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05/04/09
The Evolution of Electricity Markets
Filed under: Politics and Economics, Technology and the Law
Posted by: site admin @ 6:59 pm

There has been a perception that electricity generation and distribution is a natural monopoly since Samuel Insull decided to employ the Wright demand meter and the rotary convertor to build a central – substation styled electricity generation and distribution system in Chicago. The rotary convertor provided the technical capability to build a combined AC-DC system where central generation with distributed substations proved economically feasible. The Wright demand meter provided the economic tool to apportion fixed and variable costs between large and small customers in a way that kept large customers, who could build their own generators, and incentivized small customers, by making their incremental cost lower than that of alternative power sources. This approach, coupled with control of several key patents, made it possible for Insull to develop a “complex of holding companies that exercised control over most of the electric utilities in the United States.”

From that time until now, electricity providers have been regulated as public utilities; businesses granted legalized monopolies with a concomitant duty to serve.  This has not kept the US free from blackouts or (perceived) high prices.  With retail electricity prices varying widely across the country, and with realization that the natural monopoly really only exists in the system that delivers power from producer to consumer,  has motivated regulators to reconsider whether the legalized monopolies were “natural” or even desirable.

In fact, even before the recent attempts at retail competition in electricity, regulators began finding ways to insert competition into the mix. In Otter Tail Power v. US, 410 US 366 (1973), the Court held that distributors are required to make their distribution networks available to all electricity generators, as long as it is “necessary or appropriate in the public interest”.  This interconnection for the purposes of “wheeling” power from non associated generators had the effect of keeping wholesale prices low.  That has been followed by the Public Utilities Regulatory Policy Act (PURPA) in 1978, which include rules to encourage cogeneration by authorizing FERC to require utilities to purchase or sell electricity from qualifying facilities (QFs).  This was combined with regulatory quid pro quo whereby FERC required open access transmission in exchange for the approval of market based rates or utility mergers as a way to introduce more competition into electricity markets.

As competition grew, market based rates and incentive rates were introduced as a way to drive down retail costs. Market based rates allow electricity suppliers that can show they possess no significant market power over buyers to set their rates at whatever the market will bear. Incentive rates, on the other hand, encouraged dominant suppliers to find cheaper methods of generation, distribution and or transmission by allowing the dominant utility to keep a portion of the savings in the form of a higher rate of return for shareholders.

The “final” step in this evolution was put into motion in 1996 with FERC Order 888, which effectively split utilities into generation, distribution, and transmission units. This required utilities to separate for the purpose of determining costs, whether or not the functional unbundling involved actual legal restructuring. The goal of this regulation was to make it clearly possible for independent power generators to compete at the wholesale level .  Subsequently, FERC Order 889 required transmission utility participation in OASIS, a real-time market for wholesale power, which provided a basic market mechanism to effect the intent of order 888.

The effect of these market mechanisms have not been what was originally envisioned. Subsequent to their creation, a flourishing wholesale spot market in electricity developed in 1998, only to result in fluctuating prices that peaked more than 2 orders of magnitude higher than the previous average wholesale price and, in the case of California, the bankrupting of Pacific Gas and Electric. In addition, grid reliability did not improve, as evidenced by the August 2003 blackout.

These problems can be traced to a realization that Samuel Insull made when he first began to put together is network of electric utilities: Because electricity could not be stored, electricity supply and demand were required to match each other on a real time basis.  Until there is technology that can create appropriate storage buffers for electricity (just as we have for water or gas), electricity production must match demand on a near instantaneous basis. Since demand levels can fluctuate significantly, any system built to be reliable must be able to handle peak demand, whatever that demand is and whenever it occurs, regardless of how much that demand differs from the average.

Peak demand presents particular problems in a market driven industry. Efficiency concerns mean that there is no incentive on the part of any particular generating company to keep any more capacity available than it can reasonably hope to sell. Because peaks and averages can be widely different, insuring that peak capacity is available at all times means that some facilities will be underutilized, perhaps significantly.  This can result in a game of investment musical chairs, where some investors are left without customers. If this is coupled with a requirement to sell on the spot market, the lack of long term contracts could easily scare off investors in incremental capacity.

Currently, attempts to mitigate peaks in demand have focused on demand management, which can be done in several ways. Demand can be passively managed through the use of devices that respond to fluctuations in incoming power automatically with adjustments in the load they put on the supply.  These devices are not widespread yet (and may never be because they require adding supply management circuitry to each device). “Smart Grid” approaches use out of band signaling to deliver real time pricing information to consumer endpoints with the hope that the consumer will modify their consumption based on this information.   So far, this approach hasn’t had the desired results.

There are other solutions, however. Current work on large scale energy storage facilities can provide the needed buffer by storing energy during times of low demand and then feeding it into the grid during periods of high demand. Currently these approaches are being tried at the wholesale level as a way to mitigate the rapid fluctuations that can occur in wind power generation. In that case, the energy storage deals with fluctuating supply – the complement of the fluctuating demand problem.  They are also being tried at the retail level by “off grid” homeowners.  A quick search on the ‘Net reveals a number of companies that market battery packs for an entire home. In both these cases, we have converted the energy generator from one form (it’s original, be that coal, gas, solar, wind, etc.) to another (a battery).

In Insull’s time, significant energy storage mechanisms (other than pumped storage) didn’t exist. As a result, it made sense to create monopolies as a way of amortizing the cost of excess capacity across the largest possible customer base.  If we are to successfully move away from the regulated monopoly model of electricity generation and delivery, we must develop energy storage mechanisms significant enough to decouple energy production from demand. In order for this decoupling to be economically feasible, the amortized storage costs must be significantly lower than the average original  generation cost. 

Further, the location of the storage facility can determine the level of competitiveness on the supply side. The more closely sited the storage facilities are to the ultimate customer, the greater the choices of that customer as to the original source of power. The storage facility can even be at the retail destination, allowing the retail customer to perform energy arbitrage by purchasing cheap power at times of low demand and then reselling it back onto the grid at times of high demand.  This of course requires demand based pricing - with significant enough variations in prices to justify the investment in storage technology.  This, however, is the end result of the Smart Grid.

4 Responses to “The Evolution of Electricity Markets”

  1. Blare Says:
    Hello Guru, what entice you to post an article. This article was extremely interesting, especially since I was searching for thoughts on this subject last Thursday.
  2. Steve Hickman (admin) Says:
    I’d been studying energy markets for a while and was concerned that regulators had not thought through the consequences of attempts at deregulation.
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