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The hare and the tortoise

Posted by Sean Casten on July 7th, 2008

More on economy | energy

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Costs for utilities rise faster than politically palatable rate changes can keep up

This is one for the “Things No One is Talking About But Should” file.

Greenwire recently reported that the credit risk of our utilities depends in large part on their ability to recover rising fuel costs, and this ability is diminished due to the fact that:

High fuel costs translate directly to higher customer rates, but instituting constant and often significant increases is politically and socially unpalatable.

This gets it half right.

The half wrong part is that the fundamental upward price on electricity is only indirectly because of fuel. As I’ve shown before, the biggest upward price pressure on power is due to the fact that we haven’t built baseload power assets of any significance for nearly twenty years, and are now entering a build-cycle where we must factor much more expensive capital amortization into our power rates. Even if fuel got cheap again, we’d still be facing heavy upward pressure as we built new generation, transmission, and distribution.

But the half-right part is the more significant. In a “normal” market, higher costs translate into higher prices and markets adjust. But in electricity markets, higher costs only translate into higher prices at the rate which politically-appointed commissions can approve those higher rates. And if Gray Davis (and Maryland) have taught us nothing else, it is that that elected officials who approve big electric rate increases get fired.

This has created a situation in which the fundamental cost pressure is trending upwards much faster than politically-paced price trends. On the downside, this slows the rate at which clean energy can come online, since it must compete — at least in the near term — with a price that is, essentially, fabricated. On the other hand, this theft from Peter is unsustainable in the long run, and Standard & Poor’s notes that:

Utilities using renewable power not only may save money and bolster credit but also could profit from “free fuel” sources. With no input costs, utilities could even sell power back to the wholesale electricity market in times of above-average input conditions, the report notes.

In the medium term, things are strange. In many markets, wholesale spot prices are now higher than retail rates, creating strange arbitrage opportunities, but no long-term investment thesis.

In all cases though, the fundamentals are out-pacing politics, which virtually ensures that things will “pop” in unexpected ways. Stay tuned …

Note: This first appeared on Grist.

8 responses to “The hare and the tortoise”

  1. Darklamp said on July 10th, 2008 at 7:40 am

    I would like to add that this situation might not only cause a “pop”, but probably “black out”.

    It is quite clear to me that opportunities for energy efficiency measures are absolutely necessary if you want to deal with rising demand pressures on the grid.

    I guess the next question can be, how much time do we have?

  2. Sean Casten said on July 10th, 2008 at 8:03 am

    Darklamp,

    The core question “how much time do we have” can be taken a couple ways. Economically, I’m not sure there’s a precise answer. Our energy policy has long found clever ways to steal from Peter to pay Paul, and – while ultimately unsustainable – one has to admire the creativity we’ve applied to that endeavor!

    But to my mind, the real time line is environmental. James Hansen said 3 years ago that we had 10 years to act on GHG emissions. Move now and we avert climatic disaster. Wait and we will trigger non-linear events (like melting icecaps and methane releases from permafrost) that may well tip the globe wildly out of balance.

    I am not an environmental expert, but while I’m optimistic enough to hope that Hansen is wrong, I’m also realistic enough to know that it is massively irresponsible to ignore those experts in our midst. To the extent that we are stealing from Peter in a way that slows the rate of deployment of GHG reducing technologies (and the retirement of GHG-intensive technologies, like our fleet of really old, really inefficient central coal plants), we are making a massive environmental bet that Hansen is wrong. To my mind, that is horribly irresponsible.

  3. Jake de Grazia said on July 10th, 2008 at 10:00 am

    Any idea how much this costs now and how much it might cost 10 years from now if things continue?

    I ask because I wonder at what point this situation starts to affect government spending, national debt, and inflation significantly, affect them to a degree that it becomes glaringly noticeable.

    Here’s how I understand things (I realize that I don’t know nearly enough to be sure about this, but, now that I’ve added this disclaimer, I feel ok throwing it out there):

    If the cost to produce power is higher than the price consumers pay, then the government is subsidizing, covering the portion of the cost it’s afraid to let consumers cover themselves. In theory, the government is using tax revenues to pay for that subsidy. But, what with the war, other spending black holes, and politicians’ fear of raising taxes, tax revenues can’t cover everything, and the government is borrowing money to pay for the subsidies. And once the borrowing gets out of control, the government has to print more money to pay off its debts. Printing more money, of course, means inflation, which means that dollars are less scarce and thus less valuable, and that’s a bummer.

    So, again, my questions are: How much money are these subsidies costing? And might it, at some point anyway, be enough that it’ll start getting attention enough to hold politicians accountable for cowardly pandering to short term interests?

  4. Sean Casten said on July 10th, 2008 at 12:19 pm

    Jake,

    Good questions, although I think not quite as economically dire as you outline. In the US, the political damping of rate increases tends to come out of utility profit margins rather than out of the tax base. (This is not to say there aren’t plenty of other utility subsidies, but this is not one of them, at least for investor-owned utilities.) As such, the economic consequence of passing <100% of the cost increases along to retail rates in the short-term is a reduction in utility cash, and in the long term a reduction in utility financing capacity. (Note the emphasis on utility – one should not necessarily assume that no one builds new assets in this circumstance – simply that it compromises the ability of regulated utilities to build power assets.)

    The utility bloc is strong enough that this won’t last for 10 years, but it could compress margins and slow the rate of retail load growth for a few years, thereby putting off or slowing the construction of new wires and generators. I am the last to argue that we need more wires or inefficient central plants, but having said that, if we don’t shift resources around to accommodate more rational local generation construction, this does run the risk of compromising grid reliability.

    Make sense?

  5. Darklamp said on July 11th, 2008 at 5:28 am

    You bring up a point on spending on wires. To me, this seems to be one of the most ignored facts that everyone likes to ignore.

    I read how increasing large the investment environment is for renewable generation, but in the end, all of those investments amount to nothing if the grid itself is falling apart. I believe money can flow easily to generation, even if utilities do take their time to build it. Building generation is fun, it attracts good press, and it can be very competitive.

    With wires, though, it becomes the unwanted thing to do. As well, the raw materials needed to make the wires are increasing in price and competition.

    So when you write about generation costs, where do the costs of upgrading wires come to play? How significant is it to keep the grid alive? Especially, if much more distributed generation (renewables and others) are pushing for grid revival.

  6. Sean Casten said on July 11th, 2008 at 6:50 am

    Darklamp,

    Good questions.

    First, note that the construction of new generation does not require a de facto need for new wires. However, the construction of new central generation does make this link. If you build the generation at the point where it is used (as RED does), you don’t need to build any more wires.

    That said, you’re absolutely right that it gets ignored in the conversation, both in terms of it’s capital cost impacts and it’s operating cost impacts. To the first point, we did an analysis about a decade ago when I worked at Arthur D. Little where we went through all the annual transmission and distribution upgrades as reported by utilities to FERC, looked at the total MW of capacity added and the total expenditure and divided. This led to a whopping $1300/kW for the transmission and distribution, or a little more than the cost of a new central gas-fired power plant. (This has since been borne out by a similar analysis done by the Regulatory Assistance Project.) This sounds shocking, but checks out pretty well: amortize that at 10% over 20 years and you get 2 – 3 cents/kWh, or about the difference between wholesale and retail rates in “normal” markets.

    On the second point, the EIA does their Annual Energy Outlook every year, wherein they show – among other things – all the energy that comes into the electric system as fuel and where it goes. There’s a little line on that chart for transmission and distribution losses (e.g., the energy that gets dissipated as heat in the system and isn’t available as electricity to the user), which is currently running at about 9 – 10%. Thus, our 33% efficient central power plant is really only 30% efficient on a delivered basis, since 10% of the power it puts onto the high-voltage transmission system never gets to the end user.

    The upshot of both of these factors is that local generation not only avoids capital costs for wires, but also increases the efficiency of the central grid itself. (This latter point is a bit counter intuitive: losses in electrical distribution circuits are a function of the resistance of the wire times the square of the current. Thus, reducing the power flowing through the wire – whether through local generation, conservation or any other measure – brings about geometric reductions in distribution losses.)

    However, to a significant degree, local generation is not compensated for this benefit. That’s starting to change, most notably in New England where the ISO pays more in their forward capacity markets to local generators than central ones, for precisely these reasons. But until it is ubiquitous, we are misallocating capital towards inefficiency.

  7. Jake de Grazia said on July 11th, 2008 at 7:15 am

    That does make sense. Although I’m not 100% sure what you mean by “shifting resources around.”

    Basically, you’re saying that the government’s fear of higher prices means that utilities will make less money and thus invest less in new generation and T&D infrastructure. And, while it’s not necessarily a bad thing to keep bureaucratic, status quo loving utilities from deciding the best ways to deal with increasing demand, the wires (and plants?)that the utility investment dollars would build could be helpful in the creation of an infrastructure better capable of integrating distributed generation.

    Did I read correctly?

    If so, do we need the utilities to help do (or enable) the shifting?

    More importantly, however, what is the shifting and how do we make it happen (with or without the utilities’ cash and/or blessing)?

  8. Sean Casten said on July 11th, 2008 at 7:27 am

    Jake,

    That’s the million dollar question. The difficulties that we’re having letting retail rates reflect underlying costs right now are inherent to any top-down, centrally planned economic model. (Our electric regulation, wherein 5 smart commissioners review demand forecasts, capital budget requests and set prices is identical to Soviet 5-year plans, and suffers from the identical economic inefficiencies.)

    So do we know of any economic models better than socialism? Of course we do. But do we have the political ability to unpack 100 years of regulatory precedent that would affect a $650 billion/year industry, and can we do so without unleashing ghosts of Enron and the CA power crisis? You tell me, but I don’t see any politician pushing us in that direction.

    (Note that Enron and CA are really bad arguments against competitive markets, since neither of them were… but they are the bogeymen that must be handled politically. That is perhaps the subject for another post.)

    The utilities have no incentive to encourage that shift, and yet in the current market, they will be the victim of a failure to shift. So as easy as it is to see where we need to go structurally, there is no obvious political roadmap to do so. Suggestions welcome!

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