Pricing in Nonconvex Markets: How to Price Electricity in the Presence of Demand Response

Climate change and the transition to renewable energy sources have had a significant impact on wholesale electricity markets. This has led to renewed interest in the design of electricity markets and pricing rules for spot markets. It is well known that theoretical ideals such as Walrasian equilibria cannot be obtained because of the nonconvex nature of the market-clearing problem. Instead, current pricing rules compute linear and anonymous price signals, yet at these prices, market participants often make a loss. Such losses are compensated by individual side payments that distort the price signal and have thus come under scrutiny by regulators. In this article, the authors examine this issue in greater detail. In markets with price-sensitive or flexible demand—which becomes increasingly important with growing levels of renewables—there can be no linear pricing rule that avoids make-whole payments under the welfare-maximizing allocation. Motivated by this observation, the authors introduce a pricing rule that minimizes make-whole payments and compare it against alternative pricing schemes. Numerical experiments indicate how the novel pricing rule can substantially reduce make-whole payments without significant impact on the overall market price. The findings provide input for the ongoing policy debate on make-whole payments in wholesale electricity markets.