Avoiding the Untenable Model by Chris Trayhorn, Publisher of mThink Blue Book, January 15, 2002 Introduction What is now known as the “California experiment in electricity deregulation” has sent shock waves around the world, particularly to other U.S. states and countries considering deregulation. It would be regrettable if others use the California experience as an excuse to avoid competition and maintain the status quo. First of all, everyone should agree to set the record straight: California’s legislators were not conducting an experiment to test a hypothesis about markets as though they were in a high school lab. California was initially trying to introduce a new market structure that it hoped could bring real efficiencies to its economy. Instead, the California plan turned out to be a partial deregulatory effort that attempted to subsidize cheap electricity consumption for voters while maintaining regulatory control over the system. That effort might have worked if demand had stayed flat and cheap imports from neighboring states had continued indefinitely. A basic study of economics, however, should have suggested that electricity demand, fueled by cheap rates and a booming economy, would eventually outstrip supply. Therefore, as with many well-intentioned regulatory efforts, there were winners and losers. Generators won and tax payers, investors and ratepayers lost. Ratepayers, in particular, have lost, as they have endured blackouts and higher bills during 2001. What then for electricity deregulation and competition? Is it truly possible to deregulate the industry — especially when many expect that governments should protect them from rising prices? Standard & Poor’s experience around the world with deregulating and privatizing industries, both in power and other sectors, indicates that the answer is yes. The California experience offers a different, and sobering, lesson: partial deregulatory efforts will spell disaster for the markets — power, financial, and credit. More precisely, California’s partial deregulatory effort initiated a chain of events that culminated in a market breakdown and a credit collapse not often seen in industrialized economies. The prescriptive form for deregulation is not so difficult. Yet following it is another matter, especially since politics will lead the process. In general, Standard & Poor’s expects that competitive markets will need the following key elements to succeed: • A market framework conducive to competition and reliability • Transparent prices signals and information • A supportive public policy A Market Framework For a deregulated market to function well, it needs a framework conducive to competition. There are three key essential requirements: • The freedom of participants to freely contract with each other • Freedom to allow market forces to dictate the structure of the industry • An integration of generation dispatch and transmission with the spot market A competitive market should allow its participants — that is, buyers and sellers — to freely contract with each other for the physical commodity. Load-supplying entities, such as the utilities, should be able to contract directly with wholesale generators for long-term, medium-term, and spot market supplies as their needs dictate. Contracting can help utilities control their costs by fixing the bulk of their most predictable needs at reasonable prices. These same contracts can in turn give generators reasonable assurances that they can recoup their investments and earn a reasonable return. Medium-term contracts can address less-certain demand or periodic demand — either seasonal or time-of-day. The spot market can then supply the remaining power needs by filling in gaps between real-time demand and contracted supply. Relying completely on the spot market, as the California utilities were effectively forced to do, exposes the entire load needs to extreme price volatility, driven by occasional plant outages, fuel price spikes, or sudden weather changes. Market participants must also be able to use financial contracts, such as derivatives, options, and swaps to compliment their risk management capabilities. Again, the California market structure proved inadequate by failing to permit financial contracting. The freedom to contract should also extend to retail sales. End-use consumers should be able to contract with alternative load-supplying entities if they believe that cheaper rates are available. If the market structure limits, for whatever reason, the ability to choose retail suppliers (or for new retail suppliers to enter the market), the incumbent supplier will have less incentive to lower prices. Competing suppliers should be in a better position to provide consumer choices, such as time-of-day metering, billing options, energy from renewable sources and demand-side management options. The California retail market never really worked due in part to the flawed wholesale business. Finally, a sound market framework should recognize that the operation of the physical system — power plants and transmission lines — should reflect the value of these occasionally scarce resources on a real-time basis. Those willing to pay what the market demands for scarce resources should have access to those resources. Similarly, those who have a buyer for their services should have access to the system. If market participants can trade on a true spot market and if the system operator can ensure that the physical system runs in accordance with economic-based decisions, sufficient supplies should be available to meet the real-time demand for generation and transmission in the most efficient manner. If electricity prices consistently stay high, new investment in capacity — transmission or generation — that can lower the prices should be the response. The California market implemented a framework that prevented an efficient spot market: an independent system operator dispatched the physical system and the California Power Exchange acted as a clearinghouse of the spot market for the utilities and the generators. As such, the independent system operators were left to use nonmarket methods to intervene and maintain system reliability. That, in and of itself, almost ensured that costly inefficiencies would emerge. Transparent Price Signals and Information Discovery Any well-operating competitive market should have transparent pricing. Equally important is the ability of market participants to get sufficient market information to make informed decisions. This is primarily why airline fares and long-distance telephone rates have fallen so dramatically in the past 10 years. As a corollary, a clear connection must exist between the price that a consumer pays for electricity and the economic cost of producing and delivering electricity. The market framework must minimize, or eliminate such inefficiencies as capped retail rates or government-funded subsidies. Clear pricing is a must in order to allocate scarce resources, as well as signal the need for new investment. Without clear pricing, shortages or state-mandated rationing (i.e., rolling blackouts) will invariably result. Where prices for goods are well below their underlying economic cost, what economists refer to as “overconsumption of the common good” will usually occur. For example, a community pasture freely made available to all will soon become barren ground — in this case due to the insatiable appetite of grazing goats and cows. California’s power sector at times resembled a common pasture — stories of people taking advantage of cheap electricity rates to cool down their swimming pools during the oppressively hot summer of 2000 were not exaggerated. The California market, deregulated as it was, showed little price transparency and offered minimal information about costs. Retail consumers ended up paying a capped retail rate of about 5.5 cents per kWh when wholesale power costs increased 10 to 20 times. Utilities first subsidized the gap, later their bankers did, and then eventually the California taxpayer had to when the government stepped in to purchase power. With such low rates, consumers had no incentive to change consumption habits and demand continued to grow. In the end however, consumers will still end up footing the bill, either through the wealth-transferring effects of government subsidies, lost productivity due to outages, or retail rate surcharges needed to pay off the debts recently incurred by the utilities. In contrast, the deregulation of Australia’s national electricity market during the 1990s offers a prime example of market signals and transparency working successfully. Until then, state-owned monopolies typically built large-scale generating plants ahead of time, and significant overcapacity prevailed. Upon wholesale market deregulation, prices crashed as a result of the overcapacity, and predictably, no one has built new base load plant. Only now, with signs of higher wholesale prices emerging, are new plants being considered. At the same time, interstate transmission interconnectors are springing up in response to the market opportunities that regional imbalances create. Transparent pricing could have alleviated some of the supply shortages in California. For instance, electricity is almost always cheaper in the evenings and weekends than it is during the peak daytime, weekday hours. However, if consumers see only a uniform price, little incentive exists to conserve or change consumption patterns. If information is available, such as with time-of-day metering, variable pricing does work. For years, industrial electricity users have adjusted production schedules to take advantage of peak and off-peak pricing. Similarly, anyone traveling to seasonal vacation resorts will have experienced peak and off-peak pricing. Supportive Public Policy Finally, competitive power markets cannot work without a public policy that encourages comprehensive legislation and regulatory support. It is the responsibility of the enabling legislation to ensure the implementation of a viable market framework and transparent pricing. The wrong legislation may lead to partial deregulation with its attendant market inefficiencies and a possible market collapse. Nonetheless, the political realities of privatization and deregulation can make this a Herculean task. Many stakeholders will want to preserve subsidies, achieve certain social goals, or other advantages endowed by the incumbent system. Where natural monopolies do not exist, such as with generation, market participants should be free to make and lose money as their skills dictate. Obviously the regulators cannot permit market abuses to develop and linger, but after the United Kingdom’s experience with years of an oligopoly generation structure, few regulators will let that happen again. Generators must be diverse enough in number so that few can exercise market power illegally. Nonetheless, participants should be free to decide whether they do business and with whom. A framework that forces a player to participate on terms that are uneconomical will certainly dissuade potential new players from entering the market and will eventually force others to quit. An effective public policy should also ensure that oligopolies, duopolies, or monopolies do not form in a way that could harm consumers. Where natural monopolies naturally exist, they need to be regulated in a way so as to protect consumers from potential price abuse. As such, transmission and distribution will in almost all cases continue to be regulated. But even transmission can be misregulated; regulations that force transmission prices to be averaged over an entire market (e.g., “postage stamp rates”) will eliminate locational price signals and create an inefficient market. A competitive market should not discourage new entrants who have the capital and resources but cannot participate because of onerous regulatory hurdles. Again, the California framework prevented a viable competitive market from developing and the current crisis is exacerbating the situation. Although no single generator controls a significant market share, the regulatory and siting processes have made it almost impossible to build new generation capacity despite the interest shown by generator companies. Moreover, efforts during California’s power crisis to force generators to sell power either at a loss or with the risk of nonpayment can only sour the market. Deregulating legislation and its attendant regulations must also recognize the physical and financial complexities of the power industry. And as the California power crisis has so vividly demonstrated, these complexities extend beyond state boundaries. Effective energy policy really must seek to integrate power markets across state borders — electrons will follow the path of least resistance despite regulatory obstacles. What happens in one state can dramatically affect neigh boring states — no doubt many ratepayers in the Pacific Northwest feel that they are paying for California’s problems, and indeed they are. In addition, the legislation framework should guarantee that market participants can freely contract with each other. It should avoid the temptation to transfer the risks of a competitive market to the state. To think that the state can manage the risks of power generation, transmission and energy marketing better than the private sector invokes images of the “commanding heights” of some former centrally planned economies. Credit Outlook for Deregulating Power Sectors The California competitive power experience vividly demonstrates why a partial deregu latory effort will likely cause a market collapse as well as a destruction of credit. This, however, should not condemn other deregulation efforts. Deregulation has successfully worked in other power markets and in other industries. A framework will not succeed if it masks the underlying economic costs of production, transmission and distribution and introduces market inefficiencies. It will also fail if it forces market participants to accept market risk without the ability to enter into contract-based risk management arrangements. Competitive power markets require transparent pricing and an unfettered ability to contract with other participants. Moreover, public policy must support complete deregulatory efforts; partial attempts may potentially introduce economic complexities whose implications may not be fully appreciated until it is too late. Credit strength for deregulating markets certainly will be less than that of vertically integrated, monopoly forms of organization that operate under cost-of-service regulation. Completely deregulated markets with viable market frameworks, however, can as they have already, preserve much of their former credit strength. Some may even improve. But for a partially deregulated market, Standard & Poor’s emphasizes that credit strength will likely fall to very low levels — if not imme diately, then certainly after the market inefficiencies become too heavy to bear. Let us hope that the power industry, its regulators, and politicians will learn the right lessons from California and find the will to create viable market solutions in the future. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.