ENERGY/UTILITIES
Electricity Prices: What Does the Future Hold?
July 2002
By Heidi L. Kroll
Across the country, allegations and evidence of flawed electricity markets continue to make headlines. Bewildered consumers are left wondering what the future might hold for electricity prices and what it all means for their business. These questions require a careful look at the direction that public policy and regulation will take in the wake of widespread market failures, in addition to a sound analysis of supply and demand conditions.
Indeed, companies considering the installation of on-site electric generation, electricity supply contracts, or energy efficiency and load management investments will be in a much better position to make informed decisions if they go beyond a narrow, more traditional economic assessment of their options. Problems with electric industry restructuring, together with the fundamentals of supply and demand, have influenced electricity prices during the last few years and will continue to impact future prices until competitive market forces take hold.
Regulatory Uncertainties
Recent problems with restructuring have arisen, by and large, because traders have figured out ways to employ bidding and withholding strategies that drive market prices well above what a more competitive and balanced situation would allow. See Figure 1. These problems were exacerbated in the case of California, where consumers were largely barred from hedging their risks through the use of bilateral contracts. In properly functioning markets, prices would either be negotiated under competitive bilateral contracts or set by dynamic short-term markets. In electricity "spot markets," suppliers submit bids to the system manager for a particular quantity of power at a particular price for a particular period of time. The dispatcher then calls up generating facilities in the order of lowest to highest bids. The highest bid needed to meet demand in a particular time period becomes the price paid to all generators during that period. In theory, prices should generally reflect the marginal cost of producing power. This type of marginal cost pricing is common in many commodity markets, and generally works fairly for both sellers and buyers.
Figure 1
Monthly Average Electricity Clearing Prices
Click to enlarge
It is now clear, of course, that the market structures and rules for electric competition that were adopted in different regions across the country provided energy companies with unfettered opportunities to manipulate prices, evade detection by regulators, and earn windfall profits at the expense of consumers. The investigation into Enron's trading practices brought to light the market manipulation techniques that it and other energy trading companies have had at their disposal, strategies including "round-trip trades," "megawatt laundering," and "inc-ing," to name just a few(1).
While it is obvious that the markets are flawed, it is not clear exactly what combination of structural changes, policing strategies, and emergency measures lawmakers and regulators at the state and federal levels should OR WILL adopt in an attempt to prevent future abuses. For example, a greater number of power sales may be required to occur under medium- and long-term contracts, thus reducing reliance on spot markets. In addition, market-monitoring rules may require greater disclosure about the financial aspects of power transactions in order to ensure their legitimacy. More rigorous monitoring might also be coupled with stricter penalties if abuse is detected and with more liberal use of price caps as a stopgap to soaring prices when markets malfunction. In addition, regulatory intervention in regional planning might also increase to ensure that there are adequate electric generation and transmission resources. Whatever measures are chosen, regulators are certain to be more proactive. In the words of William Massey, a member of the Federal Energy Regulatory Commission (FERC), "What we're learning is that electricity markets are fragile and that prices can soar in the blink of an eye… When we see abuses… we have to intervene immediately(2)."
In addition to safeguarding against supply-side abuses, lawmakers and regulators are expected to expand "demand-side" options available to consumers and preserve the advantages of those already in use, including on-site electric generation and load management technologies. In the context of President Bush's energy plan and federal efforts to increase wholesale electric competition, industrial consumer groups are striving to protect the rights of cogenerators to sell excess power to utilities and to purchase backup service at just and reasonable rates. The Carper-Collins Amendment to the federal energy bill protects the operation of and investments in combined heat and power (CHP) systems while true competition in electricity markets is established(3).
It is likely that the path from a regulated industry to competitive markets will become clearer with time and that the public's confidence in electric competition will be restored. In the interim, however, this uncertainty will compound traditional market forces, increasing the likelihood for greater price volatility and magnifying price spikes.
Supply and Demand Fundamentals
In addition to the regulatory uncertainties discussed above, competitive electricity pricing is also a function of supply and demand. Prices tend to go up, for example, when demand increases due to heat waves or economic booms, or when supply decreases because a power plant goes down or new plants aren't built. Beyond the laws of supply and demand, the price of electricity also reflects some of its unique characteristics: 1) electricity cannot be easily or cost-effectively stored, 2) there are few if any substitutes, depending on what it is used for, and 3) generally, users cannot simply terminate consumption without significant disruptions in production. These unique factors magnify the impact of supply and demand imbalances on electricity prices because, in the short run, consumers cannot alter their demand much in response to price fluctuations. Most businesses have probably experienced this extreme price "inelasticity" when they have not been able to easily avoid high or volatile electricity prices.
During the late 1990's and into 2001, demand for electricity significantly increased and outstripped supply in many regions, even as new power plants were being built. Then, in the months before and after September 11th, the economy slowed and with it the demand for electricity. This helped reduce upward pressure on spot market prices, as illustrated earlier in Figure 1. With an economic recovery, demand for electricity will likely pick up and prices may increase somewhat. Even if they do, however, businesses might take some comfort in learning that real prices have reportedly declined over time. A study of 60 investor-owned utilities prepared for the Electric Power Supply Association found that the average reduction in real prices for commercial and industrial customers was 36 percent between 1985 and 2000, even in spite of real price increases in 2000(4).
Future electricity prices will also reflect the costs of producing power. The increasing reliance on natural gas-fired power plants means that these plants will continue to play a major role in setting the market prices for electricity. Extremely high natural gas prices during the last two winters largely reflected strong demand accompanied by tight supplies, which was a response to historically low prices. See Figure 2. After rising during 2000 and falling during 2001, natural gas prices are beginning to rise again, up from $2.75 per million British thermal units on January 1, 2002 to $3.61 on May 13, 2002. While natural gas prices have come down from their unprecedented levels in the winters of 2000 and briefly again in 2001, an upward trend may be developing, which would translate into higher electricity bills(5).
Figure 2
Henry Hub Spot Prices
Click to enlarge
A final consideration with respect to pricing is that if capital markets lack confidence in the electricity industry, they may charge higher risk premiums to energy companies looking to build new power plants or finance plant upgrades. Power companies would likely respond by passing higher capital costs onto consumers or by foregoing projects to increase supply altogether. Either response would tend to drive up electricity prices for consumers.
Conclusion
It will obviously take some time for the rules of restructured electricity markets to work well enough so that new investments in generation and transmission are made and prices more closely reflect marginal costs. Even then, prices could be volatile because of supply and demand cycles and disruptions.
The good news for individual electric users is that they can control their business decisions. There are a growing number of electric choices that can provide enormous value when carefully selected and tailored based on business needs. For example, on-site cogeneration, load shedding protocols, energy efficient motors, and high efficiency lighting can provide great returns on company investment for many applications. When prices spike, a whole host of techniques in the user's control become cost-effective if they have made the investment and are prepared. Forward contracts can also be an effective tool to hedge against price volatility, but when they merely lock-in high prices that improved market rules are apt to lower over time, long-term investments in and commitments to multi-fuel production systems, load management and energy efficiencies could be a better bet.
Ms. Kroll delivered a PowerPoint presentation at the IDEA's 93rd Annual Conference and Trade Show on Sunday, June 23rd. View the presentation.
Notes
1. See, for example, McNamara, Will, May 8, 2002, "How Will the 'Smoking Gun' Enron Memos Impact the Energy Industry?" SCIENTECH's IssueAlert; and McNamara, Will, May 14, 2002, "Can the Energy Industry Regain the Confidence of Investors?" SCIENTECH's IssueAlert.
2. Kahn, Joseph, Neela Banerjee, David Barboza, and Richard A. Oppel, Jr., May 12, 2002, "Will It Be California Redux? With Markets Flawed, Enron's Tactics May Live On," The New York Times, Section 3, pp 1 & 10.
3. See, for example, American Chemistry Council, April 25, 2002, "Carper-Collins Amendment Big Win for Combined Heat and Power," American Chemistry Council's Newsstand.
4. Boston Pacific Company, Inc., 2002, "2000 Data Update: Assessing the 'Good Old Days' of Cost-Plus Regulation," Electric Power Supply Association.
5. See for example Cummins, Chip, May 6, 2002, "Natural-Gas Prices Rebound After Falling Most of Last Year: Rise Inflates Electricity Costs In Some Regions of the U.S.," The Wall Street Journal Online.
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