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Discussion on the deregulation of electricity markets

June 6th, 2010 by Sylvia Beneyto, Mines ParisTech

The past two decades have witnessed efforts throughout the world to deregulate electricity markets. The world´s main economies have carried out schemes to put in place efficient and competitive wholesale markets for electricity within the framework of globalization and liberalization. Yet the physical peculiarities of electricity make it a rather complex commodity, and frequent inefficiencies and position abuses by major market players have clearly established that completely free electricity markets are simply not possible. Electricity deregulation instead requires careful monitoring by ad hoc authorities and, rather paradoxically, a whole new regulatory framework.

1. Towards electricity deregulation.

Analysis of the electricity industry begins with the recognition that there are three rather distinct components of it: generation, transmission and distribution. For many years, each sector was thought of as a natural monopoly for physical reasons (economies of scale for generation plants, losses with long-distance transmission, impossibility to duplicate transmission and distribution networks,…) and common practice was to vertically integrate the three components into state-owned or state-controlled private utilities, each region or country being effectively managing electricity as a public good. One important feature of this paradigm was supply overcapacity to ensure continuous service to end customers.

But technology improvements in the 70s and 80s shattered this model and offered the possibility of competition. Additionally, inefficiencies in the system, particularly significant regional rate disparities in the US, began to rouse the ire of consumers towards regulated monopolies and fueled the desire for change. Within the general deregulating movement in the early 90s and the widely spread faith in markets as the optimal socio-economic organizational pattern, it hence appeared natural to start thinking about commoditizing electricity, just as any other major standardized good. The rationale at that time was that any electricity consumer should be able to choose among a large set of energy providers, and competition between them would naturally increase the affordability and dependability of the service.

The key event took place in 1990 when the UK Government under Margaret Thatcher privatised the UK Electricity Supply Industry in England and Wales. The thus launched process was followed by similar measures and led to a fully deregulated market in 1998, making the UK an absolute pioneer in electricity deregulation.

This example was soon imitated throughout the world and triggered efforts whose main common traits were:
• privatization of state-owned firms
• vertical deintegration of utilities
• allowing new entry in the generation market and fully deregulate its prices.
• presence of an Independent System Operator (ISO) responsible for reliable grid operation

2. The trouble with deregulated electricity markets.

The schemes that have been put in place have worked quite well in some cases, such as the Pennsylvania-New-Jersey-Maryland (PJM) market, widely acknowledged to function properly by reliably providing cheap electricity to consumers, and often cited today by deregulation proponents.

But much less successful stories have also come up.

In the first place, the case of UK which paved the way to worldwide electricity deregulation is far from compelling and has an extensive record of questionable price savings, failure in developing competition, complaints over the practices of electricity companies and higher prices for low-income consumers .
Europe has also seen rising prices and the emergence of electricity giants rather than flourishing competition, and it still struggles with cross-border frictions and price inefficiencies. In 2006, the absence of centralized management of the European network even caused a local congestion in Germany to burst into a major blackout in Western Europe.

But the most striking example of the potential detrimental effects of deregulated electricity markets lies in the successive issues faced by the state of California between 2000 and 2001. California had hastily launched its deregulated electricity market on March 31st, 1998 due to growing anger towards a costly and unsatisfactory electricity market. Problems started arising in June 2000 with an average monthly wholesale price of $143 per megawatt-hour (more than twice as high as in any previous month since the market opened). This resulted in enormous profits for generating companies and financial crises for the regulated utilities that were required to buy power in the wholesale markets and sell at much lower regulated prices in the retail markets. The state’s largest utility, Pacific Gas & Electric, declared bankruptcy in March 2001. The state of California took over wholesale electricity purchases and spent more than $1 billion per month buying power in the spring of 2001, with average prices more than ten times higher than they had been a year earlier. Some massive blackouts that hit the state were also directly attributed to deregulation as they occurred in winter, usually a time when energy consumption is low because nobody uses power-guzzling air conditioners.

Those experiences and numerous similar cases throughout the world have shed a light on inherent inefficiencies and costs of deregulated electricity markets:

(i) There are first and foremost significant economic contradictions
• The cost of setting up and operating an ISO is substantial (on the scale of an American state, several millions of dollars for setting up and between $100M and $200M every year to operate the ISO).
• Instead of improved competition, most countries that have implemented deregulation have witnessed a quick reintegration, which led to new non state-controlled electricity oligarchies that could easily extract surplus from consumers.
• Because of the non-storability of electricity, supply and demand are very inelastic and prices are very volatile.
• In addition to inelasticity, very low price-responsiveness of the demand-side gives suppliers natural market power. During peak-use hours, a supplier can indeed become pivotal, or essential, in meeting the demand, in which case he can ask for artificially high prices (which will raise the price for all the electricity sold at that point in space and time if the network operates in a single auction system as in the US Standard Market Design). Conversely a market share as low as 6% is sufficient for a seller to push prices higher by physically withholding its supply . This kind of artificial scarcity is known to be the cause of the above mentioned winter disruption in California.
• The physical specificities of electricity requires a complicated market design which invites gaming by traders and retailers, as observed with Enron highly profitable and ethically shaky strategies.
• The end of a state-controlled guaranteed rate of return for utilities combined with higher volatility of fuel prices has increased risk and hence the cost of capital, which causes insufficient generation and transmission investment and eventually congestion and higher prices
As a result, the net benefits of electricity deregulation, if any, are unevenly distributed and clearly shifted towards suppliers to the expense of users.

(ii) Electricity deregulation is also very complicated and policymakers often fail to address properly the technical and institutional challenges of introducing competitive wholesale and retail markets. This complexity also tends to empower technical knowledge and reinforce the authority of the centralized and autonomous power exchanges, independent system operators and regional transmission organizations, further excluding local decision-making and governance from a process which the very rationale of was giving a choice to consumers.

(iii) In case of congestion, the power plants used to meet excess demand are often coal fired and have detrimental effects on the environment. The environmental cost is indeed not factored in electricity market prices which encourages producers to use cheap and dirty energy sources.

3. Discussing the adequacy of electricity with market principles

Even by making the (very daring) assumption that deregulated electricity markets could in some cases lower prices in the long term, the unavoidable reduction of monopolistic overcapacity by the market and the higher risk of disruption associated with it is potentially so harmful that even fierce electricity liberals admit that it’s impossible to give the same breathing space to sellers as in another market.

To that respect, additional measures have been put in place in the years following full deregulation. For instance on July 31, 2002, the US Federal Energy Regulatory Commission (FERC) issued a Notice of Proposed Rulemaking on standard market design (SMD) that would help states to set up efficient markets. Similarly the EU has worked on a third energy package that would tackle the remaining impediments to competition after the full opening of the market in July 2007. The most promising source of competition seems to rest upon the improvement of the transmission network but it requires investments so substantial that they could offset the expected benefits . Projects to render the demand-side more price responsive are also noteworthy but they imply an education of consumers and the purchase of intelligent electricity meters which at the moment are materially and financially difficult to put in place. Finally, incentive mechanisms for electricity providers or carriers to operate in a socially optimal way are often quite complex and can bear potential hidden gaming opportunities.

The fact of the matter is that despite the complex mechanisms surrounding them, the vast majority of deregulated electricity markets do not operate in a satisfactory way as of today. Some US states (in the first place California) have backed away from deregulation and now enjoy reliable service and low prices.
Therefore one might contemplate with awe the formidable amount of thinking produced to stick to deregulation no matter what empirical evidence shows, on finding new tricks to stitch money leaks in the system and the perilous contortions of an increasingly complex regulatory framework desperately trying to keep up with the last trouble caused by those decidedly mischievous markets… A July 2006 research paper of Severin Borenstein (“Customer Risk from Real-Time Retail Electricity Pricing : Bill Volatility and Hedgeability”) is to that regard absolutely enlightening. It advocates the use of “straightforward” financial instruments to hedge away the price risk for consumers, in effect “recreating the effects of cross-subsidy under conventional billing”. Apart from the obvious pleasure of US electricity consumers to have to read an academic research paper to be able to pay a fair price for their electricity bill, one might wonder what benefit a market structure brings in that case. More generally, if electricity markets require policy design to succeed, why wouldn’t it be appropriate to recognize policy as the key factor, rather than markets? What if free markets were simply not an adequate response to the challenge of providing electricity?

If a change in the former monopolistic framework is certainly needed, one should bear in mind that consumer choice of electricity suppliers is only one of the several options that societies have traditionally exercised with regard to electricity. More collective and deliberative decision-making processes could be worth exploring for the future of this key sector.

Sylvia Beneyto and Julien Vantyghem, Mines Paristech

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5 Responses to “Discussion on the deregulation of electricity markets”

  1. Steven Stoft Says:

    I agree.

    Having seen a bit of the California design process up close and the internal workings of FERC, I would say that ideology and hopes for an advantageous position in a poorly designed market have been the major drivers of deregulation.

    Had the process been driven by solid economic analysis, I think we would have found room for more competition in the procurement of power from private generators, but this would have been done by the old regulated utilities. Also trade between utilities would have continued to expand.

    But almost all of the complexity serves no real purpose, and when the potential gains from ideal markets are calculated they prove to be quite small. Likely they are swamped by the cost of the increased risk premiums, which will be inevitable in even the best electricity markets for decades to come. [Yes, I agree, someday demand will be so elastic that competition could work efficiently, and engineers will no longer need to worry about reliability.]

    Enormous amounts of intellectual energy have been poured into designing markets that can work in real time when the demand side of the market is not priced in real time. And most of this energy has been expended by people who do not well understand basic economics. I have had two of the top people in this field argue that hedging cannot reduce risk–only shift it. They did not know why farmers sell wheat futures to bakers. This matters since their arguments are based on risk shifting. Many others have argued that risk is a benefit. One of them (a professor at a top university) has argued that more risk should be imposed on consumers, so that generators can sell them insurance. This is just a protection racket. One honest owner of a generator in Australia explained how he had actually done this and it worked quite well. Truly, the emperor has no clothes.

  2. Paul Hunt Says:

    Many thanks for this post. It is like a breath of fresh air. It is very welcome that those with knowledge and competence in both economics and the energy industry are beginning to challenge the dogma and mantras that are being used to conceal the growing dysfunction in most electricity and gas markets not only in the developed economies, but also in developing economies.

    However, it is important to avoid being labelled as “anti-competition” and “anti-market”. This is the stock response of those who have expended enormous intellectual effort to apply their belief in the virtues of full competition in electricity and natural gas. It makes sense to recognise that the PJM market seems to work and that effective, and efficiency-generating, competition exists at the wholesale level in the US natual gas market. (The so-called “competition” we see in the EU and other markets is not generating these efficiencies and, by definition, is not competition.)

    As a result, it is also important to understand the specific institutional, regulatory and administrative arrangements that have generated these outcomes in the US and to see to what extent they may be replicated in other jurisdictions.
    t
    Finally, i believe it is not sufficient to focus exclusively on the shortcomings of the current market liberalisation process in the EU and elsewhere – important and all as this is. It will be necessary to expend effort to identify viable and efficiency-generating alternatives to the current “conventional wisdom”. I would be more than pleased to associate with other like-minded people in this effort.

  3. Russell Pittman Says:

    Excellent, thoughtful post, and excellent, thoughtful comments as well. I would make two follow-on points.

    First, if creating truly competitive wholesale markets is a challenge in places like Europe and California that enjoy the flexibility of significant gas generation capacity, it is that much more difficult in countries without much gas generation (like China) and in countries with winter peaks where much of the gas capacity is in combined heat and power plants that are not going to be shut down in response to electricity price movements (like Russia).

    Second, the good advice to consider a broad set of options for structuring electricity markets applies fully to other infrastructure sectors as well. In freight rail, for example, the restructuring model urged by pro-market reformers has tended to include at least third party access but usually gone all the way to full vertical separation. We have seen in the Americas — not just the US and Canada but also Argentina, Brazil, and especially Mexico as well — that restructuring that focuses on creating competition among vertically integrated freight rail enterprises may be a quite viable pro-market alternative — able to simultaneously avoid the costs of monopoly supply and the costs of vertical separation.

  4. Daan Terpstra Says:

    First I would like to compliment the two authors for an insightful article which puts attention to the drawbacks of deregulated electricity market. However, the authors focus on economic, regulatory and environmental difficulties which arise as a result of deregulation.

    The strength of the article diminishes as a result of the focus of the authors on the environmental consequences of a liberalized electricity market. I do realize that this is perhaps a small part of the point the authors try to make, but with regard to the consequence for the environment its quite pivotal.

    Authors state that liberalized electricity markets contribute to a decline of the environment as a result of congestion management through the use of coal fired power plants. However, I would like to state that a liberalized electricity market (at best) contributes to the environment, since plants which are used for congestion management are gas fired power plants. According to a study from the Dutch Technical University in Delft for the Ministry of Economic Affairs in 2009, the startup time of a coal plant is at least six hours. This lead-time is too long in order to execute a satisfactory congestion management. Gas fired power plants of Steam and Gas fired power plants have a startup time of, respectively, less than one hour and two hours. Moreover, electricity derived from wind can be 100% online is less than one minute.

    Above stated figures display that deregulation of the electricity market may have drawbacks, as pointed out in the article by Beneyto and Vantyghem , but is not detrimental to the environment per se. This may be regarded as a foot note to some, but with the continuously increasing attention to the environment in Europe and throughout the world, I deem this relevant.

  5. kieran donoghue Says:

    This article substitues polemic for reasoned analysis. The assertions made by the authors, including the accusation that pro-market proponents “stick to deregulation no matter what empirical evidence shows” would be stronger if they troubled to inlcude any empirical evidence (or references) to speak of.
    As Daan Terpstra comments above, the thesis that liberalised makrets are worse environmentally is entirely unsubstantiated.
    Such analysis as there is is lacking in sophistication. thus they tell us how much an ISO may cost, but fail to compare that to the benefits. Becasue California set up its deregulation programme poorly, deregulation must be a failure. The Uk experience is written off despite prices patently decreasing in real terms for much of the period since the reform programme began, and quality of service metrics improving (OK I know I’m not providing references either, but I’m short of time). The criticisms of limited competition and custoemr dissatisfaction could easily be aplpied to many other industries in most counttires: banking, supermarkets, telecoms providers, etc. Should all these sectors be vertically integrated monopolies, too?
    I’m also sceptical that the large-scale European blackout was simply down to deregulation – wasn’t it more aboput the configuration of trnasmission networks and cross-border interconnectors and how system operators were geared up to repsond? If so, that’s not directly a function of ownership, deregulated prices or even the extent of vertical separation.

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