As traffic on the roads gets busier, its speed decreases. Every single vehicle entering the flow impacts the circulation of all the others negatively: there will be friction and interference. The likelihood of collisions, stalled vehicles and, consequently, longer journey times rises as congestion occurs. If you’re sitting in a traffic jam and all you see in front of you is a stationary line of cars, you’re understandably annoyed. Congestion, however, isn’t inherently bad - it’s a sign of activity after all. But it needs to be managed; on the roads and in the energy sector, too.
Unblocking the way
The energy transition is picking up speed, but the very fact that the energy mix is changing - the share of variable renewable energy (VRE) keeps growing - means that network operators are increasingly having to deal with capacity constraints. Traditional grids cannot keep up with the progress as their expansion is very slow, and they’re often stretched to the limit and become congested. Grid congestion then causes bottlenecks which in turn threaten the secure supply of energy. A quick solution to this problem is congestion management: whenever the grid reaches its maximum capacity, it can steer excessive supply or demand, e.g. on hot, sunny days or during the winter when there is both little sunshine and wind.
Congestion in the transmission network and how it is handled has a huge impact on market prices. Depending on their design, wholesale electricity markets deal with congestion and pricing differently: price formation reflects how constrained the transmission system is. The two main market models are the zonal and the nodal structures.
Zonal design
Energy policy in Europe is based on a zonal market architecture, and uses a zonal model to deal with congestion. The EU energy market is divided into zones where trade participants are treated equally and the only limitation to trade opportunities is transmission capacity. The zones are of varying sizes, and they mostly correspond to national borders, but some member states are divided into several zones; Italy, for example, has seven. Consequently, price zones are configured based on national or regional divisions, which limits the efficiency of market integration, and when zone boundaries reflect transmission constraints, the wholesale price will vary.
Defined as the largest geographical area where market participants can trade without capacity allocation, pricing zones are determined by regulators and/or transmission system operators (TSOs). Grid congestion between the zones is reflected by price differentials, and electricity is traded based on the capacities that are available, as calculated by the particular TSOs within that bidding zone. In other words, each zone has a single price that reflects the congestion between zones, but ignores it within itself. The main disadvantage of this model is that, by definition, zonal pricing offers less granular locational signals. At the same time, if only some specific network lines are congested, it is an efficient design. Also, bigger bidding zones tend to increase liquidity and competition, and are less discriminatory for consumers - it is possible to build a power plant anywhere in the zone, and the entire market finances network development costs.
However, despite its advantages, the fact that the zonal design lacks sufficient spatial granularity is a major drawback. Increased granularity is key because it provides better market signals to both operators and generators, and offers incentives to invest in high-priced zones. Such granularity characterizes the other main market structure, the nodal model.
Nodal design
As its name suggests, the nodal market design is based on transmission nodes - i.e. points rather than zones - where electricity is generated or consumed, and prices are set according to constraints and the optimal dispatch. Used in several US regional markets as well as in Australia, New Zealand and elsewhere, this model considers location to be a key aspect of electricity, which is reflected in the price: each offer receives a local uniform price that corresponds to the particular node of the network. Since nodes measure electricity usage per community, not by region, nodal markets offer more congestion control and provide a better and more transparent pricing system. Nodal pricing reflects given network conditions, which makes it possible to determine and justify the value of price components. It encourages the active participation of consumers to dispatch power at times when prices are more attractive. While nodal pricing may be more challenging to implement, this is a major advantage, alongside lower spatial granularity and a more accurate picture of transmission system constraints than that available in the zonal model.
At the same time, the nodal design is not without its disadvantages. There is potential for high volatility at individual nodes, markets are often less flexible when new technologies are introduced, and price signals may not incentivize longer-term investments since they only reflect the current state of the market.
From zonal to nodal?
Currently, there is a heated debate about whether moving Europe from the zonal to the nodal model would help to address the limitations of the transition network and the lack or low quality of price signals for potential investors. However, given its respective drawbacks, the nodal market model does not convincingly resolve those issues either. Since grid constraints are primarily caused by a lack of adequate investment in the network itself, the challenge that any potential congestion poses can best be tackled by improving network infrastructure. As far as the price system is concerned, nodal pricing is complex and requires more computation than what most market participants can handle. The spread of big data and AI technologies that are going to shape the energy sector going forward brings with it a new approach to how data is compiled and analyzed - those who cannot adapt will be left behind.
Ultimately, introducing the nodal design in European power markets is only possible if roles and responsibilities - some of them new - are clearly defined and allocated, which would mean major systemic changes. It will be interesting to see if the EU is willing to take on this considerable challenge.
