Determining Price of Electricity in WESM

First and foremost, the price of electricity as paid by the customers is regulated by the Energy Regulatory Commission, as mandated by Republic Act 9136, or the Electric Power Industry Reform Act of 2001. Part of the amount customers pay is the generation charge, which itself has to be approved by the ERC. Usually, the ERC approves a formula so that distribution utilities don't need to get ERC approval every billing month.

How does the generation charge come about? A distribution utility (whether a private distribution utility like Meralco or an electric cooperative) may source its power from two main sources: its own contracted power supply (through power supply agreements with independent power producers, or IPPs) and from the Wholesale Electricity Spot Market, or WESM. While the price of the electricity a distribution utility gets from its contracted power supply is fixed (e.g., P9/kilowatt-hour for 10 years), the price of electricity the distribution utility sources from WESM fluctuates as the WESM is, well, a "spot market." Among other things, this means that its price is determined every interval of time (in the Philippine situation, every hour).

As a market, this means there are many consumers and many suppliers. Due to the technical limitation of electricity (i.e., electricity goes where the circuit leads to, not necessarily to who ordered the electricity), determination of price of electricity in WESM is based on "least-cost solution meeting demand." Here is how it works:

1. NGCP forecasts demand level (including reserve requirement and customer submitted demand in WESM) for each hour. 
2. IPPs submit their bids, including capacity and price offer (baseload and peak).
3. The bids are arranged from lowest-priced to highest-priced to determine which generator will be dispatched first.
4. The market price of electricity is determined by the price of the bid at the level of capacity (based on price bid) that addresses the demand, and all bidders (including lower price bids) will be paid that price. Those generators which priced their bid too high would not be dispatched, hence, not paid.
5. Reserve capacities dispatched will be priced based on the highest priced. 

To illustrate the determination of price and how demand level and supply interact to determine price of electricity in the spot market, you may see this online simulation. (You can play with the elements.)

In this simulation, you can see that the price of electricity in the spot market will be the price of the bid that meets the demand level. If the demand for electricity lowers, it is possible to have the price of electricity go down, because the next higher bid price will be dispatched. 

This says two things, among others:

1. For the IPPs, there is an incentive to increase operational (i.e., production) efficiency (i.e., lower the price). If you are an IPP and you bid at a lower price (presumably, because you have the operational efficiency to do so), when someone else with a higher price gets approved, the price of that higher offering IPP will be the price that will be paid to you.
2. For the consumers, there is an incentive to increase energy efficiency. The lower the demand, the lower the price of electricity that will be cleared (i.e., selected as that which meets demand).

However, as a free market, the determination of price is limited on the assumption of rational decision making to pursue the most cost-efficient level. This means that the WESM methodology of price determination is not exempt from outlier behavior of an IPP pursuing individual higher revenue by creating an artificial shortage of supply in one power plant and bidding a very high price on another, knowing that the artificial shortage will ensure dispatch of the highest price bid.

Reminder: Most distribution utilities source their power from power supply agreements, or contracts with IPPs. Usually, they get only 10% or unexpected demand from WESM, unless 1) their power supplier goes down or 2) there is an unexpected higher demand that their power supplier cannot provide.

Disclaimer: The above is an unofficial and non-technical interpretation of how the WESM works. WESM operation is a very complicated integrated process of economics and engineering. There are other rules and limitations in WESM that have not been included here. The above is just an attempt to  focus on the economic side of determining price of electricity. Corrections and comments will be appreciated.