Locational Marginal Pricing and FTRs
Electricity prices differ by grid location because transmission lines have limited capacity, and financial transmission rights let a trader hedge — or bet on — the price gap between any two nodes on the grid.
Prerequisites: Day-Ahead vs Real-Time Power Markets, Electricity Markets and Negative Prices
Electricity can't be stored cheaply and it flows along transmission lines that have finite capacity. Both of those facts mean the price of electricity is not one number for a whole grid — it's a different number at every location, called a node, and the differences between nodes are set by exactly the same congestion logic that widens basis in oil pipelines or gas hubs, just happening in real time, every five minutes.
Locational marginal pricing (LMP) prices electricity separately at every grid node based on the cost of serving the next unit of demand there, including transmission congestion and line losses. A financial transmission right (FTR) is a contract that pays the holder the difference in LMP between two nodes, letting a trader hedge or speculate on congestion without ever touching physical power.
Why the same megawatt-hour has different prices at different nodes
An LMP at any node is built from three pieces: the marginal cost of energy (the last, most expensive generator dispatched to meet demand), a congestion component (extra cost when a transmission line between the cheap generator and the node is at its limit), and a loss component (electricity lost as heat over distance). When transmission is uncongested, LMPs across nearby nodes are close to identical. When a line is congested, the node on the far side has to be served by a more expensive local generator, and its LMP rises relative to nodes on the near side.
An FTR is the hedge for exactly this gap. Whoever holds an FTR from node A to node B is paid the LMP(B) − LMP(A) spread when positive (and pays it if negative), precisely the congestion cost a physical trader moving power from A to B would otherwise face. A generator or load-serving entity that regularly ships power across a congested path buys FTRs to offset that risk; a speculator buys them expecting the spread to widen.
Worked example
A trader holds an FTR of 50 MW from node A to node B for a month (roughly 720 hours). Suppose the line is congested during 300 of those hours, with an average LMP spread of $18/MWh during congestion, and uncongested (spread near $0) the rest of the time. The FTR payout is approximately 50 MW × 300 hours × $18/MWh = $270,000 for the month. If the trader paid $180,000 at auction to acquire this FTR, the position nets roughly $90,000 — a bet that congestion between the two nodes would be more frequent or severe than the auction price implied.
What this means in practice
Grid operators auction FTRs so that participants exposed to congestion risk — generators, utilities, retailers — can hedge it, and so auction-clearing prices reveal the market's collective forecast of future congestion. Traders who study transmission topology and generation build-out use that to buy FTRs on paths they expect to congest more than the market currently prices in.
FTRs pay based on day-ahead LMPs, not real-time LMPs, and they are financial instruments settled centrally by the grid operator — holding one creates no obligation to actually generate, transmit, or consume power. Confusing an FTR with a physical transmission reservation is a common beginner mistake; the two serve different purposes and are cleared through entirely different processes.
Further reading
- PJM Interconnection, 'Locational Marginal Pricing Basics'