Electricity prices and fuel costs: Long-run relations and short-run dynamics Hassan Mohammadi ⁎ Department of Economics, Illinois State University, Normal, IL 61790-4200, United States abstract article info Article history: Received 10 September 2008 Received in revised form 25 January 2009 Accepted 4 February 2009 Available online 20 February 2009 Keywords: Electricity prices Fuel costs Cointegration Error-correction model Asymmetric adjustment The paper examines the long-run relation and short-run dynamics between electricity prices and three fossil fuel prices – coal, natural gas and crude oil – using annual data for the U.S. for 1960–2007. The results suggest (1) a stable long-run relation between real prices for electricity and coal (2) Bi-directional long-run causality between coal and electricity prices. (3) Insignificant long-run relations between electricity and crude oil and/or natural gas prices. And (4) no evidence of asymmetries in the adjustment of electricity prices to deviations from equilibrium. A number of implications are addressed. © 2009 Elsevier B.V. All rights reserved. 1. Introduction Electricity prices have witnessed substantial variations over the past five decades in both nominal and real terms. Following a period of tranquility in the 1960s, nominal prices increased sharply during the 1970s; stabilized in the 1980s and 1990s, and have followed an increasing trend since the early 2000. Adjusting for inflation reduces the volatility in real energy prices but the overall time series pattern remains intact. In particular, real electricity prices increased in the 1970s; had a declining pattern in both 1980s and 1990s, and have followed an increasing pattern since 2000. As one expects, other energy prices (coal, natural gas and crude oil) have followed broadly similar long-run patterns despite their varying degrees of short-run volatility. In particular, we find similar patterns between electricity and coal prices as well as in crude oil and natural gas prices. This paper examines the long-run relations and short-run dynamics between electricity prices and prices for three other fossil fuels – coal, natural gas and crude oil – with annual U.S. data over 1960–2007. In particular, it attempts to address the following questions: (1) Is there a unique long-run relation between electricity prices and fuel costs, and if so, what is the nature of that relationship? (2) What are the short-run dynamics of the relationship between electricity prices and fuel costs? In particular, does evidence support the existence of causal relations between electricity prices and fuel costs, and if so, in what direction? (3) How do electricity prices respond to exogenous shocks originating in one of the fuel markets? Do these shocks persist or are transitory? Also, how important are the shocks in each fuel market in explaining the variations in electricity prices? Finally, (4) are adjustments in electricity prices in response to deviations from the equilibrium symmetric or asymmetric? A detailed examination of these issues is important for at least six reasons. First, coal and natural gas serve as important sources of fuel in electricity generation process. According to 2007 data, more than 70% of the U.S. electricity was generated using coal and natural gas, with coal accounting for almost half of the electricity generation, and natural gas fueling another 20%. 1 Thus, changes in coal and natural gas prices can directly affect the cost of generating electricity and contribute to its price at the retail level. Second, crude oil prices may also contribute to electricity prices directly by raising electricity generation costs and indirectly through changes in market sentiments. In particular, supply-side disruptions of the 1970s due to OPEC oil boycott and the Iranian Revolution, as well as more recent demand- side speculations regarding increased consumption in economies of China and India may have contributed to fluctuations in electricity prices. Third, fuel prices may also affect electricity prices to the extent that they serve as substitutes on the demand-side of the energy market. Fourth, the electricity industry has been subject to restructur- ing at the generation, transmission and distribution levels since the 1990s. One element of restructuring has been a shift from ‘cost- based pricing’ to ‘market-based pricing’. 2 Therefore, changes in the regulatory environment may also have contributed to the behavior of Energy Economics 31 (2009) 503–509 ⁎ Tel.: +1 309 438 7777. E-mail address: hmohamma@ilstu.edu. 1 The remaining 30% were distributed among nuclear (20%), hydraulic (7%), crude oil (1%) and other renewable (2.4%). For more information, please refer to “Energy in Brief – What Everyone Needs to Know about Energy”, Energy Information Adminis- tration, 2008. 2 Steinhurst (2008) provides a review of developments in the electric industry in a historical context. 0140-9883/$ – see front matter © 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.eneco.2009.02.001 Contents lists available at ScienceDirect Energy Economics journal homepage: www.elsevier.com/locate/eneco