The Magic of the Markets

 | Oct 15, 2012 | 5:00 PM EDT
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Politicians promised renewable energy would pollute less and it would help the nation achieve energy independence. Nobody promised it would be cheap, but the big surprise is renewable energy actually lowers power prices.

The magic is in the markets. In most regions of the country, power prices are established by auctions. Generators bid their selling prices. The cheapest bids that collectively meet the forecasted demand win. The highest bid that clears the auction sets the market-clearing price for all generators.

But here is an important concept. The auction's winners are not awarded the price they bid; they are awarded the price of the most expensive bid that clears the auction. That is why they call it the market-clearing price.

Clearly, when generators participate in the power markets they should have a firm understanding of production costs. If they bid below their production costs, they are subsidizing the market. If they bid above their production costs, they may lose the bid and lose opportunities to recover other costs, such as maintenance and capital costs.

For generating companies, the obvious strategy is to bid a price that matches their production costs. If the market clears below their bid, no money is lost. If the market clears above the bid, the difference between its bid and the market-clearing price becomes the generator's gross margin.

Obviously, the last generator clearing the market is "on the margin" and it earns little to no gross margin. Typically, the marginal unit will be an inefficient fossil-fueled power plant, such as an old coal-fired plant or an open-cycle gas turbine.

But here's the magic for renewable energy: Wind and solar's production costs are near zero. Every time they run, they displace inefficient power plants, which operate near the margin. These marginal units set the market price. When they are displaced by cheaper plants, the next lowest cost plant that clears the auction sets a lower market-clearing price. As more zero-production cost plants are added to the auction, costly units are displaced and market prices fall.

Wind, solar and hydroelectric facilities are not the only resources that help keep power prices down. Energy efficiency has the same affect. As demand-response programs offered by companies like Exelon (EXC) and EnerNOC (ENOC) kick in, forward demand is shaved and marginal units are displaced.

Nuclear power offers similar benefits. The Nuclear Energy Institute claims nuclear power has average production costs of $22 per megawatt-hour. This represents a moderately low production cost and as such, nuclear power helps keep market prices in check.

It is not just market prices. Marginal units tend to be the least efficient and the most polluting. When they are displaced, less pollution is produced. So wind, solar, hydroelectric and nuclear facilities are not only free of greenhouse gases, they displace generators that produce large amounts of carbon and other greenhouse gases. Environmentally, this is a win-win.

Economic winners are business and residential consumers. As wholesale market prices fall, so must retail prices. As more wind, solar, hydroelectric and nuclear facilities are added to the mix, electric retail prices should decline.

The irony is that as more wind and solar plants are added to the fleet, market prices fall for all participants, including wind, solar and nuclear power. That is the magic of the markets.

Of course, power markets largely ignore capital costs. Some markets pay a modest fee for capacity, but for the most part, that fee is inadequate to stimulate new investments in large power projects. Subsequently, deregulated power markets are not seeing large power projects.

State and federal renewable energy programs are countering the lack of new projects. Several states offer developers short-term incentives for wind, solar and other renewables and federal tax credits augment state incentives. But after only a few years in production, government incentives vaporize and wind and solar facilities become rich sources of new tax revenues.

Falling market prices may be the reason why several utilities are beginning to shed inefficient plants and postpone nuclear investments. Companies such as Duke Energy (DUK), First Energy (FE), and Dominion Resources (D) announced the sale or retirement of approximately 50,000 megawatts of old, inefficient coal plants. Xcel Energy (XEL) recently suspended new investment in its Prairie Island Nuclear Generating Plants.

Most utilities deferred plans to build new nuclear plants. Power markets are not providing them with adequate margins to support new investments. Only Southern (SO), SCANA (SCG) and the Tennessee Valley Authority continue building new nuclear units. Paradoxically, these new nuclear units are located in a region of the country that lacks an established power market.

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