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Electricity Rates and Natural Gas

Why are electricity rates tied to the natural gas market?

One of my favorite questions I receive from prospects or new employees is “Why are we talking about natural gas prices, aren’t we shopping electricity rates?” The common misconception with electricity rates is that they are tied almost exclusively with the current price for coal. Now, it is correct in assuming that the majority of power in the United States is generated by coal-fired generators; the incorrect assumption is that the market for coal is the primary driver of electricity prices. It is in fact natural gas prices that set the market rates for electricity. Though the use of coal-fired generation continues to fall throughout the nation (51% of all power being generated by coal in 2004 versus 42% in 2011), it is still the most common form of electricity generation. Due to increased regulations being passed down by the United States Environmental Protection Agency (EPA), coal-fired generators have been forced to either install ‘scrubbers’ designed to clean the air discharged from the plants, or decommission indefinitely. The fall in coal-fired generators has had an adverse effect on the capacity portion of electricity rates (the amount of energy the grid needs to have on standby to supply your facility at any given point in time), but the increase in capacity prices has yet to outweigh the lull in the natural gas market. Many generators have decided to close their doors and erect newer, more efficient natural gas generators because of the increased regulation on coal-fired generators. The United States base load transitioning to a greater number of natural gas fired generators has also increased the overall demand for natural gas across the country. Electricity rates suffer from natural gas generators being brought online to meet the demands of the US base load. Mothballing coal-fired generation plants has certainly applied upward pressure on electricity rates throughout the nation.

See the image below for an exact breakdown of generation
in the United States
Electricity Rates

This still does not explain why electricity rates mirror the price of natural gas in the United States… Before we get too in-depth, I think it is important to understand that electricity cannot be stored very easily or efficiently. The technology we have to store energy is just not capable of keeping electricity in a usable form while remaining in a safe state. Consequently, grid operators such as the New York Independent System Operator or PJM Interconnect are tasked with ensuring instantaneous supply meets instantaneous demand. Should the balance of electricity supply and demand ever sway one way or another, the results are seen in the form of blackouts or brownouts. Voltage fluctuations are another result of the imbalance of supply and demand on the grid at any given point in time. Should supply exceed demand on the grid, customers would be served at a much higher voltage level than they are accustomed to. This can have an extreme impact on machinery and computer systems resulting in severe losses for customers.

Next, it is imperative to understand that there is a base load demand of energy which calls for power around-the-clock. This base load demand of electricity is met by generation supply, which is fairly difficult to start up and shut down at the drop of a hat, but is also the cheapest method of generation relative to the alternatives. The United States’ base load is supplied by cheap coal and inexorable nuclear reactors as they are both comparatively inexpensive and difficult to halt once they are operational, relative to hydroelectric generators or natural gas generators. Base load generators are called upon 24/7 to keep the grid stable and provide the cheapest electric rates on a daily basis. As folks start heading to work and the grid becomes more active, additional generation is called upon to match the increasing demand for electricity. This intermediate demand (early morning through midday) is met by hydro, wind, and finally natural gas generators. As a result of natural gas being more expensive than base load coal per kWh produced, the spot market for electricity starts to climb with the increased demand for electricity. Because the natural gas generation is needed to keep the grid stable, the natural gas generators are able to set the market for the other forms of generation. While intermediate and peak load natural gas generators are online, all other forms of generation (including coal) are able to charge the same rate as the natural gas generators.

Daily Energy Demand by Type
Electricity Rates

Natural gas generation may only make up <5% of the intermediate load on a daily basis, but hydro and wind generators are able to come online at the same price as natural gas generators. On days where grid operators expend all forms of intermediate load generation, (often midday through late afternoon) they call upon peak load generators to come online and meet the instantaneous demand expectations of the grid. Peak load generators are commonly solar or additional older and less efficient natural gas generators. Because the natural gas peak load generators tend to be less efficient and require more gas to run than intermediate load generators, peak load generators come online at a premium to the end-user. This illustration helps to visually express the breakdown of base, intermediate, and peak demand and how they are met by instantaneous supply of generation to maintain stability on the grid:

Demand for natural gas increases as the day wears on, and in turn prices for natural gas increase throughout the duration of the day. Because natural gas generators are able to set the price of all other forms of generation, their expenses are reflected in electricity rates to the end-user. The grid operates in a manner similar to an auction. Operators are looking for the cheapest method of generation for consumers on a daily basis. They call upon coal and nuclear generators to first supply power to the grid, next the hydro and wind generators, and finally natural gas generators to fulfill the demands of consumers. Because some natural gas generators do not have the opportunity to come online and give power to the grid on a regular basis, they would like to take full advantage of the limited number of hours they have to earn revenue. Since electricity rates are driven by the cost of last kilowatt hour of electricity produced, natural gas generators are generally the last form of generation called upon to meet peak demands. Natural gas generators are able to set their margins to what they would like to earn for coming online, (generally earning higher margins than other forms of generation) to make up for only being called upon during intermediate and peak hours.

With the increased EPA regulations on coal-fired generators, consumers will be facing more and more upward pressure on electric rates in the near future. Less coal generation will result in a greater number of natural gas generators being called upon to meet the instantaneous demand of the grid. Another factor applying upward pressure to natural gas prices is the Federal Energy Regulatory Commission’s ruling to allow the export of liquid natural gas. The export of US natural gas will result in less supply for US consumers, and will be reflected in consumers paying higher electricity rates.

Although nearly half of all US electricity is generated from coal, it is the natural gas market that informed consumers need to watch. Electricity rates will continue to climb in the near future with the decommissioning of a greater number of coal generators and increased demand from a rebounding US economy.