Are Long Term Electricity Prices Trending Downward?

So when it comes to the solar lease and the opportunity to switch to clean, solar power at no upfront cost and save money while protecting against rising utility costs, it turns out that locking into a fixed rate can sometimes become a barrier.

“What if electricity prices go down?”  some people ask. They are concerned that over time electricity prices might go down and they will be stuck paying higher prices.

To answer this question, I’ll go through in detail why I am confident that electricity prices are not going down–anytime soon or in the future.

Here is the basic summary:

Retail electricity costs are made up of the physical electricity (generation) and the cost to move that electricity from power plant to your home (transmission and distribution).

Generation costs are driven by natural gas prices. Electricity prices spiked in 2008 with the global economic bubble and crashed with the rest of the economy. Now we are back to the prices of the early 2000s and prices have already started ticking back up. New supplies of natural gas have kept prices low despite the economic recovery. But the price of gas is below the cost of extraction and we’ll soon be exporting gas to richer international markets driving electricity prices higher in the U.S.

Transmission and distribution costs are set by regulatory bodies and are based on giving investors a set rate of return on investment in infrastructure.  All upgrades, including recovery from storm damage, lead to rate hikes to ensure investors are able to recoup their investment. In other words, with all the work we need to do on the electric grid in the Northeast, transmission and distribution costs are not coming down.

So let’s explore this issue in more detail. First of all, let’s break down where retail electric prices come from.

Electricity Generation (sometimes simply referred to as ‘power’).
Electricity prices track closely with natural gas prices. Today natural gas for electricity generation is pretty cheap, historically speaking. Prices are about $4.50 per thousand cubic feet and have been between $3.00 and $5.50 for the past few years according to EIA data. This is a dramatic decline from the peak in 2008 of nearly $12.50 (again EIA data). And this makes sense based on the widely publicized shale gas production boom in the U.S. and lower demand due to warmer winters and the recession.

But are these low gas prices truly here for the long term? No way. Not a chance. And here’s why:

Exports: In order for natural gas producers to ship their product overseas, the gas needs to be liquefied (turned into Liquefied Natural Gas or LNG). Almost all of the gas currently pulled from the ground in the U.S. stays in North America. As reported widely including at, the U.S. government recently approved the construction of a fourth export facility, with more likely to be approved in the coming months. Once these export facilities are in place, suppliers will have access to other markets where gas prices are significantly higher. With Japan walking away from nuclear power in the wake of the Fukishima disaster, natural gas prices in Japan are 3-5 times the cost in the U.S. There are 11 LNG import facilities in the U.S., most of which we should expect to be turned into export facilities now that we are such a major producer of natural gas. So natural gas prices right now in the U.S. are artificially low because we don’t have access to higher priced markets in other parts of the world until the LNG facilities are set to export. And the U.S. manufacturers surely think that exporting LNG will raise prices. That’s why they are fighting to limit exports.
Extraction cost: Natural gas extraction in the U.S. has slowed a bit over the past 12-18 months simply because the price of gas is too low to sustain profitable extraction operations. The breakeven price is somewhere between $3-5, which means that prices need to get there over the long term. And that’s based on today’s extraction techniques. As we need to dig deeper with more highly advanced technical solutions that are more expensive, prices will have to continue to rise to make those investments worthwhile.

Other factors that could increase gas prices include potential regulation of fracking or greenhouse gas emissions, both of which would cause wholesale electric prices to rise.

So let’s summarize: The opening of new markets for U.S. natural gas equals more demand for natural gas. Simple supply and demand tell us that prices should rise. The fact that the new markets opening are already paying more for natural gas. This, coupled with the fundamental economics of extraction, increases the likelihood that gas prices will rise. Since gas prices drive electricity prices, electricity prices will rise.

Transmission and Distribution:
Nearly half of the retail cost of electricity is the cost of transmission and distribution. Transmission is the cost that electricity suppliers pay to use the transmission grid to move power from power plants to your utility company, who then distributes the electricity to your home. Distribution fees are the price you pay the utility to move the electricity through the distribution grid to your home. Transmission rates are set by the Federal Energy Regulatory Commission and distribution charges are set at the state level by utility commissions. In both cases, rates are set to provide a particular rate of return to investors who build and operate the transmission and distribution infrastructure.

Transmission and distribution rates typically do not decline because upgrades and maintenance to the infrastructure requires new investment, which in turn requires rates to increase in order for the utility to get its required rate of return on investment. These rate increases don’t happen frequently because the utilities need to go through a formal proceeding with the utility commission in order to prove the necessity of the increase. And, as expected, we are already starting to see utilities ask for rate increases to cover the unexpected storm damage of hurricanes Irene and Sandy. JCP&L in New Jersey announced theirs in February 2013Atlantic City Electric proposed a 7% rate increase in December 2012. Residents of Connecticut are likely to see rate hikes as well.

In conclusion, it is difficult to see a scenario in which retail electricity prices go down. Gas prices have to start ticking up in the next few years, which will lead to higher electricity generation costs on the wholesale market. We are already seeing trends in this direction. And transmission and distribution costs are fundamentally structured to keep costs rising over the long term as we invest in maintaining, repairing and upgrading the infrastructure.

I’m not a gambler but I’m betting on retail electric rates going up.