Power Play: The Effect of Locational Marginal Pricing on Market Power in the United States Electricity Sector

Abstract

Beginning in the 1990s, electricity markets in the United States saw a series of reforms intended to improve efficiency by introducing more market-based elements. One of these changes was the introduction of locational marginal pricing (LMP) – a system that assigns different wholesale electricity prices to thousands of different pricing nodes based on their locational characteristics. Previous research shows that market-based reforms in the electricity sector have led to increased markups due to upstream market power, but the role of LMPs has largely been ignored in that literature. Using data from utilities and power plants on retail prices, wholesale prices, and estimated generation costs between 1994 and 2018, I conduct a series of two-way fixed effects and panel event study analyses evaluating the effects of LMP implementation. I find that LMP systems are associated with higher wholesale markups indicative of increased market power. These results suggest that market power effects should be considered by regulators when crafting LMP systems, especially as existing LMPs are likely to need revision due to the increased deployment of renewable energy.