Module 6 — Marginal Pricing and Economic Dispatch
Lesson 6 of 8
Congestion, Zonal Pricing and Locational Marginal Pricing
Learning objectives
By the end of this lesson you should be able to:
- Understand why transmission constraints affect electricity markets.
- Explain what network congestion is.
- Distinguish between uniform, zonal and locational pricing.
- Understand the basic principles of Locational Marginal Pricing (LMP).
- Appreciate the advantages and disadvantages of different pricing approaches.
- Recognise why market prices sometimes differ between locations.
Introduction
In the previous lessons, we made one important simplifying assumption.
We assumed that electricity could flow freely from any generator to any consumer.
Under this assumption, a single market price was sufficient.
In reality, electricity networks have physical limits.
Transmission lines can become congested.
Voltage and stability constraints must be respected.
Power does not always flow where market participants would like it to.
These physical realities introduce a new question:
Should electricity have the same price everywhere?
Or should prices reflect where electricity is being generated and consumed?
Modern electricity markets answer this question in different ways.
What is congestion?
Congestion occurs when the electricity network cannot transport all of the power that market participants would like to exchange.
Imagine a simple example.
A wind farm in northern Scotland can produce:
2 GW
A city in southern England requires:
2 GW.
However, the transmission line connecting them can carry only:
1 GW.
The remaining electricity cannot be transported.
The network has become congested.
Why congestion matters
Congestion changes the least-cost dispatch.
Without network constraints, the cheapest generators would always supply demand.
With congestion, this may no longer be possible.
Returning to our example:
- Wind costs £10/MWh.
- A local gas station costs £80/MWh.
Normally the wind farm would supply all demand.
However, because the transmission line is full, some local gas generation must now operate.
The system remains physically secure, but operating costs increase.
The market must somehow account for this.
The simplest approach: Uniform pricing
The simplest solution is to ignore location altogether.
Every generator and consumer receives the same wholesale price regardless of where they are located.
This is known as uniform pricing.
Many electricity markets began with this approach because it is simple and easy to understand.
However, congestion creates a problem.
The market may schedule power transfers that the network cannot physically accommodate.
A separate system operator must then redispatch generators to maintain security.
Redispatch
Redispatch is the process of changing the market schedule after trading has taken place.
For example:
- a cheap generator may be instructed to reduce output,
- a more expensive generator elsewhere may be instructed to increase output.
Consumers continue to pay the market price.
The additional costs of redispatch are recovered through network charges or other settlement arrangements.
Many electricity markets operate in this way.
The market determines the initial dispatch.
The system operator then adjusts it to maintain network security.
Zonal pricing
One way to better reflect congestion is to divide the network into larger geographical regions known as zones.
Each zone has its own electricity price.
Within a zone:
- electricity has one common price.
Between zones:
- prices may differ.
If congestion occurs between two zones, the price in the importing zone generally becomes higher than the price in the exporting zone.
The difference reflects the limited ability to transport electricity across the constrained network.
Countries such as Sweden, Italy and Norway use variations of zonal pricing.
Locational Marginal Pricing (LMP)
A more detailed approach is Locational Marginal Pricing, often called nodal pricing.
Instead of assigning one price to an entire region, LMP calculates a separate price for each node (or bus) in the transmission network.
Each price reflects the cost of supplying one additional megawatt-hour of electricity at that specific location while respecting the physical constraints of the network.
In other words:
Electricity may have a different price at every node.
Markets such as PJM, NYISO, MISO, CAISO and ERCOT use forms of locational marginal pricing.
How LMP works
Locational Marginal Pricing combines two ideas.
First, determine the least-cost dispatch while respecting all network constraints.
Second, calculate the cost of supplying one additional unit of electricity at every location.
If electricity can be delivered easily, prices remain similar across the network.
If transmission constraints exist, prices begin to diverge.
Areas with abundant low-cost generation tend to have lower prices.
Areas requiring expensive local generation tend to have higher prices.
The three components of an LMP
In many electricity markets, a locational marginal price can be viewed as comprising three components.
Energy component
The cost of producing the next unit of electricity.
Congestion component
The additional cost created by transmission constraints.
Loss component
The additional cost associated with electrical losses during transmission.
Together, these determine the final price at each location.
A simple example
Suppose there are two locations.
North
- Wind generation
- Marginal cost: £20/MWh
South
- Gas generation
- Marginal cost: £80/MWh
If the transmission line between them has spare capacity, both locations may experience approximately the same price.
Now suppose the transmission line becomes congested.
The South can no longer import sufficient wind energy.
Local gas generation becomes necessary.
Prices might become:
- North: £20/MWh
- South: £80/MWh
The difference reflects the physical limitations of the network rather than differences in market rules.
Advantages of locational pricing
Supporters of LMP argue that it offers several important benefits.
Efficient dispatch
Network constraints are incorporated directly into market clearing.
Better investment signals
Persistent high prices indicate where additional generation or network investment may be valuable.
Reduced redispatch
Because congestion is included during market clearing, fewer corrective actions may be required afterwards.
Transparent congestion costs
Participants can observe where congestion is increasing system costs.
Challenges of locational pricing
LMP also introduces additional complexity.
Many prices
Instead of one national price, there may be thousands of prices.
Greater volatility
Prices can vary significantly between neighbouring locations.
Forecasting difficulty
Market participants must forecast prices at many different nodes.
Data and computation
LMP requires detailed network models and sophisticated optimisation algorithms.
Uniform, zonal and nodal pricing
These approaches can be viewed as different levels of geographical detail.
| Approach | Prices |
|---|---|
| Uniform pricing | One national price |
| Zonal pricing | One price per region |
| Locational (nodal) pricing | One price per network node |
Each approach attempts to balance:
- simplicity,
- computational complexity,
- economic efficiency,
- representation of network constraints.
There is no universally accepted solution.
Different countries have adopted different approaches depending upon the characteristics of their electricity systems and policy objectives.
Why this matters
As electricity systems become increasingly decentralised, congestion is occurring more frequently.
Large volumes of renewable generation are often located far from centres of demand.
Electric vehicles, batteries and flexible loads are changing how electricity flows through both transmission and distribution networks.
These developments have renewed interest in how electricity prices should reflect network constraints.
Whether this is best achieved through uniform pricing, zonal pricing or locational pricing remains one of the most active debates in electricity market design.
A key insight
Transmission networks have finite capacities.
When congestion occurs, electricity cannot always flow from the lowest-cost generators to every consumer.
Uniform pricing, zonal pricing and locational marginal pricing represent different approaches to incorporating these physical constraints into electricity markets.
Each seeks to balance economic efficiency with practical implementation, but they differ in the level of geographical detail used to determine market prices.
Key takeaways
- Electricity networks have physical constraints that affect market outcomes.
- Congestion occurs when transmission capacity limits the movement of electricity.
- Uniform pricing applies a single price across the entire market.
- Redispatch allows system operators to correct infeasible market schedules.
- Zonal pricing assigns one price to each geographical region.
- Locational Marginal Pricing (LMP) assigns prices to individual network nodes.
- LMP incorporates energy costs, congestion costs and transmission losses.
- Different pricing approaches represent different trade-offs between simplicity and accurately reflecting the physical network.
Looking ahead
So far, we have explored how marginal pricing operates and how it can be extended to account for network congestion.
The natural question is:
How well does this approach work?
In the next lesson, we examine the strengths of marginal pricing and explore why it became the dominant paradigm in electricity market design around the world.