The renewables driven revolution in electricity pricing

Away from the public eyes, one of the most radical transformations of wholesale electricity markets in the last 100 years is occurring. Since the time of Thomas Edison, almost all the electricity that we use has come from the combustion of fuels. By releasing the latent energy in coal, gas, wood or oil, we convert latent energy into heat, and use that heat to create steam. The steam forces a magnet to spin around a set of wire coils, thus creating a current. It is this innovation in science that created the modern world, but today a growing proportion of the developed (and developing) world’s electricity no longer comes from fuels. I am of course talking about wind and solar.

When power is created from the combustion of fuels it is dispatchable. This means that it can be turned on and off whenever the owner of the power station wishes. While a Nuclear plant will often generate electricity around 92% of the time, making it effectively a constant (hence “base”) generation source, most fuel based generation sources run for much less time. In the USA, coal and gas plants often run less than 60% of the time. By contrast wind and solar are not dispatchable. Rather, their production output is variable. Wind and Solar do not require a fuel to create energy, but they cannot control when they will produce electricity. It is this contrast that is at the crux of the challenge.

To ensure a power grid has sufficient electricity for all consumers, a grid operator such as National Grid, must estimate demand and source that demand on an annual, monthly, daily, hourly and sub-hourly basis. In complex power markets like the UK, the sourcing of electricity supply comes from an auction system. This is why wholesale power prices are in upheaval.

To match supply with demand, national grid asks companies that produce electricity to make offers to supply electricity. Each company states how much electricity it can supply and the price it will accept to supply that level. These prices are then sorted from lowest to highest and national grid will accept all bids necessary until it reaches the supply level it requested. This is called “Merit Order Dispatch”.

To explain this is shown in the table below:

Electricity needed 100MW   
Clearing auction price £30/MWh  
Bidder name Bidding price Quantity of power offered Quantity of Power Accepted
Wind 1 £10/MWh 20MW 20MW
Solar 1 £20/MWh 20MW 20MW
Nuclear 1 £25/MWh 30MW 30MW
Gas 1 £30/MWh 30MW 30MW
Coal 1 £40/MWh 30MW 0MW

As wind and solar have no fuel, their cost to run is essentially zero. As such they can bid any price they like. For Nuclear, the cost of fuel is considerably less than building the site, so it also bids a low price. By contrast gas and coal have to buy their fuels to combust them. As shown in the table above, coal can’t compete against wind and solar on cost and so it losses the auction. Everyone else is paid the marginal cost of production, which is the amount that gas receives (£30/MWh) and they supply the grid.

So what does this mean? Essentially as we build more wind and more solar, we will increase the number of electricity supply bids into the market which are below the viable level for any fuel based generation. This is why the USA’s Department of Energy wants to pay a subsidy to coal and nuclear. As wind and solar are not dispatchable, there is a concern that all dispatchable fuel sources will be unable to compete in the price auctions for the majority of the year, except for periods when electricity demand is extremely high. That would make most plants economically unviable, as they would be required to cover all of their capital costs, maintenance and staffing, based on generating electricity for less than 50% of the year. If these plants go, then what will provide the electricity when the sun goes down and the wind doesn’t blow? That is the question that energy market regulators are asking in the UK, USA, Europe and across the developed world.

To many the concept that renewables are cheaper than fuel based sources doesn’t seem correct. Indeed, most renewables remain more expensive than coal (though not in all areas and not by much), when considering the total cost of the system. But it is important to understand that wind and solar are fundamentally different in how they are financially structured and that explains the pricing disruption. Operations and maintenance of renewable power plants are minimal. Building the assets is the expensive part. As a result, Renewables always want to sell their power at any price in order to re-coup the cost of construction. By contrast a coal plant or gas plant will lose money if they try to sell electricity for below the cost of their fuel source. This gives renewables an incentive to bid almost zero, thus guaranteeing that they will be able to sell almost all their electricity they generate at any time.

This is actually worse in countries that have adopted a renewable government subsidy called a Feed-In-Tarriff (FIT). Under a FIT, the government guarantees the owner of a renewable company that they will receive a fixed price for the production of their electricity. However, the electricity has to be generated and supplied to the market in order to claim the subsidy. As a result, renewables have no incentive to put in competitive prices for auctions because they already have a fixed price.

What does all of this mean though for businesses, consumers and investors? Well for now it means that the annual average wholesale cost of electricity has fallen in countries like the UK on a constant basis. That also means that most households and industries have paid less in energy bills than would otherwise have been the case.Wholesale market

But while the costs of electricity have fallen, other costs are occurring across the system. As coal and gas plants cannot compete in the market they are forced to close the plants early and suspend new constructions. A great win for climate change, but an outcome that has cost European utilities half a trillion euros according to the economist. In California, where solar PV deployment is high, prices in the wholesale market now go negative for periods of the day. Yes that is correct. Producers effectively pay other people to take the power that is being produced. In the same is happening in Germany.

The move towards greater renewables in the electricity mix is vital. But like any great transformation there will be unintended and unanticipated consequences. The greater the growth of renewable energy, the more inevitable it will become that wholesale power markets will change. If consumers are focused that could potentially lead to longer term price stability and cost savings. But only if they know where to look.