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Panel expects three challenges for competitive electricity markets

Deregulating the electricity industry could reduce overall costs, but only if policymakers ensure that a few large firms do not control prices in the new markets, says a group of leading energy analysts in a new report.

The report, issued May 6 by the Stanford-based Energy Modeling Forum, is intended to advise legislators and others involved in creating new rules for electricity markets in various states, regions and countries. The 50-member group focused on the potential impact of regulatory changes that would affect how electricity is produced and transmitted to final customers. Discussion emphasized three key problems: control of market prices by industry participants, making transmission capacity more available and the environmental pollutants that are released by fossil fuels used for electricity generation.

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The report warns that the rules should take into account that:

c In any market there will be opportunities for one firm or a group of large firms to sustain prices above the least-cost level. Such efforts are particularly difficult to uncover when prices are volatile, as one would expect with a more competitive industry.

c Consumers in one area could pay substantially more for electricity than consumers only a few miles away. This is because electricity prices should reflect not just the differences in the costs of generating power but also the costs of transmitting it. Transmission costs include the expenses of power lost as heat through the wires and the added costs of trying to use congested lines.

c If more coal is used and nuclear power plants are replaced, air quality could be degraded. If such an environmental impact occurs, it may not be long term, the report indicates. Some members of the forum expect net improvements in the environment if new natural gas plants are built and new renewable technologies introduced.

The conclusions are the result of 18 months of work by members of the Energy Modeling Forum, a group of energy analysts and advisers from academia, government and the energy industry who use computer models to understand important energy and environmental problems. Rather than trying to predict what future prices will be, the group used models to help them anticipate potential problems that may arise in the restructuring process. [A copy of the forum's report on electricity markets is available on the World Wide Web at]

"None of these problems are insurmountable, but they do need to be addressed in designing competitive markets," said Hillard Huntington, executive director of the forum.

Control of market prices

The best strategy to avoid large firms sustaining prices above competitive levels is to establish a sufficient number of participating firms in the market as early as possible. For example, California has required the two largest utilities to "spin off" or sell significant amounts of their plants using fossil fuels. (In California and several other states, suppliers that generate electric power and retail firms that sell power to the customer are competing against other firms. A single entity will continue to operate the transmission and distribution lines in an area.)

The analysts say it is very difficult to estimate how much higher large firms could push prices above competitive levels. The models they use for measuring such control, or market power, focus on the potential for firms to reduce output if they were concerned solely with earning more income and did not fear regulatory intervention. In practice, fear of intervention and other considerations are likely to influence company decisions. Huntington said.

There is potential for firms to exercise market power in California in the high-demand hours in the fall and early winter months. Prices in these few hours could go more than 50 percent higher, due to market control, than needed to cover costs, although more often prices would range from only 1 to 5 percent more, the forum report says. The English experience indicated greater market power potential, while Australia and Norway revealed somewhat less.

When prices are volatile, it can be difficult to discern the causes: The fluctuating prices could reflect temporary spurts in demand or congested transmission lines or they could indicate large producers attempting to control prices at critical times.

"If temporary real shortages are producing the higher prices, market design should allow them to operate to provide the incentives to reduce these problems," Huntington said. "If a few large producers are attempting to manipulate prices, as they have done in England, policymakers need to ensure that enough firms are participating in the industry."

Transmission capacity and pricing

A second problem area involves the fact that competitive power markets depend on ready access to transmission and distribution lines. These lines can become very crowded or congested, making it difficult for generators to send their power to where the customers are. The report emphasized that these conditions often happen when prices for transmitting power fail to reflect the full cost of using key power lines.

One possible solution is a system that charges different prices at different places (or "nodes") where power is injected or used. The charges would reflect the costs imposed by lost power and by congested transmission lines. How many different prices are needed within a geographical area has been a hotly debated topic within the industry and the modeling forum, Huntington said. Allowing different prices in various locations within the San Francisco Bay Area, for example, would help reduce congestion along key electricity lines, even though many people would probably prefer to have everybody pay the same price. In addition, some differences in prices by location would encourage additional investment in the transmission system and influence the placement of new generation plants and users.

Impacts on clean air

A third problem is that the pending restructuring may degrade the environment. Many of the older coal plants in the Midwest appear to be inexpensive to operate. Owners of these units may be able to bid prices lower than competing producers and have their power sent to other regions where there exists additional demand for low-cost power. Some of these older coal plants emit relatively large amounts of sulfur dioxide, carbon dioxide, nitrous oxides, mercury and other pollutants, which contribute to air pollution.

Forum participants do not expect that national levels of sulfur dioxide will increase. Utilities that use dirtier fuels must purchase allowances, which place a national cap on how much can be emitted. However, the costs of purchasing these allowances could increase if coal rather than other fuels were used to generate additional power.

The report concluded that emissions of nitrous oxides and carbon dioxide could increase if coal is used more intensively. (Carbon dioxide contributes to global warming, or a general long-term increase in the earth's temperature.) The extent of this increase depends upon how much the electricity transmission capacity grows in response to efforts to restructure the industry. A large growth in this capacity would allow more coal to be used in one region for export to higher-cost locations, thereby increasing pollution. In addition, the result depends upon the type of generation plants that are retired. Since nuclear plants do not emit nitrous oxides and carbon dioxide, the increase in these emissions would be larger if nuclear rather than fossil fuel plants are replaced.

Due to these differences, the impacts are best described in terms of a range for increases in emissions over the next five years. Carbon dioxide emissions may grow by 3 million to 134 million tons more due to restructuring, the forum concluded. While the lower estimated increases are minor, the higher ones could equal about half of the reductions needed under plans for meeting climate change targets.

Nitrous oxide emissions may grow from 71,000 to 479,000 tons more than otherwise in this same period. However, even the higher estimated increases are relatively minor compared to the reductions anticipated from the Clean Air Act amendments.

The report is careful not to overemphasize these environmental impacts because there are important limitations on how much more coal-generated power can increase. In addition, some of the forum participants expect that within a short period, new power plants using natural gas will represent a considerable economic threat to the older coal plants, many of which will require additional expenditures to remain active. Indeed, it is possible to anticipate some net improvement in the environment if new natural gas plants are built and new renewable technologies are introduced.

Learning from models

Comprised of about 50 analysts and advisers for this particular study, the international forum has researched a variety of energy problems from world oil and gas supplies to the impact of energy use on the global climate since it was founded in 1976. Its membership changes with the issue being researched. With a mixture of government and private sector funding, the forum has developed 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," Huntington said, "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."


By Kathleen O'Toole

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