What happens to the marginal costs of electricity in the region?

What happens to the marginal costs of electricity in the region?

The marginal cost of electricity is a key indicator of the electricity market and a signal of its adjustment between supply and demand in the short term.. It reflects the cost of supplying an additional kilowatt hour (kWh) to the electrical system that results from the dispatch rule that each system follows. Electricity has high time specificity because the net demand and the cost of generating an additional unit of electricity vary continuously.[1]. In addition, the short-term cost of production is not linear, so the variations in marginal costs indicate different plants and technologies that come into operation.[2].

In countries where short-term coordination is based on offers from private agents, the spot market clearing price is a proxy that can be used for marginal cost. In a perfect market, the spot market should reflect marginal costs. In the region, most often there is no developed short-term/spot market. In many cases, dispatch is done centrally through a cost minimization algorithm, executed by the system operator, the result of which is an order of merit that reflects marginal costs. There are cases in which the short-term (or liquidation) price is the result of this minimization of costs.

A variation in marginal cost indicates changes in plants that generate at the margin. As a large part of the plants that generate on the margin during peak demand hours run on fossil fuels, the variations in marginal cost between different periods often reflect variations in the prices of natural gas and diesel. Thus, understanding and supervising the variation of marginal costs helps us understand the impacts that crises and international price shocks can have on national electricity markets..

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The shock in the world natural gas market is generating spikes in prices and very high marginal costs. For example, in Chile, the average daily real marginal cost of 2022 has been 32% higher than 2021 and 76% higher than the average of the last decade.

Marginal costs affect the economic value of short-term transactions, and in many markets they are a fundamental reference for medium- and long-term supply contracts.[3]. The variability of marginal costs is even more important with the incorporation of variable renewable energies.

Given the relevance of this information for the electricity sector, in the Energy Hub we have developed a database and analytical visualization that allows us to monitor the evolution of marginal costs, or their reference spot price, of 13 countries in the region of hourly, daily, monthly and yearly, both in local currency and in US dollars.

To illustrate, let’s see what happens in some countries in the region if we compare the variations in marginal costs between January-May 2022 with the same period in 2019 before the pandemic (see Figure 1).

Figure 1. Marginal costs of electricity markets (percentage changes Jan-May 2022 with the same period in 2019 pre-pandemic)

What happens to the marginal costs of electricity in the region?

Source: Own elaboration with data from market operators. Measured in dollars per MWh

Different factors can explain these variations. For example, the hydrology of the period can impact countries with strong water participation, such as Uruguay and Costa Rica. At the beginning of 2022, the droughts in Uruguay significantly affected hydroelectric generation, which caused this drop to be compensated with the production of thermal energy, increasing marginal costs. In other periods when there is a surplus of energy, either because there is hydrological abundance that is added with wind power, the marginal costs can reach zero. In addition, given the integration between Brazil and Uruguay, the hydrology of Brazil also affects the opportunity cost of water in Urguay.

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In more thermal countries such as Argentina, Bolivia, and Brazil, the price of natural gas is an important element in the marginal costs and its variations depend a lot on the gas market, the sources and the contracts associated with them. Bolivia depends on the national production of natural gas that it exports to countries in the region and thus the price of gas has a very different logic in countries that import this resource. Brazil – which has a system based mainly on hydroelectricity (more than 60% of generation) – and Argentina have significant domestic production and also import the resource. The combination of water variability and the import of liquefied natural gas (LNG) are important elements to explain the variability of marginal costs in Brazil.

The variability of the marginal costs depends on the characteristics of the electrical system of each country. Monitoring marginal costs is essential to better understand one of the system costs and its dynamics. This includes looking at the impact of fuel prices, changes in hydrology, or, in turn, changes in peak demand in the electricity market. Therefore, this understanding of the short-term dynamics of system operation is important to inform planners and policymakers.

Market designs that review spot price changes can be useful tools for revealing and calculating marginal cost changes. The use of these signals to communicate to end users is important for their greater participation in the management of the electrical load. This relationship allows dynamic adjustments in demand. However, the direct transfer of marginal costs to consumers must be carefully considered due to the effects that frequent large variations in marginal cost in the electricity system may have on families and the economy.

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[1] Net electricity demand is electricity demand minus non-dispatchable electricity generation, which is often considered to have zero marginal cost.

[2] For more see (Vazquez et al 2017).

[3] For more see Roubik and Rudnik (2009), Varas and Rudnick (2014), Bustos (2015)

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