Marginal pricing and the energy crisis: Where should we go?

Abstract

The fundamental principle of marginal pricing in electricity markets has been challenged following the recent European energy crisis. A main criticism targets the incapacity of current markets to drive investments, as spot prices provide only short-term information about supply, demand, and costs. This paper revisits the seminal work of Boiteux (1960) in the context of the recent energy crisis to discuss the fundamental assumption of adapted capacity, which underpins the equality between long-term and short-term marginal costs in the theory of marginal pricing. We argue that capacity is no longer adapted to current economic conditions in Europe. We then leverage mathematical programming techniques to generalize the results of Boiteux (1960) and propose a market-clearing mechanism that preserves the efficiency of current short-term marginal pricing to drive optimal plant operations while also providing a long-term investment signal when capacities are not necessarily adapted to current economic conditions. Through an analysis of captured margins, our proposal, which differs only marginally from the current market-clearing mechanism, identifies plants that should remain in the current mix and those that are no longer economical. We also discuss possible extensions of our proposal to accommodate capacity markets and price caps. Finally, we implement our models with the French power mix and demonstrate their advantages over the current market-clearing mechanism using a realistic case study.