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Natural Gas Prices and Coal Displacement: Evidence from Electricity Markets

by Fiona Paine on Thursday October 15, 2015

A recent CEEPR working paper uses data from the U.S. Environmental Protection Agency (EPA) and Energy Information Administration (EIA) along with market models to provide an in depth look at the environmental and operational effects of fuel price changes on electricity generators. Plant decisions made in the short-term to switch from coal-to-natural gas due to relative price fluctuations are analyzed across different electricity markets and ownership systems. The research was conducted by CEEPR Director Christopher Knittel of the MIT Sloan School of Management, Konstantinos Metaxoglou of Carleton University, and Andre Trindade of the Getulio Vargas Foundation.

In recent years, there has been a glut of natural gas in the US due to the proliferation of fracking technology. At the same time, international coal demand has grown while U.S. coal production has declined. Coal is a heterogeneous product, with geographical variations in price because of delivery costs. Natural gas, however, is a homogeneous product that is delivered to customers through a national infrastructure of pipelines. The result has been a rise in the price of coal relative to natural gas and thus a shift in the generation landscape. The use of coal for electricity generation in the U.S. dropped from 51% in 2003 to 37% in 2012, while natural gas usage increased over the same time period from 17% to 30%.

A key outcome of the paper was to show how generators’ response to changing coal prices depend on market structure and ownership type. More specifically, investor-owned utilities (IOUs) operating in traditional electricity markets elicited a greater response to fuel prices than both IOUs and independent power producers (IPPs) operating in restructured markets.

As the authors highlight, generators in restructured markets have less incentive to invest in natural gas capacity, limiting their ability to respond to changes in the prices of the two fuels. Using a difference-in-differences analysis, the paper shows that entities effectively reduced their investment rates after restructuring. Several characteristics of restructured electricity markets, such as increased price volatility in wholesale spot trading and the lack of long-term contracts, may contribute to the reduced investment. At the same time, traditional markets may also simply display excessive investment compared with restructured markets because of the Averch-Johnson effect, pursuant to which regulated companies engage in excessive amounts of capital accumulation to expand profit volumes.

 

Looking at the firm level, the paper addresses variation in generator efficiencies. Lower heat rates allow for a larger response to natural gas prices because there is a better chance of a generator becoming infra-marginal, all else being equal. Heat rates are, on average, lower and thus more efficient in traditional markets. On the environmental front, finally, burning natural gas is a cleaner choice than coal: Natural gas emits lower levels of almost all pollutants including CO2 per unit of heat produced. According to the authors, a 70% drop in natural gas prices between June 2008 and January 2012 contributed to a 33% reduction in CO2 emission in traditional markets and 19% reduction in emissions for restructured markets. 

As we learn more about the effects of recent shifts in coal and natural gas prices in relation to market and ownership types, we can broaden our understanding of the electricity landscape. It will be interesting to see how these changes in behavior will be translated to the long term.

Christopher R. Knittel, Konstantinos Metaxoglou, and Andre Trindade (2015), “Natural Gas Prices and Coal Displacement: Evidence from Electricity Markets.” CEEPR WP-2015-013, MIT, October 2015.