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The curious reality behind creation of a stable electricity market is the solution of a real option issue unlike any other commodity market. It is common knowledge that the absence of storage in electricity has profound impacts on the structure of the electricity market but what is its implication in market design. The graph below is a simplified illustration of the underlying problem of designing a stable electricity market.
This graph illustrates the reality that the ability to add new supply expires significantly before the purchaser must make the election to consume. The option to build new generation capacity cannot influence the market price for electricity once it has expired. A capacity charge or other mechanism that pays for reliability that does not start paying only when the option to build new generation exists is, in essence, only paying already constructed generation capacity for its existence. The market design issue for stability is to create a mechanism for creating a consumer side signal as much as two years before the first purchase date. This is the concern for market design.
The author was a project director for a World Bank project in 1999 and 2000 contracted to Teknecon Energy Risk Advisors, LLC to design a stable market for the Government of Colombia. That market design was the first to fully construct a market mechanism that could overcome the real option problem shown above. However, in solving the real option problem an underlying issue of credit capacity was uncovered.
By creating a forward market pricing mechanism that allows the cost of the real option to build generation to be borne by the consuming side of the market, the project team determined that the credit capacity of the market was insufficient to support the cost of system reliability. This led –as is being discussed in the current standard market design process in the United States – to the realization that industry-backed credit clearing would become a necessity. However, a further concern arises when the forward cost of reliability – which is the industry term for assuring enough real options on generation have been exercised – is borne by the consuming side.
In deregulation, the right of the customer to shift suppliers has been a cornerstone of the process. The problem is that reliability is a long-dated forward cost that must be borne by the entire consuming sector. If the LSE or other aggregator “purchases” forward reliability for the consumer, what keeps the consumer from “walking” from that obligation? If the obligation is to transfer with the customer, how is that mechanism communicated to the consumer and how is the transfer effectuated? These issues became very contentious issues amongst the Colombian stakeholders in the World Bank project.
While this set of concerns may appear too detailed for the initiation of the standard market design process, it is critical that the end goal of managing the disparate expirations of the real option to create supply and the real option to consume be the central focus of designing a stable electricity market.
For information on purchasing reprints of this article, contact sales. Copyright 2013 CyberTech, Inc.
Samuel Insull had this all pretty much figured out intuitively 80 years ago. Of course, he used a different jargon. His conclusion was that electricity was a "natural monopoly" and that regulation was the best compromise.
So far all unregulated schemes result in boom/bust cycles analogous to pork bellies - high price spur investments that have a delay before coming to market. Once the investments become production, price tanks. Result - a period of shortage and high price followed by oversupply and unproductive investments. Society's resources are wasted and misallocated both ways.
We all know the failings of regulation first hand so it is no panacea. Like socialism, the benefits (profits) tend to get distributed based on political power rather than economic merit.
Ultimately, there is no substitute for citizens paying attention to the market throough their exercise of political power. "Free enterprise" will always seek exclusive market power in service of maximizing profits. Professional political players will always seek to maximize their political power by allocation of public goods under their control. There will ALWAYS be some fox wanting to watch the chicken coup for us.
Michael Giberson 11.19.02
In my view, what Mr. Lord does in the above article is try to shift the question away from "regulation vs. free markets" and to a question of proper market design. Existing capacity markets in the U.S. ISOs require relatively short term commitments in return for capacity payments - exactly the problem Lord identifies above. Not surprisingly, existing capacity markets have engendered more controversy than new construction.
I'm not yet convinced that capacity markets are required for effective operation of regional wholesale power markets. But if we are going to consider them in the context of FERC's standard market design, we at least ought to consider markets properly designed to provide the services that they are intended to provide.
Joseph Diamond 11.19.02
I will be sending you a piece which is for a CEC white paper on chillers/enhancements. It is a form of comment and we would like any comments you may have. It is a draft and not for public consumption at this time. Joseph Diamond Ph. D. Economist California Energy Commission
Stephen Heins 11.19.02
Regulation vs. Deregulation may not be the right debate!
Aggregated displaced capacity (or, groups of companies who reduce electrical consumption jointly) will provide a viable commercial alternative to renewable energy or new power plants. In fact, the environmental impact of large amounts of reduced demand is far better than either source of new electrical supply.
We refer to this option as the Orion Virtual Power Plant (TM). We estimate that over 21,000 MW could be displaced by industrial/commercial customers who simply replace their HID lighting with T8 fluorescent fixtures with reflector logic. In our estimation, 100,000 MW could be displaced with a robust plan for U.S. energy efficiency.
This energy efficient strategy would greatly improve electrical availability by using the never-regulated option of the U.S. business community to use less energy. Together, the end users can render the regulated vs deregulated energy debate less important and certainly less political.
There is also something very American about individuals and individual companies taking control and accepting responsibility for their actions.
Thomas Lord 11.19.02
The article isdesigned to shift the discussion away from "regulation vs.deregulation". It is designed to posit the questions of how do we get the market to create a mechanism for buying reliability rather than capacity. This should probably be done in the context of the RTOs - rather thn a national reliability market. In this manner, those merchant plants that opt for the national market can have access but they are not compensated for something they are not providing.
I presented this commentary as the basis for discussion, rather than as the codification of a "final solution". However, any solution set that does not address the real option issues of electricity reliability and the corresponding free rider concerns is destined to create the "boom/bust" cycle.
Paolo Fornaciari 11.29.02
MARKET DOES NOT BECAME ELECTRIC
In the past years a wide belief and convincement was diffused in Italy and also in Europe, on the possibility that the completion of the liberalization and privatization process of the energy sector would have allowed the reduction of the energy bills. This had been stated by the National Industry Association (Confindustria) at the Conference “Actions to compete”, held in Parma, Italy on 16 and 17 March 2001, by the Italy’s Bank Governor Antonio Fazio, by the Italian EU Commissioner for competition Mario Monti and by the Italy’s Energy Minister Antonio Marzano affirming : “The reduction of the electricity prices is one of the mayor objectives I intend to achieve”. The oil crisis in 2000/2001 and the subsequent energy crisis in California, with several “blackouts”, have raised doubts on the real benefits achievable through liberalization and privatization of the energy sector in our country. What happened in California has not due to the public or private ownership of the State energy system, but to other causes. In the industrial world today exist private electric system, like in Germany and in the United Kingdom, which operate well and others, like the French public monopoly EdF that function also very well and even better. The negative experiences in California and in Spain should lead us to ponder. But with the energy sector liberalization, the energy bills will not decrease. It is not a problem of competition, but of diversification of the energy sources. Should we generate electricity burning oil or natural gas, the energy sources more costly, whose price have doubled or even tripled in the past few years – when all the others Nations using nuclear and coal, generates electricity at a much lower cost - there is no difference where the ownership is a public monopoly or a private investor. What is really needed is “diversification” of the energy sources, rather than “liberalization” of the energy sector : use more coal and, in future, go back to nuclear energy. It is not worthwhile to remember that after the 1973 oil crisis (Kippur war), all the others industrial nations, but not Italy, have substituted oil with nuclear or coal in electricity generation, France from 45% to 2%, Germany from 23% to 1.5%, Sweden from 19% to 3%, Belgium from 78% to 15%. We instead have increased the hydrocarbons use in electricity production from 61% to 71% ! This is way our energy bills are double than in France, three times higher than in Sweden and 60% higher than the European average, with a major cost of about 8 billions Euro (see Table attached). Energy is a very peculiar good : it shall be generated at the same time is requested, it is difficult to storage, requires long time for the construction of plants and transport lines with relevant investment and delayed revenue. Not by chance the private entrepreneurs ante Enel did subdivide the national territory in zones of competence, avoiding to compete among themselves. According to the French Economy Minister Laurent Fabius, several privatizations of public companies have led the energy bills to higher prices and according to the NUS Consulting Group: +16.5% in Germany, + 7.5% in Denmark, + 5.6% in south Africa, +2.4% in Spain and 2.3% in Canada. Luigi Einaudi, formerly President of the Italian Republic, was used to say : “ The operation of public services by the State assures results, not always valuable in money, but unquestionable advantages for the civilization of the Nations”. We will need energy, a lot of energy in the future to come. According the World Energy Council (“Energy for Tomorrow’s World- Acting Now!, April 2000”), the World energy demand in the next 20 years shall increase by 50% and it states : “ Al the industrial Nations retain that the diversification of the energy sources means simply to use more coal and no one energy source shall be abandoned for arbitrary political reasons, in particular nuclear, which does not emit greenhouse gases”. And in addition : “Governments shall shape the energy sectors”. In other words : “ Market is an essential mechanism for promoting greater efficiency in the energy sector, but is not sufficient by itself”. The EU has proposed at the recent Johannesburg Summit, to increase the renewable energies contribution up to 15% by the year 2015, but this proposal had been rejected by US, because their elevated cost. In the mean time the EU Commission, with its deliberation of November 16th 2001, had rejected the EU Green Paper on “: Towards a European strategy for the security of energy supply”, which had considered nuclear energy :” costly, undesirable, and in doubts”. Almost no one has the courage to say that nuclear energy is the solution. Only Lester Turow, Nobel Prize and prestigious chief economist at the MIT in Boston has recently written on the magazine USA Today : “ In the case of electricity, we already have a technical
Thomas Lord 11.29.02
In other instances I have noted the need for renewables to promote their usage on a consistent valuation methodology. In many cases, the apparent advantage of nuclear and large coal units is based on the rolled in rate base payment of the fixed capital costs. This makes the return required for these investments lower than corporate based capital. In addition, I have argued that deregulation has a significant imbedded increase in capital costs for the entire industry. I have no problem with nuclear generation as long as the society makes the consensus decision to provide for a manner of disposing of wastes. If the society determines that nuclear waste is "unmanagable" then the increased costs should be accepted.
The premise of this article is that the "unquestionable advantages" need not be only available through a regulated market. However, absent an adequately desgined market, I would argue that deregulated electricity markets can very easily begin to resemble the market stability of the airline industry than the crude oil market. The issue is appropriate design - something lacking to date.
Kiah Harris 12.3.02
An issue that could also be considered is the "market" creating alternatives to traditional supply from the wholesale market that shortens the time between when the market needs to send the signal for new capacity and when the capacity is added. In my view, the FERC SMD approach will do little to increase the transmission capacity since the locational marginal pricing (LMP) will usually be easier for producers to capture with adding local generation than through construction of any major transmission facilities. (Adding transmission facilities to remove a constraint would also kill someone's goose!)
We currently have "distributed" generation in the wholesale market connected by the transmission network. It is the redispatch of this distributed generation which the FERC is relying on to allow the concept of transmission congestion charges to work. Redispatch can only occur on the constrained side of a path if sufficient generation capacity exists above load needs in the constrained area. My expected outcome of SMD will be to encourage further development of distributed generation to take advantage of LMP rather than significant transmission investment.
If shorter lead times for exercising the capacity option are of benefit, then the market should see the shortest lead time for construction of capacity as a good thing, with as minimal overcapacity added as necessary. Due to the lumpy nature of central station additions to take advantage of economies of scale, more capacity is typically added than is necessary. This adds a cost to the option price that must also be born by the consumer until the load grows into the capacity, as has been occuring over the past 20 years in the US. Oddly enough, the electric industry is going to be faced with overall higher reserve margin requirements (more generation capacity) due to increasingly smaller constrained load pockets, since reserves cannot be shared over an unreliable transmission system.
As the generation additions become more local, with the extreme being additions at the end user, the capacity option for electricity could be internalized in the end user's costs as it is for other infrastructure such as air conditioners for cooling, furnaces for heating, machinery for producing widgets, etc. This essentially places the capacity option lead time on the order of weeks or months instead of years, removes the boom/bust nature of the merchant/IPP approach and brings the issue of how much should the market invest (and hence charge the customer in the option) for reliability down to the end user decision level. It will be interesting to see how the end user distributed generation market develops over the next decade.
With the market forces moving the responsibility for capacity to more local levels, the FERC envisioned wholesale market will become nothing but an instantaneous energy clearing house for non-firm electricity transactions hedged by local generation.
Thomas Lord 12.3.02
Distributed generation has the greatest likelihood of radically changing the market. The question will become whether the cost of the full grid is supportable as a method of redistributing the "non-lumpy" distributed gen. I would point to the economic problems of the Central American transmission grid supported by the World Bank which collapsed of its own weight due to the lack of economics of the carying cost of the grid versus the potential of trading gain in wholesale markets. The grid only makes sense as a bulk mover of baseload power. We can chat about this in some other forum if you like.