Some Thoughts on Electricity Markets, Single Clearing Prices, and Planning

Recently, many have called for reevaluating electricity markets. In the May 2023 issue of the Energy Law Journal, FERC Commissioner Mark C. Christie argues for a reconsideration of the single-clearing price mechanism in U.S. electricity markets, and his paper addresses electricity market issues beyond the clearing mechanism. Among a long and growing list,particularly given the recent events in Europe, some examples include Carl Pechman (2021), Antonio Conejo and RamteenSioshansi (2018), and Martin Bichler et al. (2022). Capacity markets have also been the focus of much discussion (Aagaardand Kleit, 2022).

Behind the single clearing price discussion is a debate about whether markets or planning would better serve society given its goals concerning electricity. If the primary goal is efficiency, that favors markets; if the primary goal is directing outcomes, mainly driven by State policies, then that favors planning. One’s view also largely depends on where one stands on the tradeoff between inefficient government and inefficient markets. 

In response to these calls to revisit the case for electricity markets, this blog reviews and discusses some of the issues raised (with some quotations from Shakespeare along the way).Topics include the goal of electricity markets, the need for central or organized markets, choice, the single clearing price, out-of-wholesale-market payments, and integrated resource planning. It starts with a list of priorities for reforming electricity markets.

Suggested Priorities of Electricity Market Reforms

“Something is rotten in the state of Denmark.”

Priorities for electricity market reforms, in rough order of importance, are the following (not including transmission and distribution-related issues): 

• Price-responsive demand (Borenstein, 2005): Price-responsiveloads increase efficiency, lower electricity bills, reduce the need for generation, transmission, and distribution infrastructure, and improve reliability. 

• Greenhouse gas pricing (Nordhaus, 1992; Metcalf, 2009): Greenhouse gas pricing improves efficiency, lowers the cost of achieving a specific emission reduction, and can reduce, if not replace, the distortions that out-of-wholesale markets for renewables and nuclear power. 

• Reducing out-of-wholesale market payments: Electricity markets, high penetration of wind and solar, and out-of-market payments (Pollitt and Anaya, 2016; Felder, 2011) are discussed further below, but out-of-wholesale market payments undercut wholesale markets; 

• Improving resource adequacy data, modeling, and metrics (Felder 2004; Felder, 2001) and associated market mechanisms such as capacity and energy-only markets (Aagaard and Kleit, 2022); 

• Extending reliability planning should include probabilistic reliability, resiliency, and adaptability (Felder and Petitet, 2022).

• Enhancing retail electricity rate design (Borenstein, 2016; Felder and Athawale, 2014): New retail electricity rate design is needed to further price-responsive demand and to allow for the scalability of distributed generation while financially supporting the distribution system.

• Better consumer protections and information for retail and residential markets (Fowlie, 2022; Kahn-Lang, 2022; Baldwin and Felder, 2019): Retail and residential markets are prone to unscrupulous practices by a few bad actors, and low- and moderate-income households are particularly vulnerable. Better consumer protections and information could help while allowing more choice with retail electricity purchases.

The rest of the blog discusses issues raised by some calls to reevaluate electricity markets.

Free Markets vs. Efficient Market

“Lawless are they that make their wills the law.”

There is an idea of a “free market” that maximizes fundamental choice beyond notions of efficiency. The consequence of this reasoning is that RTO markets are not markets but just anotherregulatory construct. Economists have acknowledged the tradeoff between regulation and markets (Joskow and Schmalensee, 1988; Kahn, 1971 and 1988), and the choice is really about how to combine the two. A companion view to the “free market” position is that electricity markets undercut the democratic will of States, particularly given the role of States in determining generation (Christie, 2023).

The goal of RTO/ISO markets is not a “free market/maximizing choice” but efficiency, and the means to achieve efficiency are a combination of regulatory and market mechanisms. Perhaps there is some higher political objective of having decentralized or “free electricity markets.” However, as discussed below, “free markets” introduce substantial inefficiencies with limited benefits. Furthermore, the critique of RTO/ISOs for having a single clearing price is overstated because they allow for choice,as seen in the prevalence of bilateral contracting in thesemarkets, as discussed below.

Deregulation, Restructuring, or Liberalization: Efficient Wholesale Electricity Markets Require Centralization

“A rose by any other name.” 

When the “deregulation/restructuring/liberalization” of the U.S.power sector started in the 1990s, there was extensive debate regarding how electricity was similar and dissimilar to other products, particularly natural gas and other commodities. It was well-recognized that transmission and distribution should remain regulated. 

After much debate, the prevailing view was that electricity’s loop/parallel flows and the need to balance supply and demand in real-time instantaneously distinguish electricity sufficiently from other commodities. A system operator conducting security-constrained economic dispatch and unit commitment would enhance reliability and efficiency over an utterly decentralized approach, such as contract paths (also referred to as “contract fiction”) and transmission loading relief (TLR) procedures. The tradeoff here is having a decentralized market that rarely gets available transmission right and, therefore, would be inefficient or a centralized one that uses the full capabilities of the transmission system without overusing them. Some of the numerous papers on this theme include Hogan, 1995; Baldickand Kahn, 1997; Rajaraman and Alvarado, 1998. The contract path’s inefficient use of transmission is currently a motivational force in forming an organized Western wholesale electricity market.

Of course, no one word or short term captures this unique complexity of electricity’s loop/parallel flows, etc. However, the FERC’s use of the term “organized markets” to describe RTOs is sufficiently suggestive. 

Bilateral Markets Provide Substantial Choice in RTO/ISO Electricity Markets

“A sympathy in choice.”

As noted above, the importance of choice is a common theme in the critique of organized markets. RTO/ISO wholesale electricity markets allow for bilateral agreements in which buyers and sellers negotiate contracts. Market participants can sign bilateral agreements for capacity, energy, financial transmission contracts, ancillary services, load response, and numerous risk management instruments through individual negotiations and over-the-counter platforms. Critics still raiseconcerns, however, with the lack of choice in the single clearing price, RTOs/ISOs administered markets of real-time energy, day-ahead energy, and capacity markets.

I have had clients that preferred bilateral contracts and conducted almost all their transactions within RTOs/ISOs outside of the administered capacity and energy markets and other clients that conducted all their transactions within the RTO/ISO markets. Having both sets of options seems to increase, not decrease, choice. 

As an aside, casual observation of all walks of life/business sectors/areas of life confirms that we transact in numerous products and services without price negotiations. Of course, there are also many other examples in which prices are routinely negotiated. It is unclear why this definition of choice is essentialto electricity but not to going to the grocery store or why excluding or disfavoring the single-clearing-price option enhances choice or the underlying value that choice advances.

The Economic Reasoning for a Single-clearing Price in RTO/ISO Markets

“To be, or not to be, that is the question.”

Note that a single clearing price with locational marginal prices (LMPs) means that at a given location (busbar) at a given time for a given market (day ahead or real-time), the price that electricity is bought and sold is the same.

The claim that switching from a single-clearing price, also a uniform price, to some other unspecified mechanism could save electricity consumers substantial amounts of money is incorrect. Switching to a pay-your-bid approach changes bidding strategies away from suppliers bidding their marginal costs (in a competitive electricity market), thus reducing, if not eliminating,any potential savings. This lack of consumer savings is a notable finding (e.g., Wolfram, 1999; Cramton, 2003; Kahn et al., 2001) but worth recalling the reasoning behind this result. 

The industry could switch to a “pay your bid, get paid your offer” pricing rule. What would happen? Well, for those offers to sell and bids to buy that are economical, they would be submitted at the best guess of the clearing price. So, we would be back to a single price outcome, except given that it is difficult to guess what that single price is, there would be inefficiencies due to incorrect guesses or the exercise of market power due to lack of price transparency. (Bower and Bunn, 2001). Bower and Bunn, 2000 further find that a single clearing price mechanism produces the lowest prices compared to any other one. 

I have also tried a pay-your-bid, get-paid-your-offer approachwith thousands of students in a course on electricity marketsusing a stylized bidding simulation model (Farr and Felder, 2003), and they always adjust their bidding strategy to the pay-your-bid, get-paid-your-offer rule, which imperfectly mimics the single price outcome.

What about average cost pricing? Versions of average cost pricing have been tried in actual electricity markets. It is also the foundation of cost-of-service pricing in rate of return rate making and the economic critique of inefficiency. Average cost pricing was embedded in zonal congestion pricing for energy, which resulted in inefficiency and gaming, leading multiple RTOs/ISOs (e.g., PJM, ISO-NE, CA-ISO, and ERCOT) to convert to locational marginal prices (LMPs).

Also, the goal of marginal cost pricing (a redundant and seemingly contradictory term) is efficiency, not low prices. If prices for input fuels increase, such as somewhat recent natural gas prices in Europe and, to a lesser extent, in the U.S., then the wholesale price of electricity should reflect this input fuel scarcity. 

Out of RTO/ISO Market Payments are the Issue, Not Zero Marginal Cost Resources

“There is occasions and causes why and wherefore in all things.”

A vast array of subsidies and incentives are designed to increase renewable energy. Much has been written about the wholesale price implications of large amounts of zero or near-zero marginal-cost renewable resources such as wind and solar. A common claim is that these zero marginal cost resources reduce wholesale prices requiring a rethinking of market design. Significant issues with RTO markets and surrounding policies need to be reassessed. Directly relevant to this discussion is out of wholesale market payments, such as renewable portfolio standards and subsidies, that suppress the wholesale market price. Low/zero marginal cost resources are not per se the problem, but they are the problem when they have these out-of-market payments.

This issue is not new to the industry. Hydroelectric resources have zero variable costs (although their opportunity costs could be substantial). Nuclear and coal units are examples of resources with low marginal costs (before including any negative externalities). 

The problem is not with near zero or zero variable cost units; the problem is that these resources are receiving payments outside of wholesale electricity markets. Consider the following example, assume there is a resource whose total cost per megawatt-hour (MWh) equals its marginal cost. Also, assume that this resource receives an out-of-wholesale-market paymentequal to its total cost/MWh every time it generates, along with the going wholesale price. This out-of-wholesale-market payment could be from a state renewable portfolio standard, tax credits, direct subsidies, or other sources.

So how would this resource offer into the wholesale market? It would offer $0/MWh. The resource recovers its total cost if the market clears at $0/MWh. If the market clears above $0/MWh, the owner recovers its total costs plus the wholesale price. If the market clears below $0/MWh, the resource does not run and makes $0.

What is the impact of the out-of-wholesale-market payment on the market clearing price? When the market has cleared above the resource’s marginal cost, then the resource is economical to run, and this resource suppresses the market clearing price. (The market clearing price is affected by this resource since it is running instead of a more costly one.)

If the resource’s marginal cost is above the market clearing price, it depresses it by running (after all, it offered zero) to a lower level. Society is paying for a higher marginal cost resource to run instead of a lower marginal cost one. In the case of the wind production tax credit, society was willing to pay well above the wind’s marginal costs to run, resulting in wind resources bidding in negative prices (Huntowski et al., 2012; Seel et al., 2021).

The cause is not zero or near zero marginal cost resources; instead, it is resources receiving payments outside of the wholesale market. Not wholesale market design but out-of-wholesale market payments should be rethought, and meaningful greenhouse gas pricing reconsidered.

Integrated Resource Planning is No Panacea

“Every plan breaks easily because the intention is a slave to memory.”

There are advantages to integrated resource planning (IRP). The challenges, however, are long-standing: gaming of the data and process, favoring utilities, difficulties in implementation, static and inflexible plans, and time-consuming approval processes. Many utilities have divested most or all their generation assetsand are no longer relevant entities for planners. Also, numerous utilities and states exist within a power system such as PJM, so integrating the individual IRPs across utilities and states is impractical.

A Hybrid of Markets, Mandates, and Out-of-Wholesale-Market Payments Combines the Worst of Markets and Planning 

“Neither fish nor fowl.”

Both state and federal incentives and mandates direct the types and amounts of generation investment, the current model is neither IRP nor market-based, and we could end up with the worst of both worlds (Felder, 2017). 

Bearing the Risk of Bad Outcomes

“Put money in thy purse.”

Electricity markets have shifted some risks from consumers to suppliers, although not completely depending on one’s views of how organized markets are performing and the role of stakeholders in the RTO/ISO governance process (Felder, 2012). Recall that under the cost-of-service model, the utility had an obligation to serve, accompanied by the social compact (i.e., if the utility acted prudently, it would have the opportunity to recover its investments). One motivation for electricity markets was to avoid ratepayers paying for out-of-market contracts, such as PURPA ones, partially completed power plants, and power plants with extensive budget overruns. How much ratepayers pay for these excessive costs was the stranded cost debate of the 1990s. Capacity markets have limitations, and perhaps, as Aagaard and Kleit (2022) find, they result in supplier overpayments but at least do not include partially built power plants or cost overruns. Market power and manipulation are significant concerns with electricity markets (Kelliher, 2005);overcapitalization and inefficiency are considerable concerns under a regulatory model (Averch and Johnson, 1962).

Revisiting the motivations, structure, and consequences of electricity markets is an essential discussion as the industry incorporates more renewable resources, extends its reach into the transportation and other sectors, and seeks to improve its reliability and resiliency. Past debates and discussions can help inform these efforts to continue to improve the sector’s performance.