Natural Gas' Role in PJM
Conventional wisdom may say that natural gas is the primary fuel of electricity generation in the PJM region given the following two facts:
1. The Calendar Year 2014 strips for NYMEX Henry Hub and PJM West Hub have been approximately 95% correlated since 2008.
2. Natural gas usage for power generation has increased steadily since 2008 due to decreasing natural gas prices (in fact, Cal `14 gas futures have decreased 75% since 2009).
However, despite these two facts, the region is primarily fueled by coal and nuclear sources. In 2013, natural gas was only responsible for 17% for the electric generation in PJM in comparison to nuclear (37%) and coal (42%). The total of these three fuel types accounts for 96% of the total electric generation in PJM.
This region's fuel mix has remained fairly steady over the years when compared to other regions. Going forward, there may be more growth in natural gas generation due to recent EPA regulations intended to reduce carbon and mercury emissions. However, coal and nuclear power are solidly entrenched in the regional generation stack and change is not necessarily imminent.
So, why do the natural gas and power markets have such a strong correlation despite not owning the lion's share of the fuel source?
The answer lies in the methodology to determine the hourly power price. In PJM (and other regional ISOs), the power price is established by the last generation unit selected to meet demand at any given hour, which is known as the Locational Marginal Pricing (LMP). The LMP is the marginal energy cost, or the cost to serve the next increment of demand at the specific location, or node, that can be produced from the least expensive generating unit in the system that still has available capacity. Although it doesn't provide the bulk of the generation for each interval, natural gas is often the last generator to supply the grid due to its flexibility to be dispatched quickly on short notice whenever needed. Conversely, coal and nuclear plants are typically more associated with the base load generation or the amount of power needed to meet a region's continuous energy demand, but are not available or capable of providing the flexibility to meet the constant fluctuations of system demand.
Thanks to shale gas lowering the cost of gas generation, natural gas will likely continue to make inroads in the generation sector - likely at the expense of older coal plants being shut down.
Gas will continue to be the primary driver of prices. However, it will be difficult to reach a point where coal and nuclear fuel sources are not needed since these two fuels comprise almost 80% of the generation stack at this time.
Source: U.S. Energy Information Administration, Electricity Monthly Update