Why Do Electricity Prices Change?

In other articles we have discussed the way in which electricity prices are set by utilities and by third party suppliers.  See, How Does the Electric Utility Set Its Price? and How Do Third Party Suppliers Set Their Prices?  In this article we discuss why these prices change at all.

What are some of the factors that can influence forward electricity prices?  We summarize a few important ones here.   Almost all of these factors affect supply and demand.

  • Supply is the quantity of electricity that is produced by generators and available for distribution over the wires of local utilities.
  • Demand is the amount of electricity that is called upon by consumers.

In assessing these factors it is important to bear in mind that electricity is unique in the world of commodities:  It is the only commodity that is consumed practically the instant that it is produced.  Accordingly, slight changes in supply and demand can dramatically affect price.

Note that all of the factors listed below have upside and downside risks.  As with most commodities, the upside risk is always greater than the downside.  Commodities rarely trade for 0 or below 0 (although they can: Just look at the negative interest rates now being paid for bank deposits in Europe!).  But the upside exposure is infinite.

1 .     Weather. Cold weather increases demand for energy in the winter.  In parts of the country where natural gas is the primary heating fuel, cold weather will drive higher natural gas prices.   By coincidence those places also have the largest concentration of natural gas fired generation for electricity production.  Accordingly, cold weather can drive natural gas prices higher and have a similar impact on electricity prices.

2.     Supply constraints. An explosion on a major natural gas pipeline into the supply region could prevent electric generating stations from getting sufficient fuel to operate.  This could drive up the cost of generation or, if they are shut down completely, drive up the cost of competing generation.

3.     Competing fuels. In recent years, as natural gas prices have dropped with rapidly expanding shale gas production, the price of coal has risen as the economy has strengthened and transportation costs have increased.  At the same time, federal regulatory constraints on sulfur dioxide emissions have increased the operating costs of coal plants.  These factors, in turn, have made coal less competitive than natural gas and have led to a conversion of many coal plants to natural gas generation.  In April 2015 the Energy Information Agency reported that natural gas fired power generation for the first time exceeded coal generation, 31% to 30%.  The shift to natural gas demand in some areas has increased the cost of gas delivered to the generator, thereby increasing electricity prices.

4.    Operational issues. An unplanned outage of a nuclear plant, say, or a generator explosion could create a short term shortage of electricity which would require the Independent System Operator to turn on expensive peaking plants and backup generation.

5.     Shale Gas. Expanding domestic production of natural gas has increased supply which has driven the price of gas to historic lows, thereby putting pressure on electricity prices.  These lower prices come with a caveat:  Any short term spike in demand can easily overcome the downward price trend coming from growing supply.

6.     Regulatory issues. Environmental concerns have driven many recent changes in energy markets, including issues like limits on sulfur dioxide emissions, reducing acid rain, controlling methane leakage from gas wells, and cleaning up water discharge from wells.

Individually and cumulatively these factors play a daily role in setting the market price of generating fuels like natural gas and of electricity itself.