A Rejection of Coal and Nuclear

 | May 28, 2013 | 10:09 AM EDT
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Many had expected that, after 2015, wholesale power prices would recover. Their argument had been based on the notion that coal would be forced out of the power market after the onset of new rules from the Environmental Protection Agency. That coal scarcity would then trigger a rebalance in the market's supplies, and demand and prices would recover.

It was a nice theory. Unfortunately it hasn't been quite playing out for companies like Exelon (EXC), NRG Energy (NRG), Calpine (CPN) and Dynegy (DYN).

Last Friday, PJM Interconnection announced the results from its annual auction for capacity -- and, for power producers, the numbers were disappointing. Grid-wide revenue from unforced capacity will drop by approximately $4.5 billion in 2016 and 2017.

In order to understand what's going on, look at capacity as if it were real estate. PJM will pay some owners a daily fee based on fair-market value of their property, but the owner may or may not use all of the property to produce energy. Owners are required to maintain their properties, make sure all licenses are in place and assure PJM that their properties can be used without restriction. The market determines the property's fair market value though an auction, the results of which can vary by location.

PJM's auction just procured 169,160 megawatts of capacity resources for the 2016-to-2017 delivery year. The base price came in at $59.37 per megawatt-day -- about 55% lower than the 2015-to-2016 base auction price. Last year, the auction secured 164,500 MW of power at a base price of $136 per MW.

As the graph below shows, PJM was able to secure slightly more capacity at a lower price, and there was far more capacity offered than needed. Approximately 15,500 megawatts were offered, but they failed to clear the auction.

The auction also secured 12,408 MW of demand-response, down from last year's record 14,833 MW -- and 1,117 MW of energy efficiency, down 21% from the 2012 auction.

According to PJM, there was only a minimal increase in the demand for capacity, and the results have been driven by supply-side effects. Overall, supply rose via new entry, uprates and a significant climb in imports that overwhelms the decrease in available Demand Resources -- thus leading to the price drop.

Another Surprise -- Coal

Approximately 10,000 MWe of coal capacity failed to clear the auction. According to PJM, "It would seem these coal resources, in addition to needing further investment to continue in commercial operation and possibly reflecting environmental investments that have already been made, may also not be earning sufficient energy market revenues that would keep their capacity market offers lower. Still, with all the competitive new entry, uprates, and imports, these uncleared coal resources were not necessary to reach a record 21.1% installed reserve margin."

It appears Exelon's gamble did not pay off -- or, at least, that it won't until 2017. That company had expected the market to become short capacity, but market results suggest that those expectations were wrong.

Because the auction rejected coal and underpaid nuclear, more disruptions appear to be in store. Traditional utility investors should have exited Exelon when the company cut its dividend. Speculative investors will have to ride out several more years as the market adjusts.

The same is true for NRG, which recently bought a fleet of high-performing coal plants. As with Exelon, NRG may find its top line challenged for the next several years.

PJM's recent auction only addressed capacity. Power producers must now seek additional revenue from the sales of energy in a market long in capacity. Investors sticking with independent power producers are left gambling that wholesale energy's average price will rise enough to replace the $4.5 billion in unexpected revenue losses from capacity.

PJM's auction also suggests a potentially bumpy road ahead in the nation's coal markets. Approximately 10,000 megawatts of coal capacity is in no-man's land. What happens to that capacity -- and to the coal they were to consume -- is now uncertain.

Companies such as Peabody Energy (BTU), CONSOL Energy (CNX), Arch Coal (ACI), Alpha Natural Resources (ANR) and other domestic coal producers rely heavily on the power industry for their offtake. PJM's auction will affect these companies. To the extent there is contagion in the nation's other power markets, the long-term effect on coal could be greater than many expected.

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