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Laatikollinen perunoita torikauppiaan käsissä

It can be helpful to think the electricity markets as a normal farmers market, where people go shopping for potatoes. Photo by iStock

Electricity markets for dummies – everything you need to know about the price of electricity

What sets the price of electricity, and what do potatoes have to do with it? Energy analyst and writer Rauli Partanen opens the math and mechanisms behind how electricity markets work with some very down-to-earth examples.

Electricity markets are hard for a non-expert to understand, and the choices are many when selecting a power contract. Let’s dumb it down for a moment and think the electricity markets as a normal Farmers Market, where we go shopping for our daily potatoes.

Most of us customers have an agreement with a potato seller/producer that we get our potatoes at a pre-agreed, fixed cost. On some days, we might feel bad as the daily price for other customers is lower than what we have agreed to pay, maybe because there are fewer buyers or the harvest has been good, leading to oversupply. And on other days (like during late 2021 in European energy markets), the daily prices are much higher due to high demand, low supply, and low level of stored potatoes, with a cold dark winter looming in front of us.

Some people buy their potatoes always at the daily price (or hourly spot-price in electricity markets). Imagine the organizer of the farmers market having an auction on the previous day for the potato-sellers and producers. She asks them to give a price level at which they are willing to sell any given amount of potatoes on the following day.

Let’s say one agrees to sell a ton of potatoes at 2 €/kg. Another sells 2 tons at 3 €/kg, and a third one agrees to sell 3 tons at 4 €/kg. The last seller agrees to sell 2 tons at the high price of 5 €/kg. So each seller has a different price they are willing to sell their produce at, depending on their costs and storage levels.

What sets the price

On the next day, the demand for potatoes is 8,000 kg. The market-organizer adds up the offers from the produces: 1 + 2 + 3 + 2 tons, a total of 8 tons. All the potatoes that were offered are also sold! The price that each of the producers get for their produce is the price that the highest bidder offered, 5 €/kg.

On the next day, auction results are the same, but demand decreases to 6 tons. This means that the potatoes from the highest price bidder are not needed, so he doesn’t get to sell any of his potatoes. All the rest sell their potatoes at the highest price that was included in meeting the demand, in this case 4 €/kg.

Fennovoima is a Mankala company, which means it cannot make profit but aims to sell all its potatoes, I mean electricity, to its owners at the cost it produces it.

If this occurs often, the most expensive supplier might get into financial trouble as he still has expenses to pay even if he doesn’t sell any of his potatoes. Maybe he needs to close his potato farm of shrink his operations. On the other hand, if the prices are consistently high at 5 €/kg, some of the potato farmers might want to grow their fields to increase production, especially if they think they can grow potatoes at a lower cost, which would mean higher profits. This leads to a growing supply of cheaper potatoes, which eventually lowers the prices as well, as the more expensive producers can’t sell their produce. The situation is never static or optimal but is always moving towards it.

Now you can change potato farmers to electricity sellers and producers in your mind. And the market-organizer in the farmers market is the Nord Pool electricity market. Electricity users buy electricity at the cost that the market discovers for each hour (called spot price) – unless they have a fixed-price contract with their supplier. If the spot-price is lower than the fixed-contract prices for a long time, the sellers often reduce the fixed costs in long term contracts as well, so their customers won’t go after a better price with some other supplier. Same happens to the other direction: fixed prices will need to go up if spot-prices are constantly higher, or otherwise the seller might go out of business.

A non-profit potato farm?

Let’s imagine that the low cost of potatoes attracts a potato-restaurant to open in town. The restaurant owner is concerned what will happen to her restaurant if the potato prices suddenly go up. One option she has is to buy on a long-term contract for some of her potato-supply, maybe for the next five years. This is called a ”futures contract”, which can be used by the restaurant owner to lower the risk of potato-price changes for her restaurant.

Let’s assume she wants to create a whole chain of potato restaurants and needs a huge supply at reasonable cost. She can team up with other potato users, resellers or big buyers and agree to create a co-owned potato farm. This cooperative potato farm can then sell potatoes to its owners (in relation to their share of ownership) at the cost that it can produce them, without taking a profit in between.

In the Finnish electricity sector, this kind of non-profit cooperative is called a Mankala company. Fennovoima is a Mankala company, which means it won’t make profits but aims to sell all its potatoes, I mean electricity, to its owners at the cost it produces it. Mankala company is a Finnish innovation which enabled a small, poor country to pool its resources and capital and build big projects.