Mid-Market Generators Are Gambling on Coal

 | Dec 28, 2012 | 6:13 PM EST
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It may seem incredible. Some utilities hope fleets of coal-burning generators will simply go away. If they go away, surviving generators could profit.

It's all about markets. If demand remains level and supplies decline, prices go up. If the right competitors exit the market, surviving generators win.

Under current market rules, it is in the cost leaders' interests to make sure inefficient units remain in the market. But it is not in their economic interest to keep mid-market competitors around.

As previously reported, a helpful tool to visualize this strategy is the Price Takers Curve. I've recreated the curve here to show how eliminating mid-market competition helps incumbents.



In this curve, each bar represents a generator's production cost. In this example, when system demand reaches a specific point, say 130,000 megawatts, the market price for power becomes $40.00 per megawatt-hour. All generators clearing the auction earn the $40.

The market sets a price for all generators that clear the market. The market is indifferent towards individual production costs; the market price is the price.

Obviously, if a generator has relatively low production costs, it earns higher gross margins. Higher cost generators earn lower margins.

The worst cases are when the generator's production cost equals or exceeds the market price. In the hypothetical case where system demand is 130,000 megawatts, the last generator clearing the auction has a production cost of approximately $40, which means it is operating "on the margin" and it generates no gross margin. If the generator decides to run when market prices are below their production cost, it will lose cash and its earnings will be crushed.

If generators always operate near the auction's market-clearing prices, they cannot achieve meaningful earnings. With little to no earnings, there is very little motivation to stay in the market.

With this in mind, look at the Price Takers curve. Notice the black bars. They represent the mid-market generators. They also represent some of the market's coal-fired power plants.

To the left of the black bars are the grid's nuclear plants and efficient gas turbines. Further to the left are where solar, wind and hydroelectric plants to fall.

To the right of the black bars are the grid's inefficient power plants. They include inefficient coal plants and very inefficient gas-fired plants. Further to the right are high-priced power plants that use kerosene or oil as fuel.

This leads to the third concept. In order to participate in the market, power plants must be compliant. If plant is not compliant, it will not be allowed to bid in its power.

Coal-fired power plants are the only class expecting to see new compliance issues. New Environmental Protection Agency emission rules go into effect in 2015. Most plants can technically comply with those rules, but compliance changes the plants' economics. The change is for the worse.

Faced with a depreciated asset that struggles to compete and is starving for new capex, utilities are deciding it is not worth making new investments to keep marginal assets in the market. For old coal plants, the decision to invest or retire is easy. Thousands of megawatts worth of coal plants have already decided to exit the market. The question is if how many more units will exit after they find themselves sitting on the margin for the first time.

When Coal Exits the Market

The graph and the example are oversimplifications, but the point remains. When the mid-market exists (represented by the black bars), the curve collapses. When the curve collapses, prices remain unchanged for the times when demand remains below 100,000 megawatts. But if demand creeps above 100,000 megawatts, the new midmarket price no longer begins at $29 per megawatt-hour; it now begins at $37 per megawatt-hour and accelerates upward.

With mid-market participants gone, cost leaders win. Cost leaders will see higher prices, higher revenue and higher margins.

Who are the cost leaders? Nuclear fleets owned by Exelon (EXC), Entergy (ETR), NRG Energy (NRG), Dominion Resources (D), and NextEra Energy (NEE) are cost leaders. Combined cycle gas turbines owned by Calpine (CPN) can beat many nuclear plants, as long as prices for natural gas remain low.

But nothing can beat the cost leadership of energy efficiency, wind and solar generators. EnerNOC (ENOC) and Exelon supply energy efficient solutions in the form of market-based demand-response. NextEra owns the nation's largest fleet of wind-powered generators.  NextEra, Exelon, Duke Energy (DUK), Dominion, Public Service Enterprise (PEG) and others have been investing in solar power.

A strong economy will change the outlook for mid-market generators and coal. A strong economy will increase demand for power. Higher demands will redefine the mid-market to be the more costly generators.

The big gamble is the economy. For now, many generating utilities using coal as fuel are unwilling to take that gamble.

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