Nov 26, 2008

Externalities in Energy and Credit

Why would the owner of a wind farm sell electricity to the grid at negative prices? This has been occurring with some frequency on the Texas electrical system in 2008. Partly this has to do with the isolated nature of the Texas grid and ERCOT, but the explanation also involves:

  • A producer of electricity might continue to produce & sell power at a price below his marginal cost of production (even at zero) if there are added costs of shutting the generator down and restarting it when spot rates increase again.
  • If a producer has low marginal costs and is receiving a subsidy based on production, then they may be incentivized to keep producing ever after the price becomes negative. If the producer knows that they will get a $35/MWh production tax credit then they'll keep the wind turbines running.

I wouldn't mind a few free kwh on my next electric bill, but a policy that essentially pays people to consume electricity seems a bit counterintuitive. While we can argue about the necessity of providing subsidies for renewable energy sources, this particular example highlights the unintended consequences that can result from even a well-intentioned policy.

It is somewhat reminiscent of the reaction to the Fed's commercial paper facility. Initially only the top rated A-1 paper could be purchased under the program. Of course, this resulted in A-2 issuers being at a disadvantage in the marketplace because no one wanted to buy their paper anymore, when they could get a government guarantee for a small premium. The CP facility basically crowded out other creditworthy borrowers who couldn't afford the 500bp spread.

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