Lesson 2

Electricity Pricing

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We all received one of these things in our mail box. At least if you live in Sweden then this is what your electricity bills looks like. Your consumption is being monitored in kWh, i.e. $10^6$Wh corresponding to $10^6 \cdot 3600$J (1 W = 1 J/s), where J stands for Joule and represents the amount of heat. Thus, your consumption in kWh corresponds simply to the amount of power expended for one hour. All houses or apartments have some sort of monitoring equipment that keeps track of your electricity consumption. Then you pay a price in currency/kWh for your consumption. But how is this price set? What factors influences the variation of this price and what measure as a consumer can be taken to avoid paying expensive electricity bills?

Price cross

As any goods traded, the electricity price is set by supply and demand. The easiest way to explain how electricity pricing is set is by illustrating it with a simplified example. Imagine that there are three generating companies in your country: Producer A, Producer B and Producer C. Producer A owns hydro plants, Producer B owns nuclear power plants and Producer C owns gas turbines. Each of these power plants have a total generation capacity expressed in TWh/year and a variable production cost associated with the plant. The production is arranged in ascending production cost order.

As shown in the graph, the different power plants have an installed power capacity and a variable operation cost. This production is what represents the electricity supply. Now, most of consumers are not price sensitive, which means that they would consume electricity regardless of the price change. Assuming the demand in this example is 130 TWh/year, we get the following price cross:

Therefore, in this example, the electricity price becomes 90 SEK/MWh or simply 9 öre/kWh.

Pricing controversy & market power

There is a lot of debate in Sweden about electricity prices and suspicion against producers manipulating the market. As presented in the previous example, the price is set between supply and demand. Now, imagine that the producer that owns the nuclear power plants has to run maintenance work on many of his generating units. This would decrease the total installed capacity of nuclear power and to meet the demand more natural gas production would be needed. The consequence of this is that the price cross occurs at a higher cost level, which means consumers will get a more expensive electricity bill. The controversy is that producers increase their revenues when situation like this happen. Some suggest that power generating companies often withholds information about their true installed capacity or run strategic maintenance work to force prices to go up. Fortunately, there are many inspections and regulations in place to avoid producers from exercising market power. Despite this, the suspicion never fades as there will always be a certain degree of market power.

Variable & fixed contracts

Consumers can choose between variable and fixed cost contracts with their electricity retailer. Choosing a variable contract means that the consumer will pay the price set in the market. The consumer is exposed to a risk where the price might increase significantly during months of high consumption (e.g. winter time). With a fixed contract the consumer is risk averse and pays a fixed price set by the retailer. It is hard to make a fair comparison on which one of these contracts are more beneficial for the consumer, although the popular opinion tends to state that a variable contract becomes cheaper in the long run.