Natural Gas/Electricity Price Correlations

In the electricity business, we talk A LOT about natural gas market. Where is the market going? What affects the market? If our business is mostly about electricity, why do we talk so much about natural gas? Simply put, the greatest driver of electricity prices is the price of natural gas. Let’s take a look at why this important correlation exists.

First, a significant amount of electricity that is generated in the U.S. comes from the burning of natural gas – historically it’s been about 20%. The rest comes from coal (about 50%), nuclear (about 20%), hydro-electric (about 8%) and renewable (about 1%). If 50% of all electricity generated in the U.S. comes from coal, why is the correlation between natural gas more important?  To answer that question, you’ll need to understand the order in which electricity generators are dispatched and how prices for electricity are set.

Click here to view a Gas Power chart. Continue reading to learn what it means.

Typically, generators are dispatched in a ‘least-cost first’ model, meaning the generators that can make electricity the cheapest are turned on first.

  1. Large hydro-electric units (mainly in the Pacific northwest) and wind units are typically the first to start running, which makes sense because their fuel costs are basically zero (the costs to install these units is quite high relative to fossil fuel plants, but once they’re in, the fuel costs are almost nothing).
  2. Nuclear units are also dispatched earlier because they are referred to as ‘baseload’ units, meaning they have limited flexibility to turn on and off. They are very good at generating a large and even amount of electricity, but are not typically used to ramp up and down quickly to meet the needs of incremental demand.
  3. Coal is similar to nuclear in that they are very good at providing ‘baseload’ power. Fuel for nuclear and coal plants has historically been cheaper than natural gas.
  4. Natural gas plants can be much more flexible in their ability to turn on and off and to ramp up and down to meet the needs of demand. Historically, natural gas has been more expensive as a fuel source than coal and nuclear. This has changed somewhat as the flood of cheap and abundant shale gas has hit the market, but for the most part, natural gas plants are dispatched last.

So, if natural gas plants are the most expensive to run, why is the correlation with electricity the strongest? Drum roll please…It’s because the price for all electricity is set by the plants that are dispatched last. This is called the marginal price, and all generators are paid this price (within given locational constraints).

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