The Electricity Market
What does the supply curve look like? An electricity supply curve is also known as a “stack”: the rank order line-up of all power plants in a market from least to most expensive variable cost. Power plant operators bid their plants into the market in a reverse auction. (Multiple sellers bid to sell electricity and the winner of the auction is the seller who offers the lowest price. The winning price becomes the market price, and all power plants that bid less than the winning price are “dispatched” or told to turn on and generate power.) Economic theory suggests that most of them should bid in at their variable cost: if they bid less than that and get dispatched, they lose money by operating; if they bid more than that and don’t get dispatched, they lose the opportunity to earn operating profit.
The dispatch curve or supply curve is fairly constant for any given market, only shifting as (1) plants are taken out of service for planned or unexpected maintenance, (2) as fuel prices change and consequently change relative operating costs, or (3) as new plants are built and enter the mix. The efficiency and fuel source of a power plant determines where it sits in the
stack: the deeper a plant is in the stack, the more often it will be dispatched. The marginal or “swing” plant exactly covers its variable costs, while those deeper in the stack realize a positive operating profit that contributes to covering their fixed annual costs.
In most U.S. regional electric markets, gas-fired steam plants set the market-clearing price in most hours of the year. (However, when natural gas prices are very low, coal plants can become the marginal capacity.) Moving down the stack from the gas steam plants, one then finds gas-fired combined cycles, coal plants, nuclear plants, and finally the hydro, solar and wind power plants, which have essentially zero variable costs. Solar and wind plants are known as “must-run” facilities, because they cannot actually be dispatched – none of us has control over when the wind blows or when the sun shines, so when it does, the output of those plants is incorporated into the market. Above the gas steam plants in the stack, one finds peaking plants that operate during peak demand hours with a variety of cost and response time profiles.
What does the demand curve look like? The demand curve shifts from left to right as aggregate market demand for electricity rises and falls over the course of a day, week, or season. Most electricity markets have a summer peak, brought about primarily by heavy air conditioning use; markets with high usage of electric heating also have a winter peak. The “peakiness” of a market (the ratio of peak annual demand to average demand) also varies from one region to another, reflecting the idiosyncracies of electricity usage habits. A load duration curve summarizes the demand profile in a given market, depicting the frequency of demand at various levels.
Demand for electricity is fairly inelastic, meaning the demand curve is essentially a near-vertical line. While you are not willing to turn off your air conditioner and electric stove on a hot August afternoon when the utility’s cost of power goes through the roof, some large industrial users of electricity are. Most notably, aluminum smelters that use electric furnaces often have deals with their power suppliers to shut down (and thus greatly reduce aggregate market demand) when market prices are high – they give up control over their own operations in exchange for a lower rate on the electricity they do use.