Since our last heat rates blog post was so popular, here is a follow up to help you further understand them.
#1 - The term “Heat Rate” can be used in many contexts. For a natural gas-fired power generator, it is a measure of the efficiency at which a plant converts natural gas into electricity as expressed in millions of British thermal units (MMBtu) per megawatt hour (MWh). The marginal heat rate refers to the economics for which power plants can be profitably dispatched based on current market conditions. For retail customers looking to buy electricity using a Heat Rate-type product, the Market Heat Rate is most important. This is simply the current price of power divided by the price of natural gas for a specific term and location.
For example, if power is trading at $40.00 per MWh and gas is $4.21/MMBtu, the market heat rate is 9.5 as follows. Here is the breakdown:
Heat Rate = Power Price ÷ Natural Gas Price
9.5 MMBtu/MWh = $40/MWh ÷ $4.21/MMBtu
#2 – Market Heat Rates often trend inversely to Natural Gas prices; however, this is not always the case. Typically when heat rates are high, gas prices are low. This has been the case for much of the U.S. over the last few years. Heat Rates are impacted by other factors that would alter the relationship between gas and power prices in any region by changing the demand forecast and the amount of generation available, including:
- Temperature – market heat rates are highest in the summer
- Power Plant retirements due to EPA regulations or other reasons
- Load Growth due to economy and/or population growth
- Regulatory changes such as rising price caps in ERCOT
#3 - Since Heat Rates generally have an inverse relationship to natural gas prices, buying a retail heat rate product is usually best when gas is high and heat rates are lower. In this situation, the customer can lock in a lower heat rate while deferring the fixing of the gas component of the power price with hopes that the gas price will fall prior to delivery of the power (remember, power price = heat rate x gas price).
#4 - Heat Rates trading is most active and liquid in ERCOT (Texas). ERCOT started trading heat rates because of demand from large industrials that are also heavy gas users (and buyers). These industrials would rather buy Heat Rates because it allows them to manage their gas and power positions at the same time. Furthermore, the correlation between the natural gas futures (NYMEX) and the power price is strongest in ERCOT because of the tight and less volatile gas basis.
If you have questions about heat rates, add a comment and our market intelligence team will post the answer.