The Adequacy and Cost of Natural Gas Capacity Serving the New York and New Jersey Energy Market

The Adequacy and Cost of Natural Gas Capacity Serving the New York and New Jersey Energy Market Lessons from the Polar Vortex Winter of 2013/2014 Prepared for Port Ambrose LNG Prepared by ICF International 9300 Lee Highway Fairfax, VA 22031 1331 Lamar, Suite 660 Houston, TX 77010 July 2014 June 2014

Introduction and Summary The winter of 2014 Polar Vortex events severely tested eastern U.S. natural gas and power grids, and the organizations that operate them. Although both industries ultimately met their service obligations as planned, these events revealed vulnerabilities in the adequacy and costs of energy supply in many regions of the country when cold weather hits. The Northeast U.S., and the New York City - New Jersey ( NY/NJ ) market in particular, experienced some of the tightest demand and supply conditions, with regional electric grids pushed to capacity limits, and natural gas prices that soared to record highs. Conditions such as these highlight the increasing integration between natural gas and power and can serve as a warning that merits attention. Sponsors of Port Ambrose LNG believe that their project provides a valuable option for NY/NJ natural gas capacity requirements and to that end commissioned ICF International to prepare an independent whitepaper assessing the NY/NJ natural gas and power grids and the implications of high gas prices witnessed during the Polar Vortex. The objective of our report is to present clear context and insights on nuanced and sometimes complex subjects in a straightforward manner that supports stakeholder decision-making. We focused on the combined NY/NJ market because the wholesale natural gas and power grids serving the two areas are closely linked to each other. Natural gas prices are increasingly important to the regions residents because they not only determine the cost of heating homes and businesses, but also because they set the price of electricity for millions of consumers. Our objective in this report is to provide information that will inform stakeholder decisions regarding energy policy, permitting and the need for new natural gas supply infrastructure. The views expressed in this report draw on decades of ICF s independent energy market research and our understanding of the implications for future energy infrastructure and costs. As we discuss in the report sections below, our analysis finds that the cold weather conditions experienced this winter across many parts of the market were severe, but not so severe that regional natural gas prices should have been expected to peak on certain days as they in fact did based only on the firm load for local distribution companies (LDCs). Natural gas traders expect volatile and rising gas prices when cold fronts hit the market, but the gas price spikes this winter suggest that other factors were at play. In particular, the market experienced increased winter season demand for natural gas as a fuel for electric generation. The scale and timing of this demand, coupled with already high pipeline utilization for heating loads, caused power sector buyers entering a tight market to bid exorbitant prices for the limited gas supplies available in the market. Energy stakeholders that is, everyone have legitimate concerns for infrastructure constraints that cause high natural gas prices and their compounded effect on electricity prices. If left to persist, tight energy market conditions can morph into constraints that create unhealthy costs for consumers and a drag on local economies. On the coldest days of this past January, ICF estimates that rising natural gas prices cost regional electric markets hundreds of millions of dollars. Over the longer course of a cold 1

winter, the cumulative costs to power generators and other natural gas customers could be well in excess of that. Perhaps the most alarming Polar Vortex lesson for energy stakeholders is that without action, tight gas markets and the associated adverse results will likely happen again, and with progressively more dire consequences. The NY/NJ region is certain to experience similar if not colder winter weather in the future and the growing natural gas demand for heating and electric generation will continue to trigger price behaviors that weigh on consumers. It is important to note that although the 2014 Polar Vortex temperatures were not unique to NY/NJ, the region s natural gas price spikes were. Only New England, which like NY/NJ is situated at the terminus of the North American natural gas pipeline grid, experienced triple-digit natural gas prices. Other areas from the upper Midwest to the Southeast U.S. also saw temperatures plummet, but did not experience the same degree of natural gas price volatility as NY/NJ, largely because they do not have the same natural gas delivery constraints. In the Gulf Coast, where natural gas pipelines are abundant, Polar Vortex price impacts were hardly noticed. For stakeholders concerned with rising and volatile natural gas prices, the Polar Vortex experience is not a question of natural gas pipeline reliability, but instead of infrastructure adequacy. Reliability refers to the performance of a pipeline as measured against contract obligations, and by all accounts the pipeline grid performed extremely well on this measure during the Polar Vortex. No gas shippers holding firm transportation rights reported not receiving their gas as scheduled. 1 Adequacy addresses the critical question of whether or not the regional pipeline grid has sufficient capacity to meet growing market demands, most notably power generators. Increasingly, the Polar Vortex winter and other market signals suggest that it does not. 2 There are three primary solutions to inadequate NY/NJ pipeline capacity: 1) pay the price for the status quo; 2) reduce natural gas demand; or 3) expand the capacity to deliver natural gas or other fuels into the region. Depending on the circumstances each can be a legitimate solution, and for most regions including NY/NJ, the optimal solution may be a combination of multiple options. But at some point, a growing market will require new natural gas infrastructure investments and the questions begin to focus on how. Expanding natural gas capacity that serves NY/NJ can be challenging and costly, but it is not new. In recent years several new gas pipelines and pipeline expansions have been constructed. Notwithstanding, to the surprise of many, the Polar Vortex demand conditions and corresponding price volatility indicate that more may be needed. Going forward, there are several options for adding new natural gas infrastructure in the region and fortunately for consumers there is a competitive market of 1 Outside a limited number of minor and isolated force majeure events. 2 This is particularly true for the region s natural gas fired power generators who typically rely on interruptible and other non-firm pipeline contracts to fuel their plants. The important distinction between firm and interruptible pipeline capacity is discussed in this report. 2

pipeline, storage, terminalling and producer companies that can offer alternatives. The best of those alternatives will address three key factors. At the heart of the matter for NY/NJ natural gas capacity is the distinction between firm and interruptible capacity. 3 Interruption became a reality for many gas-fired generators who needed to run during the coldest days of the Polar Vortex because much of the region s power grid relies on gasfired generation that is not backed with firm pipeline transportation contracts. The weather got cold, firm customers (such as LDCs) used their pipeline capacity, and interruptible gas users many of them generators scrambled to find what they could in the spot wholesale markets by bidding the prices up to record levels. Since natural gas reliability should ultimately be judged against firm obligations, solutions to increase NY/NJ reliability should ultimately include new firm capacity. The challenge for stakeholders is that new firm capacity is often costly and requires the long-term commitment of natural gas buyers or sellers to pay for those costs. Pipelines and other infrastructure companies are typically ill-suited to speculate on building new capacity and assuming the risks of cost recovery, absent such commitments from shippers. The mismatch in risk allocation that emerges between infrastructure companies and shippers can easily lead to inaction on important investments. For that reason, industry, regulators, and stakeholders are working in numerous forums to evaluate new policies that may incentivize the development of new gas capacity to serve power generators. Regardless of those decisions, the costs of contracting for rights to new firm capacity will be risky, meaning successful infrastructure providers will have to work hard to develop valuable service features that mitigate some of the risks. To that end desirable attributes of new firm capacity will obviously include low costs, but as important, flexibility with respect to the sources of gas supply accessed, delivery points, and contract duration. The second key factor that needs to be considered is the seasonality of growing demand. Constraints in the NY/NJ gas market going forward are most likely to exist in the winter season, when peak demands for residential and commercial customer heating are compounded by rapidly growing demand for natural gas in electric generation. Ideally, growing winter season demands could be met with new 3 Firm transportation capacity on a pipeline is capacity reserved for a customer regardless of weather conditions or other demands on a system, except for acts of God. Gas operators design their systems to meet these commitments. Gas distribution companies back their customer obligations with firm transportation service because supply reliability on the coldest of days is paramount. Interruptible service is typically surplus firm pipeline capacity that is often available during non-peak demand periods. This capacity is subject to recall or interruption if firm shippers require it. Gas users relying on interruptible capacity face the possibility of having no pipeline capacity available during cold weather, or being forced off the grid in the middle of an operating day. 3

natural gas storage facilities that can be filled in the summer and drawn down in the winter Infrastructure solutions that add year-round capacity may also add unneeded capacity and costs for consumers, but the NY/NJ geology for underground storage is lacking and the cost of LNG peak-shaving is high. For these reasons there is interest in new fuel oil tankage, but that faces cost and permitting challenges. Delivering cost-competitive seasonal services in NY/NJ can save residential and commercial heating consumers money, as well as power generators, but will likely require creative solutions. The third factor is the desirability of added diversity in the region s natural gas supply portfolio. Historically, nearly all natural gas consumed in NY/NJ was produced from conventional sources in the Gulf Coast or Western Canada, both of which are mature and in decline. The recent emergence of natural gas production in the well-publicized Marcellus Shale represents a promising and much needed new source, but NY/NJ consumers will share that resource with other regions. Numerous pipeline projects are already in development that will transport Marcellus Shale natural gas to buyers in the Midwest, Canada, Southeast and Gulf Coast. Stakeholders in NY/NJ would add diversification in their natural gas sources by seeking new supplies in addition to the Marcellus. An important consideration for stakeholder representatives in infrastructure development is maximizing the number of choices available to natural gas buyers. In the sections of this report that follow we expand on the Polar Vortex events and their relevance to natural gas supply adequacy decisions. The Polar Vortex Weather What is was, and what it was not Those who experienced the 2014 Polar Vortex winter, particularly in January, will likely remember record low temperatures. Indeed it was cold. But when assessing natural gas supply adequacy and related costs, it is important to know that by utility planning standards the cold temperatures were neither that unusual, nor unforeseen. There are two main weather condition periods that gas supply planners use to determine capacity infrastructure needs, the season and the day. Neither of these set new records in during NY/NJ Polar Vortex. It is widely reported that 2014 was the 3 rd coldest winter season over the last three decades. But utility standards often reach back over much longer periods. The National Oceanographic and Atmospheric Administration (NOAA) has ranked the winter of 2013/14 (December through February) in the Northeast as slightly below normal and only the 38 th coldest winter on record since 1895. On the coldest day of the Polar Vortex, January 7, New York City and more than 40 other stations reported record lows for that day. But the 4F degree low in New York City was the record for January 7th only. The coldest temperature on record in New York City is -4F degrees, set in January 1994. The design-day standard for utility supply planning is typically based on records extending back 50 years or longer. 4

Figure 1: NYC Regional Temperatures at LaGuardia Airport There are two key takeaways here with regard to weather. First, these types of winter season conditions can and will happen again. Stakeholders should plan for that. Second, it is a mistake to attribute the tight natural gas supply conditions and soaring prices witnessed in the market solely to the Polar Vortex weather. Gas utilities in the NY/NJ region plan for more severe conditions, and based on historical utilization patterns natural gas utility buyers would normally not have been expected to bid natural gas prices up to the levels reported. Other factors besides cold weather, namely large natural gas-fired generation demand, were at play in the market this winter. Power market trends strongly suggest that the emerging winter demand patterns will happen again. Natural Gas and Power Market Integration Lessons from the 2014 winter It is well documented that North America s electric generation fleet is migrating away from coal-fired generation to natural gas-fired technologies. Renewable energy and other sources will also capture a share of the market, but the trend is clear: by 2035 ICF projects that natural gas-fired generation will comprise more than half of North America s generation capacity. Implicit in this transition is the recognition that natural gas-fired plants will increasingly operate during the winter when natural gas demand for heating loads are at their highest, and there is concern that inadequate firm pipeline transportation could materially affect fuel supply availability and prices. 5

The Polar Vortex brought focus to these issues and the events taking place in the NY/NJ regional power (and natural gas) market are superbly recounted by ICF s Judah Rose, in his June 2014 article in Public Utilities Fortnightly. 4 Among other factors, Mr. Rose notes that an increased amount of coal-fired generating capacity was unable to dispatch when temperatures fell, perhaps the result of scaled back maintenance in anticipation planned retirements. This in turn left few options but to force natural gasfired plants lacking firm gas supplies into an already tight spot gas market, causing buyers to rapidly bid natural gas prices to record highs. The situation was so severe that counsel for PJM, the regional power grid operator for a large part of the Northeast, took the unusual step of issuing a statement that reassured generators that they would be able to recover fuel costs in excess of established price caps. The lessons revealed by the Polar Vortex are many, but foremost are that natural gas fired generation is essential in meeting winter power grid loads, and that many power plant operators lack the firm gas supplies needed to assure their availability at such times. Since cold weather is destined to return each winter, this means that unless the industries take steps to curb future gas demand or add new natural gas supply infrastructure, regional consumers will pay a price for inadequate gas supply access. 5 Natural Gas Price Volatility Why stakeholders should care Rising prices and increased volatility are natural parts of winter gas markets, and to an extent a healthy way to ration demand and extract efficiencies from the grid. As supply conditions tighten over time, however, excess volatility and persisting higher prices becomes undesirable. 6 The natural gas and power price behaviors observed during the Polar Vortex suggested unhealthy conditions. The two graphs below show natural gas and electricity prices reported at trading points across the NY/NJ and adjacent regions. In them one can see several things. First, natural gas prices this winter were extraordinarily volatile compared to normal conditions (Figure 2). Prices on January 7, and 22, 2014, two of the coldest days of the winter, exceeded $90 MMbtu (compared to an average in the mid-teens.), then peaked at more $120 MMbtu during the second Polar Vortex event. 7 Note that the price spikes were unique to NY/NJ and New England. Market prices in regions as close as Pennsylvania ( Leidy ) and the Gulf Coast ( Henry Hub ) hardly moved. 4 Rose, Judah, Waiting for the Next Polar Vortex: How recent events could prove a harbinger of winters to come. Public Utilities Fortnightly, June 2014 5 The implication is that there was plenty of natural gas available, just not enough pipeline capacity secured under contract to meet the heightened demand in the downstream market areas. Ibid. 6 These are subjective measures, and the decision challenge to stakeholders as to when volatility or prices are too high. 7 An MMbtu is a standard unit of measure for natural gas based on heat content. It is roughly equivalent to an Mcf (thousand cubic feet) which a standard unit of measure based on volume. Traders typically quote prices using natural gas heat content. 6

Figure 2: Comparison of Natural Gas Spot Prices in the Northeast and Gulf Coast; Source: SNL Energy Second, as seen in Figure 3 below, electric prices were jumping in response to rising natural gas prices. In most organized North American power markets, energy auction and compensation protocols mean that natural gas prices effectively set regional electricity prices. 8 Driven by the January 7, natural gas price spike, NY/NJ power prices jumped above $600 MW-hr, then to nearly $400 MW-hr two weeks later. 9 The co-movements of natural gas and power prices we observed indicate that several factors influence power prices, but the key point here is that if natural gas prices are going up, then so are power prices. It goes both ways, falling natural gas prices lead lower power prices. 8 Organized power markets refer to regional grids such as in NY/NJ where generators compete to sell electricity, and operate without the regulatory certainty of recovering their investments. Other regions continue to operate under a historical regulated regime where utilities are the generator and who are provided certain cost recovery assurances. 9 In his Public Utilities Fortnightly article, see Mr. Rose s discussion about PJM grid operator decision to temporarily waive price caps to allow generators to pay rising spot gas prices and dispatch electricity into the grid. (Judah Rose, 2014) 7

Average hourly power prices based on NYISO's NYC and Long Island LBMP as well as PJM's eastern LMP zones. Figure 3: Comparison of NYC/NJ Natural Gas Spot Prices to Regional Power Prices; Source: SNL Energy, PJM, & NYISO Rising natural gas prices can rifle through a local economy in at least two ways. The most immediate impact is felt in power markets, because even small volumes of high priced spot gas can set the bar for payments to all generators in a region. The power of this leveraging effect that natural gas prices have on a region s cost of electricity can be staggering. The graph below illustrates how rising natural gas prices get leveraged across power markets, to the detriment of regional economies. During the peak Polar Vortex days we estimate an average of 24,000 MWh were dispatching into the NY/NJ grid. We then compared the cumulative clearing costs for power that would be set by various spot gas prices that ranged from a normal winter average of $13 MMBtu to a Polar Vortex proxy of $90 MMBtu. 10 As shown in our example, this illustrative spot gas price spike would result in additional cleared power market costs of more than $560 million... on a single day. 10 As seen in previous chart, New York and New Jersey spot gas prices actually exceeded $120 MMBtu on January 7. 8

Figure 4: NYC/NJ Regional Power Prices as Function of Natural Gas Prices; Source: SNL Energy, PJM, & NYISO Over the course of a winter season, the same power price-setting process takes place. Although not as dramatic as on a peak day or in a peak season, tight gas supply conditions can lead to a steady economic toll whose cumulative cost can surpass the costs on any peak. Residential and commercial heating also realize potential savings from increased natural gas supply capacity, but the savings are heavily dependent on buyers and capacity providers matching the new service characteristics with the growing load profile. In most cases that load profile will indicate growing winter season requirements rather than a need for year-round capacity. In these instances, where available, new seasonal services can be significantly less costly to consumers. Price Impacts of Expanding Natural Gas Supply Capacity The Polar Vortex markets suggest that the primary concern for NY/NJ stakeholders is not natural gas supply; the global and North American natural gas resource base is vast. Nor is it operating reliability; the natural gas grid delivered as designed, and expected. As much as anything the stakeholder emphasis should focus on determining whether the natural gas pipeline grid is adequately sized for the demand it serves, and deciding what to do about it if not. Infrastructure decisions such as these ultimately distill to cost-benefit analyses. In the example scenarios above we illustrate how the costs to consumers of tight natural gas supply conditions can quickly escalate to hundreds of millions of dollars. Costs of this magnitude can support significant investments 9

in new natural gas infrastructure, the effect of which could sharply dampen peak volatility and moderate overall winter season prices. To derive a rough estimate of the potential natural gas price savings from new capacity infrastructure ICF used its proprietary market software to project average monthly natural gas prices in New York City between 2015 and 2017. As seen in the graph below, readers will note the familiar price pattern of peaking natural gas prices during the winter season. 11 We then simulated the price assuming that a new supply source comparable to Port Ambrose LNG was available to the market. Our analysis shows how a supply source such as Port Ambrose LNG has the potential to lower winter average monthly gas costs by approximately $2 MMBtu. Figure 5: Port Ambrose s Impact on NYC and Long Island Regional Gas Prices; Source: ICF International Compared to savings on a peak-day a $2 MMBtu reduction in average monthly natural gas costs may appear inconsequential until one considers that the savings will be spread over the large volumes of natural gas consumed in the NY/NJ market during the course of a winter season. 11 ICF s Gas Market Model (GMM) is an industry leading general equilibrium model that simulates market interactions between over one hundred markets and nearly fifty supply basins. 10

An important point from our analysis is the recognition that given the structure of energy markets, even comparatively minor natural gas supply capacity expansions can lead to major consumer energy cost reductions. In that regard, cost-benefit tests would likely support multiple approaches for providing new natural gas capacity into NY/NJ. The optimal solution, as discussed above, would be the one that addresses the desires for firm flexibility, seasonality, and diversification. A Good Time for Gas Supply Diversity Since World War II, NY/NJ has relied on two geographic regions for substantially all of its gas supplies, the U.S. Gulf Coast and Western Canada. Today, conventional gas production in both of those regions is in decline. The charts below give a sense of the sharp declines in gas production that have occurred, mostly in the last ten years. Figure 6: Historical Gulf Coast Natural Gas Production; Source: ICF International Figure 7: Historical WCSB Natural Gas Production; Source: ICF International It would be inaccurate to say that North America is running out of natural gas just the opposite but the location of emerging supply sources and other factors strongly suggests that NY/NJ energy market stakeholders should encourage the development not only expanded access to existing resources, but also access to new sources. The most prominent new supply basin in the NY/NJ future is the Marcellus Shale, located in the Appalachian regions of northeastern and western Pennsylvania and spreading across a large section of other states. 12 Expectations for the Marcellus Shale are robust and so far natural gas exploration and production companies have consistently surpassed projections for bringing new production on line. In addition to its huge resource base, the Marcellus Shale is attractive because it is well-situated relative to existing pipelines serving the NY/NJ region. Notwithstanding, significant long-term investments in new pipeline capacity will be needed if NY/NJ buyers are going to increase natural gas supply deliverability from the Marcellus, and not just replace production declines in the Gulf Coast and Canada. 12 The Marcellus Shale is new in the sense that it is a distinct shale layer within the larger Appalachian Basin, a resource base that has produced oil and gas for more than a century. 11

If there is a concern NY/NJ stakeholders should have regarding the Marcellus Shale it is that everybody wants Marcellus gas. As illustrated in the map below, natural gas buyers are supporting the development of large volume pipeline services that will transport Marcellus Shale in every direction, including markets in New England, Chicago/Upper Midwest, Ontario, Gulf Coast, Southeast/Florida, and to international buyers as liquefied natural gas. Figure 8: Planned Gas Pipeline Flows From the Marcellus Shale; Source: ICF International It is logical for NY/NJ to rely on the Marcellus Shale for future natural gas supplies, but NY/NJ consumers are going to share the resource with other regions. For that reason among others, stakeholders in an energy market as large and critical as NY/NJ would be well-served to entertain options that provide additional supply source alternatives and redundancy. Conclusions The NY/NJ energy market is huge and complex, and natural gas and electricity markets revealed stress points at critical times this winter. These stress conditions are likely to repeat, as the underlying causes have not abated, and consumer energy bills will feel the effect. At the same time, the region s traditional supply sources are waning, and its gas buyers will compete with other regions to purchase 12

growing Marcellus Shale supplies. Until new solutions, including new natural gas transmission capacity, are in place, the resulting costs of the status quo are likely to rise. Stakeholders and their representatives have an opportunity to address the challenges before conditions are chronic and the consequences more dire. Ultimately, addressing as delivery constraints will likely require a suite of responses, and an LNG import terminal in the NY/NJ area could be one of those responses. 13