To put it as it is, electricity as a commodity is not the easiest to understand. There are various factors that move the price of electricity. Several education-driven researches have mentioned factors such as system-wide capacity level, load level or generation outages and so on, as some factors that affect the price of electricity. For what it is, the fact that the demand and supply spectrum of electricity varies significantly from time to time (could vary significantly from one hour to the other) is one of the reasons for the complicated nature of the price structure of electricity.
However, in here, the focus will be on the fundamentals, from where other pricing models find their root. These fundamentals are factors that move the demand and supply of electricity. Before diving into discussing these factors, it’s important to set a foundation for how these things affect the price of electricity.
Speaking in economic terms, whenever demand rises to exceed supply, there is a high chance that an increase in price would follow. In addition, in an event that supply had been in excess of demand, the price of electricity is expected to be low. However, if demand rises to match supply (and not necessarily rise above it), there is also a chance that an increase in price would follow.
On the other hand, if demand had been in excess of supply, chances are the price of electricity is already high. Therefore, if supply grows to fit the demand, the prices are expected to come down. You can apply these principles to the effects that the factors below have on electricity to determine if you should expect a price increase or a decrease. However, you should note that these rules aren’t absolute. Things turn out differently in the real world.
Drivers of electric demand
According to a research funded by the European Commission titled, “COST ASSESSMENT OF SUSTAINABLE ENERGY SYSTEMS,” the assessment of the demand for electricity must factor in two aspects: Income drivers and price drivers. The report says income drivers take into account macroeconomic and demographic factors such as gross domestic product, or GDP, growth, growth in household disposable income, population growth, growth in the number of households or the living space per capita, etc. On the other hand, price drivers take into account price level for electricity and other energy sources that could substitute electricity.
How the economy drives the demand for electricity
Historically, it has been proven that economic growth is an important driver of electricity demand. While there is no one-to-one relationship between GDP growth rates and the growth rates of electricity, a correlation is visible – and it is a positive correlation. In other words, it has been found that a growth in GDP is usually accompanied by an increase in the consumption of electricity. Here is a logical explanation for that correlation.
In general, GDP growth is indicative of an increase in economic activities as well as an increase in available income. Bear in mind that GDP growth, among other things, embodies an increase in industrial output. For an increased industrial output to be achieved, more energy would be required, which most likely involved an increase in the demand for electricity.
Such correlation would be found for just about any sector you examine. And as it’s been seen over the years with the increase in the price of electricity, you can expect that an improvement in economic conditions can lead to an increase in the price of electricity. However, you should also note that a point of saturation would always be reached, when GDP growth won’t necessarily mean increased energy demand.
Peak load and seasonal variation
As you probably already know, storing electricity is still a huge challenge to the industry. In most cases, it has to be consumed as it’s produced. This is the main reason for the variation in electricity demand from time to time. And considering that we live in a world with different weather conditions, you can expect that the demand will be very high during summers. During such periods, the peak price of electricity is usually high.
In part, it’s safe to say the hotter the weather, the higher the demand for electricity, which could lead to an increase in price. The price becomes especially high when the system is unable to meet up with the demand. In addition, in a highly industrial environment, you can expect that the peak prices would be high – during the day – since the demand for electricity at such time is high.
The intensity of energy demand is another factor that contributes to the movement of the price of electricity. As a rule of the thumb, the more industrialized an economy is, the higher the energy intensity. For instance, the European economy is now tending toward being a service-intensive economy, which has seen its energy intensity drop. You can view this as a move to reduce energy consumption in Europe where electricity is expensive. By way of comparison, take a look at china, which has a more industrialized economy. Its energy intensity has been on the rise over the past several years due to the fact that it’s become more industrialized. And despite the fact that its electricity is regarded as cheap, there has been an increase in its electricity price.
Drivers of electricity supply
There are a number of factors that can affect the supply of electricity. However, here are the top two that usually affect electricity price.
This represents that biggest determinant of electricity price. For sustainability’s sake, electricity has to be sold at a price that is above the price of its generating fuel. Therefore, in general, the higher the price of the fuel – notably coal – the higher the price of electricity. So a major challenge in the electricity industry is the challenge of getting cheaper fuel to generate electricity.
According to the report from ECON referenced above, national policies play an important role in forming the electricity supply structure. With the growing awareness of global warming, governments are on the lookout for ways to reduce energy consumption. This could affect the supply of fuel such as coal, which would effectively lead to an increase in the price of electricity. Policies such as renewables portfolio standards, or RPS, can also affect the supply of electricity.
Overall, when looking to know what could move the price of electricity, it is very important to take into account the present circumstances. You have to answer questions like are fuel prices high or low? What’s the weather condition like? How industrialized is the environment? What are the governmental policies in place? These present a good starting point to predicting the direction of the price of electricity.