Why electricity needs a market
Electricity is unusual as a product. It cannot easily be stored in large amounts, it must be produced at almost the same moment it is used, and it travels over shared wires. Even so, in many countries it is bought and sold through markets, because competition among generators can encourage efficient operation and investment. Other countries keep a more traditional model in which a single regulated utility owns generation, wires and retail supply. Both models exist, and many places use a hybrid.
This article focuses on the market model, which is how power is bought and sold between producers and suppliers.
The main players
- Generators produce electricity from sources such as natural gas, wind power, solar power, nuclear power or hydropower plants.
- Suppliers or retailers buy power in bulk and sell it to homes and businesses.
- Network companies own and operate the wires. They are usually regulated rather than competitive.
- System operators keep supply and demand matched in real time.
- Customers range from households to large industrial users.
Wholesale electricity
Wholesale electricity is the bulk power traded before it reaches the final customer. Trading happens over several time frames:
- Long-term contracts. Generators and suppliers can agree prices months or years ahead. This lets generators plan investments and lets suppliers offer stable retail prices.
- Day-ahead markets. Participants submit offers to sell and bids to buy for each hour or half-hour of the next day. The market operator matches them.
- Intraday markets. Adjustments are made closer to delivery as forecasts of demand and wind or sun change.
- Balancing. Close to or during delivery, the system operator pays generators or consumers to adjust output or use so the system stays balanced.
How prices are set
In many wholesale markets, generators offer power at prices related to their costs of running. The operator sorts offers from cheapest to most expensive and accepts enough of them to meet expected demand. This ordering is often called the merit order. In a common design, every accepted generator for that period receives the same price, set by the most expensive one needed, called the marginal unit.
This has several consequences. Plants with low running costs, such as wind and solar, tend to be accepted first. When demand is high and expensive plants are needed, the price rises for everyone. When many cheap sources are available, prices can fall very low and even go negative in some markets. Because gas-fired plants are often the marginal unit, gas prices can strongly influence wholesale power prices in many places, though the effect varies by region and hour.
Critics of this design say it can pass volatile fuel prices through to consumers and may not give enough signal for building plants that run rarely but matter for reliability. Defenders say that a single price rewards efficiency and gives clear incentives. Many governments have adjusted their markets over the years, and proposals for alternatives are widely discussed.
Capacity and reliability
Energy-only markets pay for the power actually delivered. Some regions add capacity mechanisms, which pay owners of plants, storage or demand response for being available when needed. Supporters see them as insurance for reliability; critics worry about cost and about favoring particular technologies. Concepts such as capacity factor, which describes how much a plant produces compared with its maximum potential, help show why a plant that runs rarely can still be valuable.
From wholesale to retail
Customers rarely see wholesale prices directly. Retail suppliers combine wholesale costs with network charges, taxes and levies, their own operating costs and a margin. They may buy ahead and hedge, which smooths out price changes but can mean retail prices lag the wholesale market. Tariff structures such as fixed or variable tariffs and time-of-use tariffs determine how much of the price movement customers feel.
Rules
Markets work within rules. A regulator typically monitors for manipulation and approves design changes, and rules cover how new generators connect to the electricity grid. Small rule changes can shift costs and revenues among participants substantially, so they are often contested.
Renewables and storage change the picture
As variable generation grows, markets face new questions. Wind and solar have low running costs but depend on weather, so their output may be abundant at some times and scarce at others. This raises the value of flexibility, whether from storage, flexible demand, interconnections with neighboring areas or controllable plants. Market rules determine how well these services are rewarded. Because energy storage can buy power when it is cheap and sell it when it is expensive, it is one example of a technology whose business case is closely tied to market design.
Limits and criticisms
Markets are not a complete solution. Electricity is essential, demand in the short term is not very responsive to price, and a few large companies may have market power in some areas. Prices in the market may not reflect the full social cost of emissions, which is one reason governments combine markets with other policies. Others argue that too much intervention distorts price signals and raises costs. Experiences differ by country and period, and no design is perfect.
What to take away
When you read about “the market” in electricity, it generally means a set of rules for matching sellers and buyers across several time frames, overseen by regulators, and layered under the retail prices consumers see. Understanding that layering helps explain why a rise in wholesale costs does not show up on a bill instantly, and why a change in market rules can have wide effects. This is a general explanation; specific markets have their own detailed rules.