TODAY’S STUDY: WIND, NATURAL GAS AND ENERGY MARKETS

Revisiting the Long-Term Hedge Value of Wind Power in an Era of Low Natural Gas Prices

Mark Bolinger, March 2013 (Lawrence Berkeley National Laboratory)

Executive Summary

Expanding production of the United States’ vast shale gas reserves in recent years has put the country on a path towards greater energy independence, enhanced economic prosperity, and (potentially) reduced emissions of greenhouse gases and other pollutants. The corresponding expansion of gas-fired generation in the power sector – driven primarily by lower natural gas prices – has also made it easier and cheaper to integrate large amounts of variable renewable generation, such as wind power, into the grid.

At the same time, however, low natural gas prices have suppressed wholesale power prices across the nation, making it harder for wind and other renewable power technologies to compete on cost alone – even despite their recent cost and performance improvements. A near-term softening in policy-driven demand from state-level renewable energy mandates, coupled with a possible phase-out of a key federal tax incentive over time, may exacerbate wind’s challenge in the coming years.

As wind power finds it more difficult to compete with gas-fired generation on the basis of nearterm cost, it will increasingly need to rely on other attributes, such as its “portfolio” or “hedge” value, as justification for inclusion in the power mix. This article investigates the degree to which wind power can still serve as a cost-effective hedge against rising natural gas prices, given the significant reduction in gas prices in recent years, coupled with expectations that prices will remain low for many years to come. It does so by drawing upon a rich sample of long-term power purchase agreements (“PPAs”) between existing wind generators and electric utilities in the U.S., and comparing the contracted prices at which utilities will be buying wind power from these existing projects for decades to come to a variety of long-term projections of the fuel costs of gas-fired generation modeled by the Energy Information Administration (“EIA”).

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The wind PPA sample – consisting of 287 contracts totaling more than 23.5 GW of operating wind capacity in the U.S. – exhibits a high degree of long-term price stability. On average and in real dollar terms, the buyers of the wind energy in the PPA sample will pay no more per MWh twenty years from now as they do today. In contrast, natural gas prices are difficult to lock in for any significant duration, making it hard to capitalize on today’s low prices. Although short-term gas price risk can be effectively hedged using conventional hedging instruments (like futures, options, and bilateral physical supply contracts), these instruments come up short when one tries to lock in prices over longer terms – e.g., greater than five or ten years. It is over these longer durations where inherently stable-priced generation sources like wind power hold a rather unique competitive advantage.

Comparing the wind PPA sample to the range of long-term gas price projections reveals that even in today’s low gas price environment, and with the promise of shale gas having driven down future gas price expectations, wind power can still provide long-term protection against many of the higher-priced natural gas scenarios contemplated by the EIA. This is particularly true among the most recent wind PPAs in the sample, which likely better represent current wind pricing, at least on a national average basis. These newer wind contracts not only provide ample long-term hedge value, but on average are also directly competitive with gas-fired generation in the near term.

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Introduction

One of the largest energy supply developments of the past decade has been the application of horizontal drilling in combination with hydraulic fracturing to unlock seemingly massive deposits of “shale gas” – natural gas that was previously considered to be trapped in shale rock formations. In the United States, where the enabling technology was developed and first applied on a large scale, the U.S. Energy Information Administration (“EIA”) estimates that shale gas accounted for 34% of total domestic natural gas production in 2011, up from 23% in 2010 and just 4% in 2005, and projects that shale gas’ share of domestic production will increase to 40% by 2018 and 50% by 2037 (EIA 2012a).

Not only has its proportional contribution increased;shale gas has also played a major role in reversing what had been a declining trend in absolute overall domestic gas production in the U.S. since 2001. After hitting a low of about 18 trillion cubic feet (“Tcf”) produced in 2005, domestic gas production increased by nearly 5 Tcfthrough 2011, led by a more than 7 Tcfincrease in shale gas production (i.e., production from non-shale resources continued to decline over this period). Looking ahead, the EIA projects that total domestic gas production will increase by another 3.6 Tcf per year by 2020, 3.2 Tcf of which will be shale gas(EIA 2012a).

One consequence of expanding domestic shale gas production is less need to import natural gas into the U.S., either from Canada or Mexico via pipeline or from other countries in the form of liquefied natural gas (“LNG”). At the same time, with the price of natural gas significantly higher in parts of Asia and Europe (where natural gas prices are more closely linked to oil prices) than it is in the U.S., opportunities to export domestic gas surplus have grown. The EIA reports that in 2011, rising exports and lower imports reduced net gas imports to 1.95 Tcf, the lowest level since 1992 (EIA 2012d), and projects that the U.S. will be a net exporter of LNG by 2016, and a net exporter of natural gas overall by 2020 (EIA 2012a).

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This “gas revolution” in the U.S. is having, and should continue to have, a profound effect on the electric power sector. With ample supply pushing natural gas prices down to historic lows – spot gas prices fell below $2/MMBtu in April 2012 – aggressive fuel switching from coal to natural gas has been occurring in the power sector. Coal-fired generation fell from 49.6% of all U.S. power generation in 2005 to 42.2% in 2011, while natural gas-fired generation grew from 18.8% to 24.8% (EIA 2012a). Additional fuel-switching occurred in 2012, with coal expected to have dropped to 38% of all electricity generation while natural gas rose to 30% (EIA 2012a). Looking ahead, the implementation of air quality regulations from the Environmental Protection Agency – principally the Mercury and Air Toxics Standards (“MATS”) and the Clean Air Interstate Rule (“CAIR”) or its successor – islikely to further benefit gas relative to coal.

The ongoing switch from coal-fired to gas-fired generation in the U.S. is, arguably, a positive development within the powersector, on several fronts. Natural gas is cleaner-burning than coal, and therefore emits fewer criteria pollutants (NOx, SOx, particulates) and greenhouse gases when combusted to generate electricity. Gas-fired generation is also more flexible than coalfired generation (in terms of its ability to ramp output up and down), which provides a number of system benefits, including greater ease in integrating variable renewable generation sources like wind and solar into the nation’s power grids. These renewable power technologies generate electricity without direct emissions and with very little water use, and help to diversify the nation’s power mix, thereby protecting against future adverse impacts (be they environmental, cost-related, and/or security-related) from any single technology or fuel.

On the other hand, the impact of shale gas development on natural gas and wholesale power prices has also made it harder for wind and solar to compete with gas-fired generation. Fuel costs make up the vast majority of the operating cost of gas-fired generation, so when fuel costs are low, so is the cost of gas-fired generation. And with gas-fired generation commonly serving as the marginal supply resource that sets the market clearing price in wholesale power markets in many parts of the country, there is a strong correlation between natural gas fuel costs and wholesale power prices in most parts of the U.S.

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As an example of the impact of low natural gas prices on the relative economics of renewable energy, at a delivered gas price of $4/MMBtu, fuel costs account for roughly 85% of the total operating cost – of around $30/MWh – of an efficient combined-cycle gas turbine (EIA 2010). While some wind power projects in the U.S. that are sited in excellent wind resource areas are already selling power to utilities at prices in the neighborhood of $30/MWh (a “post-incentive” price that reflects federal and state government incentives received), in general, $30/MWh is difficult for any type of non-gas generator to compete with.

As such, there is a risk that an acute focus on cheap natural gas in the near-term could slow or delay the transition to cleaner, more-sustainable forms of power generation, such as wind and solar, over longer terms, and that the U.S. could, as a result, end up heavily dependent on gasfired generation (Jacoby et al. 2012). This may be of particular concern at present, given that state renewables portfolio standards (“RPS”) are unlikely to drive as much demand for wind power over the next few years as they have in recent years (BNEF 2012), and as the federal production tax credit (“PTC”) for wind – which helps to make the cost of wind generation more competitive with other forms of power generation – faces serious risk of being phased out in the coming years(AWEA 2012c).

At this time when wind, solar, and other renewable generating technologies are facing reduced policy support and are having difficulty competing with gas-fired generation in the near-term on cost alone, it is useful to keep in mind other “non-cost” attributes that may help to justify the continued addition of fuel-free renewables to the power mix. In addition to the environmental benefits mentioned above, another important attribute – and the focus of this article – is the ability of wind and other fuel-free renewables to deliver a stable-priced product over very long time frames. In other words, adding wind power to a portfolio of generating assets will partially hedge or insulate that portfolio against the risk of rising fuel costs over the long term.

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This “hedge value” that wind and other fuel-free renewables provide has been studied in the past – though primarily during periods of high gas prices and high gas price volatility – using a variety of methods(Awerbuch 1993, 1994, 2003; Bachrach et al. 2003; Bolinger et al. 2006; Bolinger and Wiser 2008; Huber 2012; Humphreys and McClain 1998; Kahn and Stoft 1993; Wiser and Bolinger 2007). This article builds on the existing literature by taking a comparatively simple and empirically grounded approach to demonstrating the long-term hedge value of wind power. Specifically, it draws upon a rich sample of long-term power purchase agreements between existing wind generators and electric utilities in the United States, and compares the contracted prices at which utilities will be buying wind power from these existing projects for decades to come to a variety of long-term projections of the fuel costs of gas-fired generation. This comparison revealsthat recognizing the long-term hedge value of wind power is just as relevant today, at a time of historically low natural gas prices, as it has been in the past when gas prices have been higher.

This article proceeds as follows. Section 2 makes the case for valuing wind power as a longterm natural gas price hedge by contrasting the characteristics of a large sample of wind power purchase agreements(“PPAs”)to the shortcomings of conventional gas price hedging instruments like futures and options contracts. Although these conventional hedging instruments can be used effectively to hedge gas price risk in the near-term, they come up short when one tries to use them to lock in prices over longer terms – e.g., over the average 20-year duration of a wind PPA. Section 3 sets up an empirical comparison between wind power prices from this PPA sample and long-term natural gas price projections, in order to explore whether wind power can provide this long-term hedge in a cost-effective manner. Section 4 presentsthe comparison graphically and discusses results, and Section 5 draws conclusions.

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Conclusions

Expanding production of the United States’ vast shale gas reservesin recent years has put the country on a path towards greater energy independence, enhanced economic prosperity, and (potentially) reduced emissions of greenhouse gases and other pollutants. The corresponding expansion of gas-fired generation in the power sector – driven primarily by lower natural gas prices – has also made it easier and cheaper to integrate large amounts of variable renewable generation, such as wind power, into the grid. Opportunities abound for even greater cooperation and coordination between cheap natural gas and wind power in the years ahead (Lee et al. 2012).

At the same time, however, low natural gas prices have suppressed wholesale power prices across the nation, making it harder for wind and other renewable power technologies to compete on cost alone – even considering their recent cost and performance improvements. A near-term softening in policy-driven demand from state-level RPS policies(in large measure because wind and other renewables have, in recent years, been added at a pace that exceeds state RPS targets), coupled with a likely phase-out of the federal PTC over time, may exacerbate wind’s challenge in the coming years.

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If wind power finds it more difficult to compete with gas-fired generation on the basis of nearterm cost, it will increasingly need to rely on other attributes, such as its “portfolio” or “hedge” value, as justification for inclusion in the power mix. This article finds that wind’s hedge value is as important today as it has ever been – i.e., despite the current low gas price environment, wind power can still provide a useful hedge against rising natural gas prices, particularly over the long term.

At least from a hedging perspective, this long-term hedge value is arguably more important than whether or not wind is competitive as a natural gas fuel saver in the near term. This is because short-term gas price risk can already be effectively hedged using conventional instruments like futures, options, and bilateral physical supply contracts. It’s only when one tries to lock in prices over longer terms – e.g., greater than five or ten years – that these conventional hedging instruments come up short. It is over these longer-term durations where inherently stable-priced generation options like wind power hold a rather unique competitive advantage.

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Recent statements from two prominent buyers of wind power – the Public Service Company of Colorado (“PSCo”) and Google – highlight the importance of long-term hedge value in their purchase decisions. For example, in testifying before regulators about its recent 25-year PPA with the 200 MW Limon II wind project, PSCo noted that “Whenever wind energy is generated from the Limon II facility, it will displace fossil-fueled energy on the Public Service system, mostly energy generated from natural gas. We think of this wind contract as an alternative fuel, with known contract pricing over 25 years that will displace fuels where the pricing is not yet known. That is the essence of the fuel hedge” (Haeger 2012). PSCo also notesthe difficulties of replicating thissame degree of long-term price stability through the natural gas market: “We typically don’t have a lot of long-term natural gas contracts…especially ones that go out 25 years. So this [the Limon II wind contract] is basically providing a long-term fuel contract or energy contract at known prices” (Haeger 2011).

Google, meanwhile, has entered into long-term PPAs with at least two different wind projects, with the primary purpose of hedging the cost of electricity at its data centers. When asked about these wind PPAs, a Google official stated “We see value in getting a long-term embedded hedge. We want to lock in the current electricity price for 20 years. We are making capital investment decisions [regarding data centers] on the order of 15 to 20 years. We would like to lock in our costs over the same period. Electricity is our number one operating expense after head count.” He went on to say that Google’s interest is primarily long-term in nature: “We are less concerned about hedging our cash flows on a quarter by quarter basis. We are more concerned about the long term.” As such, even though the wind PPA prices that Google is paying are apparently above-market in today’s low wholesale power price environment, “We just want to ensure the project is there in the later years” – i.e., when wholesale power prices are less certain and therefore price protection is presumably more important (Chadbourne & Parke LLP 2011).

At least for these two prominent and very different purchasers of wind power in the U.S., longterm hedge value appearsto be an important consideration. Greater and more widespread recognition of wind’s portfolio value among other potential wind power purchasers could help the nation to move forward – even within an era of low natural gas prices, and even if the PTC is eventually phased out – with both gas-fired and renewable generation.

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