April 15, 2021
In this mini blog series, we will shed light on the inner workings of the Alberta electricity market so that you understand where your charges are coming from and how to approach your MLA on issues related to your utilities.
Our goal, as always, is to help consumers save money on their monthly utility bills.
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Welcome back to our mini blog series on the Alberta Electricity Market! To recap:
• The wholesale electricity market in Alberta is set up as an auction.
• Generators above a certain size connected to the grid must submit an offer to produce electricity unless their facilities are unable to do so - these are the sellers in the auction.
• The sellers’ offers can be anywhere from $0 and $999.99/MWh. Offers are ordered from cheapest to most expensive into a stack called the merit order. Each minute’s price is set at the last offer in the merit order needed to meet demand.
• Only generators that offered at or below the price set by the market are called to produce electricity. Any generator that produces electricity receives the market price (averaged over an hour) even if they offered in at a lower price.
In our last blog, we explained how these wholesale prices feed through into the prices you pay as a large or small consumer in Alberta. In this entry, we’ll focus on what causes the wholesale prices to be higher or lower at any given time. While small consumers in Alberta on fixed rates do not face these prices directly, they do influence the prices for variable rate consumers, as well as products that retailers can offer over time.
What Determines How Sellers Offer in the Market?
Electricity can be generated in different ways, and different types of generators have different costs that are reflected in their offers. No generator will want to offer at prices below their costs for production since they would lose money unless they are constrained to do so (more on this below). In some cases, generators may choose to offer at much higher prices.
Let’s look a little more at costs and constraints.
Costs
The costs of producing an extra unit of electricity consist of fuel costs, carbon levies, and some operational costs.
Generators that burn natural gas must pay for fuel, with their costs varying by the price of natural gas and how efficiently they convert natural gas into electric energy. Under provincial rules, all but the most efficient natural gas technologies must also pay carbon levies. This type of generator typically offers into the market no lower than what it costs to produce that extra unit of electricity. The same applies to coal facilities, albeit with a different fuel type and higher carbon levies.
Some large industrial and oil sands facilities produce electricity by burning natural gas as a by-product of producing the heat or steam they need for on-site processes (sometimes referred to as co-generation). Because the primary need is for heat or steam and the electricity is a by-product, it is typically offered to the electricity market at $0. Some industrial sites have generation over and above what is needed to produce heat or steam, this is typically offered at no less than cost, similar to other gas generators.
Some technologies like wind and solar may not have any fuel costs, and by generating electricity, they also produce Renewable Energy Certificates (RECs), or other offsets, that may be sold elsewhere. Typically, wind and solar generators offer at $0 in the Alberta electricity market to maximize the number of RECs for sale.
Constraints
Simply defined, constraints are something that limits or restricts someone or something. All forms of electricity generation will face some sort of constraint, affecting the way they generate electricity and bid into the wholesale market.
Some generation technologies are not designed to be completely flexible and, once they are running, cannot maintain production below certain minimum levels. To reflect this constraint, offers of $0 are made into the merit order to almost certainly ensure that they are selected to generate.
Yet other types of generation may face different restrictions. Hydroelectric generators may be required to release water in order to keep our rivers healthy or supply irrigation downstream. That water can power turbines within those generators as it passes by and is also typically offered at $0. Water in hydroelectric dams that doesn’t need to be released may be offered at higher prices. In doing so, the hydroelectric operator may reserve the water behind the dam to generate at another time when market prices might be higher (we think of units having high opportunity cost - if you generated electricity now, it would prevent you from generating when prices are higher).
Regulations and rules also impose constraints. In the last blog, we have already mentioned a limit on offers being no less than $0 and no higher than $999.99. Common to nearly all auctions, there are also strict prohibitions against sellers working together to set their offers. Alberta’s electricity market is unusual in that there are no restrictions placed on how close sellers’ offers must be to actual costs (i.e. offers are significantly higher than actual costs) - this allows for a practice known as economic withholding, which we explain below.
In Alberta, the most important constraints on how high a seller may offer come from other competitors who may undercut offers, from large industrial customers who may cut consumption if prices look likely to be high and from importers who may bring energy into Alberta if prices are sufficiently high. Much less obvious is that a generator selling into the auction may have already pre-sold electricity to industrial customers, retailers, or even speculative traders such that they are not much interested in the prices that occur in the auction.
What Do Offers in the Alberta Electricity Market Actually Look Like?
You may have noticed so far that lots of electricity in our wholesale electricity market should end up being offered at $0 and some no lower than cost. And that is exactly what you see. Remember that generators do not receive the price offered but rather the market clearing price in Alberta’s electricity market. Over time as constraints, costs, and the balance between supply and demand change, so do prices.
With the merit-order shown in the figure above (Scenario 1) at low demand levels, the price might be just $30, but with high demand levels (Scenario 2), it might be at $52.75. In the figure below, we show the same merit orders with less supply. Even though the level of demand is the same (between Scenarios 2 and 3), prices are higher as there is less supply available. In Scenario 4, you can see how less supply and even higher demand results in higher prices.
Prices can and do sometimes get much higher. Very rarely, the supply and demand balance gets much tighter, and that can cause prices to rise significantly. Much more common is the balance between supply and demand gets somewhat tighter, and some sellers sense an opportunity to influence the market price by placing offers at higher prices. This is shown in Scenario 5 (below).
In this example, one of the coal offers has been increased to $999.99 and one of the natural gas offers to $700. The wholesale clearing price in this example is $700/MWh. Note that the coal offers at $999.99 are not called upon to generate (and don’t get paid). However, if the owner of the generator has other units that are called upon to generate (such as the first coal generator at the top), they now receive $700 rather than the market clearing price of $53.20 in Scenario 4.
If those higher offers by the coal and gas unit are not being made because of higher costs, the generator is likely motivated by the desire to increase market prices to benefit their other generation. In this case, we say the generators are said to be engaging in “economic withholding.” Usually, such periods when economic withholding results in very high prices are relatively short. For example, as demand drops or more supply returns to the market, the opportunity to influence prices upwards disappears.
Over the longer term, high wholesale prices might also cause large customers and retailers to hedge future consumption by buying in advance from generators. This, in turn, reduces or even eliminates sellers’ desire to engage in economic withholding in the wholesale markets. What emerges is something of a dance between buyers and sellers in the wholesale market that plays out over time. That dance plays out over long time frames since if market prices look like they will be high in the future, new generators may enter the market.
In many electricity markets, economic withholding is not allowed or is limited. But it is an important part of how the Alberta electricity market works. Without economic withholding, some electricity generators in Alberta would be highly unlikely to make a sufficient return to cover the capital costs of building and maintaining plants that we currently have available.
With lower revenues, less generation would exist, and generators would rely heavily on periods where we were close to shortages to produce high prices that would pay for those capital costs. Relying too heavily on these shortages comes at a higher risk. We might not have enough generation to meet demand and experience rolling blackouts - something everyone is keen to avoid. There are other alternate designs of electricity markets that don’t rely as heavily on economic withholding, but those alternatives come with advantages and disadvantages.
Summary
That’s a lot of information to take in, so a summary is in order. Most markets for commodities see price changes because of changes in supply and demand. Most markets also see price changes when the level of competition changes, which might allow for profitable economic withholding. The balance between supply, demand, and the level of competition all change over time. Electricity markets are no different from many other markets in that respect.
The major differences between electricity markets and other markets are that changes in market conditions can occur very fast and that is largely a function of it being difficult to store large amounts of electricity (as electricity storage becomes cheaper and more widespread, it really will be a game-changer for most electricity markets).
We’ve referred to the interaction in electricity markets between sellers and buyers as something of a dance. So, where are we at in the dance right now?
Over the last five years, we have been moving from a period where supply was abundant, and natural gas prices (the fuel for many generators) were low. As a result, electricity prices were low. Since that time, some generators have not been able to generate sufficient revenue and have retired.
In the interim, prices have risen somewhat, as have carbon levies, which influence some generators’ costs. Lower demand for electricity (in part due to the impacts of the pandemic) has moderated those increases.
We can’t say for certain what prices will be for the remainder of the year, but there are indications that average prices may be higher and more volatile than we have seen in recent years. Looking further out, average prices look set to fall, but that is not certain. The only thing that is certain is the dance between sellers and buyers continues to play out over time.
Stay Tuned for Part 3
In our next blog, we will look at how these practices are reflected in political strategies. The impact of price spikes, economic withholding, and the merit order bidding process all played a role in this year’s high prices for electricity and natural gas. How the UCP and NDP are choosing to handle customers with high bills will be the focus of the next article.
About The Author
Matt Ayres, Ph.D.
Matt loves explaining how electricity markets work! Matt currently works as a consultant and has over 20 years of experience working in a number of electricity markets, including the CEO and Chief Economist of Alberta’s electricity watchdog, the Market Surveillance Administrator. Matt is also an Executive Fellow at the School of Public Policy and an Adjunct Assistant Professor in the Department of Economics at the University of Calgary. Any views expressed are those of the author and not the views of any organization to which they are affiliated.
Contact: Matt Ayres (LinkedIn)