Stanford News

1/21/97

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Competitive markets in electricity don't always lead to low prices, economist says

In the recent debate over California deregulation of electricity generation, the United Kingdom was prominently featured as an example of a workable electricity market. But Stanford economist Frank Wolak warns of problems with the design of the market in the U.K.

In joint work with Robert Patrick of the Graduate School of Management at Rutgers University, Wolak argues that the market rules set up by the U.K. government, combined with the number and relative sizes of the companies serving the market, allow the two largest firms to set high prices by strategically withholding part of their available generation capacity.

Because of the market rules governing the determination of electricity prices, "when the demand for electricity is high enough that the two largest companies both know that substantial fractions of their generation resources are needed to serve the market, these firms have little incentive to offer power at the lowest possible price," said Wolak, an associate professor in the Economics Department and deputy director of the Center for Economic Policy Research.

Wolak believes such market flaws are a natural outcome of the political give-and-take that inevitably accompanies a switch from a monopolistic market structure to a so-called "competitive" one. During a recent interview in his office in the economics building, he pulled off the top shelf a document thicker than a city phone book. "These are the rules of how the market works in the U.K.," he says, and then apologizes for using so many acronyms in discussing it. With pages and pages of definitions in the rulebook, he says, it would take all day to explain the market if he didn't take some shortcuts.

If it's that complicated, could it be that British consumers were better off when they were served by a government-owned electricity monopoly? Wolak hoists his palm from his desktop to his chest, as if to ward off such heresy. "Wait, wait," he says. "It's important to emphasize that in most markets, you don't get this kind of complication."

He pauses a moment, searching for an example. "Look," he says, "I can explain the operation of most securities markets very easily. Why? Because the rules evolved over time through voluntary agreements among the participants. If you set up a market in securities that consumers don't like, they will go to another market to trade. Consequently, the market evolves into something relatively easy for participants to deal with or it ceases to exist."

But in the case of electricity markets, "a quasi-legal regulatory process usually designs the rules governing the operation of the market."

In this process, "people with vested interests on both sides of all dimensions of the debate make their recommendations to the regulator, usually a public utilities commission," Wolak says. "The issues are then decided on the basis of the facts presented as well as the relative amounts of political clout possessed by each of the participants. As a result, the final outcome is often an uncomfortable combination of the divergent recommendations of the many participants in the dispute.

"That's why I like to study these things," he says with a grin. "But I've always felt it is not the best possible way to design a market."

Nevertheless, Wolak emphasizes that regulators need to be involved in the design and management of these competitive electricity markets. Based on his analysis of the U.K. market, he has the following recommendations:

Wolak notes that one major difference between the former monopoly supply regime and the current regime in the U.K. is the tremendous amount of price volatility that now exists. Wholesale prices are set for 48 half-hour periods on a daily basis. The average ratio of the high-to-low price within the day is approximately 4-to-1, and the highest this ratio has been for a single day is more than 70-to-1. If retail customers faced these kinds of price differences across periods in the day, Wolak expects that very different patterns of consumption within the day would occur.

Monopoly supply regimes set stable prices for electricity and require large amounts of often unused capacity to manage variations in the demand for electricity within the day and across days and weeks within the year, he said. "In contrast, the U.K. experience indicates that the competitive regime will use substantial price increases to smooth electricity consumption within the day in order to make more efficient use of a given amount of generation capacity."

That happens because the market allows those consumers who adjust their demands in response to large price increases to achieve substantial reductions in their overall electricity bills. Those who don't may pay more initially than they did in the former monopoly supply regime, Wolak says, but eventually as competitive pressure causes inefficient producers to drop out and more efficient producers to enter the market, the prices for all energy consumers should fall.

"A competitive electricity market will share many features with the airline industry. Consumers that can plan ahead and are flexible about when they will consume will find low prices for the electricity they consume. Those who cannot plan ahead and must consume during the peak time of day may find themselves paying very high prices for electricity."

In the U.K., for example, some water utilities that also process sewage found that they could process it in the middle of the night instead of paying higher daytime electricity rates. Some hotels have learned to heat water to high temperatures in the middle of the night, which makes the water hot for morning showers, but then they let the water cool down during the day. In essence, they are using their capital equipment ­ their water system ­ to store electricity, he explained.

Residential customers may eventually have similar options, he said. Household electric meters today don't keep track of precisely when electricity was consumed, but Wolak says "there are moves afoot to construct so-called smart houses, where the house has a computer hooked up to a utility with a program that can say, if the price [of electricity] reaches a certain amount, turn off the refrigerator for a half hour."

The California legislature and Gov. Wilson authorized a switch to a competitive electricity market in this state as of January 1998. Many of the details of the operation of the market are yet to be worked out. If it is properly designed, Wolak says, benefits should flow to consumers soon after, with those better able to manage their electricity consumption realizing the largest benefits from this new mode of electricity supply.

Wolak's study of the electricity market in England and Wales is available for $5 from the Stanford Center for Economic Policy Research (Publication No. 463). Internet users with the capability of printing encapsulated PostScript documents can print a copy by first navigating to Wolak's Web homepage ­ http://www.stanford.edu/~wolak.

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By Kathleen O'Toole