ENERGY/UTILITIES
Making Economic Sense of Electricity Price Spikes
There's a pattern to be seen if you know where to look
October 2002
By Dr. Lisa K. Shapiro
as originally published in Energy User News
When electricity prices quadruple over the course of a few months, many companies that are unhedged and unprepared get hurt. Because prices will probably rise again, companies that can make economic sense of price spikes will be better prepared to manage their energy costs.
External Shocks
Electricity price spikes can be caused by external shocks to the economy. A few producing countries, for example, largely control oil supply; oil is an oligopolistic market. By controlling supply, a few players effectively set the price.
The ripple effects of a shock depend upon its timing, magnitude, and type, and we cannot completely insulate ourselves from them. Fortunately, external shocks tend to be infrequent and easy to recognize. The price spikes in the electric market during the last few years are best explained by the fundamentals of commodity pricing and by problems associated with electric restructuring.
Electricity Commodity Fundamentals
Like any other commodity, electricity is subject to the law of supply and demand. When demand increases, prices tend to go up. If supply cannot increase to meet the new level of demand, prices tend to be bid up even further. For example, when Volkswagen introduced its New Beetle to an expectant public, prices were bid up beyond dealers' stickers until increased production balanced demand. The supply and demand principles are essentially the same for most commodities.
Figure 1. Growth in electric
industry capacity versus demand.
(click on chart for larger view).
During the late 1990s, and largely due to the electronic economy, demand for electricity significantly increased. Demand outstripped supply in a number of markets, even though new capacity was being added. For example, in the Midwest in June 1998, because of an unusual heat-wave, and because some generating plants were down for scheduled and unscheduled outages, there were several days of significant price spikes. Figure 1 compares the growth in electric industry capacity with actual sales.
In addition to supply and demand, the price of electricity reflects some of its unique characteristics.
- Electricity cannot be easily or cost-effectively stored.
- There are few substitutes.
- Generally, users cannot simply terminate consumption without significant disruptions in production. These unique factors magnify the impact on price of supply and demand imbalances.
The effect of price changes on supply and demand is called "elasticity." Broadly stated, elasticity of demand is the measure of how steeply demand goes down when prices go up. Elasticity is different for each commodity and reflects the particular characteristics of the commodity's use and markets.
In the short run, system-wide elasticity for electricity is near zero. There is almost no reduction in demand as prices rise on an hourly basis. This is because users do not have a stockroom full of spare electricity; they cannot use a substitute input; and, if they ceased their use while the price was high, many would suffer unacceptable disruptions in operations.
In the long run, however, users can be more elastic by shifting to more energy-efficient technologies, by acquiring multi-fuel production systems, or by implementing load-management techniques. All of these have been employed in a variety of industries. Figure 2 illustrates the long-run decline in energy usage per unit of value added to the economy.
Figure 2. U.S. total energy consumption
per dollar of GDP (click on chart for larger view).
Volatility in Short-Term Commodity Markets
In the traditional regulatory regime (which still exists in most areas of the United States), supply is planned, thereby reducing the likelihood of shortages. Between 1978 and 1992, regulators kept the capacity margins for America's utilities averaging between 25 and 30%. This significant excess capacity could buffer large fluctuations in supply and demand.
Power plant investors are guaranteed a return on their prudent investments, which is determined by regulators rather than market discipline. Prices are set according to how much the utility spends. This "command and control" regulatory system unintentionally rewards over-investment and does not sufficiently discipline inefficiencies. Under the traditional regime, it is not uncommon for two utilities in the same region to have vastly differing prices, a situation the market would not tolerate. Under the traditional regulatory model, dispatch-the order in which plants get turned on and off-is done in the order of least to most expensive, with the highest-cost plants reserved for the hottest days or other times of high demand. Prices to consumers are generally set at around the average cost of producing power.
In a deregulated market, this is all different. Prices are generally set by forward contracts, and by dynamic short-term market situations. Competitive 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. Prices are thus generally set at the marginal cost of producing power.
Odd as it sounds, marginal cost pricing and highest-bid-sets-the-price-for-all is common in many commodity markets and generally works fairly for both sellers and buyers.
Problems arise in the electricity market, however, when there are too few players on the generating side or not enough excess supply among them. In those situations, all suppliers benefit because the last (highest) bid sets the price for the entire period. Unfair market power can be exercised, either because of strategic bidding by low- or modest-cost suppliers or because of the need to draw upon a limited number of high-cost generators to meet demand. When either occurs, the market goes well above (sometimes by many multiples) what a more competitive and balanced situation would allow. In addition to growth in demand outstripping growth in capacity across the country over the last five years (as shown in Figure 1), since 1992 average capacity margins have declined to less than 16%. Just a few plants being off-line at times of high demand in some markets, without other balancing factors, can lead to non-competitive market conditions.
When necessary goods are in short supply, exorbitant prices are no surprise. For example, suppose a supplier in a region of limited excess supply submits a bid for a large portion of its power at well below cost and then submits a second bid for the remainder of its capacity at a price well above cost. The generator can thus gamble that, while not all its capacity will be bought, some block of late-bid high-priced power will be used and will be priced at the exorbitantly high level. That block will then set the price of all the power sold, earning generators greater profits than they could if prices were set closer to marginal cost.
In a perfectly competitive market, a single supplier cannot affect the market in a way that leads to prices well above marginal cost. Other suppliers would see the opportunity to undercut the higher priced firm, yet still earn strong profits. Eventually, the higher priced supplier would be forced to cut prices or go out of business.
But even in commodity markets that are competitive, prices tend to be volatile because of supply and demand cycles and disruptions. Forward contracts are thus an important tool for purchasers to hedge against the risk of volatility. Businesses need to consider this approach.
Figure 3. California monthly average clearing prices
(click on chart for larger view).
Any well-managed company knows that the purchase of an input that is a major cost factor of production should not be completely left to volatile short-term commodity markets. But that is precisely what happened in California when regulators barred the wide-scale use of forward contracts and forced nearly all producers and consumers into the volatile spot-market. This worked fine as long as there was sufficient excess supply. As the market tightened in early summer 2000, however, no mechanisms were in place to keep prices from quadrupling. Wholesale spot market prices increased by as much as 100 times in the space of a single hour (see figure 3).
The market structure (how competitive the market is) and the market design (the actual bidding rules and types of contracts which are available) can thus have an enormous impact on the magnitude, frequency, and duration of price spikes. California failed spectacularly with its supply/demand imbalance, disallowance of traditional risk management techniques, and capped retail prices. Because of lower demand due to a cooler summer, a softening economy, and increased conservation and load management, California was able to retreat from the crisis. Much of the electrical load also moved to forward contracts, improving competitiveness in the real-time market.
Finally, in a newly deregulated marketplace, regulatory uncertainty can create greater volatility and magnify price spikes. In New England, where roughly 80% of the electric load on long-term contracts afforded more price stability, uncertainty about the Federal Energy Regulatory Commission (FERC) treatment of certain power costs probably has added a penny or two per kilowatt-hour premium at certain times. Market structure and design challenges have also contributed to the problem (see figure 4).
Figure 4. New England monthly clearing prices
(click on chart for larger view).
Deregulation's Future
In the real world, there are few examples of perfectly competitive markets. In the restructured electricity context, it will take time for market rules to work well enough so that prices more closely reflect marginal costs.
Government, electric users, generators, and the market itself are all undergoing changes that will eventually allow prices to maintain competitive levels.
Just two years ago, supply planning was considered an anathema to electric deregulation. But the rolling blackouts in California dramatically increased policymakers' attention to supply issues. President Bush's highly publicized energy plan advances a major role for governmental intervention in the market. It takes specific positions on the quantity of new supply that should be built over the next several decades and has thus increased interest in planning among states and interest groups. In states that have not deregulated, there is a new scrutiny of supply-demand balances. In states that have already deregulated, there is an increased focus on how market structure and design rules influence competitiveness.
The most obvious way to address supply problems is to build new generating facilities. New gas-fired plants are now on-line or under construction everywhere. As noted, under traditional utility regulation, prices are set at about average costs, whereas under deregulation, prices tend toward the marginal cost. In a deregulated market, when marginal cost is higher than average cost, prices will be higher, all other things being equal. Thus in a region where a higher cost plant sets the price a significant amount of the time and there is little excess capacity, competitive suppliers are building new inexpensive natural gas units in the hopes that they will be able to sell the power at the higher marginal costs.
Because marginal costs can be higher than average costs, some policymakers oppose deregulation. But this underestimates the ability of a well-functioning market to discipline prices and create value through new service offerings. It also overestimates the ability of the command-and-control model to allow for the creation of new billing, delivery, or other innovative services. Moreover, commodity prices have fallen in most major markets. The fundamental conditions that drove up prices last summer, and are driving them down now, affect both regulated and deregulated markets. Last winter's four-fold increase in natural gas prices, for example, largely reflected strong demand accompanied by supplies that were tight due to the gas-drilling market's response to recent historically low prices.
Beyond new supplies, regulators in non-deregulated states have been looking at ways to create incentives for more efficient production through performance-based ratemaking techniques. Regulators in deregulated states have been looking into market structure and rules so they will not repeat the California experience. Even FERC has recognized that the deregulated electricity markets have not yet developed structures and rules to adequately discipline prices and has finally supported price caps in a variety of markets.
Currently, it is often impossible to move power from low-cost sources to places where it is needed because the transmission capacity is not available. Consequently, hundreds of millions of dollars are being spent on high-cost, low-efficiency plants because they are local. Money is also being spent on new facilities to increase local power supply. These "congestion costs" cannot be rooted out without an investment in transmission.
Thus, transmission of electricity — moving it long distances between states and regions — is a promising area for addressing price volatility, as having better transmission can help discipline prices. Moves are now afoot to form strong, independent regional transmission organizations to ensure that effective choices are made between more generation plants and more transmission lines. Some regions of the country have had regional power pooling systems for decades. But making transmission work with competitive generation will require an effective and independent transmission manager.
Figure 5. Electric price caps
(click on chart for larger view).
The best news, however, is that individual electric users still control their business decisions. Putting aside the California debacle, new supply, and better transmission, there are increasing electric choices for many businesses. Conservation and load management techniques can provide enormous value. For example, energy-efficient pump motors, high-efficiency light bulbs, on-site cogeneration, and load-shedding protocols can provide great returns on company investment for many applications. When prices spike tenfold, 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 be an effective tool to hedge against price volatility, but when they merely lock-in high prices that shifting market rules would have lowered, long-term investment in and commitment to load management and energy efficiencies could be a better bet.
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