"Spark spread" sets value, but as prices diverge from system
lambda, merchant plant buyers will be flying blind.
Many power plants will be bought and sold in the next decade....
technical innovations have lowered the cost of building these plants. The cost of building a combined-cycle, gas-turbine unit of 250 megawatts, for example, now runs roughly $500/kW, down from about $700/kW in the early '90s. Similarly the cost of a 250-MW coal-fired plant has declined, from about $1,500/kW to about $1,100/kW today.
The Price Component: Greater Uncertainty
Spot markets today set wholesale power prices at the margin. That process should continue. What will change, however, is the definition of the "margin."
Until now, the short-run variable cost (em the system lambda (em has been the key determinant of the wholesale price of electricity. This mechanism has worked because integrated utilities have recovered most of their costs from their retail customers (em a captive franchise. For these utilities, the wholesale market is just a place to gain incremental revenues by boosting capacity factor. This type of market tends to create a positive correlation between the wholesale spot price and the short-term variable costs. And, since fuel costs represent the dominant share of variable cost, the correlation has linked power prices to fuel costs. %n3%n Moreover, this correlation could grow, as fuel suppliers seek to tie their prices to electric prices in an attempt to garner market share. This correlation tends to protect plant owners in that, over time, increases in fuel prices will correspondingly increase electric prices. Rising fuel prices tend to raise revenues for all electric generators.
This market cannot continue, however. Future wholesale power prices are unlikely to look anything like those in today's spot markets. At some point, the market must move beyond short-term marginal pricing to recover some of the longer-term fixed costs, beyond those reflected in the system lambda. Merchant plants will need to cover longer-term variable costs in the wholesale electricity market (em not the retail market. Without covering what are now considered "fixed" O&M costs, operating merchant plants would have to shut down. Thus, the key question for power plant investors is simple: When will the market move to this longer-term equilibrium?
The answer will prove elusive. The outlook is for uncertainty, volatility and cyclical price behavior. Wholesale electric prices already show highly volatile behavior and this tendency well may increase. In the competitive Scandinavian electricity market, for example, average annual prices vary by a factor of four. Cyclical market behavior has yet to come to electricity, but is likely to play a significant role in the industry, one that will prove critical to investment decisions. %n4%n
The transition to competition could prove the most volatile, because the change will occur in increments. The correlation between fuel and power prices likely will weaken as factors other than fuel price (e.g., the need to cover cost currently defined as "fixed") assume more importance in wholesale electric pricing. This change will make it more difficult to keep the spark spread positive. Rising fuel prices no longer will raise all electric revenues.
Instead, investors must examine risk in both power and fuel markets simultaneously. The goal will be to keep the spark spread positive. Plant-specific fuel issues must be