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An Intro to Locational Marginal Pricing

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Locational marginal pricing (LMP) serves as a valuable mechanism for pricing electricity in managed wholesale markets. It defines the price for electricity in real time at specific points referred to as nodes within a transmission system. These prices represent clear benchmark signals for buyers and sellers in electricity markets. They provide vital insights into decisions concerning infrastructure investment, enable higher levels of grid stability, and produce competitive markets for reliable power sources.

LMP fluctuates on an hourly basis depending on various factors and can vary significantly between locations. According to leading economists, LMP sends accurate price signals to generators and customers, informing them when and where power is cheap or expensive. Market participants benefit from access to transparent real-time data to make reliable decisions about investment, resulting in more innovation, efficiency, reliability and market liquidity.

Chart showing average locational marginal prices in Texas

Figure 1: Average locational marginal prices in Texas colored by price range. Source: Enverus P&R — Enhanced LMP.

Day ahead vs. real-time energy markets

Generally, most ISOs have day-ahead and real-time LMP. Day-ahead LMP involves pricing in day-ahead markets, allowing participants to buy and sell wholesale electricity a day before they operate, avoiding potential market volatility. The day-ahead energy market includes a financially binding schedule of commitments for the sale and purchase of energy. Every day, the ISO develops a price based on the data submitted to the market. Usually, a supply bid or demand offer will be cleared by the day-ahead energy market if the rate equals or is less than the LMP for a specific location.

Real-time LMP represents a price in real time and allows participants to buy and sell power during the day of operation. For example, at noon you anticipate you require 100 megawatts of electricity demand and purchase that exact amount the day before on the day-ahead market. However, when the time comes, demand is a little higher at 105 megawatts, so you buy the additional 5 megawatts on the real-time market. Prices for this market are typically more volatile compared to the day-ahead market prices.

The real-time energy market balances the differences between day-ahead commitments and real-time demand for production of electricity. The real-time energy market generates a secondary financial settlement. It creates the real-time LMP that is either paid or charged to market participants within the day-ahead energy market for demand or generation that differs from the day-ahead commitments.

Graphs showing LMP summary for a single node in ERCOT

Figure 2: LMP summary for a single node in ERCOT. Source: Enverus P&R — Enhanced LMP.

What are the three core components of an LMP?

LMPs consist of three core components: energy price, congestion cost and losses.

System Energy Price The energy component of all LMP is the price for electric energy at the “reference point,” which refers to the load-weighted average of the node prices. The costs of producing electricity by a generator are dependent on several factors, including the price of fuel, which can fluctuate considerably over time. Generators provide their output into the market at prices that consider these factors and other potential production costs.

Transmission Congestion Costs The congestion aspect of node LMP refers to the marginal costs of congestions at a particular node compared to the load average of the system prices. When demand is low, electricity typically flows unrestrained from point to point in the grid. As demand starts to rise, the physical constraints of the transmission system may influence how much power can flow safely through lines and substations. Furthermore, some equipment or lines may not be operating due to maintenance or repair. As congestion occurs, the cost of moving electricity along those lines gets bid up.

Cost of Marginal Losses The third component of LMP is known as the cost of marginal losses. Losses are effectively the electricity lost during the process of long-distance transport.

Marginal loss prices are an element of marginal pricing and reflect the fractional change in cost due to the shift in system line losses. The loss element of LMP at a particular node represents the cost of losses at that location respective to the load-weighted average of the system node prices. In some situations, like in ERCOT, marginal line losses are not considered in the price formation.

Graphs showing decomposition of the Lost Pines 1 natural gas plant's marginal cost components

Figure 3: Decomposition of the Lost Pines 1 natural gas plant’s marginal cost components. Source: Enverus P&R — MUSE.

What are locational marginal prices used for?

For everything! Without prices and transparency, there is no efficient market. LMP makes the whole electricity market work — it’s crucial in fulfilling workflows for developers looking to site a project. Developers need to understand the price they can receive for their electricity in the merchant market and may use historical prices to inform power purchase agreement rates or they can index to a particular price node. Traders utilize this data to facilitate a liquid market and make trade decisions based on a plethora of factors including the impact of outages, congestion and weather. They also use it to understand what the impact of the different components of LMP are on the price, particularly the impact of congestion, which can be used for many meaningful trade opportunities.

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Sarp is Senior Director of Power & Renewables Analytics at Enverus. He has research and modeling experience in the upstream, downstream and power markets and has presented his work at various academic conferences around the world, including those organized by the SPE and the IAEE. He has also been published in the SPE Economics & Management Journal for his work on the long-term economic viability of production from unconventional liquids-rich reservoirs. Sarp’s focus on data-driven modeling and his ability to incorporate the effects of technological and market advances into analyses provides clients a thorough picture of the present and the future in their area of interest within the oil and gas industry. Sarp holds a Master of Science in Mineral and Energy Economics from the Colorado School of Mines, a Master of Science in Petroleum Economics and Management from the Institut Francais du Petrole (IFP School), and a Bachelor of Arts in Economics from the University of Chicago.