Locational Marginal Pricing in North American Power Systems

Mr. Henry Louie, University of Washington, USA

Prof. Kai Strunz, Technische Universität Berlin, Deutschland

Abstract

The methodology used in the pricing of electrical energy is a fundamental characteristic of electricity market design.
In deregulated North American power systems the utilization of locational marginal pricing is the dominant approach
to pricing electrical energy. Locational marginal prices (LMPs), which are spatially and temporally distinguished nodal
prices based upon short-run marginal costs, reflect economic and physical realities of the power system as well as operating
constraints. In addition, LMPs can be used to ascertain transmission congestion costs and are often included in ancillary
service market clearing or settlement calculations. It is therefore requisite to understand the fundamentals of LMPs to be
able to analyze deregulated North American power system economics. In this paper, the concept, calculation, utilization
and practical application of LMPs as well as a thorough educational illustration are provided.

1 Introduction to be fully implemented in the California ISO (CAISO) in

The North American power system served approximately
4,926 TWh of electrical energy to customers in the U. S.,
Canada and Mexico in 2006 [1]. In the U. S. and Canada,
the majority of the load is procured through market trans-
actions in the geographic footprint of Regional Trans-
mission Organizations (RTOs), which are independent,
revenue-neutral entities charged with, among other respon-
sibilities, maintaining system reliability and market over-
sight [2]. Market designs differ amongst RTOs; however,
a characteristic common to many is the utilization of lo-
cational marginal prices (LMPs) for electrical energy pric-
ing [3].
Locational marginal pricing, which is based on the short-
run marginal cost of supplying energy, was developed in
the 1980’s [4, 5, 6] and has grown to be the dominant
method of pricing energy in electricity markets in North
America that operate under the auspices of an RTO [7, 3,
8, 9, 2]. The use of LMPs has grown because the phys-
ical constraints of the system and economic realities are
accurately represented. The resulting LMPs can be readily
utilized to price transmission and to determine congestion
costs. This paper formulates the concept of LMPs in an
educational manner and provides details on their practical
calculation and utilization in North American power sys-
tems.
Currently, nodal LMPs are utilized in four North America
RTOs: Midwest Independent System Operator (MISO),
New England RTO, New York ISO (NYISO) and the
Pennsylvania-Jersey-Maryland Interconnection (PJM) [2].
In addition, LMPs are included in the new market designs
2008 and in the Electric Reliability Council of Texas (ER-
COT) in 2009 [8]. Other markets rely on bilateral transac-
tions, zonal pricing, or the last cleared generation offer to
set electricity prices. The impetuses for the adoption of the
LMP-based pricing are to achieve greater market efficiency
and to more accurately represent the price of transmission
and the cost of congestion [8, 9].
The LMPs are computed for each node and market period
in both the forward and balancing energy markets. The
forward energy market is typically for a period one day
ahead, commonly called a day-ahead market. The LMPs
are utilized in the market settlement processes to determine
generator payments and load charges by multiplying the
amount of energy produced or consumed at a node by the
LMP at that node. In addition, LMPs are used in ancillary
service calculations and to price transmission and manage
congestion and therefore the understanding of their cal-
culation is crucial in North American power system eco-
nomic analyses.
The paper is arranged as follows. In Section 2, the concept
of locational marginal pricing is introduced. In Section 3,
the practical calculation of LMPs is formulated. In Sec-
tion 4, an educational illustration of LMP calculation is
demonstrated on a four-bus study system considering the
effects of congestion. Conclusions are drawn in Section 5.
2 Concept
The concept of locational marginal pricing is to assign the
price of energy based on the short-run marginal cost of
supply. In so doing, economic signals for system opera-
tion are provided, including costs of congestion. An anal-
ogous formulation of LMP calculation for reactive power
is possible; however, real power is the focus of this paper
as reactive power and other component costs of supplying
energy are compensated in ancillary service markets and
market settlement procedures [3, 6].
The short-run marginal cost at a node is equal to the change
in optimal economic cost associated with supplying an
additional increment of load at that node. This value is
readily available from the Lagrangian multiplier associated
with the nodal real power balance equation at the solution
to the N -node Optimal Power Flow (OPF) problem:
min {f (PG , PD )}
where
N
X N
X the calculation.
f (PG , PD ) = CG,i (PG,i ) − CD,i (PD,i )
i=1 i=1
and CG,i (PG,i ) is the generator cost as a function of the
real power output of a generator at node i, PG,i , and
CD,i (PG,i ) is the dispatchable load cost as a function of
the real load at node i, PD,i . Nodes without generation or
without load have the respective PG,i or PD,i values set
equal to zero. This optimization is subject to:
g(x) = 0
h(x) ≤ 0
where x is a vector of the optimization variables, which
include generator power output and dispatchable load; and
g(x) and h(x) are equality and inequality constraints,
respectively. The equality constraints are composed of
the nodal power balance equations, whereas the inequality
constraints are the voltage, branch power flow and genera-
tor maximum and minimum output limitations.
The definition of the LMP—the cost of serving an ad-
ditional increment of load at a node—is equivalent in
meaning to that of the Lagrangian multiplier of the real
power balance equation at the node at the optimal solution.
Therefore, the LMP for node j is:
LMPj = λ∗p,j
where λ∗p,j is the Lagrangian multiplier at the optimal solu-
tion to (1) associated with the real power balance equation
at node j. Obtaining the LMP from the OPF implicitly
includes voltage, transmission and generation constraints
that affect the economics of the delivery of energy in a
transparent fashion.
3 Practical Calculation
Solving (1) for each market period is not practical in most
market applications due to computational and implemen-
tation requirements. Therefore, in practical application
the simplified dc system model is used in LMP calcula-
tions [7]. Differences in specific LMP calculation method-
ologies between the RTOs dictate that a specific method
be delineated hereafter, though it is noted that similar ap-
proaches are used in other markets.
In the following formulation, the LMP calculation is reflec-
tive of the method utilized in the PJM market, which is se-
lected due to its prominence as the world’s largest electric-
ity market and its lengthy experience with LMPs [7]. The
most notable influence of this method is the omission of the
losses and the utilization of a dc system model [10]. Losses
can be ignored without significant inaccuracy if they are
small in value, as in the case of tightly meshed systems in-
(1)
dicative of certain regions of North America. In addition,
generation offers and load bids and not costs are utilized in
(2) The LMP at a given node can be decomposed into the
marginal cost of generation based upon generator offers,
congestion costs and marginal loss costs [6]. Consistent
with the dc model, marginal loss costs are ignored and the
LMP for node j can then be expressed as:
K
X
LMPj = λs − µk ψk,j (6)
k=1
(3) where λs is the marginal price of generation at the refer-
(4) ence node, K is the number of branches, and µk is the
shadow price of the congestion of branch k. Conceptually,
the shadow price, µk , is the change in cost due to an in-
cremental relaxation of the constraint on branch k. The In-
jection Shift Factor (ISF) [11], ψk,j , is the fraction of real
power that flows on branch k due to a unit production of
power at node j and consumption of power at the reference
node under dc assumptions. A derivation of ISF calcula-
tion is reserved in the Appendix. The sum of products of
µk and ψk,j is the congestion cost.
The variables λs and µk are Lagrangian multipliers whose
values are determined from solving an incremental linear
optimization around a given operating point. The oper-
ating point in terms of real power produced, PG,j , and
(5) consumed, PD,j , at each node j is based upon the sched-
uled dispatch and load in the day-ahead market and is in-
put from a state-estimator in balancing markets. Nodes
without generation or without load have the corresponding
PG,j and PD,j values set equal to zero.
The objective of the incremental optimization in the prac-
tical LMP calculation of an N -node system is:
(N N
)
X X
min OG,i (∆PG,i ) − OD,i (∆PD,i ) (7)
i=1 i=1
where ∆PG,i and ∆PD,i are the changes in real power
production and consumption from the operating point, and
OG,i (∆PG,i ) and OD,i (∆PD,i ) are the offers and bids as- 4.1 Study System Parameters
sociated with the changes, respectively. The hypothetical
changes to power production and consumption must re-
spect the power balance equation, generator and dispatch- The study system is comprised of four buses and four
able load limits: branches with equal reactances of 0.10 p.u. The corre-
sponding ISFs for a unit of power produced at each bus
N N
X X with Bus 1 arbitrarily selected as the reference is shown in
∆PG,i − ∆PD,i = 0 (8)
i=1 i=1
Table 1.
min max
∆PG,j ≤ ∆PG,j ≤ ∆PG,j ∀j ∈ (1, . . . , N ) (9) Table 1: Injection Shift Factors
min max
∆PD,j ≤ ∆PD,j ≤ ∆PD,j ∀j ∈ (1, . . . , N ) (10)
Injection Branch Terminus Buses
where the superscript max and min refer to the maximum Bus 1–2 2–3 2–4 4–3
and minimum changes to real power production and con- 1 0 0 0 0
sumption at each node, respectively. In addition to the con- 2 −1 0 0 0
straints in (8)–(10), the limitations on branch flow must be
3 −1 −0.667 −0.333 −0.333
obeyed:
4 −1 −0.333 −0.667 0.333
N
X
− Fkmax ≤ {(∆PG,i + PG,i )ψk,i } −
i=1 Table 1 is interpreted as follows. Concerning the second
N
X row, if 1 MW of power is injected in Bus 2 and withdrawn
{(∆PD,i + PD,i )ψk,i } ≤ Fkmax ∀k ∈ (1, . . . , K) from the reference bus, Bus 1, then 1 MW would flow from
i=1 Bus 2 to Bus 1. No power would flow on any other branch
(11) due to this injection. Therefore, since the ISF are direc-
tional, there is a −1 in the second column and zeros in the
where Fkmax is the magnitude of the maximum power flow
third through fifth columns. For the third row, the power
limit on branch k. In certain markets, only branches at or
flow resulting from an injection of 1 MW of power into
approaching their limits are included in (11).
Bus 3 divides between the branches in accordance with the
Solving (7) produces the Lagrangian multipliers λs and µk .
branch impedances enroute to the reference bus. Account-
The Lagrangian multiplier, λs , is associated with the power
ing for the direction of the ISFs defined in Table 1 and due
balance equality constraint (8), whereas µk is associated
to the equal branch impedances, one third the power flows
with branch power flow constraint. There is a µk for each
from Bus 3 to Bus 4 and then to Bus 2; two thirds of the
constraint in (11).
power flows from Bus 3 to Bus 2. The entire unit of power
A consequence of utilizing the dc system model is that flows from Bus 2 to Bus 1. The elements in Table 1 for the
voltage, stability and reactive power constraints cannot be other bus injections are calculated in a similar fashion.
explicitly modeled. In practical application, these con-
straints are approximately represented and enforced in The system has three generators, whose technical and eco-
LMP calculation as real power branch flow constraints. nomic data are shown in Table 2. In this educational il-
lustration, it is assumed that generator offers are linear,
as described by the coefficient c1 and that the load is not
4 Educational Illustration dispatchable. Differentiation of the generator offer with
respect to power for each generator gives the offer-based
A four-bus study system is used to demonstrate the prac- marginal generation cost which is used in LMP calcula-
tical calculation of LMP under two scenarios: Uncon- tion. It is also assumed that the market period is one hour.
strained Case and Constrained Case. It is shown that in the For the purposes of clarity in illustration, voltage limits and
Unconstrained Case, the only non-zero component com- losses are ignored.
prising the LMP is the marginal generation price and hence
the LMPs are uniform. In the Constrained Case, conges- Table 2: Generator Data
tion in the network results in non-zero and non-uniform
Gen. c1 P max P min
congestions costs and there is differentiation in LMP. The
illustration also shows that the definition of the LMP as the Bus ($/MW) (MW) (MW)
cost to serve an additional increment of demand at each 1 20 500 0
node is equivalent to (6) if linear generator energy offer 3 25 200 0
functions are utilized. 4 30 200 0
4.2 Unconstrained Network $20/MWh at all buses.
The results for the Unconstrained Case are summarized in
The calculation of the LMP is intuitively demonstrated by
Table 3. The absence of congestion or other constraints
determining the change in total cost of supplying energy
has lead to uniform LMPs equal to the marginal generation
when the demand is independently increased at each bus
cost of $20/MWh. From the last two columns of Table 3, it
by 1 MW for one hour. The dispatch, load and resulting
is seen that money charged to the loads equals the money
branch flows are shown in Fig. 1 with a resulting total pro-
credited to the generators. Therefore, the RTO remains
duction cost of $8, 000, which is found by evaluating the
revenue neutral and there are no congestion costs.
generator offer functions at the given dispatch.

400 MW 1 2 3 0 MW
200 MW
Table 3: Unconstrained Case Results
LMP Generation Load Credit Charge
100 MW 300 MW Bus ($/MWh) (MW) (MW) ($) ($)
100 MW 100 MW 1 20 400 − 8,000 0
2 20 − 100 0 2,000
4 3 20 0 300 0 6,000
4 20 0 0 0 0
0 MW
0 MW Total 8,000 8,000

Figure 1: Illustrative 4-bus system for the unconstrained

case.
The LMP at Bus 1 is calculated by assuming a hypotheti-
cal load of 1 MW is present at Bus 1. The least cost hy-
pothetical dispatch that serves the load is to increase the
power output of Generator 1 by 1 MW to 401 MW, thus
increasing the operating costs to $8,020—an increase of
$20. Therefore the LMP at Bus 1 is $20/MWh. A visual-
ization of this LMP calculation is provided in Fig. 2.
4.3 Constrained Network
The next scenario examined includes a branch power flow
constraint. Assume that the real power flow on branch 4–3
is limited to 50 MW and that the dispatch, load and result-
ing branch flows of the system are shown in Fig. 3. The
production cost for this dispatch is $8,750.
250 MW 1 2 3 150 MW
100 MW

401 MW 1 2 3 0 MW
200 MW
100 MW 300 MW
50 MW 50 MW
1 MW 100 MW 300 MW
100 MW 100 MW 4

4 0 MW
0 MW

0 MW
0 MW Figure 3: Illustrative 4-bus system for the constrained case.

Figure 2: Conceptualization of LMP calculation for Bus 1.
For Bus 2, an increase of load to 101 MW can be economi-
cally met by increasing the power output of Generator 1 to
401 MW, resulting in an increase in operating costs by $20.
Therefore the resulting LMP of Bus 2 is also $20/MWh. In
fact, since there are no constraints and marginal losses are
ignored, the LMP at each node is equal to $20/MWh. This
result is applicable to any system with like conditions.
This intuitive result is now compared with (6). Solving (7)
yields a λs value equal to $20 and µk equal to zero for
all branches k. Therefore, from (6) the LMP is equal to
The LMP for Bus 1 and 2 are the same as in the uncon-
strained case as Generator 1 can supply one additional MW
of power without violating the branch limit. However, if
the load at Bus 3 is increased to 301 MW, Generator 1 can-
not supply additional power since it would cause the power
flow on branch 4–3 to increase past it’s limit to 50.333
MW. Instead, power must come from the next cheapest
power source—Generator 3—whose increased power out-
put to 151 MW does not affect the power flow on branch 4–
3 if the load is concomitantly increased to 301 MW. There-
fore, the production cost increases to $8,775—an increase
of $25, and hence the LMP at Bus 3 becomes $25. The vi-
sualization for this LMP calculation is provided in Fig. 4. manner is a significant advantage of LMPs and allows
for loads to hedge against high energy prices through fi-
250 MW 1 2 3 151 MW nancial instruments such as Financial Transmission Rights
100 MW
(FTRs) [12, 7].

Table 4: Constrained Case Results

100 MW 301 MW LMP Generation Load Credit Charge
50 MW 50 MW Bus ($/MWh) (MW) (MW) ($) ($)
1 20 250 − 5,000 0
4
2 20 − 100 0 2,000
0 MW 3 25 150 300 3,750 7,500
0 MW
4 15 0 0 0 0
Figure 4: Conceptualization of LMP calculation for Bus 3. Total 8,750 9,500

Finally, in order to serve an additional MW of load at Bus

4 at the lowest production cost, Generator 1 increases its
power output by 2 MW to 252 MW and Generator 3 de-
creases its power output by 1 MW to 149 MW, as shown in
Fig. 5. The resulting power flow on branch 4–3 in this case
is 50 MW and the net result is an increase in production
cost by $15. Therefore the LMP at Bus 4 is $15/MWh.
Note that this value is less than the offer of any generator.
252 MW 1 2 3 149 MW
101 MW
100 MW 300 MW
51 MW 50 MW
4
0 MW
1 MW
Figure 5: Conceptualization of LMP calculation for Bus 4.
Solution of (7) yields λs equal to $20 and a non-zero µk
for branch 4–3 of $15. Since the ISFs for Bus 1 and 2 onto
branch 4–3 are zero, the LMP is equal to $20/MWh. For
Bus 3, the ISF is equal to −0.333 so that the LMP becomes
$25/MWh in accordance with (6). In similar fashion, the
LMP for Bus 4 is computed to be $15/MWh. Therefore,
the results are identical to the approach of increasing the
demand by 1 MW at each bus.
The results for the Constrained Case are summarized in
Table 4. The presence of congestion has caused differen-
tiated LMPs equal to the marginal generation cost as de-
termined from generation offers plus the congestion costs.
From the last two columns of Table 4, it is seen that money
charged to the loads is greater than the money credited
to the generators. The congestion costs are equal to the
difference between the money charged and credited and
is equal to $750. Quantifying the congestion cost in this
5 Conclusions
Locational marginal pricing is a powerful and elegant tool
that is commonly used in electricity markets in the U. S.
and Canada. The method of assigning nodal prices based
upon short-run marginal costs, which is interpreted as the
cost of serving the next increment of demand at each node
in the system, is intuitive and adequately reflects system
constraints and economics. Based upon this definition, the
LMP at a node is equal to the Lagrangian multiplier asso-
ciated with the real power balance equation at that node.
In practice however, a simplified dc model is employed
and the LMP can be determined from an incremental lin-
ear program by adding the offer-based marginal generation
cost at the reference node with congestion costs, as shown
in this paper.
The calculation of LMPs for a four-bus study system for
constrained and unconstrained operation illustrated an in-
tuitive method for calculating LMPs and demonstrated the
utility in LMPs to determine congestion costs. The con-
gestion costs are determined from the differences in LMPs
between two nodes and are used to economically manage
congestion through the use of financial instruments such as
financial transmission rights.
The use of Injection Shift Factors (ISFs) is a computation-
ally efficient method of determining the impact of changes
in generation or load on branch power flow under dc as-
sumptions.
In accordance with the linear problem formulation, the to-
tal real power flowing on any branch under dc assumptions
is found by:
F = Hθ (12)
where F is a vector of branch power flow, H is a matrix
of coefficients that relate the node voltage angles, θ, across
a branch to the power flowing on that branch. The ele-
ments of H are determined from the bus impedance ma-
trix. Since there is a linear relationship between the bus
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
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