Streetwise Professor

February 18, 2021

How Low Can Prices Go, and Why?

Filed under: Climate Change,Economics,Energy,Politics,Regulation — cpirrong @ 6:04 pm

A quick follow up to the previous post.

I noted that negative prices have been a thing in Texas for years. Indeed they are in every market with substantial renewables penetration.

This is particularly true in the US, where the Production Tax Credit pays qualifying renewables facilities $23/MWh to produce, regardless of prices. Meaning that a recipient of the PTC will continue to produce even if prices are -$22.99/MWh.

So why do prices go negative? In particular, why do other producers who do not get the credit continue to produce even when there are negative prices? Why don’t enough of them cut output to make sure that prices don’t fall below variable cost?

The answer in a word is: indivisibilities. Or, if you prefer, non-convexities.

Specifically, many thermal generators incur costs to shut down or start up. These are basically fixed costs, of the avoidable variety. A unit currently operating can avoid shutdown costs by continuing to operate. A unit currently idle can avoid startup costs by remaining idle. Minimum run times and ramping constraints are other examples of non-convexities.

So, for example, when demand is low and wind turbines continue to blend birds (and generate electricity), prices can go negative but a gas or coal or nuke plant may continue to operate (and incur fuel costs as well as incremental O&M) because it is cheaper to PAY to sell output (and pay variable costs as well) than it is to shut down.

If the cost of adjusting output of a plant to or from zero was zero, whenever prices fall below marginal operating cost the plant would shut down. This would put a floor on prices equal to marginal cost. However, if there is a fixed cost of adjusting output to or from zero, it can make sense to continue to operate even when prices do not cover variable costs–and when prices are negative–in order to avoid paying this cost of shutting down (and/or the cost of starting back up again when prices are higher).

Generation technology is such that efficient baseload plants (i.e., units with lower per MW variable costs) tend to have higher shutdown and startup costs, and more acute operating constraints that give rise to other forms of non-convexity. As in all things in life, there tends to be a trade-off: low variable costs must be traded off against higher avoidable costs/less flexibility to adjust output. Thus, negative prices hit such units especially hard. They are faced with the bleak choice between paying to sell what they produce, or paying a cost to avoid producing. Obviously this choice is bleaker, the costlier it is to avoid producing. For many, the cost of shutting down is big enough that they continue to spin even when prices are negative.

Economists have long known that non-convexities can interfere with the operation of a price system. If you look at classic Arrow-Debreu proofs of the welfare theorems (i.e., that competitive prices call for the efficient level of production and consumption), you’ll see that they assume that production technologies are convex. That is, they assume away things like shutdown and startup costs. When production technologies are characterized by non-convexities (e.g., fixed avoidable costs), the proofs don’t go through.

Indeed, an equilibrium in prices and output may not exist if indivisibility problems are sufficiently severe: in my earliest academic life, my work on applying core theory focused on this issue. If an equilibrium does exist, it may be inefficient.

Put simply, the invisible hand can get really shaky if indivisibility problems are severe.

Liberalized electricity markets (e.g., PJM and other ISOs) have devised various means of addressing these indivisibilities. The results are not first best, but the mechanisms allow an energy market with prices approximately equal to marginal cost to survive.

The subsidization of wind, especially through the PTC, greatly exacerbates indivisibility/non-convexity problems because its effects fall with particular force on generating units with more pronounced indivisibilities. These tend to be the most efficient, and also the ones most essential for maintaining reliable system operation.

This means that although renewables subsidies punish investment in thermal generation generally, they punish investment in units that operate nearly continuously at low cost with particular severity. Having these units available nearly 24/7/365 is vital for keeping electricity prices low, and for ensuring a highly reliable power system.

So the distortions caused by renewables subsidies, particularly of the pay-to-produce variety, are more severe than “we have too much renewables capacity and too little thermal capacity.” Yes, that’s a problem, but the distorted price signals also distort the types of generation invested in. In particularly, they are particularly punitive to generation with more acute indivisibilities. Since these also tend to be low operating cost, high reliability technologies, that is a very costly distortion indeed.

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  1. Are the windmills mature enough so we phase out their subsidies ? Or do we keep in place the existing loophole and build MORE ?
    Now everyone can understand the structural culprit of the most recent winter blackout, well beneath the Texas ERCOT: Windmills federal tax credit, “exacerbates indivisibility/non-convexity problems” in the market.

    The other point is the dispatch, actual wind model vs realized. Forecasting the wind available for generation is the widow maker.

    In markets such Texas with an high-level of renewables penetrability, we are reaching a point of non-return, a boiling point towards the total collapse of the system.

    Comment by ex UH student — February 18, 2021 @ 7:55 pm

  2. Thanks for the article! Did you hear about recent democratic bill in congress, which would prohibit twice impeached presidents from having any federal buildings named after them and being buried in Arlington? It’s incredible how hateful and ridiculous some democrats are!

    Comment by mmt — February 19, 2021 @ 4:19 am

  3. I don’t know about the US, but in large parts of Europe you also need to take into account the effect of combined heating plants. As they have to fulfill their delivery obligations on heat supply (in Hamburg or Berlin, for example, district heating is a big thing) they are “must run”-plants. Depending on the technical specifications they cannot simply stop to produce power, so their power output has to be sold at literally any price.

    Besides, there are also some subsidies on power produced in these combined heat plants (policy makers deem them environmentally friendly because of the higher overall efficiency). In these cases, even if some of the power output could be cut, they would again produce power until power prices go below “minus subsidy”.

    Comment by EB — February 19, 2021 @ 5:26 am

  4. I’m puzzled: the problems you describe cannot have been a surprise. They must have been predicted beforehand. So how did such economically suicidal laws get passed? Did everyone concerned make a conscious decision to Think Like A Californian?

    Comment by dearieme — February 19, 2021 @ 1:38 pm

  5. Yet another fascinating economic post! I swear, I’m gonna show up at UH with a limitless supply of Scotch and tuition money to get a better understanding of economics.

    Comment by The Pilot — February 19, 2021 @ 9:20 pm

  6. Surely there is a way to pay off the windmill owners such that negative prices are avoided. Or are negotiating costs is this identification fervor environment to high? Surely other places around the world have dealt better with this issue.

    Comment by Lee Benham — February 21, 2021 @ 12:33 pm

  7. @Lee–Yes. Dr. Coase, call your office! There is a bargain to be structured that makes the pie bigger, and can therefore support a bribe of the wind producers. The question is whether there will be political entrepreneurs who can structure that bargain–and get it passed.

    Comment by cpirrong — February 21, 2021 @ 5:25 pm

  8. Craig: Thanks for this insightful analysis. Do you have any ballpark estimates of the elasticity of the indivisibility/non-convexity problem wrt subsidies of renewables?

    Comment by Phil Rothman — February 21, 2021 @ 9:43 pm

  9. @The Pilot. Thanks. I’d look forward to having you as a student . . . especially if you are bring the Scotch!

    Comment by cpirrong — February 22, 2021 @ 3:28 pm

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