Electricity: the fuel of electric vehicles (EVs). The price of electricity: a key determinant of their economic viability. Policies to support renewable energy and reduce carbon emissions tend to push electricity prices up. Under what circumstances will the mass scale deployment of EVs in the United States – supported by McKinsey research findings – help to mitigate or reinforce these upward pressures on power prices?

When comparing operating costs between EVs and conventional internal combustion engine cars, one must consider the price of electricity and how demand for power for EVs and PHEVs will affect it. At the most fundamental level, EVs will increase the total demand for power. While researchers have noted that “[o]ne result could be an upward pressure on wholesale electricity prices,” they have also concluded that “the average cost of power declines because all of the power is produced and consumed off-peak and contributes no additional fixed cost.” We set to examine this issue.

Two important features of the power sector are that (1) electricity demand varies throughout the day (and year), and (2) power currently cannot be stored cost-effectively. The result is that many generators operate at a relatively low capacity factor, meaning that a substantial proportion of the electricity generating plants sit idle for a considerable portion of their useful lives. Stated differently, except at periods of the highest peak demand – the middle of an afternoon on a hot summer day – there is excess generating capacity. Economics usually determines which plants run most of the time (those with lower variable costs) and which ones are only used to satisfy peak demand (those with high variable costs).

Wholesale prices in electricity markets are usually set by the costs of the marginal plant (i.e., the last plant that is dispatched to satisfy demand at any given hour of the day). Since peaking plants – those dispatched to cover demand at peak periods – tend to have higher variable costs, power prices are higher during those periods, as shown in the figure below. Furthermore, besides covering the variable costs, power prices need to allow these plants to recover their fixed costs. The less they run, the higher the peak prices have to be to allow for fixed-cost recovery.

The deployment of EVs will certainly increase electricity demand. However, to understand the effect on wholesale power prices, it is essential to know when in the day that additional demand will occur: peak or off-peak periods. If it happens during peak periods, then the cost of generating this power will be more expensive than the average cost of generating power because plants used on peak days tend to have the highest operating costs. Moreover, were large numbers of vehicles routinely charged at peak hours it is possible that additional generation capacity might be required to maintain reliable operation of the grid.

However, as long as consumers can be motivated to charge during off-peak hours – which seems quite likely given that cars will typically be parked for an extended period at home overnight – there should be ample generating capacity and less of an effect on prices. (Time-of-day pricing could also influence these decisions). In fact, some utilities have started to offer special rates aiming to induce off-peak charging. In short, if all goes as planned, the impact on wholesale prices will depend on “whether the average variable costs associated with the additional generated [electricity] are greater than or less than the reduction in average fixed cost achieved by spreading fixed costs over more kWh.”

Average variable costs of power generated from each different fuel would generally be higher as a greater quantity of that fuel (i.e., gas or coal) is burned to generate additional electricity. Furthermore, as a general matter, the total operating costs of peaking plants should be higher than the operating costs of baseload ones, meaning that average variable costs of power generated by any particular fuel would tend to rise as more power is generated using that fuel.

Average fixed costs expected to be lower a generating plant operate at higher load factors because fixed costs can be recovered over an expanded output, thus requiring a smaller price-cost margin on every kWh sold.

How does this play out? Well, it depends on two key factors: (1) the relative weight of fixed versus variable costs for a given electricity market/utility; and (2) the amount of idle capacity during off-peak periods. With large scale EV deployment and assuming off-peak charging, wholesale power prices should generally tend to decline as more power is generated at otherwise idle plants with low variable costs, allowing their fixed costs to be spread over more units of output. Conversely, wholesale power prices will likely increase where variable costs dominate, which would occur when charging takes place at peak and there is relatively little spare off-peak capacity.

What can we conclude? As oftentimes in economics: it depends. Though we expect most charging to take place during off peak hours, resulting overall in average power prices that are lower than they otherwise would be, wholesale prices could in theory go either way depending on which effect dominates: decreasing fixed costs or increasing variable ones. However, there is support for our expectation: researchers at Pacific Northwest National Laboratory found4 that, under a range of scenarios, average wholesale prices do fall with increased penetration of EVs.

Diego Villalobos Alberú is currently studying for his masters in public policy at the University of Chicago.

His work appears here through the consideration of the United States Association for Energy Economics.

The United States Association for Energy Economics is a non-profit organization of business, government, academic and other professionals that advances the understanding and application of economics across all facets of energy development and use, including theory, business, public policy and environmental considerations.

The association will host its 30th Annual Conference on October 9-12 2011 at the Capital Hilton Hotel in Washington, DC.

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