How the electricity market works

This post is addressed to Robert Colvile, the director of the Centre for Policy Studies, who has formed some mistaken views about what might be done to bring electricity prices down. This is understandable; there is a lot of misinformation out there, and the truth is counterintuitive. This is my attempt to explain it.

Dear Robert (if I may)

Over the weekend, you wondered why people were telling you that windfarms were very expensive. You pointed to a graph you had seen of the costs of various forms of generation, which seemed to show that onshore wind was very cheap. If the cost of onshore wind is so low, you wondered, how could more of it drive up the price of electricity?

This post is an attempt to explain what is going on.

There are three things you need to understand before we can get to the nitty gritty. Firstly, cost and price are different. Cost is what it takes you to make, buy or produce something. Price is what you sell it for.

Secondly, electricity is a commodity. In other words, when people are selling it, they are all selling the same thing.

Thirdly, everyone in the electricity market is a rapacious capitalist (just as they are in all markets).

Now to the detail. The second of these points has important implications for the way the market works. Different electricity generators have different costs - some can produce more cheaply than others. But this doesn’t make them reduce their prices - they are rapacious capitalists, after all. Instead, they try to get just as much cash for their electricity as they possibly can.

How much is that? Well, each day, everyone in the market has to make bids to deliver power the following day. Depending on demand, the grid might need more or less supply. If demand is high, they might need to call on more expensive generators to switch on. If demand is low, not so much. So the game that everyone plays is to work out who is the most expensive generator that will have to operate, and more importantly, how much they will demand to switch on. Then, everybody tries to bid, near as dammit, the same price.

The result is that everyone in the market ends up being paid more or less the same amount – the same amount as the generator who needs the most to get them to switch on. In the UK, this “marginal generator” (in the jargon) is almost always a gas-fired power station.

This all has very important implications for energy policy. For example, and for the purposes of your tweets over the weekend, Robert, it doesn’t matter whether wind is lower cost than gas-fired power or not. Everyone is paid the gas-fired price anyway! (Note the difference between cost and price here.)

Unfortunately though, these market mechanics also have important implications for your preferred energy policy – namely to increase the use of onshore wind. If you have more wind (onshore or offshore, it makes no difference), then gas-fired power stations will run less often. That means that when they do run they will have to charge a higher price. And since everyone in the market gets the same price as the gas-fired power stations, almost everybody in the market wins. They all get higher prices, paid for by consumers, except for the gas-fired power stations, who will have both higher costs and higher prices.

So to spell it out once again, a policy of expanding the use of wind power will increase consumer prices, even if the costs of wind are lower.

In a second post, I’ll show that the cost of wind isn't actually lower at all. But that’s enough for one evening.

Caveat: This is a somewhat idealised story. In reality, only a fraction of electricity is traded on the open market, with most changing hands through opaque power purchase agreements. It it hypothesised that this makes little difference at the end of the day, but it's hard to say.