Renewables scored a major victory recently in the natural gas heartland that is Texas. In a resolution adopted by the Austin City Council on August 28, the city declared solar energy its default generation resource, in part noting “that solar energy represents a cost-competitive means of securing clean peak power hedging against the volatility of fuel-dependent thermal resources” such as natural gas.
Fixed-price renewables free insurance against price-volatile fossil-based power?
That same resolution improves how to calculate that hedge value in an updated methodology for Austin’s municipal utility, Austin Energy, in its value of solar tariff (VOST). The VOST was first considered in 2006 and eventually adopted in 2012.
Austin’s improved inclusion of an energy price hedge value (like the monthly premium of an insurance policy) for renewables such as solar and wind incorporates RMI’s recommendation—described in 2002’s Small is Profitable and further articulated in 2012’s Utility-Scale Wind and Natural Gas Volatility—to include such hedge value in electricity price “apples-to-apples” comparisons of price-volatile fossil-based power against fixed-priced wind and solar.
All forms of generation—fossil-fueled and renewable alike—have upfront capital costs to build generating assets, but renewables’ significant price hedge edge over fossil fuels highlights the fact that once built and operating, renewables such as wind and solar are fuel free, with essentially negligible operating costs, while central thermal generation such as natural gas power plants have significant ongoing fuel costs, which can be highly volatile. And hedging against future fuel price increases, as well as the volatility of those prices, is an important aspect of utility electricity price planning.
A 2013 report from Lawrence Berkeley National Laboratory further reinforced that perspective, noting that “…wind contracts…provide ample long-term hedge value,” and that “considering wind power as a long-term natural gas price hedge is just as relevant today—in an environment of low gas prices—as it has been in the past when gas prices have been higher and more volatile.”
Apples are not oranges
The value of locking in pricing (i.e., the premium value derived from insulating against volatility) is a real value fixed-price renewables (wind/solar) provide to utilities and their customers. The problem is that utilities aren’t normal free market businesses. They can’t cleanly monetize the value of that risk mitigation. They’re usually paid to invest in physical things, like grid equipment and generation facilities, not on how much they insulate customers from fuel price spikes. So, they have little incentive to ascribe a clear hedge value.
Yet if solar/wind long-term contracted power prices are considered on an equal basis to fluctuating natural gas power plant prices, as they often incorrectly are by utilities and their public utility commissions, that’s like a bank saying that a 5- or 7- year adjustable-rate mortgage (ARM) is the same as a 30-year fixed-rate mortgage. Many people who have suffered recent foreclosures have learned the hard way that’s not true—the ARM exposes you to potentially big spikes in your mortgage’s interest rate, which can really hit your bottom line. In the electricity world, unfortunately it’s the private citizen—utility rate-payers like you and us—again who would have to eat the negative outcome. Banks were thought too big to fail, and utilities are often too oddly incentivized to care.
Calculating the hedge value
Actually calculating the hedge value of renewables is tricky. Renewables pricing (such as is set in PPAs) have per-MWh electricity prices locked in over longer terms (e.g., 25 years), while natural gas futures curves typically only look as far out as 10 years. In addition, the hedge premiums above (or, theoretically possible, below) the futures pricing is not transparent. The hedge premium is the difference between futures and forward contract pricing, but forward contract prices are hidden in confidential contracts between natural gas providers and their large industrial customers. How do you calculate the hedge value between a known value (wind/solar) and a mostly unknown one (natural gas)?
That’s where RMI’s proposed methodology comes in. Just because exactly determining the fair value of hedged electrical pricing exactly is hard, doesn’t mean it cannot be, at least minimally, determined. Austin’s updated VOST—to its credit—now does. It utilizes RMI’s 2012 white paper recommendation to add the actually purchased natural gas hedge contract costs to a transparent-basis for the natural gas price. For Austin, the transparent price of natural gas is the 10-year NYMEX futures curve for natural gas trading and a best-fit extrapolation of that curve for years 11 to 25. This valuing of hedged energy costs is admittedly an undervaluing. Utilities only buy natural gas hedge contracts a few years out and not over the next 25 years (again, they’re not incentivized to protect the customer long-term), but it’s certainly more than the standard hedge value awarded of $0.
Being transparent about value
Ascribing a tangible and transparently-determined value to renewable’s energy pricing is a big deal, not just for RMI seeing its recommendations validated with real-world application, but for the larger evolution of awarding fair value to distributed energy solutions. Austin’s updated VOST at last takes this into account, and attempts to quantify it with hard numbers. But there’s still a long road to go standardizing hedge calculation methodology, or even simply recognizing that such value should be attributed to renewables in utility rate and tariff making in more markets.
Dan Seif (firstname.lastname@example.org) is a senior consultant at The Butler Firm, PLLC, specializing in renewable energy finance and markets, and a former principal in RMI’s electricity practice.
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