Module 6 — Marginal Pricing and Economic Dispatch
Lesson 4 of 8
Scarcity Pricing
Learning objectives
By the end of this lesson you should be able to:
- Understand what scarcity pricing is and why it occurs.
- Explain why electricity prices rise during periods of limited supply.
- Understand the relationship between scarcity pricing and reliability.
- Recognise the role of scarcity pricing in energy-only electricity markets.
- Appreciate both the strengths and criticisms of scarcity pricing.
- Understand the connection between scarcity pricing and long-term investment incentives.
Introduction
In the previous lesson we learned that wholesale electricity prices are determined by the marginal generator.
Most of the time, this produces relatively stable prices.
However, electricity markets sometimes experience periods when prices rise dramatically.
Prices that are normally tens of pounds per megawatt-hour may increase to hundreds—or even thousands—of pounds per megawatt-hour.
Why would electricity become so expensive?
The answer lies in one simple idea:
Scarcity.
Just as airline tickets become more expensive when only a few seats remain, electricity prices can increase sharply when generating capacity becomes scarce.
This behaviour is known as scarcity pricing.
What is scarcity?
Scarcity occurs when available electricity supply is only just sufficient to meet demand.
Imagine a system where:
- almost every generator is already operating,
- reserve capacity is limited,
- demand continues to increase.
The electricity system is approaching its physical limits.
At this point, supplying one additional unit of electricity becomes increasingly difficult.
The value of reliable electricity therefore rises.
Why prices increase
Suppose demand increases from:
39 GW
to
39.1 GW.
If sufficient generation remains available, the additional demand can be supplied relatively easily.
Now imagine demand increases from:
49.9 GW
to
50 GW,
when the entire system has only:
50 GW
of available generation.
Supplying that final increment of demand may require:
- expensive generators,
- emergency reserves,
- imported electricity,
- demand reduction.
The final unit of electricity has become much more valuable because the system is nearly full.
Scarcity pricing in practice
Electricity markets reflect this increasing value through higher prices.
As available generation becomes scarce:
- wholesale prices increase,
- additional generators are encouraged to operate,
- consumers may reduce demand,
- flexibility resources become more valuable.
Scarcity pricing therefore helps balance supply and demand without requiring central planners to decide who should consume electricity.
The economic argument
Economists often describe scarcity pricing as an efficient market signal.
High prices communicate two important messages.
Short-term message
Electricity is currently scarce.
Resources capable of generating or reducing demand are encouraged to participate.
Long-term message
Reliable generating capacity has value.
Investors observing repeated scarcity events may decide to build additional generation, storage or demand flexibility.
Scarcity pricing therefore influences both operational decisions and future investment.
An example
Suppose a gas turbine normally operates only during winter evenings.
Most of the year it earns little revenue.
However, during a handful of scarcity events, wholesale prices become very high.
The generator earns significant income during these periods.
Over many years, these occasional scarcity revenues contribute towards recovering its investment costs.
Without scarcity pricing, such generators might never recover enough revenue to remain economically viable.
Scarcity pricing in energy-only markets
Energy-only markets rely particularly heavily on scarcity pricing.
Recall from the previous module that energy-only markets pay generators only for the electricity they produce.
Generators receive no payment simply for remaining available.
Periods of scarcity therefore become critically important.
They provide opportunities for generators that operate infrequently to recover both their operating costs and part of their long-term investment costs.
In this way, scarcity pricing supports reliability without requiring separate capacity payments.
Demand response
Scarcity pricing does not only influence generators.
Consumers may also respond.
Imagine electricity prices increasing significantly for one hour.
Some consumers might choose to:
- delay charging an electric vehicle,
- postpone industrial processes,
- reduce heating or cooling slightly,
- discharge home batteries.
Demand therefore becomes part of the balancing process.
Scarcity pricing encourages flexibility on both the supply and demand sides of the electricity system.
Scarcity and reliability
One useful way to think about scarcity pricing is through reliability.
Reliable electricity requires spare capacity.
Maintaining spare capacity costs money.
Scarcity pricing allows those costs to be recovered during the relatively small number of periods when that spare capacity becomes essential.
In effect, the market places a higher value on electricity when reliable supply becomes more difficult.
Price caps
Many electricity markets place limits on how high prices may rise.
These are known as price caps.
Price caps are often introduced to protect consumers from extremely high prices.
However, they also create an important trade-off.
If prices cannot rise sufficiently during scarcity events, generators may earn less revenue.
This can reduce incentives to invest in new generation.
Finding the appropriate balance between protecting consumers and encouraging investment is one of the central challenges of electricity market design.
The missing money problem
Suppose scarcity prices are limited by regulation.
Consumers benefit from lower prices during shortages.
However, generators receive less revenue.
Some generators may no longer recover enough income to justify remaining available.
This reduction in investment incentives is known as the missing money problem.
It is one of the principal reasons why some countries have introduced capacity markets.
Advantages of scarcity pricing
Supporters argue that scarcity pricing offers several important benefits.
Efficient signals
High prices encourage additional supply and reduced demand.
Investment incentives
Periods of scarcity reward resources that improve reliability.
Technology neutrality
Any technology capable of responding to scarcity can benefit.
Generators, batteries and flexible consumers can all compete.
Reduced need for intervention
Rather than governments deciding which generators should be built, market prices provide investment signals.
Challenges and criticisms
Scarcity pricing also attracts criticism.
Price volatility
Electricity prices can become extremely volatile.
Consumer impacts
Very high wholesale prices may eventually increase consumer bills.
Political acceptability
Periods of exceptionally high prices are often unpopular and may lead to regulatory intervention.
Investment uncertainty
Investors cannot know exactly how frequently scarcity events will occur or how much revenue they will generate.
Some argue that this uncertainty makes long-term investment unnecessarily risky.
Scarcity is becoming more complex
Historically, scarcity largely reflected shortages of generation.
Modern electricity systems are more complicated.
Scarcity may also arise because of:
- transmission constraints,
- local network congestion,
- limited flexibility,
- insufficient storage,
- renewable variability.
This raises an important question.
Should every location experience the same scarcity price?
Or should prices differ depending upon where scarcity actually occurs?
This question leads directly to the next stage in the evolution of electricity markets.
A key insight
Scarcity pricing reflects the increasing value of electricity when supply becomes limited.
High prices encourage additional generation, reduced demand and long-term investment in reliable resources.
In energy-only markets, scarcity pricing plays a particularly important role because generators rely on these occasional high-price periods to recover part of their long-term investment costs.
At the same time, scarcity pricing raises important questions about price volatility, consumer protection and investment certainty.
Key takeaways
- Scarcity occurs when available electricity supply approaches demand.
- Electricity prices increase during scarcity because reliable supply becomes more valuable.
- Scarcity pricing encourages additional generation and demand reduction.
- Energy-only markets rely heavily on scarcity pricing to provide long-term investment incentives.
- Price caps can protect consumers but may weaken investment signals.
- The resulting reduction in investment incentives is known as the missing money problem.
- Scarcity pricing can improve both operational efficiency and long-term reliability but remains one of the most debated aspects of electricity market design.
Looking ahead
Scarcity pricing determines how revenues are distributed between generators and consumers.
Some participants benefit when prices increase, while others pay more.
Economists use the concepts of producer surplus and consumer surplus to analyse these outcomes.
In the next lesson, we examine these ideas and explore how electricity markets create value for different participants.