There is a phenomenon known in financial markets as an "inverted yield curve." Like a stray elephant in Central Park, it is a reliable indicator that something odd is going on. It seldom lasts long, as markets quickly note and adjust to the weirdness.
Prices in current electric markets are similarly inverted, especially in the coal belt. Like Manhattan elephants and inverted yield curves, they signal strange goings-on. However, this one shows no signs of correcting itself soon.
Shapely yield curves
The yield curve is a financial term that describes nothing more than the interest rate paid (typically on federal bonds) as a function of bond length. The basic idea is that the longer you have to hold a bond before it pays off, the higher the return you'd expect. Let's put this very simply: suppose you paid me $100 today, and I promised to return it to you in a year, with interest. For the sake of argument, we'll say that we agree on 5 percent interest. Now let's say that I offer the same deal, except I keep the money for two years. You'd likely ask for a higher rate of interest, reflecting the greater risk. After all, the longer you let me keep your money, the more likely I'm going to squander it all on obscure Doors records.
The yield curve is simply a quantification of this reality. Longer cash lock-ups equal higher interest rates.
But every once in a while, the relationship breaks down, and you can actually get a cheaper interest rate on longer-term money. The yield curve is then said to be inverted. Most commonly, this is seen as a sign that economic troubles are ahead, since it implies that investors will pay a premium to get their money out of this risky economy sooner. Sometimes though, its just an aberration, in which case financial traders quickly run in to invest their money and bet on a correction. In all cases, the yield curve tends to adjust back to its normal shape, either because the coming bad economy comes (in which case the future is now brighter) or because traders arbitrage away the difference.
Electric prices
In commodity markets like electricity, there is no analogy to long-term investment (you can't loan electricity, after all). But there is an analogy to the yield curve in the form of wholesale and retail prices. Just as short-term investors can cash out and reinvest before long-term investors have the opportunity, so too can wholesale power buyers buy and sell power before it ever gets to the retail customer. And for similar reasons, wholesale power prices are supposed to be lower than retail prices.
When this doesn't happen, it's a sign of market weirdness. After all, who would buy power only to sell it at a loss? But it does happen. California saw this happen when their -- whatever you do, please don't call it deregulation -- market restructuring imposed a cap on retail rates in the name of consumer protection but let wholesale prices float. When fundamentals drove wholesale rates above the retail cap, massive disruption ensued.
But notice a key difference: an inverted financial yield curve reflects something fundamental about the economy, and creates opportunities for arbitrage. The California example was caused solely by screwy regulation, and it took more screwy regulation to fix. (PG&E bailouts, massive roll-back of market restructuring and a hiatus in Terminator sequels.)
We are now seeing a similar inversion all over the country. It is caused by similar regulatory goofiness, but is not so easily fixed.
West Virginia is illustrative. Their average retail power prices are about $54/MWh. Average prices paid by industrials are even lower, at about $40/MWh. (See here.) The state is a part of PJM, which gives us a window into wholesale electric prices. Today, those markets are trading at $55 -- 65/MWh.
What gives?
As regular readers know, coal isn't cheap. Moreover, none of the new options we have for central-station power are cheap. Just about all of them will require new construction that will need something north of $100/MWh in retail rates to pay off the investment. Indeed, throughout the coal-belt today -- which has, recall, historically been the part of the country with the cheapest power -- it is actually cheaper to burn natural gas in existing plants than it is to build a new coal plant. That's not because natural gas is cheap. Indeed, as strange as it may seem that wholesale prices are touching $65/MWh when retail is only $54, the much bigger gap is to the power plants West Virginia regulators are approving that will require $110/MWh or higher. And while our regulatory model provides no immediate way for that price to ripple into retail rates, it is starting to creep into wholesale prices, as the PJM data shows.
This is a really hard onion to un-peel. While wholesale rates are set by markets, retail electric prices are set -- in part -- by politics. Utility commissions set these rates which remain largely fixed for the 5-10 year period between new utility rate cases. (This is especially true in the coal-belt, where most utilities remain fully regulated -- the market restructuring in the mid-1990s was primarily in the gas-dominated west and northeast.) This means that if retail rates don't increase, utilities will go broke. On the other hand, if elected officials raise electric rates too quickly, they tend to become former-elected officials.
Meanwhile of course, there are no shortage of options to install cheaper power generation, especially at industrial facilities using opportunity fuels and cogen. Such investments would fix the inversion if they were built. But what's the incentive to build? Just the displacement of retail rates? Those are the low ones! I'd really like to get credit for the displacement of those $100/MWh commission-approved rates, but since I'm not a regulated utility, I don't have access to that upstream market. As a result, the self-correction that is built into financial markets to fix yield curve inversions is completely excluded from electric markets.
What it all means
Just as a financial inverted yield curve is a reliable indicator that an economic downturn is coming, the inverted yield curve in today's electric sector is a good sign not only that power price increases are coming, but also that they will be concentrated in the coal-belt. Given the huge number of U.S. manufacturers that are located in the coal belt precisely because of their long-term access to cheap power, this is a really bad thing. Higher power prices in the manufacturing sector have a habit of leading to factory closures and layoffs, quickly rippling into broader economic dislocation.
A CESOP would help to fix this, but it will take time to be enacted. Those markets (like PJM) that have mature wholesale power markets can help address as well -- to the extent that retail participants can access those upstream markets. ISO-New England's forward-capacity market is another step in the right direction, although it is also a slow-moving process, with three-year ahead forward markets.
In the immediate term though, it is hard not to see this causing pain. The fact that we don't have any short-term medicine to address is a direct result of a regulatory model that lets utilities build expensive central plants even while it blocks the private sector from building cheaper, local alternatives. The problem is the regulation. The solution is regulatory reform. Knowing as much, inaction is inexcusable.
Driver, where you taking us?
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Comments
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amazingdrx Posted 6:43 am
18 Aug 2008
Retail is 11 cents per kwh here, rates to industry around 6 cents per kwh.
Here's a way to invert the yield curve, hehey.
Go on the rate/timing plan that charges 6 cents per kwh most of the night, then goes up to 21 cents per kwh in most daylight hours and 42 cents per kwh in peak load timwe for about 2 hours per day.
Store 6 cent per kwh electricity in batteries for low power needs during the high rate periods. Only use high power appliances and loads during the 6 cent per kwh period.
What would this do to the system Sean? How about if solar panels were added after the batteries payed back in halved electric bills over a year or so.
http://amazngdrx.blogharbor.com/blog John Schneider, Northern Wisconsin
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Sean Casten Posted 9:27 pm
18 Aug 2008
The inversion is happening because no one is willing to build new generation without also getting their capital back. (Quite understandable, really: would you spend a million bucks to build a widget factory that cost $1 per widget to produce widgets and then sell the widgets for a buck?). As this new generation comes on line, it won't be built unless investors can see a way to also get a return on their investment. If you're a utility, you can get that through the magic of the utility commission approval process. If you're not a utility though, you can't do that - so you don't build. That has created a window for natural gas plants to run a little harder (since they presently are off more than they are on due to high fuel costs), which are more expensive than all the amortized base-load generation, but cheaper than what new-build will require with capital recovery. This is what is in turn driving the PJM rates up above $54.
Re: your idea, there are certainly opportunities to make money off of on-peak/off-peak arbitrage. Near my old home in Massachusetts, there was a big pumped hydro facility that did exactly what you describe, pumping water to the top of a mountain at night with cheap electricity, then running it back through turbines during the day to take advantage of cheaper rates. There is an efficiency penalty to this for simple thermodynamic reasons - whether a pumped hydro scheme, a battery or a reversible fuel cell, you never get as much energy out as you put in. As such, this isn't necessarily a very environmentally beneficial approach, even if it does create some economic gain (since you now use more fuel per useful MWh.) This is especially true in the coal belt, where the baseload power is coal (meaning that's what you're using inefficiently at night) and the peak power is natural gas, which you are displacing during the day. Put solar panels on and you're even worse, since those are presumably also not going to run at night!
Keep in mind also re: solar that those don't pencil at $54 either. I'm not even sure they'd be built at $100 - so they're no magic bullet to this particular problem.
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David Mack Posted 5:20 am
21 Aug 2008
Picken's plan is for wind to generate 20% of US electricity, replacing natural gas that could then be used for transportation. He estimates it would cost 1 trillion plus 200 billion in transmission and that seems really expensive. Does that figure even seem realistic to you? It also doesn't make sense to replace peak power with intermittent power, so I'm pretty sure he's pushing this policy out of self-interest.
It seems to me that industry has noticed the electricity inversion caused by the regulated market. They see it as an opportunity to lobby the next set of regulations in their favor for the next build cycle. If regulations stay the same and expensive coal gets built, the ratepayer pays. If plans like Pickens' or other big renewables get subsidized, the taxpayer pays. If we're paying anyway, we might as well build renewables, but let's look at other options first.
CHP seems to be the only cheap source of power. I've seen your company make claims that CHP could replace 20% of US capacity for only 350 billion in capital costs, less than a third of the wind plan estimate. So you're lobbying for deregulation, in your interest and the rate/taxpayers'. There must be a constituency for cheap and efficient electricity that can help your lobbying efforts. I see you're trying to get the environmentalists on side by posting here. How about manufacturing? Are they not lobbying for CHP because the utilities buy them off with cheap power deals? Is there another cheap power source that is held back by regulation?
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Sean Casten Posted 7:18 am
21 Aug 2008
The energy users are consistently in favor of low-cost energy. That keeps them pretty well aligned with us. Many of them also own on-site cogen plants and they want competitive prices for their power. Again, we're aligned. On the other hand, they are understandably reluctant to endorse changes that cause short-term price increases, even if they will logically lead to long-term reductions - which, at core, is what deregulation-done-right inevitably entails as subsidies are removed and markets can then more rationally allocate capital.
All of which comes back to a favorite quote from a friend at ACEEE that "there is no natural constituency for energy efficiency". It's a great observation, and one that I think can be extended more broadly to say that there is no natural constituency for economic efficiency.
But I'm thinking if we rant long enough we can at least get Don Quixote on our side!
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David Mack Posted 9:14 am
22 Aug 2008
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