Presently, one-sixth of our electric bill goes to pay for fossil fuels to generate electricity. When fuel prices were higher the percentage was even bigger. Despite all the hoopla about deregulation and decarbonization, electricity prices have moved more in line with fuel costs than any other element of expense like interest or labor. (See Figure 1.) To make the link between fuel cost and price more direct, the wholesale markets for power establish their prices based on marginal (meaning fuel ) costs. No financially sensible power generator would produce electricity if power prices did not at least cover fuel costs. So, fuel cost sets the bottom or bare minimum acceptable price.
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Figure 1. Components of the real price of electricity (approximate) in 1990 cents
Fuel expenses for US electricity generators are, in real terms, at the lowest point in 60 years. And at these multi-decade low price levels many of their fuel suppliers are in financial jeopardy and it is likely some will reorganize financially in bankruptcy. Low energy prices also make it harder to economically justify green projects. But here we expect public policy rather than simple cost per kwh will determine the electric industry’s direction.
Eventually, most fossil-fueled electricity generation will close for one simple reason, not being cost-competitive. And this will have a profound impact on how we price as well as finance the electricity business. (We have laid out these issues in detail in a paper prepared for the Society of Utility and Regulatory Financial Analysts).
The most important change is that the costs of producing electricity will become mostly fixed. And utilities are already highly capital intensive businesses by nature. This trend to 100% carbon-free production of energy will make them even more so. Consequently, we believe investors may be reluctant to commit money to new power projects, whose costs are largely fixed (i.e. mostly capital costs) without the financial guarantees of long term contracts. This is a lesson learned from the last round of speculative spending on power generation assets at the turn of the century. The wholesale, or next-day power market, does not give investors—who are in effect the providers of long term capital— the financial security they need to commit.
In the absence of fuel price-driven volatility, wholesale power markets whose prices derive from the price of fuel (mainly natural gas), will lose their reason to exist. To state the obvious, marginal cost pricing schemes do not work when there are no marginal costs.
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What follows? The return of the power pool or bilateral markets? Or will new technologies allow consumers to disconnect from the grid or provide their own backup? To us, the answer is less than clear but we are certain of one new thing. Going forward, the decision to connect to the grid, whether for a homeowner or steel factory owner, will increasingly become a matter of simple financial calculation. Customer choice, in this case, means having the option of producing and storing electricity on-premises, assuming one is willing to absorb the considerable upfront capital expense. In other words, having a relationship with the electricity grid may become one of financial discretion.
Third, high fixed cost businesses like utilities that secure revenues via strong contracts (which produce predictable earnings streams) can raise money from investors at a low cost. At present we see considerable demand to finance these types of assets especially from dedicated “green” investor funds, pension funds and insurance companies all seeking safe, predictable returns. Once capital costs crowd out most of the other items in the utility’s expense structure, procuring capital at the lowest possible cost becomes the primary business imperative.
Finally, the price of electricity should become more stable and predictable. One caveat here is that the pricing of power is a socio-economic activity and thus subject like all human activity to chicanery or abuse. In the past, we have seen poorly designed power trading arrangements become subject to abuse at the hands of unscrupulous hedge funds or other speculators. Regardless of the colorful names describing these elaborate shenanigans, market participants exacerbated power shortages— by withholding supply (or storage)— to achieve an abnormally high price for their electricity. There is no shortage of examples of such behavior in the American and British deregulated electric industries.
This leads us to a related question. Should grid-scale energy storage even be a public utility or are there alternative ownership, management, and regulatory structures that should be considered? Time to think about this sooner rather than later.
It may seem odd to prepare to say goodbye to fossil fuels. They seem so cheap at present. But reliance solely on market prices can be deceiving. They do not include everything especially with regards to the future.
By Leonard Hyman and William Tilles for Oilprice.com
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