The primary role of a market price is to establish equilibrium between supply and demand. This task is especially important in the power markets because of the inability to store electricity and the high costs associated with any supply failure. The spot market at Nord Pool Spot is an auction based exchange for the trading of prompt physically delivered electricity. It is the central market for Nordic electricity.
The spot market carries out the key task of balancing supply and demand in the power market with a certain scope for forward planning. In addition to this, there is a final balancing process for fine adjustments in the real time balancing market.
The ’Invisible Hand’ which creates equilibrium in most other markets is replaced in the power markets by a concrete visible hand. This is the spot market which receives bids and offers from producers and consumers alike and calculates an hourly price which balances these opposing sides. Nord Pool Spot publishes a spot price for each hour of the coming day in order to synthetically balance supply and demand.
Every morning Nord Pool participants post their orders to the auction for the coming day. Each order specifies the volume in MWh/h that a participant is willing to buy or sell at specific price levels (EUR/MWh) for each individual hour in the following day.
Electricity produced at the lowest cost every hour of the day
A well-functioning and competitive power market produces electricity at the lowest possible price for every hour of the day. The balance price represents both:
i) The cost of producing one kWh of power from the most expensive source needed to be employed in order to balance the system - either from a domestic installation or from external imports. Or:
ii) The price that the consumer group is willing to pay for the final kWh required to satisfy demand.
The price formation process is therefore economically effective for society.
Nord Pool Spot establishes prices in the same way as other energy markets
In the political debate surrounding energy, this type of price formation is labelled marginal price setting. This gives a false impression that the establishment of prices in the electricity market is different from the price formation process in other commodity markets. The only difference lies in the significantly higher requirements for the secure delivery of electricity because it must be delivered at the precise moment it is needed by the consumer. The inelasticity caused by the inability to store electricity causes this difference. Market price formation is therefore a more accurate term than marginal price setting.
There is, however, a great difference between electricity and the other energy (and commodity) markets in that the variable costs of production vary so greatly between different types of installation – wind and hydropower with a virtual nil cost at one extreme and gas turbines at the other end of the scale.
In order to satisfy fluctuating consumer demand at the lowest cost, a broad variety of generating techniques are required. Some installations are capital intensive but can be run year round and are relatively fuel efficient (hydro, nuclear, coal-fired). Other units such as CHP (combined heating and power) are used less frequently to cover winter heating demand at times of higher prices. Whilst energy intensive units such as gas fired turbines are used for brief periods of very high price and demand.
The market produces cost efficiency
The spot market equilibrium price is also the reference price for the futures and forwards markets at Nord Pool Spot, which are of vital importance for the efficient use of hydro power in the mixed hydro-thermal Nordic system. The futures and forward prices at Nord Pool Spot reflect the value of water at different times and are therefore necessary for the optimal use of hydro power during different periods of time.
The primary function of an organised spot market for electricity is to maximise cost efficiency by supplying the demand for power from the most economic source available. It is difficult to achieve such optimization without a continuous price setting mechanism producing a transparent equilibrium price. The large differences in production costs for the different generating units entail a high risk for losses of efficiency stemming from a poorly functioning pricing system. In addition, a much greater reserve capacity would be necessary in order to guarantee supply in a system without a successful spot market.
In summary – price levels in the spot market are determined by the balance of supply and demand and as such are only affected by changes in this relationship.
School of Business, Economics and Law
Lennart Hjalmarsson. Professor of Economics at Gothenburg University and Honorary Professor and Honorary Doctor at Academiei de Studii Economice in Bukarest. Obtained his PhD from Gothenburg University in 1976. He held positions at Oslo University, Wissenschaftszentrum Berlin, Vanderbilt University (visiting) and the Ministry of Industry, Stockholm. His main research fields are industrial and energy economics. He has served as Chairman, Member or Expert of several government panels, especially on energy policy issues in Sweden.