Scarcity pricing in power: how tight systems drive extreme prices

What scarcity pricing is (and what it isn’t)

Scarcity pricing in power markets describes prices that mirror the marginal value of reliability and flexibility when supply nearly matches demand. It shows how costly the next megawatt is once operational headroom is limited.

The key point is not average conditions but how close the system is to its constraints. Scarcity pricing occurs when there are limited options, such as low reserves, restricted imports, inflexible plants, or demand that cannot be easily decreased.

It is equally important to be clear about what scarcity pricing is not.

It is not simply fuel-driven rallies. Gas prices can be high even without scarcity if the system has sufficient margin and flexibility. This does not necessarily lead to blackouts. Scarcity pricing often prevents physical failures by limiting demand through higher prices. However, it is not always apparent in daily averages. Scarcity usually occurs during a few specific hours, such as evening peaks or sudden intraday stress events.

At its core, scarcity pricing is a distribution problem. When systems are tight, the upper tail of the price distribution becomes decisive. A handful of extreme hours can dominate value, risk, and P&L.

The mechanics: why small tightness changes cause huge price moves

Scarcity pricing naturally exhibits a convex shape. When profit margins are high, producing an additional megawatt costs relatively little. Conversely, when margins are low, the cost of generating the next megawatt rises sharply as options become limited.

Several structural features drive this convexity. Ramping constraints mean the plant cannot respond instantly. Reserves can be depleted faster than expected. Import capacity may be constrained precisely when it is most needed. Unit commitment inflexibility means that once the committed stack is fixed, marginal adjustments become costly.

As delivery approaches, behaviour shifts. Bids grow less sensitive to price since participants need to balance their positions. For a short trader, accepting a high price may still be less costly than holding an imbalance into a stressed system. That's why scarcity pricing tends to be most intense near real time: the need to balance overrides standard price sensitivity.

In these conditions, a seemingly minor change in system tightness - a minor outage, a forecast downgrade, or a flow constraint - can trigger disproportionately large price moves.

Where scarcity appears first: day-ahead, intraday or imbalance markets

Scarcity pricing varies across different market levels.

In the day-ahead market, scarcity indicates the forecast consensus. When tightness is broadly anticipated, such as during a cold winter peak, a scarcity premium might already be included. Nonetheless, day-ahead prices usually reduce uncertainty and often underestimate the risk of extreme outcomes.

In intraday markets, scarcity pricing becomes more dynamic. As wind, solar, temperature, and outage forecasts update, the market reprices tighter conditions. Scarcity often emerges late, when flexibility to respond is limited, and revisions matter more than levels.

In both imbalanced and balanced markets, scarcity is often detected first and most clearly. These markets respond to real-time stress and reserve depletion rather than forecasts. When reserve scarcity bites, imbalance prices can spike well beyond spot prices, reflecting the true marginal cost of keeping the system balanced.

This creates a typical scarcity cascade: forecasts deteriorate, intraday prices reprice upward, imbalance prices spike as reserves are activated, and those signals spill back into near-dated forwards and peak blocks.

How scarcity risk prices into forwards and spreads

Scarcity pricing does not only matter in spot and balancing markets. It also shapes the forward curve.

Winter and peak premia can be understood as scarcity insurance. Buyers pay to reduce exposure to a small number of potentially catastrophic hours. When systems are expected to be tight, this insurance becomes more valuable.

Typical scarcity-related spread behaviour involves peak/base widening as stress intensifies during peak hours. It also includes increased time spreads, especially in the evening peaks compared to surrounding hours, and regional basis widening when imports are limited or interconnectors become unreliable.

Scarcity is often misvalued. Markets tend to overvalue scarcity during panic, driven by limited information, or undervalue it when complacency prevails after extended calm. Recognising whether the market is overpaying or underpaying for tail risk is essential for portfolio managers.

Trading and risk management lessons from scarcity regimes

Scarcity regimes change how risk behaves, and trading approaches must adapt accordingly.

P&L becomes tail-driven. A handful of hours can dominate results, making average-based metrics misleading. Position sizing often needs to be reduced, not because opportunities disappear, but because the distribution of outcomes becomes more extreme.

Liquidity worsens during scarcity events, with bid-offer spreads widening, market depth shrinking, and execution risk rising. Strategies that depend on smooth exits may fail precisely when they are most needed.

Governance is crucial. Pre-set scenario boundaries and actions are necessary. When scarcity occurs, there is seldom time for calm improvisation. Desks with pre-agreed responses generally perform better than those reacting spontaneously.

Finally, post-event learning is essential. After a scarcity episode, traders need to determine whether the cause was forecast error, an outage shock, a flow constraint, or a combination of these. This understanding directly improves stress and reliability analysis.

Conclusion

Scarcity pricing reflects how the market values reliability when resources are limited. It is not a flaw in power markets but a deliberate feature - one that gains significance as systems operate nearer to their maximum capacity.

For traders and portfolio managers, understanding the mechanics of scarcity pricing is essential not only for profit but also for survival. Tight systems reward those who respect convexity, prepare for tails, and manage risk with discipline rather than bravado.