The Competitive Market for Power in the U.S.: The Role of ISOs and PXs


Until the mid-1990s, the electric energy business in the United States was a highly regulated, vertically integrated industry in which decisions were made on a centralized basis. Unlike the competitive markets which existed at the time in such markets as Argentina, Chile, the U.K., New Zealand, and Australia, rates for energy and transmission in the U.S. electricity industry were set under a command and control regime of regulation. Individual states set the rates, terms, and conditions for retail energy transmission and distribution while the Federal Energy Regulatory Commission (FERC) set them for wholesale power and transmission.

Under this "command and control" regime, industry participants were forced to focus on the need for local self-sufficiency and reliability, rather than developing a cost-effective means of generating and delivering a reliable source of power. These objectives came at huge cost and inefficiency. First, to maintain local self-sufficiency and reliability, substantial investments had to be made in infrastructure which was utilized , at best, half of the time. Second, many vertically integrated utilities were inefficient energy producers that hid behind the ostensible objectives of reliability and local self-sufficiency as a method of protecting their own franchises from more efficient competitors.

Under the guise of protecting the reliability of their own systems, a majority of utilities refused to allow other utilities or energy suppliers access to their transmission grids or, if they did allow them, they favored their own power generation by imposing surcharges or operating limitations the effects of which were to render the competitor's all-in cost of power uneconomic. Such industry practices severely limited the growth of a competitive power generation market. As technology advanced and the needs of the economy changed, the industry, however, was forced to face the same type of wrenching change that the telecommunications and natural gas industries had faced previously. The new challenge was to move from simply meeting a basic need for electricity to satisfying the sometimes competing objectives of enhancing economic efficiency, ensuring continued reliability of service, promoting customer choice, and, ultimately, achieving a robust competitive market.

This article examines the development of competitive power markets in the United States and assesses the role power exchanges (PXs) and independent system operators (ISOs) have played (and will play) in such markets' development and evolution. Following a general discussion of ISOs and PXs, this article will look specifically at the recently inaugurated New York ISO, focusing on its operating, scheduling, and pricing mechanisms. This article will conclude with a brief analysis of the extent ISOs and PXs have achieved the above objectives of a deregulated marketplace as well as how new developments in information technology can help rectify the deficiencies ISOs and PXs have exhibited to date.

The Journey Toward a Competitive Marketplace

The initial step toward developing a competitive electric energy market in the United States came with the passage by the U.S. Congress of the Public Utility Regulatory Policies Act of 1978 (PURPA). PURPA and its implementing regulations, spawned the growth of the independent power market and the construction (financed primarily through the project finance market) of a substantial amount of non-utility owned generation capacity-particularly in the northeastern United States and California. For the first time, entities other than investor-owned or public utilities could own and operate substantial amounts of electric generating capacity in the United States and, importantly, require the very utilities which sought to protect their own backyard to purchase this non-utility generated electricity. PURPA, however, was only a limited step toward deregulation as it set very specific ownership and operating requirements on such non-utility generators, criteria the utilities were all too happy to seek to enforce. In addition, these independent generators possessed very limited rights to send their power across the utility-controlled interstate transmission grid in the U.S.

Without the unbundling of generation from transmission and distribution services, a true competitive market in the U.S could not occur as vertically integrated utilities still possessed the incentive to use their transmission system to benefit their generation. It was only after the U.S. Congress passed the Energy Policy Act of 1992, and FERC promulgated Orders 888 and 889, in 1996, that true unbundling of the electric industry into its component services of generation, transmission, distribution, and ancillary services began. Following the promulgation of these two FERC orders, however, wholesale sellers of power were, for the first time, guaranteed non-discriminatory access to the interstate transmission grid. This unbundling of interstate transmission service through an "opening up of the wires" set the stage for competition for retail electricity customers.

PXs and ISOs: The Centerpiece of Retail Sector Deregulation

While FERC, whose jurisdiction is nationwide, controlled the restructuring of wholesale energy sales and transmission (or the sale and transmission of electric energy in interstate commerce), retail sector deregulation and implementation of customer choice falls under the control of individual states.

As of today, several states throughout the country have developed or are in the process of developing their own models for retail deregulation. These include California, Illinois, New Jersey, New York, Massachusetts, and Pennsylvania-states with large populations, high energy costs, and numerous non-utility generators. While the models each of these states have implemented differ in its details, they nevertheless share the same objectives of enhancing economic efficiency, ensuring reliability, promoting customer choice, and achieving a robust competitive market. Each of these states, to one extent or another, provided for open access to the retail transmission and distribution system of every utility within its jurisdiction. In so doing, these states have employed models that have at least two common components-the PX and the ISO.

The ISO's specific purpose is to coordinate all transmission functions without favoring any generator over another. Independent coordination of transmission is a pre-condition to the development of an open market; without it, utilities could "game" the transmission network by using it (and pre-existing transmission system constraints) to benefit their own generation. ISO responsibilities include providing open and fair access to the transmission system and ensuring the reliable operation of the bulk power system. The ISOs function on a utility, state, or regional basis. The California and New York ISOs (Cal-ISO and NY-ISO) perform their function on a statewide basis, while the utilities in Massachusetts are subject to a regional ISO (ISO-NE, formerly NEPOOL, the New England Power Pool).

Similarly, the PX's specific purpose is to set the price of power in competitive markets. Under the traditional command and control system, rates for transmission and energy were developed on a cost-of-service basis. A utility's cost of constructing and operating its system coupled with a reasonable return on capital invested in transmission, distribution, and generating facilities represented the major components of rates. Under the new regime, the price for power is market based. The PX is responsible for conducting an auction for power sellers and buyers through the development of spot markets for various energy products. In addition, the PX acts as a scheduling coordinator that delivers transmission information to the ISO for scheduling. The PX receives buyer and seller bids, establishes a market-clearing price, coordinates scheduling of power transactions, settles trades, and provides for billing and collecting of payments for energy and ancillary services. The market-clearing price is usually determined by matching total demand bids with total supply bids to establish the price for each hour in the trading day. From this information, energy supply and demand curves are determined. The intersection of these two curves marks the market-clearing price. Currently, markets are being created for a range of energy products, including day-ahead, hour-ahead, and real-time energy.

To promote true competition, the ISO and PX should function separately. The states implementing ISOs and PXs, however, are approaching this separation of functions differently. In California, to avoid the possible use of inside information regulators decided that the Cal-ISO should have no direct role in the auctioning of electricity. California Power Exchange (CalPX), a separate entity, is responsible for the auctions. CalPX serves as an independent market facilitator, providing price discovery to market participants and establishing hourly electricity prices through electronic auctions that determine the Market-Clearing Price. Sellers must inform the CalPX of the sources planned for power production, and buyers must provide the delivery point for their purchased power. CalPX then schedules supply and demand with Cal-ISO, who coordinates the transmission scheduling. In New England, a different approach is used. The ISO and PX functions are combined in a single organization, ISO-NE, which administers the region's transmission reservation system as well as manages the bulk power grid and wholesale electricity market. Similarly, New York has developed a hybrid form in which NY-ISO performs both the PX and ISO functions.

NY-ISO

The restructuring of the vertically integrated utility industry in New York began in May 1996 as a result of a New York Public Service Commission order requiring each investor-owned utility to file a restructuring plan. The New York Public Service Commission order called for retail competition starting in 1998 and suggested the creation of an ISO to assume operational control of the investor owned utilities transmission assets. In the order, the New York Public Service Commission expressed a preference for the divestiture of generation assets and indicated that it would allow the recovery of prudent and verifiable stranded costs. Restructuring agreements for all of New York State's investor-owned utilities have now been approved and are being implemented. Retail access was implemented throughout New York State by year end 1999. Most New York investor-owned utilities are divesting their generating assets and will become primarily distribution companies, likely resulting in fragmentation in the ownership of New York State's generation assets and increased competition for generation sales. It is possible that divestiture could lead to the concentration of divested generation in the hands of a relatively small number of new owners, which in turn could reduce competition. To date Sithe Energy, NRG, and Orion Power (a joint venture between Constellation Energy and Goldman Sachs) have individually acquired a significant amount of the installed generating capacity in New York formerly owned by the state's investor-owned utilities, however, it is more likely than not that regulatory oversight will prevent any concentration that might be harmful to competition from occurring, and will seek to maintain or increase competitive pressures.

Historically, the New York Power Pool operated a centrally-dispatched pool to minimize member production costs and to maintain statewide reliability. It also coordinated the operation of the bulk power transmission facilities in the state. The New York Power Pool system has become an ISO, which now administers an open access transmission tariff and an independent system operator services tariff which have been accepted by FERC, subject to minor changes to comply with FERC requirements. NY-ISO commenced trial operations on November 18, 1999. The NY-ISO system originally envisioned the establishment of three new entities, NY-ISO, the New York State Reliability Council, or NYSRC, and the New York Power Exchange. NY-ISO is a non-profit New York corporation under FERC's jurisdiction. It will be governed by a board of directors comprised of representatives from all market participants, including buyers of power, sellers of power, consumer groups and transmission owners. The NYSRC will have the primary responsibility to preserve the reliability of electricity service on the bulk power system within New York State and will set the reliability standards to be used by the Independent System Operator. The New York Power Exchange was envisioned to be the main power exchange to facilitate competition in the power markets, and to operate the actual day-ahead and real-time markets for installed capacity, energy and ancillary services. The New York Power Exchange has not been implemented, its proposed functions are being handled instead by NY-ISO. In a filing in December 1997 with the Federal Energy Regulatory Commission, or FERC, the utilities that are members of the New York Power Pool withdrew their original application to form the Power Exchange, proposing instead that the functions envisioned for the Power Exchange be offered by the Independent System Operator. It is unclear whether a power exchange separate from NY-ISO ever will be implemented. It is possible that other entities may form competing power exchanges in the future.

The New York Power Pool member systems serve over 99% of New York State's electric power requirements. Currently, its members are the investor owned utilities in the state, the New York Power Authority, and the Long Island Power Authority. In addition, over 5,000 MW of capacity is owned by independent power producers, who sell the bulk of their output to investor-owned utilities under long-term contracts. New York Power Pool is interconnected with New England Power Pool to the Northeast, Hydro Quebec and Ontario Hydro to the north, and Pennsylvania-New Jersey-Maryland Power Pool, or the PJM, to the south.

Transmission System Market. Transmission access will be available to all market participants on an open access and non-discriminatory basis. The wheeling party will pay the independent system operator a transmission service charge that has three components, a transmission service charge, a transmission use charge, and a New York Power Authority transmission access charge.

The transmission service charge is an hourly rate that recovers the embedded fixed costs of the transmission system. The transmission service charge is assessed on the basis of hourly metered loads for deliveries within the independent system operator's control area (including purchases from the power exchange, bilateral transactions, and imports) and on the basis of scheduled deliveries for exports or through transactions. Transactions that are not subject to this charge are the transmission provider's use of its own system to provide bundled retail service to its native load customers, retail transmission service pursuant to another tariff or rate schedule that explicitly provides for other transmission charges, and wholesale wheeling agreements pursuant to existing bilateral contracts that have been grandfathered by the parties. Loads within the independent system operator control area will pay a single system rate based on the costs of the transmission provider where the points of delivery are located. Wheeling transactions that involve exports or through system transactions will pay a transmission service charge based on the costs of the transmission provider that owns the intertie which serves as the point of delivery to an adjacent control area. The second rate component, the transmission use charge, recovers any congestion costs associated with the transaction and marginal losses. Customers wishing to receive firm transmission service under bilateral transactions must agree to pay transmission use charges. Congestion costs are based on constraints on the optimum economic operation of the system. Parties can hedge their exposure to congestion charges through transmission congestion contracts which will be auctioned biannually. Marginal losses are the real power losses associated with each additional megawatt-hour of consumption by load, or each additional megawatt-hour transmitted under a bilateral transaction as measured at the points of withdrawal.

The final rate component, the New York Power Authority transmission adjustment charge, is assessed on all transactions and is intended to recover any shortfall in New York Power Authority's revenue requirement that is not recovered in New York Power Authority's transmission service charge. Unlike other investor owned utility members of the independent system operator, New York Power Authority does not operate a separate service area and most of its customers are located in the service areas of other transmission providers.

New York Power Pool Wholesale Market. Generators may transact in the centralized wholesale power exchange implemented by NY-ISO, and may compete in distinct markets for energy, installed capacity and ancillary services. Pricing is based upon market clearing prices which are the prices at which sufficient electricity will be supplied to satisfy all demand for which bids have been submitted. The generator is paid the market clearing price, not its bid price, at the point it supplies energy to the system and the purchaser paying the market clearing price at the point it receives energy from the system.

Bilateral Energy Markets. Any generator in the state has the right to sell its output of energy to any wholesale customer statewide including utilities, municipalities, and energy supply companies. Generators can sell energy under bilateral contracts, with pricing and other provisions determined by two-party negotiation. Customers that want to engage in bilateral transactions must schedule either firm or non-firm transmission service with the independent system operator.

Outlook

The recent development of a competitive electricity market and the implementation of PXs and ISOs in various states has not been troublefree. Inefficiencies continue as entities that had enjoyed monopoly status for over a century are forced to deal with true market forces. For example, it cannot be said that true real-time market-pricing has become a reality in these markets. Three major impediments to a truly competitive market in many of the states where ISOs and PXs have been implemented are:

  • A lack of transparency in ISO operations;
  • Failure to implement performance measures; and
  • A lack of accountability with regard to achieving the objectives of deregulation.

Transparency. Transparency in ISO operations means that the ISO and/or the PX must clearly disclose the methods and processes by which a market clearing price is set. Without transparency market participants have no assurance that the price they pay or receive is the "true" market price for that power. The setting of a market clearing price cannot be a black box event.

Performance Measures. The ISOs and PXs that have been implemented do not subject themselves to the same rigorous performance measuring standards and goal-setting processes that entities in truly competitive industries must do to survive. Without the existence, and widespread publication, of such measures market participants and consumers have no idea as to whether the ISO and PX are accomplishing their goal of achieving market-based pricing in the respective markets in which they exist.

Accountability. Accountability is directly tied to the existence of performance measures. In any competitive industry, when management does not achieves its goals it is replaced. Will the leadership of the ISOs and PXs be subject to the same rigor of the marketplace? If management is not accountable, then these new entities will merely replace utilities as forces for maintaining the status quo.

The Promise of e-Commerce

Today's information technologies, have the potential to yield promising results in combating the inefficiencies and problems that have arisen to date in implementing ISOs and PXs. As has been already demonstrated on consumer products and business-to-business auction sites, such technology should be well suited for the real-time matching of supply and demand that is required by electric power markets. Some ISOs already employ the technology, albeit in a limited fashion. For instance, the NY-ISO system dispatchers receive bids for energy via the Internet from a variety of new market participants such as public and private power providers, power marketers and brokers, and retail energy service providers. Similarly, the Cal-ISO experiences 10,000 hits a week on its Internet site. Yet, the limited use of e-commerce technology, while encouraging, does not, however, go far enough. Moreover it remains to be seen whether the ISO/PX can truly embrace the rapidly evolving e-commerce potential on the path toward maturity and self-help.

As has occurred in other industries, what may be necessary is that an entity other than the existing ISOs and PXs must build such an auction mechanism from the "bottom-up." Indeed, some entities have already begun forming e-commerce electricity exchanges and these nascent electronic marketplaces may in fact someday replace the ISOs and PXs. Currently these exchanges perform only limited functions, such as providing an automated mechanism to form bilateral contracts. These online exchanges accept buy orders at bid prices or sell orders at offer prices. One such exchange set up by Unitil Resources, Inc., offers an Internet-based auction for energy service by matching customers' energy requirements with suppliers to provide the best, real-time prices for energy.

To truly supplant the institutionalized ISO and PX-and provide for an actual competitive marketplace-online exchanges must do much more. They need the ability to simultaneously match multiple bids and offers (much like an online stock exchange), immediately schedule all necessary transmission electronically, and provide for online financial settlement. Under this structure, all transactions would take place completely online, subject to widely accepted contractual terms and conditions, and market participants would not have to go offline to finalize the contractual details of their transaction. Ideally, this online marketplace would be able to act on a national basis-while recognizing whatever regional constraints that may exist, including physical transmission limitations. An online marketplace that fulfills those requirements has the potential to eliminate completely the problems of ISOs and PXs that exist today.