Energy Information Administration


Putting Economic Power In Distributed Power
Electric Power Research Institute's Distributed Resources Week 1997 (October 22, 1997)
AUTHOR: John Herbert

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Putting Economic Power in Distributed Power

  • A distributed electricity generation system, often called distributed power, usually consists of relatively small generators to support manufacturing and commercial establishments. The economic value of distributed power can be increased significantly when it is coupled with natural gas because:

    • Natural gas and electricity (power) are often traded on transparent, spot markets
    • .

        - It is important that prices and other key information supporting trade are readily and inexpensively available to the widest number of interested parties.

    • Natural gas and power are very price volatile.

      1. - In fact, they are probably the most volatile prices among commonly traded commodities. This volatility is likely to continue because of the major influence that difficult-to-predict weather has on the demand for these commodities and, in the case of power, on unpredictable unplanned outages. Natural gas price volatility is extremely high, but as we shall see by the examples in this presentation, power price volatility is even greater

    • Very active futures contract markets are available for hedging natural gas price risk and for price discovery.

      1. - Although in general it is important for a company to consider making additional revenues by using its assets to capture the returns associated with the volatility; at times a company will want to fix or control this price risk to ensure that funds are available for specific major investments. Price discovery is probably the greatest benefit of a futures market because of the markets response to all information and because of the large volume of trade and the great price transparency.

  • In this presentation we will explain the:

    • Importance for distributed power of liquid, spot markets for gas and power, especially electronic auction markets that can be described as fair

      1. - It is important that the market be electronic because of the greater efficiency when compared with a phone and fax market. The fairness of the market is important for encouraging maximum trade. The number of theoretical and applied academic papers on informationally efficient and fair markets underlines the possible importance of this characteristic. Theorists try to work out the rules for a fair market beforehand. Oftentimes, the industry proceeds with a few principles and then develops and adjusts rules based on complaints by participants in the market.

    • Special importance for distributed power of futures markets for gas, especially when changes in natural gas futures prices are correlated with changes in natural gas spot prices in market areas in gas consuming regions

      1. - This correlation allows the futures market to be used as an effective tool for hedging price risk in market areas. If changes in these prices are not highly correlated then it is difficult to use the futures market to hedge price risk.

    • Importance of understanding price behavior of power and fuel inputs in order to maximize the economic value of distributed power

      1. - When the correlation between power and natural gas prices breaks down, then trading opportunities surface. When the difference between the two prices is great, it usually signals significant trading opportunities. When the two price series are highly correlated and differ by a relatively constantamount, then the price difference probably represents differences in the transaction and operating costs of doing business in the overall market.

    • Importance of viewing distributed power as an operational option

      1. - When distributed power is viewed as an operational option, then the flexibility associated with this option can be evaluated using market prices and standard formulae for evaluating how the value of the option changes with changes in price and volatility.

    • Importance of understanding and tracking differences in price behavior of natural gas and power in related markets

      1. - Simply stated, when differences in price behavior are not well understood, it is impossible to maximize the value of an operationally flexible asset. However, an increase in the number of companies trading in the market results in a reduction in price volatility over time. As more companies attempt to exploit the price difference commercially, these profits represented by the price differences are competed away.

  • A Mini Case Study Based on Market Activity in the Washington, DC/New York City Distribution Corridor
      1. - This map shows what we describe for illustrative purposes as the Washington, DC/New York City Corridor, which includes the Pennsylvania/New Jersey/Maryland (PJM) electricity (power) market and the Transco-Zone 6 portion of the Transco Pipeline System, which extends from Northern Virginia to New York City. Transco transports large volumes of natural gas from Louisiana near the Henry Hub to the East Coast. The daily spot price data presented in the following graphics are PJM electricity prices from Power Markets Week published by McGraw-Hill Inc., Transco-Zone 6 natural gas prices from Gas Daily published by Pasha Publications, and NY No.2 fuel oil prices from the Wall Street Journal published by Dow Jones & Co., Inc.

    • Examining Power and Fuel Prices in Market Areas

    Figure 1. Energy Prices in the New York City/ Washington DC Corridor

      - This graph shows power, fuel oil, and natural gas prices per million Btu (MMBtu). The power price was converted to Btu using a heat rate of 7.5 MMBtu per megawatthour (Mwh). The items to note on this graph are: the large variability in power prices and differences and similarities in energy prices at different times of the year. For example, natural gas prices tend to be lower than power and fuel oil prices for much of February and March and fuel oil and power prices tend to be very similar. Thus, there are profits to be made from substituting natural gas for oil and power during that time. A company that uses natural gas to generate power and then sells the power would benefit substantially. On the other hand, from mid-November to the end of January, natural gas prices tended to be above power prices. Hence, a company would have benefited from selling any natural gas it had rights to and buying power.

  • Comparing Power and Natural Gas Prices in a Useful Way - A Simple, First Step, Diagnostic Graph
  • Figure 2. A Power Price/Natural Gas Price Comparison

      - In this graph two things are clearly shown: (1) when and by how much power prices exceed gas prices and (2) the variability and persistence of price differences. Such characteristics of the price series are important for understanding the economic significance of taking advantage of price differences in a distributed generation system. In the figure, dashed lines are used for illustrative purposes to indicate transaction costs and other costs associated with very active market activity. The area between the solid red line in the upper part of the figure (above zero) and the dashed line represents the maximum gains, on average, from selling power and buying gas when power prices exceed gas prices. The absolute value of the difference between the red solid line and the dashed line in the lower part of the figure (below zero) represents the gains from selling gas and buying power. The sum of the two areas gives a rough indication of the possible gains when the company uses distributed power as a strategic asset.

  • Comparing Power and Fuel Oil Prices (the Competitive or Substitute Fuel) in a Useful Way

  • Figure 3. A Power Price/Fuel Oil Price Comparison

      - This figure is similar to Figure 2, except that fuel oil is used instead of natural gas. Again a company might want to shade in the area above and below $0.50 per MMBtu, which represents the transaction and other costs associated with very active switching between using a fuel to generate power or selling the fuel and buying power.

  • Comparing the Competitive or Substitute Fuels in a Useful Way
  • Figure 4. A Natural Gas/Fuel Oil PriceComparison

      - The large number of negative values, or the large area below the zero line and below the dashed line relative to the area above the zero line and the dashed line, indicates that natural gas is a better choice for generating power than fuel oil. The next graph shows this more clearly.

  • Showing the Relative Value of Using One Fuel Rather than Another
  • Figure 5. Volatilities in New York City/Washington, DC Market Area

      - The relative value of using natural gas rather than fuel oil can be assessed by subtracting the area above zero and above the dashed line (green area) from the area below zero and below the dashed line (blue area). This provides a crude measure of the incremental gains from using natural gas instead of fuel oil even before the price of power is considered as part of an active trading strategy. The magnitude of the difference in the two areas multiplied by average daily fuel use represents a rough estimate of the savings in fuel expenditures from using natural gas instead of fuel oil.

  • Price Volatility

    1. -- What Is It?
      - Volatility is the annualized value of the standard deviation of daily percentage price changes. The annualization is obtained by multiplying the standard deviation obtained from daily data by the square root of 250, the number of trading days in a year.
      - How Do We Measure It?
      - The estimator we use is the (Ln(High Price for a day) - Ln(Low Price for a day))*9.5. We often take a simple average of these values by dividing by the number of days to get an estimate of volatility for some time period. We use this estimator because it can be computed anywhere on the simplest of calculators and is a more efficient estimator than the standard estimator.

    Figure 6. Volatilities for Natural Gas (Henry Hub)

      - Figure 6 shows annualized average daily volatilities for natural gas and power using the conventional estimator because daily ranges were not available. These volatilities, especially for power, are several times as large as those for other commodities. The dashed line at 20 percent represents an upper bound for the volatility of most other commodities (corn, wheat, copper, Eurodollars, etc.). This graph points up one of the difficulties of using the standard estimator. The standard estimator requires several times as much data to get the same level of precision as our favored estimator. When the volatility is great, we would like to study it in more detail to identify when a shift in the volatility may have occurred within a month.

  • Importance of Understanding the Relationship Between Futures Prices and Spot Prices

    1. - Understanding the relationship between spot and futures prices is important for understanding how good a hedge can be obtained from using the futures market. For example, changes in futures prices need to be strongly correlated with changes in spot prices to get a good hedge from involvement in the futures market. In addition, if there is a relationship between a spot price and a futures price, then the futures market can be used for price discovery.

  • Using Futures Markets to Hedge Price Risk in a Market Area

    1. - Using the futures market to hedge price risk requires a good understanding of how prices in these two markets behave. Again, an understanding of the strength of the average relationship between the two price series is extremely important.

  • Using Distributed Power to Hedge Price Risk - A Simple Example

    1. - The following graphic shows how a company could obtain a price hedge with distributed power. If a company accurately estimates its average use during some period (e.g., 100 units), purchases a distributed power generator that is geared to this average usage, and its incremental demands for power are independent of price, then the company can effectively hedge its price risk by selling natural gas when actual usage is below average usage and buying natural gas when actual usage is above average use. It does not matter whether the price of gas, which is expressed in cost per Mwh generated, varies randomly or systematically about the average price paid under the contract for natural gas supply. There are more advanced strategies that depend on the correlation between a customer's incremental demands for gas and price. These strategies can provide both hedging and additional profits from arbitrage opportunities.

    Obtaining a Price Hedge wiWith Distributed Power-- An Example

  • Financially based models can be used to track the real-time value of operationally flexible assets such as distributed power when reliable volatility estimates can be calculated.

    1. - An estimate of volatility is the most important input to these models as the other estimates required to do the calculation change hardly at all in the short run. Thus, an estimate of the commercial value of distributed power can be calculated as the relative price of power and natural gas changes once we have an estimate of volatility.

      - Financial models can be used to evaluate the changing value of a distributed power generator over time based on the volatility of price, the heat rate of the fuel, the interest rate for money, the relative price of power and an energy source, and other factors. These models allow a company to determine how the value of an asset is changing as volatility and other parameters are changing in the marketplace.
  • Conclusions
    • Distributed power could have significant additional value as an operationally, flexible asset supporting trading in power and natural gas as liquid, active electronic spot and futures auction markets continue to develop.

    • The value of distributed power as an operationally flexible asset is greatly influenced by the behavior of the difference between power and natural gas prices and volatility.

    • Since wide use of distributed power should increase the overall reliability of power distribution in the United States, power price volatility should decline over time. Some of the current volatility in electricity prices is explained by unplanned outages of large generators. Thus, as more small generators are scattered across the United States, the power system will be less dependent on large systems. In fact, the smaller generators can be used to provide additional incremental supplies formerly obtained from large generators where the power is transported over large distances with the attendant high cost of such transmission.

    • Nonetheless, as long as weather remains an important factor determining power demand and natural gas prices and power prices are not perfectly correlated, distributed power will remain an important asset for hedging price risk and for trading opportunities. For example, winter weather will continue to cause sudden and significant shifts in energy demand, causing natural gas prices to rise. As long as power prices do not move as much as natural gas prices (are not perfectly correlated), this represents an opportunity for owners of distributed generation to sell natural gas and buy power and capture additional profits. On the other hand, when power prices rise unexpectedly in the summer relative to available natural gas supply, gas-fired generation represents a hedge against higher power prices.

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