Utilities' Power Prices Could Swing Wildly

 | Nov 26, 2012 | 5:00 PM EST  | Comments
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Stock quotes in this article:

exc

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etr

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cpn

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nrg

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fe

All indications point to a sustained period of low prices for wholesale electric power. There will be seasonal variability, but average annual prices will likely remain flat. As a result, generating utilities such as Exelon (EXC), Entergy (ETR), Calpine (CPN) and NRG Energy (NRG) will likely see revenue remain within a tight range until market conditions change. And market conditions will change.

Don't blame the economy for lackluster prices; the markets are also a factor. Deregulated generators rely on power markets for prices and margins. Complicating generators' future are new "circuit breakers" that are being built into the markets to smooth out demand, remove volatility and force market prices to remain low.

One type of circuit breaker is called demand-response. In some markets, when market prices drift to higher levels, large power users are offered financial incentives to reduce demand and shed load. As time progresses, more demand-response programs will be offered. That's one of the main ideas behind installing "smart meters" for residential and small-business consumers.

Nevertheless, some utilities believe that by 2015, the circuit breakers will become inadequate and that the power markets will improve. In particular, Exelon believes that sustained low prices will force competitors to exit and leave the market short of capacity. When supplies are lower, Exelon believes, power prices will creep upward.

FirstEnergy (FE) seems to agree. In a recent mailing to its retail customers, FirstEnergy warns of skyrocketing prices, particularly after 2015. Its projected "price to compare" starts at about 6.3 cents per kilowatt-hour for 2013, it jumps to 7.4 cents in 2015, and it ramps up to 9.2 cents by 2019. FirstEnergy is recommending that its consumers pay above-market prices for the next two or three years so they can save in 2015 and beyond.

To be clear, nobody knows what prices will be in 2015, let alone 2019. But Exelon and FirstEnergy may be right. Around 2015, the supply-demand curve could shift substantially. A number of utilities have already announced their plans to withdraw assets from the power markets. Dozens more will likely retire by 2015, the deadline for power plant owners to meet new Environmental Protection Agency mandates. Faced with the decision to upgrade or retire, some owners will find the additional capital requirements needed to upgrade to be unprofitable, and they will retire their underperforming and marginal plants.

From the utility's point of view, it may make financial sense to retire marginal plants. These plants' energy rarely produces gross margin, and they struggle to produce a profit. The only reason owners keep them in the fleet is to capture other sources of revenue, such as capacity and ancillary service payments. But if these marginal units no longer comply with EPA regulations, they no longer qualify for those miscellaneous payments. When there's no possibility of revenue, it becomes a simple business decision to exit the market.

It's a little trickier than it first appears. It turns out that the least efficient power plant in the dispatch sets the market-clearing price. As economically inefficient power plants exit the market, average market-clearing prices fall further, and a new group of power plants finds itself sitting on the margin.

But it's not in a cost leader's financial interest to have all its competitors exit the market. It's in its interest to have middle-market units exit and have high-cost generators remain. From the generating utility's point of view, pricey, oil-fired power plants should remain in the market and serve peak periods of demand.

Why?

Because electricity produced from oil is up to 10 times more costly than electricity produced from natural gas. As such, when oil-fired power plants are dispatched, market-clearing prices skyrocket. When market-clearing prices leap, gross margins improve for all market participants. This includes all the wind, solar, hydroelectric, nuclear, natural gas and large coal-fired power plants that remain in the market.

The only barrier to sky-high power prices is the circuit breakers. And many experts believe there is a practical limit to the efficacy of these programs. That's what underlies Exelon and FirstEnergy's gamble: They believe demand-response programs will not keep up with growing capacity shortages.

Complicating their gamble is the health of the nation's economy. If the economy is restored, demand for power will jump, and their gamble may pay off. If the economy remains lackluster, all bets are off.

From the point of view of the investor, owning power-generating utilities in deregulated power markets could be a highly speculative investment. Investors are not only gambling on the economy, they are also gambling on the future value of a market-based commodity.

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