Electricity Markets and the Grid

How the power grid keeps supply and demand in constant balance, and how wholesale markets decide which power plants run.

Electricity is unusual among products because it is very hard to store in large amounts and must be produced at almost the exact moment it is used. The power grid is the network of power plants, high-voltage transmission lines and local distribution wires that carries electricity from where it is made to where it is used. Keeping that network working means matching supply and demand not once a day, but every second.

Balancing supply and demand every second

When you switch on a fan, a power plant somewhere must produce a tiny bit more electricity almost instantly. If demand runs ahead of supply, or supply runs ahead of demand, the grid’s frequency drifts away from its target, which is 50 cycles per second in India and Europe and 60 in North America. Drift too far, and equipment can be damaged or large blackouts can follow. A grid operator, an organisation responsible for a region’s grid, watches demand around the clock and instructs power plants to raise or lower output to keep the system balanced.

How wholesale markets choose which plants run

In many countries, power plants sell electricity in a wholesale electricity market, where generators offer power and large buyers, such as electricity retailers and distribution companies, purchase it. Each generator offers to supply a certain amount at a certain price, usually close to its marginal cost, which is the extra cost of producing one more unit of electricity. For wind and solar farms, marginal cost is close to zero because sunlight and wind are free. For coal or gas plants, marginal cost is mostly the fuel they burn.

The grid operator lines up the offers from cheapest to most expensive. This ranking is called the merit order. Plants are switched on in that order until enough power is supplied to meet demand. In many markets, every generator that runs is then paid the price offered by the last, most expensive plant needed. That final plant is said to set the price.

Walking through a merit order

Picture a small grid that needs 900 megawatts in one hour. Solar and wind offer 300 megawatts at close to 0. A hydro plant offers 200 megawatts at 20 dollars per megawatt hour. A coal plant offers 300 megawatts at 50 dollars. A gas plant offers 300 megawatts at 90 dollars. Solar, wind, hydro and coal together supply 800 megawatts, which is not quite enough, so 100 megawatts from the gas plant are needed. Because gas is the last plant called, the price for that hour is 90 dollars, and every running generator receives it. If demand had been just 800 megawatts, the price would have been only 50 dollars.

Why pay everyone the same price?

Paying every plant the final price can seem generous to cheap generators, but it has a purpose. It encourages each plant to offer its true costs rather than guessing what others will bid, and the extra earnings for low-cost plants help them pay back the large cost of building them. Critics point out that it can make power very expensive when a costly fuel, such as imported gas, sets the price. Countries organise their markets differently: some, including India, combine power exchanges with long-term contracts between generators and state distribution companies.

Confusing the wholesale price with your bill

The wholesale price is only one part of what households pay. A typical electricity bill also covers the cost of building and maintaining transmission lines and local wires, metering, losses along the way, and often taxes or subsidies. That is why a big change in wholesale prices can show up only partly, or after a delay, in household bills.

Key takeaways

Electricity must be generated at almost the same instant it is used.
Grid operators constantly balance supply and demand to keep the system stable.
In wholesale markets, plants are called on in merit order, from cheapest to most expensive.
Often the last plant needed sets the price that all running plants receive.
Household bills include network costs, taxes and more, not just the wholesale price.