Marginal pricing in day-ahead markets

This article is the second in a series of posts, dedicated to a number of concepts with high relevance in today's electricity or gas markets. Through this series, the CREG intends to provide some clarity in increasingly complex energy markets.

Today's topic: marginal pricing

What's the issue?

The price of electricity is established according to the common economic theory of supply and demand. In the Belgian day-ahead market, which is part of a larger, coupled European market, the marginal pricing principle, also often named “pay-as-clear", dictates that the most expensive generation unit needed to cover the demand for electricity sets the price to be paid by all consumers as well as the revenue earned by all generators within one zone.

This single price for electricity is a crucial parameter in today’s electricity markets, as it aims at forming a signal for investment in generation and transmission capacity. On the other side of the value chain, it constitutes the basis on which consumers’ electricity bills are calculated, either directly or indirectly.

Why does it matter?

Electricity prices in the spotlights

During the second half of 2021, the price of electricity in European countries has risen to reach new records. The main cause of that steep increase is the recent rise in the price of natural gas across Europe. Other factors that influenced that price, yet to a much smaller extent, include an especially low renewable energy production during those months, unplanned unavailability of nuclear power plants, as well as increase in pricies for carbon allowances for emitting CO2 under the EU ETS. One could therefore ask oneself: why would the electricity prices in Europe, where natural gas only accounts for 21% of the total generation[i], be so tightly linked to gas prices? The answer is the following: electricity markets are based on the principle of marginal pricing in which the most expensive production unit selected to produce will fix the price for all other producers.

In a time of energy crisis where numerous European households will struggle to pay their bill, it is therefore rightful to scrutinize the design of our markets and to understand the rationale behind these choices.

A market price directly impacting the consumers' bill

Asking themselves the same questions, concerns were shared by governments of several EU countries that issued a common letter asking for a reform of the wholesale electricity market in order “to better establish a link between the price paid by the consumers and the average production cost of electricity in national production mixes”. [ii]

Indeed, the wholesale price of the electricity markets are directly defining the “commodity” price component of a consumer’s energy bill. Varying across countries and regions, the share of that component represented on average only 17 to 20% of the bill of a Belgian residential consumer, depending on the region, in 2020 (43% in 2021); for large industrial consumer this is far higher. [iii] Even if some components of the bill are not impacted by the recent market price increases, considering that gas power plants are the ones that mostly define the market price in Belgium and its neighboring countries, it is certain that the electricity and gas bill of the Belgian consumer will be significantly higher due to the recent market events.

A price signal for investments

Other stakeholders directly impacted by the market prices are the market participants themselves.

On the one hand, all market participants representing consumers need to pay the market price. This price, if sustainedly high, especially for market participants that did not sufficiently well hedge their positions, can lead to huge financial losses and potential bankruptcies which directly impact the end consumers.

On the other hand, all market participants get the so-called inframarginal rent, an amount equivalent to the difference between the market price and their marginal cost.  Higher inframarginal rents lead to higher potential revenues for new, low-cost generation units such as renewable energy sources. High prices therefore strongly remunerate low-operational costs units and act as price signal for new investments.

At the same time, this model has shown its drawbacks in Belgium and other countries that, for example, needed to resort to capacity remuneration mechanisms to compensate a lack of revenues from the energy market, mentioned by many investors to be a principal barrier to invest in new generation units in the last years. This is particularly relevant in light of historical low day-ahead prices and is known as the so-called “missing money problem”.

How does it work?

In a nutshell [iv]

The merit order

The sequence in which electricity producing units are asked to contribute to the supply of electricity, is called the merit order. It is constructed by sorting the units by increasing variable cost of producing one additional MWh of electricity, also known as the marginal cost of that unit.

These variable costs relate to the operation of electricity units and are mostly linked to the cost of the fuel. Fossil-fuel combustion power plants typically have high marginal costs, linked to the cost of underlying commodities such as coal, gas or oil, and the thermal conversion factors. As the prices for purchasing these underlying commodities may fluctuate heavily depending on market movements, the relative position of these production units in the merit order may change from time to time. Because of these movements, the merit order is not a static sequence.

By contrast, renewable and nuclear units have low operational costs per generated MWh of electricity, sometimes even close to zero. This means that they are found at the start of the merit order: in order to meet demand, they need to generate electricity before the more expensive units do.

When ranked according to the merit order, the variable costs of the cumulatively generated output constitute the supply curve for electricity in any given hour of the day-ahead timeframe (see blue line in the figure above).

The marginal price

At the clearing point of the supply and demand curves, the marginal price is established. This price is the revenue that all production units receive for their cleared volume, regardless of their supply bid price, and the cost that all market participants pay for their electricity offtake, regardless of their demand bid price. It constitutes one unique price per bidding zone and reflects, according to economic theory, all available information with regards to supply, demand and available transmission capacity for the system.

This is also called the pay-as-cleared mechanism and works as opposed to a pay-as-bid mechanism, where a generation unit would be remunerated according to their own cost (as declared in its supply bid) instead of according to the marginal cost of the last generation unit which is needed to clear the demand curve.

Inframarginal rents

Through the pay-as-cleared mechanism, generation units which are dispatched earn a revenue which exceeds their supply bid. This is needed to cover fixed operational costs and investment costs of these plants. The inframarginal rent (which equals the difference between the marginal clearing price and the marginal cost of a selected unit) is crucial for this purpose and serves as a long-term signal for investment into production capacity. However, these inframarginal rents can lead to high electricity prices which constitute a non-negligible cost for consumers, in particular during periods of high prices.

One step further: peak load pricing

We may wonder how these fixed and investments costs can be recovered in an energy market applying the marginal pricing which constitutes the only revenues for units with high marginal costs. Economists foresee that the revenues coming from the marginal price rule during “off-peak hours” have to be complemented by the revenues resulting from “on-peak hours” where total demand exceeds the generation capacity and must be rationed. During these periods, demand determines the electricity price as the demand’s needs are more expensive than any generators’ marginal cost. It can be shown that short-term optimal prices based on this principle correspond to optimal generation capacity: if generation capacity increases, the number of on-peak hours will decrease, reducing the revenues earned during these periods. These revenues should allow for the recovery of fixed operational and investment costs: this is called the “peak-load pricing principle”.

What role does the CREG play?

Market monitoring

Market monitoring is a key task of the CREG, assigned by European and national law. Indeed, throughout the year, the CREG monitors multiple market indicators and publishes several studies on this topic, aiming at providing a complete view on the main market price drivers as well as the behavior of market participants. In 2021, CREG published a specific report focusing on the recent surges in electricity and gas prices.

The CREG is currently studying the impact of the high prices on the profitability of different kinds of production technologies. This estimation of the occurrence of “excess profits” is an important element in the discussion on the (re)distribution of social welfare generated by the marginal pricing mechanism in day-ahead markets. 

REMIT

The CREG plays an active role of surveillance of the Belgian markets. According to the EU Regulation on Market Integrity and Transparency (REMIT), manipulations of wholesale energy markets are forbidden. To describe those manipulations, the regulation states that they involve actions undertaken by persons that artificially cause prices to be at a level not justified by market forces of supply and demand. In a world where market participants would be allowed to place bids that must also represent their capital expenses, like in a pay-as-bid mechanism, such surveillance of market manipulations would be extremely complex, creating a more favorable environment for gaming and market manipulations. 

Market design

As the Belgian federal energy regulator, the CREG plays a leading role in market design activities both at European and federal levels. Very recently, the CREG has been actively involved in the revision of the Capacity Allocation and Congestion Management regulation in which it has been proposed to keep the marginal pricing mechanism for the European coupled day-ahead and intraday auctions.

At the European level, analyses are ongoing to improve the market design, wherever possible. The CREG actively contributes to discussions on the appropriate market design, in light of the current challenges and the ambitious goals of the energy transition. Upon the initiative of ACER and the European Commission, the CREG and its colleague-regulators in the European Union are exchanging their views on the recent price increases, the impact of the market design and possible regulatory and policy measures to address the observed problems.

Want to learn more?

The CREG published a report on the root causes leading to the recent surges in electricity and gas prices for the wholesale and retail market segments (available in EN, FR and NL).

A dedicated chapter on day-ahead markets (including observed prices and what drives them) is included in the CREG’s annual monitoring reports. The most recent edition is the Monitoring Report 2020 (study in EN with summaries in NL and FR).

In response to a request from the European Commission, ACER analysed the root causes of the recent price spikes against the backdrop of the current wholesale market design for natural gas and electricity. The marginal pricing of electricity in the day-ahead market and the underlying drivers is explored in this Preliminary Assessment. (link) The final assessment is foreseen in April 2022.

Footnotes

[i] International Energy Agency (IEA), https://www.iea.org/regions/europe, 2019

[ii] https://www.politico.eu/wp-content/uploads/2021/10/06/Common-Statement-Energy-prices-2-1.pdf

[iii] https://www.creg.be/nl/consumenten/prijzen-en-tarieven/infografieken

[iv] In order these mechanisms properly, simplifications needed to be introduced to avoid an overly complex image. In the real-life functioning of the day-ahead price formation mechanism, additional aspects such as co-optimization, complex products, convex hull pricing, flow factor competition et cetera can have an impact on the outcome of the market clearing mechanism.