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The Most Effective Way

Market prices send investors clear signals to invest in the most efficient means for producing electricity.

Fortnightly Magazine - October 2006

Higher electricity prices have drawn sharp attention to the design of organized wholesale electricity markets—particularly to areas where residential customers’ rates will increase because multi-year rate freezes are ending.

Rising costs for the fuel used to generate electricity have driven wholesale electricity prices higher. The price of natural gas has increased dramatically, although oil and coal prices also are higher than they were two years ago. These underlying fuel-cost increases would have pushed up electricity prices no matter how prices were set.

Nevertheless, because of higher electricity prices, some suggest changing the way that markets set wholesale electricity prices, or doing away with competitive markets entirely and returning to government regulation of prices. They say that the design of the markets exaggerates the effects of natural-gas price increases and unfairly rewards generators that use lower-cost fuels.

Organized Markets Promote Efficiency

A market-based system provides the best investment and performance incentives. Market prices send investors clear price signals to invest in the most efficient means for producing electricity. Plant operators have the financial incentive to operate and maintain power plants effectively and at the lowest cost possible. Investment and operating decisions are made at the investors’ own risk and potential for reward.

Spot markets send instantaneous price signals to producers and consumers about the need for additional power supplies or for conservation. Spot-market prices are volatile because they instantly reflect real-world conditions. The volatility of spot markets creates risk of profit or price changes. Typically, long-term contracts provide a means to reduce the risk. Long-term contracts do not reduce prices or increase profits; they create more stable prices and profits by reducing the amount of fluctuation.

Regulation Stabilizes Prices At the Cost of Efficiency

Regulation (the fixing of prices by the government) tends to reduce the risk of profit or price changes. Profits to investors remain fairly stable regardless of investment decisions or operating efficiency. Consumers have less risk of price shocks. Regulated price changes are slower than price changes in a market-based system, both because of the slowness of the regulatory process and because the process tends to look at historical rather than current costs.

Under government regulation, costs tend to be higher than they would have to be because there is little incentive for efficiency. In fact, the traditional regulation system by its design encourages inefficient investment in generation facilities. Under regulation, the predominant way a utility can increase its profits is to increase the amount of money it invests in facilities that are paid for by customers. Because regulation is backward looking, producers and consumers receive incorrect price signals about the need for conservation or for investment in additional generation. The risks of investments or operating performance are borne largely by consumers.

Indeed, it