Electricity Market Drivers
- June 5, 2018
Like most other commodity markets, electricity pricing is driven by supply and demand. When demand outpaces supply, prices rise, and vice versa. For example, when power generation and heating needs are competing for natural gas supply during the coldest days of the winter, prices spike (e.g. Jan/Feb 2014, Jan 2018). And when demand is low, such as during the shoulder months when there’s little need for heating or cooling, prices tend to be flat. Not only are electricity rates specific to each property, there are also numerous market drivers that influence the price you see on your electricity bill.
Natural Gas Market Fundamentals – As nuclear, coal, and oil-fired electricity generation slows and plants are retired, there is an increased reliance on natural gas-fired generators. At about 32%, natural gas was the largest source of US electricity generation in 2017 (EIA). Due to its short start-up time, low fuel cost, low cost to build, and relatively low emissions, natural gas is typically the marginal unit of generation, i.e. the price setting generator. Because of this, natural gas prices are directly correlated to electricity pricing as the marginal unit of generation (more so in some regions such as NYC vs. other territories such as parts of PJM). As a non-renewable energy source, the price of natural gas is determined by:
- Natural Gas Production – The past decade has consisted of continual increased growth of US natural gas production. Although production seems to be stable, this does not mean that natural gas prices are always stable. Depending on factors like weather and location of production, regional natural gas prices vary.
- Natural Gas Storage – Storage levels are key indicators for how accessible natural gas will be to power plants, especially those in the Northeast region. When demand increases in the winter months, high storage levels are necessary to maintain supply reliability and cap the price of natural gas.
- Exports (LNG, Mexico) and Imports (LNG, Canada) – Due to increased production, the United States has relied less on natural gas imports and has become a net exporter in 2017. Pipeline exports continue to grow along with the LNG export capacity. However, if demand growth outpaces the US supply due to their LNG exports to Mexico, there could be an upward pressure on domestic pricing.
- Weather – Often considered more of a demand-side factor, very severe weather events can affect the supply of natural gas as well. It is common for cold weather-related constraints to be present in the winter months that limit the production of natural gas.
- Weather – The increased demand in cold months puts upward pressure on natural gas prices. When there is unexpected severe cold weather, natural gas prices are especially sensitive due to their inability to react quickly to short-term increases in demand. In the summer, when consumption rises due to air conditioning use, levels of natural gas injections in storage often decrease. This can lead to shortages in the winter, resulting in higher prices. Weather can have an even greater effect on natural gas prices if the pipeline system is already operating at its capacity.
- Industrial Demand – The industrial sector, which uses natural gas as fuel and feedstock for making the majority of their products, is a major consumer of natural gas, comprising 34% of overall natural gas consumption in 2016.
- Power Generation – Since natural gas has become the leading source of electricity generation in the US, fluctuations in power demand have a large influence on natural gas prices.
- Macro Economy – Economic conditions have a direct relationship with natural gas. If the economy is booming and production is increasing, then natural gas prices will likely rise due to increased consumer and manufacturer demand. Alternatively, weak economies or recessions will cause downward pressure on pricing due to decreased national production.
Capacity Market – Capacity represents the need to have ample generating resources available to deliver power when needed, especially in case of a grid emergency. Utilities must make sure there are adequate resources available to meet the peak demand for electricity at any given time. The capacity market exists to incentivize investment in the development of generating capacity to ensure the grid does not experience brown- and black-outs whenever it peaks. Basically, a centralized generation/distribution grid is built to ensure reliability for a few hours of the year, with the cost spread out over the rest of the hours, contributing to the capacity rate you pay. Capacity market characteristics vary by region (NYISO, PJM, ISO-NE), but prices of capacity generally vary on how much is needed to meet demand.
- NYISO – Capacity prices are determined by auction (six-month strip, monthly, spot) and bilateral transactions. For each capability period, the NYISO publishes a demand curve that reflects various requirements (installed reserve margin, locational minimum unforced capacity) which ultimately affect pricing for the period. Capacity is priced on a $/kW-month basis with prices varying based on the amount of capacity generation bid into the market. Plant outages, maintenance, mothballing and more can impact the amount of capacity bid.
- ISO-NE – Oversees the Forward Capacity Market (FCM), which aims to attract new investment in resources, and maintain existing ones where and when they will be needed. They also assess the potential retirement of power plants and other changes to the system that could affect system needs. The FCM works to procure enough capacity to meet anticipated demand for the next three years, compensate suppliers for the capacity cost of existing generation, import or demand resource, attract new resources to constrained regions, and penalize those who don’t provide enough capacity during a shortage event.
- PJM – Capacity prices are determined by its Reliability Pricing Model, procuring capacity on a rolling three-year schedule. The specific capacity price for an account is determined by the user’s peak load contribution (PLC). The ratio between the capacity tag and annual kWh is a major determinant in the $/kWh of the capacity rate component of electricity pricing.
To learn more about what drives electricity and capacity pricing by territory, download the Electricity Markets Explained report.
The natural gas and capacity market are still just part of what influences the price you pay for electricity. But they are important to follow and understand to manage your peak load and develop a strategic procurement plan. EnergyWatch provides weekly updates that will inform you of natural gas market fundamentals and alert you of expected peak load days.