The primary role of a market price is to establish equilibrium between supply and demand. This task is especially important in the power markets because of the inability to store electricity and the high costs associated with any supply failure. The day-ahead market at Nord Pool is an auction-based exchange for the electricity to be delivered physically.
The day-ahead market carries out the key task of balancing supply and demand in the power market with a certain scope for forward planning. In addition to this, there is a final balancing process for fine adjustments in the real-time balancing market.
The ’Invisible Hand’ which creates equilibrium in most other markets is replaced in the power markets by a concrete, visible hand. This is the day-ahead market which receives bids and offers from producers and consumers alike and calculates an hourly price, balancing these opposing sides. Nord Pool publishes a price for each hour of the coming day in order to help balance supply and demand.
Every morning members post their orders to the auction for the coming day. Each order specifies the volume in MWh/h that a member is willing to buy or sell at specific price levels (EUR/MWh) for each individual hour in the following day.
Electricity produced at the lowest cost every hour of the day
A well-functioning and competitive power market produces electricity at the lowest possible price for every hour of the day. The balance price represents both:
i) The cost of producing one kWh of power from the most expensive source needed to be employed to balance the system - either from a domestic installation or from external imports.
ii) The price that the consumer is willing to pay for the final kWh required to satisfy demand.
The price formation process is therefore economically effective for society.
Nord Pool establishes prices in the same way as other energy markets
In the political debate surrounding energy, this type of price formation is labelled marginal price setting. This gives a false impression that the establishment of prices in the electricity market is different from the price formation process in other commodity markets. The only difference lies in the significantly higher requirements for the secure delivery of electricity because it must be delivered at the precise moment it is needed by the consumer. The inelasticity caused by the inability to store electricity causes this difference. Market price formation is therefore a more accurate term than marginal price setting.
There is, however, a great difference between electricity and the other energy (and commodity) markets in that the variable costs of production vary so greatly between different types of installation – wind and hydropower with a virtual nil cost at one extreme and gas turbines at the other end of the scale.
In order to satisfy fluctuating consumer demand at the lowest cost, a broad variety of generating techniques are required. Some installations are capital intensive but can be run year-round and are relatively fuel efficient (hydro, nuclear, coal-fired). Other units such as CHP (combined heating and power) are used less frequently to cover winter heating demand at times of higher prices. Whilst energy-intensive units such as gas fired turbines are used for brief periods of very high price and demand.