The Growing Tariff Fault Lines: Marginal Pricing at Wholesale & Regulated Pricing at Retail level

India’s Electricity Tariff Paradox : Marginal Pricing at Wholesale, Administered Pricing at Retail — and the Growing Fault Lines in Between

1. Introduction: Reform Without Alignment

India’s power sector today stands at a peculiar crossroads. On one hand, policymakers and regulators are pushing steadily—almost inevitably—towards market-based mechanisms at the wholesale level: economic dispatch, merit-order optimisation, GNA access, price discovery, and competition across regions. At the same time, retail electricity tariffs—the prices ultimately paid by consumers—remain largely administered, politically sensitive, and insulated from real-time system costs. This divergence between a gradually liberalising wholesale market and a rigid retail tariff framework has created a deep structural fault line in the sector.

This growing structural mismatch lies at the heart of many of India’s persistent power-sector problems: stressed DISCOM finances, rising regulatory disputes, inefficient dispatch, hidden subsidies, and mounting operational stress on system operators.

Recent initiatives such as Security Constrained Economic Dispatch (SCED) and proposals like Market-Based Economic Dispatch (MBED) aim to deepen marginal-cost-based price formation at the wholesale level. However, these reforms are being attempted without any commensurate reform of the retail tariff framework—a contradiction that becomes sharper as renewable penetration rises and flexibility requirements explode.

To understand why this matters, one must first understand how marginal pricing and the merit order actually work, and what they imply when transplanted into a system like India’s.

2. Marginal Pricing and the Merit Order: The Economic Logic

Marginal pricing is often portrayed in policy debates as a “design choice” or a regulatory construct. In reality, as the background paper clearly explains, marginal pricing is simply how prices emerge in any competitive market.

In electricity markets:

• The market-clearing price is set by the marginal plant—the most expensive generator required to meet demand at a particular moment.

• All dispatched generators receive the same uniform price, regardless of their individual costs.

• This price reflects the short-run marginal cost of meeting the last unit of demand.

The so-called merit order curve is nothing more than the supply curve of the power system, ordered from the cheapest to the most expensive available generators. When demand increases, costlier plants are brought online, pushing up the clearing price.

Two features make electricity special:

1. Non-storability (at scale): prices must adjust continuously to balance supply and demand.

2. Time-specificity: electricity has value only at the instant it is consumed.

This naturally leads to extreme price volatility in marginal pricing systems—prices can swing from near zero to very high levels within hours, depending on demand, weather, and availability of low-cost generation. To eliminate marginal pricing outcomes, market participants would have to be forced to act against economic logic through price caps, subsidies, or administrative dispatch. Such interventions do not remove costs; they merely shift and obscure them.

Importantly, these high prices are not a “market failure”. They serve a critical function:
they generate contribution margins for infra-marginal plants, which are essential to recover capital costs and signal new investment.

3. India’s Wholesale Market: Part Market, Part Regulation

India has not yet adopted full-scale marginal pricing across its wholesale electricity procurement. Instead, it operates a hybrid model:

• Long-term PPAs (~87%)
  – Cost-plus or competitively bid, capacity-backed contracts
  – Fixed charges + variable energy charges
  – Dispatch largely governed by contractual and regulatory arrangements

• Short-term markets/ OTC & Exchanges (≈13%)
  – Day-Ahead Market (DAM)
  – Real-Time Market (RTM)
  – Term-Ahead contracts
  – Ancillary Services (in transition)

• Centralised optimisation mechanisms
  – SCED: voluntary pooling of ISGS thermal plants for least-cost dispatch
  – MBED (proposed): mandatory, market-clearing based national dispatch

SCED already represents a significant step towards marginal cost optimisation, even though settlement remains largely outside a full market framework. MBED would go further, effectively decoupling dispatch from individual PPAs and letting price signals drive scheduling decisions. From an efficiency standpoint, the direction is sound. From an institutional standpoint, it creates deep tension. While economically superior, MBED amplifies price volatility exposure for DISCOMs.

4. Retail Tariffs: Frozen in a Cost-Plus Time Warp

While wholesale procurement is inching towards market logic, retail tariffs remain almost completely regulated:

• Tariffs are:
  – Determined annually in Advance
  – Based on historical cost approvals
  – Averaged across time, geography, and consumer classes

• Key features:
  – No linkage to real-time wholesale prices
  – Limited and crude Time-of-Day (ToD) differentiation
  – Heavy cross-subsidisation from C&I consumers to domestic and agriculture
  – Significant political intervention

Even ToD tariffs, where implemented, are ex-ante administrative constructs, not reflections of actual system marginal cost. They do not transmit scarcity, surplus, or flexibility signals to consumers.

The result is a fundamental disconnect & Wholesale prices are becoming more dynamic and marginal, while retail prices remain static and averaged. Someone must absorb this difference. In India, that “someone” is almost always the DISCOM.

5. MBED and SCED Without Retail Reform: A Structural Contradiction

Introducing MBED or expanding SCED in such an environment creates three inter-linked problems.

(a) Price Signal Mismatch

Marginal pricing works only when price signals travel through the system:

• From generation → procurement → retail → consumption.

In India, the signal stops at the DISCOM boundary.

DISCOMs may face:

• High clearing prices during peak or scarcity periods

• Volatile procurement costs driven by gas, coal shortages, or ramping constraints

But they cannot pass these costs through to consumers in real time. Retail tariffs are fixed; political tolerance for volatility is near zero.

The outcome:

• Procurement risk is socialised onto DISCOM balance sheets

• Market efficiency improves on paper, but financial stress worsens in practice

(b) Risk Without Reward for DISCOMs

In a true market:

• Retailers manage price risk using hedging, contracts, and dynamic pricing.

• Consumers adjust demand in response to price signals.

In India:

• DISCOMs bear price risk without pricing power.

• Consumers remain insulated from scarcity.

• There is little incentive for demand-side flexibility

Although DISCOM power-procurement costs are trued up by regulators, true-up does not correct the fundamental aberration created by introducing marginal pricing at the wholesale level without retail tariff reform. True-up is an ex-post accounting adjustment, carried out with a time lag of one to three years, whereas marginal pricing operates ex-ante and in real time, reflecting instantaneous system scarcity and flexibility needs. As a result, DISCOMs must absorb volatile market prices upfront and recover them later—often partially, delayed, or amortised—turning market price signals into deferred regulatory assets rather than actionable incentives. More importantly, true-up averages and socialises real-time price signals, insulating consumers from scarcity and eliminating incentives for demand response, flexibility, or efficient consumption. Thus, while true-up may ensure eventual cost recovery, it merely shifts and obscures risk rather than allocating it efficiently, leaving the core mismatch between dynamic wholesale prices and static retail tariffs fundamentally unresolved.

MBED effectively converts DISCOMs into involuntary market participants, without giving them the tools of a retailer in a liberalised market.

(c) Political Re-regulation Risk

When marginal pricing produces high prices—as it inevitably will during tight conditions—the pressure to intervene rises.

Internationally, this has taken the form of:

• Price caps

• Windfall taxes

• Ad-hoc market suspensions

India is not immune. Without retail reform, wholesale market reforms risk being rolled back at the first serious price shock.

6. Renewables, Must-Run Status, and the Merit Order Distortion

Renewables sit at the heart of India’s energy transition—and at the heart of its pricing paradox.

(a) Zero Marginal Cost, Infinite Priority

Solar and wind have:

• Near-zero marginal cost

• Must-run status

• Priority access to the grid

• Exemptions from many commercial disciplines (deviation penalties, backing-down compensation norms, transmission waivers)

In a marginal pricing framework, this means:

• Renewables always sit at the leftmost end of the merit order

• They suppress prices during periods of high availability

• They displace flexible thermal generation, even when system value is low

This is economically logical—but systemically incomplete.

(b) Missing Price for Flexibility

What the merit order does not price adequately in India:

• Ramping capability

• Start-stop costs

• Reserve provision

• Inertia and grid-forming services

As renewables rise:

• The energy price collapses during solar hours

• But the cost of maintaining reliability rises

Without a robust ancillary services and capacity remuneration framework, these costs are pushed into:

• Uplift charges

• Regulatory adjustments

• DISCOM losses

Again, the consumer sees none of this directly.

7. The Impossible Job of the System Operator

System operators—NLDC, RLDCs, SLDCs—are increasingly asked to square the circle:

• Integrate must-run renewables

• Maintain frequency and reserves

• Accommodate constrained transmission

• Dispatch on economic principles

• And yet respect rigid contractual, regulatory, and political constraints

Marginal pricing assumes:

• Dispatch decisions follow prices

• Prices reflect scarcity and flexibility

India’s system operators operate in a world where:

• Prices are partial

• Contracts dominate

• Many resources are non-dispatchable in practice

This leads to:

• Out-of-market actions

• Frequent manual interventions

• Hidden system costs not reflected in tariffs

8. Why Marginal Pricing at Wholesale Will Eventually Force Retail Reform

The one point is unambiguously clear: you cannot eliminate marginal pricing outcomes without intervention. India currently attempts to do exactly that—embracing marginal logic upstream while suppressing its consequences downstream.

This equilibrium is unstable. As renewable penetration increases and MBED-like mechanisms expand, one of three things must happen:

1. Retail tariffs must become more dynamic
   – True time-varying prices
   – Better targeting of subsidies
   – Protection through income support, not price suppression

2. DISCOMs must be structurally reformed
   – Ring-fencing of supply and network functions
   – Risk-aware retail supply businesses
   – Hedging and portfolio management

3. Or wholesale reforms will stall
   – Re-regulation in response to price volatility
   – Loss of investor confidence
   – Continued inefficiency disguised as stability

There is no fourth option.

9. Conclusion: Reform Sequencing Matters More Than Reform Speed

India’s power-sector reform debate often focuses on what to reform—markets, dispatch, exchanges, renewables. Far less attention is paid to when and in what sequence.

Introducing marginal pricing-based wholesale mechanisms like MBED and SCED without reforming retail tariffs is not neutral. It shifts risk, obscures costs, and deepens financial stress—while giving the illusion of efficiency.

Marginal pricing is not the enemy. In fact, it is indispensable for a modern power system. But it demands institutional honesty:

• If prices are allowed to reflect scarcity, someone must see them.

• If consumers are protected, protection must be explicit and targeted.

• If DISCOMs are to act as market intermediaries, they must be given market tools.

Until retail tariff reform enters the centre of the conversation, India’s electricity sector will remain trapped in a paradox—market logic without market accountability, and reform without resolution.