Gap between on-peak, off-peak power prices traced to technology

Sponsored by

Kemm Farney, DRI*WEFA

Over the past year, DRI*WEFA has become involved in several running debates in which it was argued that on-peak and off-peak power prices will converge over time. DRI*WEFA believes that the currently observed spread between on-peak and off-peak power prices will persist as a result of technical and equipment limitations.

One factor that will prevent price convergence is the economics of advanced gas turbines. The advanced gas turbines now being marketed and put in place are technically wonderful machines. If skillful process operators use them properly, they will perform pretty much as advertised. They are fragile, however

Based on recent cost engineering studies, DRI*WEFA concludes that the new gas-fired combined cycle machines now being put in place will not have a cycling advantage over the existing fleet of the best coal and nuclear plants. Instead, they will be forced to compete for market share during the off-peak period.

The off-peak period will be characterized by excess capacity due in part to the amount of new capacity expected in the next several years. According to our most recent tabulations, the number of announced new power projects in the US totals more than 300 GW. While it is unlikely that all of this announced capacity will ever be completed (this total is best viewed as an inventory of projects that developers believe have the best economic potential), a substantial portion will be built. Further increases in capacity will come from the de-bottlenecking of existing power plants, which can be done at very low cost.

These increases in capacity, combined with the fact that the new gas-fired combined cycle machines will not have a cycling advantage over the existing fleet of the best coal and nuclear plants, will result in off-peak markets characterized by significant excess supply, low prices and poor profitability.

The experience in actual markets supports our view. DRI*WEFA has continuously monitored power prices and power price volatility in every market in the world where prices are reported since the earliest days of power trading. Even in markets with long histories of transparent price signals in both wholesale and retail markets, we do not find evidence of on-peak/off-peak power price convergence.

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PJM began trading its real time Locational Marginal Priced (LMP) product in 1998, and since then PJM has arguably become the most liquid power market in the world. Once again, the price spreads continue to be large, usually exceeding 30 percent of the on-peak price and often exceeding 50 percent of the on-peak price (see Table 1).

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Table 2 illustrates this same data for ECAR. This data begins in May of 1999, because it was not until then that Power Markets Week believed there was sufficient liquidity in the market to publish an index. Once again, the price spreads are quite significant, in this case-the largest we've seen among these comparisons and almost always exceeding 30 percent.

The marketplace in ECAR is completely bilateral; there is no ISO governing transactions, and liquidity is small. In contrast, the marketplace in PJM is market oriented, governed by an established ISO and possesses the greatest liquidity of any power market in the world. Yet in comparing Tables 1 and 2, it is clear that even though there are large differences between ECAR and in PJM, there is little difference in the pattern of the on-peak and off-peak pricing spreads. DRI*WEFA anticipates that these spreads will grow in nominal terms, but will become progressively smaller in real terms over the forecast period.

DRI*WEFA finds that there are a number of very persuasive reasons to believe that the currently observed spreads between on-peak and off-peak prices will be persistent. First and foremost, the technology of generation is such that even newly constructed power plants will find it very difficult to avoid cycling; the off-peak period is likely to always be over-supplied. Second, cutthroat competition among plant operators will almost certainly exacerbate this problem, driving off-peak prices even lower and making the off-peak business even more unprofitable. Finally, cross-market comparisons between any of the transparent power markets in the U.S. fail to find any indication that on-peak/off-peak price convergence is occurring.

Farney, Vice President of Electric Power at DRI*WEFA, can be reached by contacting the company at 800 Baldwin Tower, Philadelphia, Pa. 19022.

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