Friday, July 22, 2011

Electricity Regulation and Deregulation: The Past and Future

Buried at the end of a previous post, I included a few links to free training on electricity grids and electricity markets that have been graciously placed on online by the PJM, which operates the world's largest competitive wholesale electricity market and North America's largest power grid. For those of you looking for an exciting job in the electricity business, the PJM has job opening at its HQ in Valley Forge, PA. [Note that PJM stands for Pennsylvania, New Jersey and Maryland, but the actual area covered by this Independent System Operator (ISO) is now much larger than the three states listed in its name.]

While I've talked a lot about electricity-backed currency, I've specifically not discussed the question of regulation vs. deregulation of electricity markets. Mostly, I've avoided this topic because there's already been a lot of discussion on this topic because there's a lot of real world examples of the pro's and con's of electricity deregulation. There are success stories, like England/Wales, and then there are horror stories, like in California. Most countries have tried some form of electricity deregulation by now, and there are a few 'best practices' that are starting to rise to the top. A good review article on this topic can be found online at Paul Joskow's MIT website, and it's called Lessons Learned from Electricity Market Liberalization.

This post is intended to highlight some of the 'lessons learned' in Joskow's article as well as those given by Rothwell & Gomez in their 2003 book Electricity Economics. Some forms of regulations are better than others, so I'll summarize what I can glean from Joskow's article and Rothwell&Gomez's book.

I'll start off with some relevant quotes the book:

"Changes in electricity generation technology have prompted the realization that generation need not be a regulated monopoly to be socially efficient. Unlike transmission and distribution, which are best served by regulated monopolies under current technologies, the regulation of generation and retail sales might be best done through market discipline."

"Transmission and distribution are still considered natural monopolies that require regulations. To achieve effective competition, regulation is still needed to ensure open, nondiscriminatory access to the transmission grid for all market participants."

In some locations with monopolies on generation:
"Because of the monopoly status of the provider, the regulator periodically sets the tariff to earn a fair rate of return on investment and to recover operational expenses. Under this regulated framework, firms maximize profit subject to many regulatory constraints. But because utilities have been allowed to pass costs on to customers through regulated tariffs, there has been little incentive to reduce costs or to make investments with due consideration of risk."  "However, under competition, the recovery of investment in a new plant is not guaranteed. So, risk management becomes a crucial part of the electricity business."

Here's my summary of the quotes above:

The transmission and distribution of electricity are natural monopolies and, therefore, these markets require significant amounts of regulation in order to make sure that a company doesn't take over the electricity grid, and then refuse to sell to certain individuals or companies on its black list. On the other hand, wholesale electricity generation is a perfect place for free-market principles because, most of the time, there is no monopoly on the generation side.

Here are some good quotes from Joskow's review article. He has a slightly different opinion on transmission and distribution. He's more in favor of regulations that force quality of service into the transmission and distribution sectors.
1) "Privatization of distribution and transmission companies combined with the application of Performance Based Regulation (PBR) imposes hard budget constraints on regulated network firms and provides better incentives for them to reduce costs and improve service quality. In addition, the efficiency of competitive wholesale and retail markets depends on a well functioning supporting transmission and distribution network infrastructure."

"Generator market power [i.e. a monopoly] arises as a consequence of transmission constraints that limit the geographic expanse of competition, generation ownership concentration within constrained import areas, the non-storability of electricity, and the very low elasticity of demand for electricity."

I'll rephrase these quotes, as best I can, into non-technical language:
1) The transmission and distribution companies (i.e. the owners of the grid itself) can be regulated successfully by writing legislation that is performance based. An example would be if the company gets paid only if new electricity customers are connected to the grid within a certain amount of time. This is just one example of Performance Based Regulation.
2) Monopolies arise because a) there is a mismatch with the transmission network and the generation network, b) there are not enough generators in a certain area, c) electricity can not be stored cost effectively, and d) customers don't know the price of electricity that they pay so they don't stop using electricity when the price of electricity is high.

And now I'd like to summarize Joskow's "Textbook Prescription" to successfully implementing electricity deregulation:
1) Privatization of state-owned electric monopolies
2) Vertical separation of potentially competitive segments from segments that will continue to be regulated
3) Horizontal restructuring of the generation segment to create an adequate number of competing generators to mitigate market power
4) Horizontal integration of transmission facilities and network operations to encompass the geographic expanse of "natural" wholesale markets
4a) The designation of a single independent system operator to manage the operation of the network, to schedule generation to meet demand, and to maintain the physical parameters of the network (frequency, voltage, stability), and to guide investment in transmission infrastructure to meet reliability and economic standards
5) The creation of voluntary public wholesale spot energy and operating reserve market institutions to support requirements for real time balancing of supply and demand for electric energy
6) The development of active "demand-side" institutions that allow consumers to react to variations in wholesale market prices and fully integrate demand side responses to energy prices and reliability criteria into wholesale and retail markets
7) The creation of independent regulatory agencies with good information about the costs, service quality and comparative performance of the firms supplying regulated network services, the authority to enforce regulatory requirements, and an expert staff to use this information and authority to regulate effectively the prices charged by distribution and transmission companies and the terms and conditions of access to these networks.
8) Transition mechanisms to move from the old system to the new system

I'll quickly summarize some of the longer "textbook" things to do to help lower the price of electricity :
2) Separate those companies that will be regulated (like the transmission and distribution companies) from those companies that will be forced to compete on an open market (like the electricity generation companies)
3) Make sure that there are enough companies in an area so that the open market is actually a market and not a scam between companies in collusion.
4a) And this is key:  Make sure that there is one company that is the independent system operator  (the ISO)
6) There needs to be ways for customers to know what is the price of electricity, so they don't waste electricity when the price is high. This means that we need to include software on the major appliances so that they are aware of the price of electricity, and then will lower the amount of electricity being used or will turn off the appliance depending on the price of electricity on the open market at the time. [This is one of the reforms that I would most like to see implements where I live.]
7) Make sure that the regulatory agency has some teeth! And is well educated!

So, let's step back and summarize in the words of Rothwell & Gomez:

"The brief history of this process [deregulation] shows that there is still much to be learned. Despite this, there is a consensus (1) to introduce competition into wholesale and retail markets by deregulating generation and opening retail and (2) continuing to regulate network activities. But the experience also shows that those governments that started deregulation are continuously revising their regulations."

And I would like to end this post by reemphasizing that deregulation of electricity markets is incomplete until there is demand-side response to changing electricity prices. Of course, the demand-side response can not occur until there are whole-sale markets for electricity generation. So, the deregulation we've seen so far (such as within the PJM) is a good first step, but there is still a problem on the demand side. Customer's don't know what is the price of electricity, and therefore, they will never act efficiently to turn off appliances.

So, while I think that there have been some important steps forward in the electricity market over the last thirty years, there is still a lot more we need to do. There's a lot we can do to keep electricity prices lower just by communicating to residential electricity users what is the price of electricity. In my opinion, the solution to this problem is pretty simple:
1) A person's electricity bill should reflect the price of electricity when that electricity was being used.  In technical terms, the electric bill should be the integral over time of "the amount of electrical power times the price of electricity." This is the best way to force demand-side response. But then there's the next step.
2) We need to have software on our appliances so that the appliance will use less electricity when prices are high. For example, the refrigerator or the AC might raise the temperature when prices are high, and lower the temperature again when prices are low. In cases when a brown out or a black out is near, a text message should be sent to customers from their appliances letting  them know that prices are really high, and the appliance will ask if it's okay for the appliance to shut down temporarily. This is already happening with electric vehicles; however, in most locations, customers don't pay more in electricity when the prices are high, so there's no real incentive to charge at night when prices are low compared to charging during the day when prices are typically high.

I think that the revolution in wireless technologies that we see around us must soon be used to help us lower electricity prices by allowing 'demand-side' response to high electricity prices. This will be a fairly simple way for us to keep electricity prices low and to reduce the chances of over heating the electricity grid.

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