Locational Marginal Pricing

LMP is a core component of wholesale electricity market design whereby the price paid to feed in a kWh from a specific location on the transmission grid and the price charged to withdraw a kWh at a specific location reflect the real costs of grid congestion affecting those locations. When there is no congestion, a kWh produced anywhere on the grid can be delivered anywhere else on the grid, that is, all buyers have access to energy from the next lowest cost producer regardless of where it is.

When congestion creates blockages, however, incremental demand in the affected locations can no longer be met by the next lowest cost producer on the grid and must instead be met by higher-cost production on the ‘right’ side of the blockage. Energy from low-cost producers affected by congestion either will be curtailed or, if they continue to produce beyond the level of demand on the ‘wrong’ side of the blockage, will cause disruption in neighbouring control areas by being shunted around the blockage as dictated by physical laws (creating so-called loop flows). The result is that the true marginal cost of energy is higher in some parts of the grid and lower in others. Failure to reflect locational costs in wholesale energy prices can harm consumers in the short term by incentivizing uneconomic behavior among buyers and sellers and in the long term by obscuring the relative value of investment options for reducing grid congestion and optimizing the value of system resources.

Congestion will typically affect marginal cost at multiple feed-in and withdrawal locations in different ways depending on where they are relative to the congested facilities. These locations are referred to as nodes, thus the term ‘nodal pricing’ often used for LMP. As the energy transition proceeds, these congestion-driven nodal cost differentials will become more common. Nearly all liberalized markets outside Europe have adopted nodal pricing in some form over the past 20 years as the share of variable resources has grown.

Across most of Europe, however, wholesale energy prices are not based on LMP but rather reflect a large zone approach to wholesale pricing. Within zones, which in most cases are defined by Member State borders, there is one wholesale energy price regardless of location. Zonal prices differ from one another only to the extent that congestion arises on the interconnections between these politically defined zones. This ignores both the congestion that arises within Member States and that the locations where congestion frequently does occur — the physical reality one would expect the boundary of a uniform pricing zone to reflect — are not strongly correlated with Member State borders.

Some parts of Europe (Italy, the Nordic region) attempt to mitigate these issues by creating smaller pricing zones (market splitting), the boundaries of which are meant to reflect locations of structural congestionstructural congestion Congestion in the transmission system that is predictable, is geographically stable over time and is frequently reoccurring under normal power system conditions., giving rise to locational price differences that better align producer and off-taker incentives with real locational costs and benefits. This can improve resource scheduling and investment signaling. But congestion can still arise from time to time within these smaller zones, and the location of structural congestion is not static over time, meaning the design of zonal boundaries may lag reality.