Turning On The Lights: Deregulating The Market for Electricity

Policy Reports | Regulations

No. 228
Friday, October 01, 1999
by Vernon L. Smith and Stephen Rassenti

Wires Companies

In a deregulated market with separate generation and delivery systems, wires companies - the transmission and distribution systems - will schedule power in their areas to minimize customers' energy costs and will deliver power to the points where interregional networks connect. The wires companies will provide construction, operation and maintenance of the systems, including poles, wires, substations, transformers, meters and service connections.35

When a third party cannot or will not supply the promised power, and backup power is unavailable, the wires companies will take steps to maintain operation of the electric system. If a company cannot obtain power, it will curtail service according to predetermined standards. But such contingency planning primarily will serve as assurance of a smooth transition from regulation to competition. If the price is right there will be no problem enticing adequate supplies at competitive market rates.

Retail customers will be able to buy electricity as a commodity or, if they prefer, the wires company can do so on their behalf and charge them for the power.36 Since the supply and wires businesses will be separate, supply companies will be free to compete for long-term contracts with individual customers or they can bid to supply power for pooled demand in a wires company's territory through the spot scheduling center discussed below. The dispatch center associated with the wires company will manage the flow of power to the consumer.

Better Service. With no ties to the supply companies, wires companies will be indifferent to the supplier chosen by customers. Their primary focus will be on service. In that way, customers will benefit from commodity markets. But for the immediate future, local utilities will continue to discharge their legal obligations to maintain a stable power supply, build infrastructure, provide service and pursue social programs. Competition will prevail in the production of the commodity (electricity), but familiar local hands will restore power in emergencies.

"Scheduling is the core service of the delivery company."

Scheduling. Scheduling is the core service of the delivery company. Since electricity cannot be stored, a supply cannot be built up to meet future peak periods.37 That is one reason why utilities are willing to give discounts to large users that contract for interruptible supply - allowing the utility to cut off or reduce power during peak demand periods. With interruptible supply contracts, the utility can survive peak demand periods without maintaining expensive generating facilities that stand idle at other times. Interruptible supply is also possible for individual retail consumers. For example, New Zealand and Australian utilities can turn off residential hot water heaters by remote control at peak demand periods. These interruptions usually are brief - perhaps 15 minutes - but they add up to lower costs for consumers and less facilities demand for the supplier.

Utilities use algorithms (special calculations according to formulas) to determine the minimum cost of delivering power based on the generators used, their location and the users' location. The electricity comes from a mix of "base load" and "load-following" power station units. Base load units are always on-line, supplying the minimum amount of energy always in use. Load-following units are on automatic generator control and their output fluctuates to synchronize supply with demand by changing the fuel feed rates. This instantaneous response precludes system instability, blackouts and brownouts during times of peak demand.38 However, the response of load-following units can be subject to market discipline through bids to supply peaking power in the spot market. Alternatively, wires companies can supply load-following generation until generation and distribution are completely separated.

The Spot Market for Electricity. Power will always be available through a spot scheduling market, open for bidding to both customers and generators. The spot prices for power at a specific location (based on the results of the bidding) will be public information, so customers and generators can make intelligent bids and informed decisions about buying for the short term or contracting for the longer term.

"Institutions and practices in the electricity business will evolve naturally and flexibly depending on need, as they have in the long-distance telephone business."

Institutions and practices in the electricity business will evolve naturally and flexibly depending on need, as they have in the long-distance telephone business. To keep costs as low as possible, all who consume or produce power should participate in the spot market, with all other contracts being financial hedges (like futures market trading) to protect the participants against spot-market price volatility. This is desirable for two reasons:

  • The cost of power lost in transmission is a function of total rather than individual flows and can be allocated to each individual's activity if all location prices are determined simultaneously.
  • When transmission line flows are constrained, bids and offers in the spot market provide a natural basis for determining who must be curtailed since upstream generators with the lowest bid prices are accepted up to the last bid needed to provide the constrained flow. Nonmarket-based priority and rationing schemes and secondary markets in constrained capacity contracts will be unnecessary.

Interruptible bulk customers could participate in the spot scheduling market using special bids with price limits. These bids will have a lower priority during times of peak demand than will spot market price bids by the delivery company's other customers.39 The latter will pay whatever price is necessary to obtain spot market power and have priority over all limit price bids. If the spot price exceeds the bid limit price of a bulk customer, that customer will be interrupted. The bid limit prices signal the terms on which those customers accept interruption.

Rate Regulation. Wires companies thus will be able to charge wholesale prices determined by the market, plus a fee for maintaining and operating the grid. For the time being, that carrying charge could continue to be regulated by state utility commissions on the traditional cost-of-service basis or, more imaginatively, incentive- and performance-based regulation.

Less invasively, price ceilings could be used. In the United Kingdom, charges for the wires of both local distribution systems and transmission are subject to ceiling price caps. These can increase annually by a certain factor: the retail price index (RPI), less a target rate of real price decrease (X) to reflect productivity gains. The price level and the "X" factor are subject to review every five years or so. This "RPI minus X" pricing provides an incentive to control costs within these ceilings. If a company is able to reduce costs, it can keep the money saved.

"The role of regulatory agencies will be limited."

Quality Regulation. The role of regulatory agencies will be limited. State public utility commissions will establish minimum standards for service and perhaps reserve margins to protect customers. The FERC will establish rules to guarantee generators and customers have access to transmission services but will not set prices. Reliable transmission will continue to be assured through standards established by regional electric reliability councils and the North American Electric Reliability Council.

No additional regulations or federal controls will be necessary. Delivery companies will only prosper if they and their customers get electricity, so they will have every incentive to sell access to their wires and to operate their systems efficiently and reliably.

Further, with generation assets spun off to unregulated companies, concerns about monopoly power will recede. At any rate, monopoly will be subjecf the wires business could continue as mentioned above, with rates for supply left to the forces of supply and demand.

Alternatives to Regulation. Initially, regulation of the wires business could continue as mentioned above, with rates for supply left to the forces of supply and demand. However, rate regulation of the wires business should be only an interim step. Once deregulation of supply occurs and its benefits accrue to consumers and businesses, states should explore ways to reduce rate regulation and enhance competition in wires. States should pay particular attention to new developments in technology, contractual arrangements and property rights - and assure themselves a role as laboratories of innovation.

Freedom of Entry. Whether the wires business is regulated and how long any regulation lasts should not infringe on a customer's right to bypass the grid and generate his own electric power. Efficient gas generators, fuel cells and sun-powered cells are available now, and entrepreneurs already are working on other power sources. Customer choice will help control prices for generating and delivering electricity.

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