Electricity Deregulation Explained (2 of 3)

This is the second in a series of three blog entries that attempts to explain electricity markets: why regulation was necessary at one time, why it may not be now, and what it means to be an electricity consumer in the wake of deregulation. Part 1 provides the background. Part 2 explains how deregulation works from a consumer’s perspective. Part 3 describes the choices available to deregulated market participants and the near-term outlook for deregulation at the time of this writing (November 2007).


HOW DOES DEREGULATION WORK?

Welcome to the 21st century. Electricity purchase and consumption is a multi-part task. Keep in mind that electricity consumption is paid for in three parts: (1) the energy commodity itself, in units of kilowatt-hours, or kWh; (2) the capacity for delivering the energy (if electricity is the "beer," then the capacity is the "mug"); and (3) the ancillary services that ensure the safety and reliability of the distribution system itself. The electricity market constantly adjusts the output of power generators in response to the demands placed on it. A customer’s total expenditure for electricity reflects not just the price and volume of these components, but also the time at which they are consumed.

The traditional regulated utility “bundled” together the provision of electricity—a commodity—with the cost of distributing power and servicing the related infrastructure. In contrast, the deregulated market allows customers to shop their commodity needs in the open market. In this market, the local utility retains the responsibility for distribution and service, but acts a as a “middleman” between power generators and the consumer, making wholesale electricity purchases which are in turn delivered to retail consumers.

Regulators recognize that most residential and small business electricity consumers don’t wish to be saddled with the many choices presented by deregulation. Therefore, the traditional utility company remains the “provider of last resort,” which allows consumers to maintain the simplicity of a traditional utility relationship. However, the utility may not always provide the lowest of prices, especially when its procurement strategy is to make one or two large annual wholesale power purchases in a market that experiences price fluctuations in 15-minute intervals.

The open market for electricity is notoriously volatile for a variety of reasons. The demand for electricity varies with the weather and the time of day. Power generation facilities are not all created equal: some are more expensive to run than others. The cheapest-to-run generators tend to operate the most. The more expensive units add to power supply as demand increases, as it does on hot weekday afternoons when air conditioning is at a premium. Predicting electricity demand is about as reliable as a meteorologist’s ability to predict the weather. Coordinating power generation capacity is an imperfect task, and as a result, demand and supply imbalances create price spikes and volatility.

Whereas the price of an office chair stays constant, 24 hours a day, seven days a week for a long period of time, electricity prices vary by the 15-minute interval. You can store an inventory of chairs in a warehouse until they are sold, but you can't do the same with significant amounts of electricity.

Read Part 1 or proceed to Part 3