The spark spread is the difference between the wholesale market price of electricity and its cost of production using natural gas. The spark spread can be negative or positive. If it is negative, the utility company loses money, while if it is positive, the utility company makes money. This measure is important because it helps utility companies determine their bottom lines (profits). If the spark spread is small on a particular day, electricity production might be delayed until a more profitable spread arises.
Breaking Down Spark Spread
The spark spread is a standard metric for estimating the profitability of natural gas-fired electric generator. It is the difference between the input fuel costs and the wholesale power price. For electric power generation fueled by natural gas, this difference is called the spark spread; for coal, the difference is called the dark spread. The spark spread is typically calculated using daily spot prices for natural gas and power at various regional trading points.
Calculating Spark Spreads
According to the EIA, the spark spread is calculated using the following equation:
Spark spread ($/MWh) = power price ($/MWh) – [natural gas price ($/MMBtu) * heat rate (MMBtu/MWh)]; where MWh is megawatt-hours and MMBtu is a million British thermal units.
A vital component of the spark spread equation is the heat rate, or measure of efficiency, of an electric generating unit. According to the EIA, one limitation of the spark spread calculation is that it does not take into consideration other costs associated with the generation of electricity, such as pipeline costs or fuel-related finance charges, and other variable costs (like operations and maintenance costs), taxes, or fixed expenses.
The following chart shows the three-component prices (power price, natural gas price, and spark spread) per megawatt-hour. When natural gas prices exceed power prices, the spark spread is negative, and power utility companies are losing money.
Also, the EIA publishes a daily price table showing spark spreads for ten different regions around the U.S. Changes in spark spreads for a given electricity power market indicate the general operational competitiveness of natural gas-fired electric generators in meeting the market’s electricity demand.
"Spark spread" is also the name of a trading strategy based on differences in the price of electricity and its cost of production. Investors can profit from changes in the spark spread through over-the-counter trading in electricity contracts. Energy derivatives allow investors to hedge against or speculate on changes in electricity prices.