Monday, January 27, :34 PM ET Gas reliance under renewed scrutiny after epic power price spikes

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1 Monday, January 27, :34 PM ET Gas reliance under renewed scrutiny after epic power price spikes By Everett Wheeler and Peter Marrin Favored for its relatively low price and economic benefits, natural gas has continued to cut into the market share of U.S. power generation, especially in the East; however, record electricity price spikes so far in January have shown chinks in the armor and could have regulators rushing to repair their vision of a supposed cheaper, greener grid. Power prices have experienced a stretch of generally low value in recent years, giving regulators little pause over stricter environmental standards that will force a lot of coal generation offline and giving market players in most parts of the country little concern over an increasing dependence on seemingly abundant natural gas to fuel power generation. However, the bouts of epic cold experienced so far in January might give regulators and market players alike a reason to rethink the future of power generation in the U.S. as most spot markets across the Northeast reached highs never before seen in more than 12 years of SNL record-keeping. "We do not believe the latest gas price spikes are an aberration, rather they are in part the realization of a deficient energy policy, where a 'log jam' of disparate interests have increasingly pointed to each other as to who is responsible," UBS analyst Julien Dumoulin-Smith said in a Jan. 27 note to clients. "While progress on increased gas-electric coordination has been slow, we see the latest wild oscillations as driving need to coordinate improved scheduling of when gas and power resources are committed." In New England, spot power prices at the Mass hub for Jan. 23 reached $395/MWh, while New York Zone J spot prices for Jan. 24 cruised to a new all-time high of $426.75/MWh. In PJM, Western hub prices for Jan. 22 were pegged as high as $442/MWh. According to data from SNL Energy, natural gas as a fuel for power generation has taken on increased importance in recent years, accounting for more than 40% of total winter power capacity in New England and New York. Source: SNL Financial Page 1 of 6

2 In New England, natural gas-fired generation accounts for 15,843 MW, or 43%, of the region's 36,839 MW of winter capacity. In New York, gas-fired plants account for 21,895 MW, or almost 53%, of New York's 41,538 MW of total winter capacity. And in PJM, gas accounts for 61,566 MW, or about 30%, of the region's 202,630 MW of total winter capacity, still short of the 77,461 MW, or 38%, held by coal but with hefty retirements on the horizon. However, the increased dependence has come with a cost, quite literally, as natural gas prices have exhibited increased volatility in recent years especially in In New England, the widely watched Algonquin Citygate broke into the triple digits in late November 2013 and reached an index of $32.25/MMBtu by gas day Dec. 16, By Jan. 23, the hub reached an index of $77.595/MMBtu, its highest ever recorded in 12 years of record-keeping. In New York, new pipeline transmission capacity was thought to have alleviated a lot of bottlenecking and price spikes at Transco Zone 6 New York leading into the winter. Leading up to 2014, the hub only broke into the double digits once on Dec. 12, 2013; however, the new year brought big changes, with Transco Zone 6 NY averaging above $10/MMBtu more often than not so far in January, which included an all-time high index of $120.75/MMBtu for Jan. 22, almost double its previous all-time high. Even the typically more subdued markets have sprung to action in January. Despite its close proximity to the Marcellus Shale, Tetco-M3 sprang to a high of $91.673/MMBtu on Jan. 23, more than double its previous high recorded almost 10 years ago, while in the Midwest, Chicago Citygate ran to as high as $12.801/MMBtu on Jan. 6, its highest point in five and a half years. Source: SNL Financial Page 2 of 6

3 Natural gas prices have been especially volatile given a tightening in pipeline capacity. SNL Energy pipeline data shows natural gas deliveries so far in the winter of have rocketed within the heavy demand zones, well above previous winters. The pipeline congestion and subsequent price spikes are especially troubling for power generation because most power plants receive the gas to run their plants just in time through interruptible contracts that are bumped when the demand to heat homes and businesses, which hold firm contracts, is so high there is no spare capacity left on the pipelines. In such instances, plants are forced to shut when they are needed most, all for lack of adequate fuel. Regional real-time markets most vulnerable to gas supply tightness During the extreme "polar vortex" cold snap in early January, forced outages in PJM approached 40,000 MW, or 20% of PJM's total generating capacity, with up to one-third of the outages in PJM due to lack of gas delivery capability to generators that rely on interruptible capacity. MISO lost 28,736 MW, or 22% of its total generation. High demand and unit outages posed problems again during a cold snap through Jan. 24, but unlike the first round of cold, SNL pricing data shows the latest Source: SNL Financial Page 3 of 6

4 bout of arctic air was especially problematic for the eastern parts of PJM, where a large amount of outages occurred. A representative with PJM Interconnection LLC declined to offer specific outage information for the latest cold snap, but the grid operator did stress the need for conservation in the eastern reaches of the PJM grid, a call that was prompted by "continuing frigid weather increasing the demand for electricity and placing stress on generating resources." "The prolonged, extremely cold weather is causing high demand for electricity. As a result, PJM and its members are managing a very tight power supply. The prolonged cold requires some generating units to operate more often and for more hours than normal. It also stresses generator components. Any resulting unplanned shutdowns can further tighten power supplies," the Jan. 23 statement read. A representative from PJM would not comment on specific plant outages but did note the heavy reliance on gas-fired generation in the eastern reaches of PJM, a dependence that was highlighted by the loss of both Calvert Cliffs nuclear reactors on Jan. 21. The plant is owned jointly by Exelon Corp. and EDF Group. Data from SNL Energy shows that during both cold snaps, real-time prices reacted with extreme spikes up to and above, when accounting for congestion costs and ancillary services the $1,800/MWh price cap. During shortages in PJM, the energy component of the locational marginal price, or LMP, is capped at $1,000/MWh plus twice the reserves penalty factor of $400/MWh. On Jan. 7, amid record demand and unprecedented systemwide outages, almost every one of PJM's 20 zones from ComEd near Chicago to the Pepco zone serving Maryland approached the price cap. However, the reaction of the PJM real-time markets during another cold snap a few weeks later on Jan. 22 presented some unique differences from the Jan. 7 price spike. For one, prices on Jan. 22 did not reach quite as high and, more importantly, the price reaction was far more regional. The BGE and Pepco zones, both serving the Maryland area, saw prices once again hit the peak above $1,800/MWh. In direct contrast, at the same time, prices at ComEd on the far western reaches of the grid were below $200/MWh. Source: SNL Financial Page 4 of 6

5 The importance of price spikes According to a recent report from ICF International, the failure of nearly 40 GW of PJM generation capacity on Jan. 8 highlights the need to provide more incentives for performance generally and especially during the winter. "Up to 88 percent of forced outage capacity is from oil- and gas-fired generation e.g., diesels, combustion turbines, steam/fossil (which can be coal or oil and natural gas), and combined cycles. This highlights the need for weatherization and other steps to provide for generation availability and appropriate fuel supply during extreme cold events," the report said. Incentives such as high hourly energy prices and other market rules should be re-evaluated to ensure they are appropriate to meet the needs of the grid during times of high demand and forced outages, ICF said. "U.S. policy on price spikes is very diverse and it is very unlikely that all of the prevailing approaches are appropriate. Rather, it is indicative of the need for greater attention to this critical tool for providing incentives for actual operation during critical periods." Price caps during shortage events range from a $5,000/MWh level in ERCOT to a $1,000/MWh level in New England and New York. "Price spikes allow the market to efficiently send signals that resources are needed," ICF noted. "Price caps are being raised in some markets, but in light of the critical need to ensure public health and safety, more attention is required on the impacts of energy market price caps on reliability. Thus, while some steps will alleviate the price increases (e.g., firm fuel supply and changes in the resource mix that favor availability year round as opposed to summer only), others may raise prices (e.g. raising the price cap during shortage events to ensure that power plants have the appropriate incentive to be available when needed, regardless of season and hour of the day). However, these changes are needed to prevent worse reliability problems during the next cold snap." Dumoulin-Smith said with gas prices hitting historic highs, price caps of $1,000/MWh warrant re-evaluation as the "marginal" cost of dispatching gas peaking plants appears to be "uneconomic" within the context of these price caps. "Using the cleared price of gas of ~$125/MMBtu in recent days would suggest even a 9,000btu/KWh (standard) peaking facility would bid in their marginal costs at $1,125/MWh (not to mention the higher cost of other marginal peaking facilities)," he said. Both PJM and NYISO have filed to amend their tariffs to reflect this higher cost of gas in their markets. Dumoulin-Smith said the need for tariff revisions is particularly relevant in the context of a wave of pending coal-to-gas conversions, which typically result in very inefficient conversion of gas into power, with heat rates typically in the 12,000-13,000 range. Iffy gas fuel procurement reopens door for coal According to Laura Sheehan, senior vice president at the American Coalition for Clean Coal Electricity, PJM power suppliers asking regulators to lift the Source: SNL Financial Page 5 of 6

6 power price cap because of the high cost of gas "is proof positive of the challenges our nation's electric grid faces should the current Administration and environmental activists achieve their goal of shutting down clean coal plants in the United States." "Unfortunately, because of an overreliance on natural gas in some areas of the country, many Americans will see a price spike in their heating bills this winter. And this is a result of just one cold snap. The implications of an entire winter season with reduced coal-fired power, or none at all, would bring serious economic harm to families and companies across the country," Sheehan said. Coal-fired generation during cold snaps offers particular advantages to natural gas, which is a just-in-time fuel that has been known to have deliverability issues. "First, utilities have been holding large stockpiles of coal on site for the last couple of years and are starting to draw them down, so that might mitigate and any delivery issues that could have arisen," Paul Georgia, chief economist at National Mining Association said in a recent . "Second, coal is sold on long term contracts and rarely purchased on the spot market, so delivery problems might push the price of electricity up, but have little effect on what utilities are actually paying for coal." But the increased use of gas for power generation, most often at the expense of coal generation, goes beyond economics and could pose a question of reliability. According to ICF, the EPA's Mercury and Air Toxics Standards rule and other environmental regulations have put 15,000 MW in the retirement queue in PJM. "This large and growing amount of coal plant retirements will further increase the reliance on natural gas and oil units, and this coal generation capacity will likely not be available for the next polar vortex," ICF said. "There is little doubt that if these retirements had all already occurred without other offsetting changes such as lower forced outage rates at oil and natural gas and other plants, and the construction of alternative resources, the results would have been more dire. Rather than PJM instituting voltage reductions, there would likely have been rolling blackouts threatening space heating, and hence, public health and safety," the ICF report said. And just like the recent price spikes, the reliability risks can be very region-specific, with the PJM East region looking to hefty retirements. In addition to the EPA's MATS regulations slated to go into effect in 2015, the New Jersey High Electric Demand Day, or HEDD, rules could down a lot of oil-fired generation, putting increased dependence on gas-fired power supply. In addition, in Maryland and Pennsylvania, new laws targeting nitrous oxide emissions could "drive a 'second wave' of coal retirements in ," Dumoulin-Smith said. Market prices and included industry data are current as of the time of publication and are subject to change. For more detailed market data, including SNL power and natural gas index prices, visit our SNL Commodities pages. Forward prices are provided by OTC Global Holdings. For natural gas pipeline flow data, visit our Operational Capacity page. Source: SNL Financial Page 6 of 6