For Some, Coal Contracts are, “Heads I Win, Tails You Lose.”

, Senior Energy Analyst | October 30, 2019, 4:42 pm EST
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There is a pervasive myth in the electric sector that the owners of coal-fired power plants all sign long term contracts for coal. Once upon a time, that may have been true; but that simply isn’t the case today.

The myth continues to be perpetuated by the orthodoxy within the industry and that can lead to some perverse outcomes, including uneconomic operations of coal plants that can cost customers hundreds of millions, if not billions of dollars a year.

I’ll be presenting my latest research on coal fuel contracts and accounting practices at an annual conference of energy economists. One of my big takeaways is that these contracts are not being structured to benefit customers. Here’s a breakdown of the data.

Are long-term contracts standard practice?

Most coal plant operators are required to report some very basic details of fuel contracts to the Energy Information Agency. This includes the length of fuel contracts.

Looking over that data reveals something that might surprise many within the industry:

90% of coal (by volume) are purchased via contracts that are set to expire in 5-years or less. And over half of coal is purchased on the spot market.

Spot market purchases of coal are far more popular than multi-year contracts, particularly amongst merchant power plants that bear the full risk associated with longer-term contracts.

Note the difference between merchant generators (that are 100% reliant on wholesale markets and bi-lateral contracts for revenues) versus public power and monopoly utilities, that have captive customers who are forced to continue paying the utility company even if they make a bad decision on fuel that is uneconomic.

Merchant generators procure two-thirds of coal via the spot market and none have any contracts longer than 20-years. In contrast, public power and regulated utilities are much more likely to sign longer contracts, locking their customers into buying coal for years to come.

Even so, long term contracts should be considered the exception, not the standard.

Do long term contracts provide pricing benefits?

Counterparties of long-term fuel contracts often point to two elements of signing a long-term contract as the primary benefits: price discount and price stability. Price stability is probably a fair argument to make but does that stability maintain its virtue if it comes at a cost premium?

Luckily, monopoly utilities are required to report price and length to the EIA, so we can mine that data and look at price vs contract length.

If we benchmark coal prices to the spot market something interesting is revealed. Short-term contracts (1-10 years) are generally procured at prices reasonably similar to the spot price (with virtually no premium or discount). Mid-length contracts (11-20 years long) are procured with a slight price premium. Long-term contracts (over 21 years long) are on average procured at a slight price discount but some long-term contracts, like the contract at Dolet hills that has another 34 years attached to it, are locked in at prices over 5 times higher than spot prices. While there are examples of price discounts for the long-term contract, they are hardly a guarantee.

The most expensive contract price for coal is also one of the longest in the industry.

The current state of coal economics in power markets

So, maybe these coal contracts aren’t great, but where’s the harm?

Our energy markets are changing, and coal is having a hard time keeping up. Coal power plants are often described as “baseload” resources, the grouping of resources that are sufficiently inexpensive and efficient such that they make sense to operate around the clock over the course of the year. Coal has historically enjoyed this status as a result of the market’s failure to incorporate externalities.

In most markets today, those externalities have still not yet been internalized, but low gas prices, low demand, and increasing amounts of wind and solar entering the market have driven market prices such that large swaths of the coal fleet are no longer economic to run year-round.

Some coal plants have opted to switch to seasonal operations while others have decided to stubbornly operate year-round despite the market price signals strongly pointing to a change in operation behavior. Often, those coal plant owners will point to their contracts as the justification for them operating year-round, saying the contracts have liquidated damages clauses wherein the offtake of the coal either has to pay for the fuel regardless of whether or not it takes the fuel (so-called “take or pay”).

I’ll devote a future blog debunking the validity of that claim but for now, let’s focus on the impacts of the utilities running the coal plants year-round…

During the months when market prices are lower than the costs to burn fuel at a coal plant, the coal plant owner will often reduce the output of their coal plants but not turn them off. This still means the plant owner is opting to burn expensive coal, then sending the bill to customers.

So, when market prices are low, it is the captive customers that bear the cost. By extension, it is those same customers who bear the risk associated with future prolonged periods when the coal plants are uneconomic.

Market prices fluctuate over time making coal plants, that were previously thought of as “baseload,” uneconomic for long periods of time.

But that is only one side of the coin? What about the other times, when market prices are higher than coal plant costs, is it customers who benefit then?

Depends.

When market prices rise, utilities will ramp up the output of power plants and sell energy to the market at a profit. Those profits don’t necessarily go to the customers, they often go to investors.

Some regulators have approved “profit-sharing” mechanisms wherein utility investors have to share market profits with customers. While this is marginally better than when all the profits go to investors, but if the profit-sharing isn’t accompanied by cost-sharing (where the investors are also on the hook for market losses) then the risks are asymmetric. This would at least provide some symmetry to the risk exposure; customers cover 100% of the losses but they also benefit from 100% of any gains. But the window for that upside risk (the potential for there to be some positive benefit) is shrinking as more renewables come online and as some form of carbon regulation becomes inevitable.

So, effectively, customers get saddled with all the costs and none of the benefits.

Customers should be the priority

At present, too many electric customers in the US are burdened with all the downside and prevented from benefiting from any potential upside. What is particularly nefarious is that the downside risk is 100% avoidable, the utilities could simply not operate their uneconomic coal plants at a loss and buy lower-cost energy off the wholesale market.

By AKS.9955 – Own work,
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