PJM Price Formation: Why It’s Important to Understand

CI.EN.BG PJM Price Formation (1)

As a Regional Transmission Operator (RTO), PJM is an independent organization that oversees the wholesale electricity market serving the following states: Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia, and D.C.

They ensure that consumer electricity demand is met with power that’s generated at the lowest possible cost. By creating a supply and demand curve, the most cost-effective price sets the hourly LMP (locational marginal pricing). As PJM explains, LMP is similar to the notion of a taxi ride. Light traffic tends to equate to a consistent cost, which is similar to periods of low congestion (or demand) on the grid. Fares (or in the case of electricity, rates) are lower. But when demand for taxis (or electricity) goes up, so do costs.

How supply and demand affect electricity prices
Since electricity can’t be stored like natural gas, power plants are bidding into the market every hour of the day and PJM is stacking them up to create the lowest price for energy to meet consumer demand. As the day progresses, customer behavior increases the demand for power and higher-priced plants must come online. The last plant that is needed to meet demand will set the equilibrium price for that hour. Equilibrium price refers to the point when supply and demand are in equal balance.

Adapting to changing demands on the grid
Over the past several years, changes to the power grid have resulted in the need for specific generators to be online to maintain reliability, even if they aren’t the lowest cost. Since they aren’t being dispatched due to price, these resources are not setting the hourly price and as a result, are compensated with out-of-market payments. One example of this could be a coal plant that is expected to be needed during the peak of the day. Since it can take several hours for a generator to increase their output, they will receive these out-of-market payments through the night to make sure they are available later in the day.

How payments to generators can affect your price
The extra costs associated with keeping power plants operating and ready to respond to peak demand must be recouped somewhere. As a result, they are allocated to customers in a method that is not transparent and creates a risk that cannot be mitigated by suppliers with traditional market-based strategies.

PJM is considering changes to avoid out-of-market payments
To avoid out-of-market payments to generators, PJM is in the process of changing the fundamentals of the market. This process of changing the way the hourly energy price is created is often referred to as price formation.

One example of these changes involves transforming the way reserves are priced in the market. Reserves are basically additional resources that can react very quickly if the need occurs. PJM has proposed to price these reserves into the hourly LMP. In other words, they artificially boost the demand needed to maintain the reliability of the grid. It also makes the costs more transparent upfront, as opposed to handling behind the scenes.

PJM ran a simulation of 2018 prices given their proposed changes and it would have resulted in a 7% average increase to LMP.

How to Protect Your Power Costs
PJM’s proposal will go to the Federal Energy Regulatory Committee (FERC) to approve or alter, which makes timing of the increases difficult to determine. PJM said it could potentially be in place by June 2020. This means in the near future, price spikes could be passed on to your business. By locking in a long-term contract, you could avoid many of these expected risks. Protect your business now to better control your electricity costs.

We're here to help