Which Holds the Real Price Advantage?
Mark C. Beyer is chief economist of the New Jersey Board of Public Utilities. This article expresses his views and not necessarily those of the New Jersey BPU, its commissioners, or its staff.
On an average cost basis, natural gas currently holds the price advantage in hot water and space heating markets. However, on a marginal cost basis, electricity may present price challenges to drive consumer choice away from natural gas if real-time pricing, thermal storage and digital control options are made available to consumers.
Average Cost Pricing
The price of natural gas based on average costs is currently considerably lower than the price of electricity based on average costs; however, the marginal cost of natural gas may be considerably higher than the marginal cost of electricity.
The price, or average cost, of electricity or gas service is normally expressed per unit of output. This is obtained by dividing the cost of service, including fuel, appropriate operating expenses, depreciation and taxes plus a fair return on invested capital, by the output, expressed in terms of kilowatt hours for electricity or therms for natural gas.
This type of pricing is referred to as average cost pricing. It is contrasted with marginal cost pricing, which is the change in total costs that results from the addition of one unit to total output.
Marginal Cost Pricing
The marginal cost of electricity is the fuel cost to produce an additional kilowatt hour of power associated with the last generating unit dispatched, which varies by time of day and from day to day, depending on demand and available production resources.
With the increasing production of electricity from solar and wind, which have no variable costs, the marginal cost of power could be zero or very low. It could even be negative at certain times of the day or night if we factor in the production tax credit applicable to wind resources.
The marginal cost of natural gas is the commodity cost of the gas that is determined by supply and demand in the relevant market areas. Although the price of gas varies depending on such factors as the weather and location, the price of natural gas is largely fixed at any given time.
Electricity versus Gas
The price of electricity per Btu based on average costs is usually much more expensive than the price of natural gas. This relationship is true whether natural gas is priced based on average costs or marginal costs, as the marginal cost of gas normally does not fluctuate much over short time intervals.
However, the price of electricity per Btu based on marginal costs may be considerably lower than the price of natural gas when the electric grid is being primarily supplied by wind and solar, whose marginal costs are zero. In this situation, electricity may have a significant price advantage over natural gas.
See Figure 1.
Subsidies in the form of investment and production tax credits and renewable energy credits are likely to accelerate the construction of zero or very low marginal cost generation as renewable resources achieve grid parity in more locations. Improvements in wind and solar technology will also play a role.
Real Time Pricing and Digital Controls
Advanced metering, which is currently being installed by many electric utilities, makes real time pricing of electricity likely. Real time pricing means that electricity is priced based on its marginal cost of production at the time it is consumed.
With advanced metering and real-time pricing, the price of electricity to the consumer may be zero, extremely low or negative at certain times of the day. Consumers would be motivated to heat water during times of low cost electricity and rely on thermal storage during times of high cost electricity.
Storage for hot water and space heating would allow the consumer to capture the benefits of the large price differential that exists in electricity markets. That is because zero or very low marginal cost electricity sets the market clearing prices during certain hours of the day. In addition, thermal storage is a much lower cost approach to solve issues caused by solar and wind resource variability than is battery storage.
Digital controls with real time pricing enable load shifting from high cost on-peak hours to low cost off-peak hours, which makes consumer cost savings possible if rates are properly structured. This is an example of the application of the Internet of Things.
Thermal storage could be fueled with either electricity or gas. That would allow hot water and space heating normally provided by gas in markets where the fuel is available to be replaced by electricity during hours when electricity is cheaper than gas. Demand for electricity and gas likely would become more price elastic in such situations.
There may come a time when low marginal cost electricity would obviate the need for installing natural gas service at some locations, especially in new construction. Such slowed growth could have negative implications for the valuation of natural gas distribution utilities.
Environmental and Economic Impacts
The environment benefits from a preference for electricity because the low or negative marginal cost electricity often is produced by zero carbon resources such as solar and wind. They would displace higher carbon content natural gas. Pricing that recognizes the extremely low or even negative price of electricity at certain times increases economic efficiency and maximizes the return on investment in advanced metering.
This approach represents efficient demand-side management because it employs the price mechanism to shift demand for electricity to hours of excess energy supply.
Real time pricing made possible by advanced metering technology assures that consumers can react to changing prices. They can optimize the allocation of scarce resources in an economically efficient and environmentally beneficial manner.
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