To understand the difference between wholesale energy markets and traditional financial markets, it is important to understand the nature of electricity trading in comparison to financial assets such as equities, bonds and commodities. The most important difference is that electricity is produced and consumed instantly. At the wholesale level, electricity cannot be stored, so demand and supply must be constantly balanced in real time. This equilibrium leads to a vastly different market design than in ordinary capital markets.
It has also restricted access to wholesale markets because when markets are open, their intimidating technology keeps less experienced traders away. Regulators encourage traders to join the markets, but potential participants must show financial strength as well as technical knowledge in order to be granted access.
It is not advisable to deal with these markets without sufficient information, and this article is only a start.
Market organization and design
Energy markets are also heavily fragmented compared to traditional capital markets. The day-forward and real-time markets are managed and operated by Independent System Operators (ISOs). These nonprofits are organized on a physical grid arrangement commonly referred to as a network topology. There are currently seven ISOs in the United States. Some cover primarily one state, such as the New York ISO (NYISO) while others cover multiple states, such as the Midcontinent ISO (MISO). ISOs act as market operators, performing functions such as power plant dispatch and real-time power balancing operations. They also act as exchanges and clearing houses for trading activities in various electricity markets.
Although ISO does not cover the entire US power grid; Some regions, such as the southeastern states, are bilateral markets where trade is carried out directly between generators and load-serving entities. Some settlements are made through bilateral EEI agreements, which are equivalent to ISDA agreements in the electricity markets. Grid operations are still somewhat centralized in these states. The reliability and balance of the grid is handled by the Regional Transmission Operators (RTOs). ISOs are former RTOs that are eventually organized through market forces into a centralized market in the name of economic efficiency.
volatility and hedging
There is a lot of volatility in spot prices due to lack of storage and other more complex factors. Some of this implied price volatility seeks to price electricity for delivery to generators and load-serving entities at a later date, usually a day out. This is called the Day-Ahead Market (DAM). This combination of day-ahead and real-time markets is known as the dual settlement market design. The forward prices remain volatile due to the dynamic nature of the grid and its components.
Energy prices are influenced by a variety of factors that affect the supply and demand balance. On the demand side, commonly referred to as load, the main factors are economic activity, weather and general efficiency of consumption. On the supply side, commonly referred to as production, fuel prices and availability, manufacturing costs and fixed costs are the main drivers of the price of energy. There are several physical factors between supply and demand that affect the actual clearing price of electricity. Most of these factors relate to the transmission grid, the network of high voltage power lines and substations that ensure safe and reliable transportation of electricity from generation to consumption.
highway system analogy
Imagine a highway system. In this analogy, the driver will be the generator, the highway system will be the grid, and what the driver is going to see will be the load. The price will be considered as the time taken to reach your destination.
Note that I mentioned not just the roads, but the road system, which is an important nuance. The highway system is equivalent to high voltage power lines while local roads are analogous to a retail distribution system. The retail distribution system is made up of the poles you see on your street whereas the grid is made up of large electric pylons with high voltage lines. ISO and general markets are primarily related to the grid while retailers or Load Serving Entities (LSEs) get electricity from the substation to your home.
So let’s remember, cars are power, people are generators, destination (getting off the highway and not someone else’s home) is the load and the price is the time. We’ll use this analogy from time to time to explain some more complex concepts, but remember that the analogy is imperfect, so consider each context of the analogy independently.
local marginal pricing
All ISOs use a form of pricing called local marginal pricing (LMP). It is one of the most important concepts in electricity markets. “Local” refers to the clearing price at a given point on the grid (we’ll learn why prices are different at different locations in a moment). “Marginal” means that the price is determined by the cost of delivering one more unit of electricity, usually one megawatt.
Therefore, LMP is the cost of providing one more megawatt of electricity to a specific location on the grid. There are generally three components to the LMP equation: energy cost, congestion cost and loss. Energy cost is the compensation required for a generator to produce one megawatt in the plant. Losses are the amount of electrical energy that is lost while zipping along the lines.
These first two components are fairly simple, but the last one, congested, is more difficult. Congestion is caused by the physical limitations of the grid, i.e. transmission line capacity. Power lines have the maximum level of power they can carry without overheating and failing. The loss is usually thought of as heat loss because some of the power heats the line rather than simply being transferred through it.
Coming back to our analogy, overcrowding can be considered a traffic jam and the damage will be equal to wear and tear on your car. Just as you don’t worry about your car breaking down while driving to a friend, damages are fairly constant across the grid and are the smallest component of an LMP. They also mainly depend on the quality of the road on which you are driving.
looking to reduce costs
So, given that LSEs are looking to reduce their costs, they rely on ISO to send them the lowest cost generator to supply power. When a low-cost generator is unable to deliver power at a given point due to line congestion, the dispatcher will instead send a different generator elsewhere on the grid, even if the cost is higher. It’s like driving to the destination even if someone else is far away, but with the traffic so bad, the person living close by can’t even hit the highway!
This is the main reason why prices vary by location on the grid. At night, when there is less economic activity, and people are sleeping, there is a lot of space on the lines and therefore fewer crowds.
So referring to our analogy, when there are few people on the road at night, there is no traffic, and therefore the difference in prices is mainly due to damage or wear and tear of your car. You might ask: “But not everyone will take the same amount of time to drive from their home to their destination, and you said the price is the same as driving time, how could that be?”
Remember that prices are set on margin, so the price is set as the next unit to be produced, or the time it takes for the next person to drive to their destination. You will be paid for that “time”, regardless of how long it takes you to reach your destination. So staying close to your destination is the best way…