Physical withholding refers to the act of keeping power generation capacity out of the market, particularly during times of high demand. We have seen some aspects of this in Lesson 7 when we studied California's electricity crisis, but we'll review the basic idea again here.
Our example will focus on an electricity market that has five power plants:
- Generator A has 10 MW of capacity with a marginal cost of $10/MWh.
- Generator B has 15 MW of capacity with a marginal cost of $15/MWh.
- Generator C has 20 MW of capacity with a marginal cost of $30/MWh.
- Generator D has 25 MW of capacity with a marginal cost of $40/MWh.
- Generator E has 10 MW of capacity with a marginal cost of $70/MWh.
We'll assume that there are no fixed costs, and that demand in the market is 55 MWh, as shown in the figure below.
You'll note from the figure that if the market behaves competitively (and all generators make supply offers to the RTO at their marginal costs), then the System Marginal Price will be $40/MWh.
Now suppose that your power generation firm owns plants A and D. Under the scenario shown in the figure, you would earn profits of ($40/MWh - $10/MWh) × 10 MWh = $300 on Generator A and no profit on Generator D (because D is the marginal supplier in this market). But suppose that you were to remove Generator D from the market and not submit a supply offer for Generator D at all. The physical withholding of Generator D would result in the System Marginal Price increasing to $70/MWh, as shown in the figure below.
Following the withholding of Generator D, profits on Generator A would be ($70/MWh - $10/MWh) × 10 MWh = $600. You still don't earn any profit on Generator D, but removing that plant from the market has resulted in additional profits for your other power plant.