The Markets Will Decide

 | Sep 30, 2013 | 7:00 PM EDT  | Comments
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Leaders cannot claim the future by clinging onto the past. In the energy industry, the past was about government controls. It is also about forcing uneconomic assets into a regulated marketplace. The future is about markets.

To see the future, look no further than coal, nuclear, natural gas and fuel oil. Some believe these commodities are some of the nation's most important sources of energy. They would be right, but all these fuels have one thing in common; they are used to manufacture electric power. As such, these fuels are one step removed from the most critical commodity of all.

Electric power is also a tradable commodity. Technically, it is possible to trade electricity on the New York Mercantile Exchange as if it were crude oil, natural gas or fuel oil. But most wholesale power is traded in North America's real markets, the 10 regional transmission organizations (RTOs). This is where the real action can be found.

Because RTOs are invisible to many in the public, most do not appreciate how the 10 power markets affect their daily lives. Consequently, many become caught up in circular arguments about the relative merits of power plant fuels like coal, nuclear power and natural gas.

The arguments are mostly academic. The markets sort out the relative importance of each fuel. Their importance is in the context of their ability to produce power. Fuels than can produce power cheaply have higher values than more costly fuels. In the end, the market price of power becomes important.

It turns out utilities have been trading electricity among themselves since the time of Edison. In the 1990s, the Federal Energy Regulatory Commission (FERC) implemented market-based programs to formalize trading over state lines. They did it through RTOs.

As RTOs developed and matured, the electric commodity became more important. A decade ago, trading between utilities was considered physical. Today it is financial.

The shift from physical to financial has been a huge benefit for businesses, local governments and other consumers. It has been a disaster for traditional power producers.

In power markets, the cost leaders are the winners. But many older coal and nuclear plants were designed to serve a base load. They were not intended to be the market's cost leaders. They are not the market's cost leaders. As such, they cannot always compete, or if they can they lose margin.

To be clear, power markets do not care if the electricity was produced by a solar panel, a pound of coal, a minute of nuclear fission, a whiff of natural gas or pint of oil. All they care is that power producer delivers their product to a predetermined physical trading point at a specified price. It is up to power producers to manage their costs and any difference between their costs and market prices is their margin.

Production costs will be the critical success factor. Those units saddled with high fuel and production costs will be forced out of the markets. This is why American Electric Power (AEP), FirstEnergy (FE) and PPL (PPL) are retiring dozens of coal-fired plants, some of which comply with regulations. This is why some nuclear plant owners like Entergy (ETR), Dominion (D) and Duke Energy (DUK) are throwing in the towel for old and new nuclear units.

The cost leader is energy efficiency. And yes, there is a market for saving energy. FERC designed the power markets to treat energy efficiency the same as energy consumption. As time passes, consumers will see more programs to encourage them to opportunities to use energy-efficiency programs.

Right behind energy efficiency are wind and solar power. More producers like NextEra Energy (NEE), Duke Energy, Exelon (EXC) and even Southern (SO) use solar or wind power.

These giants in the utility industry are investing in these low-cost sources because they can achieve margins and returns. They earn the returns through tax and production credits. They also earn their returns through the highly-efficient power markets.

Coal-fired and nuclear power is great sources of reliable power. In the old days of regulated assets, they would be the foundational sources of an integrated utility plan. Today, coal and nuclear power plants are only marginally competitive. The markets invite them to participate, but do not reward them with margins.

Coal and nuclear power will remain in the power markets. Their numbers will decline, but the most efficient will remain.

While politics is involved, the markets will become the deciding factor for most utilities. Investors will need to look at the markets when they analyze a utility's production assets. If the utility does not own cost leaders, they will struggle.

If the utility operates in one of the remaining regulated states, old-school rules are still in play. Those are the states where markets have no impact on revenues or earnings. But their time in the regulatory sun may be short. There is a movement to deregulate most of the country.

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