ECON 575

Electricity Market

Semester 222
 Outline
• Characteristics of electricity market
• Cost approach
• Electricity market reform
• Peak load pricing

2
 Electricity Market (1)
• The Electricity market consists of:
– Electricity generation
– Transmission
– Distribution
• Very similar to oil and gas in which there is
upstream, mid-stream, and downstream

3
 Electricity Market (2)
• Electricity market is “special” because of its
unique characteristics with natural monopoly
– The cost of providing electricity to consumers is
lower if the power plant is very large (especially for
transmission)
– Economies of scale
– Hence, a natural monopoly case
• It makes sense to have a vertically integrated
market (one large firm) due to natural monopoly

4
 Electricity Market (3)

Source: Energy Information Administration (2019) 5

 Natural Monopoly (1)
P

PM

P*
MC
D

QM Q* Q
MR
6
 Natural Monopoly (2)
• Striving for a perfect competition market
would not work because naturally the
suppliers will be operating at a loss
• A regulated market with controlled price and
subsidy is one way to tackle this issue
– Unit subsidy could work but requires a large
amount
– Government / regulator may want to cover the
exact operating losses only
7
 Natural Monopoly (3)
P

PM

P*
MC
D

QM Q* Q
MR
8
 Cost Approach (1)
• In order to ensure that the power plant are
making “acceptable profit”, the government
would have to set a price that covers:
– Fixed cost (capital cost of building a power plant)
– Variable cost (labor, maintenance, operations,
rent)
– An “attractive” profit

9
 Cost Approach (2)
• Based on the quantity of electricity
demanded, the government would know the
required electricity generation capacity
• Automatically, the costs can be estimated
based on:
– Power plant generation capacity
– Utilization rate
– Life span of the power plant

10
 Cost Approach (3)
• With the knowledge of the year-to-year costs
and electricity generated, the Levelized Cost of
Electricity (LCOE) can be determined
• LCOE is then used to decide the price of
electricity

– The unit is $/KWh

– Don’t forget discount rate to calculate Present
Value
11
 Electricity Market (4)
• However, with a vertically integrated system,
problems exist because of lack of competition
– No incentives to minimize costs
– No incentives to become more efficient because
revenue is guaranteed
– No incentives to over-achieved (maximize profit in
one of the sector, for example generation,
transmission, and distribution)

12
 Electricity Market Reform
• Due to limitations of the vertically integrated
system, government / regulator may want to
deregulate
– Opening up specific part of the market
– The first obvious choice is to open up electricity
generation part

13
 Open Market for Generation (1)
• Open market solves all of the competition
problems, yet we know that the price of
electricity will be high
• One-way to ensure that the electricity
generation is always at the lowest price is to
have auction

14
 Open Market for Generation (2)
• Auction is done based on the market demand
– Might be for a month
– For a day
– For an hour
• Power plants will put a price for their electrical
loads (power delivery)
• The power plant with the lowest cost will
always win the first bid

15
 Open Market for Generation (3)

P
($/KWh)
Bids
Power plant Price Quantity
$/KWh KWh
A 0.72 1500
B 1.32 6000
C 1.76 3000
D 0.93 2500
Q (KWh)

16
 Further Open Market (1)
• Two types of bidding:
– One-sided bidding
• Only power plants will bid
• All the bids will be pooled by an independent operator
– Two-sided bidding by reforming the distribution
sector
• Both power plants and distribution grids will bid
• All the bids from both sides will be pooled and the
equilibrium market price is based on the intersect of
bids from producers and consumers

17
 Further Open Market (2)
• The distribution firm (grid) will submit a bid to
the independent operator based on the
demand of their costumers
– Bid will contain the price that they are willing to
pay as well as quantity
– The grid that is willing to pay the highest price will
get the “first delivery” of electricity

18
 Further Open Market (3)

P
Bids ($/KWh)
Grid Price Quantity
$/KWh KWh
1 0.55 5000
2 1.12 2400
3 1.25 1000
4 0.84 3800
Q (KWh)

19
 Further Open Market (4)
• Combining the bids from both sides results in
a supply and demand model
– Equilibrium will be determined by the market
forces
– Solves the issue of no competition and no
incentive to be more cost-efficient

20
 Pricing Issues (1)
• Another issue in electricity market is pricing because
of peak and off-peak demand
• During the peak period, large generation capacity is
needed
– Does that mean that power plants will have big
generation capacity? But that is costly!
– Electricity storage is also expensive!
• One of the solution is to price the electricity
differently during peak and off-peak to incentivize
consumers to use less during the peak period
21
 Peak-Load Pricing (1)
• One common way is peak-load pricing, especially for
vertically integrated market
• The idea is that:
– charge the consumers with the capital and the operational cost
during the peak period
– charge the consumers with the operational cost during off-peak
period
• We only do this when the quantity demanded during
peak period is higher than off-peak even after the
implementation
– In order to maximize welfare

22
 Peak-Load Pricing (2)
P

Cpeak + Ck

Cop

Dop Dpeak
Qop
Qpeak* Q
23
 Peak-Load Pricing (3)
• If the quantity demanded during peak hours
turns out to be lower than off-peak after the
implementation:
– Combine the demand by price (vertical addition)
– The MC is the addition of operational costs during
peak and off-peak period and the capital cost
– The price charged to consumers depends on the
period

24
 Peak-Load Pricing (4)
P

Cop + Cpeak + Ck

Ppeak

Pop
Dop Dpeak
Q*
Q
25
 Pricing Issues (2)
• What about the pricing issues in unregulated
market?
– The common strategy is to break the market based on
the period
• Some independent operator pools bids based on every hour
instead of every day
• In some countries, it went as far as per minute
– Another strategy is to have 2 separate markets
• Forward/Futures market (based on contract) and spot market
(real-time market)
• Different market for base load and peak load

26
 Conclusion
• Electricity market is still evolving
• Governments are aware that a smart and
sophisticated grid that could handle fluctuation in
the power delivery is required
– Especially with the addition of renewable energy that
are intermittent
– Attempting to solve the problem from the delivery side
• Another side of the story is to “nudge” consumers
behavior in regards to electricity consumption

27