The Cost of Reliable Electricity
Posted on 04-13-2018
By Nick McClure
In order to provide the on-demand electricity on which U.S. consumers depend, regional grid operators must balance electricity supply and demand by coordinating numerous power plants to produce electricity when demand is high and stop production when demand subsides. U.S. electricity demand in the summer and winter can be more than 40% greater than demand in the spring or fall and severe demand spikes occur on particularly hot or cold days. The fluctuations mean that some plants that are needed to meet peak demand must sit idle when demand is lower. Of course, idle power plants cannot generate revenue from electricity production, which may prevent operators from investing in new plants and lead them to prematurely retire existing plants. To ensure operators build and maintain enough capacity to meet peak demand, grid coordinators pay operators for simply having capacity available, whether it is used or not.
For large parts of the Mid-Atlantic and Midwest United States grid coordination is the responsibility of PJM Interconnections, which ensures adequate capacity through competitive capacity auctions. Since 2004, PJM has held an auction each May for capacity that must be available in three years; the most recent auction in May 2017 was for capacity in 2020. The basic elements of the auction are as follows: PJM estimates the amount of generating capacity needed to meet peak demand and seeks bids from operators willing to supply a certain amount of capacity at a certain price. PJM arranges the bids in ascending order by price. The price of the bid at which the capacity need is satisfied sets the “clearing price.” In 2016, the PJM capacity auction clearing price was $59.37 per megawatt-day, which is the price operators that submitted bids at or below received per day for supplying one day of megawatt capacity. If an operator supplied 10 megawatts of capacity for the entire year, they received $216,700 in capacity payments: $59.73 * 10 megawatts * 365 days.
Hypothetical capacity auction for 600 megawatts of generating capacity
Illustrative example developed by the author.
Depending on the distribution company, capacity payments may or may not appear as a separate charge on consumers’ electricity bills, yet all electricity consumers bear the cost of capacity payments. In 2016, PJM capacity payments totaled $3.67 billion and total electricity generation in the PJM service area was 792 million megawatt-hours, meaning capacity payments of $4.63 per megawatt-hour. With average middle Atlantic household monthly electricity consumption at 0.698 megawatt-hours, the average household paid $3.23 per month in capacity payments, or about $39 for the year.
Capacity payments cover a portion of the fixed costs of power plants. This means that if the power plant that sets the clearing price has high fixed costs, capacity payments will be high. Conversely, if the clearing price setter has relatively low fixed costs, capacity payments will be lower because fewer resources are required when a low fixed cost power plant sits idle. Since PJM’s first capacity auction in 2004 for capacity in 2007, clearing prices have ranged from a low of $16 per megawatt-day to a high of $174. Because the auctions are held three years in advance, the clearing price signals to operators the future capacity needs of the system: sustained high clearing prices encourage capacity investments; low prices encourage capacity retirements.
Following three years of clearing prices at or above $100 per megawatt-day, the most recent clearing price, for capacity in 2020, fell to $76.53 due to additional natural-gas fired capacity. Traditionally, coal-fired and nuclear power plants have been major participants in PJM’s capacity market; however, new capacity from natural gas-fired plants accounts for 80% of capacity additions since the market began in 2007. In four of the five years from 2015 to 2019, more natural gas capacity was added per year than cumulative coal or nuclear capacity additions since 2007. Despite new rules that were expected to benefit coal-fired and nuclear plants, the nuclear operator Exelon announced plans to close its Three Mile Island plant after it failed to clear the latest auction.
The clearing price drop is even more striking given the expansion of solar and wind generating capacity. Lacking control over when electricity is generated, wind and solar are poor candidates for capacity markets and so their addition to the grid creates less competition among capacity market participants. If not for additional natural gas-fired capacity, coal-fired and nuclear plants would benefit from less competitive capacity markets and higher clearing prices. With low fixed costs, low fuel costs, and the ability to quickly increase electricity generation, natural gas-fired power plants have not only lowered the price of generating electricity, but also lowered the price consumers pay for reliable electricity.
Nick McClure is a Master of Public Administration student at the University of Pittsburgh, Graduate School of Public and International Affairs. His research and professional interests center on state and local public finance issues related to energy, infrastructure, and the environment.
About the blog: The GSPIA Energy and Environment blog provides commentary and analysis that furthers understanding of E&E issues of public interest. Its primary contributors are GSPIA faculty and students.