I recently got into a discussion with an engineering friend who works in the energy markets and I thought I'd share some of what I learnt. 

If you are like me you might be unsure about the driving factors behind the recent rise in energy prices and why a shortage in one area (natural gas) can seem to push prices up so much when accounting for only around a fifth of generation.

In Australia energy generators submit to market how much energy they have available to sell and the price at which they will sell it. They do this every five minutes and then the Australian Energy Market Operator (AEMO) ranks the offers from least to most expensive. Then aims to dispatch the lowest cost energy mix to meet current demand. 

Every half an hour the most expensive price dispatched at each five minute interval is averaged and then that is the price that the generators receive for the power dispatched. (This has actually changed to five minute settlements as of last year)

A few things stick out straight away when thinking about this mechanism

- A high cost generator required for only a short period of time risks not getting that price so I would imagine they would set prices with a healthy margin to offset this risk. (This has actually changed to five minute settlements as of last year)

- This is fantastic for the low cost generators who must make a ton of cash when the high cost generators are required.

- Because price is set at the margin increases my not be linear and certainly might actually be expected to increase exponentially as more expensive opportunistic generators begin to set the price.

A great example of the older mechanism is shown below with the current system settling at the five minute intervals being the only difference.

Australia's grid is interconnected and has five distinct regions South Australia, Melbourne, Tasmania, New South Wales and Queensland.

Important bits of infrastructure include regional reference nodes which are the largest load centres and the point where price is determined. 

Interconnectors are the links between the regions. These will allow the flow of low cost generation to areas of high cost generation bringing down the average wholesale price. However it is important to note that these interconnectors have a finite capacity and if that is exceeded regions pricing can separate between regions. 

I hope this sheds some light on the system and raises some interesting ideas around incentives and explains why niche parts of the overall generation can potentially have outsized effects on the home bill.

It's worth noting that while not perfectly analogous this system is similar many developed countries with deregulated energy markets and helps contextualise some of the news about insane energy prices you see today. Each grid and country has its own challenges however as you now know energy price is set on the margin so prices may correlate far more than you would expect between markets with radically different energy mixes.

Source: https://www.aemc.gov.au/