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Not So Fast

Proving market performance requires detailed analysis.

Fortnightly Magazine - January 2010

PJM, as in several other RTOs, the price for the units selected for dispatch is set by the highest offer price from a dispatched unit, or the marginal unit. During peak hours, relatively more expensive units are used to meet demand and often these units use natural gas. As a result, the wholesale price can climb quickly—and to hundreds of dollars per megawatt hour—when these units are dispatched.

However, while natural gas frequently might be on the margin, especially during peak hours, it isn’t the fuel that’s most often on the margin during the year in PJM; coal is on the margin for more hours. For total hours during the year in 2008, coal was the marginal fuel 78 percent of the hours, with natural gas 17 percent of the hours, and a mix of several different energy sources used for the remaining hours. Again, as with percent of generation, natural gas appears to have a disproportionate impact on the price of electricity.

A more detailed examination shows that fuel cost price changes don’t always precisely match the movement of electricity prices on a shorter time scale, for example, day-to-day or month-to-month. 3 The two might even move in opposite directions, as they did in 2005 in the aftermath of Hurricane Katrina. Power prices were rising through the summer of 2005, but after Katrina hit at the end of August and natural gas prices soared the next couple months, power prices actually fell from September through November.

The explanation is that this is typically when load drops as the region moves into the cooler fall months. The dramatic run-up in natural gas prices was offset by the drop in electricity demand. Clearly, customer load changes are a significant factor in influencing electricity prices—and even can be more important than a fuel-cost change in the opposite direction, depending on the relative size of the changes. Overall, both demand and fuel costs are significant determinants of electricity prices.

Currently, electricity demand has been falling due to the economic slowdown. Overall, electricity sales have decreased 4.3 percent for the 12-month period ending in August 2009; industrial sales are down more than 11 percent for that same period. At the moment, fuel prices and demand have been moving in the same general direction, unlike the fall of 2005.

But what do these correlations say about the market’s performance? Can we draw any conclusions from this relationship and assess the market’s performance? In a word: No. Conclusions can’t be drawn about the competitiveness or performance of the market based solely on the assertion that the price variation is due to fuel costs or demand. Wholesale electricity price increases don’t mean generators have market power any more than price decreases mean they don’t have market power and the prices are the result of competitive forces. Observing electricity price changes and their correlation with fuel costs and demand aren’t a substitute for careful analysis of market performance.

Of course for any competitive industry, lower prices for an important input would be expected to decrease the price of the final