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What Drives Energy Prices?

June 15, 2015

At Enel X, we’ve invested countless hours understanding energy markets and explaining them to our customers, who spend about $15bn on energy annually. While gaining a full understanding of the market can require years of hands-on experience, reading this will give you enough background to become a sharper energy buyer.


The Rule of Thumb: Where Natural Gas Prices Go, Electricity Prices Follow

You may have noticed that we talk a lot about natural gas. We do that because, currently, natural gas has the largest influence on electricity prices. But the reason why isn’t altogether obvious: the connection derives from the way independent system operators (ISOs) set the price of energy; that is, how much they charge the end-user at any given moment.


How ISOs Determine Electricity Prices

At the most basic level, ISOs (like PJM and ISO New England) aim to meet 100% of customer electricity demand at any given moment using the cheapest and most reliable resources available.

ISOs determine which resources are reliable through a long and ongoing vetting process, but a very simple equation governs which resources are cheapest:


(Heat Rate x Cost of Resource) + Added Fees


The lower the sum of this equation, the cheaper a resource is. Here’s what each term means in plain English:

  • The “heat rate” is an expression of how efficiently a power plant transforms a resource (like coal) into electricity. It is measured at the plant-level, because all plants have varying degrees of efficiency even when burning the same resource. For example, an older nuclear plant will have a higher heat rate compared to a newer, highly efficient nuclear plant, even though both use the same raw materials. And the higher the heat rate, the more a power plant needs to ask for each MW produced to cover the cost of production
  • The “cost of resource” is the cost of the raw material a plant burns to generate energy, such as, a barrel of oil or a pound of coal. Over the past 30 years, this cost has been what determined the cheapest energy prices. For example, the cost of coal was much lower than natural gas in the 90s, so coal plants could bid into the market at a lower cost than gas plants, despite coal having a higher heat rate.
  • The “added fees” represents all of the other costs a plant needs to recuperate—most commonly infrastructural and labor costs—as well as their profit margin.


Reliable renewables have become an ISO's first choice because in the above equation, only one of the terms—the added fees—applies. Solar, hydroelectric, and wind all have a heat rate of zero, and use resources that are acquired free of charge. Thus, electricity from renewables is generally significantly cheaper for ISOs than electricity generated at power plants.


So ISOs will exhaust electricity from reliable renewable resources first to meet as much consumer demand as possible. However, there isn’t a single region of the US where renewable sources can meet anywhere close to 100% of consumer demand. After renewables, the next cheapest source of energy comes from nuclear reactors. But there isn’t enough nuclear power available in the US to meet all the remaining consumer demand that renewables can’t cover.


Trailing behind renewables and nuclear energy, the cheapest energy source in the US is still coal. But even on top of renewable and nuclear power, there isn't enough coal power to meet demand except when demand is at bare minimums (see graph below).

The next resource suppliers turn to is natural gas. There is enough electricity produced at natural gas power plants to cover the remaining consumer electricity needs on all but the hottest and coldest days. ISOs in the most populous regions of the country—New England, New York, Texas, and California—rely on natural gas plants to meet daily energy demand.


Logically, an ISO would pay the cheapest resource—say a collection of hydroelectric facilities—its asking price per kilowatt, and the next cheapest resource—a nuclear power plant—its asking price, and so on, until the ISO met its demand. Then the ISO would charge consumers the average rate they paid to procure all that electricity from different sources. But the industry doesn’t work this way.


Instead, every plant gets paid the same rate per kilowatt as the plant that provides the final kilowatt needed to meet all user demand. For example, a wind farm that charges the ISO $0.04/kW and a gas-fired plant that charges the ISO $4.00/kW will both get paid $4.00/kW if it becomes necessary for the ISO to call on that gas plant to meet demand. This is true even if the wind farm meets 99% of demand and the supplier only has to use the gas plant to meet that last 1%.


Because the system works this way, the price per kilowatt charged by the energy plant that meets the last of the ISOs consumer demand (i.e., the “marginal plant”—in the above graph the plants sitting right on the three vertical lines) is all important in determining your energy price.


As I said earlier, the “marginal plants” across most of the country are fired by natural gas, as they have been for about a decade. So natural gas prices have become the strongest influencer of electricity prices.


What Affects Natural Gas Prices

Knowing that natural gas prices are the biggest driver of energy prices, we focus on the events and conditions that are affecting natural gas prices. In order of importance, those are:


The Weather: Hot and cold temperatures, as well as extreme weather events, affect both natural gas prices and electricity prices directly. In extreme weather, increased demand for heating and cooling leads to more electricity demand and depletion of stored gas. Higher demand and less supply, like in any industry, causes higher prices.


For example, the 2012 winter was extremely mild. This meant demand from natural gas power plants decreased and we were able to store more gas, so prices dropped significantly. The subsequent 2013 and 2014 winters were vicious, causing large withdrawals from natural gas storage leading to a shortfall in gas that drove prices higher for years.


Natural Gas Production: The US has had an incredibly easy time producing natural gas over the past decade due to increased fracking. However, this doesn’t mean gas prices are highly stable. They can vary considerably week over week depending on what’s being produced where.


Natural Gas Storage: The amount of natural gas the US keeps in storage is a key indicator of how accessible natural gas will be to plants, especially in the Northeast. Ample storage allows for the uninterrupted supply of natural gas to plants at relatively low prices during the large withdrawal season (typically November through March) as the demand for heating increases, and mitigates any potential supply disruptions. High storage levels above historical norms may decrease prices, while storage levels below historically measured levels may lead to an increase in prices. Of course, the country can only store as much natural gas as space allows, so sustained periods of extreme weather, where natural gas plants around the country are working at maximum capacity, can still deplete supplies and drive up prices.


Pipeline Capacity: Even when there’s ample gas in storage, huge weather-induced demand spikes can drive prices up because gas can only get from storage facilities to power plants so quickly. Ninety-five percent of the time, we have more than adequate infrastructure to supply power plants with the gas they need to meet demand. But during those bitterly cold or scorching hot weeks, when demand is at its highest, plants can be without the raw materials they need to produce sufficient power to meet consumer need. Rising prices will reflect that.


Geopolitics: Major international shifts can play a huge role in gas prices. If global demand for natural gas rises sharply and US producers perceive exporting to be more lucrative than selling domestically, gas prices stateside will rise. Conversely, if renewable generation sources are developed internationally that can be implemented in the US on a large scale, they could lead to a surplus of natural gas, driving prices down.


The Bottom Line

Even though your system operator is procuring power from all different types of sources—hydroelectric, wind, solar, nuclear, gas—because of the way system operators pay plants, the amount you pay per kWh is determined mostly by the current price of natural gas in your region. It’s that simple.


Predicting what natural gas prices will be isn’t as straightforward. It requires you to consider everything from the long-term weather forecast to current gas storage levels to what’s happening in East Asia. That’s a job we leave to our experts.