The Impact of Fuel Costs on Electric Power Prices
By: Kenneth Rose
The recent dramatic increases in retail electricity prices in some states, such as Connecticut, Delaware and Maryland, have been characterized by some as due directly and primarily to fuel cost increases, particularly natural gas prices that spiked in the wake of the major hurricanes in 2005. While natural gas prices have played a role, the story is more complex. Other factors include customer load and its seasonal variation and supplier risks. Fuel prices and electricity prices are not perfectly correlated and even move in opposite directions at times. While natural gas prices may have an impact, this is disproportionate to the amount of natural gas used to generate electricity, compared to other sources of fuel used.
There are several recent overall trends in the cost of fuels to generate electricity that have affected nearly every region of the United States:
• petroleum and natural gas prices increased steadily from 2002 through 2005;
• natural gas costs have increased more than other fossil fuels and have generally been more volatile;
• natural gas prices have decreased since early 2006;
• regional weighted average fossil fuel costs vary considerably, due to regional variations in generation energy sources; and
• regional costs for natural gas, while not identical, typically move in the same direction and are similar in magnitude.
Consider the connection between fuel costs and electricity prices in the PJM region. PJM is a regional transmission organization (RTO) that covers all or parts of 13 states and the District of Columbia, from the mid-Atlantic area through northern Illinois. PJM operates several different markets, including a real-time energy market. Figure 1 plots the PJM RTO-wide real-time energy market’s daily, monthly, and annual load-weighted average prices for 2005 and 2006. For both years, the peak monthly electricity prices occurred in August, although December 2005 was only $3 lower than the August 2005 monthly average. The highest daily average electricity price of both years was $250 on Aug. 1, 2006, which occurred during a series of hot days in the region from July 31 through Aug. 3, when the average daily price exceeded $120 each of those days. The 2005 and 2006 annual load-weighted averages were $63 and $53 per MWh, respectively.
To examine the connection with the price of natural gas, the monthly and annual average electricity prices of Figure 1 are shown in Figure 2 on page 48 with the monthly average natural gas cost for New Jersey, Pennsylvania, and Maryland (as measured on the right axis in dollars per MBtu). The impact on natural gas costs from Hurricane Katrina can clearly be seen in the rise in the monthly averages from September 2005 through January 2006. Average monthly natural gas costs then dropped back to the about the same levels seen in the first seven months of 2005.
It appears from the graph that the general direction of the averages is similar. However, there are important exceptions. First, electricity prices during the summer of 2005 (June through August) increased sharply before natural gas costs increased. Gas prices increased sharply in September and peaked (for this entire two-year period) in October 2005. Moreover, while natural gas costs were reaching their peak, electricity prices fell from September through November 2005. Electricity price averages and natural gas costs increased together again in December 2005, then both decreased through June 2006. Again during the summer, electricity prices increased during July and August 2006, while the natural gas cost remained at levels seen in the first half of 2005. The months during this two-year period when the electricity price and natural gas cost moved in opposite directions, that is, during both summers and in the fall of 2005, can be attributed to changes in the customer load for the PJM RTO. While electricity prices and natural gas costs often moved together, the exceptions suggest that customer load is also important.
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Several states in the mid-Atlantic area conduct auctions or bidding programs to secure power for retail customers that do not purchase power from an alternative supplier. In 2005, the District of Columbia, Maryland and New Jersey conducted an auction. The prices determined in those auctions ranged from $58.3/MWh in D.C. to $65.8/MWh in New Jersey. In 2006, Delaware, Pennsylvania and Virginia also conducted auctions. The 2006 auction prices increased significantly, ranging from $98.7/MWh in Maryland to $110.2/MWh in D.C. and Pennsylvania. This was an increase of 67 percent for the highest prices (comparing 2005 to 2006) and an increase of 69 percent for the lowest auction prices.
These results in particular were often attributed to the higher natural gas prices that resulted from the 2005 hurricanes. Figure 3 shows the 2006 auction/bidding results with the PJM daily prices and monthly weighted averages for 2005 and 2006. The 2006 auction/bidding results exceeded every monthly weighted average price in PJM for both years—exceeding the highest monthly average by $12/MWh to $23/MWh and also well above the annual weighted averages for both years.
Natural gas: the marginal fuel in PJM—While natural gas and electricity prices are often correlated, as Table 1 (page 47) shows, natural gas is far from the primary fuel used to generate electricity in PJM. In 2006, natural gas accounted for only 5.5 percent of the generation in PJM. Coal and nuclear sources accounted for more than 91 percent of the generation.
The typical explanation for this disproportionate impact of natural gas on wholesale power prices is that natural gas is often the marginal fuel. That is, during peak hours relatively more expensive units are used to meet demand and often these units use natural gas. As a result, the wholesale price can climb quickly and to hundreds of dollars per MWh when these units are dispatched, as seen in the daily price in Figure 1 (page 47). During these peak hours, when the demand for electricity increases to a point where the highest priced generation units are needed to meet the demand, the price for all units selected for dispatch are set by the highest priced marginal generation units’ bid price.
However, this use as a marginal fuel does not fully explain the disproportionate impact that natural gas prices have on electricity prices. 
Click here to view Kenneth Rose's presentation at APPA's 2007 Symposium: Assessing Restructured Electricity Markets.
Kenneth Rose is an independent consultant and a senior fellow at the Institute of Public Utilities at Michigan State University. Dr. Rose is a nationally recognized expert with more than 20 years of research experience in the structure, economics, and regulation of U.S. electricity markets. He previously was a senior institute economist at the National Regulatory Research Institute at Ohio State University and a lecturer for the School of Public Policy and Management at OSU.
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