Electricity Market Fundamentals
Executive Summary
Key Takeaways
- ✓ Electricity markets are structured as regulated, merchant, or hybrid arrangements, and the specific market a project sells into determines whether its revenue is set by an approved tariff, a wholesale clearing price, or a blend of contracted and market-based mechanisms.
- ✓ Regulated markets set revenue through a cost-of-service or approved tariff mechanism, giving a project revenue certainty that a model can represent as a defined price schedule rather than a forecast.
- ✓ Merchant markets clear on a merit-order basis, dispatching the lowest-marginal-cost generation first, and a project's realized price and dispatch volume both depend on where it sits in that merit order.
- ✓ Hybrid structures, including capacity markets and contracts for difference, combine a contracted or administered payment with market-based exposure, and each component should be modelled separately.
- ✓ A power project model should represent the specific market mechanics of the jurisdiction and market the asset actually sells into, rather than a generic wholesale price assumption applied irrespective of market structure.
Objective¶
This guide covers the electricity market structures a power project financial model needs to represent, within Energy Financial Modelling: regulated, merchant, and hybrid arrangements, and the dispatch mechanics underlying each.
Regulated Markets¶
In a regulated market, a project's revenue is set through a cost-of-service or approved tariff mechanism determined by a regulator, giving the project revenue certainty that a model can represent as a defined price and volume schedule rather than a market-dependent forecast. This is the simplest revenue structure to model, but it should still be built as an explicit, sourced schedule referencing the actual regulatory determination, not an assumed flat rate.
Merchant Markets and Merit-Order Dispatch¶
In a merchant market, generation is dispatched in order of increasing marginal cost — the merit order — until forecast demand is met, with the market clearing price typically set by the marginal (highest-cost dispatched) unit. A project's realized price and dispatch frequency both depend on where its own marginal cost, reflected in its heat rate for fuel-based generation or its near-zero marginal cost for renewables, places it in this order. See Merchant Power Models for how this should be built into a forward price curve and sensitivity range.
Hybrid Structures¶
Capacity markets. Pay generation for being available to dispatch, independent of whether it is actually called upon, layered on top of — not blended with — any energy revenue the asset earns when dispatched. See Capacity Payment Models.
Contracts for difference. Pay or charge the difference between an agreed strike price and the prevailing market reference price, effectively converting merchant price exposure into a defined net price while still requiring the underlying market price to be modelled to calculate the settlement amount.
Why Market Structure Should Drive Model Structure¶
A model built around a generic wholesale price assumption, applied irrespective of the actual market the asset sells into, misrepresents both the revenue certainty and the dispatch mechanics that determine a project's actual cash flow. The model should instead be built around the specific market structure and jurisdiction the asset operates in, with regulated, merchant, and hybrid components each represented through their own appropriate mechanism.
Common Construction Pitfalls¶
Generic wholesale price applied to a regulated asset. Ignoring an available cost-of-service or tariff determination in favor of a generic merchant price forecast understates the revenue certainty a regulated asset actually has.
Merit order and marginal cost ignored for a merchant asset. Modelling a merchant asset's price as a flat forward curve without reference to its own position in the merit order can materially misstate both realized price and dispatch volume.
Capacity and energy revenue blended. Combining capacity payments and energy (dispatch) revenue into a single line conceals that one is availability-based and the other is dispatch-dependent, obscuring each risk's actual driver.
Recommended Practices¶
- Identify the specific market structure — regulated, merchant, or hybrid — the asset actually sells into before building the revenue mechanism.
- For merchant exposure, reference the asset's position in the merit order (marginal cost or near-zero renewable cost) when building the price and dispatch forecast.
- Model capacity payments and any contract-for-difference settlement as distinct line items, separate from underlying energy revenue.
Continue Reading¶
Related Pillars¶
Related Technical Guides¶
Related Glossary¶
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Frequently Asked Questions
What are the main electricity market structures a power project can sell into?
Regulated markets, where revenue is set through a cost-of-service or approved tariff mechanism; merchant markets, where revenue is set by a wholesale clearing price determined through merit-order dispatch; and hybrid structures that combine contracted or administered payments with market-based exposure.
How does a regulated market differ from a merchant market for modelling purposes?
A regulated market gives a project a defined, approved tariff or cost-of-service revenue mechanism that a model can represent as a scheduled price, while a merchant market requires a forward price curve and dispatch assumption, since both price and dispatch volume are determined by the market's clearing mechanism rather than a fixed schedule.
What is merit-order dispatch?
The mechanism by which a wholesale electricity market dispatches generation in order of increasing marginal cost until forecast demand is met, with the clearing price typically set by the marginal (highest-cost dispatched) unit — a project's position in this order determines both its dispatch frequency and the price it realizes.
What are capacity markets and contracts for difference, and how should they be modelled?
Capacity markets pay generation for being available regardless of dispatch, separate from any energy revenue it earns when dispatched; contracts for difference pay or charge the difference between a strike price and the market reference price. Both should be modelled as distinct components layered on top of, not blended with, the underlying market revenue.
Why does market structure matter for a power project financial model specifically?
Because it determines whether revenue is a scheduled, near-certain figure (regulated) or a forecast dependent on market clearing dynamics (merchant), which directly affects how much revenue risk the model needs to represent and test through sensitivity analysis.
References
Related Articles
Energy Financial Modelling
Energy financial modelling is the discipline of building financial models for power generation assets, independent power producers, and renewable energy projects — structured around a technical output schedule and an electricity revenue stack that a standard corporate or general project finance model has no direct equivalent for. This page is the hub for the Knowledge Centre's energy and power modelling content: how a power project model is architected, how electricity markets and dispatch mechanics translate into revenue, and how power purchase agreements, capacity payments, and merchant exposure combine into a project's revenue structure. Technology-specific renewable energy models (solar, wind, storage, hydro, and others), technical and commercial modelling mechanics, and institutional practice for this asset class are indexed here as the domain expands.
Energy Revenue Models
A power project's electricity revenue is rarely a single price applied to total output — it is typically a stack of contracted (PPA), capacity, and merchant components, each with its own price-setting mechanism and risk profile. This guide covers how to build that revenue stack as separately priced, explicitly modelled modules, and how to combine them into a single reconciled revenue output without losing the visibility each component requires.
Merchant Power Models
Merchant power revenue is sold at prevailing market price rather than under a fixed-price contract, carrying genuine, undetermined price risk that a static assumption understates. This guide covers how to build merchant exposure into a power project model: constructing a forward price curve, testing an explicit sensitivity range around it, representing any hedging arrangement, and modelling the merchant tail that follows PPA or contract expiry.
Capacity Payment Models
Capacity payments compensate a generation asset for being available to generate, independent of whether it is actually dispatched, and require a distinct modelling treatment from energy (dispatch-based) revenue. This guide covers how capacity payment mechanics — availability testing, penalty and de-rating provisions, and contract tenor — should be built into a power project model as their own explicit revenue component.
Heat Rate
Heat rate expresses the amount of fuel energy input required to generate one unit of electricity output, the standard efficiency metric for thermal and other fuel-based generation. A lower heat rate indicates a more fuel-efficient plant, and heat rate directly determines a plant's marginal cost and therefore its position in a merchant electricity market's merit-order dispatch.