Electricity Deregulation Explained (3 of 3)

This is the third 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).


PARTICIPATING IN DEREGULATED ELECTRICITY MARKETS

The consumers that exercise choice in electricity markets pursue a trade-off among simplicity, price, and fairness. A consumer usually can obtain any two of these merits at the expense of the third. These are the options:

• “Simple and cheap” at the expense of fairness. Electric utility service requires a lot of capital investment in distribution infrastructure. Utilities hate to lose a large customer because the capacity to serve that customer becomes idle. There’s no revenue to offset the ongoing carrying costs of this idle capacity—unless the cost is passed on to remaining utility customers. By the way, these other customers as a community may already be suffering because that big facility has moved elsewhere for cheaper electricity rates, taking with it the employees who supported local businesses. The simple and allegedly cheap solution would be to redistribute utility’s cost of serving the large ex-customer among the many remaining small consumers, so that each bears a small burden. After a series of these redistributions, the remaining customers will ask if their growing cost burden is indeed fair.

• “Simple and fair” is not always cheap. Would it not be fair and simple to have electricity prices reflect the cost of its production? This sounds good until we recall that the cost of power production is tremendously volatile even within the course of a single day. A price spike at the wrong time could ruin the budgets of businesses and households alike. In these instances, electricity prices pegged to the cost of production expose consumers to up-side price risks.

• “Cheap and fair” is not simple. Today’s volatile electricity prices can be managed with sophisticated portfolio management techniques borrowed directly from the financial sector. This involves paying a premium for contracts to receive electricity at predetermined prices, terms, and quantities in advance of a specified date. Note that these contracts do not provide “cheap” prices. Instead, the contract provides a reliable price which ostensibly reduces the consumer’s exposure to future, unpredictable price spikes. The consumer pays the supplier a premium (an increment of value over and above the electricity commodity itself) for the privilege of having a reliable price. Portfolio strategies allow a consumer to cover some or all of their anticipated electricity needs for months or even years in advance. The portfolio manager follows daily power markets for opportunities to make contract purchases. This may sound complicated because it is, especially for residential and small business consumers. Larger power consumers either develop a staff professional to perform these tasks, or enlist a consultant to do the same.

The turmoil that follows in the wake of electricity deregulation has been attributable to a lack of preparation—on the part of suppliers and consumers. Deregulation has been subject to political compromise, particularly when electricity price caps were imposed for an interim period to “phase in” deregulated markets. Maryland experienced exceptional market turmoil when price caps set in 1999 were lifted as planned in 2006—exposing consumers to the prevailing cost of electricity. The timing was terrible, as it coincided with the aftermath of the 2005 hurricane season, which had caused extensive damage to the natural gas supply infrastructure upon which electricity production depends. Consumers faced a potential 70 percent rate hike for electricity. In response to popular outcry, legislators intervened in the rate-making process to “force-fit” low prices, which effectively usurped the administrative power of Maryland’s utility regulators. The “low price” solution, by the way, was one that simply deferred consumer costs over time.

Not surprisingly, there is popular support in deregulated markets such as Maryland for restoring traditional regulation to the electricity market. This means putting power generation and distribution under the care of a local monopoly.


NEAR-TERM OUTLOOK

Proceeding with electricity deregulation is like squeezing toothpaste from a tube: you can only go forward, and you can't put the toothpaste back in the tube. This is because deregulation required utilities to separate the assets that generate electricity from the assets used to distribute power all the way to the customer. To go back to the old business model, utilities would be forced to build or buy back power generating plants. This initiative would have enormous costs. Who would pay for these plants?
• If private investors foot the bill, then the utility needs to guarantee those investors a rate of return that is at least as attractive as other investment opportunities. Returns to the investor would have to be reflected in the rate for electricity sold by these new plants.
• If electricity consumers pay the utility to bring these plants online, this also means raising electricity rates.
• What about the “government?” This means raising the money through taxes. This money still comes from consumers’ pockets.

Add to this dilemma the potential for market friction between neighboring states. The delivered price for electricity could be very different in neighboring states simply because of each state’s regulatory approach. States that attempt to re-regulate electricity may impose costs that ensure that their electricity will be priced higher than it is in a neighboring state without that burden. The desire for price arbitrage across state lines would benefit consumers while possibly harming utility investors. This renews questions about fairness. And yet again, citizens may look to their lawmakers for arbitration.

As the year 2010 approaches, only a handful of states have implemented electricity deregulation. Their progress has been stalled by memories of California’s 2003 deregulation debacle, which was neither well-designed nor-well executed. Some states, like Virginia, are indeed taking steps to move backward in the deregulatory process. But for reasons discussed here, the outlook is for more deregulation, not less. Currently, the advantage falls to the informed consumer that is prepared to exercise the choices—however complex they may be—offered by today’s deregulated utility markets.

*END*

See Part 1 or Part 2