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Consumers Win if Electricity Production Capacity Remains High

There are many pundits writing about the U.S. electricity markets today who hope that their readers haven’t studied market behavior and competitive price formation.

They want their readers or listeners to accept their narrative and believe that keeping struggling generators in the market will be a costly market intervention resulting in higher customer prices. The opposite is more likely to be true. In competitive commodity markets, production capacity reduction nearly always results in higher prices as supply tightens.

That almost immutable fact is the reason why OPEC establishes production quotas and lowers those quotas if prices fall too low due to an imbalance in the market. It’s why the Department of Agriculture has been funded to buy surplus production during years with bumper crops so that excess supply does not push market prices so low that farmers cannot recover their costs.

I believe it is a major reason why a large coalition that includes numerous competitors in the electricity generation market have joined together in a formal coalition to resist Secretary of Energy Rick Perry’s proposed grid resilience pricing rule.

According to a recently published Axios column by Ben German, the Affordable Energy Coalition includes the following members: Advanced Energy Economy, the American Wind Energy Association, BP, the Electricity Consumers Resource Council, Energy Storage Association, Industrial Energy Consumers of America, and the R Street Institute (formed in 2012 by former employees of the Heartland Institute).

Supply And Demand Effects Amplified In Electricity Markets

Though similar to other commodity markets, electricity has unique qualities that make production capacity reduction particularly rewarding for producers that remain in the market while also being particularly dangerous for customers who prefer reasonably predictable electricity prices.

Since electricity is virtually impossible to stockpile, there isn’t an inventory buffer that moderates price behavior during unplanned outages or spikes in customer demand.

That same just-in-time characteristic of electricity – along with the fact that electrical power is the motive force that enables nearly every aspect of modern living in cities and suburbs – makes many customers insensitive to price variations. Even if prices scream up to a level ten times as high on Tuesday as they were on Saturday, demand does not fall off very much.

Suppliers may apologize and act contrite about the high prices, but there are numerous participants in the market that enjoy putting the extra cash into their banks. They actively seek to cut someone else’s production capacity enough to make those “good times” occur more often. They know they are unlikely to be held accountable for “price gouging” because they can blame The Market as being the perpetrator of high prices.

Customers are sometimes hit with shockingly high power bills weeks to months after a series of events – like slightly more frequent and chillier cold fronts than usual – that caused the high prices. The delay tends to protect the decision makers who caused the price spikes from being held accountable.

Which Generators Need Rule Changes To Remain In the Market?

Most at-risk generators today are characterized by relatively high fixed costs, low marginal costs that approach zero, stable electricity output that eases the challenge of grid management, and enough secure, on-site fuel to withstand disruptive events in fuel supply infrastructure and the resulting market price fluctuations.

The owners of the generators have a limited ability to take action to reduce the fixed costs. For at-risk nuclear plants they are the result of regulatory ratcheting, politically motivated overreactions and industry self-imposed reactions intended to ward off too many new regulations. Nuclear plants built in the 1970s and operated by a staff of 250 people now have payrolls in the range of 700-1000.

They are not producing any more power, but they produce an amazingly voluminous flow of documentation. They employ full time security forces that rival the size of the guard force present at the Kings Bay Naval Submarine Base when I served there in the 1980s.

During my time at KBNSB there were as many as five SLBM carrying submarines in port at any one time.

The nuclear industry spent at least $3 billion in reaction to the events at Fukushima, even though none of the reactors in the U.S. are on sites that are susceptible to station blackouts from tsunamis or any other external event.

What Happens When Large Generators Are Forced To Exit Market?

The generators that are struggling in today’s occasionally oversupplied market are also large enough so that each time one is pushed out of the market, the supply demand balance price point measurably shifts in the direction of higher prices.

In the old days of rate regulated utilities, there was some truth to the assertion that excess capacity causes consumer prices to be higher than they would be without that capacity. Electricity rates for those monopoly utilities were set using the carrying cost of capital equipment plus that “rate base” multiplied by a fixed percentage for allowable return on investment.

Excess, often idle capacity caused the rate base to be higher than needed, raising both consumer prices and the company’s revenue – due to having a larger base number multiplied by the same fixed investment return percentage. Public overseers were tasked with being judicious about the investments they allowed the utility companies to put into the rate base, while also recognizing that some excess capacity was needed to assure reliable service.

Regulators also had a direct line of accountability if the utility experienced a failure to deliver power when it was needed because of avoidable mistakes like failing to maintain reserve generators properly.

That paradigm is invalid for restructured power markets. Excess capacity means more competition in the business of selling kilowatt-hrs. Competition keeps wholesale prices low, but it can produce prices that are so low that total revenue generation is less than what is needed to cover costs. With reasonably functional markets, low market prices will gradually correct themselves by discouraging new market entrants and by causing high marginal cost producers to reduce their output or shut down altogether if they cannot improve their operations.

Why Have Market Prices Been So Low?

Unfortunately, the electricity markets have been disconnected from that kind of capacity restraining feedback. During a period of virtually flat demand, federal, state and local governments have supplied tens of billions of dollars in capacity construction incentives for wind and solar. Those incentives have worked to help those sources move down the price curve associated with repetitive construction and manufacturing.

The significant and growing output from the new, heavily incentivized generation capacity has displaced output from existing generators and has made a big contribution to maintaining the oversupply of natural gas that has kept prices of that commodity so low since the start of the Great Recession.

The large, steady, low marginal cost generators whose stability is a major beneficial feature have difficulty covering their fixed costs of operation in an environment with prices that are often below everyone’s unsubsidized cost of generation. The extreme example proving this seemingly contradictory statement is when prices on the wholesale market fall below zero and generators have to pay to put their power onto the grid.

The explanation for that incredible situation is that some market participants receive $23/MWhr for all the electricity they produce, even at times when it is unwanted.

Generators whose costs are mainly driven by the cost of fuel that is delivered just in time for burning have more options for remaining viable in a market characterized by widely varying prices. They can cut most of their costs by closing their fuel supply valves and sending their small crews home. While shut down, their generators need less maintenance personnel. Since they store little or no valuable fuel on site, they have few, if any, site security personnel requirements.

At the times when electricity demand is high, prices rise into the range where generating and selling electricity is profitable enough to pay all operating costs with a little – or a lot – extra to spare. Flexible units can be quickly started to capitalize on the profitable period. They can shut down and reduce their ongoing costs just as quickly.

Those rapid start, reasonably reliable generators could be considered to be almost as valuable for grid stability as the less flexible large generators in need of assistance if they made a few changes. Even if mechanically sound with high availability numbers, no thermal generator can run without fuel.

The cheapest kind of fuel contract is one that allows delivery interruption if there are constraints in the supply capacity. Any generators supplied by interruptible, just in time fuel is only as reliable as the fuel supply on an almost minute by minute basis.

If operators of this kind of generation want to earn consideration as a reliable power source, they can choose to enter into contracts that put them higher on the fuel delivery priority list.

They can also invest in systems that allow on site fuel storage, either in the form of distillate fuel or LNG. Either choice will come with an incremental increase in cost, which will lead to wholesale price bids that are more reflective of the true cost of providing dependable electricity.

Is The Price Of Electricity As Important As Some Proclaim?

Though I’ve read dozens to hundreds of commentary articles over the years talking about the importance to customers of achieving the lowest possible market prices, I’ve had a number of opportunities to observe the way that suburban customers behave when they are faced with loss of access to sufficient quantities of electricity.

They will often spend thousands of dollars to purchase stand-by generators and they will willingly operate those generators if the power goes out. They won’t think too hard about the fact that each kilowatt-hour of power supplied by running a small gasoline engine starts at about $0.50 – including generator capital and maintenance – and goes up from there if retail gasoline prices rise above $2.50 per gallon.

Even those lucky few who have access to natural gas distribution lines with adequate capacity to support a customer base with a substantial number of running generators will find that the prices for delivered gas in most locations translate to rather expensive kilowatt hours.

Admittedly, few of the people operating generators to make it through a power outage will even bother to calculated the cost of keeping their refrigerators and television sets running while their neighbors figure out how to get a generator of their own.

Bottom line of this rather rambling commentary is that reasonable incentives to retain reliable generators can lower market price averages by serving as a buffer to restrain frequent spikes. That’s why there is such a loud outcry from competitors with tenuous, variable price fuel supplies and from weather-dependent market participants that have no control over whether or not they can supply electricity when demanded.

The post Consumers win if electricity production capacity remains high appeared first on Atomic Insights.

Photo Credit: Bruce Guenter via Flickr

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