Congestion Costs and LMP

A wind farm in West Texas produces electricity for $20/MWh. A gas plant in Houston bids $80/MWh. Normally the cheap wind wins. But if the transmission lines between them are full, the grid operator dispatches the gas plant anyway. The price difference is not a market failure. It is the market revealing a physical constraint.

Locational marginal pricing (LMP) assigns a distinct price to each grid node based on which generator must actually run to serve load there. When lines are uncongested, prices converge. When a line hits its limit, prices diverge: the constrained zone relies on expensive local generation, and the gap equals the economic cost of congestion.

The setup. Zone A has surplus wind at $25/MWh. Zone B has only gas at $90/MWh. The connecting line is capped at 500 MW, but Zone B needs 800 MW.

If Zone A's price is $25, what is Zone B's price?

Zone B's LMP rises to $90/MWh, the cost of the marginal local generator. The $65 spread is the congestion cost. Ratepayers in Zone B pay $65 more per MWh than they would if the line had spare capacity. That $65 also represents the annual value per MWh of building additional transmission.

LMP congestion costs matter for policy in three ways. They expose a hidden tax on consumers in constrained zones. They drive transmission investment decisions: planners compare projected congestion costs against line construction costs. And they create the economic case for co-locating generation near demand, even at higher development costs.

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