Why Real-Time (Index) Prices Matter to You
Where were you on January 7, 2014?
If your answer is the Northeast or Mid-Atlantic, your business was probably affected by surging energy prices during the Polar Vortex. You are not alone—at least 195 companies mentioned “weather” in their quarterly earnings calls between January 1–March 12, 2014.
Why is it that some facilities’ budgets seem more susceptible to extreme weather events than others? The answer relates primarily to how you buy energy—specifically, whether your bill contains any exposure to real-time (also called “index”) prices. What may come as a surprise, though, is that facilities paying a fixed price for electricity can be impacted by real-time price spikes, too.
Fundamentally, real-time prices are market-based electricity prices that follow basic principles you might pick up from an Economics 101 textbook. In the unfortunate event you don’t have one of those lying around, here’s a quick summary:
Where Real-Time Prices Originate
In most competitive electricity markets, prices are calculated based on the available supply of electricity and projected demand for that electricity. As supply dwindles while demand remains steady, prices rise. In this case, “dwindling supply” means relying on power generators that have higher variable operating costs.
Resources with the lowest variable operating costs are always dispatched first, while more expensive generating units—like peaking power plants—are brought online when demand increases. Importantly, all supply resources which are included in the dispatch get paid based on the cost of the marginal generator—that is, the most expensive plant required to operate to meet demand.
That cost, which is constantly varying, accounts for much of index prices.
Source: U.S. Energy Information Administration.
Note: The dispatch curve above is for a hypothetical collection of generators and does not represent an actual electric power system or model results. The capacity mix (of available generators) differs across the country; for example, the Pacific Northwest has significant hydroelectric capacity, and the Northeast has low levels of coal capacity.
The cost of procuring power isn’t the only thing that makes up index prices, though. Because transmission and distribution (T&D) are required to get electricity from the power plant to your facilities, grid operators need to factor in “congestion” on the wires into the price of electricity.
Congestion makes electricity more expensive in some areas of the grid at different times, and higher costs are then in turn passed on to consumers. These, together with the cost of procuring electricity, form index prices.
This approach is used in most of the deregulated markets in the US, as well as in Australia’s National Energy Market (NEM) and New Zealand’s electricity market.
Each day, grid operators calculate hourly prices for the upcoming day using sophisticated optimization models that balance supply offers and forecasted demand and account for grid constraints. These prices make up the “day-ahead index”.
Because the grid requires close synchronization of supply and demand at all times to maintain stability, grid operators will adjust the supply dispatch down to the minute in real-time. This adjustment re-calculates the supply/demand equation and yields updated prices known as the “real-time index”.
Why Index Prices Matter to Me
Enough economics—time to talk about how index prices affect your business.
If the first week of January 2014 is seared into your memory, you’re probably purchasing energy for your facility in a way that leaves you more exposed to the fluctuations in index prices.
Indexed and hybrid procurement strategies allow you to proactively manage your load and eliminate the variable load premium that a supplier will include in a fixed-price contract. You can also reduce operating costs by knowing how index prices vary throughout the day, and by scheduling load and operations during times when prices are low.
Source: Energy Research Council
If you have exposure to index prices, it’s critical to stay aware of market conditions. When prices spike to the levels seen in January 2014, you run the risk of blowing your operating budget. Consider setting a “strike price”, so that you can take action to reduce your demand when electricity costs would make it unprofitable to operate.
On the other hand, don’t ignore index prices if you’re on a fixed-price contract! Certain contract provisions allow suppliers to pass through the costs incurred by price volatility to the consumer, which can add 1-3% to your overall energy bill.
In 2014, PJM won an appeal with the Federal Energy Regulatory Commission (FERC) to recover costs of over $1,000/MWh incurred during the January Polar Vortex. This left some PJM customers with "pass through" or "change in law" provisions in their fixed-price agreement paying higher rates for the whole of 2014.
While soaring index prices can mean trouble for exposed ratepayers, they can be mitigated with smarter peak demand management.