Electricity Industry Restructuring: Outlook for the Future

1. Electricity Industry Restructuring: Outlook for the Future James Bushnell University of California Energy Inst. www.ucei.berkeley.edu

2. Outline • Origins of liberalization • Not as advertised • Unhappiness with competition, retail choice, investment • New regulatory structures • Capacity markets, Regulation, Market monitoring, govt. investment • Concluding Thoughts

3. Why Restructure? • Politically motivated by high rates, government financial problems, and ideological trends toward deregulation • Regulation/Government ownership had created inefficiencies • Largely through bad investment decisions • Also some operational inefficiencies • Large decrease in generation employment over last 15 yrs. • Some improvement in US heat rates at divested plants • How might we save money from restructuring? • Let “markets” make better investment decisions • rate-payers not on the hook for bad decisions • these benefits accrue very slowly

4. Electricity Restructuring:a generic blueprint • Deregulate power production • No explicit obligation to serve specific customers, investment based upon price forecasts • Revenues determined by market-based prices • Grid ownership (Trans & Dist) remain regulated • Privatised in many countries • Create ISOs responsible for operating grid and maintaining system balance • ISOs run operating reserve and `imbalance energy’ markets • Institute retail choice • Plan for no retail rate regulation after a “transition”

5. Not as advertised: Compromises of the Market Vision • Ownership remains mixed (still Govt. and Utility ownership) • New construction by these entities in many places • Issue of crowding out merchant investment • Concerns of supplier market power have led to regulator intervention in energy pricing • Structural solutions not undertaken • Relatively low price-caps • Explicit or implicit intervention in bidding practices • Retail deregulation has stalled in many regions • Many customers remain with incumbent on quasi-regulated rates • Issue of providing incentives for those retailers • Resource “adequacy” regulations have been introduced • intended to influence investment

6. Competition

8. The Challenge of Competitive Electricity Markets • Lack of price-responsive demand • Costly storage • Frequently binding capacity constraints, long construction lead-times • Transmission • Generation • Even firms with small market shares can enjoy substantial market power under the right (wrong) circumstances

12. Forward Commitments and Oligopoly • Forward contracts increase spot production • Less incentive to raise spot prices if most sales are already locked up under fixed-price contracts • Desire to capture market from competition leads to equilibrium forward contracting by all firms • more output by all firms relative to when there is no forward market • Pushing market forward allows for more supply and demand response • More potential suppliers

13. Vertical structure and forward commitments • Usually we think of wholesale (upstream) price determining the (downstream) retail price • Issues are usually foreclosure, raising rivals costs vs. double marginalization • In some markets, retailers make forward commitments to customers • utilities – telecom services – construction • In these markets a vertical arrangement plays the same role as a forward contract • a pro-competitive effect • A balanced generator-retailer does not have a big net position in the wholesale market

20. Can Restructured Markets Work? • Nature of electricity makes it more difficult to achieve a competitive market structure • is it impossible? Evidence indicates no. • The California market was hurt by • Rigid retail prices & lack of real-time pricing • somewhat tight reserve margins • somewhat concentrated generation ownership • lack of forward contracts • Other markets that share all but the last feature (contracts) have been viewed as successes

21. California Crisis was Not a shortage of generation capacity • 2000 Projected CA reserve margins

22. But a shortage of money

23. Investment in Generation

24. Reasons Offered Why Investment Intervention is Needed • Factors present in other industries • inelastic demand • lack of storage • capital intensive industry, long-lead times • Hybrid (merchant, government, utility) ownership • Supplier market power • Irresponsible retailer policies • unwillingness to match demand and supply at retailer level • relatively low price caps in some markets (compared to airline bumping) • Safe harbor `default’ rates for customers whose retailers go under

25. Alternative Paths to Resource Adequacy • “Energy only” markets • higher price caps • more and better defined ancillary services purchasing • May be combined with hedging requirements • Backstop procurement • Energy only market with resource “guidelines” • ISO or other agency makes a payment or long-term contract with specific resources it deems necessary for reliability • LSEs are billed for cost (probably controversial)

26. Alternative Paths to Resource Adequacy • Capacity Markets • ISO sets capacity “target” (say 15% over forecast demand) • ISO or other agency makes a periodic payment to all certified “resources” (monthly, annual) • LSEs are billed pro-rata by demand • LSEs may sell into the market (take both sides) • Price may be influenced by a “demand curve” for capacity • Resource Adequacy obligations • all load serving entities must procure “resources” to cover their forecast demand • procurement left to LSEs • penalties for non-compliance

27. International Overviewfor most part capacity markets are a US “innovation” • Energy-based • UK, Australia, New Zealand, US MISO? • Implicit backstops (procured by Gridcos,etc.) • With mandatory options contracts? (Texas) • Capacity markets • ‘1st generation’ PJM, NEISO, NYISO • ‘2nd generation’ PJM, NEISO • Longer-term, more targeted incentives • Resource Obligations • California • Impeneterable - Spain

28. Arguments for Capacity Markets • random rationing creates a “free rider” problem – capacity markets eliminate shirking • No one likes price volatility, so it is costless to establish standards that reduce volatility • The costs of getting investment wrong are much greater on the downside than the upside • To what extent are these self-inflicted problems? • Lack of RTP, critical-peak pricing, and the randomization of outages creates the disparity

29. Concerns About Capacity Markets • Implementation creates a bias towards higher reserve levels • Allocation of costs tend to be smoothed amongst many hours • Capacity markets in practice distort markets by artificially smoothing price volatility • means more consumption & capacity on peak • means higher average cost • Buying capacity does not guarantee you get energy • Could empower more subtle forms of supplier market power

30. Concluding Thoughts • Reform has improved efficiency • Demand response still needed • Competition is a difficult problem • Appears to be manageable in much of the world • Long-term contracts are critical to market performance • Solves most of the competition and investment problems • How to get firms to sign them? • Is vertical integration the most reliable way?

31. Thank You