# Presentation: 128080

## Economics of Electric Utility Deregulation: Transmission and Distribution

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

## Organization

-  Overview of transmission issues including a description of current institutions.
-  Transmission Pricing Models
-  Distribution Pricing and Regulatory Models
-  International Examples
-  Conclusions

## Background

- For many years, the electric industry in the U.S. primarily was characterized as:
**Vertically-integrated, investor-owned utilities (IOUs)**
**Most IOUs owned Generation, Transmission, and Distribution**
**Most IOUs planned adequate supplies of each to meet their internal needs**
**There was little inter-utility (much less inter-regional) power trading**
**Some publicly-owned utilities:**
**Owned some Generation**
**But most were transmission customers (TCs)**

## Background (Cont.)

- Voluntary cooperation between utilities resulted in adequate reliability for many years.
- However, things began to change with the development of competitive wholesale markets.

## Transmission

- For transmission, many current proposals emphasize the importance of non-discriminatory open access rather than efficient pricing. If, however, one of the principal goals of restructuring is rationalizing the power industry's capital stock, then the pricing of transmission is also of critical importance.
- As a regulated, “natural monopoly” service can be a serious bottleneck to other regulatory changes.

## Why is it Important

**T****he relationship between generation and transmission is a close one. Generation and transmission are complements, which together produce delivered electricity. But, they are also, increasingly, substitutes and this trend is likely to accelerate as competition develops.**
**Although transmission costs represent only about 2 percent of an investor-owned utilities' operating expenses, they are nonetheless important. Workable competitive power markets require ready access to a network of transmission and distribution lines that connect regionally dispersed end-users with generators.**

## Unique Characteristic of Electricity Transmission

**Because of the physical characteristics of electricity, congestion in one part of the network can be caused by activities elsewhere. According to Kirchoff's laws, power follows the path of least resistance, moving along parallel paths and often taking a circuitous route to its destination. This "loop flow" characteristic differentiates electricity transmission from other transportation systems, such as highways, railroads and pipelines, and makes it difficult to define property rights in terms of a simple "contract path" between two points.**

## Unique Characteristic of Electricity Transmission (continued)

**Capacity on a path may not be available when needed, due to the actions of other parties, because power injected at any one location in the network may affect the availability of transmission capacity elsewhere. This physical characteristic of electricity networks has been used to justify the view that, quite apart from market power issues, the transmission system requires some form of centralized control which is usually provided by engineers.  The role of the state or other regulatory body is to provide the correct incentives or regulations for these managers.**

## History: Great Northeast Blackout (1965)

- 30 million without power from Canada to NJ leads to creation of NERC, North American Electric Reliability Councils
- 10 regional councils - ASCC, ECAR, ERCOT, MAIN, MAAC, MAPP, NPCC, SERC, SPP, WSCC
- More recently on January 17 California experienced rolling blackouts for the first time since WWII.  California measured on a international basis is the world’s 7th largest country.

## A History of NERC

**The North American Electric Reliability Council (NERC):**
**Was created following the 1965 blackout as a voluntary organization intended to forestall proposed federal legislation**
**NERC was created (and is owned) by the Regional Reliability Councils (RRCs)**
**NERC is charged with assuring reliability of the “bulk power” system**
**NERC does not involve itself in reliability of the distribution system (which by the way is the major source of power supply disruptions).**

## A History of NERC (Cont.)

**The North American Electric Reliability Council (NERC) (Cont.):**
**NERC, as presently structured, has no legal authority to:**
**Require compliance**
**Require funding**
**Grant even limited antitrust exemptions**
**For three decades, NERC (and its RRCs) worked cooperatively to make sure “the lights stayed on”**

## A History of NERC (Cont.)

**NERC worked quite well for many years:**
**Most “transmission providers” (TPs) were IOUs (Independent Owned Utilities)**
**TPs dominated NERC**
**NERC developed “Operating Policies”**
**TPs voluntarily implemented these Policies**
** ****Costs shifted from one TP to others were assumed to “wash out”**

## The Need for Legislation

- The restructuring of the electric industry made NERC recognize the need for legislation:
- Marketplace participants began to recognize that all reliability actions had commercial implications (and, of course, vice versa)
- Marketplace participants began to demand equal representation in NERC.

## The Need for Legislation (Cont.)

- Voluntary cooperation between TPs became strained as cost shifting  brought commercial implications
- Marketplace participants legally questioned the “right” of TPs to set transmission policies, again which started to have very important commercial implications.
- NERC vividly recognized that it had no enforcement authorities

## NERC’s “Consensus” Legislative Proposal

- Key provisions include:
**Accreditation by FERC of a single North American electric industry “self-regulating” reliability organization (SRRO) -- under the regulation of FERC**
**Governance by a purely independent Board**
**An open, non-discriminatory, fair and balanced operating process.  A critical feature of the legislation and a necessary condition for ensuring competition.**

## NERC’s “Consensus” Legislative Proposal (Cont.)

**Key authorities of the SRRO:**
**Set and enforce compliance with broad-based reliability standards throughout North America**
**Delegate certain implementation and enforcement authorities to affiliated regional reliability entities (ARREs)**

## What are the Implications For Reliability With No Bill?

**First, we must clearly distinguish between:**
**Bulk power reliability and**
**Distribution reliability**
**Federal legislation will address ONLY bulk power reliability**
**The bulk power system, by definition, is interstate in nature.**
**States are unable**** ****to deal with interstate reliability issues**

## Definition of Efficient Transmission Pricing

**Efficient pricing of transmission means that prices should equal marginal costs, which consist of marginal line losses and, in the event of a transmission constraint, transmission congestion rents. Efficient transmission pricing is necessary to assure economic dispatch of existing generation capacity -- delivery of electricity to consumers at its minimum cost, including both generation and transmission costs. If transmission is priced below its marginal cost, it becomes profitable to import power from distant generating sources, even though less-distant sources might entail a lower (social) cost. If, on the other hand, transmission is priced too high, the geographic market for electricity is artificially narrowed, which limits the importation of low-cost generation and the competitiveness of the generation market in general.**** ****[**James Bushnell and Steven Stoft]

## Definition of Efficient Transmission Pricing (continued)

**Over time, efficient pricing of transmission is necessary to send the correct signals to the market concerning expansion of existing transmission capacity and the location of new generation capacity. If transmission prices do not accurately reflect the costs of transmission, including transmission constraints, participants in the market will not be able to correctly determine whether those constraints are best addressed through expansion of transmission capacity or the installation of new generation capacity closer to the load.**** ****In other words efficient transmission pricing is a necessary condition for a efficient electricity market solution.**

## More Practical Definition of Efficient Pricing

- In addition to meeting revenue requirements, transmission pricing should ideally do the following:
- promote efficient day-to-day operation of the bulk power market
- encourage investment and determine location of generation
- encourage investment and determine location of transmission lines
- compensate owners of transmission assets and encourage the optimal expansion of the network; and
- be fair and practical to implement.

## Efficient Transmission Pricing 

**The transmission price between any two locations, A and B, is simply the difference between the delivered electricity price at A and the price at B. In the absence of congestion, this price should equal marginal line losses i.e. marginal cost. When congestion occurs, the price difference between A and B should be larger than marginal line losses by an amount reflecting the opportunity cost of congestion -- the costs incurred when more expensive plants are forced to operate due to "out-of-merit order dispatch".**

## Pricing: Postage Stamp Pricing

- The simplest and most common type of transmission pricing is postage stamp pricing. A postage stamp rate is a fixed charge per unit of energy transmitted within a particular zone, regardless of the distance that the energy travels. Transmitting across several utility systems or zones and accumulating utility or zone access charges is often called "pancaking." Postage stamp rates are based on average system costs and may have a variety of rate designs, based on energy charges (cents per kWh), demand charges (cents per kW), or both energy and demand charges.

## Pricing: Flow-Based Pricing

- One type is "megawatt-mile" pricing, where the transmission rates explicitly reflect the cost of transmission, based on both the megawatts of power flow and the distance between the receipt and delivery points. The cost of transmission per megawatt-mile is the total cost averaged over megawatt miles of usage.

## Pricing: Congestion Pricing

- Congestion pricing sets transmission rates to allocate limited transmission capabilities over constrained interfaces to those transmission customers that most value the ability to make power transfers. Thus, rates increase as the demand for electricity transmission increases and the system is used efficiently
- Prices that do not increase as congestion increases will tend to allocate the transmission capacity inefficiently, because available capacity is not necessarily allocated to the user for which the transmission has the greatest value.

## Transmission Contestability 

**It has been almost an article of faith that transmission is a natural monopoly and that grid owners would be able to exercise monopoly power if market-based transmission pricing were permitted. The development of gas-turbine as well as other technologies is changing this picture. These new technologies can make it relatively inexpensive to install small-scale generation capacity any place natural gas is (or can be made) available (a limited option in many parts of the world), and bypass or reduce dependence on the grid. This can make the transmission network contestable. In essence, the natural gas pipeline network can become a transporter of electricity (in another form) and therefore a competitor to the electricity transmission network. Clearly this is a issue for countries such as Bangladesh which has options.**

## Independent System Operator (ISO)

- The power industry is now moving toward a system in which operation of the transmission network, including pricing, would be placed in the hands of Independent System Operators (ISOs). ISOs across the country are in various stages of development, but none has yet started operating. They are intended to be agents of all the stakeholders in the market -- generators, transmitters, consumers and the "public interest" -- but beholden to none. In particular, ISOs would not have any ownership interest in generation or transmission assets.

## ISO Operations

**In the ISO framework, the owners of the grid would receive a regulated payment to cover embedded costs and would not receive congestion rents. A system for distributing congestion contracts would be developed. For example, participants might be able to obtain congestion contracts by paying embedded costs (i.e., some administratively determined payment) to the grid owner or buying them in the secondary market. Holders of congestion contracts would receive the congestion rents collected by the ISO and thereby insulate themselves against the costs of congestion.**
**The ISOs would also be likely to have a direct role in transmission capacity decisions, although the mechanisms for making these decisions are not well defined. Whether ISOs would have the appropriate incentives to expand transmission capacity efficiently is, an open question.**
**Providing the proper economic incentives for transmission expansion is a critical regulatory decision.  This issue has not been addressed by many and clearly has little impact in the short run but could have serious consequences over time.**** **

## ISO Operations (continued)

**The attribute most critical to the success of a transmission network under ISO management is that it yield locations prices that accurately reflect marginal transmission costs, including congestion rents. If this is not the case, the entire framework will not allocate transmission and generation resources efficiently.**** **
**Under the ISO framework, electricity prices at the various locations are determined by the bidding behavior of generators and electricity customers, but there is no active quoting of transmission prices. Under some regulatory schemes the transmission price is simply the residual -- the difference in the price of delivered electricity between any two nodes -- and the transmission operator has no transmission pricing function.**

## Problems of Under pricing Transmission--The Argentina Example 

- Data from the Argentina electricity market are consistent with the economic experiments and illustrate some of the problems that develop when transmission prices do not reflect capacity constraints
- Because transmission is not priced at its incremental cost, however, new generation capacity is being added in the Comahue region, which already has over 5,100 MW of generating capacity, much more than the 2,600 MW of peak transmission capacity connecting it to the major consuming area, Buenos Aires. Thus, uneconomic generation decisions are encouraged when transmission prices do not reflect congestion costs.

## "buy-sell" model 

**In the buy-sell framework, the grid owner would trade "delivered electricity" -- offering to purchase at injection locations and to sell at withdrawal locations. As would be the case under any system, the operator would hold trading sessions for periods ahead of time. If the flow pattern associated with a given set of prices was not feasible, the operator would adjust prices accordingly**
**Prices would be lowered at any node where the supply of power became excessive or the demand insufficient. Similarly, prices would be raised any place the supply was insufficient or the demand excessive.**** **

## "buy-sell" model (continued)

**Generators and users could hedge against changes in the spot price of electricity using "contracts for differences". These contracts are the economic equivalent of long-term contracts for physical delivery and, as Hogan and others have shown, are the most obvious way to incorporate bilateral transactions into the system. In essence, a generator and customer contract for a specified amount of power at a given price, but there is no obligation to deliver the electricity. If the contracted price is lower than the spot price, the generator is obligated to pay the customer the difference. If, on the other hand, the contracted price is higher than the spot price, the customer is obligated to pay the generator the difference.**** **

## Transmission Summary

**The potential costs of government failure and market failure should be carefully weighed against each other in determining whether transmission pricing should be market-based. Market-based pricing should be given serious consideration for two reasons. First, there are numerous competitive pressures on transmission owners (or operators including the state).  Most importantly, the gas turbine technology ( in some regions of the world) is rapidly eroding the transmission network's natural monopoly, which has provided the basic rationale for regulation. **
**Second the ISO has been presented as the ideal planning organization, with no economic interests or incentives except to run the transmission system and determine transmission prices in the public interest.**** **

## Transmission Summary (cont)

-     **B****y its very nature, transmission capacity can create winners and losers among suppliers and consumers of electricity. The distributional effects can easily be orders of magnitude greater than the efficiency effects (according to some analysts). 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.**

## Productive Efficiency Performance Indicators: Transmission

**transmission losses;**
**system reliability; and **
**operation and maintenance costs per MWh**

## Distribution

- Distribution has high fixed cost – considered by many (but not all) to be “natural monopoly”. An interesting counter example is the fiber optic network.
- Retail sales do not have high fixed cost and are potentially competitive.

## History of Distribution

**The distribution level of the franchise is both the historical and structural center of the industry. At one time, before the advent of state regulation, it was common for municipalities to offer the distribution franchise for competitive bidding. With the establishment of state regulation, monopoly service became the rule. **
**At the regulatory level the "natural monopoly" of the franchise has been enforced by the "exclusive" and "indeterminate" rights granted to a utility for a service territory and extended to transmission and generation to supply that service territory. It has also been supported by the "quasi-governmental status" conferred on electric utilities in order to provide service to the distribution level. Along with the franchise agreement there was also a requirement to provide services to all potential customers.**

## Duplication

**Local distribution systems are often thought to present the strongest argument for natural monopoly: to avoid inefficient duplication. It is significant that in the 1915 report of the Arizona Corporation Commission, stated that the distribution of electricity that was “essentially and rightly monopolistic.” **
**One flaw in this view is that, in other industries, such “duplication” is the norm and widely applauded as providing diversity of service. For example, innumerable neighborhoods are served by multiple supermarkets and service stations, sometimes located next to each other, and shopping malls normally have competing stores selling the same product. Contrary to the conventional view, New Zealand has eliminated the monopoly franchising of local distribution. Also the recent growth in fiber optic networks are not regulated.**

## Massachusetts' Competitive Franchise 

**In Massachusetts, legislation was introduced in December to establish rules and guidelines for municipalities to take back distribution franchise rights from private utilities and offer them for bid under time-limited contracts, similar to bidding for other municipal services such as cable television. The creation of local "Consumer Service Districts" allowed by the legislation would be optional, based on traditional franchise law, and would rely on a system of mixed regulation that allows competition within a framework of guidelines established by the state. The generic terms of the franchise contracts would include provisions to protect programs such as demand-side management and integrated resource planning, as well as protection of low-income consumers. For states that currently allow limited use of local electric franchises, it would allow the next logical step of bidding for those franchises as access to transmission opens up. [****Michael K. Block and Thomas M. Lenard]**

## Massachusetts' Competitive Franchise (Cont.)

**Under the Massachusetts legislation a municipality would establish a Consumer Service District (CSD) by a two-thirds vote of its city council or board of selectmen. To prevent carving of sweetheart districts within the municipality, the CSD is defined by the borders of the entire municipality. Thus, all classes of consumers are contained within the CSD and problems of class discrimination common to retail wheeling proposals are avoided.**
**Upon formation of a competitive franchise CSD, negotiations with utilities are to be conducted first with the current service provider, and after issuance of an RFP, with selected bidders**

## Massachusetts' Competitive Franchise (Cont.)

-  If the current service provider loses the contract competition, it is allowed to file for "stranded investment" recovery.
-  If the utility meets these conditions and a facility or contract is determined by the Department of Public Utilities to be "stranded investment," the DPU may instruct that the capacity and/or energy, or the entire assets of a facility, be sold at prevailing market rates in order for them to qualify for stranded-investment compensation. Any resulting loss of the sale would be shared between the CSD's ratepayers and the utility.

## California Proposal

**Last fall the California consumer organization Toward Utility Rate Normalization (TURN) announced plans to submit legislation for "Community Access To Competitive Electricity.'' **
** ****TURN's plan would create a competitive pressure using the distribution franchise, similar to the pressure generated by the Massachusetts legislation. Under TURN's plan a "Consumer-Owned Utility" (COU) could be established by local agencies under the roof of county government, a water district, or a municipality. While the Massachusetts legislation is based on traditional franchise law, TURN's proposal is based on creation of a municipal utility system. But unlike municipal utilities, the COU would not acquire the assets of the distribution system; it would lease both transmission and distribution services. Also unlike the Massachusetts competitive franchise plan, the COU would take on all the operations of the system from metering to power supply planning, although the critical function would be negotiating and purchasing power supplies on the wholesale market.**

## New Zealand 

**The 1989 Report of the Electricity Task Force called for distribution, which for 70 years has been operated by local municipalities, to be privatized, with direct ownership in the form of transferable shares. Exclusive franchising for both the local lines service and energy would be eliminated. This means that the entry of competing supply lines is not prohibited, although new lines connecting with an existing distribution network must meet the latter's technical standards. The task force recognized that the owners of existing lines have a “natural line franchise” which, because it is indeed natural, needs no legal protection. The threat of entry, being real and legally open, can therefore help discipline prices.**
**Interestingly this proposal ignores the role of the government in granting eminent domain, a necessary condition for constructing distribution and transmission facilities in many parts of the world.**

## New Zealand (Cont.)

**The New Zealand proposal has a novel feature (for electricity markets but a feature similar to that of open access to interstate natural gas transmission) : free entry by retail power merchants. Anyone will be free to buy power under contract or on the spot market, pay the local rental rate on wires, and go into the power-marketing business in competition with local distributors. Distributors cannot prevent entry by power merchants and must charge them the same cost-based rental rate—subject to challenge—that they charge their own retail customers. A power merchant passes through the distributor's rental charge for the wires. This renders the energy marketing portion of the business highly contestable.**

## International Prices

## New Zealand Prices

## Productive Efficiency Performance Indicators: Distribution

**system average outage frequency; **
**system average outage duration; and **
**average customer outage time**

## Borenstein Conclusion

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## Borenstein Conclusion (cont)

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## Summary and Conclusions

-  Efforts to deregulate the electricity industry have gained popularity because of the wide perception that:
- Current regulations favor inefficient state run or monopolistic enterprises that lead to inefficient industries.
- Price or cost differences are now well known and industrial and other customers want to benefit from efficiencies.  In addition growing world competition in the production of goods and services leads businesses to seek the lowest cost inputs.

## Summary and Conclusions II

-  Simply put the decision to deregulate (or perhaps better put re-regulate) resides on:
- What are your regional competitors doing? (i.e. will they get a competitive advantage).
- What are costs of continuing current regulations and ownership compared to the benefits of a new regulatory system.

## Summary and Conclusions III

-  Deregulation plans must include all sectors i.e. generation, transmission and distribution.  A regulatory failure in any of these sectors could cause the whole plan to fail.
-  In general generation is considered to be the most likely sector for near complete deregulation.

## Summary and Conclusions IV

-  In the transmission and distribution areas a case can be made for public ownership or control.  However there is significant disagreement over this.
-  Some localities use a franchise approach in the transmission and distribution area to encourage economic efficiencies.

## Summary and Conclusions V

-  In undertaking any deregulation effort there are many lessons to be learned from the experiences of other countries.  Any evaluation of these experiences should focus on a bottom line related to consumer prices, availability, supply security and the rate of return of suppliers.
- There is also a huge volume of economic studies on this subject which should be reviewed.  To some extent that has been done here.

## Summary and Conclusions VI

-  The careful use of “transparent” well developed (and audited) contracts are likely to be critical when considering deregulation efforts.
-  Other objectives such as reliability, universal access etc. should be considered.

## Summary and Conclusions VII

-  The economies to be gained from the deregulation of generation could be large (although California may disagree).
-  The economies to be gained from deregulating transmission and distribution are likely less that than for generation but the potential diseconomies of poor regulations in these areas could be very high. What’s been going in California (the world’s 7th largest economy) comes to mind.

## References

**Transmission and Generation Investment In a Competitive Electric Power Industry , James Bushnell and Steven Stoft, January 1996.**
**Presentation by: Dr. John Anderson, Executive Director Electricity Consumers Resource Council (ELCON) at: Congress 2000:  The Outlook for Energy Legislation**
**Creating Competitive Markets in Electric Energy, Michael K. Block and Thomas M. Lenard**
**Regulatory Reform in the Electric Power Industry, The Cato Review of Business & Government, Vernon L. Smith**
**The Trouble With Electricity Markets (and some solutions), Severin Borenstein**
**Transmission Pricing Issues for Electricity Generation from Renewable Resources, Larry Prete, Energy Information Administration**
**Reform in the Queensland Electricity Supply Industry, Queensland University of Technology**

## Glossary of Terms I [Queensland University of Technology]

**Data Envelopment Analysis measures the overall efficiency of an organization relative to an efficient frontier. **
**Total Factor Productivity measures the overall performance of an organization against the industry average. **
**Productive Efficiency measures the extent to which production costs are being minimized. **
**Price Efficiency is the extent to which prices reflect the cost of production. **
**Investment Efficiency measures the amount of capital investment. **
**Price Risk refers to the volatility of the spot market, and reflects both intra-regional and inter-region price risk.**** **

## Glossary of Terms II [Queensland University of Technology]

**Volume Risk refers to the possible variation between customer demand and retailers' demand forecasts. **
**Ring-Fencing or organizational separation assumes network operation is managed independently of any other business activity. **
**A Code of Conduct is a regulatory mechanism which addresses a range of non-price discrimination. **
**Demand Management describes a techniques for identifying and controlling service demand. **
**Rate of Return Regulation provides for an acceptable return on network assets based on asset valuation. **

## Glossary of Terms III [Queensland University of Technology]

**CPI-X Regulation provides for an acceptable return on network assets based on a revenue or price cap relative to the consumer price index (CPI). **
**Forced Outage refers to either a complete (or partial) unscheduled equipment (or component) or service failure. **
**Forced Outage Rate refers to the mean number of complete (or partial) failures per unit of exposure time. **
**Value Management describes a technique for providing minimum cost service delivery at adequate levels of performance and quality. **
**Stranded Costs are those investments which are expected to become uneconomic when competition is introduced and pool prices fall.**