To understand the difference between wholesale energy markets and traditional financial markets, it's important to grasp the nature of trading electricity, compared to financial assets like equities, bonds, and commodities. The most important difference is that electricity is produced and consumed instantly. At the wholesale level, electricity cannot be stored, so demand and supply must constantly be balanced in real-time. This balancing leads to a significantly different market design compared to common capital markets.
It has also restricted access to the wholesale markets because while the markets are open, their intimidating technicalities have kept less-experienced traders away. Regulators encourage traders to join the markets, but potential participants must show financial strength as well as technical knowledge to be granted access.
It's not advisable to tackle these markets without sufficient know-how, and this article is only a start.
Market Organization and Design
Energy markets are also much more fragmented than traditional capital markets. The day-ahead and real-time markets are managed and operated by Independent System Operators (ISO). These non-profit entities are organized on a physical grid arrangement commonly referred to as network topology. There are currently seven ISOs in the United States. Some cover mainly one state, like the New York ISO (NYISO) while others cover several states, such as the Midcontinent ISO (MISO). ISOs act as market operators, performing tasks like power plant dispatch and real-time power balance operations. They also act as exchanges and clearinghouses for trading activities on different electricity markets.
ISOs don't cover the entire U.S. power grid though; some regions like those in the southeastern states are bilateral markets where trades are done directly between generators and load-serving entities. Some settlements are done through bilateral EEI agreements, which are the equivalent of ISDA agreements in power markets. Grid operations in these states are still centralized to a certain extent. Grid reliability and balancing are operated by Regional Transmission Operators (RTO). ISOs are former RTOs that eventually organized into a centralized market in the name of economic efficiency through market forces.
Volatility and Hedging
The lack of storage and other more complex factors lead to a very high volatility of spot prices. To hedge some of these inherent price volatility generators and load-serving entities look to fix the price of electricity for delivery at a later date, usually one day out. This is called the Day-Ahead Market (DAM). This combination of Day-Ahead and Real-Time markets is referred to as a dual settlement market design. The Day-Ahead prices remain volatile due to the dynamic nature of the grid and its components.
Energy prices are influenced by a variety of factors that affect the supply and demand equilibrium. On the demand side, commonly referred to as a load, the main factors are economic activity, weather, and general efficiency of consumption. On the supply side, commonly referred to as generation, fuel prices and availability, construction costs and the fixed costs are the main drivers of the price of energy. There's a number of physical factors between supply and demand that affect the actual clearing price of electricity. Most of these factors are related to the transmission grid, the network of high voltage power lines and substations that ensure the safe and reliable transport of electricity from its generation to its consumption.
The Highway System Analogy
Imagine a highway system. In this analogy, the driver would be the generator, the highway system would be the grid, and whoever the driver is going to see would be the load. The price would be considered as the time it takes you to get to your destination.
Notice that I mentioned the highway system and not simply roads, which is an important nuance. The highway system is the equivalent of high voltage power lines while local streets are analogous to the retail distribution system. The retail distribution system is made up of the poles you see on your street while the grid is made up of big electricity pylons holding high voltage lines. ISOs and the general market are mainly concerned with the grid while retailers or Load Serving Entities (LSE) get the power from substations to your home.
So let’s remember this, cars are power, people are the generators, the destination (a highway exit and not someone else’s home) is the load and price is time. We’ll use this analogy from time to time to explain some more complex concepts but remember that the analogy is imperfect, so treat each reference to the analogy independently.
Locational Marginal Pricing
All ISOs use a form of pricing called locational marginal pricing (LMP). This is one of the most important concepts in electricity markets. The "Locational" refers to the clearing price at a given point on the grid (we’ll get to why prices are different at various locations in a moment). The "Marginal" means that the price is set by the cost of delivering one more unit of power, usually one megawatt.
Therefore, the LMP is the cost of providing one more megawatt of power at a specific location on the grid. The equation for an LMP generally has three components: the energy cost, the congestion cost, and losses. The energy cost is the compensation required for a generator to produce one megawatt at the plant. Losses are the amount of electric energy lost while zipping along the lines.
These first two components are simple enough, but the last one, congestion is trickier. Congestion is caused by the physical limitations of the grid, namely transmission line capacity. Power lines have a maximum level of power they can carry without overheating and failing. Losses are usually considered to be heat losses as some of the power heats the line instead of simply transiting through it.
Returning to our analogy, congestion could be considered to be traffic jams and losses would be the equivalent of the wear and tear on your car. Just like you don’t worry about wear and tear on your car when visiting a friend, losses are fairly stable across the grid and are the smallest component of the LMP. They also mainly depend on the quality of the road you are driving on.
Looking to Minimize Costs
So, given that LSEs are looking to minimize their costs, they rely on the ISO to dispatch the lowest cost generator to supply them with electricity. When a low-cost generator is willing but unable to deliver power to a given point because of congestion on the line, the dispatcher will instead dispatch a different generator elsewhere on the grid, even if the cost is higher. This is similar to having someone else drive to the destination even though they live further away, but because traffic is so bad, the person living closer cannot even get on the highway!
This is the main reason prices differ by location on the grid. At night, when there is a low economic activity, and people are sleeping, there is plenty of room on the lines and therefore very little congestion.
So referring to our analogy, when there are few people on the road at night, there is no traffic, and therefore the price differences are mainly caused by the losses or wear and tear on your car. You may ask: “But not everybody will take the same time to drive from their home to their destinations, and you said price is the same as driving time, how can that be?”
Remember that prices are set at the margin, so the price is set as the next unit to be produced, or the time it would take for the next person to drive to their destination. You would get paid that “time” regardless of how long it took you to get to your destination. So is living close to your destination the best way to get rich? Well, not exactly. Sticking to the analogy, building close to the destination takes much longer and is much more costly.