A Primer on Electric Utilities, Deregulation, and Restructuring of U.S. Electricity Markets W.M. Warwick July 2000 Revised May 2002

The First Five Chapters The basics of the electricity industry: – Ch. 1 – Introduction – Ch. 2 – Definition of a Utility – Ch. 3 – Generation (discussed generator design, measures of plant efficiency, plant construction, plant operation, plant selection and dispatch, and reserve margins) – Ch. 4 – Transmission and Distribution (adequacy, reserve margins, and system reliability) – Ch. 5 – Utility Operation Under Regulation (rates and costs)

Chapter 6 – Deregulation Setting the Stage for Deregulation Before the 1970s, the cost of generating power decreased as utilities built larger power plants (due to increased efficiency and lower production costs) Utilities would request rate reductions to stimulate demand. More demand meant ever larger plants. It was a win-win era. – Consumers received abundant cheap power – Regulators saw rates decrease, electrification increase, and economic growth – Utilities and their stock holders gained financially

Setting the Stage for Deregulation 1970s – Oil Embargo – Fuel costs rapidly increased – In turn, electrical rates increased Unstable supplies and prices of traditional fuels caused shift towards coal and uranium (nuclear) – These plants were much more expensive to build – Rates increased further Rate increases and a “bad” economy caused demand decreases 1980s – many utilities found themselves on the verge of bankruptcy

Setting the Stage for Deregulation Trends from the 70s and 80s gave rise to deregulation – Energy efficiency efforts increased from oil price shocks. Engines used in peak demand plants became cheaper and more efficient. – The natural gas industry was deregulated

Key Features of the Regulated Utility Model Regulated utilities own most of the generation needed to meet the needs of customers in a dedicated service territory. The local utility may import power to meet demand some months and export surplus power to adjacent utilities during others. Neighboring utilities may use the local utility’s transmission lines to wheel power through to other utilities. FERC regulates the use of transmission lines, including rates, for wholesale transactions, although each state continues to set rates for the portion of transmission lines not used in wholesale trade. If the local utility is a major utility (a utility with its own generation and transmission) it manages its own generation and transmission using a control center that dispatches both. The control center may provide a similar service for smaller, adjacent utilities. Regulated utilities have an “obligation to serve” all customers with all the power they require, including adequate generation, purchased power, and transmission, including spare capacity to ensure they can meet peak demand and maintain reliability. Inter-utility sales of this surplus power may, nevertheless, result in an active and competitive wholesale power market, although FERC regulates prices in the wholesale power market.

Traditional Industry Structure

Restructured

Post-Restructuring Wholesale markets now feature transparent prices determined by market participants – Often in the form of bid-offer auctions where market clearing price is known by all participants Typical concerns of power traders: Market power Market manipulation

Market Power Incumbent Utilities advantages: – Own sufficient generation to meet market – Usually own transmission (which all traders need to access market) – Have brand awareness in retail market Taking away the advantages: – Market is enlarged so neighboring incumbent utilities are participants – Utilities required to divest generation assets – Utility power sales occur through 3 rd party exchange (prevents “sweetheart” deals with favored retail customers & withholding capacity to manipulate prices)

Market Manipulation Ways of manipulation – Restricting power generation – Manipulating power exchange – Restricting transmission access FERC set out orders requiring nondiscriminatory access Encouraging/mandating transmission scheduling to be turned over to ISOs/RTOs

Plant Selection & Dispatch in a Power Exchange Power exchanges or pools – not individual utilities – determine which plants operate and what they are paid for power Accomplished using bid prices (from a variety of auction styles) in several related markets – Day ahead market – Hour ahead market – Real time market

These markets are at the heart of restructuring. They will be the largest determinant of future investment decisions going forward.

New Institutions: ISOs & RTOs Central points of control for generation and transmission Independent from generation and transmission owners Primary mission: facilitate commercial electricity transfers without compromising reliability – Short run: ensuring generation reserve margins – Long run: reliability maintained through adequate transmission capability

Problems ISO coordinate transmission planning and expansion – Transmission grid is overextended (i.e. over utilized) – Investment in transmission has not been taking place because of uncertainty regarding cost recovery