What determines the value (price) of electricity?
In practice, the pricing of electricity can be a complicated story. The details are usually quite market-specific, since they are dependent on the specific policies and market operations within a particular power system; along with the value chain structure within a market (i.e. who sells what to who).
However there are some essentials and terminology that it’s important to be aware of and be able to think about, which are summarised in this article.
Whichever particular market you look at, the aim of this summary is to encourage you to recognise and consider the underlying economic “free market” value principles (from supply and demand balancing). These principles will hold even if there are reasons why changing “values” are not efficiently captured in changing “prices” in a particular country or regional system. The latter implies that electricity is not being priced in a “free market” way, for which common culprits include policy mechanisms such as subsidies or taxes; or market structures lacking competition in electricity production and/or purchase. Even if these exist, it is still worth thinking about how prices (and related business risks) might change if they were taken away in future!
It’s important to state that we are focusing here on the sale of electrical energy (i.e. being paid per MWh or kWh).
Firstly we need to differentiate which type of price we are talking about, based on where we are in the supply chain.
As the operator of a power plant, we are generally interested in the wholesale price of electricity – the price we are paid to sell electricity into the grid. That’s going to be our focus later on in this article.
However as an energy consumer, we are more interested in the retail price – the price that we pay to whoever is making this final sale. The retail price will capture a number of value additions on top of the wholesale price, not least payments for grid transmission and distribution of the electricity. Government taxes and payments to cover subsidised producers may well be included in there too, as may various other additions and profit margins accrued between the power plant and our electricity meter. Typically the retail price for a consumer may be 2-3 times the average wholesale price as a result.
(It’s important to note the use of the word “average” wholesale price here – wholesale prices can vary widely around this average, for reasons discussed later)
For example this chart is taken from the website of one of the UK’s biggest electricity retailers (SSE):
In some cases, where consumers are large (i.e. industrial or other commercial users), they may buy power directly from power plants; with the price most often set by means of a negotiated “power purchase agreement” (PPA). An increasingly popular model for smaller commercial consumers is to sign an agreement with an aggregator, who is then able to add up the demand of its multiple customers to create enough combined buying power to negotiate a better electricity purchase price (either directly from a supplier or by trading with greater buying power within an electricity market). In both cases of course, the idea is that bigger consumers can command a lower retail price than smaller ones, such as households.
Household retail electricity prices become most relevant to the business of power generation when the latter can occur at the former – most commonly by means of a solar array on a rooftop.
If a household generates its own solar electricity, then it can avoid paying for electricity delivered through the grid at retail rates. (In some markets it may even get additional financial benefits too). By comparison, if an independent power producer (IPP) builds a solar farm and sells its output into the grid at average wholesale prices, that output is less valuable in terms of £ per kWh (or your preferred unit) than is the rooftop output to the homeowner. That’s because the value to the homeowner is retail price (as an avoided cost); at least double the average wholesale price that the IPP receives (as revenue). The same principle is true of bigger consumers too – for example if a business builds a solar array atop one of its warehouses. Though the value difference may be smaller, since they may be paying less for their retail electricity than a householder in the first place.
This example is important when you think about the “cost of energy/electricity” (for example “levelised cost”, LCOE). For the household, the cost per kWh to produce electricity from their own solar array can afford to be much higher than the IPP’s cost to produce electricity from a large solar farm in the centre of the grid, because the value (price) of each kWh is much higher too. In other words, whether electricity production is profitable doesn’t just depend on the cost to produce it; it depends on the value of that electricity; which in turn depends on who is crystallising that value and what their price point is (and how many other entities, processes and profit margins it has passed through along the way).
Wholesale Prices and the “Merit Order”
In terms of “economics 101”, prices in a free market situation are determined in the following way:
- A “demand curve” describes how the level of demand for a product varies with its price. For most products, as the price decreases, the demand for it goes up (more people can afford it, or deem it worth paying for).
- A “supply curve” describes how the available supply of a product varies with its price. As the price rises, the available supply goes up (it is more attractive to sell and even suppliers with a higher cost base can make money, so enter the market)
- Where the supply curve crosses the demand curve, demand is exactly met by available supply for one particular price: the “market price”.
There are lots of reasons why prices might not be set like this in reality (each with implications as to how the status quo is maintained), for example:
- They may be capped by governments (who, to meet demand, must subsidise suppliers to enter a market that would otherwise be unattractive)
- They may be controlled by a monopoly provider (who can exert control over levels of demand by pricing as it chooses)
- They may be negotiated privately between individual purchasers and preferred suppliers (for a variety of reasons)
- There may be other barriers to suppliers entering (or indeed leaving) a market, such as long lead times or setup/withdrawal costs (making it hard for suppliers to react to demand changes fast enough)
All of the above can be applied to electricity markets, to different extents in different places.
Monopoly suppliers and buyers are still common, as is a lack of separation between electricity producers and wholesale electricity buyers (who may then become sellers of electricity on a retail level, to end consumers). Retail electricity prices are capped in many markets, requiring subsidy or support down the value chain at the wholesale level (often this value chain consist of one or more government-owned entity anyway).
In many cases though, competitive electricity markets or exchanges are used to determine wholesale electricity prices, by efficiently balancing supply with demand to set an appropriate price. The details of individual market operations can be complex and can vary, as can the timescales of different markets from long-term trades to more immediate ones; on day-ahead and shorter (e.g. 30-minute) timeframes. (Ultimately the system operator has to be able to balance supply and demand on a second-by-second basis of course, which involves financial buy/sell transactions at very short notices).
Let’s take a typical day-ahead market as an example.
On the one hand buyers of electricity submit bids saying how much electricity they want and how much they are willing to pay, with these bids covering periods during the following day (typically 30 mins or an hour). These buyers could be large “utilities” or aggregators who will then re-sell the electricity to small end-customers, or they could be large end-consumers buying directly. By adding up all this demand information, the entity who is in charge of operating the power market can create a demand curve (i.e. the total electricity requirement and its sensitivity to price in each period the following day).
Also bidding into the market are all the various suppliers – the power plants – saying how much electricity they will commit to providing and at what price. These bid amounts are stacked up in order of price, lowest first. On a plot of quantity vs. price, these stacked up bids produce a supply curve known in the power industry as the “merit order curve“. Where the last (highest) price in this stack of bids matches the demand from buyers, the market price is determined (and all buyers and suppliers in the market take this price).
The video below illustrates the merit order concept graphically, along with highlighting some important issues around the changing supply mix and electricity price; particularly how the introduction of renewable power sources can affect wholesale prices on electricity markets.
Finally, it’s important to stress that even in countries where traded electricity markets to set wholesale electricity prices are well-established, not every kWh of electricity is priced this way – a large proportion of electricity may still be sold via “bilateral” (private) trading agreements, directly between a buyer and a seller. Or, as discussed in the video, selective policy mechanisms or subsidies may distort the economics of market-based prices.
So while it’s extremely useful to consider some of the fundamental principles underlying the value of electricity, at different times and to different market players, in practice the economics of any individual power project is hugely dependent on the pricing constraints imposed by the market in which it is operating.
Merit Order Illustrated – Video
NB. For further reading around variations in wholesale electricity pricing, this article describing extremes (both and high and low) might be of interest too.
NB2. An online version of the illustrative chart shown in the video above is now available here.