Marginal Pricing and the Energy Crisis: Where Should We Go?

Abstract

The fundamental principle of marginal pricing in electricity markets has been strongly challenged following the recent European energy crisis. One of the main criticisms is the inability 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 techniques of mathematical programming to generalize the results of Boiteux 1960 and propose a market clearing mechanism that preserves the efficiency of current short term marginal pricing to induce optimal plants operations while also providing a long term investment signal when capacities are not necessarily adapted. Through an analysis of captured margins, our proposal, which differs only marginally from the current market clearing, 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.