Banananomics: Surprising Fundamentals of Electricity Markets

Surprising Fundamentals of Electricity Markets

Electricity is generated using various resources and technologies with differing cost volatility.

Inputs that matter: Most electricity is produced using conventional sources such as natural gas, oil, coal, and nuclear, with variable input costs.

• Power producers must manage costs using forecasts, manual trading, or statistical algorithms.

• These systems can neither handle the dynamics nor the enormous access to information of the power system.

• Information complexity is set to increase as renewable energy, grid storage, and alternative means of production come online.

The opportunity: Retail electricity prices are primarily determined by wholesale futures contracts traded in the commodities markets (i.e., NYMEX and ICE).

• Understanding the cost of electricity is a requirement for producers and customers with significant power demands, such as manufacturing facilities, data centers, hospitals, and distribution operations.

• Unlike other commodity trades, buying an electricity or gas contract commits the buyer to the deal with no option to resell or terminate the agreement.

• Futures contracts are for monthly terms for peak, off-peak, and some solar-specific periods.

• Power contracts are based on grid regions such as PJM, MISO, and ERCOT in the US and many others in the EU and UK.

• In the US, these contracts cover deregulated areas such as Texas, Ohio, Connecticut, Illinois, Pennsylvania, and New York.

Zoom in: Electricity is priced differently based on usage during specific times during the day and the duration of power levels.

• For example, customers who consistently use power have a high load factor with low demand usually qualify for lower electricity rates.

• In contrast, customers who use much power over a short period have a low load factor but high peak demand and pay higher rates for both power and delivery charges.

Between the lines: The spark spread estimates the profitability of a natural gas-fired electric generator.

• The spark spread is the difference between the input fuel costs and the wholesale power price.

• The spark spread is calculated using daily natural gas and power spot prices at various regional trading points.

• At times, the spark spread can be negative as fuel prices outstrip the cost of electricity.

• When temperatures increase, the associated gas and power prices become more volatile.

Follow the money: As nuclear interest renews and more renewable sources enter the grid, the spark spread will become less critical.

• For example, Germany’s small and medium-sized companies increasingly turn to solar power to cover their electricity consumption, as energy prices have remained relatively unchanged despite falling natural gas costs.

• In contrast, energy prices in France went negative due to increased renewable energy production.

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