Academic journal article Baltic Journal of Economics

The Dangers of Marginal Cost Based Electricity Pricing

Academic journal article Baltic Journal of Economics

The Dangers of Marginal Cost Based Electricity Pricing

Article excerpt

Abstract

Led by energy and environmental policies the EU power sector is undergoing vast changes to achieve a market driven and sustainable future. Market based price discovery and different renewable support schemes are seen as key solutions in achieving the desired future production mix. Most liquid power markets use marginal cost based price discovery where the price is set by marginal costs of the last producer needed to cover all load, usually a fossil fuel power plant. At the same time the majority of new investments are made with significant help from government support schemes in renewable production capacities, which have very low marginal costs. The increasing share of renewable production will thus impact price levels in day-ahead markets. This paper analyses the potential impact of more renewable electricity production on price discovery in the NordPool Spot market, which already has a high share of renewable electricity traded. Results show that ceteris paribus NordPool Spot is likely to have very high price volatility in the future and alternative revenue sources are required for new investments.

Keywords: Electricity price; marginal cost; NordPool; renewable energy

Introduction

The European Union's 20-20-20 targets commit member countries to 20% renewable energy use by year 2020 with expectations for renewable electricity share as high as 60%. Even larger ambitions are being considered for 2050 with almost 100% of electricity used in the European Union coming from non-C02 emitting sources (European Commission, 2012). Increasing oil prices further encourage use of renewable energy. This topic is equally intensively discussed in Northern Europe, which has one of the world's most integrated international electricity markets - the NordPool - where all electricity trading between Norway, Denmark, Sweden, Finland, Estonia and Lithuania takes place. Latvia is expected to join NordPool in June 2013.

According to economic theory, in perfect competition market price is equal to the marginal costs of producers. The purpose of marginal cost pricing in electricity markets is to differentiate consumption by time of use and geographical area so costs could be conveyed to consumers in a fair way. Consumers on the other hand could make an informed decision about their consumption level in order to economize it (Malik and Al-Zubeidi, 2006). This is also the underlying logic for trading at NordPool. The sale price is determined by the marginal cost of all producers and the bidding price of the most expensive auction winning unit at each point in time sets the sale price for any given time (Nielsen et al. 2011). As the marginal costs are higher for fossil fuel based power plants (owing to fuel and C02 emission costs), volumes produced by such plants will eventually determine the overall price level in the region.

Such a scheme works well as long as there is some predictability in the system. However if fossil fuelled plants are increasingly replaced by renewable sources of energy the system price is likely to decrease: wind, solar and hydro power plants have no fuel or emission costs and depending on the technology used some of those plants could also be subsidised. This means that if all consumption could be covered by renewable production with low marginal costs, the price of electricity on the day-ahead market would drop. This would reduce revenues for power producers and could make it unattractive for new investors to set up new production capacity in the region. Whereas literature exists on the topic of integrating more renewable capacity to electricity markets, to the authors' knowledge broader public discussion on this issue in Northern Europe is yet to take off.

This article is set up as follows. First, relevant literature is reviewed to indicate the most appropriate costing methodology for electricity markets, showing why and how marginal costs are the best choice. Second, marginal costs of various production technologies are presented, providing a comparative overview of generators used to feed electricity to the NordPool power exchange. …

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