Demystifying the spot market

The concept of supply and demand is fundamental to the mechanics of the wholesale market. In the case of energy generation, demand is how much energy is needed and supply refers to how much energy is available for dispatch through the energy network, from energy generators like coal or gas power plants and wind farms.

This supply / demand balance has a corresponding impact on wholesale prices. More on that later…

But first, what are wholesale prices?

Wholesale prices are the prices paid to generators for the supply of electricity on a day-to-day basis.

What are some of the recent influences on wholesale prices?

Wholesale electricity spot prices have reached historical highs in recent years, primarily because of:

Less supply – The sudden closure of Hazelwood power station in 2017 meant there was not enough time for new generation to be built as replacement, resulting in less generation available to meet electricity demand (a tighter supply and demand balance).
Increased input costs - Gas and coal prices have been increasing. These input / fuel costs directly impact the cost of supplying electricity.

How are wholesale prices determined?

Electricity from utility-scale generators, including AGL’s generators, is sold on the spot market. All electricity supplied to the spot market to meet demand, is sold at the ‘spot price’. Then, the average spot price over a period of time is the wholesale price.

How does the spot market work?

The spot market was designed to find the lowest cost electricity generation per Mega Watt hour (MWh), by prioritising supply of energy from the lowest bids first.

Step-by-step spot pricing

As demand is constantly changing, the market operator forecasts how much electricity will be needed every 5 minutes.
The market operator finds the cheapest electricity to meet demand by asking generators how much electricity they can provide, and the price, for every 5-minute interval.
Generators bid the quantity of electricity they can supply and the price they want to receive for each 5-minute interval.
Bids are placed in order from cheapest to most expensive up to the level required to match demand (the ‘bid stack’).
The market operator will then select the cheapest bids from generators until there is enough supply to meet demand.
The energy from these selected generators is dispatched (the market operator tells them to generate).
The spot price for each 5 minute interval is the price of the final bid that made up the bid stack to meet demand.
All generators in that bid stack of dispatched energy, are then paid the average spot price over a 30 minute period.
Generators that are not needed to meet demand (which are not dispatched) do not receive any payment. These are the higher priced bids.

Bringing this all together

In the context of less supply and increased input costs, generator bids have been higher because the costs of producing energy have been higher for much of the generation output in the NEM. This has meant the bids placed in the bid stack have been higher than they were previously.

While higher spot prices don’t sound great, the silver lining is that it encourages new generation to be built. Just like Uber’s pricing model, where higher prices encourage more drivers. Once there are enough drivers to meet demand, the pricing reduces.

In the case of generation, a higher average spot price is traditionally a trigger to encourage more generation to be built, however at the moment, increased policy certainty will ultimately be the best signal for the market.

And more generation in the NEM will ultimately mean more bids competing for selection in the stack, which will help bring down spot prices.