# Presentation: 174865

## Economics of Electric Utility Deregulation: Generation

- Dr. Mark Rodekohr
- February 2001
- Bangladesh Ministry of Energy and Mineral Resources

## Organization

-  Economic Basis and Objectives of Deregulation
-  History of Industry and Regulations
-  The Elements of an Efficient Market
-  Contract Structures
-  Case Studies of Several Countries
-  Summary and Conclusions

## Regulated Electric Utilities

## Why Deregulate

**Few people argue that the basic economics of transmission and distribution have changed. But, over time, the optimal scale of generating plants (due to gas turbine technology) has declined making this sub-sector less likely to be labeled a natural monopoly. **
**Uneconomic PURPA**** (Public Utility Regulatory Policies Act) ****contracts and nuclear power investments were the primary reasons that some states found themselves in the 1990s with electricity prices that were well above the going-forward cost of building and operating new gas- or coal-fired power plants. Other states—those that had not pursued nuclear power and had been more cautious in signing long-term contracts under PURPA—retained relatively low prices. That contrast was probably the driving force behind the restructuring movement in the United States.**

## Economic Issues

- The combination of very inelastic short-run demand and supply (at peak times) with the real-time nature of the market (costly storage and grid reliability requirements) makes electricity markets especially vulnerable to the exercise of market power through withholding of capacity. However if the market is defined more broadly (i.e. energy services) this is less of an issue.
- The ability of firms with modest market shares to exercise market power is greater than in most other industries. That is why concentration measures are not very informative when applied to electricity markets.

## Demand – Supply Shifts

- Price

- Quantity

- S

- Q

- Q1

- P

- P1

- D

- D1

- Relatively small
- Shifts in either
- Supply or demand
- Cause large changes
- In prices

## Perfect Competition

**Competition, or more precisely perfect competition, is a market state characterized by price taking on the part of both suppliers and demanders. This means that no party believes it could act on its own to change the market price and benefit from this action. This is the short-run criterion for competition. The long-run criterion requires that there be minimal barriers to the entry and exit of suppliers from and into the market. **
**The term "well-behaved costs" refers to a number of characteristics, some subtle. The major cost requirement is that the costs of production must not show increasing returns to scale to such an extent that a few firms will grow large enough to dominate the market and no longer be price takers. Such a situation leads to what is called a natural monopoly. A second cost requirement is that start-up costs be small. It is interesting to note that the electricity is a focus of this discussion when other industries like automobile product where entry costs are even higher is never discussed. **

## Perfect Competition (cont.)

**However, it is now recognized that poor (or expensive) information on the part of either suppliers or demanders can make a market very inefficient and even lead to its collapse. In electricity markets, demanders may have poor information about real-time price changes (and to some extent regulations prevent them from getting this information), and generators may have poor information about prices over the next few hours or days when they make a decision to start up. Both of these can cause, or contribute to, inefficiency.**

## Short-run competitive dynamic

-  A price taking supplier will always produce more if its marginal cost, MC, is less than the market price, P. This is because every unit it produces for MC it sells for P and makes an additional profit of (P-MC). Similarly, a price taker will always produce less if it finds its MC > P.

## In the Long Run, Price Equals Average Cost 

- The process of long-run competition involves investing in plant and equipment, not simply changing the output of existing plants. This dynamic requires a definition of long-run profit. Profit is of course revenue minus cost, but economics defines costs slightly more broadly than does business. Economists will define cost to include a normal rate of return on all investment and costs are measured as opportunity costs, not simply historical costs. This rate of return is defined to include a risk premium.

## Other Economic Factors

- The availability of electricity is a necessary condition for economic growth as most industries cannot develop without this resource. In other words is electricity like any other infrastructure investment.

## Impacts of a Unchecked Monopoly

- A monopolist maximizes revenue by extracting as much consumer surplus as possible.  Therefore in the unregulated electricity market:
- Residential users with few alternatives would be charged the most followed by commercial customers and last by industrial customers, this is called price discrimination and serves to extract all consumer surplus.
- Industrial users often have the ability or potential to generate their own power and therefore are less likely to face high prices.

## REGULATION: OUT WITH THE OLD,IN WITH THE NEW

- In implicit or explicit recognition of the vulnerability of electricity markets to market power, almost every organized electricity market currently operating around the world has in place some form of price or revenue cap. Some view these regulations both in the U.S. and in other countries as a means of securing profits and limiting competition.
- Traditionally the United States has used a rate of return approach (a form of revenue cap, more specifically limits on the rate of return) while the U.K. and Australia have used a price cap.

## Vision

- The elimination of the traditional utility requires the creation of a new paradigm. Several competing visions have emerged, [Blumstein and Bushnell, 1994] most of which share the common goal of a market where supply conditions, demand conditions, and transmission constraints, are reflected in price signals rather than accommodated through quantity constraints and planning processes.

## Fundamental Issue of Deregulation

- At the most fundamental level, there are four economic problems that must be solved by an efficient electricity industry:
-  investment in generation capacity,
-  stranded costs, - largely a political issue in the short term
-  investment in delivery capacity,
- and dispatch.

## Peculiarities of Electricity

- Flows of electricity across the network of interconnected power lines cannot be directed (“Kirchoff’s Law”).
- Electricity has traditionally been produced on demand in the U.S. so blackouts don’t occur (which is not true for many other countries) - can’t be stored (or it is very expensive); must always be in balance.
- Developments of markets requires reforms by both state and federal agencies.
- Has a long regulatory history of at least 100 years.

## Implications of Peculiarities 

- Some have argued that, the non-storability of electricity, combined with very little demand elasticity and the need for real-time supply/demand balancing to keep the grid stable, has made restructuring of electricity markets a much greater challenge than was inferred from experience with natural gas, airlines, trucking, telecommunications (which was similar to electricity), and a host of other industries.

## Three Divisions of Electric Industry

- Generation - competitive?
- Transmission - natural monopoly - regulated by the Federal Energy Regulatory Commission (FERC)
- Distribution - natural monopoly - regulated by state commissions

## Transmission

-     More importantly, by its very nature, transmission capacity creates winners and losers among suppliers and consumers of electricity. The distributional effects can easily be orders of magnitude greater than the efficiency effects [James Bushnell and Steven Stoft]. If your firm owned all the generation in New York City, how would you feel about proposals to beef up import capabilities into the city? The economic and political dynamics that have arisen in the electricity industry resemble those surrounding trade policy, as firms seek to preserve their advantages in serving local markets.

## Distribution

- Distribution has high fixed cost - natural monopoly (However look at the New Zealand experiment)
- Retail sale does not have high fixed cost - potentially competitive

## Early History

- 1882 Thomas Edison’s first power plant
- Industry sought regulation from “debilitating” competition (there is some debate on this view some have argued that the industry sought secure profits)
- 1907 WI&NY regulate electricity

## Federal Power Commission

- 1920 - Federal Power Commission
- regulate surplus power from federal irrigation and water control projects
- 1935 - includes all sales of electricity across state boundaries
- 1977 becomes FERC - 5 commissioners

## Public Utility Holding Company Act (1935)

- Transformed multi-state, complex holding companies
- Created simple corporate structures regulated by states
- confined acquisition of assets

## 1950’s-1960’s

- First commercial nuclear plant (1957) in Shippingport, PA
- Power Survey (1964)
-  demand will grow from 200GW  (1964) to 525 GW (1980)
- nuclear predicted to cost 0.5 cents/KWH including capital, investment, fuel, op. Cost

## Great Northeast Blackout (1965)

- 30 million without power from Canada to NJ
- leads to creation of NERC, North American Electric Reliability Council’s
- 10 regional councils - ASCC, ECAR, ERCOT, MAIN, MAAC, MAPP, NPCC, SERC, SPP, WSCC
- MAIN - Mid-American Inter-connected Network

## 1970’s

- Oil embargo - tripling of oil prices - rate increases (1973)
- 212 requests for rate increases totaling $4.5 Billion PUCs approved about 1/2, P increase, Q decrease
- 113 planned nuclear plants scrapped (Q decrease, cost increase (alternative production sources relatively cheaper), public concern)
- 67 planned coal-fired plants scrapped, (1972-1984)

## PURPA 1978

- Qualifying facilities - cogenerators (using traditional fuels) or renewable energy sources
- Utilities must buy at avoided cost of new generation

## Creating Competitive Generation

- PURPA 1978 required utilities to buy from, non-utility generators that are determined to be “qualified facilities”
- Energy Policy Act of 1992 –
- exempt wholesale generators
- transmission-owning utilities had to deliver power from generators to other utilities or wholesalers at reasonable, non-disc. Cost-based rates
- FERC 888 procedures for this, how to compensate for losses

## Industry Structure

- In 1999, 3,156 investor owned, Federal, and cooperative electric utilities in US.
- 2,008 publicly owned
- 900 cooperatives
- 9 Federal

## Industry Structure

- 239 IOU’s, investor-owned utilities
- only 7.6 percent of total regulated utilities
- 74.1 percent of MWH (megawatt hour) sales to ultimate consumers
- 40.7 percent for resale
- Most electricity comes from IOUs that are integrated - generation, transmission, distribution, retail sale

## Industry Performance

## Industry Performance (continued)

## Features of an Efficient Market

**Efficient Pricing - A principal characteristic of any efficient market, whether or not it is run as an auction, is that the prevailing price is close to the marginal cost of producing the product. Meeting that condition requires that sellers do not have the ability to raise prices above their marginal costs. For instance, a monopolist has an ability to raise its price because it knows no one can under cut it. Generally, the more sellers there are in a market the less likely it is that anyone can raise prices above marginal costs without being under cut by a competitor. There could be imperfect information because of uncertainty about the level of demand. **
**Efficient Entry – Since a large numbers of sellers is a necessary condition firms must be able to enter the market easily.  A uniform price auction (next slide) and the ability to strike long term contracts supports this type of market.**

## Methods for Achieving Efficient Pricing

-  Uniform Price Auction – all sellers receive the highest accepted bid price.
-  Discriminatory Price Auction – sellers receive what they bid for all bids that are taken.
-  It is not clear which is the preferred method the U.K. is moving away from the uniform price auction to the discriminatory price auction. As of January 2001 California used the uniform price auction approach this could change at any time.

## Bankability

- For a non-utility generator (NUG) to obtain financing for the construction of a power plant it is advantageous for that NUG to have a long-term contract for the sale of the plant’s potential power generation. To the extent such a contract reduces uncertainty and makes it possible for a NUG to obtain financing we will say that the contract provides “bankability.” In general bankability increases as the certainty of the income stream from the contract increases.

## Contract Structure is Critical

- A wide variety of physical and financial contracts are currently traded in the power markets. Analyzing these contracts is more difficult than analyzing their counterparts in the interest rate, foreign currency and equity markets. This is partly because electricity cannot be easily stored or transported and so exhibits a very complex price behavior. Difficulties related to transmission and distribution, generation, varying ecological considerations and other constraints mean that not all electricity can be valued equally. Although this view is not uniformly held.

## Types of Transactions

-  **SPOTS** - purchase or sale of an asset at the prevailing market price
-  **FORWARDS** - contracts to buy or sell an asset at a future point in time. The characteristics of forward contracts therefore specify:
- commodity description;
- delivery price;
- delivery date and time; and
- delivery location.

## Types of Transactions (continued)

**FUTURES** - Futures are similar to forwards. The most important difference is that whereas a forward contract is bilaterally negotiated between two parties who are transacting directly with one another, a futures contract is traded on an organized exchange.
**SWAPS** - essentially it is an agreement between two counter parties that allows them to swap two different kinds of cash flow
**OPTIONS** - the seller is obliged to make delivery of the underlying asset, and the buyer is obliged to pay the previously agreed upon price for it

## Types of Transactions (continued)

-  **CAPS AND FLOORS** - Just as a swap is a portfolio of forwards, each one with a different delivery date, a cap or floor is simply a portfolio of options, each one with a different expiration. A cap is a portfolio, or "strip", of calls, while a floor is a strip of puts.

## Transaction Options

## Contract Complexity 

- Under a **contract for differences (CFD**), the demander will pay the seller ( *p**c** - *p) q, where *p *is the contract price, *q *is the contract quantity and *p**c** *is *C *the market’s spot price.
- The **transmission congestion contract (TCC) **provides the right R, which pays the holder the amount (pj – pi)Rij , which we will call the contract’s **yiel**d where i is the transmission node and j is the receiving node.

## Transition Issues: Stranded Costs 

**With the introduction of competition, utilities have been concerned that construction costs that they incurred under their monopoly service territory agreements may not be recovered and will be "stranded" by consumers leaving their system for less expensive power elsewhere. **
**Stranded costs are defined by recovery proponents as those costs that were legitimately and prudently incurred under the "old" regulatory regime that are not economically recoverable under the "new" competitive regime that is being entered. However it is interesting to think about how large the stranded costs could be for a 20 year old plant that has been depreciated and even subject to accelerated depreciation.**
**Stranded Benefits are defined as a increase in asset values due to deregulation. **

## Transition Issues: Stranded Costs and Takings (cont.)

**Examples of stranded costs include uneconomic nuclear power plant investments and above-market electricity supply contracts under PURPA. The magnitude of potential stranded costs is uncertain. FERC estimates total retail and wholesale stranded costs to be as high as $200 billion. Others have estimated much and some much lower.**
**The choice of recovery method (i.e. the structure of rates charged to customers) and the size of recovered costs will affect both total sales of electricity and consumer welfare.  The availability of new turbine technology will limit the design of effective rate structures.**

## New Generation Technology

- High efficiency gas turbines
- lower construction costs
- lower operating costs, at a smaller scale than older units but still not a low as coal
- Compared to new coal-fired generators new smaller units generate electricity at the same low cost as very large units that were built only a few decades ago

## Implications of New Technology

- Because of smaller and lower cost plants, generation has moved from a natural monopoly to potentially competitive industry.
- But if you generate, how do you get it to consumers?

## Case Study: Argentina

**The current system, designed for private enterprise, is unique in that it divorces utility earnings from their capital-investment costs. Of further interest, while provisions for rate of return on capital have been abandoned, the regulatory scheme essentially provides for rate of return on variable costs such as labor, administration and organization, fuel, and so forth, reflecting the importance of labor to the governing coalition.**
**By 1994, the government had sold majority stakes to three distribution firms, serving a total of 3,954,333 customers; six transmission companies, accounting for a total of 14, 971 kilometers of lines; and 21 generating plants, ranging in capacity from 47 to 1400 megawatts, for a total capacity of 10,203 megawatts. The government held 39 percent of shares for itself, distributed 10 percent to workers, and sold the rest on the stock market.**
**Electricity generation is essentially unregulated, with no need for (prospective) generators to obtain permission prior to building or adding to generating facilities. **
**Electricity transmission and distribution are classified as public services. Transmission companies may not buy and sell electricity. Like distributors, they are considered natural geographical monopolies and are obliged to supply access to transmission lines as long as they have capacity to spare, for which they charge a fixed transport fee**

## Case Study: Argentina

**The national electricity regulating body (Ente Nacional Regulador de la Electricidad, or ENRE) regulates transmission and distribution companies and, for the most part, both are covered by the same regulatory provisions.**
**While the wholesale electricity market is largely unregulated, with prices subject basically to the pressures of supply and demand, the retail market is not. Distributors operate regional monopolies under five-year licenses from ENRE and, therefore, do not face market competition. The licenses stipulate a tariff structure, which then serves as the basis for all price adjustments****. **

## Case Study: Chile

-     **The electricity sector in Chile is regulated by a single body—the National Energy Commission (CNE). **
**Certain classes of service are unregulated. In general, prices may be freely contracted for large users (over 2000 kW)**
**In its rate-setting role, the CNE—again, like its Argentine counterpart—is supposed to take into account the real costs of producing, transmitting, and distributing electricity. To this end, it sets maximum allowable rates that are supposed to reflect the long-run marginal costs of operations **
**Prices at the distribution end of the electricity pipeline are set on the basis of wholesale, or “node” prices plus value added in distribution. Node prices for electricity are set twice yearly to “reflect an average of the marginal costs of supply incurred in generation and transmission**

## Case Study: Chile

**The twist to this scheme is that CNE-determined node prices “cannot diverge by more than 10 percent from prices [for equivalent tension and power levels] not subject to price regulation**
**What we observe in Chile meets our expectations. The amount of electricity generated in Chile has risen steadily, with prices changing little throughout the 1980s. Further, electricity self-generation has continued to rise since privatization (see Spiller and Martorell 1994, 41, Tables B:VI and B:VII). This suggests that prices still are high enough to make it worthwhile for relatively inefficient producers to continue generating electricity rather than buying it off the grid.**

## Case Study: U.K.-History

**Electricity privatization and reform got off to a relatively late start in the United Kingdom, having its origins in the passage of the UK's Electricity Act of 1989. The industry was initially restructured by the government along functional lines. Guiding the government's restructuring was the idea that electricity generation and marketing could be made competitive industries, while transmission and distribution needed to be treated as natural monopolies for the indefinite future. Regulation would therefore gradually be withdrawn for the former segments but remain for the latter. For the still regulated segments, a new form of regulation (based on a price cap) was introduced--along with a new regulatory authority, the Office of Energy Regulation (OFFER). On Vesting Day (April 1, 1990) a newly-created electricity industry emerged. **

## Case Study: U.K.

**In a reversal of the situation that existed at privatization, 2000 has seen the end of the generating market dominance enjoyed by PowerGen U.K., National Power, and, since 1996, TXU Europe. Up until 1999, these three generators set prices in the U.K. pool for over 90% of the time. However, as a condition to the acquisition of supply businesses, National Power and PowerGen U.K. were forced to divest 4,000MW of coal-fired capacity each, allowing in new entrants AES Corp. and Edison Mission Energy Co. This has led to increased competition and lower pool prices from the start of 2000. PowerGen U.K. and National Power are in the process of voluntarily divesting additional generating capacity, which may bring in further entrants, and in theory, more competition to the U.K. market.**

## Case Study: U.K. - Results

**Although UK electricity reforms are not yet a decade old, some general assessments can be made regarding their performance. In terms of efficiency, the reform of the electric industry in the United Kingdom is generally viewed as a success. By any measure, the current industry is markedly more efficient than it was prior to privatization. However, where issues of fairness and equity are concerned, the industry reforms have been controversial. The new system has been criticized for unfairly and disproportionately benefiting industry shareholders and corporate executives over taxpayers, rate payers, and electricity industry employees. The auction of electricity assets to the general public was criticized for failing to obtain the full value of the assets offered for the treasury. Further, a large share of the industry's efficiency gains was realized through massive workforce reductions****.**

## Case Study: U.K. (continued)

**During the first half of 2000, credit quality in the U.K. electricity sector has shown a marked deterioration as cash flows come under pressure from increased acquisition activity, regulatory action, and an increase in competition in generation. Further erosion in credit quality is likely to occur in the generation sector over the next 12 months. The increase in the number of participants in power generation as a result of power station sales by the major generators will bring greater competition in the electricity sector, and the arrival of new electricity trading arrangements (NETA) in November 2000 will introduce demand-side bidding for the first time, which may also depress output prices.**** **

## Privatized Electricity in the U.K.: A Performance Appraisal 

**In the seven years since privatization began, the UK electricity industry has clearly become more efficient. In 1995, the United Kingdom produced 8 percent more electricity than in 1988. Between the 1989/1990 and 1995/1996 fiscal year timeframes, employment in the UK electricity industry was reduced by roughly fifty percent. Reductions in prices as a result of the periodically scheduled regulatory reviews clearly had an impact on later price reductions to electricity consumers. Although consumers have generally experienced lower inflation-adjusted electricity prices since privatization, gains to larger consumers have generally exceeded those to households.**

## Other Regulatory Issues: Price Caps Versus Rate-of-Return Regulation

**Price-cap regulation is generally viewed as a relatively recent form of regulation, and is most frequently associated with the ongoing regulatory reform and privatization in the United Kingdom. In contrast, rate-of-return regulation is the most commonly used form of utility regulation in the United States, and has been in use for decades. Both forms of regulation, however, attempt to accomplish the same goal: to reduce the power of natural monopolies to restrain output, raise prices, and realize super normal profits. In theory, the way the two regulatory methods accomplishes these goals differs considerably. **

## Other Regulatory Issues: Rate-of-Return Regulation

- Rate-of-return regulation is also called cost-of-service regulation in that it essentially allows companies to pass through those costs which are deemed necessary by the supervising regulatory body to ensure that an adequate level of service is provided to end users. During periodic regulatory reviews, expenditures that are deemed appropriate by the regulatory body are added to the rate base. In order that appropriate levels of capital investment are undertaken, supervising regulatory bodies (in the United States, these are generally State public utility commissions) estimate appropriate rates of return for the regulated utility, based in part on the cost of capital to the utility.

## Other Regulatory Issues: Price Caps 

**Price-cap regulation has been the common means of regulation for the recently privatized industries in the United Kingdom. For several reasons, rate-of-return regulation was rejected in the United Kingdom. For one, obtaining detailed industry data was deemed an excessively expensive effort that would require a large bureaucratic structure. Further, it was felt that regulators would always suffer from a disadvantage, given that any information the regulator obtained from the regulated industry was always incomplete relative to the information possessed by the industry, leaving the regulator in an inferior negotiating position relative to that of the industry. Moreover, as stated earlier, rate-of-return regulation offered insufficient incentives for the utilities themselves to reduce costs aggressively.**

## Other Regulatory Issues: Reliability and Peaking Power

- How reliability can be regulated remains a little talked about regulatory issue that needs to be addressed.
- In the private sector it seldom pays to provide that 1 to 10 percent of capacity which can stand idle for long periods therefore any regulatory changes need to directly address the effect they may have on peaking power generation and the expected economic consequences (i.e. the California problem).

## Other Regulatory Issues: Stranded Costs

-  In the U.S. stranded costs (largely due to uneconomic contracts and nuclear plants) are estimated to be between $10 and $300 billion.  Investors and consumers differ sharply on how these costs should be handled.
-  Stranded costs are not much of an issue when deregulation starts from a base of state ownership. In this situation asset valuation becomes a bigger issue.

## Other Regulatory Issues: Availability

-  Under complete deregulation rural customers (i.e. small markets) would be the last (and most expensive) to get access if they were provided access at all (look at the cable TV industry in the U.S.). This issue is likely roads and other public infrastructure decisions.
-  Therefore any regulatory change needs to address the issue of universal access, in the U.S. the Rural Electrification Administration was created to deal with this issue.

## Summary

-  At this point we have looked at the economic basis underlying the deregulation movement, the history of the industry, methods for achieving a efficient market and presented a number of case studies.

## CONCLUSIONS

- The movement toward less regulation and more reliance on market processes in the electricity industry has enormous potential benefits but also potential risks (others will address California as a case in point). A move toward deregulation that does not take the issue of market power seriously can undermine the goals of industry restructuring and even, as in the case of England and California, produce a regulatory backlash. Any restructuring initiative must recognize that the lack of economic storage and of price-responsive demand can produce serious market disruptions. Furthermore, levels of transmission capacity that may have been adequate under regulation may not be able to support effective competition.

## CONCLUSIONS (continued)

-  In the classical economic sense electricity deregulation would better be termed as a reduction in regulation as almost no one believes the all out deregulation of all aspects of this industry would function.

## References

**Transmission and Generation Investment In a Competitive Electric Power Industry **, James Bushnell and Steven Stoft, January 1996.
**Electricity Restructuring: Deregulation or Deregulation?, ****Severin Borenstein and James Bushnell,  Regulation Volume 23 No. 2.**
**Political Institutions and Economic Development: The Case of Electric Utility Regulation in Argentina and Chile, William B. Heller and Mathew D. McCubbins**
** ****Electricity Markets: Should the Rest of the World Adopt the United Kingdom ’s Reforms ? ****Catherine D. Wolfram**
**U.K. Electricity Sector: Highly Charged Market Causes Credit Concerns ****Standard and Poor’s **
**The Economics of Competition, Steven Stoft, 2000**
**Clarity in Understanding Electricity Contracts and their Associated Risks, *****Robert Maxant, Rich Tanenbaum, and George Travers***** **
**Electricity Reform Abroad and U.S. Investment, Energy Information Administration 1997.**
**Winners and Losers in the Transition to a Competitive Electricity Industry: An Empirical Analysis, Ethier and Mount, Energy Journal**