The Economics of Electricity Markets

4Efficient Short-Term Operation of an Electricity Industry with no Network Constraints

Let us start by putting aside network issues. Let us suppose that we have a set of generators and loads that (for the moment) are all located at the same point on the network. Now imagine that you are an omniscient all-powerful operator, able to control all of the generation and consumption resources in the economy. How should you use this stock of generation and consumption resources in the most efficient way possible? We start by focusing on the question of the efficient use of a set of generation resources. Consideration of this question leads us to the notion of the merit order. In the next section, we shall ask whether it is possible to achieve this efficient outcome using decentralised decision-making and market signals alone.

4.1 The Cost of Generation

Let us focus first on the optimal use of a set of existing generation assets. As we saw in Part II, electricity is produced by physical equipment, which we will refer to as an electricity generator.

We will focus in this section on the short-run economic costs incurred by a generator in producing its output. In general, the costs incurred by a generator will depend on many parameters (such as the price of the input fuel and the cost of capital). We will focus on how the costs incurred by a generator might vary with the level of output of the generator (i.e. the rate at which the generator produces electrical energy). Let us call the rate ...