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LMP Works!

Locational marginal prices in PJM respond to demand and fuel costs.

Fortnightly Magazine - January 2010

fuel prices had remained at their 2004 levels, the load-weighted average LMP in 2005 would have been comparable to 2004. However, in 2005, gas prices increased by $2.41/MMBtu on average, which led the actual load-weighted average LMP to increase more than $19/MWh. In 2006, the market witnessed a retreat in gas prices and load-weighted average LMP. Likewise, if the higher 2005 fuel prices prevailed, the load-weighted average LMP would have been higher—as represented by the fuel-cost adjusted LMP. In 2007, despite a relatively small change in fuel prices—as evidenced by the small uptick in gas prices—on a fuel-cost adjusted basis, LMPs were much higher than in the previous year. This relatively large increase in LMP in spite of steady fuel prices is explained by the load growth between 2006 and 2007.

In 2008, gas prices increased—leading to an increase in load-weighted average LMP—but on a fuel-cost adjusted basis, LMP was down from the previous year. This result was driven by a drop-off in hourly average demand from 2007 to 2008. Through 2009, the steep fall in gas prices led to a steep fall in load-weighted average LMP. On a fuel-cost adjusted basis, through June of 2009, fuel-cost adjusted LMP also is down from the previous year’s load-weighted average—again driven by a continuing decrease in electricity demand from the previous year.

Electricity Demand and LMP

While fuel prices explain a great deal of price movements, changes in demand also factor into LMP movements. As demand increases, LMPs also increase if fuel prices remain constant. In contrast, as demand decreases—as was the case during 2009 and the last half of 2008—LMPs also should decline if fuel prices stay constant. In addition to long-term trends, demand in the electricity market also shows seasonal variability when demand is higher during the hot summer months ( e.g., June, July, and August) and during the height of winter ( e.g., December, January and February) while the spring and autumn months experience lower demand as heating or cooling needs are reduced.

Figure 4 s hows the hourly average load by month in PJM from May 2005 through May 2009 mapped against the monthly load-weighted average LMP over the same period. 5 When average hourly load (shown by the red line) is at its highest during the summer and winter months, LMP (blue line) also is at its highest. Similarly, during the fall and spring months, when loads are at their lowest, LMP also is down relative to the summer and winter months.

Much like with fuel prices, it’s helpful to examine annual hourly average load alongside LMP on an average and fuel-cost adjusted basis (see Figure 5) .6 As has been discussed in the context of fuel prices, changes in hourly average load also explain movements in LMP.

For example in 2007, the fuel-cost adjusted LMP was almost $10/MWh higher than the 2006 load-weighted average LMP. The explanation for the jump in LMP, holding fuel costs constant, is the more than 3,000-MW ( e.g., 4.6 percent) increase in hourly average load from 2006 to 2007. The