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most energy markets work using "spot markets", where everyone puts in an offer for how much electricity they can provide and at what price, and then everyone gets paid the highest price based on what's used. With the current excessively high prices of natural gas in Europe, this leads to absolutely massive electricity bills for consumers while also causing producers of very cheap electricity like nuclear and renewables to receive just as massive excess profits.

What I'm wondering: why is this system used? Why can't a system be used where the price is based on the actual energy mixture, such that e.g. if out of every 100 MWh used 40 is renewables at 50 EUR each and 60 is gas at 300 EUR each, the final price for those 100 MWh is 20,000 instead of 30,000 EUR? I get that might incentivize the cheaper producers asking for higher prices and thus partially negating the intended effect, but there must be a way around that?

Adam Bailey
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Nzall
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  • Note: due to my inexperience with this particular stack, I may have chosen an inappropriate tag. If a different tag is more appropriate, feel free to update it. – Nzall Aug 30 '22 at 06:42
  • What do you mean with "renewables at 50 EUR each"? Are these 50 EUR supposed to be marginal costs? – VARulle Aug 30 '22 at 08:48
  • @VARulle I have no idea how much renewables cost and just pulled a number out of thin air for a quick example. I have no idea how much nuclear or renewable energies usually cost. – Nzall Aug 30 '22 at 08:56
  • I'm not asking about the number, I want to know what "at 50 EUR each" means in your example. E.g. "producing at marginal costs of 50 EUR" or "producing at average costs of 50 EUR" or "selling at a price of 50 EUR" etc. – VARulle Aug 30 '22 at 09:07
  • @VARulle What I'm talking about is that in this example the renewable is offered at the spot auction at a price of 50 EUR per MWh, which should mean that in this example 40% of the cost of the electricity the end consumer uses should be charged at that price and not the 300 EUR that the gas price is based on. – Nzall Aug 30 '22 at 09:26
  • Well, if the gas price in a competitive market is 300 EUR, then these 300 EUR are also the marginal costs of gas-based electricity. Then why would a gas-based electricity producer sell at this "averaged" price of 200 EUR? – VARulle Aug 30 '22 at 10:45
  • @VARulle No, in this case, if the consumer uses 40 MWh at 50 EUR and 60 at 300 EUR, then those first 40% would be charged at 50 EUR, and the producer offering those would get 50 EUR, and the latter 60% would be charged and paid to the producer at 300 EUR. So they both get paid according to their offer. Though as people answered, this would incentivize the producer offering at 50 EUR to instead offer at 299 EUR such that they still get as much. I assume there might be some way to counter that, but I'm not smart enough to figure that out. – Nzall Aug 30 '22 at 12:18
  • Ah, o.k., now I understand. Yes, that would push offer prices of low-cost producers upwards. I don't see how to possibly avoid this under incomplete information about true costs, however. – VARulle Aug 30 '22 at 12:36
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    +1 You are raising an important issue, although your claim about massive excess profits is an oversimplification and likely to be country-dependent given both the high capital costs of nuclear and (in the UK at least) government subsidies for renewables where the amount of subsidy depends on the market price (see here. – Adam Bailey Aug 30 '22 at 13:20
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    @AdamBailey Many nuclear power plants have already been fully amortized by their owners and are being kept open on government orders. In Belgium, they're talking about keeping nuclear plants with microfractures in the reactor core open for a little while longer because of the gas prices. – Nzall Aug 30 '22 at 13:28
  • @Nzall: it's unclear what you mean by "most energy markets use spot markets". In fact, there are several energy markets, depending on how you look at it. Most wholesalers actually make individual contracts with exporters (sometimes over extended periods of time) to hedge against short-term volatility. So they actually use a "futures market". Of course, the spot market plays a role in the pricing, especially over time. – BrsG Aug 30 '22 at 16:40

5 Answers5

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There are two major issues to consider here, first is the difference between a typical uniform price auction used in many electricity markets and the pay as bid mechanism you're recommending. The auction design impacts bidder behavior. I'll spare the mathematical proof, but if a bidder is uncertain about what others in an auction will bid:

  • In a uniform price auction (absent market power, which is an issue separate from your concern), each bidder has an incentive to bid their true marginal cost. If they bid less, they might get stuck selling at a price below their marginal cost. If they bid more than marginal cost, they might be called on to produce zero when price was above their marginal cost and it would have been profitable to produce.
  • In a pay-as-bid auction, every bidder has an incentive to shade their bids above their true marginal cost. This leads to a case where the auction price is always above the marginal cost of the most expensive producer called upon in a given hour. So while it might "save" money in some hours with a few high-bid producers, it would lead to higher costs in general.

Second, an electricity generator will want to produce when prices are at or above their marginal costs. This means they might earn zero profits some of the time. Most methods of creating electricity, however, require expensive capital equipment and they sink these investments prior to making production decisions. Generators (can, depending on the market design) recover these fixed capital costs by selling electricity when prices are above their marginal costs. Absent periods when price are above marginal costs, a generator would never be able to cover those capital costs and would go out of business.

This also creates an incentive for new firms to enter electricity markets when prices are high. If generators are able to freely enter the market (and again I will spare the mathematical proof), they should earn just enough short-run profit to cover the depreciation of their capital. Large profits in electricity markets will lead to entry, until entry is no longer profitable.

What we're seeing in EU (and to a lesser degree other countries including the US) is the spike in natural gas prices is causing a windfall for generators who rely on other energy sources to produce electricity. If these windfalls are something people expect, there should be sufficient entry that long-run profits of generators are still close to zero. If the windfalls are unanticipated, they result in extranormal profits. Whether firms should be able to retain those windfalls is an equity or political issue, not one of economics.

Remember, however, that investors see these high current fuel prices and will respond to them by investing in new (and likely not gas-powered) generation capacity. In the end, large profits now will lead to the entry of new generation assets which will bring prices down, even if gas prices were to remain high. If you change how generators are remunerated you can destroy that incentive.

CompEcon
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    The issue here is the time frame. If a producer invests in new capacity now, it will take a few years until it becomes available on the market and needs to run for years to become profitable. If everyone expects the current gas prices are a temporary one-time situation, no investment will happen and profits still accumulate. But as you wrote, possibly capturing these profits would be a political question, not an economic one. – quarague Aug 31 '22 at 08:30
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    quarague - that was once true, but is becoming less so over time. Wind, solar pv and particularly batteries have much lower lead times than other technologies. Grid-scale batteries have been delivered in 100 days in Australia. Most countries have an absolutely ridiculous backlog of 'proposed' projects, that are already significantly progressed in planning respects, but haven't reached financial close - https://aemo.com.au/-/media/files/electricity/nem/planning_and_forecasting/generation_information/2022/nem-graphic.png? – Scott Aug 31 '22 at 22:32
  • @Scott I think just looking at lead time is misleading. Renewables do have a short lead time, but they don't add a lot of generation, so you need to repeatedly build power plants over and over until you eventually have a sizable addition, which can take a long time. Nuclear on the other hand, is the complete opposite, it has a very long lead time but a single power plant once it's up and running can add a lot of generation to the market at once. It's sort of a tortoise and hare scenario. – Crazymoomin Sep 02 '22 at 13:40
  • @Crazymoomin - that used to be true.

    Australia has recently started construction on its first gigawatt scale wind farm (capacity over 1 GW). https://reneweconomy.com.au/first-concrete-foundation-poured-in-australias-first-gigawatt-scale-wind-project/

    That is smaller than a nuclear plant, yes, but not by that much.

    Also, claiming you "repeatedly" have to do something is misleading. Multiple projects are worked on simultaneously, even by some quite small companies

    Australia installed 7 GW of large scale renewables in 2021, for a grid with approx 50 GW of total installed capacity.

     – Scott Sep 15 '22 at 06:48
  • Source for the above.

    https://www.minister.industry.gov.au/ministers/taylor/media-releases/australia-sets-new-renewables-records-2020

    And of course, Australia is a small country by population. We are roughly 1 New York City, IIRC

     – Scott Sep 15 '22 at 06:49
  • @Scott you can only build so many renewables at once, much like you can only build so many nuclear power stations. You are necessarily limited by available materials, suppliers, construction workers, and construction companies able to take on the work. Hornsea 1 is a 6GW capacity offshore wind farm in the UK, but it still took 10 years to fully construct. Assuming a 30-40% capacity factor, that's not far off how long it would take to build an equivalent nuclear power station, just you wouldn't get a gradual increase in output, it would come in chunks. – Crazymoomin Sep 15 '22 at 09:19
  • @Scott Also, I wouldn't use Australia as a good example here, for two reasons: 1. Their climate and population density is totally different to the vast majority of Europe making some renewable and storage technologies more viable, and 2. Their overall energy mix is actually pretty carbon intensive, thanks to a lot of coal burning, I think even Germany performs better, and the UK certainly does. – Crazymoomin Sep 15 '22 at 09:32
  • What kind of mathematical assumptions does a uniform price auction require to prove that each bidder has an incentive to bid their marginal cost? It seems like most large-capacity bidders can simply collude to raise their prices by e.g. 10% and still get called on to produce. Small-capacity bidders will always produce, but their total capacity is smaller than demand. I'm guessing energy supplier capacities follow a power law distribution, so there are probably few large-capacity bidders. Is there empirical evidence that this mechanism is actually working (i.e. producing marginal cost bids)? – TheIntern Oct 15 '22 at 06:26
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most energy markets work using "spot markets", where everyone puts in an offer for how much electricity they can provide and at what price, and then everyone gets paid the highest price based on what's used. With the current excessively high prices of natural gas in Europe, this leads to absolutely massive electricity bills for consumers while also causing producers of very cheap electricity like nuclear and renewables to receive just as massive excess profits.

This is actually considered a feature of the system, not a bug.

First, the system is set up not just in order to maximize efficiency but with environmental goals in mind. By rewarding renewables which generally have a very low marginal cost of producing electricity, it incentivizes people to invest in them. This in the long run increases the number of green power plants and helps to decarbonize the grid.

Second, the system actually encourages users to conserve energy when supply is limited due to exogenous shocks (eg Putin turning the gas supply off). The EU simply presently does not have enough capacity to produce abundant cheap energy without relying on Russian fossil fuels. Adopting a less efficient energy market would just mean more waste, and people would have to pay higher prices, either directly or indirectly through subsidies funded by taxes or by enduring energy rationing/blackouts.

A recent report by ACER shows that this mechanism delivers both efficiency and helps promote green energy sources. It also finds that high prices are not a result of this system but rather exogenous shocks (See ACER 2022).

Of course, it sucks to pay a high energy bill (I am an EU citizen paying these high prices too) but this is a price that has to be paid if the EU society wants to pursue green energy and keep Ukraine in its sphere of influence.

Glorfindel
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1muflon1
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  • Sorry, dumb question, I don't know much about economics; how does this system produce a greater incentive to invest in renewable than the one that would be present anyway from consumers opting for the cheapest priced energy? – Clumsy cat Aug 30 '22 at 15:44
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    @Clumsycat because then renewables would have lower rate of profit (as they would have to charge lower price - energy markets are quite competitive competition would drive the price down note a wind farm does not compete just against coal plant but other wind farms). Low rate of profit means low return for investors. Low return for investors means less incentive to invest in industry. Which business would you prefer to invest? One where you barely break even or one where you have sizable profit margin? Most people will choose the latter. This biases the capital allocation towards green energy. – 1muflon1 Aug 30 '22 at 16:52
  • This addresses how profits are allocated across domestic producers (by kind of fuel). Might be worthwhile pointing out that producers, if they rely on fuel imports, often have term contracts with suppliers, that hedge against short-term volatility. Only if fuel prices are high over sustained periods of time does it lead to distortions of current proportions. – BrsG Aug 30 '22 at 16:56
  • @BrsG that is all true although many firms hedge oil/gas just for 6 or 12 months ahead (and the Russian invasion started about 6 months ago so now firms will have to start pricing it in), also current higher price is not just a result of a quick transitory shock if USA is hell-bent on reducing its oil output, and EU hell-bent on completely cutting off Russian hydrocarbons. If there is expectation the input prices will get more higher in the long run firms might also start to adjust prices now regardless of hedging – 1muflon1 Aug 30 '22 at 18:08
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    "but this is price that has to be paid if EU society wants to pursue green energy and keep Ukraine in its sphere of influence." [citation needed]. Right now, it looks like we'll still get high energy prices, a highly dependent society on fossil fuels from other rogue states, and a lot of domestic coal. – Eric Duminil Aug 31 '22 at 08:06
  • @EricDuminil 1. Decarbonization of the grid being costly is common knowledge in environmental econ, you can look it up in any undergraduate textbook if you need source for it. 2. We will be more dependent on coal and other rogue states because green transition can’t happen overnight, and there is a of ideological opposition to Nuclear. 3. The point is that the high energy prices are not result of this but EU having less domestic hydrocarbons and being forced to get more expensive ones since hydrocarbons from Middle East or Latin America are more difficult to get to EU than from Russia – 1muflon1 Aug 31 '22 at 08:30
  • Thanks. We actually agree on those 3 points. What bothers me is that "Decarbonization of the grid being costly" (which is true) doesn't imply that if you pay a lot for electricity, you'll get a decarbonized grid. As you mentioned, with the ideological opposition to nuclear, Germany ended up paying a lot for the Energiewende and still has a pretty bad gCO2/kWh. – Eric Duminil Aug 31 '22 at 08:35
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    I'd of course note that the EU somehow doesn't consider nuclear to be green, partially due to "activists" funded by Russia. – JonathanReez Aug 31 '22 at 23:22
  • @JonathanReez From an American perspective, nuclear power being considered not green is an idea well sold by the end of the Soviet Union, with Three Mile Island and Chernobyl pretty much cementing it. I don't agree with the arguments against nuclear being green, but the arguments themselves--nuclear waste and nuclear meltdowns--are pretty clear. – prosfilaes Sep 01 '22 at 13:58
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    @prosfilaes The thing is, those arguments are purely emotional. There are actual arguments against nuclear power based on rational things like the time and cost to deploy, but no discussion ever even gets that far. – barbecue Sep 01 '22 at 18:05
  • @barbecue I don't think "most of Central Europe was covered in radioactive dust from a nuclear meltdown, leaving 2600 sq. km still uninhabitated 35 years later, and we don't want to repeat that" is purely emotional. In any case, it's not "somehow", and Russian propaganda being a major part of it seems unlikely. – prosfilaes Sep 01 '22 at 18:37
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    @prosfilaes Emotional in the sense that the risks from nuclear power are assigned much higher weight than those caused by fossil fuels. The fact that coal-fired power plants cause millions of deaths is ignored, while deaths due to a much more rare and isolated event are given undue weight. That's emotional, not rational. – barbecue Sep 01 '22 at 19:31
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    @barbecue Rare, dramatic events are much scarier than things of the everyday background. We adapt to the constant, and are hammered by surprises. So people are more concerned about the surprises, the unpredictable. That you weigh things differently is not about rationality, it's about fundamentally non-rational weights. – prosfilaes Sep 01 '22 at 19:58
  • @prosfilaes I see what you just described as an emotional response. So we seem to agree. – barbecue Sep 01 '22 at 20:29
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Because it incentivizes the cheaper producers to ask for higher prices. If the solar farm costs basically \$0/MWh and the gas turbine costs \$1000/MWh, then the solar farm has to predict whether the gas turbine will be on tomorrow, and bid $999/MWh when it thinks the gas turbine will be on. You get the exact same resource allocation and price, but now the solar farm manager has to hire someone to do the bullshit job of predicting whether the gas turbine will be on.

user253751
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  • It is not bullshit, it merely provides 0 direct benefit to society (: – Giskard Aug 30 '22 at 07:34
  • @Giskard that's what a bullshit job is – user253751 Aug 30 '22 at 07:35
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    I thought a bullshit job is one that if were it not done, not even the firm would notice. The point is the utter pointlessness, not a utilitarian pointlessness. – Giskard Aug 30 '22 at 07:37
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    I've read Graeber's essay when it came out. – Giskard Aug 30 '22 at 07:39
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    @Giskard one category of Graeber's bullshit jobs are goons that exist to fight off other organizations' goons. Those definitely help the firm. – user253751 Aug 30 '22 at 08:23
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    Indeed! – Giskard Aug 30 '22 at 08:45
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    Isn't it the gas turbine company that needs to predict whether the sun will be shining tomorrow and then set the price accordingly? – BrsG Aug 30 '22 at 16:49
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    @BrsG The gas turbine company wants to run the gas turbine whenever it generates a net profit. There's only two components to that; the cost to run the turbine, and the credits they receive for generating electricity. So, they want to set their bids such that they'll be selected to run whenever the price of electricity is higher than the operating costs to run the plant (note that the system operator picks who runs at any given time based on their bids, cheapest to most expensive). The turbine doesn't need to care about the sun at all; all they need to care about is their own operating costs – Josh Eller Aug 30 '22 at 19:24
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    @JoshEller: they want to watch their competitors though: without sun there won't be any competition from solar, so they can ask for a higher price. – BrsG Aug 31 '22 at 07:14
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    @BrsG Sure, if there was one solar plant and one gas turbine in the market, then yeah, the gas turbine could set whatever arbitrary price it wanted. In practice, there are hundreds of gas turbines that are all competing against each other. If one turbine sets its bid too high, it'll simply never be selected to run, compared to all the turbines that bid using their actual operating costs. You could collude with other turbine owners to raise the price of electricity, but that's textbook market manipulation, and is very illegal (the Enron scandal was for some slightly sneakier versions of this). – Josh Eller Aug 31 '22 at 12:47
  • @BrsG Yes, that's also true - the gas turbine company has the incentive to predict the price that will meet the demand. If it thinks $1500 will be the market-clearing price it should bid $1500 (or $1499) – user253751 Aug 31 '22 at 15:21
  • @user253751 That's not correct, because everyone who's generating electricity gets paid the marginal price for each MWh they generate, regardless of what their bid was. If you bid in $500 per MWh, but the current price is 1500, you're getting paid 1500. Bids determine when plants are turned on, not how much they get paid; if you bid 1500, then you won't be turned on until the current price is 1500. If your gas turbine costs 500 to run, you want to bid 500 (or 501). Otherwise, anytime the price is between 500 and 1500, you'll be sitting idle instead of making a profit. – Josh Eller Aug 31 '22 at 19:24
  • @JoshEller If you were the biggest generator, you might find it more profitable to withhold some power and drive the price up - up to a point. And if there is not enough power then what is the marginal price, infinity? I suppose this is the "absent market power" mentioned by CompEcon. – user253751 Aug 31 '22 at 20:02
  • @user253751 Yes, generation owners with control over a large portion of the generation in a market could attempt to withhold power and drive prices up. That's known as market manipulation, and is illegal. Regulators will generally break up companies before they get to this point, and will pay very close attention to anyone even near it. If there's not enough power, then yes, the marginal price would theoretically go to infinity. In practice, energy markets have price caps to prevent exactly this situation during shortage events (also emergency reserve markets, which is a whole 'nother thing) – Josh Eller Aug 31 '22 at 20:10
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    @JoshEller: That's how the system does work. You're replying to comments exploring the system proposed in the question, where each bidder can only receive the price they bid, and explaining why that system would be worse. – Ben Voigt Sep 08 '22 at 15:53
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I get that might incentivize the cheaper producers asking for higher prices and thus partially negating the intended effect, but there must be a way around that?

You answered it yourself. The spot market merely formalizes what people will do anyway. In a free market, cheap producers will take a guess at the marginal price and make theirs 5-10% cheaper. Nobody is dumb enough to sell at production cost when others ask twice as much and still find a buyer. The spot market formalizes that principle and removes the guesswork. The intention is that everyone bids their true price, thereby preventing hype, groupthink, and other human-related phenomena that drive stock prices up or down for no reason.

There must be a way around that?

Maybe there is, but not without heavy government intervention and price fixing. In the short term such price fixing may be feasible based on market prices from a year ago, but in the long term you need some kind of market mechanism.

Rainer P.
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The basic idea of the market is to incentivise consumers to reduce consumption at times of high demand, and producers with high-cost (inefficient) plant to keep it operable to supply into such peaks rather than to decommission it. Whether the market is set up in the optimum way to achieve this, I won't opine on.

However, there is a glaring omission from today's electricity systems: a shortage of energy storage systems. In the past, with fossil fuels, the storage was large heaps of coal and tanks of oil. When we moved to gas, the amount of stored energy was eroded because gas storage is more expensive. Moving to intermittent renewables, this weakness is now revealed. It is the inability to release stored energy into peaks, which causes the high peak prices.

Hopefully the market is now incentivising the construction of energy storage devices(*), to store intermittent renewable energy at times when there is actually a surplus to be released at times when the price is high. There are already a few days in the UK when the wholesale price of electricity goes negative because of low demand and good wind conditions. Wind turbine operators are hen paid to shut them down, because there is no consumer to match with their production. This energy should not be lost, it should be stored.

(*) I know that they are being constructed. I am invested in a couple of companies funding such developments. Energy storage should become a huge growth area. It's just moving from prototypes to grid-scale developments.

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