Reactive power is a very complicated concept to understand technologically, but a fairly simple one economically. Here we will focus on the economics, but to do so we'll need to understand a little bit of the physics. If you want to know more about the mysterious nature of reactive power, I strongly encourage you to read Alexandria von Meier's excellent book Power Systems: A Conceptual Introduction.
Recall from the beginning of the term that electric power actually has two components: current and voltage. In an alternating current power system, the current and voltage that are produced are not constant. Both are sine waves with a frequency of 60 cycles per second or 60 Hertz (this "frequency" is an important concept that we'll come back to later in this lesson). If the voltage and current waves peak at exactly the same time, as shown in panel (a) of the figure below, they are said to be "in phase." If the voltage and current waves do not peak at exactly the same time, as shown in panel (b) of the figure below, then they are said to be "out of phase."
Power systems need the voltage and current to be as close to being "in phase" as possible. If the only devices that were connected to power systems were simple resistors (like a light bulb or basic toaster oven), then it would not be that difficult to keep the power system in phase. Some types of everyday devices, such as air conditioners, refrigerators, pool pumps or anything else that uses an electric motor, can actually knock the voltage and current out of phase. These devices are sometimes called "inductive loads" because they draw current but can reduce voltage, or they produce a weak electromagnetic field that can push the voltage out of phase with the current.
If the voltage winds up out of phase with the current, this reduces the amount of power that can be delivered (remember that power = voltage times current) and some of those inductive loads may not work as well (and light bulbs may not be as bright, and so forth). The difference in the phase between the voltage and current, or what additional voltage would be needed to restore the system to being in phase, is known as reactive power.
The power that we actually consume (voltage times current) is sometimes called "real power" to differentiate it from reactive power. In this class, if we simply use the term "power" then that will always refer to real power.
This leads us to the first economic principle of reactive power: Real power and reactive power are complements in consumption. Many devices that use electricity require not only real power to perform their basic functions but reactive power to compensate for the effect that these devices have on the voltage.
When the power grid needs more reactive power, this can be effectively produced at the power plant. Remember that most power plants produce electricity through a coil of wire that is rotating in a magnetic field. (How quickly does that coil rotate? 60 times per second, or 60 Hertz, which is the same frequency as the voltage and current wave forms.) If the voltage and current waves are out of phase, that can be corrected by adjusting the strength of the magnetic field, which a power plant operator can do by moving the coil of wire ever so slightly. This is what we call the "production" of reactive power. The word "production" here is kind of misleading since reactive power is neither a thing (like a molecule of gas or drop of oil) nor a force (like electricity). But we use the term as a kind of short-hand.
There is a catch, however, which leads us to the second economic principle of reactive power: Reactive power and real power are substitutes in production. If a power plant wants to produce more reactive power, it has to reduce its production of real power by a little bit. Exactly how much is determined by the engineering design of the power plant. Since reactive power is neither an object nor a force, there is no direct cost involved in producing reactive power. There is, however, an opportunity cost to the power plant in the form of foregone real power production.
Some specialized devices, like capacitor banks, can also provide reactive power. At the margin, however, it is often cheaper to produce reactive power from an existing power plant than to build a new capacitor bank. Many such capacitor banks do exist in real power systems, particularly close to cities where building power plants may be difficult.
Prior to electricity restructuring, electric utilities would adjust the output of power plants when more reactive power was needed. The economic costs of that were internalized by the utility - if the system needed so much reactive power that it significantly increased the cost of generating real power, those costs would show up in the form of higher electric rates.
In areas that have undergone electricity restructuring, however, no power plant would voluntarily provide reactive power because that would mean less real power that it could sell in the market. PJM and other market operators have generally solved this problem by requiring generators to produce reactive power when requested, with any foregone real power consumption compensated based on opportunity cost. For example, if a generator is asked to reduce output by 1 MWh to increase reactive power, and if the market price is $25/MWh, then the generator would be compensated $25 for that action to increase reactive power.