Refreshing price formation policy in wholesale electricity markets


In less than two decades, the rise and proliferation of organized wholesale electricity markets has resulted in more efficient and reliable operations and investment in the bulk transmission system. These markets, administered by regional transmission organizations (RTOs) or independent system operators (ISOs), rely on market prices to signal efficient and reliable behavior among market participants. In short, the success of these markets depends on healthy price formation.

Ideally, short-term markets would reflect the marginal cost of operating the grid reliably and the value of resource scarcity when such conditions arise. This is difficult in practice, as all operational and physical constraints are hard to represent and incorporate into software that computes prices. When market design differs from system-reliability requirements, it causes RTO/ISOs to “commit” (instruct a resource to turn-on) or “dispatch” (adjust output of an operating resource) resources in a manner inconsistent with market outcomes. If market prices do not cover the costs of these out-of-market resources, the RTO/ISOs pay them out-of-market “uplift” payments that are ultimately charged to customers. The causes of uplift often aren’t transparent. They also impose costs on customers that are both unpredictable and impossible to hedge.

When there are inconsistencies between market prices and system dispatch, existing resources may be used inefficiently, investment signals can be muted and it can elevate concerns about reliability. The situation also creates false arbitrage opportunities, which lead to market manipulation. Concerns about this process of price formation have grown as market fundamentals shift and the resource mix. Recognizing this, most RTO/ISOs have pursued market-design reforms to improve price formation. The subject has also caught the eye of the Federal Energy Regulatory Commission (FERC).

In 2014, FERC launched the price formation initiative. It began with technical conferences and staff papers and led into four notices of proposed rulemaking, two of which were finalized in 2016 (Order Nos. 825 and 831). The final rules clearly improved market design and price formation, while posing limited implementation challenges for RTO/ISOs. The pending rulemaking proposals, however, elicited a wide range of responses from leading industry experts. In particular, debate over pricing commitment costs for fast-start resources, and the specific methodologies to allocate uplift costs, have proved contentious. The new FERC leadership, which will determine the direction of these pending rulemakings, has the opportunity to pursue other areas to improve price formation.

A key area for improvement is shortage or scarcity pricing. The remaining items are mostly incremental improvements to marginal-cost pricing. However, these lower-salience reforms have cumulative and synergistic effects that could substantially affect system efficiency, reliability and market outcomes. Moreover, they become more significant as the generation mix evolves to include many variable (e.g., wind and solar) and use-limited (e.g., energy storage) resources, which result in more dynamic supply fundamentals that multiply the challenges for market design and administration to produce accurate price signals.

Market design changes, including those for price formation, should not be used to pick technology winners. Yet it is unavoidable that such changes will alter competitive relationships between technology and fuel types. Improved price formation will better reflect stressed system conditions, like shortages (better dependability valuation) and dynamic system conditions (better flexibility valuation). This would probably benefit hydropower and energy storage the most, as many forms of each are both highly dependable and flexible. Nuclear power would benefit from reforms that reward dependability, while resources like fast-cycling natural gas-fired plants would benefit from stronger flexibility incentives. More dynamic pricing would also encourage price-responsive demand, which has substantial potential as “smart” technologies evolve.

In many ways, FERC’s price formation initiative embodies the proper role of a regulator. At the same time, some specific FERC actions could result in overly prescriptive, or potentially perverse, requirements. The key for new FERC leadership is to prioritize the most important areas of reform and encourage a culture of ongoing RTO/ISO price-formation improvements. More sunlight, limited prescription and performance-based regulation offer a pathway to efficient markets and good governance. With that, further enhancements to price formation will extend U.S. leadership on electricity policy and make the economy more competitive for decades to come.

Image by jaroslava V