The marginalist system of electricity pricing makes us pay for cheap nuclear energy at the price of very expensive gas

The wholesale price of electricity in the month of June has broken all records. With an average of 83.3 euros per MWh managed to exceed the previous maximum of January 2017 of 71.49 euros. In fact, it has not been unusual to see days with values ​​very close to 100 euros per MWh. So much so that the government has established relief mechanisms on the bill. And all this taking into account that there are very cheap energies such as nuclear and renewables.

The main problem is that there have been two factors that have driven prices: one, that CO2 charges have been very high throughout the month; two, gas prices are also skyrocketing. Both factors have made gas generation very expensive and due to the pricing system, all producers have been paid at such high prices. Why? By the marginalist pricing system.

Set production prices

When we are in a competitive market, a mechanism must be established to see who produces electricity at all times and the marginalist system is what it does. On the one hand the demand is ordered and on the other the supply. They both get married and the cut-off point sets the price at which everyone is paid.

The best way to understand it is to see it with an example, completely invented: at a certain moment there are a demand of 30,000 MW. On the supply side there is nuclear power, 10,000 MW, at zero price. Wind, 10,000 MW, at zero price. Then solar energy, 3,000 MW at zero price too. Then come the combined cycles (gas), 10,000 MW, at a price of 80 euros / MWh. And finally, coal, 8,000 MW at 120 euros / MWh.

When supply and demand are matched, it would look like this: 10,000 MW of nuclear, 10,000 MW of wind, 3,000 MW of solar and 7,000 MW of combined cycles. They would be left out of the combined cycles and coal. And the matching price, that of gas, with 80 euros / MWh, is paid to all producers (nuclear, wind, solar and combined cycles).

That’s the reason why the system is called marginalist, because everyone is paid the marginal price of matching supply and demand, regardless of what each one offers. And that is why all producers, even the “cheap” ones, are being paid expensive gas prices and CO2 quotas.

Other pricing systems

Many, when they understand the system, think that this way of setting prices is unfair and that electricity is overpaid, but it is not. This system is the one used by all OECD countries, it is the one set in the European Union and it is the one that, in theory, gives the cheapest prices.

The alternative is a “pay-as-bid” system in which each bidder receives what they bid. And why doesn’t this system give lower prices? Because bidders behave differently.

In the marginalist system, bidders with negligible variable costs bid at a very low price (zero in some cases). This includes nuclear, wind, hydro, solar … they are ways of producing electricity that do not use fuel (or the cost is negligible, as in the case of nuclear power). In general, these technologies have fixed costs (debt, personnel, etc.) and it does not matter if they are stopped or if they are at full capacity, the costs are the same. Therefore they always want to produceregardless of the price they receive.

In the case of fossil technologies, such as fuel, combined cycle or coal, the variable costs are important. The price offered is always higher than the variable cost, the price of fuel, so as not to lose money when producing. Therefore there is a minimum price offered.

Therefore, in a marginalist system, technologies with negligible variable cost offer at a very low price, sometimes zero. And technologies with significant variable cost will bid at a price that allows them to cover their variable costs..

If the system is changed to a “pay-as-bid”, the technologies of negligible variable cost would stop offering at zero price and would use another, more complicated strategy. They would study the rest of the plants, their production capacity, the prices of the variable costs of the competition, etc. and they would bid at a higher price but one that allowed them to win. They would add complexity. And experience tells us that the countries that use this system do not achieve cheaper prices..

Is a reform necessary?

Although in theory the marginalist system is the best and the “pay-as-bid” does not provide better prices, the truth is that the market is changing. There is a growing dichotomy between technologies without variable costs and technologies with very high variable costs. And therefore in the future we will see low prices (when technologies without variable costs cover the demand) and high prices (when gas has to come in). And this means that there will be moments of prices so low that not even the technologies without variable costs will be able to cover their real costs and other occasions when they are more than compensated.

This duality is motivated by the great introduction of renewable technologies in the grid on the one hand, and also receivable for CO2 emissions from fossil technologies. And it is something that we will see more and more in the future, since we are getting more renewables and on the other hand, charging more and more for CO2 emissions.

So it may make sense to go to a “pay-as-bid” pricing system. It is a reform that has to be done within the EU, it is not something that depends on Spain. And as the network evolves it is something that will become a reality. On average there will be no big changes, but in practice instead of seeing ups and downs in prices we will see more stability.


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