electricity when the demand outstretches the renewable generation, as generators set the price in those periods.
What are the advantages?
The main advantage of this system is to decouple renewable energy electricity prices from the prices of fossil fuels. Each generator can offer prices based on its LCOE.
The risk of price cannibalization during hours with intense sunshine or wind still exists, as buyers will be setting the electricity prices during those hours. This incentivises the deployment of energy storage. Battery operators would store electricity during low-price periods to sell it a few hours later during the evening peak.
Moving away from the marginal price model will lower the average electricity prices during times of high gas or oil prices. This reduces the production costs for energy-intensive industries like steel making, pulp and paper making, data centres, etc., which will help mitigate the displacement of jobs into countries with lower electricity costs.
What are the drawbacks?
It is fair to point out that this mechanism can work in two directions. During times of extremely low gas prices (when gas is cheaper than the LCOE of renewables), the need for renewable energy generators to earn back their high upfront construction costs will increase the average price of electricity.
But these periods will reduce in frequency if we factor in the cost of carbon and the fact that gas is only seen as a transitionary fuel on our way to a 100% carbon-neutral power system.