Wednesday, December 30, 2009

Electricity in NH - Did restructuring cause higher prices in New England?

Seabrook Station Nuclear Power Plant - Seabrook, NH

With more snow coming and the faint hum of the oil burner in the background, it seems like a good time for a follow-up in my electricity restructuring series. Lately, there's been a growing concern that restructuring is not working and perhaps we should re-evaluate our current "simulated market competition" approach to electricity markets.

In Connecticut, some state officials want to return to the old regulated monopoly model. The justification is that electric rates in Connecticut are higher than nearly anywhere else in the country and they say that's proof that restructuring has failed. These officials point out that the lowest electricity prices are often found in states that still use the regulated monopoly model for electricity generation.

Correlation does not imply causation

In light of these assertions, I'm reminded of a favorite phrase of economists, scientists, and statisticians - Correlation does not imply causation. In other words, when two things are related, you can't just assume that one caused the other. Just because New England has high electricity rates and has restructured their electricity markets doesn't mean that restructuring caused the high rates.

In fact, in Connecticut, and in New England, electricity rates have long been higher than average rates in the rest of the country. Generally, the states where electricity restructuring took hold were the states with the highest rates to begin with. That makes sense since we New Englanders have a pretty strong "if it ain't broke, don't fix it" sensibility. If electricity rates in New England weren't broken, my guess is we'd have left well-enough alone.

It turns out that the main explanation for higher electricity rates in New England is that for lots of reasons, we decided to generate our power with more expensive fuels like nuclear, natural gas, and oil and we don't use as much cheap coal as other regions. In the US overall, inexpensive coal is used to generate almost half of all electricity, while in New England, it's used to produce only 12%. Nuclear, gas, and oil together produce almost 70% of electricity in New England, but only 40% nationally. Our focus on fuels such as nuclear and natural gas keeps our air cleaner, and may be necessary due to our region's resources, but it comes with a cost.

Power Generation by Fuel Source in the US (EIA Report, slide 20)

Connecticut legislators also have another beef with restructuring. They argue that ISO-NE's marginal-price-based bulk power markets cause ratepayers to overpay for electricity. They say that paying all generators the price that "clears the market" and matches up supply with demand gouges consumers and sends excess profits to lower-cost energy producers. There may be something to this concern, but the challenge is to find a solution that can correct the problem without introducing even greater inefficiencies.

Marginal pricing - it's just how free markets roll

Supply and demand intersect at market clearing price and quantity

Under marginal pricing, the market price for everyone is set by the last unit of a good that's needed and supplied in the market. All suppliers (power generators) are able to sell their output at that last or marginal price. If the cost of supplying the last unit is roughly the same as the cost of supplying all other units, this isn't a big deal. However, if the marginal cost of production (the cost to make each additional unit of output) is sharply increasing, producers who have lower costs get excess profit because they get to sell their inexpensively produced output at the market price set by the last unit produced. In electricity generation, low-cost coal based producers can get a bonus because the marginal price of electricity is usually set by more expensive natural gas generators. Under a regulated monopoly model, utilities could only recover their actual cost of generating the power needed, plus a fixed profit.

Although these inefficiencies can be real, in a free market system, most prices are set using marginal pricing. Marginal pricing is how the market figures out the price of a gallon of gasoline, the price of a home, and the price of a new TV. Sure, there are other approaches, but in reality, once you decide that a market-based pricing scheme isn't good enough, you're on the hook to out-design the market and that's usually tough to do. Reverting to the regulated monopoly cost-plus approach has its own inefficiencies. The question boils down to which "synthetic" market structure can achieve the best result.

Generating capacity - do you come from a land of plenty?

One important step in assuring that the cost of electricity is reasonable is to assure that there's enough generating capacity. Under perfect, free-market competition, there would be hundreds of firms entering and exiting the power generating market and the supply of generating capacity would naturally meet up with the demand. Unfortunately that didn't happen with power generation in the early days of restructuring, and some regions experienced serious electricity shortages as demand grew faster than supply.

Since the market didn't naturally build the needed capacity, regulators tweaked things by creating a system of "capacity payments" to encourage power generators to build and maintain enough capacity to serve the market's needs. That sounds reasonable, but as with much of restructuring, getting the incentives right has been tough. In practice, capacity payments aren't just paid to owners that build new plants, they're also paid to existing power plant owners. Many economists believe this is inefficient and raises prices more than is needed to assure adaquate capacity.

In the end, it's all about the risk

While it's vital for restructuring that regulators get the market mechanisms and incentives right, the more I learn, the more I become convinced that a huge part of the equation is understanding how risk is allocated, and how we'd like it to be allocated. Exactly how should the risks of a new coal scrubber, wind plant, or nuclear power plant be allocated? Who should pay if things don't turn out as planned? Who should profit if things go better than planned?

Advocates of the regulated monopoly approach suggest that because regulated utilities have a lower cost of capital, they can offer a less expensive model for power generation. IMO, this view is incorrect. Unlike merchant power generators, utility power plant owners are basically risk pass-through entities. They have lower financing costs because the risk of their capital projects is passed on to ratepayers. Sure, there are some benefits from the certainty of a captive consumer base, but most of those benefits can also be enjoyed by merchant generators using power purchase agreements to pre-sell their output. In the end, there's really no free-lunch in terms of cost-of-capital. The power plants that regulated utilities build are every bit as risky as those that merchant generators build. It's just a question of how the risk is allocated and who pays if things go bad.

It seems that trying to figure out if one regulatory scheme is better than another without delving into the risk model is like trying to decide if bonds are better than stocks by looking only at last month's returns. Unless you've uncovered what the risks are and who's on the hook for them, the pricing at any instant could be a mirage.

So, did restructuring cause higher electricity prices in New England? Personally, I don't think so. There have certainly been challenges in getting the market structure right, and these could have increased costs some. Still, I don't see any obvious signs of market failure either. To me the key in all this is to get the incentives and the risk sharing right.

Developing a robust electricity generation and delivery system that can meet our needs today and in the future involves taking risks. The ultimate question is this: How much risk do we, as electricity consumers want to transfer onto investors and how much are we willing to shoulder by ourselves? IMO, a purposeful allocation of risks and rewards should drive electricity market structure and getting that right will lead to the best outcome for consumers and for our economy.

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