1. Electricity Industry Restructuring: Outlook for the Future James Bushnell University of California Energy Inst. www.ucei.berkeley.edu

2. UC Energy Institute2 Outline Origins of liberalization Not as advertised –Unhappiness with competition, retail choice, investment New regulatory structures Capacity markets, Regulation, Market monitoring, govt. investment Concluding Thoughts

3. UC Energy Institute3 Why Restructure? Politically motivated by high rates, government financial problems, and ideological trends toward deregulation Regulation/Government ownership had created inefficiencies –Largely through bad investment decisions –Also some operational inefficiencies Large decrease in generation employment over last 15 yrs. Some improvement in US heat rates at divested plants How might we save money from restructuring? –Let “markets” make better investment decisions –rate-payers not on the hook for bad decisions –these benefits accrue very slowly

4. UC Energy Institute4 Electricity Restructuring: a generic blueprint Deregulate power production –No explicit obligation to serve specific customers, investment based upon price forecasts –Revenues determined by market-based prices Grid ownership (Trans & Dist) remain regulated –Privatised in many countries Create ISOs responsible for operating grid and maintaining system balance –ISOs run operating reserve and `imbalance energy’ markets Institute retail choice –Plan for no retail rate regulation after a “transition”

5. UC Energy Institute5 Not as advertised: Compromises of the Market Vision Ownership remains mixed (still Govt. and Utility ownership) –New construction by these entities in many places –Issue of crowding out merchant investment Concerns of supplier market power have led to regulator intervention in energy pricing –Structural solutions not undertaken –Relatively low price-caps –Explicit or implicit intervention in bidding practices Retail deregulation has stalled in many regions –Many customers remain with incumbent on quasi-regulated rates –Issue of providing incentives for those retailers Resource “adequacy” regulations have been introduced – intended to influence investment

6. Competition

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8. 8 The Challenge of Competitive Electricity Markets Lack of price-responsive demand Costly storage Frequently binding capacity constraints, long construction lead-times –Transmission –Generation Even firms with small market shares can enjoy substantial market power under the right (wrong) circumstances

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12. UC Energy Institute12 Forward Commitments and Oligopoly Forward contracts increase spot production –Less incentive to raise spot prices if most sales are already locked up under fixed-price contracts Desire to capture market from competition leads to equilibrium forward contracting by all firms –more output by all firms relative to when there is no forward market Pushing market forward allows for more supply and demand response –More potential suppliers

13. UC Energy Institute13 Vertical structure and forward commitments Usually we think of wholesale (upstream) price determining the (downstream) retail price –Issues are usually foreclosure, raising rivals costs vs. double marginalization In some markets, retailers make forward commitments to customers –utilities – telecom services – construction In these markets a vertical arrangement plays the same role as a forward contract –a pro-competitive effect –A balanced generator-retailer does not have a big net position in the wholesale market

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20. UC Energy Institute20 Can Restructured Markets Work? Nature of electricity makes it more difficult to achieve a competitive market structure –is it impossible? Evidence indicates no. The California market was hurt by –Rigid retail prices & lack of real-time pricing –somewhat tight reserve margins –somewhat concentrated generation ownership –lack of forward contracts Other markets that share all but the last feature (contracts) have been viewed as successes

21. UC Energy Institute21 California Crisis was Not a shortage of generation capacity 2000 Projected CA reserve margins JulAugSept.Oct.Nov.Dec. 17.7%17.4%21.3%44.3%47.5%44.4%

22. UC Energy Institute22 But a shortage of money

23. Investment in Generation

24. UC Energy Institute24 Reasons Offered Why Investment Intervention is Needed Factors present in other industries –inelastic demand –lack of storage –capital intensive industry, long-lead times –Hybrid (merchant, government, utility) ownership –Supplier market power Irresponsible retailer policies –unwillingness to match demand and supply at retailer level –relatively low price caps in some markets (compared to airline bumping) –Safe harbor `default’ rates for customers whose retailers go under

25. UC Energy Institute25 Alternative Paths to Resource Adequacy “Energy only” markets –higher price caps –more and better defined ancillary services purchasing –May be combined with hedging requirements Backstop procurement –Energy only market with resource “guidelines” –ISO or other agency makes a payment or long-term contract with specific resources it deems necessary for reliability –LSEs are billed for cost (probably controversial)

26. UC Energy Institute26 Alternative Paths to Resource Adequacy Capacity Markets –ISO sets capacity “target” (say 15% over forecast demand) –ISO or other agency makes a periodic payment to all certified “resources” (monthly, annual) –LSEs are billed pro-rata by demand –LSEs may sell into the market (take both sides) –Price may be influenced by a “demand curve” for capacity Resource Adequacy obligations –all load serving entities must procure “resources” to cover their forecast demand –procurement left to LSEs –penalties for non-compliance

27. UC Energy Institute27 International Overview for most part capacity markets are a US “innovation” Energy-based –UK, Australia, New Zealand, US MISO? –Implicit backstops (procured by Gridcos,etc.) –With mandatory options contracts? (Texas) Capacity markets –‘1st generation’ PJM, NEISO, NYISO –‘2nd generation’ PJM, NEISO Longer-term, more targeted incentives Resource Obligations –California Impeneterable - Spain

28. UC Energy Institute28 Arguments for Capacity Markets random rationing creates a “free rider” problem – capacity markets eliminate shirking No one likes price volatility, so it is costless to establish standards that reduce volatility The costs of getting investment wrong are much greater on the downside than the upside To what extent are these self-inflicted problems? –Lack of RTP, critical-peak pricing, and the randomization of outages creates the disparity

29. UC Energy Institute29 Concerns About Capacity Markets Implementation creates a bias towards higher reserve levels Allocation of costs tend to be smoothed amongst many hours Capacity markets in practice distort markets by artificially smoothing price volatility –means more consumption & capacity on peak –means higher average cost Buying capacity does not guarantee you get energy Could empower more subtle forms of supplier market power

30. UC Energy Institute30 Concluding Thoughts Reform has improved efficiency –Demand response still needed Competition is a difficult problem –Appears to be manageable in much of the world Long-term contracts are critical to market performance –Solves most of the competition and investment problems –How to get firms to sign them? –Is vertical integration the most reliable way?

31. Thank You