2005 02 Reaping the Benefits of Electricity Reform - PA Viewpoint on Energy - EDK

8/14/2019 2005 02 Reaping the Benefits of Electricity Reform - PA Viewpoint on Energy - EDK

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03Introduction

06Reaping the benefits

of electricity industry

reform: defining and

limiting the use of

price controls

14Generation asset

ownership: the more

things change the more

they will remain the

same

24Comparing approaches

to promoting renewable

energy: prospects for

wind energy in the UK

and the US

38Liquefied natural gas

is more flexible than

pipeline gas: but can

this value be extracted?

on Energy: shortages, surplus and the search for value


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ContentsIntroduction 03

Reaping the benefits of electricity industry reform: 06

defining and limiting the use of price controls

Generation asset ownership: 14

the more things change the more they will remain

the same

Comparing approaches to promoting renewable 24

energy: prospects for wind energy in the UK

and the US

Liquefied natural gas is more flexible than 38

pipeline gas: but can this value be extracted?


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By Edward Kee

Reaping the benefits of electricity industryreform: defining and limiting the use of pricecontrols

Viewpoint on Energy

Over the last two decades, competition and markets

have been introduced into the historically regulated

electricity sector. This reform of the electricity

industry, including newly established markets, has the potential

to provide benefits compared to regulation. These benefits

(see Electricity market benefits) are the reason that these reformshave been considered and implemented in many countries.

However, these newly created electricity markets are often saddled

with price controls and other interventions that have the potential

to reduce or remove market benefits. PA believes that the benefits

of electricity markets will only be possible when intervention

in these markets (including price controls) is limited and

well defined.


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07

Viewpoint on Energy

ELECTRICITYMARKETBENEFITSThe reform of the electricity sector, including markets and competition, replaces

regulation. Under this reform, participants respond to market prices to create benefits,

as compared to regulation:

Investments The largest benefits from electricity markets will come from a shift

to market-driven investments that replace regulated utility expansion planning and

rate-base additions. Investment-related benefits will not be seen for years due to

the long life and long development cycle of electricity industry investments. Themagnitude and timing of these investments is dependent on investors who will

demand real electricity prices (ie, without price controls) in electricity markets thatcan be expected to continue into the future.

Operational improvements Unregulated power plant operators will seeincreased profits if they reduce costs and increase output, while regulated electric

utilities recover costs in rates and may have few incentives to reduce these costs

or to increase output. In a reformed electricity sector, power plant operations are

modified to increase the reliability and flexibility of power plants, lower fuel costs

(eg, renegotiate fuel contracts or add on-site storage), increase thermal efficiency

(eg, upgrade turbines to raise thermal efficiency), and reduce other costs.

Owners of existing power plants that were built under regulation, but are now

operating as unregulated participants in a market, have made modifications to

increase maximum output and ramp rates, decrease minimum output, reduce start-

up times, reduce minimum downtimes and otherwise increase the power plants

ability to profit in the market. Significant performance improvements have beenseen when regulated utility plants are sold to unregulated owners and operated in a

market.

Resource allocation A regulated power plant that would be uncompetitive in amarket might continue to operate, contributing to a regulated utilitys return and

recovering fixed costs in rates. In an electricity market, the most efficient and

productive power plants will take a larger share in a market, and a power plant

that does not earn sufficient profits to cover fixed operating costs will face financial

stress. Over the short term, power plants competing for market share in each hour

will also ensure that an efficient use of fuels is made, based on the cost of producing

electricity.

Innovation Regulated cost recovery may blunt the incentives to undertake

innovative approaches to reducing cost and increasing output. Market participants

will try to maximize profits by pursuing innovations in investment efficiency,operational efficiency and productivity. A number of such innovations have beenseen since the advent of unregulated independent power plants.

Demand-side response Under electricity regulation, infrastructure is built to meet

the projected peak demand, plus a margin for reliability under a defined set of

contingencies. This regulated approach has the effect of maximizing the size andreturns of regulated utility companies. The response of consumers to real (and

real-time) market prices for electricity has the potential to: lower investment in supply

side resources; lower market prices; reduce opportunities for generators to game

the market; decrease price volatility; increase security of supply; and decrease

environmental impacts.


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Viewpoint on Energy

Electricity sector reformdriven by benefits

Reform of the electricity sector replacingtraditional electricity industry regulation withcompetition and markets is largely driven bythe promise of benefits. Regulation of electricutilities has been the norm over most of the lastcentury and has resulted in well-developed powersystems in most developed countries. However,electric utility regulation results in higher pricesand lower levels of service than markets mightprovide because:

Regulated utilities, without the incentivesand disciplines (eg, higher profits, loss ofcustomers) imposed by the market, will have a

reduced focus on customer service, productivityand efficiency

Operating and investment decisions underregulation are made without market priceinformation, without the discipline of risk,and with the potential influence of specialinterest groups.

The introduction of competition and markets inthe electricity sector has the potential to increasethe focus on customer service, productivity andefficiency, and to provide a market mechanismto govern sector investments. The result hasbeen a series of new electricity markets aroundthe world.

Markets in the electricitysector

All markets are defined by prices, with marketprices providing information about the relativescarcity of products to buyers and sellers. Buyersand sellers in a market act on this price informationto coordinate their economic activity.

Electricity markets are no different. Electricitymarket prices provide important information onrelative scarcity to buyers (both wholesale andretail electricity users) and sellers (generators).The economic activity that is coordinated by theinformation in market prices includes real-timedispatch of power plants, trading, consumptionand investment.

Electricity can be considered as anothercommodity similar to wheat or oil, althoughelectricity markets are different from othercommodity markets. The most importantdifference is that electricity market prices may beeven more volatile than the prices in most othercommodity markets. Electricity market prices donot have the same buffering mechanisms that areseen in most commodity markets, such as:

Stored inventory (electricity storage is expensiveand difficult, so there is little of it)

Ability of consumers to respond to prices bylimiting or deferr ing purchases (there are limitedopportunities to limit or defer electricity use;real-time pricing and metering might encourage


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Viewpoint on Energy

more investment and behavior changes toincrease this)

Availability of good substitutes (there are fewother products that can easily be substituted forelectricity).

The result, predictably, is the potential for highly

volatile prices. Electricity market prices mayexhibit large and frequent swings, largely drivenby hourly, daily, weekly and seasonal movementsin demand. Events on the supply side, such aspower plant or transmission line outages, alsocause price swings.

These volatile electricity prices provide usefulinformation to manage supply (and demand,where possible) on an hourly and daily basis in anelectricity market. In electricity sector reform, amarket-driven supply and demand process withprices replaces the real-time system control anddispatch process in a regulated system.

The change from regulation to markets inelectricity involves significant changes in theway that buyers and sellers of electricity operate.Electricity market prices that reflect real-timesystem information allow more parties torespond and take the actions that lead to benefits.However, electricity price volatility is unfamiliarand raises concerns with many buyers and sellersof electricity that have long experience with flatfixed prices for electricity, as seen in regulation.

When electricity market participants understandand even expect volatile prices, they will act tomanage the risk presented by volatility. This riskis managed by entering into hedging arrangements,by changing use or production patterns tobenefit from price swings (eg, interruptible loadand peaking plants), or by physical hedgingthrough vertical integration between loads andpower plants.

However, some market participants respondto volatile electricity market prices by seekinggovernment or regulatory intervention.

Electricity market pricecontrols

Regulatory intervention and price controls inelectricity markets may be seen as normal, eventhough market prices are an important part ofelectricity markets.

Many electricity users, as a result of a century ofregulated and cost-based rates, are uncomfortablewith, and may be opposed to, the concept of

market-based electricity prices. Most electricityconsumers have consumed electricity under apolitical and regulatory paradigm that allowedthem to get as much electricity as they wanted,

when they wanted it, for a relatively fixed (andsometimes subsidized) price.

Governments, politicians, regulators andcustomers may view an individual customersrights to this regulated paradigm of on-demandelectricity at fixed prices as paramount. Political

intervention in electricity markets is helped by: Timing: It is all too easy for government to

intervene in the electricity market to produceimmediate benefits (eg, lower and stable prices)for voters, especially when any detriments ofthe intervention (eg, lower investment, lowerreliability and eventually higher prices) may notbe seen for years

Status quo: This intervention is made simplerbecause it can be characterized as a return tothe benign status quo ante of regulation, ratherthan intervention in an established and acceptedmarket

Fear of failure: Some highly public (and littleunderstood) perceived failures of electricitymarkets (eg, California) allow intervention to bebased on an expectation that electricity marketswill fail.

The result is that most electricity markets havehad price controls and intervention even beforethe markets were established. These price controlswill make electricity markets less effective and willreduce or even remove market benefits.

Price controls reduce marketbenefits

When market prices are controlled or capped,the resulting price information (ie, aboutrelative scarcity) does not reflect actual marketconditions and may lead buyers and sellers to takeinappropriate and inefficient actions.

Many of the benefits of electricity markets arisefrom the response of market participants to pr ices.Price controls short-circuit this market mechanism.Market prices under price controls or other

intervention are not real. These unreal pricesdo not provide accurate signals of underlyingmarket conditions, so that market participantswill respond to these false price signals and marketbenefits will be blunted or even destroyed.

Electricity market prices may exhibitlarge and frequent swings, largelydriven by hourly, daily, weekly andseasonal movements in demand.


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Viewpoint on Energy

It is fairly easy to identify overt price caps, but there are other ways to intervene in electricity

markets that may not be so easy to identify. Some examples:

Subsidies In the move to encourage certain types of investment, some electricitymarkets have implemented rules and procedures that have the effect of intervening in

the market. In the most benign case of subsidized entry, a certain type of investment is

given money to overcome a real or perceived economic disadvantage in the market. This

has the predictable effect of causing more investment in the subsidized investments

than is warranted, with the potential to depress market prices. Some markets, worried

that market investment will not occur in a manner that results in reliable service, offerspecial incentives to new generation entry. This has the predictable result of pre-

empting market entry, lowering prices, and ensuring that any new entrant will demandsimilar treatment and incentives.

Skewed rules Another approach to encourage certain types of investment is to insert

special treatment for those investments into the market rules. An example might be a

requirement that wind generators receive preferential dispatch, even though this mightbe accomplished only with some difficulty in a functioning electricity market. Similar

rules might state that wind generators never see prices that are below zero. Such

skewed rules may have similar effects in encouraging excess investment in the targeted

generation, but may have more significant and unintended consequences in the market.

One important issue in such rules changes is that potential for other market participants

to be placed at a disadvantage as a result of the working of the rules.

Socialization of costs A common approach to markets is using non-marketapproaches to recover some costs that would otherwise be part of real-time market

prices. An example is the cost of managing congestion in the England & Wales market,

where this cost is not seen in electricity market prices, but is recovered from customers

in a more diffuse manner. The result is severe blunting of the price signals that wouldotherwise drive investment to reduce congestion.

Price formation that hides real prices Another subtle form of electricity market

price control is the use of uniform or zonal prices. Electricity prices may have stronglocational differences that are not reflected in uniform or zonal prices. Ignoring locational

electricity price differences leads to such things as regulatory must-run power plants,

constrained on/off payments to generators, rationing (eg, power outages), and non-market

incentives aimed at power plant investment location decisions. A similar approach might

set prices on an hourly basis, when actual market prices would have significant

differences within an hour.

ELECTRICITYMARKETINTERVENTION


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Viewpoint on Energy

In the short term, price controls may lead toshortages at times of peak demand under cappedprices or the need for extensive interventionof system/market operators. In the long term,price controls may lead to inappropriate levels ofinvestment.

Most markets provide system/market operatorswith tools (eg, reserves, emergency powers todirect operation, etc) to manage the market in theshort term with price controls. When the levelof intervention is high, intervention may replacemarket prices as the primary tool for managingthe system.

The ultimate impact of price controls in electricitymarkets may not be obvious for some time. Pricecaps that seem harmless and even beneficial tosome participants in the short term may havea negative impact on the level, type and timing

of new power plant investments that will not beseen for years. These same price caps may leadthe owners of existing power plants to shut themdown rather than continue with losses.

Price caps will result in higher consumption andless investment in power plants than an unfetteredelectricity market. The increases in demand asconsumers use more electricity are inconsistentwith lower investment in power plant capacity.This problem has led to a variety of capacitymechanisms that are meant to maintain reliabilityby replacing the investment signals from real

market prices with some artificial signal.

Electricity markets with price controls or otherintervention may produce outcomes that areworse than the outcomes in a well-run, regulated,vertically integrated industry.

Limit price controls andintervention to preservemarket benefits

Electricity markets, like all markets, relyon price signals to participants. The benefitsof electricity markets may not survive thedistortion of these price signals by price controlsand other intervention (see Electricity marketintervention). Price controls and marketintervention must be limited and well-definedin order to ensure that the benefits of marketsare available. PA believes that the followingguidelines, for governments and regulators, willhelp preserve real price signals and the marketbenefits that arise from participant response tothese price signals.

1. Understand markets, accept pricevolatility and manage expectations

Accept that electricity market prices will bevolatile, with variations over time and acrosslocations. The important information in theseprices is needed to allow participants to take

actions to manage the market. Prices should behigh when supply is short and low when there isexcess supply, both in the short term (ie, in hourlyspot prices) and in the long term (ie, in long-termhedging arrangements and the annual averagespot price). Some actions:

Educate market participants about electricityprices that these prices will be volatile andwill reflect underlying supply and demand.Realistic expectations will help participants dealwith actual prices.

Encourage and assist participants to developappropriate hedging and risk managementapproaches.

Implement transitional risk managementprograms when moving from verticalintegration and regulation to electricity markets,using vesting contracts or similar approaches.1This will serve to minimize the price shockfactor and will have the effect of jump-startingan active hedge market.

Ensure that market participants do not expect

that demands for price controls or interventionwill succeed.

Strive for stability and predictability. Electricitymarkets are a unique mix of short-term activities(demand and generation must be matched ineach second) and long-term assets (power plantstake years to build and last for many decades).Participants will not undertake long-terminvestment and operating strategies that areneeded to achieve short-run efficiency unlessthere is the expectation that the market is hereto stay.

2. Do not use price controls andintervention to manage other problems

It sometimes seems easy to address difficultproblems in industry structure (eg, generatormarket power, lack of real-time demand response,or transmission congestion) with the use of pricecontrols or other intervention. Price controls willnot solve these problems, only mask the effects ofthe problems and prevent any market solutionsfrom occurring. Some examples:

1 Vesting contract is a term used to refer to a range of transition instruments that are used to temporarily convey the benefits of vertical integration to disaggregated market

participa esting Contracts: A Transition Tool.

The Electricity Journal, July 2001.


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Viewpoint on Energy

Market power is best addressed by structuralsolutions (eg, requiring divestiture of assetsby dominant participants) and by aggressivelegal action against participants that takeillegal actions.

A lack of real-time demand response can best be

addressed by implementing real-time meteringand educating users, not by putting automaticmarket price mitigation schemes in place that aresupposed to be a proxy for demand response.

Transmission congestion and local supply/demand imbalances are best managed bysolutions that modify the supply/demandbalance. Price controls through uniform orzonal pricing will only mask the real problem,will prevent market solutions, and may evenexacerbate the real problem.

A need for more generation that leads to highmarket prices will best be managed by addingmore generation, not by putting price caps inplace. High prices are the market signal for newentry (and also for lower consumption). Theuse of non-market incentives (eg, subsidizedpower purchase agreements) will also corrodethe effectiveness of price signals and marketparticipant response to them.

3. Adopt price controls and otherinterventions carefully and with

clear limits

While the market will work best when left alone,there may be times when there is no choice butto use some sort of price control or intervention.In such instances, the actions should be as limitedin time and scope as possible, and should becarefully examined to minimize unintendedconsequences:

Allow the market to work as much as possible.It is better to have high price caps (and lowprice floors) that allow the

market to work much of the time, than toset price controls that are in effect much ofthe time. An example is a Value of Lost Load(VoLL) price cap.2 Such a cap might be asubstitute for demand response that is set at ahigh level that increases over time (see case studyon Australian market that follows.)

Limit any price controls with explicit sunsetprovisions. Such provisions might include aprice control mechanism that is due to expire ona fixed date or a VoLL price cap that is removedwhen an adequate level of market demandresponse is seen.

Avoid other regulatory interventions that mayhave the indirect effect of controlling prices,such as out-of-market incentives3 for new entryor demand rationing.4

Demand clear thinking, wide consultation andan economic impact analysis that covers anappropriately long time period before adoptingprice controls. Recognize that the negative effectsof price controls may not be seen for years.

Do not let one side of the market (eg, consumers)dominate the debate or drive intervention andprice controls electricity markets have buyersand sellers; both are necessary for the market towork and both have valid interests. 5

If some intervention is required, avoid the use ofex post facto price controls, such as those sought

for the California market (eg, repayment bygenerators of revenues during periods whenprices were high in 2000). There are few thingsthat will undermine confidence in markets andblunt participant activity in markets so muchas the possibility of ex post revisions to alreadysettled market outcomes.

By following these guidelines, governments andregulators can define and limit the use of pricecontrols, thereby reaping the benefits of electricityindustry reform.

2 The Value of Lost Load or VoLL is a price that is meant to be reflective of the price at which consumers would shed load, if they could respond to price. In market designs, VoLL

prices are Also, when the market fails to clear so that

load is shed involuntarily, the VoLL price is in effect for similar reasons.

3

Offering a subsid fered.

4 In the summer of 1999/2000, the Victoria state government (Australia) responded to price spikes and the potential for outages following a large power plant outage by ordering that

air conditioning be turned off. This had the effect of lowering demand significantly, so that Victoria electricity market prices were extremely low and power was exported to neighboring

states where prices were at more normal summer peak levels. Subsequently, the Australian market rules were modified to invoke VoLL pricing when such government interventions

occurred.

5 Markets are defined by the interaction of supply and demand; all too often, electricity markets become an exercise in supplying an unresponsive demand that seeks protection from

the market, rather than participating in the market. Sellers with large sunk capital investments may have few options and may be seen in the post-Enron industry as convenient

political targets.

Edward Kee is a Member of the PA Management Group. He works for the firms global energy team, based out of Washington, DC.


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The Australian national electricity market (NEM) is an

energy-only market. There are no separate capacity

payments or other market mechanisms to drive capacity

investments. In the NEM, all generator revenue comes from

sales at spot prices that may be supplemented by revenue

from participation in the reserves market. Outside the NEM

market, a wide range of contractual market arrangements

also produces profits for generators.

The NEM has a VoLL cap on spot prices that was initially set

at AUS$5,000 per MWh and was raised to AUS$10,000 per

MWh in 2003. While market prices rarely reach the level

of these price caps, market participants expect that spot

prices can and sometimes will reach the VoLL price cap.

Investments that ensure reliability during system peaks

may only earn revenue from an energy-only market such

as the NEM for a few hours per year. The price that would

be required to provide incentive for these peak reliability

investments was considered in setting the level of VoLL.The high level of the VoLL price cap provides incentives for

reliability of supply through investment in peak generation,

demand-side facilities and network investment. In one

form or another, the market will need to pay for peaking

investments if reliability is to be maintained.

In the NEM design and initial reviews, a number of alternative

approaches to generation adequacy were considered and

none was regarded as superior to the energy-only market

with a VoLL cap. The VoLL cap approach allows spot prices

to clear at a sufficiently high level to remunerate peakgeneration investments.

In the application to increase the level of the VoLL price

caps, it was argued that increasing the level of the VoLL

spot price cap would benefit the public by increasing the

incentive for market responses by both the demand and

supply sides, ensuring the future reliability of the system

and reducing the price distortion introduced by a market

cap.6

Interestingly, market participants were in favor of keepingthe VoLL cap and increasing its level. Market participants

have come to expect that prices may get very high at times

and have developed strategies for hedging this price risk.

The participants in the Australian market have high levels of

coverage using contracts for differences. This high level of

contract coverage, initially a result of vesting contracts that

are now expired, is the result of a bilateral market between

buyers and sellers that has developed with no intervention

from outside. New generation entry, supported in part by

market hedge contracts, has been seen in South Australia,Queensland and even in Victoria.

South Australia and Queensland had tight supply situations

and resulting high prices (occasionally at VoLL levels)

when the NEM started in 1998. In both regions, new market-

based entry in base-load and peak-load power plants has

significantly moderated prices in both regions, and in some

hours, both regions are exporting to the rest of the NEM.

Victoria had a surplus of base-load coal stations when the

market started in 1998, but has recently seen price spikes

in the summer peak months that led to recent marketinvestments in peak-load power plants.

Case study: Australian electricity market VoLL price cap increase

Our thought-piece outlined some guidelines for price

controls and market intervention. The Australian national

electricity market provides an example of a price cap that is

applied in a manner that is consistent with those guidelines,

with the result that the market has not been harmed by the

price cap.

13

6 For more information, see ACCC Determination, Applications for Authorisation, VoLL, Capacity Mechanisms and Price Floor, 20 December 2000, authorisation nos: A90711,

A90712, and A90713; pages 67 (www.accc.com.au).

Viewpoint on Energy

2005 02 Reaping the Benefits of Electricity Reform - PA Viewpoint on Energy - EDK

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