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No Crystal Ball Necessary: Energy Efficiency Can Help Mitigate Price Volatility

Electricity bills don’t make for terribly exciting reading, but as boring as they may look, there is much more going on beneath the surface. Whereas the price most people pay for electricity remains steady from month to month, electricity costs can change dramatically from one hour to the next for the utilities that send the bills.

For example, weather can cause demand to spike, raising prices as well, and suddenly the cost of the electricity is much different from the price we see on our bill. It generally falls on utilities to manage this problem, and in our new report, Estimating the Value of Energy Efficiency to Reduce Wholesale Energy Price Volatility, we estimate the costs of the risks that come with this kind of volatility and show how energy efficiency can play a useful role in mitigating those risks.

Utilities have to make plans several years at a time, setting electricity prices (with approval from regulators) to make sure they bring in enough money to cover their costs. They know that the weather is going to be bad at some point, but they don’t know when or how bad. One option is just to pay high prices when they come, hope that they set prices right, and ask permission from regulators to cover the difference if they’re wrong.

Alternatively, utilities can essentially buy insurance by entering into long-term contracts for electricity at a fixed price, or by using financial markets, buying options on futures or other markets that don’t deliver actual electricity but rather pay the utility a certain amount of money if electricity prices rise above a particular level. However, the price for electricity in a long-term contract is generally higher than current expected prices, and financial instruments cost money to buy. If electricity prices don’t rise high enough, the utility loses money.

In general, utilities tend to do some of both, but regardless of what they do, volatility in electricity prices imposes costs on the system, and the only question is how much.

The polar vortex as an example

The 2013–2014 polar vortex shows how much this matters. In the PJM service territory that covers a large section of the mid-Atlantic states, electricity prices typically run in the range of $40 per megawatt hour (MWh). But during the polar vortex, prices jumped to over $100 per MWh and stayed there, spiking to over $1500 per MWh for a few hours. Utilities that had to buy power in real-time (or spot) markets were facing costs over 30 times higher than normal. Managing the risks of price volatility is an important business.

In our report, we calculated the value at risk to utilities from energy price volatility for the 12-month period including the polar vortex (June 2013–May 2014) and again for the 12 months following. Looking at the day-ahead electricity market, we found that in the year of the vortex, price volatility created risk of as much as 25% of electricity costs. This means that if a utility knew the polar vortex was going to occur at some point in that year, they should have been willing to pay up to 25% extra over the entire year to avoid having to buy electricity on the day-ahead market.

We also looked at the following year which had much more normal weather, and while the cost of risk was lower, it still averaged a substantial 14% of the wholesale cost of electricity over the entire year.

Efficiency can reduce exposure to price volatility and risk

Energy efficiency has many well-recognized and understood benefits: it is generally less expensive than electricity itself, it reduces pollution, and increases comfort. Investing in energy efficiency creates more jobs than producing the electricity it replaces. In addition to these and other benefits, energy efficiency also reduces exposure to electricity price volatility, reducing risk and its attendant costs.

Well-designed efficiency investments act similarly to long-term supply contracts. Once the investment is made, it saves energy over its useful life, and the price doesn’t go up and down with wholesale electricity prices. Every kilowatt-hour (kwh) of saved electricity is one less kwh that has to be bought on volatile wholesale markets or long-term contracts, or that has to be hedged through financial instruments.

Instead of buying electricity and the cost of mitigating risk on top of it, when utilities invest in energy efficiency, they avoid the costs of risk and pay less for the underlying electricity in the first place, a double benefit that utilities and other planners should be sure to include when making long-term decisions about how to provide critical services to their customers. Given that some extreme weather events are likely to become both more common and more extreme, it will be increasingly important to recognize this feature of energy efficiency and use efficiency investments to manage this growing risk.

By Jim Barrett, Visiting Fellow

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