Like most of the world, the UK uses a system called Pay as Cleared to set electricity prices. Under this system, all generators - even those who bid in at a lower price - are paid the top clearing price for electricity. The flexibility offered by gas generators means they are often the ones called upon top-up supply and so they end up setting this final price. In the UK this topping up results in the highest priced electricity in Europe.
This system has come under fire recently but it’s how markets are supposed to work.
In a local farmer’s market, a similar mechanism is at play. Though different stallholders may have different prices they would be willing to sell at, the price of goods is often the same across different stalls, the ‘Clearing Price’. All stallholders end up charging and receiving the same price.
In the UK electricity market, where the price is set by the Balancing Mechanism. Generators make bids to increase supply or to reduce demand and when the two are matched, the market has ‘cleared’ and everyone receives the final clearing price.
But selling electricity is more complicated than selling tomatoes.
Firstly, most suppliers will have secured contracts in forward markets and the Balancing Mechanism is only used for fine tuning.
Secondly, large parts of the market operate irrespective of the clearing price. Renewables work on a mechanism called Contracts for Difference, which means that the price they get is set in a long-term auction not the balancing mechanism.
Then there is the essential nature of electricity. If tomatoes are too expensive, customers could switch to buying carrots instead. And if people stop buying tomatoes, stallholders will lower their prices again. But in electricity markets demand is less responsive to price increases. Tomatoes are easier to give up than electricity.
An alternative mechanism is called Pay as Bid, where everyone pays and gets what they bid into the Balancing Mechanism. There’s no single market price, more like the souk than the sleepy market town. Advocates say that this would result in cheaper electricity for consumers, detractors point to the billions that have been invested on the basis that the market operates Pay as Cleared.
Despite numerous attempts no electricity market has fully moved away from Pay as Cleared. Perhaps we are stuck with it?
