The electric sector’s price inversion
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.
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.
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?