IEEE Power & Energy Magazine - January/February 2021 - 66

P3

P2

P2

nd
Dema 2

nd
Dema 1

Dema

nd
Dema 3

marginal costs, such as solar, wind, hydro, nuclear, coal, gas,
and/or diesel generation. In those systems, supply sets the spot
price most of the time, meaning that prices are equal to the
short-run marginal cost of the most expensive unit in operation. In such cases, many of the low-priced generation units
recover a large fraction of their investment during times when
more expensive generators set the spot price. This is particularly true for renewables, which have extremely low variable
costs (typically, only a few dollars per megawatt-hour and
linked to wear and tear and other operating costs) and can
be considered as virtually equal to zero for all intents and
purposes. For example, a wind unit that runs at a time when
demand is high and the spot price is set by a diesel generator earns a short-run profit equal to the difference between
the marginal costs of the diesel unit and the wind generator. In the relatively mature markets of the United States and
Europe, the somewhat predictable behavior of the supply and
demand curves has resulted in moderately stable spot prices,
which eases the predictability of revenues needed by generators to secure financing with lenders.
In contrast, electricity systems with high renewable
shares may have much less variety in the variable cost of
generation technologies. Figure 1(b) shows the supply and
demand curves for a hypothetical system where all the generators have zero marginal cost, akin to how supply curves
would look in a system with a lot of generation from abundant hydro, wind, and solar resources. Note that, in those
cases, any time that demand is low enough, spot prices are
equal to zero. However, when demand goes up, prices can
increase dramatically, allowing all technologies to recover
their investment costs. Although all generation units benefit
from scarcity prices, their occurrence in the case depicted in
Figure 1(a) is particularly important to ensure that peaking

(US$/MWh)

(US$/MWh)

nd
Dema 1

nd 2

for the efficiency induced by these market-based signals.
Under some specific assumptions (such as perfect competition), if the wholesale electricity price in each period and
location reflects only the short-run marginal cost of an incremental change in demand (plus the cost of reducing demand
when capacity is scarce) without the consideration of capital
costs, a spot market can guarantee the efficient operation of
generation units in the short term and incentivize the entry
and exit of generation units of the right size, with the right
technological characteristics, and at the right locations in a
transmission network.
Figure 1(a) illustrates the supply and demand curves for
a hypothetical system with four generation units with different marginal costs. The intersection of supply and demand
curves defines both the spot price and the demand level that
must be supplied with the available generation units. Note
that, for most demand levels, the intersection point occurs
at one of the horizontal segments of the supply curve, which
means that spot prices coincide with the marginal cost
of some generation unit (e.g., the resulting spot price for
Demand 2). However, the intersection of supply and demand
can also occur at vertical segments of the supply curve when
generation capacity is scarce. In these cases, the resulting
spot prices are higher than the cost of the most expensive
generation unit running in the system (e.g., the resulting spot
prices for Demand 1 and Demand 3) and are often referred
to as scarcity prices. In equilibrium, this set of spot prices,
including scarcity prices, allows for all the efficient units to
cover both operating and capital costs.
The supply curve in Figure 1(a) is representative of most
historical and current systems, with a steeply sloped demand
curve (low elasticity) and a supply curve (also called a meritorder curve) formed by a portfolio of units with different

P1

Q1

Q2

Q3

P1 = 0

Q1

(MW)

(MW)

(a)

(b)

Q2

figure 1. The supply and elastic demand curves for a system (a) with a mix of different conventional generation units and
(b) where all units have zero marginal cost.
66	

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january/february 2021
IEEE Power & Energy Magazine - January/February 2021

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