Restructuring in the electricity industry is becoming increasingly widespread, both in the United States and across the globe. The power industry has been described as an industry that “is transforming itself from one characterized by stodgy regulated utilities with set rates of return and low volatility to one characterized by non-regulated marketers, self-employed traders, independent power producers and diversified companies not traditionally known for their power expertise. Seven C’s in particular are facing the industry today – competition, customer choice, convergence, consolidation and constant change.”
However, The New York Times points out that, “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 declines.” Due to electricity’s unique physical properties, some degree of market power is inherent in the electricity industry. The magnitude of market power amongst generators is likely to be more extensive than was originally expected and, as a result, the transmission, distribution, and retailing of electricity are consequently more important than it was initially anticipated.
Some have proposed long term contracts to minimize volatility in the markets and minimize market power. However, long term contracts are only part of the solution to smooth transaction prices. If savings are ever to be passed on to the consumers it is essential that there is increased real time demand responsiveness amongst customers.
ELECTRICITY PROPERTIES, SUPPLY AND DEMAND, AND HOW FIRMS EXERT MARKET POWER:
In order to fully understand the complex electricity industry and how firms are able to exert market power, one must first understand electricity’s unique physical properties that make it such a distinct commodity: storage, capacity constraints, and capital intensive. Electricity is extremely costly to store. Our storage capabilities (batteries or pumping water uphill to store potential energy) are inefficient and for the most part cost prohibitive to implement in any effective manner. Second, there are significant short run capacity constraints. That is to say there is a limit to the amount of electricity that generators can produce and the transmission lines on the grid can handle. If there is a shortfall in supply it is not the case that a few marginal consumers with high demand elasticity do not get their electricity, but rather the integrity of the entire grid is jeopardized, as was the case in the 1977 New York City blackout. Last but not least, electricity generation is a very capital intensive process, and therefore the industry has lengthy time requirements for new participant entry.
The unique properties of electricity as outlined above cause the supply and demand of electricity to be quite unique as well. Electricity is unique in that its physical properties of electricity generation make the matching of supply and demand particularly difficult, while the physical properties of the transmission and distribution make it critical that the supply exactly match the demand at all points. Demand is very inelastic in the short run because consumers can’t observe, let alone, respond in real time to changes in price and supply becomes inelastic as generators and transmission lines near their peak capacity.
It might be useful to consider a real world example to grasp these stochastic supply and demand notions completely. Consider for instance a sweltering summer afternoon in New York. The grid needs virtually all its resources in production in order to meet the demand of the city’s inhabitants so they can run their air conditioning machines and keep their houses pleasantly cool. If there is only a few percent margin of reserve capacity, then electricity producers with even relatively small percentages of total output become crucial to meeting the demand of the entire grid, and can therefore charge extremely high prices.
In most other markets there are a number of constraints that prevent firms from exerting market power. If the good is storable, unlike electricity, then consumers can store the good to protect themselves against their vulnerability to price volatility. In markets where consumers receive real time price information before purchasing then they will forego transactions where the asking price is too high. If there is supply elasticity, then when one firm demands prices that are too high there will simply be a shift of market share to another firm who is producing the same good more cheaply. Of course, these attributes are not ubiquitous in the electricity industry and Severin Bornstein and James Bushnell point out that, “The combination of very inelastic short-run demand and supply (at peak times) with the real-time nature of the market (costly storage and grid reliability requirements) makes electricity markets especially vulnerable to the exercise of market power.”
A firm exercises market power when it reduces its output or raises its offer price in order to change the market price. Again, a numerical illustration is the easiest way to grasp this concept, as shown in the following excerpt from Severin Bornsteins paper Understanding Competitive Pricing and Market Power in Wholesale Electricity Markets:
“Consider for instance a firm that is selling 10 units of output and the market price is $15. If that firm could influence price by reducing its output to 9 units – causing price to either raise to the point that total demand is reduced by one unit or some other seller is induced to increase its production by one unit to compensate, or some combination of these two effects – then it would compare the profit from selling 10 units at $15 with selling 9 units at some higher price. In the later case, the firm would also save money by having to produce only 9 units instead of 10. If reducing its output to 9 caused the price to rise to $17, then the firm’s total revenue would rise (from $150 to $153) causing its profits to rise even before accounting for its cost saving from having to produce only 9 units of output instead of $10.”
Similar logic and math applies if the firm chooses to raise its price as opposed to decreasing supply in order to increase its profits. It is certainly not hard to see how this simple example could be applied to actual electricity markets, resulting in a profit increase of billions of dollars.
One of the most infamous examples of market power in the electricity industry (along with an accounting scandal and collusion) is that of Enron. As Public Citizen reported, "Because of Enron’s new, unregulated power auction, the company’s 'Wholesale Services' revenues quadrupled — from $12 billion in the first quarter of 2000 to $48.4 billion in the first quarter of 2001." Enron was essentially manipulating the markets by shutting down generators to withhold energy. The New York Times reports that audio tapes “provide new details of market manipulation during the California energy crisis that produced blackouts and billions of dollars of surcharges to homes and businesses on the West Coast in 2000 and 2001.”
The energy market was in those early deregulated stages a fairly opaque market. Deregulation was new and there were some looking to exploit the market in all the confusion. As more areas refashion their electric industry, it is important that they learn from the trials and tribulations of the markets that deregulated early, like California. Severin Borenstein points out another notable example of confusion in California’s energy market that could have led to massive market power, “Following the confusion surrounding a FERC order deregulating the prices of this form of reserve, prices surged from the previously regulated range of $10/MW to $9999/MW. Some market participants apparently thought that the ISO could not accept bids exceeding 4 digits. That was incorrect. In fact the price during this time had no limit at all, and a bid in the millions of dollars per megawatt would have been acceptable under the market design that existed at the time.” Shortly after a price cap was instituted that limited bids to $250/MW
Usually when one firm is experiencing favorable conditions due to market power, other firms will simply come in as new competitors. However, as previously addressed, the electricity industry has high barriers to entry. Severin Bornstein and James Bushnell point out that, “With environmental and other licensing restrictions, new entry can easily take 3 to 5 years. Likewise, the technology for real-time price notifications and responses by consumers is not widely available, and not likely to be for at least quite a few years.”
SOLUTIONS TO PROMOTE EFFICIENCEY, AND SAVINGS TO CONSUMERS
This analysis of the energy industry is meaningless without an appropriate proposal of ways to promote efficiency and pass savings to customers. Long term contracts have been seen as one approach to smooth electricity prices and prevent the volatility in the market. Forward contracts are not unique to the energy industry, and have been used in other markets throughout time to hedge against volatility and overexposure. It seems like a simple idea and a perfect solution, but as we will see it does have significant limitations as well as limited benefits.
Proponents of forward contracts often point to the summer of 2000 in California where forward contracts turned out to be beneficial as their prices were well under the prevailing spot price during that time. In essence it seems like a great idea, enter into forward deals to hedge against skyrocketing prices like in the summer of 2000. However, as Severin Borenstein point out that, “while long-term contracts reduce variability in the cost of buying power, long-term contract prices are unlikely to be systematically below spot prices on average. On average, a purchaser buying power in forward markets (or through long term bilateral contracts) will not receive lower power costs than a purchaser buying in the spot market.”
The hedge against volatility in the futures contract does not come for free; there are commissions and fees as in any other market. However, there is potential for price lowering effects if many people enter into these long term contracts. Bornstein explains that, “locking in some purchase in advance reduces the ability of multiple firms to behave less competitively among themselves. The idea, basically, is that if firms are maintaining high prices by mutually foregoing aggressive price cutting, then the existence of many forums for trading especially over time, make it more difficult to maintain such mutual forbearance.” Selling in advance essentially promotes competition and if a firm has already locked itself into forward deals it has less incentive to try to manipulate prices in the market through market power.
However, as was stated earlier, forward contracts do have their limitations, and there are some negative aspects for consumers. The danger with forward prices is of course the possibility of locking in a higher price than the spot market. This is especially the case as large utilities that act as energy service providers (ESPs). Bornstein points out those ESPs, “are concerned that in such a situation the state regulatory agency might decide that the contract purchase price was “imprudent” and not allow the utility to pass through he costs to consumers.” This again shows the difficult conflict as regulation and deregulation collide. As the old adage goes, hindsight is 20/20, but predicating energy prices in the future can be very difficult. Generally hedging through the use of forward contracts does not save money on average compared to relevant spot prices and puts ESPs in difficult binding situations where they might not be able to pass additional charges along to consumers.
Forward contracts are an important component of solving the fundamental problems of the energy market, but shouldn’t be seen as the sole solution. Forward rates simply smooth price volatility with a slight cost to consumers. Consumers must become more price responsive in order to experience significant benefits from deregulation and to promote efficiently competitive. Price responsive consumers would solve the mismatches between supply and demand and would ride the energy market of the wealth transfers from consumers to producers due to market power.
It is surprising that in today’s increasingly interconnected Wi-Fi world real time widely available energy prices are not available. People have a world of information at their fingertips due to today’s blackberrys and iphones. Stock prices and sports scores are instantly available, but why aren’t energy prices from your local utility. Surely it wouldn’t involve much software innovation to take energy pricing information from your local utility and send it to your Blackberry, iPhone, or PDA. If people had this information they could and would certainly respond to the new pricing information by turning down their energy use in times of high prices. Consumers who are price responsive create truly competitive and efficient energy markets.
It may be the case that we are currently at a crossroads in electricity pricing, and that widely available pricing will be sent to your phone in the coming years. The technology is fairly new; blackberries have only been around for a few years, and the iphone only came out this year. There may be a lag before these newly emerging technologies actually accept the needed software and infrastructure to allow for real time pricing. Another emerging technology that could have an immense impact on the electricity market and surely the power industry is the electric plug in car. Chevrolet has a concept vehicle called the Volt that is projected to release in 2010, and if it becomes widely available could lead to smoother energy pricing.
The way the electric plug in car could affect energy pricing is by not only taking energy from the grid to charge its batteries, but also sell it back to the grid in times of high prices. Remember, as we said earlier that one of electricity’s unique properties that makes it a difficult commodity to deal with is that it’s non storable. However, if electric cars become widely available, all those lithium ion batteries would have enormous storage potential. It does not make sense to invest in lithium ion batteries solely for the purpose of electricity storage, but fortunately in this instance they are an essential component needed in the car. If electric plug in cars catch on, it would most likely be an enormous benefit to consumers due to the car’s ability to smooth electricity prices by selling electricity back to the grid.
A consumer could set his car/charging station with predetermined buy and sell strategies. For example, he could program the car/charging station to buy from the grid whenever electricity is between $10/MW and $50/MW, but sell a portion of the electricity back to the grid when prices go above those levels. The Chevy Volt website points out that 78% of commuters drive less than 40 miles per day. The Chevy Volt is unique in that if you live less than 20 miles from work, as most people do, then you could drive to work without ever using a drop of gas. I know my commute is much less, and I probably use my car only 5 miles a day. In my case I could program my car/charging station to sell the majority of my electricity back to the grid when there is a profit to be made making my daily commutes even cheaper and helping to smooth electricity prices in the market.
The electric plug in car is fascinating for a number of reasons in today’s world as we are so heavily dependent on oil despite fears of global warming. However, the benefits are not limited to lessening our oil consumption. If cars could sell electricity back to the grid, less electricity would need to be produced due to their lithium ion battery storage potential and this would limit our green house gas emissions from power plants as well. However, as was the case with blackberrys, iphones, and pda’s we are currently at a crossroads as these new technologies have only recently become available. The electricity markets will probably benefit from these technologies, but only time will tell.
As we have seen, the unique characteristics of electricity and the power market make electricity a fascinating commodity but also a very complex one. The movement away from stodgy old regulated utilities to competitive market processes does have enormous potential benefits, but also potential risks. Any deregulation movements must take market power into consideration as it can produce serious market disruptions that negatively affect consumers. The potential benefits depend on whether consumers become more demand price responsive.
Bibliography
Bornstein, Severin, and James Bushnell. Electricity Restructuring, Deregulation or Regulation? Program on Workable Energy Regulation. 2000. 3.
Bornstein, Severin. The Trouble With Electricity Markets (and some solutions) Program on Workable Energy Regulation. 2001. 9.
Bornstein, Severin. "Understanding Competitive Pricing and Market Power in Wholesale Electricity Markets." Elsevier Science Inc. (2000): 49-56.
Egan, Timothy. "Tapes Show Enron Arranged Plant Shutdown." New York Times 4 Feb. 2005.
Johnston, D. “Competitive Era Fails to Shrink Electricity Bills.” New York Times 15 Oct. 2006
Joskow, Paul L. "Restructuring, Competition and Regulatory in the U.S. Electricity Sector." The Jounral of Economic Perspectives 11 (1997): 119-138. Jstor.
Public Citizen’s. United States. Cong. Senate. Blind Faith: How Deregulation And. Washington: GPO, 2001.
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