Views on Restructuring
This month, Speakout features three distinct views of the problems inherent in the deregulation of electric energy, along with some solutions. "Electricity Restructuring in Britain: Not a Model to Follow" and "Putting Consumers First"--Ed.
The rolling blackouts and soaring prices now besetting California's electric system are only the first and most visible signs of deeper problems affecting the U.S. grid. Among them are neglect of the nation's electrical infrastructure, poorly structured electricity markets, and a lack of incentives for new investment.
Ultimately, most of these problems spring from a lack of understanding of the power system's unique nature and technical complexity, resulting in a hodgepodge of policies that ignores both technological and economic reality. Fortunately, a variety of new technologies are available to help resolve these fundamental issues in a cost-effective, expeditious manner.
Because electricity is so fundamental to our emerging digital society, economic growth will depend critically on providing more reliable, lower-cost electric power. Meeting these twin goals has been the primary aim of the country's experiment with electricity deregulation, and understanding what went wrong in California can help other jurisdictions achieve a smoother transition to competitive power markets. More vigorous competition will be needed if the electricity infrastructure is to keep pace with demand growth, as will the simultaneous incorporation of new technologies that can revolutionize power generation and delivery. Therefore California's mistakes must not be misinterpreted as controverting the urgent need for change. Rather, it is vital that the causes of the current crisis be identified and that the viability of different solutions be explored, both for California and for the rest of the global power market.
Inadequate infrastructure incentives
Neglect of the power system has resulted primarily because restructured electricity markets have not yet matured enough to supply adequate incentives for infrastructure investment. Until the 1990s, U.S. utilities retained a comfortable capacity margin of 20-30 percent over peak demand; but since restructuring began in 1992 with passage of the National Energy Policy Act, margins have declined to less than 15 percent on average. The situation has been particularly acute in California where a booming economy and a dearth of major new power plants have raised demand until it is outstripping supply growth by a factor of 10 to 1.
Transmission capacity has done no better, having failed to keep up, particularly along the state's main north-south corridor. Even now, projected growth of the California transmission system is only about half a percent over the next decade.
Three serious market flaws are also illustrated by the California experience. First, wholesale power was made too dependent on the spot market. Utilities had been strongly encouraged by regulatory policy to sell their fossil-fuel generation facilities, yet discouraged from locking in stable prices through long-term contracts. Second, the wholesale market organization was fragmented by a poorly structured separation of the independent system operator (ISO) from the power exchange (PX). This separation allowed generators to "game" the market by bidding only a portion of their capacity ahead of time into the PX, and then reaping exceptionally high prices when the ISO was forced to buy power in real time to balance supply and demand. Third, retail prices were frozen, which meant rising wholesale prices could in no way be moderated by being passed on to consumers so as to reduce their demand.
Pennsylvania provides a contrasting example of how deregulation can work. Electricity rates there, once 15 percent above the national average, now are more than 4 percent below. Several differences from California are worthy of note: Pennsylvania has taken a regional approach by joining with four other states to form the country's largest electricity market. Within the state itself, utilities generate more than 95 percent of their electricity from relatively inexpensive coal and nuclear plants, while California relies heavily on natural gas, which fluctuates more widely in price and has recently become very expensive.
Moreover, new plant construction has kept pace with demand in Pennsylvania, and its utilities were not required to sell off their generating plants to out-of-state companies. Utilities were also encouraged to enter long-term contracts for power, rather than be forced to rely on a volatile spot market. Finally, restructuring was not imposed all at once. Instead, a two-year pilot program allowed the state to work out any bugs.
Load management is key
The most effective short-term step that can be taken to ease the California crisis and help prevent its spread is to improve load management. Electricity customers need to be given incentives to conserve energy when it would do the most good from a power market standpoint. For those customers who are particularly risk averse, a fixed-price rate can still be offered, but with an "insurance premium" tacked on to protect against rising rates.
Large customers can be offered special rates to interrupt power when conditions are tight, or opportunities to sell power they generate. Probably the most effective option is to institute time-of-use rates and real-time pricing. In this way, the customer would know the price of electricity at any given time. The price reflects the cost of power generation and delivery at that given time, changing minute to minute, hour to hour.
My organization, the Electric Power Research Institute, has studied the benefits of real-time pricing and found, for example, that it could lower peak demand in California this summer by 2.5 percent, thus helping reduce wholesale prices by 24 percent. Inexpensive electronic meters, now being introduced, can facilitate the spread of real-time pricing.
Other technologies can be applied on the supply side in the medium-to-long term. Fossil-plant upgrades, for one, could add 5 percent to the capacity of many units, including an estimated total of 3700 MW in California. Transmission system capacity, too, can be improved by advanced technology, even before new lines are added. Using tools such as the dynamic thermal circuit rating (DTCR) software package can increase the throughput of some thermally constrained transmission paths by 10-30 percent. For areas of the transmission system that are stability constrained, power electronic technologies known as FACTS (flexible ac transmission systems) can boost power flow by 20-40 percent, at a much lower cost than building new lines.
Still other technologies are available to upgrade maintenance practices throughout the industry, assist service providers with rate design and market simulation, and help system security coordinators integrate grid operations on a regional scale. Now is the time for engineers to help policy-makers better understand the technical complexity of power systems and become aware of new technological opportunities for solving the current problems before they spread even further.
Electricity Restructuring in Britain: Not a Model to Follow
By Theo MacGregor, MacGregor Energy Consultancy
The model on which U.S. electric industry deregulation was based is, after 10 years, a failure. The system, established in Britain in 1991, was designed and created through a nondemocratic process--without public participation or transparent information about the cost data underlying prices.
Although world oil and natural gas prices plummeted, and electricity employment was reduced by 50 percent, generating prices in the UK remained so far above the cost of production that the power companies literally did not know what to do with all their profits. In a single year, one of the two private power-generating companies that were created--National Power--paid dividends to stockholders that exceeded the entire value of the company's stock at privatization.
The privatization of what had been a government monopoly also resulted in one transmission company and 12 regional electric distribution companies (RECs). These were seen as natural monopolies that would need regulating into the future, whereas it was thought that the generators would soon be competitive and would not need regulating. An Office of Electricity Regulation (OFFER) was established to set price caps for the RECs, and monitor monopolistic behavior on the part of the generators. Eventually, the office forced the two companies to divest themselves of a significant number of their power plants; yet prices remained high above costs.
A Birmingham University professor, Stephen Littlechild, was appointed the first OFFER director-general in 1989. He instituted a Power Pool bidding system that was supposed to lower prices for electricity by subjecting power generation to competitive market forces. Eight years later, an investigation was conducted by OFFER and led to the following conclusions:
"There is strong evidence that Pool prices were being manipulated; that participants in the pool have been using the rules for their commercial interests; and that higher wholesale prices have been established that will mean higher prices for customers. And this manipulation has been accelerating."
When Littlechild created Britain's Power Pool, the theory was simple: every day, generating companies would bid to supply the nation's grid system for each half-hour of the following day. The lowest bidders would supply the system, and consumers would benefit from the competition in the form of lower prices. Markets, not regulation, would thus set electricity prices.
Unfortunately, Britain's market-based electricity pricing system became the model for restructuring around the world, including the United States. The model has spread despite its failure to do what it was supposed to do: namely, reduce prices for consumers.
Indeed, after nearly a decade of market pricing, electricity prices for residential customers in England in 2000 were 44 percent higher than in the United States, and they had risen considerably since 1989 when privatization was enacted.
Economic efficiencies, the market way
The major argument made by economists to promote deregulation and market competition in electricity pricing is that markets lead to economic efficiencies. If unfettered by regulation, the argument goes, prices will rise and fall with demand; the "proper" price signals will lead to efficient usage and energy conservation; plants will be built when and where needed; and the need for regulation will decline.
In Britain, as in California and everywhere else market pricing of electricity has been tried, theory is bumping up against reality. In Rio de Janeiro, Brazil, for example, prices following privatization shot up 400 percent, 40 percent of electricity workers lost their jobs, and the lights went out.
In the real world, power markets are too easy to monopolize and manipulate--that is, to game--for the theory to hold. Short of price regulation, there is no set of rules or regulations that can prevent the wild price swings and increases that are endemic to markets. And the electricity industry embodies all the elements of what used to be (and sometimes still is) called a "natural monopoly": there are no good substitutes; only one provider can efficiently distribute electricity; market entry barriers are high (extremely high capital costs and siting barriers, among others); electricity is economically infeasible to store for most purposes; because it is a necessity; demand is notoriously unresponsive to price changes; and price signaling among suppliers is incredibly easy.
In fact, one of the early proponents of deregulation in a number of industries (rail, trucking, airline, and electricity), Alfred Kahn, an economist at Cornell University and former chair of the New York State Public Service Commission, now says: "I am worried about the uniqueness of the electricity markets. I've always been uncertain about eliminating vertical integration....It may be one industry in which it works reasonably well."
In Britain, the added cost of simply developing and running the new wholesale market for the first five years was £726 million (approximately US $1.1 billion), including extensive modifications after only two years. After just about a decade of high prices and market manipulation, Britain spent an additional £100 million to eliminate the Power Pool and institute the New Electricity Trading Arrangements (NETA) that are supposed to foster commodities-style dealing in Britain's £7.5 billion wholesale power market.
The electric industry itself has spent far more because companies have had to install complex computer systems and trading desks to be able to participate. In the meantime, consolidation in the industry has meant that there are only six vertically integrated electric companies that serve 12out of the 14 regions in the country. Most of these companies supply their own customers, the bilateral contract market is disappearing, and there are disincentives to sell into the spot market.
More rules and regulations than ever
Unlike the Power Pool model, where power was centrally dispatched (similar to California's system except that hedging --buying power on the futures market to "hedge" against prices rising--was allowed), NETA allows self-dispatching, which allows the generator companies to send out power as they see fit. Ninety percent of trades happen in the bilateral market, where a buyer contracts for power directly with a supplier, and about which there is no public information available. The remainder take place in the Power Exchange, and the system is then balanced by the system operator. The balancing process and announcement of final prices could take months, during which everyone is kept in the dark.
NETA was just put in place on 27 March 2001, so it is too soon to know whether it will foster competition and lower consumer prices. The cost of the system, plus higher natural gas prices in the UK, may actually lead to increased prices, according to Simon Harrison, director of energy consultants at Mott MacDonald, and Martin Stanley, president of trading at TXU Europe, a major electricity generator and supplier in the UK.
Thus, far from simplifying pricing and eliminating regulations, more rules and regulations than ever existed before have been implemented since restructuring of the industry began, and more are being demanded daily. These rules and regulations--like the structure of the new power exchange itself--have been designed and put in place without the full participation of those affected by them.
During the 1990 privatization process, the British government established "consumer councils" to (allegedly) protect the public's interest in fair and reasonable electricity prices. However, members of these councils were appointed by the regulator himself! Councils issued statements supporting the regulator and never mounted any serious challenges to his decisions on prices. Recently, in the guise of regulatory reform, the British government announced that the regulator would no longer choose the consumer representatives; rather, the central government would select certain consumer organizations to review otherwise "confidential" documents provided by the electric companies. They still would have little influence, and other interested parties still do not have the right to participate in the process.
Even as the United States has moved to deregulate wholesale electricity prices and taken steps in some states toward market pricing of retail sales, one major difference between the restructured electric systems in Britain and the United States remains: in the United States, stakeholders participate fully in the process.
Another difference is that, instead of being allowed to claim that cost data are confidential and not to be shared, U.S. electric companies must provide information to the regulators and to the public that will allow "just and reasonable" rates to be determined.
The principles of democratic regulation have been sorely challenged lately by the U.S. Federal Energy Regulatory Commission's handling of wholesale pricing in the West and elsewhere, and by the market structure created in California. The hope for restoration of reasonable pricing lies in the fact that the people affected by the outcomes are participating in the decisions being made: through litigation, negotiation, and legislation.
In Britain, as in most other nations (except Canada), democratic regulation is a contradiction in terms. The high and volatile prices inherent in unfettered markets will become a feature of the U.S. electric industry as well--unless public participation and transparency of information continue to be standard practice in the pricing of electricity.
Putting Consumers First
By Glenn English, National Rural Electric Cooperative Association
California's troubled experiment with deregulation has turned up the volume on the debate over a new U.S. national energy policy. Electric industry and other energy problems are today's lead stories in the evening news and the morning papers. Yet fundamental consumer protections are conspicuously absent from most legislative and regulatory deliberations on deregulation or restructuring.
All consumers--residential and commercial, small and large alike--are entitled to reliable, universal electric service priced at a reasonable rate. This principle has been the bedrock of state and federal regulation of the electric industry for decades, and it is being carelessly tossed aside in the name of "competition" or "choice."
Competition is not the end--it is a means to an end. Competition is not, therefore, the goal of electric industry restructuring. The goal is reliable, universal service at a reasonable rate. And that means putting consumers first. Instead, the opposite is happening.
One of the curious features of electric retail competition as it has unfolded is that the choice is not really the consumer's to make; it is the suppliers who choose the customers. It is completely up to the power suppliers to decide which states and utility territories they will enter, and which customers in those territories they will serve.
To date, very few suppliers have chosen to serve residential and rural customers. Commercial and industrial customers are the lucrative accounts--the customers who are chosen in the new "competitive" market.
Last summer, customers of San Diego Gas & Electric Co. burned their electric bills to protest sudden huge price spikes. Most of the new competing power suppliers in California have exited the state's flawed electricity market, returning customers to their original utilities. Predictions for electric consumers in California this summer are dire: the situation will get far worse before it gets better.
But California is not an anomaly. The Boston Globe recently reported on the status of deregulation in Massachusetts by describing the plight of one couple and the situation of thousands more: electricity is costing them more under deregulation. They switched to a new power supplier in their area, one that offered a discount, but that company, Utility.com, went out of business. According to the Globe, the couple has been unable to find another company willing to sell them electricity at the same discounted rate. They were forced to return to their original power supplier, which converted their account to its higher-priced "default service" for new or returning customers provided for in the state's new deregulation law. Where were the benefits of choice or competition for those consumers?
Some may not be chosen
On a different note, in Pennsylvania, which has been enjoying good press on its restructuring law, electric cooperatives began offering retail choice of electric energy to their customers in January 1999. But not one alternative retail power supplier has entered, or registered to serve, any of the cooperatives' service territories so far.
Now that we know that choice can mean that some customers won't get chosen, and that while power suppliers may have legitimate reasons for exiting or declining to enter certain markets, such a situation creates a serious problem because electricity is an essential service. Someone has to supply it dependably and at a decent price.
U.S. electric cooperatives are private, not-for-profit electric utilities. There are more than 900 of them, providing electric service to more than 34 million people in 46 states. They are owned by the consumers they serve and offer a real alternative to electricity customers seeking basic consumer protections and self-reliance.
Putting consumers first means that policy-makers should allow consumers to provide for their own energy needs. Through the cooperative business model, consumers can join together to protect themselves from forces in the industry that threaten to abandon the long-held obligation to serve all customers.
At one time, the promise of universal service saw electric cooperatives stepping forward to wire rural America and bring electric service to farm families. Today it means that consumers may have to look to electric cooperatives to provide them real access in a marketplace dominated by a few giant corporations whose mission is to put their investors ahead of customers.
Since the advent of restructuring, a wide array of groups has chosen the cooperative business model to provide for their energy needs. New cooperatives have appeared on both coasts and in the heartland to aggregate electricity and other energy purchases and to provide energy-efficient services and even new generation. These include housing cooperatives in New York City; fruit growers and processors, independent oil producers, and other agricultural groups in California; a neighborhood technology organization in Chicago; and electric cooperatives with industrial energy users in Michigan.
Nonetheless, most electricity consumers still face great risks in a deregulated electricity marketplace. As industries deregulate, what usually happens? Companies--the banks, the airlines, telecommunications firms, and the trucking industry--merge. They do not merge necessarily to become more efficient, to lower prices, or to produce better products. They merge to dominate markets and then squeeze out the competition.
A wholesale market is crucial
There is much work to be done to protect the nation's electricity consumers from ill-advised tinkering with the electric industry. A few issues already loom large. A well-functioning wholesale market is crucial to a successful retail market. True retail choice is impossible if there is insufficient generation, concentration of generation ownership in too few hands, insufficient transmission to move electric power from generators to customers, or discrimination in transmission access.
Attempts to repeal the Public Utility Holding Company Act, which have increased momentum on Capitol Hill, should be stopped, unless the act is replaced with adequate and enforceable consumer protections. Only real oversight and enforcement authority can determine whether mergers and acquisitions in the investor-owned utility sector are truly in the public interest, not just in the interest of stockholders.
The quickly changing energy landscape gives the nation's cooperative electric utilities a unique opportunity for leadership in consumer protection. We do, however, urge all electric industry stakeholders to join with us in putting consumers first.