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Competitive electricity markets: Modelers try to anticipate problem spots
If frost wipes out the Florida orange crop, we expect to pay more for oranges. If thousands want to attend a football game or rock concert, we expect scalpers to resell tickets at exorbitant prices. But if similar phenomena affect the supply or demand for electricity, Americans don't expect to suddenly pay more. How will consumers and politicians adjust to the potential new reality of competitive markets for electricity?
The answer to that question depends partly on how volatile prices will be and how much congestion occurs along power transmission and distribution grids as a result of the new markets. Establishing estimates has been a major focus of electricity market modelers members of a working group of the Energy Modeling Forum who met at Stanford Sept. 11 and 12.
The forum is composed of economists and engineers from academia, government and industry who devise or use computer models for tracking and predicting the world's energy situation. Formed in the aftermath of the OPEC oil crisis 21 years ago, the international forum has researched a variety of problems from world oil and gas supplies to the impact of energy use on the global climate. Its membership changes with the issue being researched. Analyzing competitive wholesale and retail electricity markets is a new topic, brought on by the sudden rush to deregulate regional or statewide electric monopolies in order to reap benefits from free-market forces. In California, for example, consumers will be faced Jan. 1 with selecting an electricity supplier, just as they now select among competing long-distance telephone companies.
"People are moving faster on this issue than the analysts can sort through completely," said Hillard Huntington, a senior research associate in Stanford's School of Engineering and executive director of the forum. "If you set up an electricity market with an ironclad structure and rigid rules, you may be setting yourself up for some unpleasant surprises. As we become more knowledgeable about how these systems work, people will need to make adjustments."
In California, the state's big electric utilities, such as Pacific Gas & Electric in Northern California, are in the process of selling off some of their power generating plants, just as AT&T divested the Baby Bells. The requirement is imposed on them to reduce the potential that they can manipulate the competitive market that is to begin on Jan. 1. They will still own the transmission and distribution lines that deliver current to each business and residence, but they will have to let other generators use those lines, which will be managed by an independent systems operator. Other distributors and generators of power are expected to enter the competition for both wholesale and retail customers, thereby substantially reducing the cost of electricity by the time the transition is complete in 2002. In the interim, the Legislature has mandated a 10 percent price reduction on Jan. 1 for residential and small commercial customers.
The forum is not studying California's plans specifically but looking at generic issues such as the potential impact of competitive markets on air pollution, price volatility and power supply problems in portions of the transmission and distribution network. A Stanford-based project with a mixture of government and private sector funding sources, the forum has a reputation for credibility because it brings together professionals with differing knowledge bases and vested interests in the energy field. "One of the forum's key roles," said Huntington, "is to compare different estimates and sort through the assumptions that analysts have used in their modeling. In that way, we hopefully educate the people who use these models in the public policy arena so they can make better decisions."
The working group issues formal reports, but most of its findings are conveyed quickly by the group's members to their own organizations, including government officials in several countries, privately owned utility companies and nonprofit research institutes like Resources for the Future, which is active in environmental analysis.
Air quality and nuclear plant closures
A more competitive industry can lead to greater air pollution, because older coal-fired plants are relatively inexpensive to operate, Huntington said. Over the longer term, however, some participants think that newer combined-cycle gas-turbine plants based upon jet-engine technology will compete effectively on costs with existing coal plants where capital costs have already been recovered.
If pollution does increase in the short run in some market areas, Huntington said, regulators can "implement plans for emissions trading like we have now for sulfur dioxide emissions, or they can require utilities to pay an extra charge for the pollution they are producing, which would cause them to incorporate that extra cost in their decisions."
Estimates of the increased levels of pollutants nitrogen oxides and carbon emissions are critically sensitive to assumptions about how much competition will trigger early closure of nuclear power plants. Stanford economist Geoffrey Rothwell has analyzed nuclear power plant investment and costs under alternative electricity prices and shutdown rules. By tracking how the utilization of each nuclear plant and its average variable cost of power changes over its licensed lifetime, he forecasts that electricity generated from nuclear plants is likely to decline from about 640 Terawatt-hours (Twh) to a range of approximately 285 to 395 Twh over the next 20 years. This range lies closer to the more likely result than the pessimistic projections of nuclear closures reported recently by the U.S. Energy Information Administration, Huntington said.
Establishing the proper short-run signals and long-run incentives for using the electricity transmission grid lies at the heart of the restructuring process. Richard Green, an economist from the University of Cambridge, presented findings from an international comparison of transmission pricing in eight regional markets. Public agencies have adopted a range of approaches for incorporating short-term operational losses and congestion into their pricing schemes. In some countries they rely upon explicit detailed systems models to set prices that vary by location, he found, but in other countries they ignore these considerations altogether. Meanwhile, all regions face a difficult problem in providing the right incentives for long-term investment in expanding transmission when and where it is needed.
"In California, there has been concern that transmission capacity does not become congested," Huntington said, "and there are some instances now where capacity is constrained. In other countries, like England and Norway when they deregulated, they didn't worry as much about congestion, although we heard in our discussion that they are becoming more concerned with this problem as restructuring has shifted power flows from one transmission line to another as a result of decisions about where electricity is produced and needed in the system."
If transmission pricing works as hoped, competitive markets should reduce the current disparity in regional prices, Huntington said. If hydroelectric power producers in Oregon and Washington, for instance, find that they can earn higher profits by sending more power to California, and if investors have the incentive to expand transmission capacity between regions, prices in California will fall and those in the Northwest will rise.
Price volatility and market power
A potential obstacle to markets working efficiently is the so-called "market power" of large companies, he said. Market power is the ability of a particular seller or group of sellers to maintain prices profitably above competitive levels for a significant period of time by manipulating their participation or that of competitors in the market. At the recent Stanford meeting, several participants expressed fear of the reverse problem: people jumping to the conclusion that the market has been manipulated if prices suddenly spike up, when in fact, spikes are the typical way that market forces tell investors to build a plant in a particular place or change their operations to improve efficiency.
A striking feature of competitive electricity markets is the tremendous volatility in prices within a day and across days of the week, according to Frank Wolak, a Stanford economics professor. When he compared the variability in prices in four markets England and Wales, Norway and Sweden, New Zealand, and two states of Australia he found systematic differences.
Hourly and daily price volatility is much greater in both England and Wales and Victoria (Australia) than in either Norway or New Zealand. The English and Victorian electrical systems are dependent on fossil fuels, while the other two systems rely almost exclusively on hydroelectricity. Hydroelectric power prices tend to fluctuate more with the availability of water on a seasonal basis than from day to day. Greater fluctuations in prices also could be due to private rather than public ownership of generation, or to mandatory pools where sellers must sell their power rather than optional ones where they can also enter into bilateral trading with consumers.
Wolak also emphasized that both the number of competitive firms and the rules by which they compete the rules governing bidding and the operation of the power pool influence the behavior of prices. In England and Wales, he concluded in another study, market design deficiencies make it possible for the two largest producers to manipulate prices by strategically adjusting their output. Wolak said that his comparison suggests it is more critical to ensure enough competitive suppliers in the initial design of the market, but if you can't, the specific rules for how bids are placed can also help reduce flaws. (Robert Wilson, a professor in Stanford's Graduate School of Business who specializes in pricing and auctions, is applying his skills to designing the bidding rules for the new California market.)
Given the questions about potential manipulation or congestion problems, are public agencies and elected officials moving too far and too fast to competitive markets? Huntington says that study participants have differing views but agree that policymakers should build in flexibility when designing market rules so they can adapt to changing conditions and learn from others engaged in restructuring power markets.
"There is a belief, at least in this country, that the way we regulated power companies caused them to build too much generating capacity and at too high a cost for rate-payers," he said. "Electricity is very expensive in California, New England and New York and yet there are neighboring regions where electricity costs considerably less. . . . You have industrial customers saying, 'It's too expensive for me to operate my manufacturing plant here,' so that has put a lot of pressure on some state governments to try to lower the price."
Consumers would see these benefits in the longer run, he said. Meanwhile, it is critical that whatever market design is implemented performs well on a daily basis. "We are used to having power without interruptions in this country. Poorly designed rules could risk a possible brown out or a temporary loss of power, causing a furor that could derail the process."