Why do windfarms get the gas price?

Time after time, I come across people saying that it’s madness that everyone in the electricity market receives the same price as the most expensive generator to run (typically a gas-fired power station). Such claims are in fact a misconception. It is perfectly logical, and this is an attempt to explain why.

In this example, I assume a grid with three kinds of generator:

·         offshore windfarms

·         new, efficient gas-fired power stations

·         old, inefficient gas-fired power stations.

All have capital and operating costs, and the gas-fired power stations have fuel costs as well.

The graph below shows how the unit costs might pan out. Think of these as being the charge for the year (for each of capital, operating and fuel costs) divided by the annual output.

The important thing to understand is that capex and opex costs are fixed. That is to say, they are incurred whether or not the generator gets to run. Fuel costs are variable – they are only incurred if the generator actually runs.

A generator will refuse to run unless it is at least going to cover its variable costs. For a windfarm, which has no variable costs, it means that if the market price is above zero, they are good to go. They might only bid £30 say. Then they have made what accountants call a “contribution to fixed costs”.

But, as the graph shows, once you add in the fixed costs, a windfarm needs £100 per megawatt hour to make a profit. (This is why people saying “wind has zero marginal cost” are being deceptive - who cares, when its fixed costs are so eye-watering?).

So how does it make up the extra £70/MWh? Bear with me, and you’ll see.

Because windfarms can bid so low into the market, they will always run, but that will still not be enough to meet demand, so we will need to switch on some gas-fired power stations too.

They too have to cover at least their variable costs. The graph shows that for a modern, efficient one, this might necessitate a price of £50/MWh. Let’s say they bid £55, thus making a contribution of £5 to their fixed costs.

An old, inefficient gas-fired unit, however, will need to bid at least £70/MWh. If demand is only at average levels, the new units will cover the remaining demand and the old ones will be priced out of the market.

But note again that £55 is not enough to cover the new units’ full cost of £60.

But here’s the important bit. By giving the windfarms the market clearing price of £55 – the price bid by the (new) gas-fired unit – rather than the windfarm bid price (£30), we go a long way (but not all the way) towards covering their total costs of £100.

So at the moment, the new gas-fired units have covered £55 of their £60 cost base, and the windfarms have covered £55 out of £100. So nobody is making a profit yet.

If demand is high, the old gas-fired units come into play. Knowing that they are the only option available to the grid, these will charge through the nose. If they bid, say £120, that’s what everyone else gets too. So, for a short time at least, it’s payola time – the windfarms and the new gas-fired units make lots of money, and the old ones at least get to run.

But such periods are the exception rather than the norm. On average, the new gas-fired units should be able to cover their full costs and make a profit – they don’t need many payola days to cover their remaining capex and opex costs, which are rather small. However, the old ones run so rarely, they simply can’t make enough money in the open market, and they will need subsidies to keep them afloat. These are delivered through the Capacity Market.

The windfarms also need subsidy, because they might only make £70 on average, not enough to cover their full costs of £100. The mechanism here is either the Renewables Obligation or the Contracts for Difference scheme.  

Conclusions

Giving everyone the market clearing price doesn’t lead to anyone making excessive profits. Indeed for windfarms, it’s not even enough to make them profitable.