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.