In parts 1-3 of this series, we’ve looked at a great deal of factors that influence the energy bills paid by residential and C&I customers. However, we have yet to discuss the biggest influence on energy prices - the wholesale cost of energy. In this fourth installment of our series, we'll unpack how retailers navigate the volatile energy market, balancing customer needs with financial stability.

Pricing 101 Part 1

Part 2

Part 3

Factors Influencing Energy Prices

As discussed in part 1, energy prices can largely be thought of as the interaction of two markets, retail and wholesale. The energy retailer can be thought of as a market maker, acquiring energy from a variety of generators in order to provide a simple purchase experience for end consumers. 

Purchasing energy from the wholesale market is the biggest cost for energy retailers. There will be only limited room for retailers to compete on price and still make a profit. Thus, minimizing wholesale costs is vital for retailers - and for end consumers. It is not impossible for C&I customers to have access to wholesale markets through indexed products or PPAs, but these complex structures are not available to residential or smaller business customers. In this section, we will look at how wholesale prices are determined, and the ways in which retailers might be able to influence them.

Cost of Power

• Supply and Demand

As with any market, price is ultimately determined by the intersection of supply and demand. Demand is not complicated: anytime a customer uses energy. When you switch on a light, demand increases. When a factory is built, demand increases. If businesses close, demand decreases. Retailers predict demand based on historical consumption patterns and a wide number of other factors, meaning that accurate forecasting is the best weapon for lowering wholesale costs. Energy purchased at shorter settlement periods is more expensive, with peaking power the most costly. Reducing the amount of capacity purchased from these sources by maximizing forecasting accuracy and the amount of capacity bought upfront will reduce the total cost of energy, even if the final amount delivered is the same. 

As we covered in parts 2 and 3, retailers do have some options to try to reduce demand, or at least spread it out to prevent high peaks. C&I customers can be subject to load shifting and demand management, allowing retailers to take a direct role in reducing demand, but these methods are only just starting to become available for residential customers. Instead, time of use tariffs encourage users to use energy when prices are lower.

Supply is much more constrained. In a normal market, supply will respond to demand as it increases, returning price to the equilibrium. If the price of corn rose, farmers would simply plant more corn - but it takes time for corn to grow; increasing power generation capacity by building new plants is a long and expensive process. During severe weather events, wholesale energy prices can spiral to incredible levels as demand peaks; some types of power generation depend on electricity being available to begin generating, so in blackout scenarios, they aren’t even able to respond to demand. 

In the long run, generation capacity will go up or down depending on the construction or decommissioning of power plants. In the short run, weather plays a role; the increasing development of renewables means that generation costs can swing wildly if conditions are favorable or unfavorable (and weather has a big impact on demand as well). The intermittent nature of renewable energy generation will be one of the main challenges that retailers have to face in future as the energy industry transitions to net zero.

It is also worth considering geographic factors. Electricity cannot be transmitted over unlimited distances; a power plant in the UK could not feasibly supply customers in California as the cost of building transmission would be massive and losses occur during the transmission of power over long distances, even if you built enough lines. However, this does not mean local power networks must be confined to individual states or countries; in Europe, undersea cables connect the UK’s power generators to continental Europe and vice versa, allowing either side to sell or buy energy when needed. In the US, most transmission networks function across multiple states. The US grid is split into 3 separate interconnections, covering the East, West, and Texas. Still, even in these cases, power does not move easily across all regions within each interconnect. Across the continental US, there are 6 entities that manage the grids covering the US, Canada, and some of Mexico. Larger grids increase capacity, but also increase demand, so prices only fall when there is excess capacity in some regions.

• Fuel Costs

As generation capacity is fixed in the short term, the price of a unit of energy is most heavily influenced by the costs of fuel for a generator. Fossil fuels remain the most common source of power for most countries, which means the price still depends heavily on the cost of raw materials; largely coal, oil and natural gas. Nuclear does require fissile materials, but the efficiency of uranium is so high that marginal costs are inconsequential. Determinants of the cost of fuel are too big a topic to be covered in an unrelated blog post, but readers are likely aware of the global markets for oil and gas. Prices spiked in Europe due to the withdrawal of Russian gas supplies in the wake of the war in Ukraine. The US has been able to increase its supply of natural gas through fracking, keeping fuel costs down. 

The most common types of renewable energy, solar and wind, do not rely on fuel and so are not subject to the swings in price that we’ve seen recently. In fact, regions with a lot of renewable capacity are seeing the so-called “duck curve” effect, where peak periods for solar during the day result in zero or even negative marginal costs, which is posing a new set of challenges for retailers. Nonetheless, the biggest issue with renewable energy is still intermittency, preventing retailers from having access to renewable energy at all times.

• Purchase Type

Earlier, we discussed the increased cost of power purchased at short settlement periods, and it is worth separating this. Power is bought ahead of time to meet demand, at different intervals. Years ahead, retailers assess the minimum amount of power they will need to meet demand and buy what is termed “baseload” from generators. To meet actual demand, retailers then operate on a series of markets with shorter time intervals, from month-ahead to even as short as 5 minute settlement periods in some energy markets around the world. The more energy purchased in short-term markets, the higher the cost. 

Costs to Serve

Once you move past the purchase of wholesale energy, there are several fixed costs which need to be paid for to ensure that energy can be delivered.

• Transmission and distribution costs

The infrastructure of the energy grid requires constant maintenance and investment to remain effective at delivering energy, which means recovering costs from customers. As discussed in Part 1, transmission and distribution networks are monopolies; there is no room for competition to reduce prices. In telecommunications, rival companies can and have laid their own cabling in order to offer better deals to customers, but this isn’t feasible for energy. 

• Government Regulations and Taxes

Only two things are inevitable in life, and energy does not escape. Governments impose taxation upon the provision of energy as they do with any other service. In the US, there are no federal taxes on energy bills, but each state will have their own taxation, typically sales taxes, applied to bills. There may also be additional local taxes.

Regulatory charges will relate to specific policy goals, whether that be demand management, decommissioning costs, or carbon taxes. However, often the largest charges are related to the factor below.

• Environmental Policies

Subsidizing renewable energy or funding investment in more renewable generation is the most common regulatory charge applied to energy bills and can form a large part of bills if governments are particularly aggressive. For example in the UK, net zero contributions could form as much as a quarter of a household bill. It remains to be seen if US states will follow the lead of the Europeans on this however.

Future Trends in Energy Pricing

The prices paid for energy are constantly in flux, as the past few years have shown. Nonetheless, the general trend is for advances in technology to keep lowering the prices paid at wholesale and at retail.

• Impact of renewables

The transition away from carbon-intensive energy sources and towards low carbon, renewable energy will have two big impacts on energy pricing, due to unit costs and intermittency. First, the cost per unit with renewables is very low, often near zero, which can drastically lower marginal cost if conditions are right. In California, this phenomenon has given rise to the term “duck curve”, describing the graph of daily prices. During the day time when solar is at its generating peak,

However, the flip side of this is intermittency. Generation will vary constantly based on conditions, sometimes cutting out completely. As electricity storage remains immature, grids which rely heavily on renewables will need to supplement capacity with more consistent sources, which at the moment are largely natural gas based plants. This can produce wild swings in daily electricity prices in local areas.

As more is invested into battery storage and the technology advances, this problem may be mitigated, but it will likely remain a consideration for the short and medium term.

• Technological advancements

We have just addressed the importance of advances in battery technology, but this is not the only area where technology will play a role. Electrification is increasing, notably for vehicles, which will increase demand for electricity, though this will be balanced by increases in efficiency. As mentioned above, more tools for demand management, both at residential and C&I consumers, will give utilities more options to balance the grid. 

More speculatively, advances in power generation could have huge impacts on the wholesale cost of electricity. Small modular reactors (SMRs) and hydrogen have shown promise, but are still costly to deploy. The holy grail remains fusion, but it is also a technology that is perpetually “decades away”. More likely in the near future is greater use of storage technologies, opening up more low-carbon sources of energy that can be deployed across different time periods.

• Regulatory changes 

Government charges and regulation already form a chunk of every bill sent out to customers, and this is only going to become more important as more nations start to adapt their generation mix and governments look to invest in aging infrastructure.

Conclusion

That’s the end of part 4! We’ve covered the drivers of wholesale energy costs, as well as potential changes in the future that will influence the price that retailers pay. With this, you are now familiar with the basics of electricity pricing and the function of deregulated markets. The final part will examine the unique differences and challenges of the gas market - stay tuned!

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