Integrating Energy Markets— How Substitutes, Complements are Evolving

Although representing some of the most volatile commodities traded, energy markets have maintained fairly consistent relationships ...

by Tanya Bodell, Energyzt

Although representing some of the most volatile commodities traded, energy markets have maintained fairly consistent relationships with one another, consistently serving as collaborators or competitors (in economic parlance, complementary goods or substitutes). Recent changes in regulatory policy and market conditions are now redefining many of these traditional relationships and realigning directional influences.

Substitutes to Complements

Substitutes are competing products and services that can be used in place of one another. Holding all else equal, if the price of a good increases, demand for the substitute good also increases. Natural gas and electricity have been long-standing substitute goods for end users, a rivalry that began when Thomas Edison perfected the incandescent lightbulb as a cleaner, safer alternative to gas lighting. Although electric lighting quickly trumped natural gas lamps, both energy sources have continued to serve as competing home heating and cooking sources.

Liberation of regulated energy markets prompted a new relationship between natural gas and electricity in the late 1980s. Through subsequent build out of combined cycles and combustion turbines, natural gas-fired generation in the U.S. consumed nearly one-third of total natural gas production in 2011. The power sector is the primary source of swing demand for natural gas in the short run and in most U.S. power markets serves as the most cost-effective source of long-term generation supply. Lower natural gas prices result in greater demand for natural gas-fired power generation, transforming these former substitutes into complementary goods. The long-standing relationship between power generation and load also is changing. Traditionally representing a natural hedge of long and short positions in power, generation and load officially became substitutes when allowed to compete against one another in formalized capacity markets. As new technologies and regulatory support enable demand response to expand into wholesale electricity markets, expect continuing competition between these two substitutes. Demand response, however, also might turn into a complementary good for renewable resources. As the market seeks flexible resources to integrate intermittent renewable resources into the transmission system, automated load-reduction technologies might enable renewable generation resources to integrate more cost-effectively, turning renewable generation and demand response into complementary goods.

Complements to Substitutes

Complementary goods are products or services for which an increase in demand for one good will increase demand for its complement and a decrease in demand for a good will decrease demand for its complement. The traditional economic example is peanut butter and jelly, two goods that improve the value of the other when combined.

Renewable resources and transmission are examples of complementary goods. The existing transmission system was built to deliver energy from fossil fuel power plants to load centers. Promoting significant levels of renewable resources through renewable portfolio standards required significant build out of the transmission system. Federal tax credits and subsidies reduce the price for renewable energy resources, increasing demand for renewables as well as for new transmission lines required to bring those resources to market. Failure to extend renewable energy production tax credits that expired in 2011 has impacted development of renewable resources and certain transmission projects.

Environmental policy in a different form, however, is promoting demand for transmission investment. In response to economic conditions and pending emissions standards, more than 50 GW of coal-fired generation is anticipated to retire over the next five years. As large, coal-fired power plants shut down, new transmission constraints and congested pathways likely will occur. New transmission investment, generation plant build out and commercialized energy storage solutions might compete as substitutes to adapt the existing transmission system to a new generation supply mix.

The electricity sector is transitioning in response to a new set of market fundamentals and policy decisions. Beware of old rules and embrace new ways of thinking; shifting markets create new ways to unlock value.

Author
Tanya Bodell is executive director of Energyzt, a collaboration of energy experts intent on understanding the impacts of energy integration. Reach her at 617-416-0651 or tanya.bodell@energyzt.com.

“Opposites are not contradictory but complementary.” — Niels Bohr

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