A Newspaper Peeks at Power Industry and Restructuring

Michael Giberson

In what is identified as the “first article of a series,” the New York Times reports that the results of power industry restructuring have disappointed many people.

A decade after competition was introduced in their industries, long-distance phone rates had fallen by half, air fares by more than a fourth and trucking rates by a fourth. But a decade after the federal government opened the business of generating electricity to competition, the market has produced no such decline.

Instead, more rate increase requests are pending now than ever before, said Jim Owen, a spokesman for the Edison Electric Institute. … The investor-owned electric utility industry published a June report entitled “Why Are Electricity Prices Increasing?�? [PDF; Link added]

I suspect any reader with much background in the industry will be disappointed with the confused reporting, and any reader without such background will just end up confused. The article jumps from California to Connecticut, from open access transmission policies to power market design issues, from wholesale industry reforms to retail industry changes, back and forth, with little evidence of any deep understanding of what is going on. Maybe as the “first article of a series,�? the intent here is mostly to raise questions that will be addressed more completely in the forthcoming articles.

Admittedly, the reporter faces a most daunting task if he seeks to tell clearly the story of the restructuring of the electric power industry. At one end the industry is buffeted by the vagaries of the world oil and gas markets and at the other end the industry is bedeviled by the storms of state and local politics. A count of all the members of Congress, federal, state, and local regulators, and state legislators having a hand in policies affecting the industry over the past ten years would easily get into the thousands. Multiply that number by a factor of hundred and you get an estimate on the number of people in the energy industry involved in promoting, implementing, or coping with the legal and regulatory changes. A tough story to tell, and so far the Times is not off to a good start.

A few specific reactions are in the continuation.


…the Federal Energy Regulatory Commission and other federal agencies warn in a draft report to Congress that “customers may experience rate shock�? as utilities seek to make up for revenue they did not collect during the period of artificially reduced prices and to cover higher costs of fuel. They warned that “this rate shock can create public pressure�? to turn back from electricity prices set by the market to prices set by government regulators.

The article does not make clear that only the still-regulated part of utilities get the opportunity to “make up for revenue they did not collect during the period of artificially reduced prices.” A competitive industry may face periods of high prices and periods of low prices — perhaps even artificially high or low prices — but no government agency is guaranteeing that the industry will get high prices later to make up for low prices now. However, the opportunity to “make up for revenue they did not collect” is not some sinister plot to screw the consumer, but rather the evolved wisdom of regulatory law that says the state must allow a fair rate of return when it regulates prices.

But [competition among producers reducing prices to consumers] has not happened. A truly competitive market has never developed, and, in most areas, the number of power producers is small. In New Jersey, for example, only six companies produce power, and not all of them sell to every utility.

If the market is contestable — if the barriers to entry are small — then “only six” may well be plenty to provide competitive results. As a matter of fact, while their may be only six companies owning generators in the state, last year there were eleven companies among the winners in the state’s auction to supply basic generation service, and this year twelve companies were among the winners. These companies may be buying power at PJM spot prices or under contracts with companies in New Jersey or elsewhere. To some extent limited transmission capacity constrains the ability of New Jersey consumers to reach cheaper power available elsewhere, but this is a limit that is becoming undone by restructuring.

The “only six companies produce power, and not all of them sell to every utility” remark hints at a lack of competitiveness, but simply counting the number of producers is inadequate as a guide to identifying market power. And, in any case, six doesn’t seem like a bad number when you also consider the ability to import power into the state from elsewhere in the region.

And if electricity is needed from more than one producer, utilities pay each one the highest price accepted in the bidding, not the lowest. This one-price system, adopted by the industry and approved by the federal government, is intended to encourage investment in new power plants, which are costlier than older ones.

But critics say that … the auction system can be manipulated to drive up prices, with the increases passed on to customers.

Here the article is referring to the use of uniform pricing rules in the part of the country with wholesale markets organized by regional transmission groups. While uniform pricing rules can be made to sound costly and dangerous — the price paid to a low cost coal power plant is the same as the price paid to a high cost gas turbine — the rule encourages investment in more efficient generators when compared to pay-as-bid or other pricing rules.

As the “critics say,” the auction can be manipulated to drive up prices, generally by a utility with a large portfolio of generators withholding some of its capacity from the market during high demand days. All of the markets employing the uniform price rules also have anti-manipulation rules and market monitors who work to detect and deter such activities. Despite the article’s reference to California and Enron, my recall is that Enron did not engage in withholding of the sort at issue here, but mostly manipulated other kinds of rules or took advantage of flaws in the California market design to extract money while operating within the rules.

Such investors have in some cases resold power plants they just bought, making a large profit. In other cases, investors have bought power plants from the utilities at what proved to be bargain prices, then sold the electricity back at much higher prices than it would have cost the utility to generate the electricity.

In still other cases, investors have bought power plants from utilities and agreed to contracts to sell power back to the utilities that resulted in the investors going bankrupt. In part the problem was that a great deal of the sales of generators took place in the late nineties, when oil and gas prices were relatively low and stable. Since late 2000, such fuel prices have been much higher on average. The unexpected change in fuel prices most certainly produced some winners and losers. While in some cases the price of the generator, when evaluated after the fact, turned out to be a bargain, that is sort of like pointing out after the horse race is over which of the $2 bets turned out to be a bargain. Hardly evidence of a systematic policy flaw, and of absolutely no value in formulating new policies.

“Change,�? Professor [Alfred E.] Kahn said, “is always messy.�?

Good ol’ Professor Kahn. Under appreciated in the business of restructuring is that traditional cost-of-service utility ratemaking has been developed more than one hundred years. Policymakers didn’t get it right first thing, but rather the “state of the art” of regulation evolved over time. The highly refined “state of the art” utility regulatory system of the seventies, eighties, and nineties produced a number of high profile expensive disasters at ratepayer expense. The problems associated with regulation were bad enough that some legislators and regulators were willing to give markets a little more scope for action. The “how” has not been easy to devise, and, as Kahn said, it has been messy. This messiness appears to me to have the usual marks of a social learning effort — a lot of trial and error, a lot of noisy disputation, some serious efforts at reform, some serious efforts to defend regulation, and a lot of pure rent-seeking behavior. Messiness is in itself no guarantee of progress, but cleanliness would be a sure sign of sterility.

“We recommend total abandonment of restructuring,�? Cato said. If the public rejects a greater embrace of markets, Cato wrote, the next best choice would be a “return to an updated version of the old�? system.

The Cato Institute, it seems, has little stomach for all of this messiness. Cato, apparently shocked and disappointed that legislators and regulators chose not to implement its first choice of policies (a rapid withering away of the state), now thinks that legislators and regulators should get back to the relatively safe and sterile business of improving upon the regulatory state of the art.

A study issued in June by the Edison Foundation … called for relief in the form of higher rates.

The article doesn’t make clear that the “study issued in June by the Edison Foundation,” cited in the article’s final paragraph is the same report as was named in the story’s second paragraph, “Why Are Electricity Prices Increasing?�?


12 thoughts on “A Newspaper Peeks at Power Industry and Restructuring

  1. Nice analysis, Mike.

    Yes, the article was a hatchet job, reflecting very limited knowledge of the industry on the one hand, combined with a bit of prejudice that certainly consumers are being screwed over by utilities.

    The problem with most articles of this type [including a paper referenced in the article] is given precisely in the article:

    “The Federal Energy Regulatory Commission and five other agencies, in the draft of the report to Congress, are unable to specify any overall savings. “It has been difficult,? the report states, “to determine whether retail prices? in the states that opened to competition “are higher or lower than they otherwise would have been? under the old system.”

    This is a knowledge problem. Several papers have been written in recent years, including one referenced in the NYT article, comparing rates between “regulated” and “unregulated” states. Mainly these refer to the state of retail access in these states, and not to wholsale markets. In any case, it is difficult to find a contiguous state that has not been touched by competitive wholesale markets, especially including some of the states most notoriously dominated by large vertically integrated utilities protected by regulation. Some of these areas received large “gifts” of unregulated capacity that has yet to be completely absorbed. So, it’s not just FERC that can’t quite tell whether we’re better off or not… it’s not realistic to think that anybody can. We can’t unwind history and put it back together under a different set of conditions.

    And of course, as long as I’m commenting I am obliged to support your comments on California and Enron. The Western Energy Crisis of 2000-2001 was a supply crisis at its root, a collision of several trends with a sudden drop in hydroelectric generation. It is now available for all to observe in public data. Physical withholding was isolated and rare, and the only documented case I know of Enron actually doing it was almost 1000 miles away from the constrained area that was having *local supply* problems. It’s likely that there was capacity available much closer to the problem, but it couldn’t reach the problem area because of transmission constraints. Naturally, people in the market took advantage of the situation, and there were some bad lingering effects of it all. However, people need to know that “manipulation” and “withholding” did not cause the crisis.

    “California” won’t happen in the Eastern US (unless there is a widespread fuel shortage or nuclear event) not because of better rules or regulation but because the East isn’t at the mercy of such large hydroelectric output variations.

  2. Is it really such a bad thing to have providers paid-as-bid? Large power plants aren’t THAT easy to build…we might be waiting a long time for more efficient plants to come along and knock the high cost suppliers out of the game, and in the meantime we are paying the low cost providers a lot more than they would probably accept.

  3. Pay-as-bid really doesn’t accomplish much that is good. It just changes the game and winds up being less efficient than single-price auctions.

    Let’s go to the extreme: Say we’re a run-of-river hydro plant. We don’t have a lot of choice about whether we run or not; if we don’t generate what’s available then we have to spill it. If we don’t use it, we lose it. We are classic price takers, in that we will take whatever the power is worth when we have to generate it. In a single-price market we implement this by bidding a zero price, equal to marginal cost. That guarantees that we will run and that we will get paid what the power is worth. But in a pay-as-bid market we’re going to be in a game of price guessing. We’re going to be trying to figure out the maximum price we can bid. There will be uncertainty and mistakes, and sometimes we’ll fall through to real-time. But our bid price will always be well above marginal cost. [Don’t think for a minute that bidding behavior will be the same regardless of the pricing mechanism.] The single-price auction actually encourages a marginal-cost bid, where the pay-as-bid auction encourages lots of guessing to optimize above-marginal-cost bids.

    The time to have dealt with these issues was when infra-marginal plants were being sold to unregulated market participants. Nuclear plants sold dirt cheap, but still the buyers were taking on quite a bit of risk in that timeframe. Regulators were glad to let’em go. Blame them. They could have said, “You know, those plants might be really valuable if energy prices ever go up again.” But they didn’t say that, and they let the utilities sell cheap. So, the money those plants are getting now is the same money you lost when your utility and regulators let them go. Everybody knew what they were doing, or at least they believed they did.

  4. Pay-as-bid really doesn’t accomplish much that is good. It just changes the game and winds up being less efficient than single-price auctions.

    Let’s go to the extreme: Say we’re a run-of-river hydro plant. We don’t have a lot of choice about whether we run or not; if we don’t generate what’s available then we have to spill it. If we don’t use it, we lose it. We are classic price takers, in that we will take whatever the power is worth when we have to generate it. In a single-price market we implement this by bidding a zero price, equal to marginal cost. That guarantees that we will run and that we will get paid what the power is worth. But in a pay-as-bid market we’re going to be in a game of price guessing. We’re going to be trying to figure out the maximum price we can bid. There will be uncertainty and mistakes, and sometimes we’ll fall through to real-time. But our bid price will always be well above marginal cost. [Don’t think for a minute that bidding behavior will be the same regardless of the pricing mechanism.] The single-price auction actually encourages a marginal-cost bid, where the pay-as-bid auction encourages lots of guessing to optimize above-marginal-cost bids.

    The time to have dealt with these issues was when infra-marginal plants were being sold to unregulated market participants. Nuclear plants sold dirt cheap, but still the buyers were taking on quite a bit of risk in that timeframe. Regulators were glad to let’em go. Blame them. They could have said, “You know, those plants might be really valuable if energy prices ever go up again.” But they didn’t say that, and they let the utilities sell cheap. So, the money those plants are getting now is the same money you lost when your utility and regulators let them go. Everybody knew what they were doing, or at least they believed they did.

  5. The CA “fiasco” is getting ready to happen again, in spades, without manipulation (except by CA government).

    BPA must re-evaluate the fraction of its capacity which is “reliable” and the fraction which is “source of opportunity”. CA must also re-evaluate its conventional capacity reserve margin in light of its aggressive RPS, especially if wind is to be a significant part of the new renewable power. Otherwise, reliability will be “blowin’in the wind”.

    To D.O.U.G.’s final point above, one must ask a question with far broader applicability. How is it possible for generating capacity of any kind to be “stranded” in a situation of low capacity reserve margin? Is there a generating plant anywhere, sold subject to a “stranded capacity charge”, which is selling power for less than it was being sold before the sale? Is there such a plant which is worth less than its selling price today? I rather doubt it.

  6. > Is there such a plant which is worth less than its
    >selling price today? I rather doubt it.

    I suspect there is a gas plant or two out there that is somewhat less profitable than was expected in 2001, when gas prices were under $3. Coal and nukes are more profitable, but that is almost tautological when the cost of production of a substitute good had doubled. Had gas prices stayed down (which was the conventional wisdom of the time) those deals wouldn’t look so sweetheart today.

    >How is it possible for generating capacity of any
    >kind to be “stranded” in a situation of low >capacity reserve margin?

    In 2002, Texas, at least, had a margin close to 30%. What has happened in the interim is that virtually nothing, other than wind, has been built, and demand has caught up to capacity.

    Had gas not risen, there would be some ‘stranded costs’ today. At the time, nuclear power was being subsidized, in the sense that the sunk capital costs were being reimbursed despite the fact that a ‘competitive’ price for power wouldn’t have given them full return on investment. In the ’90s, nuclear power looked like a white elephant, and those plants looked to be bleeding money. Now, nukes are making back far more than capital costs. Again, it could have gone the other way.

    On all of these issues, you have to look at these questions ex ante – what was known, then? Hindsight is 20-20, but foresight is not, except for those with the gift of prophesy, a sadly small band in these times.

  7. > Is there such a plant which is worth less than its
    >selling price today? I rather doubt it.

    I suspect there is a gas plant or two out there that is somewhat less profitable than was expected in 2001, when gas prices were under $3. Coal and nukes are more profitable, but that is almost tautological when the cost of production of a substitute good had doubled. Had gas prices stayed down (which was the conventional wisdom of the time) those deals wouldn’t look so sweetheart today.

    >How is it possible for generating capacity of any
    >kind to be “stranded” in a situation of low >capacity reserve margin?

    In 2002, Texas, at least, had a margin close to 30%. What has happened in the interim is that virtually nothing, other than wind, has been built, and demand has caught up to capacity.

    Had gas not risen, there would be some ‘stranded costs’ today. At the time, nuclear power was being subsidized, in the sense that the sunk capital costs were being reimbursed despite the fact that a ‘competitive’ price for power wouldn’t have given them full return on investment. In the ’90s, nuclear power looked like a white elephant, and those plants looked to be bleeding money. Now, nukes are making back far more than capital costs. Again, it could have gone the other way.

    On all of these issues, you have to look at these questions ex ante – what was known, then? Hindsight is 20-20, but foresight is not, except for those with the gift of prophesy, a sadly small band in these times.

  8. One thing that gets lost in the comparison of electric deregulation with that of say, telecom – is that in telecom the marginal cost of providing the next level of service was ususally lower than the average cost – in the energy business its almost always the reverse.
    And, natural gas deregulation did result in substantial savings to industrial consumers – but what is often forgotten is that these savings came mostly from breaking long term “take or pay” contracts with gas producers.

Comments are closed.