Understanding Spark Spread: A Beginner's Guide to Power Plant Profitability
Power plant owners and energy traders use different metrics to measure the profitability of their assets. One such metric is called spark spread, which is the product of the price of natural gas and the heat rate of a natural gas power plant subtracted from the wholesale market price of electricity. The way spark spread is calculated is key to understanding spark spread and its importance in energy markets. In this blog post, we’ll explore spark spread, factors affecting spark spread, the impact of spark spread on energy markets, how heat rate is used to calculate spark spread, and how spark spread is being impacted by renewable energy.
What is Spark Spread?
Asset profitability is important in any sector, including for electricity generation power plant owners. The spark spread is the difference between the wholesale market price of electricity and the cost of producing electricity using natural gas. Spark spread can be positive or negative. A positive spark spread means that the power plant is profitable or in the black. A negative spark spread indicates the power plant isn’t profitable or is taking a loss.
Understanding spark spread comes down to profitability. If the goal is to have profitable electricity-generating assets, a positive spark spread is desirable. If the spark spread is negative, the assets are either not profitable or taking a loss. A negative spark spread may be a signal to the power plant owner to decrease electricity generation or not produce electricity at all.
How to Calculate Spark Spread
To calculate the profitability of a natural gas power plant, or spark spread, subtract the product of the price of natural gas and the heat rate from the wholesale market price of electricity. Spark Spread = Electricity Price ($/MWh) - [Natural Gas Price ($/MMBtu) * Heat Rate (MMBtu/MWh)]. MWh is megawatt-hour and MMBtu is a million British thermal units.
Another way to think about spark spread is it’s the difference between the input fuel (natural gas) cost and the wholesale price of electricity or the output. Daily spot prices are used to calculate the price of natural gas and electricity at various liquid trading hubs, which are then fed into the spark spread equation.
Using Heat Rate to Understand Spark Spread
The heat rate is the amount of fuel used by a power plant to generate one kilowatt-hour (kWh) of electricity. Heat rates are measured in British Thermal Units (Btu) per net kWh of electricity generated. Net generation is the amount of electricity a power plant supplies to the transmission line network that’s connected to the power plant. Power plant efficiency is calculated by dividing the Btu content of a kWh of electricity (3,412 Btu/kWh) by the heat rate. For example, a power plant with a heat rate of 9,500 Btu has an efficiency of 36% (3,412 BTU/kWh / 7,500 Btu).
Spark spread equals the wholesale market price of electricity minus the product of the cost of natural gas and the heat rate of a power plant. For example, let’s assume the wholesale market price of electricity is $25 per megawatt-hour (MWh), the price of natural gas is $2 per million-BTU (MMBtu), and the heat rate is 10,000 Btu/kWh. The spark spread in this example would be $5 per MWh ($25 - ($2 * (10,000 Btu/kWh / 1,000 kWh/MWh))).
Factors Affecting Spark Spread
Natural gas is the underlying fuel source in calculating the spark spread so factors impacting the price of natural gas impact the spark spread. Natural gas prices, electricity demand, power plant efficiency, environmental regulations, weather, technology improvements, and geopolitical events can all be factors affecting spark spread.
The price of natural gas can be correlated to electricity demand, weather, and geopolitical events. If electricity demand increases, the demand for natural gas can increase, which in turn increases the price of natural gas. Similarly, weather (cold or hot) can increase or decrease the amount of natural gas used to power natural gas plants. Environmental regulations like greenhouse gas emissions reduction or carbon dioxide emitted into the atmosphere play a role in how much natural gas can be used to generate electricity. Lastly, geopolitical events that negatively impact the availability of natural gas supply can increase natural gas prices.
Understanding Spark Spread in Different Regions
The region where the natural gas power plant is located impacts its spark spread. Regions with a high penetration of natural gas power plants tend to have a greater correlation between natural gas and electricity prices. This makes intuitive sense because natural gas prices are used to determine the spark spread.
Regions like the Northeast, the West, and the South tend to have higher spark spreads as more natural gas is used for power generation which increases the demand for natural gas. The Midwest and the Southwest tend to have lower spark spreads for different reasons. Coal is an abundant and cheaper power generation fuel source compared to natural gas in the Midwest, decreasing demand for natural gas. The Southwest has an abundance of natural gas in conjunction with lower electricity demand which puts downward pressure on natural gas prices.
Impact of Renewable Energy on Spark Spread
Policies incentivizing renewable energy usage can put downward pressure on natural gas usage in power markets. Decreased usage of natural gas tends to reduce the demand for natural gas which in turn decreases the spark spread. Separately, policies focused on greenhouse gas reduction or coal usage may increase the demand for natural gas power plants to fill the hole left by coal plants retiring from the electricity grid.
Renewable energy penetration can also reduce the need for natural gas plants to offer their electricity to the market. A decrease in natural gas power plant demand, driven by the increased usage of renewable energy, can reduce the price of electricity. As renewable resource market share increases, it’s possible spark spreads become less relevant as natural gas is driven off the system.
Conclusion
Power plant owners and energy traders know how important understanding spark spread is and its impact on power plant profitability. Natural gas prices, electricity demand, power plant efficiency, environmental regulations, weather, technology improvements, and geopolitical events can all play a role in the spark spread. The heat rate is a metric multiplied by the natural gas price and subtracted by the wholesale electricity price to determine the spark spread. Different regions in the US have varying spark spreads primarily driven by the amount of natural gas available for power generation. It’ll be interesting to see how the profileratiion of renewable energy on the electricity grid impacts spark spreads over time.
