Electricity market

Based on Wikipedia: Electricity market

The Invisible Auction That Powers Your Life

Every time you flip a light switch, you're the final link in one of the most complex trading systems ever devised. Somewhere, milliseconds before that bulb illuminates, a cascade of transactions has already occurred—generators bidding against each other, grid operators making split-second decisions, and prices fluctuating more wildly than any stock market you've ever seen.

Peak electricity prices can soar to one hundred times their off-peak levels.

Think about that for a moment. Even the most expensive beachfront hotel room in summer only costs three or four times what you'd pay in the dead of winter. But electricity? The same product, delivered through the same wires to the same outlet, can cost a hundred times more at 6 PM on a sweltering August evening than it does at 3 AM on a mild spring night.

This is the strange world of electricity markets—a system so peculiar that economists have spent decades trying to figure out how to make it work properly. The fundamental problem is deceptively simple: electricity cannot be stored in meaningful quantities. Unlike oil that sits in tankers, grain that fills silos, or even airplane seats that can be held until departure, electricity must be produced and consumed in the exact same instant. Supply must match demand not just every hour, but every second.

How We Got Here: A Brief History of Electric Power

When Thomas Edison and his contemporaries first started selling electricity in the late 1800s, nobody regulated it. You bought power from a producer who built their own network of wires to reach your home or factory. It was like having multiple competing subway systems, each with their own tracks—wasteful, chaotic, and ultimately unsustainable.

Governments stepped in. By the 1950s, every developed country had created some arrangement to manage this essential service, but the solutions varied wildly.

France, Italy, Ireland, and Greece each created a single government-owned company that did everything—generated the power, transmitted it across high-voltage lines, distributed it to neighborhoods, and billed the customers. One company, one system, one set of rules.

The United Kingdom took a different approach. The government owned the Central Electricity Generating Board, which handled generation and transmission, but then split distribution among fourteen separate electricity boards scattered across the country. Think of it as the government controlling the power plants and major highways, while regional authorities managed the local streets.

Germany mixed things up further, combining a handful of regional companies that generated and transmitted power with municipal utilities handling the final delivery to homes and businesses.

Japan divided the entire country into ten territories, each controlled by a single vertically integrated monopoly—companies that owned everything from the power plants to your electric meter.

And then there was the United States.

The American system defies simple description. Some states like Hawaii relied entirely on privately owned utilities. Nebraska went the opposite direction, with only publicly owned power companies. The Tennessee Valley Authority—the country's largest generation company—is owned by the federal government. The Los Angeles Department of Water and Power belongs to the city. Countless small towns formed municipal utilities or joined together in rural electric cooperatives. Regulation favored local and cooperative ownership, creating a patchwork that reflected American federalism at its most fragmented.

Despite their differences, these systems shared common features. There were no competitive markets. No formal wholesale trading. Customers had exactly one choice: the utility that served their address. Prices were fixed by regulators and barely changed regardless of actual costs. You paid the same rate whether electricity was abundant or scarce.

The Revolution: Turning a Public Service into a Commodity

Chile, of all places, started the revolution. In 1979, amid broader economic reforms, the country began restructuring its electricity sector. By 1982, new laws had codified these changes, creating competitive markets where generators bid against each other to supply power.

A few years later, two American economists, Paul Joskow and Richard Schmalensee, published a book that would reshape how policymakers thought about electricity. "Markets for Power: An Analysis of Electrical Utility Deregulation" argued that competition could work in electricity, at least for generation. The wires themselves would remain natural monopolies—it makes no sense to build parallel sets of power lines—but the power plants at one end and the retailers at the other could compete.

The philosophical shift was profound. Electricity was being transformed from a public service, like sewerage, into a tradable commodity, like crude oil.

Around the turn of the 21st century, country after country restructured their power industries. The United Kingdom dismantled the old Central Electricity Generating Board. Australia created competitive wholesale markets. Parts of the United States embraced retail choice, allowing customers to pick their electricity supplier for the first time.

But the transformation was never complete. As of the 2020s, traditional regulated monopolies still dominate large swaths of North America. The debate over which system works better continues.

The Unique Physics of Electricity Markets

To understand why electricity markets are so strange, you need to understand what happens inside the grid every single second.

When you turn on your air conditioner, you're not drawing from some reservoir of stored electricity. You're creating an instant demand that must be met by a generator somewhere producing more power at that exact moment. The grid must balance continuously, with supply matching demand within fractions of a second.

The safety margins are terrifyingly thin. Often, the only buffer is the kinetic energy stored in the physically rotating machinery—the massive turbines and generators spinning in power plants across the grid. These machines act like flywheels. If demand suddenly exceeds supply, they slow down slightly, releasing their stored energy to cover the gap. If supply exceeds demand, they speed up, absorbing the excess.

This is why grid operators care obsessively about frequency. In North America, the grid runs at 60 hertz—the generators complete sixty rotations per second. In Europe and most of the world, it's 50 hertz. When supply and demand are perfectly balanced, the frequency holds steady. When they're not, it drifts.

The frequency cannot drift far. Most electrical equipment is designed to operate within a narrow band. Push the frequency too high or too low, and devices start disconnecting automatically to protect themselves. If enough equipment disconnects, the grid can cascade into blackout.

This creates an economic problem unlike any other market. A typical consumer has no idea what the current grid frequency is. They pay the same fixed price per kilowatt-hour whether the system is strained to breaking or awash in surplus power. They can suddenly decide to run their dishwasher, turn on every light in the house, or fire up an electric vehicle charger—and somewhere, instantly, a generator must respond.

The Complications of Generation

Different power plants respond at vastly different speeds.

Natural gas turbines can ramp up in five to thirty minutes. Coal plants take hours. Nuclear facilities, with their complex safety systems and thermal dynamics, need even longer. You cannot simply call a nuclear plant and ask them to double their output in the next ten minutes.

Many fossil fuel plants cannot even be turned down below a certain level. They might be able to run at full capacity or at sixty percent, but not at twenty percent. Shutting them down entirely and restarting later is expensive and time-consuming, so operators often keep them running even when electricity is temporarily abundant.

Now add renewable energy to the mix. Solar panels produce power when the sun shines, not when customers need it. Wind turbines spin when the wind blows, which might be at 3 AM when demand is lowest. These variable renewable sources can ramp up or down from one minute to the next based solely on weather conditions, creating challenges for grid operators trying to maintain balance.

The result is a market where supply cannot always respond smoothly to demand, where the product cannot be stored, where prices must somehow coordinate the actions of thousands of generators and millions of consumers in real time.

How Wholesale Markets Actually Work

Modern electricity markets solve this coordination problem through auctions—continuous, rapid-fire bidding processes that determine which power plants operate and at what price.

Here's how it typically works. The market operator—an independent entity responsible for keeping the grid balanced—collects bids from generators. Each power plant submits an offer specifying how much electricity it can produce and at what price. The operator then stacks these bids from lowest to highest, creating what's called a supply curve.

Simultaneously, the operator forecasts demand for each time interval—usually in chunks of five, fifteen, or sixty minutes. They dispatch the cheapest generators first, working their way up the supply curve until they have enough power to meet expected demand. The last generator needed to balance supply and demand sets the clearing price.

This is where things get interesting. Most electricity markets use what's called marginal pricing or pay-as-clear settlement. Every generator that's dispatched receives the clearing price, not their individual bid price.

Imagine three power plants bid into a market. Plant A offers electricity at $20 per megawatt-hour, Plant B at $40, and Plant C at $60. If demand requires all three plants to run, the clearing price becomes $60—and all three plants receive that price, even though Plants A and B bid much lower.

This might seem unfair, as if Plants A and B are receiving windfall profits. But economists argue this system encourages generators to bid their true costs. If you're Plant A and you know you'll receive whatever the clearing price turns out to be, you have every incentive to bid low enough to ensure you get dispatched. Bidding higher than your actual costs just risks being left out of the market entirely.

The alternative, called pay-as-bid settlement, creates perverse incentives. If generators receive exactly what they bid, then everyone tries to guess the clearing price and bid just below it. This rewards sophisticated market players who can estimate other bids and punishes smaller participants. It also makes the market less transparent—new entrants cannot simply look at current prices to decide whether their plant would be profitable.

Ancillary Services: The Unsung Heroes of Grid Stability

Selling energy is only part of the story. Electricity markets must also procure a variety of supporting services that keep the lights on but don't directly produce power.

The most important of these are reserves—generators standing ready to produce electricity if needed but not actually running. Think of them as the backup quarterback, suited up and watching from the sidelines.

Spinning reserves are generators already synchronized to the grid and running at partial capacity, able to ramp up within minutes. Non-spinning reserves are offline but can start quickly. Operating reserves provide a broader cushion against unexpected demand spikes or generator failures.

Then there's frequency regulation—generators that continuously adjust their output up and down in response to second-by-second fluctuations in grid frequency. These plants might be told to produce slightly more power one moment and slightly less the next, smoothing out the tiny imbalances that could otherwise accumulate into larger problems.

Voltage control and reactive power management address the electrical engineering realities of alternating current transmission. Without getting too deep into the physics, power grids need to maintain proper voltage levels throughout the network, which requires generators and specialized equipment to provide or absorb something called reactive power—a concept that makes electrical engineers' eyes light up and everyone else's glaze over.

None of these services produce electricity that anyone directly consumes. In a pure energy-only market, the providers of these services would earn nothing. Yet without them, the grid would collapse. Modern electricity markets must therefore create separate mechanisms to compensate these essential but invisible contributions.

The Capacity Problem

Here's a troubling scenario that illustrates why energy-only markets struggle.

Suppose you want to build a new power plant. You run the numbers and discover that, in a typical year, wholesale electricity prices would cover your operating costs with a modest profit on most days. But your plant would only be truly needed—and therefore truly profitable—during a handful of extreme demand days when prices spike to a hundred times normal.

Now imagine those extreme days don't materialize. Maybe it's a mild summer. Maybe a competing plant starts operating. Your expensive facility sits idle for months, then years, hemorrhaging money. Eventually you go bankrupt, the plant closes, and when an extreme weather event finally does occur, there isn't enough generation capacity to meet demand.

This is called the missing money problem. Energy-only markets may not provide enough revenue to maintain adequate generating capacity for worst-case scenarios. Plants that are rarely needed but occasionally essential cannot survive on energy sales alone.

Many markets address this through capacity mechanisms—separate payments to generators simply for existing and being available if needed. These capacity markets essentially pay power plants to be ready, whether or not they ever produce a single electron of electricity.

Critics argue that capacity markets are expensive subsidies for inefficient old plants. Supporters counter that they're essential insurance against blackouts. The debate continues in regulatory proceedings and academic journals around the world.

The Transmission Puzzle

Electricity must flow through physical wires, and those wires have limits.

The transmission network is like a highway system. Some routes can handle heavy traffic; others are narrow country roads. When too much electricity tries to flow through a constrained pathway, operators must redirect power through less efficient routes or limit generation in certain areas.

This creates what economists call congestion—not the traffic kind, but the electrical equivalent. A generator in one part of the grid might be the cheapest option to serve customers in another region, but if the transmission lines between them are maxed out, that cheap power cannot reach those customers. Local generators must be dispatched instead, even at higher cost.

Sophisticated markets handle this through locational marginal pricing, also known as nodal pricing. Rather than having a single wholesale price for an entire region, the price varies at each node—each point where electricity is injected into or withdrawn from the grid. A generator in a congested area might receive a different price than one in an uncongested area, even though both are selling the same product.

This creates markets for transmission rights—financial instruments that pay out when congestion occurs between two locations. If you're a generator stuck behind a transmission constraint, you might buy rights that compensate you when your cheap power cannot reach customers. If you're a trader betting on grid congestion patterns, you might speculate on these rights the way others speculate on oil futures.

The Retail Side: Where Most People Meet the Market

Most consumers never interact with wholesale markets directly. They see only their retail electricity bill—a simplified summary that obscures the complex trading happening behind the scenes.

In traditional regulated markets, the price consumers pay bears little relationship to real-time wholesale costs. Regulators set rates based on the utility's average costs over a year or more. When wholesale prices spike during a heat wave, retail customers see no change in their monthly bill. When prices plummet overnight as demand falls, customers don't benefit either.

Some restructured markets allow retail choice—customers can pick their electricity supplier, much like choosing a cell phone carrier. Retailers compete by offering different pricing plans, renewable energy options, or customer service approaches. They buy power wholesale and resell it to homes and businesses, profiting on the margin.

More recently, some markets have begun experimenting with real-time pricing for retail customers. Smart meters can track consumption by the hour or even by the minute, and some utilities now offer plans where prices vary based on wholesale market conditions. Customers who can shift their electricity use to off-peak hours—running the dishwasher at midnight instead of 6 PM—can save money while helping balance the grid.

These dynamic pricing schemes remain relatively rare. Most consumers still pay flat rates, insulated from the wild price swings happening in wholesale markets. Whether that insulation is a feature or a bug depends on your perspective.

The Carbon Question

Electricity markets have an externality problem. When a coal plant generates power, it produces not just electricity but also carbon dioxide—a greenhouse gas that contributes to climate change. The market price for electricity doesn't automatically account for this environmental cost.

Carbon pricing attempts to correct this. Cap-and-trade systems set a limit on total emissions and create tradable permits that polluters must hold for each ton of carbon they release. Carbon taxes directly charge emitters based on their pollution. Either way, the goal is to make the price of electricity reflect its true cost to society, including environmental damage.

When carbon has a price, the economics of different generating technologies shift. Renewable energy, which produces no direct emissions, becomes more competitive. Coal, the most carbon-intensive fuel, becomes relatively more expensive. Natural gas, which emits less carbon per unit of electricity than coal, falls somewhere in between.

The interaction between carbon markets and electricity markets adds another layer of complexity to an already intricate system. Generators must now factor carbon prices into their bids. Wholesale prices reflect not just fuel costs and plant efficiency but also the value of emission permits. The marginal generator—the one setting the clearing price—might be different when carbon is priced than when it isn't.

The Rise of Distributed Energy

For most of electricity's history, power flowed one direction: from large central power plants through transmission and distribution networks to passive consumers. The biggest generators were often far from population centers—hydroelectric dams in remote mountains, coal plants near mines, nuclear facilities built where land was cheap and neighbors few.

That geography is changing. Solar panels now adorn millions of rooftops. Small wind turbines spin in backyards. Battery systems in garages and basements store electricity for later use. Electric vehicles, when plugged in, become mobile power storage that could potentially feed energy back to the grid.

These distributed energy resources, often abbreviated as DERs, complicate the traditional market structure. A home with solar panels is no longer just a consumer but also a potential producer, sometimes drawing power from the grid and sometimes feeding excess generation back. A business with battery storage can shift its consumption in time, charging when prices are low and discharging when they're high.

New market designs are emerging to accommodate these resources. Aggregators bundle thousands of small DERs into virtual power plants that can participate in wholesale markets. Local flexibility markets allow distribution system operators—the entities responsible for the lower-voltage wires that connect neighborhoods—to procure services from these distributed resources to maintain grid stability at the local level.

The concept remains relatively new, and the optimal design for these markets is still an active area of research. Should homeowners with solar panels receive the same price as utility-scale generators? How should grid operators compensate batteries that help smooth out local voltage fluctuations? Can electric vehicles participating in charging management programs be reliable enough to bid into ancillary services markets?

These questions have no settled answers yet. The electricity market of 2030 may look quite different from today's, and the market of 2050 may be almost unrecognizable.

Why This Matters

Electricity markets are not just an esoteric concern for economists and engineers. The design of these markets shapes the technology we use, the pollution we breathe, and the bills we pay.

Markets that reward flexible generation encourage investment in gas turbines that can ramp quickly. Markets that pay for capacity keep old coal plants running. Markets that price carbon make renewables more competitive. Markets that allow demand response let consumers become active participants in grid management rather than passive recipients of power.

The stakes extend beyond economics. Electricity is essential to modern life. When markets fail—as they did catastrophically in California in 2000-2001 and Texas in February 2021—people suffer. Businesses close. In extreme cases, people die.

Getting electricity markets right is not just about efficiency. It's about building an energy system that can handle the challenges of the 21st century: the growth of renewable energy, the electrification of transportation and heating, the increasing frequency of extreme weather events, and the urgent need to reduce greenhouse gas emissions.

The invisible auction that powers your life is getting more complex. But perhaps, as engineers and economists learn from decades of experimentation, it's also getting smarter.