An overview of electricity market reform and deregulation

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C . K . W O O D E P A R T M E N T O F E C O N O M I C S H O N G K O N G B A P T I S T U N I V E R S I T Y

Objective

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Present an overview of electricity market reform and deregulation

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Offer a list of key questions to help frame the discussion and guide the decision-making process

Why should we care?

3  Electricity cannot be economically stored and must be supplied in real time to meet fluctuating demand  Real time demand can sharply spike due to extreme weather and is price insensitive  Electrical equipment can fail unexpectedly  Renewable generation (solar and wind) is as available, intermittent, and non-dispatchable  Reliable supply can only occur with capacity reserve and backup facilities   More volatile total demand, more total capacity Higher failure rates, more facilities

Why should we care?

4  Electricity has no close substitutes for many end-uses (e.g., motor, lighting, cooling, electronics)  Electricity can only be produced and delivered with equipment already in place  Electricity requires capital intensive investments with long lead time  Electricity service disruption can have large economic consequences Though dangerous, electricity theft does occur, at times with fatal consequences (e.g., KFC thief)

Transformative events

5  Electricity market reform and deregulation results in (a) competitive wholesale energy markets with hourly prices by location; (b) inter-regional trading; and (c) retail competition for customers  Large-scale renewable energy development requires flexible generation and load to accommodate intermittent, unpredictable and as-available generation (e.g., wind)  Smart grid, smart meters and smart appliances enable electricity product differentiation and responsive/flexible loads  What’s next for Israel?

What is a desirable outcome?

6 Safe, reliable, and environmentally friendly service at just, reasonable and stable rates, which requires:  Least-cost investment and operation  Diversified demand-supply mix for energy security, including reliable integration of renewable resources  Efficient pricing of differentiated services to meet diverse customer needs  Investment and pricing decisions sensitive to unpriced environmental factors  Recovery of reasonable risk-adjusted return on and of investments

Market organization options What are the drivers for change?

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Government ownership Privately owned integrated utilities Market reform and deregulation Pre-reform: Europe, Ontario, China, Australia, New Zealand, Singapore Rate of return (ROR) Regulation: North America Performance based Regulation (PBR): UK and Australia North America: California, Texas, PJM, New York, New England Canada: Ontario and Alberta European Union Australia New Zealand

Degree of decentralized decision making

Stylized model

8 Wholesale Generation Market (Pool Structure) Bilateral Market Financial (Contracts) Market Distribution Companies

Customers

Retailers

Design stage

Path to success

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Market design Good design Bad design Implementation stage Successful implementation Unsuccessful implementation (e.g., few sellers) Operation stage Existing capacity surplus, fast market entry, and elastic demand Existing capacity shortage, slow market entry, and inelastic demand Gains: Lower costs, lower prices, more choices, better reliability Losses: Higher and more volatile prices, capacity shortages, lower reliability

Status in the US

10 Source: http://www.eia.doe.gov/cneaf/electricity/page/restructuring/restructure_elect.html

Anticipated challenges

11  Electricity deregulation is complicated, with many under-estimated challenges  The cost of setting up and operating an Independent System Operator (ISO) is substantial  Marrying competitive generation with grid operation leads to many markets: (a) energy markets (e.g., forward, day-ahead, hour-ahead, real-time); and (b) ancillary service markets (e.g., spinning and non-spinning reserves, regulation, voltage support, real power loss, energy imbalance)  Electricity spot prices are highly volatile due to random demand, fluctuating fuel cost, unpredictable equipment failure, and intermittent renewable generation, necessitating risk management by market participants  Market power abuse is common in deregulated markets  When supply is short, even minor capacity withholding can be highly effective and profitable, at the expense of consumers

Anticipated challenges

12  Electricity deregulation may cause insufficient investment because price and revenue volatility discourages investment, even in the face of capacity shortage  Renewable energy development erodes the incentive to invest in flexible generation critically needed for reliable grid operation  Deregulation can jeopardize reliability: merchant generation investments do not always occur in the right place at the right time  Deregulation seldom reduces generation cost  While competition reduces labor and O&M costs, generation cost may not fall because merchant generation’s capital cost exceeds a regulated utility’s capital cost  Dysfunctional input markets may preclude an efficient output market because of vertical market power abuse  Contract breach can occur, especially when the wholesale market price explodes

Key questions

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Question

What are the key drivers for change? And what does one ultimately want?

Will there be adequate capacity after the reform?

Remarks

As in a medical case, not knowing what’s wrong with the patient, it is difficult to find a fix. Answering these questions sharpens what one wants from deregulation.

Adequate capacity provides the reserve required for reliable service, stable price, and market power mitigation.

Will many price-taking sellers compete for sales to many buyers?

Will efficient investment occur?

A few dominant sellers can abuse their market power to raise prices. However, too many sellers can result in fierce price competition, rendering the industry financially unstable.

Deregulation replaces centralized planning with decentralized decision-making driven by market prices. To date, market competition, absent long-term contracts, has failed to induce much merchant generation in the US.

Will there be sufficient transmission available under open access?

Will the input markets be competitive?

Transmission congestion limits trading that would have caused electricity to flow from low-cost areas to high-cost areas. As well, it creates load pockets and exacerbates market power.

A dysfunctional input market can compromise the economic performance of a wholesale generation market.

Question

Will electricity end-users see and respond to wholesale price changes?

Will there be strong and enforceable rules and laws?

How will open access occur?

Will transaction costs be large?

Will the post-reform spot price be reasonably stable?

Will deregulation harm reliability?

Key questions

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Remarks

Demand response reduces market power and improves reliability. However, electricity consumers, especially households, prefer rate stability and are insensitive to hourly price variations.

They are required to prevent gaming, market power abuse, and contract breach.

Generation competition cannot occur without open access. If transmission is publicly owned, open access can be more readily implemented than otherwise. The US achieves open access via Order 888 that preserves the rights of transmission owners and allows for stranded cost recovery.

Large transaction costs dissipate potential benefits from deregulation. Moreover, some transaction costs (e.g., ISO and market set up) must be committed upfront.

High and volatile prices can doom a market reform because of unstable bills that force politicians “to do something” like price capping which discourages investment.

Centralized planning and investment have yielded highly reliable service, which may not be the case under decentralized decision making.

Key questions

15 Will there be active forward trading?

Question

Will deregulation adversely affect income distribution?

Remarks

Forward trading facilitates market power mitigation, price discovery, and risk management.

Even if deregulation can produce positive net benefits, electricity producers and large customers are likely to receive the benefits, while households and small business customers pay higher rates.

Will there be commitment to deregulation?

Will electricity consumers be made better off?

Can the projected benefits of deregulation be obtained via other means?

If deregulation fails, can it be reversed?

If voters and politicians would reverse deregulation after the inevitable price spikes, deregulation should not have occurred in the first place.

Deregulation should be based on a careful cost-benefit analysis, not an ideological belief in competition. Deregulation is not the only mechanism to improve the performance of an electric sector. Competitive procurement and performance based regulation is a less risky alternative.

Deregulation often entails divestiture of the integrated utility’s assets. Once done, it is almost impossible to put the pieces back together again.

C.K. Woo, Ph.D. (Economics, UC Davis)

16  Dr. Woo is Professor and Head of the Economics Department of HKBU and Senior Partner (now on leave) of Energy and Environmental Economics, Inc. ( www.ethree.com

), a consulting firm located in San Francisco  He specializes in energy economics and applied microeconomics. With 30 years of industry experience, he has participated in electricity market reform in California, Texas, British Columbia, Ontario, Macau and Hong Kong  He has co-authored 12 papers with Professor Asher Tishler on the Israeli electricity industry  He has over 100 papers in such scholarly journals as Energy Policy, The Energy

Journal, Energy, Energy Economics, Journal of Regulatory Economics, Journal of

Public Economics, and Quarterly Journal of Economics  Recognized by Who’s Who in America, he is (a) a senior fellow of the US Association of Energy Economics; (b) an associate editorial board member of Energy and The Energy Journal; (c) a guest editor for a special issue of Energy Policy on renewable energy