Locational marginal pricing (LMP) provides efficient price signals that reflect the marginal cost of electricity generation and consumption subject to the actual physical constraints of the network. It reveals the true value of consumption and production behaviours by location and time and in so doing provides an important signal for efficient decisions about where to locate production, consumption and network investments.
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.
Source: Reitzes, J., et al. (2007). Reformulation of Figure 1, from the Brattle Group report, Review of PJM’s Market Power Mitigation Practices in Comparison to Other Organized Electricity Markets. Prepared for PJM Interconnection, LLC, September 14, 2007. Used with permission.
Proponents of zonal pricing maintain that it improves trading liquidity and dilutes market power and that the net efficiency benefits of nodal pricing are relatively minor. There may have been some merit to these arguments historically when generation was predominantly dispatchable and was added in increments commensurate with the existing grid and the location of demand. Nonetheless, the claimed liquidity benefits are artificial — physics and the associated impacts on cost do not go away and must be addressed administratively — and localized market power persists and simply becomes less visible.
Nodal markets outside Europe have established trade in insurance products (often called financial transmission or congestion rights) to mitigate concerns about the effects of congestion on trading liquidity. They have likewise built measures into their trading operations rules that mitigate localized market power directly (employing ex ante mechanisms in the hours and minutes before gate closure that mitigate problematic behavior or trading outcomes that evidence problematic behavior) rather than relegating the job of detection and mitigation to obscure, slow-moving ex post regulatory and competition authority processes. At the same time, as legacy generation is supplanted by variable renewables in locations driven more by the quality of the resource than by proximity to transmission and demand, the efficiency and asset optimization benefits of LMP become more important.
In the end, the critical variable is how much potential benefit LMP can deliver in the form of more efficient and flexible utilization of grid resources against the political considerations of paying different wholesale prices at different locations within a Member State. Global experience suggests that as we move to more capital-intensive, dispersed and variable resource portfolios and a significant scale-up of related investment in networks, the benefits of LMP make nodal pricing a more compelling proposition.
Energy Price Formation
The scope of this factsheet is locational pricing. These reforms sit alongside other important design elements in supporting efficient formation of energy prices, notably scarcity pricing (see Scarcity Pricing factsheet) and marginal and single prices in imbalance price formation and in balancing markets (see Efficient Price Formation factsheet), as presented in the figure below.
More broadly, marginal pricing (also known as pay-as-clear), which is currently a feature of wholesale markets in Europe, incentivises the party with the cheapest additional offering to balance demand and supply for electricity. A clearing price that is linked to marginal cost thus drives minimisation of total long-run cost and maximises societal welfare.
- Supports locational investment signals for generators and consumers and addresses network bottlenecks, without costly redispatch
- Focus of reform: wholesale prices
- Allows efficient valuation of reserves that enable the least cost penetration of renewables, and limits need for costly interventions
- Focus of reform: Imbalance pricing and balancing energy prices
Energy Price Formation
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- Supports an efficient allocation of effort between markets
- Focus of reform: imbalance pricing and balancing energy prices
- Provides efficient signals to guide balancing behaviours and removes unhelpful signals to integrate vertically
- Focus of reform: imbalance pricing and balancing energy prices
Source: RAP graphic
References and Further Reading
- Antonopoulos, G., Vitiello, S., Fulli, G., and Masera, M. (2020.) Nodal pricing in the European internal electricity market. European Commission.
- Ashour Novirdoust, A., Bichler, M., Bojung, C., Buhl, H. U., Fridgen, G., Gretschko, V., Hanny, L., Knörr, J., Maldonado, F., Neuhoff, K., Neumann, C., Ott, M., Richstein, J. C., Rinck, M., Schöpf, M., Schott, P., Sitzmann, A., Wagner, J., Wagner, J., & Weigelzahl, M. (2021). Electricity spot market design 2030-2050. Fraunhofer.
- Graf, C., La Pera, E., Quaglia, F., & Wolak, F. A. (2021.) Market power mitigation mechanisms for wholesale electricity markets: Status quo and challenges. Stanford University and Freeman Spogli Institute for International Studies.
- Reitzes, J., Pfeifenberger, J., Fox-Penner, P., Basheda, G., Garcia, J., Newell, S. & Schumacher, A. (2007). Review of PJM’s Market Power Mitigation Practices in Comparison to Other Organized Electricity Markets. The Brattle Group.