How Natural Gas Shapes Electricity Prices: The Hidden Force Behind Your Energy Bill

The Gas X Factor

On the cusp of the 5th Industrial Revolution, tensions are escalating as energy-intensive industries clash with environmentalists who argue for the elimination of all fossil fuels, including natural gas. In most cases, die-hard environmentalists imply that this must happen immediately, stating that the goal should be to electrify everything. But what exactly does that mean?

Simply put, "There is no Gas X pill that we can take to get rid of natural gas anytime soon." - Energy Ninja??

The call to eliminate fossil fuels and electrify everything is a comprehensive strategy aimed at addressing climate change by reducing greenhouse gas emissions. It involves transitioning to a renewable energy-based electric system, modernizing infrastructure, enhancing energy efficiency, and implementing supportive policies and measures. While the goal continues to gain traction on a global scale, the transition must be managed carefully to ensure reliability, economic stability, and social equity.

The Bridge Fuel?

Recognizing the pivotal role of natural gas is essential when considering any transition. Natural gas serves as the marginal fuel driver in determining electricity pricing, highlighting its significance in energy markets. Notably, natural gas-fired generation has become the largest source of electricity in the United States, surpassing coal and other sources due to its affordability, efficiency, and relatively lower emissions of carbon dioxide. According to the U.S. Energy Information Administration (EIA), natural gas consistently contributes the largest share of electricity generation in the country, a trend solidified since around 2016. Often regarded as a "bridge fuel," natural gas facilitates the transition from high-carbon sources like coal to low-carbon and renewable energy sources, including nuclear power.

What Does the Term Marginal Fuel Mean and Why Is It Important?

In electricity markets, the term "marginal fuel" refers to the fuel source that is most often used to meet the last unit of electricity demand. This concept is crucial for determining electricity prices.

Natural gas frequently plays this role in many electricity markets due to several key factors:

1. Flexibility and Quick Response: Natural gas power plants, especially combined cycle gas turbines (CCGT), can be ramped up or down relatively quickly compared to coal or nuclear plants. This makes them ideal for adjusting supply to meet real-time electricity demand, which can fluctuate significantly.

2. Operational Costs: The marginal cost of generating electricity from natural gas is often higher than that of other sources like coal, nuclear, or renewables. This is because natural gas prices can be volatile and influenced by market conditions. Since electricity prices in wholesale markets are typically set by the cost of the marginal unit of supply, natural gas often sets the price.

3. Renewables and Baseload Power: Renewable energy sources like wind and solar have very low marginal costs (almost zero), and they generate electricity when weather conditions are favorable. Baseload power plants like nuclear and coal operate continuously at a stable output. When electricity demand exceeds what renewables and baseload plants can supply, natural gas plants are often dispatched to meet the additional demand.

4. Market Dynamics: In competitive electricity markets, generators submit bids to supply electricity. The market operator then dispatches plants in order of increasing bid prices until demand is met. The highest accepted bid (the marginal bid) sets the market clearing price for all generators. Since natural gas plants are often the last to be dispatched due to their higher variable costs, they frequently set the marginal price.

Impact on Electricity Pricing

Peak Demand Periods: During periods of high electricity demand, such as hot summer days or cold winter nights, natural gas plants are typically the marginal generators. Their higher operating costs result in higher electricity prices during these times.

Price Volatility: The price of natural gas can be volatile, influenced by factors like weather, geopolitical events, and supply disruptions. This volatility can translate into fluctuating electricity prices.

Incentive for Investment: Knowing that natural gas often sets the marginal price can influence investment decisions. Investors might be more inclined to invest in natural gas plants or other technologies that can quickly respond to demand changes.

Example Scenario

Imagine a region where the demand for electricity increases during the late afternoon as people return home and turn on appliances. Renewable sources like solar may begin to wane as the sun sets, and baseload plants continue to operate steadily. To meet the rising demand, grid operators call upon natural gas plants. Since these plants incur higher fuel costs, the price of electricity rises to reflect the cost of producing the additional power from natural gas. Thus, the electricity price in the market increases, being set by the cost of natural gas generation at the margin.

It goes without saying that natural gas is often the marginal fuel in electricity pricing due to its flexibility, relatively higher operational costs, and the role it plays in meeting variable demand, especially when renewable sources are insufficient. This dynamic ensures that natural gas frequently influences the market clearing price, thereby affecting overall electricity prices.

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Need Help with Your Natural Gas and/or Power Procurement, Real-time Energy Analytics, and/or Utility & Energy Infrastructure?

Ralph Rodriguez, LEED AP OM is the Energy Ninja and Legend Energy Advisors manages:

1. Over $2 Billion in commodity risk for our clients.
2. Real-time Energy Analytics (PUE) in some of the most energy intense industries in N. America.
3. Utility & Energy Infrastructure Advisory at a level that is different than traditional advisors, consultants, and engineers.

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