How wholesale electricity prices are established and what it means to you.

Electricity pricing is a great mystery to most people. A price is established, you pay the bill, and the lights stay on. Everyone is happy. However, for many electricity consumers, especially large volume users such as businesses, factories, and municipalities, a little understanding of the electricity market can pay huge dividends through lower electricity prices and more efficient use of the electricity that you use.

A Unique Commodity

Electricity is a unique commodity. Most commodities are able to be stored and used only when needed; thus, allowing producers to hold the commodity, whether it is corn, oil, or steel, until the market favors their sale. This is supply and demand at its finest. But electricity is different. For one, electricity cannot be stored efficiently meaning that once it is generated it must be consumed. Second, electricity is subject to reliability constraints. So many people rely on electricity that laws have been passed and organizations created just to ensure availability. Together these factors create a situation of immediate demand and supply that must be managed and organized so that the lights stay on, and electricity producers are adequately compensated. In response to this need, the stacked bid auction was developed. But before one can understand how the stacked bid auction works to establish wholesale electricity prices, one must understand how electricity is generated.

Sources of Electricity Generation

The United States generated 4,054 billion kilowatt hours of electricity in 2012. The following chart depicts what resources were used to generate this electricity:

Coal and natural gas account for over two-thirds of electricity generation despite increased regulations on fossil fuel emissions. Meanwhile renewable sources like solar, wind, biomass, and geothermal provide less than 7% of total generation. Each of these generation sources have their strengths and weaknesses which help explain their level of use.

Renewable sources tend to use cheap fuel sources (sunlight, wind, biomass) but because they only generate electricity intermittently, they can’t be relied upon to fulfill baseload demand; the minimum amount of electricity needed to meet demand. Nuclear and hydropower also use cheap fuel sources and can be relied upon to fulfill baseload demand, for generators using these sources rarely power down. Coal remains a relatively cheap and steady fuel source, though regulations threaten to change that in the upcoming years. Natural gas is a more expensive generation fuel, but natural gas generators can provide a consistent level of power with less environmental impact than coal.

The Stacked Bid Process

Regional Transmission Organizations (RTO) or Independent System Operators (ISO) are responsible for coordinating the above mentioned array of generators to meet their regions power demand at the least cost possible. In order to ensure that they are able to do this, each RTO/ISO has established Day-Ahead Power Markets. These markets forecast the needed electricity demand throughout a region for the next day, at one hour intervals. The RTO then holds a stacked bid auction for generators to commit their generated electricity for each of these one hour periods. Bids are accepted until the anticipated demand is met, with the lowest bids being accepted first. Whatever the bid of the generator that meets the final demand threshold, will be the price that is paid to all accepted bidders, no matter what price they initially bid. Because generators must at least recoup their cost of goods sold, (primarily fuel costs) the generators with the lowest fuel cost supply the lowest bids. Solar, wind, biomass, hydro, and nuclear generally come in lowest and are assured of having their capacity utilized. Coal is the next cheapest and during peak hours (the hours with the highest demand) generally sees all its available capacity used. Because of its higher costs, natural gas is usually the last generation type dispatched to meet peak demand. This means that all other generators receive the bid price for their contribution of the last accepted natural gas generator. As one can see from this, the price for natural gas becomes the key determining factor of electricity prices, despite the fact that it is not the primary resource used for electric generation. To better illustrate this let take a look at an example:

The following table shows how a typical stacked bid electricity auction may play out.

Bids for 11:00 to 12:00 EST – 25 MW Demand

As this example shows, the RTO accepted all bids until it fulfilled the demand of 25 MW for this one hour interval. Though Natural Gas Plant B bid 4 MW of capacity, only 1 MW was needed to reach the 25 MW demand, so Natural Gas Plant B would only receive payment for the 1 MW that was dispatched. Natural Gas Plant C will not receive any payment during this interval despite bidding 7 MW of capacity because their bid was higher than Natural Gas Plant B and no further capacity was needed after Natural Gas Plant B’s capacity was dispatched. All generators that had their bids accepted will be paid the $5. 60/MW that Natural Gas Plant B bid as the last accepted bidder. There is really no incentive for generators to arbitrarily place a high bid in the stacked bid auction, for they would risk not getting paid at all. This fact explains why many renewable plants place such low bids because unlike coal or natural gas that can store their fuel and burn when need, renewables, especially solar and wind, can’t save their fuel for use at a later time. Overall, this system allows wholesale electricity to be dispatched to meet the needs of a region at the lowest cost possible.

How You Can Benefit From This Knowledge

There are two ways you can take advantage of understanding and monitoring this information. First, you will know what generation resource is driving electricity prices. Usually this has been natural gas, especially during peak demand hours. However, with increased fracking and shale production, which is reducing natural gas prices, and stricter environmental regulations, which is increasing coal prices, this could change in the coming years. By knowing which resource is driving prices and the trend in that resources price, you can better coordinate your purchasing of electricity to maximize savings for your organization.

But don’t be fooled into thinking that you can receive your electricity at the wholesale price. Energy is just one component that makes up the electricity price you pay. When you purchase electricity through a supplier, things such as capacity, transmission, credit and supplier overhead will impact your electricity price. Distribution and taxes will also affect how much you ultimately pay. However, by purchasing electricity through a supplier you are assured a fixed price that you can budget for without being subject to the hourly fluctuations that exist on the wholesale electricity markets. That price security can be quite valuable to your organization.

Second, your organization can use this information to adjust your electricity consumption patterns, which can create significant savings in electricity costs. Electricity is more expensive during peak demand hours, which generally occur during normal business hours, because expensive natural gas is the driver of power prices during this time. Some organizations have the ability to shift some of their electricity demand to off-peak hours, when inexpensive coal is usually determining electricity prices. The difference between peak and non-peak prices can often exceed 50%.

Unfortunately, only those with interval meters, meters that measure usage on an hour-by-hour basis, will see direct savings through these adjustments. For those with a traditional meter, the utility assigns a load profile based on their usage and how similar customers distribute that usage. This usually means natural gas will be the primary indicator of electricity prices for these customers.

Regardless of your meter type though, by shifting some of your electric load away from peak hours you can reduce your Capacity Peak Load Contribution (PLC), which can provide savings on your electricity. Each year every electric account within each RTO region is assigned a portion of that regions peak load capacity. How exactly this is accounted for varies greatly by RTO and even within RTOs. Some RTO regions will assign capacity PLC based on the peak demand hour during the five highest demand days (PJM), while others will simply look at the peak demand hour during the highest demand day (NYISO and ISO-NE). Accounts that use large amounts of electricity in a short period of time, especially during peak hours, are considered inefficient and pay a premium to support their capacity requirements. Accounts that are able to reduce their electricity use and spread that use more evenly across the day, especially away from peak hours, will be charged far less for their capacity requirements because they are placing far less strain on the grid.

Alternative Utility Services, Inc. is a licensed energy aggregator and consultant that can help organizations within PJM, NYISO, and ISO-NE pinpoint the times that capacity PLC numbers will be determined through our Capacity PLC Advisory Services. AUS develops solutions to promote energy curtailment during these times, helping save organizations money on energy costs.