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PUR Guide 2012 Fully Updated Version

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Carbon In Electricity Markets

Price transparency will drive GHG reductions.

Fortnightly Magazine - August 2009

they incur as a function of their investment decisions. Analyzing a project’s potential risk and return is made easier, and can be done more accurately, when prices in the market are transparent.

Marginal Pricing and Carbon Reductions

It’s widely recognized that economic efficiency (social optimality) involves the market price of a good being equal to the marginal cost of producing that good. This often is referred to as the marginal-cost pricing principle. A situation in which the market price is greater than marginal cost is less than optimal because another unit of the good could be produced at a marginal cost below what the market is willing to pay. Both producer and consumer are better off if production is increased in this situation. Alternatively, if prices are below marginal costs, welfare is increased by reducing production levels, since the marginal production cost is greater than consumer willingness to pay (market price).

In electricity markets, market-based marginal-cost pricing reflects the variable generating cost of the most expensive unit needed to meet load. It provides the proper price signal for dispatch of existing resources, new entry of generation, innovation, and customer demand response, since the incremental cost is fully reflected in the price earned by suppliers and paid by wholesale purchasers. Market-based marginal-cost pricing ultimately will lead to an efficient allocation of resources and resulting in optimal average prices over the long-term.

Because marginal costs represent the incremental cost of serving the final unit of demand, market-based marginal-cost rates directly are impacted by changes in input costs (such as fuel, environmental costs and capital costs) and the marginal supply-demand balance of generation and load.

The incremental cost of serving the final increment of load represents the true opportunity cost that new resources appropriately can benchmark against. In other words, if market prices rise to a level where they allow new capacity to cover operating and capital costs, then that capacity will have an incentive to enter the market. If market prices remain below this level, the market will utilize cheaper existing resources.

The choice of electricity generating technologies depends on the forward-looking economics of different types of generation using the various price signals generated by competitive markets. The price signal for revenues is the forward price of electricity that reflects a market consensus on future electricity supply and demand and the marginal costs of converting different fuels into electricity. The price signals for costs are the forward prices for different types of fuel ( e.g., gas, coal, etc.) that reflect supply and demand conditions in those markets.

Decision makers can integrate these price signals into a consistent picture of the relative economics of different generation types and then decide accordingly. Different decision makers may have different long-term expectations and different appetites for risk, but each decision maker will monitor market prices and invest capital derived from decisions based on these differences in expectations and risks.

Carbon Prices and Dispatch Order

Price signals for electricity and CO 2 emissions can act in concert to change the dispatch order and increase investment in new renewable