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The Double Edged Sword of Equating Supply and Demand

After California's recent experience, the many investment opportunities created by the utility industry deregulation are in jeopardy. Electric system reliability is a political necessity. The reverberations from California's rolling black-outs have stalled the trend to generation market deregulation which seemed so inevitable just two years ago. The seismic waves even threaten to cause states which have started their deregulation to reverse that process.

Most of the North American business opportunities in the electric industry discussed in this volume depend upon a continuation of the deregulation of the electric generation market, and a trend toward stability and predictability in the electric markets. State legislatures and Congress need to facilitate with legislation such market deregulation. They also need to exercise discipline by keeping their hands off the competitive markets so created - to let them work efficiently.

Unless public policies are adopted which cause (and assure) that electric reliability will co-exist with competitive markets, competitive markets will be the political victims. This article discusses a policy initiative which would allow electric system reliability and substantially unfettered competition in the generation market to cohabit. Policy answers to this reliability issue will be necessary to sustain, for the long run, the restructured industry's investment opportunities.

Supply equals demand in a competitive market equilibrium. Economics 1. The formula for an efficient market mechanism. Is it also the formula for an unreliable electric energy market?

When supply just equals an electric market's coincident peak demand, there is no room for error in the marketplace. If the coincident market peak demand exceeds projections, or if generating plants expected to be available are not, electric shortage results. Such events are absolutely likely to occur. And, in a large, regional interconnected electric grid, it is difficult to isolate the effect of electric shortage just to the piggies who build their houses out of twigs or straw. The voltage drops which occur when use exceeds supply at a material level affects the entire grid. Saving the grid from rolling blackouts has more to do with which loads can be controlled than it does with the firmness of service contracted for at wholesale by the retail providers.

Reliability Based on System Reserves

In each of the state jurisdictions regulating electric utilities, and in the nation's several reliability councils, this problem came to be solved by requiring firm, system electric generating supply reserves ranging from 15% to 20% above the forecast, coincident, non-interruptible demand peak for the portion of the electric grid served by each retail electricity supplier. The cost for this reserve capacity - which if maintained reduced the risk of actual shortage to a near 0 probability - was borne as an insurance premium against interruption in the rates paid by retail customers. Through paternalistic regulation, electric shortage became a theoretical, latent risk in the electric marketplace and in the political world.

Reliability an Externality

As the nation came to count on, even expect, excess generating capacity, the political dynamic in some jurisdictions began to focus on the relative cost of electricity - and of course carrying reserve capacity to insure against shortage exerts upward pressure on costs. When the political world (and the regulatory world under its thumb), began to take the excess generating capacity of the 1990's for granted, the standard short political attention span turned to its normal inquiry "What have you done for me lately?" And the answer to that question in a number of states (at least New York, California, Massachusetts, Illinois, Pennsylvania - not insignificant jurisdictions) was - disproportionately high rates in a generation market with excessive system reserves. Supply exceeded demand, and prices were high. Unlocking that generation market - which was no longer an apparent natural monopoly - to competition seemed the logical and all too simple answer. Competition is efficient. It drives the market to the cheapest marginal cost solutions. It equates supply and demandÂ…. It equates supply and demand. It equatesÂ….

Equating supply and demand is a double-edged sword. It removes the latency of electric shortage and creates a shortage risk which is allocated by the marketplace. But the participants in the marketplace operate in an interconnected electric grid. The piggies built separate houses of brick, twigs and straw. Each to his own fate. But in the electric grid, due to interconnection, the piggies build a condominium, and the piggy using straw would build the foundation. Decisions by separate consumers cannot necessarily be insulated from having a collateral affect on other consumers served by that grid - an externality of the competitive generation market, in economic parlance.

So, is reliability an externality to the competitive market? If it is, even Adam Smith would urge its regulation. But can you regulate the system reserves without ruining the efficiency of the marketplace? Following is a proposal to deal with system reserves (which are assumed to be the necessary bedrock of a reliable market with a very low probability of shortage) as a market externality by assuring its existence extrinsic to the generation supply provided by the competitive market. This need to keep the system reserves outside the supply perceived to exist in the competitive marketplace is driven by the efficiency of the market's ability to equate its perceived supply with demand. Perceived capacity in excess of demand will beg the reserve supplies (if they are available to the market) to be sold, possibly twice. Suppliers will gamble with shortage, and the market will be left with economic sanctions. And economic sanctions cannot be delivered at 120 or 220 volts.

Utility Regulation - Darwinian Evolution

What many legislators seem to have forgotten is that utility regulation evolved in a Darwinian manner, adjusting to cope with the Great Depression, World War driven shortages, runaway inflation, and the constant specter of political tinkering in response to populist or Wall Street pressures. The regulation evolved to compensate for the famous populist, Huey "the Kingfish" Long, who ruled the Louisiana utility regulation from the Governor's mansion – and as well to avoid the machinations of Wall Street reflected by the likes of Insul.

In this evolution, utility commissions became quasi-judicial bodies subject to restraints on ex parte communications, and staffed by civil servants. Politicians grew wary of "tampering" with utility regulatory commissions based upon flak they could get from civil servants for political meddling - and out of recognition that the decisions were mostly no-win from a political standpoint. The three "R's" – rates, reliability and ratings (financial) – all had to be balanced, and politicians were better off not taking credit/blame for the outcome.

That is, until 1995. Then, blinded to the risks of political tinkering by excess electric generating capacity and seduced by the political pressure to reduce high electric rates (or otherwise punish increasingly unpopular utilities), legislatures and political leaders in California and elsewhere jumped into the utility regulation pool. The changes made proved the short institutional memory of legislatures, and their short institutional planning horizon. Having legislatures in one term rewrite utility regulation is like handing an American Express Platinum card to a teenager. Instant gratification wins out over long term planning.

The legislatures forgot why certain provisions in the regulatory schemes existed at all. For instance, purchased power adjustment clauses or periodic rate cases were important financial pressure release valves. When they are eliminated, financial explosions can occur (PG&E's bankruptcy).

Basic Changes of Incentives

The old regime rewarded investors only for building so-called "rate based" generation, transmission and distribution assets - so the equity owners were highly incented to build reliability-enhancing assets. Utility regulatory commissions were charged with assuring adequate service, but spent as much time assuring that utilities did not overbuild or unnecessarily guild the reliability lily. When legislatures changed the regulatory game from rate based returns to performance based rates, the owner's incentives were turned upside down - but the regulatory process was not ready to become the adequate electric supply, electricity service reliability police. Frequently, an organism doesn't understand why it evolved all of its parts - but the spleen and appendix can seem awfully important when they are damaged. The sophistication and effectiveness of the old regulatory processes (at least from a system reliability standpoint) is much more obvious in retrospect, now that the system perceived to have been broken has not been properly "fixed."

Now that the legislatures and politicians seem to be in charge of regulation, and we can again understand the problems from giving them the keys to this ignition, maybe the best strategy is the one which minimizes the amount of state regulation needed. This could be accomplished with a real, robust, competitive generation market, coupled to a situation in which the 15-18% generation reserve is controlled and operated by the RTO outside of the generation market - deployed in a disciplined manner simply to avoid shortage and support reliability in the RTO's grid.

Another Job for the RTO

Will a competitive wholesale market that includes a robust spot market provide 15-18% system capacity reserves? Will the electric retail service providers selling firm service be required to have term, firm contracts covering a full 115% of their firm service capacity requirement, 100% of the time? If not, the market will not provide that 15% reserve.

And even if there is a regulatory process which sets a 115% of firm service capacity control requirement, if the players in the electric grid in which the market is located do not all play by the rules of the game, the 15% reserves will not exist. Assume Oregon and Nevada have assured 15% system reserves in their service areas, but California has not. A collapse of the electric grid due to a substantial supply shortage in California will not easily be isolated to the retail suppliers without firm contracts covering 100% of their capacity requirement.

In order for there to be 15-18% system reserves, either the market, or regulation as a market surrogate, must demand and be willing to pay for and maintain as ready 15-18% more capacity than is likely to be used at any time. If all firm service suppliers playing in the market were required to have 115% of their firm service demand covered by long term capacity contracts, this would help support adequate capacity reserves. It probably would not assure adequate reserves.

Who would regulate this requirement? Effective regulation requires watching both the retail sales contracts and the underlying wholesale market. Will all of the players play by the rules? Such a regime would minimize the value of the spot market, and would substantially limit its use to interruptible service users and providers. Is there electric system infrastructure switching capabilities that can restrict the effects of system shortages to just those customers whose electric supply purchasing decisions failed to assure against shortage? Probably not for a long time. And these electric circuits/markets are frequently interstate.

Experience and intuition suggests system reserves in the range of 15% to 18% are an externality to a competitive market. In the competitive market, attention to costs will cause all participants to test just how thinly they can cut the size of fixed carrying costs attributable to reserving firm generation capacity. Suppliers will attempt to sell a given unit of capacity as many times as possible. Suppliers will make dispassionate, economic decisions about the risk of shortage to their customers. If there is only a competitive wholesale market, or if that wholesale market is dominant in the generation market, the wholesale buyer with an absolute supply obligation which suffers the supply shortfall becomes a desperate market participant on the demand side. California, here we come.

If adequate system reserves are an externality, they need to be provided for the electric system by a supplier, and with costs borne, outside the market. How could this be done?

The RTO Solution

A regional transmission organization (RTO), scaled to the geographic size of the electric circuit (grid) defining the generation market, is in a position to:

  1. Know the system demand requirements, and to reasonably forecast that electric system's future demand and capacity requirements;

  2. Collect transmission tariffs from all participants in that electricity market who benefit from the existence of a competitive market and the reliability afforded by 15-18% system capacity reserves;

  3. Own, and withhold from the market except only as necessary to support system reliability, 15-18% generating reserves in excess of that system's forecast peak - which a competitive market would be expected to supply; and

  4. Insure that the cost of assuring reliability with such system reserves could be spread and borne by the beneficiaries of that reliability for that electric circuit grid/market through inclusion in transmission tariffs.

Will policymakers focus upon the need for 15-18% system reserves; conclude this is best treated as a market externality; and put the job of assembling, carrying the costs of, and levying charges to cover those costs into the hands of the RTO which is charged with providing the electric transmission infrastructure necessary to support that competitive generation market? Who else has a jurisdiction, and interest, and a "taxing" method, which is co-extensive with the electricity circuit and marketplace? Another job for the RTO!

Without the RTO doing this job, there is an inherent disconnect between the regulation of firm capacity sales from the generator (as done, say, by Pennsylvania-New Jersey-Maryland requiring that capacity reserves be added into and paid for in that sale) and the sale of firm power at retail (by a regulated or a direct access provider). An unregulated market might replace 15-18% actual physical capacity reserves with economic sanctions and contract remedies as the answer to the risk of shortage. Will the political will tolerate actual shortage, albeit offset by economic remedies? Or will the longevity of competitive generation markets be better sustained by actual physical system generating reserves of 15-18% above the demand and supply as equalized by the competitive marketplace, financed through RTO tariffs levied upon the market participants realizing the benefits of that reliability insurance against shortage?

As states now implement policies which foster competitive electric generation markets, and as those markets become efficient, supply will rather quickly match demand. But the interconnected electric grids typically span several state jurisdictions. The grid might be comprised of various institutional electric market outcomes - ranging from true open access, to traditional regulation. A hodge podge of brick, twigs and straw solutions to the reliability issue. The overall result for the grid is that electric demand will not include a 15% excess capacity reserve, the electric market will operate continuously at the ragged edge of shortage, with shortage as a real and not a latent risk for the whole grid - even those portions which do not contribute to the problem.

If the wholesale purchasers themselves operate in competitive markets (and are not required by regulation to maintain 15% capacity reserves), they will cut costs and test the market's willingness to endure shortage. Even normal commercial sanctions applicable to suppliers who fail to meet their contractual supply obligations will replace the necessity, electricity, with dollars of liquidated damages. And dollars can't run computers, or escalators, or surgical rooms.

So, can a robust, competitive electric market achieve reliability for an interconnected electric grid with a hodgepodge of institutional policies regarding competition? Probably not. At least, not without a very intrusive level of regulation of both wholesale suppliers, wholesale purchasers, and retail providers. Regulation which is likely to severely compromise the benefits of competition. Absent policing the whole supply chain throughout the grid (the reliability region) to assure 15% reserves up and down the supply line - the free market will push the system towards 0% reserves.

What system could avoid continuing, pervasive regulation to assure reliability creating system reserves? If the RTO, coextensive with the electric grid which constitutes the market, owned or otherwise controlled generating capacity equaling 15% of the coincident peak for the market covered by the RTO - and reserved in a disciplined manner that capacity outside the competitive market for use only in time of shortage - reliability might be assured.

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