COMPETITIVE MARKETS FOR ELECTRICITYGENERATION

John C. Moorhouse

The Trend toward CompetitionThis paper discusses the feasibility of replacing regulation or state

ownership with market competition in electric power generation.Interest in competitive electricity markets has been stimulated byrecent experiences in the United Kingdom and Brazil with privatiza-tion, with deregulation in the United States, and with partial reformin Norway. Whilethe Thatcher government policy offers lessons aboutthe process of privatizing a state monopolyenterprise, the Americanexperiencebecomes relevant to ourunderstanding of howincreasinglycompetitive markets for electricity actually work. The continuinggrowth of competition in American electricity markets is an unantici-patedconsequence of the 1978 passage ofthe Public UtilityRegulatoryPolices Act. Designed as aconservation measure, PURPA establishedthe right of cogenerators and Independent Power Producers (IPPs)to sell electricity to local regulated Investor-Owned Utilities (IOUs).

Such rights were broadened substantially by the passage of theEnergy Policy Act of 1992 which requires transmission line ownersto wheel bulk power (Walters and Smith 1993). Thus, under currentfederal regulations nonutility power producers can sell electricity toany utility on the grid. Furthermore, in April 1994, the CaliforniaPublic Utility Commission adopted a policy establishing completeopen access to all powerproducers. By 1996 independent generatorscan compete to sell electricity directly to large industrial customers,effectively bypassing traditional utilities. By 2002, the policy permitsall electricity consumers, regardless of size, to purchase electricity

CatoJournal, VoL 14.No.3 (Winter 1995). Copyright © Cato Institute. All rights reserved.The author is Professorof Economics at Wake Forest University. A shorter versionof

this paperwaspublished In 199~in Frenchas “Bisque etConcurrence,” Le Communkateur28: 199—223. The author would like to thank Henri Lepage for his helpful comments onan earlier draft.

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from any utility or independent generator on the grid. No longer willthe consumer be restricted to buyingelectricity from the local utility.Acompetitive market forgeneration will havebeen established (Hoff-man 1994).

There are further lessons to be learned from the way the naturalgas market hasdeveloped in the United States followingderegulation.Particularly relevant havebeen the separation ofproduction, pipelinetransportation, and distribution into independent operations; thegrowth ofthe spot andfutures market for gas, andthe latter’s replace-ment of the long-term contract in the buying and selling of naturalgas (Doane and Spulber 1994). In the United States, the majority ofnatural gas sales to local distributors are on the spot market (Lyons1990).

The system evolving in the United States provides increasing com-petition and diversity among generators. They vary from establishedutilities, IPPs, andcogenerators to small producers thatuse renewablefuels and other nonutility generators. In 1983, the NUGs provided2.5 percent of total United States generating capacity, by 1991 theyprovided 9 percent of the total and were building over half the newcapacity installed in the nation (Michaels 1993). Once the genie wasout of the lamp, the benefits of competition insured that more openmarkets for generation would spread.

The European Community is addressing these same issues andhasagreed to draft directives calling for open access in energy markets.As of January 1993, the European Commission seeks to let large usersof electricity—those using 100 gigawatts or more ofpowerper annum(aluminum, steel, chemicals, glass, and fertilizer)—to purchase elec-tricity from any supplier in the Community. Energy Commissioner,Antonio Cardos e Cunha (in the Financial Times 1992), summarizesthe goal,

Our aim is to transform the energy market in Europe—which isfundamentally national and based on administrative focusing onprice—and replace it with a European unit in which cross-bordertrades could be significant and prices would react according tonegotiations between buyer and seller.

The paper is organized as follows. The next section deals withthe twin ideas that the generation, transmission, and distribution ofelectricity is anaturalmonopoly andinvolves only technical issues. Thefollowing three sections present a model of competitive generation,outline the major advantages of competitive electricity generation,and discuss how electricity would be priced in a competitive market.The next section compares and contrasts how the market addresses

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the problem of risk with the way it is dealt with under regulation orstate ownership. The final section presents asummaryandconclusion.

A Change in the Climate of IdeasThe British andAmerican reforms arose in part because two funda-

mental ideas have been successfully challenged during the last twodecades. The first idea is that the electricity industry is a natural

• monopoly. The second, independentbut complementary, idea, partic-ularly influential in Europe, is that the generation, transmission, anddistributionof electricity raisepurely technical problems to be solvedby engineers.

Ideas have consequences. Anydiscussion of the electricity industryalways starts with the observation that the industry is capital intensiveand, because power cannot be stored, it must be generated so as tomeet instantaneous demand. These characteristics coupled with thenaturalmonopoly argument are saidto justi1~rgovernment franchisingand regulation or, alternatively, state ownership.’

The notion that the provision of electricity presents only technicalissues naturallyjustifies thevertical integrationofgeneration, transmis-sion, and distribution into a state-owned monopoly. it is worthwhileexploring the challenge to these two ideas in greater detail becauseopening up thedebate hascreated an intellectualclimate more condu-cive to reform.

Natural Monopoly

The traditional economic justification for the regulation or stateownership of electric utilities is that utilities are natural monopolies.Economies of scale and scope, and the economies associated withvertical integration mean that unit costs decline throughout the rele-vant rangeofproductionasoutput increases. Such economies precludecompetition, according to theconventional view, because a single firmcould supply the entire service area at lower cost than could two ormore firms. Given its cost structure, an establishedutility could under-cut its rivals and drive them from the market. Moreover, attemptedentry represents awaste ofresources either becauseof an unnecessaryduplication of facthties or because such, investment would not beviable in the face of undercutting. Secure from competition, themonopolist would exploit the consumer if not for regulation orstate ownership.

‘The latter neverproved popular inthe United States exceptfor smallmunicipal distributioncompanies and two huge Federal power facilities, TVA and Bonneville.

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During the last 20 years, a growing body of evidence, primarilyfrom the UnitedStates, hasundermined theview thatelectric utilitiesare natural monopolies (Hammond 1986). LeonardW. Weiss (1975:136) argues that the postwar technological trend toward buildinglarger generating plants, in the United States, ended in themid-1960s,“Most important regions could support enough generating plants topermit extensive competition if theplants were under separate owner-ship and had equal access to transmission and distribution.”

In the late 1960s the conventionalwisdom in the industry was thatnew plants burning fossil fuels had to have a generating capacity offrom 1,000 to 1,500 megawatts and that the optimal capacity of anuclear plant might be even larger. As Edward Berlin, Charles J.Cicchetti, andWilliam J. Gillen (1974: 9) observe, thermal efficiencyis not the whole story; reliability plays a role:

The effect of unit size on reserve requirements is a straightforwardproblem. The contingencyto be guarded against is that aparticularunit will not be available when needed. Ifgenerating capacitycon-sists of a large number of small units, risk Is spread over each ofthe units.... The forced outage rate for fossil-fueled plants over600 mw is more than twice that of plants below 600 mw.

Within bounds, the implication is clear: smaller plants are morereliable than large-scaleplants. Whendynamic reliability is played offagainst static design efficiency (economies of scale and scope), theoptimal scale for plants is smaller than originally thought. Finally, anumber of studies suggest that economies of scale and scope in thegeneration of electricity may not be significant enough to undergirdnatural monopoly.2

William J. Baumol, John C. Panzar, and Robert D. Willig (1982)argue, in their seminal work Contestable Markets and the Theory ofMarket Structure, that even if economies of scale and scopeS arepresent, they are neither necessary nor sufficient for natural monopolyto exist. Making the critical dynamic distinction between fixed costs(costs that are not zero when output is zero) and sunk costs (capitalinvested in plantandequipment thathasno alternativeuse or opportu-nity cost), they observe that only sunk costs give an existing firmthe cost advantage necessary to insulate it from competition. Absentsignificant sunk costs, potential entry undermines monopoly pricing;natural monopoly is not sustainable. Such markets are said to becontestable (Panzar and Willig 1977).

2See Christensen and Green 1976, Huettner and Landon 1978, CowIng and Smith 1978,Stewart 1979, and Jaskow and Rose 1985.

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While it is not obvious that electric markets can legitimately beclassffied as contestable, nuiltiproductproduction, uncertaindemand,risk aversion, and interproduct (interfuel) substitution are all condu-cive to potential entry (Sharkey 1982). Don Course>’, R. Mark Isaac,and Vernon L. Smith (1984: 111) conclude from their research that

the most significant result.., is that the behavioral predictions ofthe contestable market hypothesis are fundamentally correct. It issimplynot true that monopolypricing is a ‘natural’ result ofa. marketmerely because firms in the market exhibit decreasing costs anddemand is sufficient to support no more than a single firm.

Thus this research suggests that competition can be substituted forgovernment regulation and state ownership to assure’ good perfor-mance in, at least, the generation of electricity.

Technological Efficiency

The other intellectual tradition that has been influential in thegovernance of electric utilities argues that the generation, transmis-sion, and distribution of electricity can be reduced to a set of purelytechnological problems. Because engineering efficiency should guidethe design and development of electric power facilities, this viewconcludes that engineers should operate such facilities as state enter-prises. The reliable provision of electricity is vital to public welfare.The public is best served when a staff of civil servants, trained inengineering, attend to these technical matters.3

Yet the generation and distribution of electricity is not primarily,let alone exclusively, amatter of technology. Consider the concept ofefficiency. Technological efficiency is always defined as the rate atwhich an input is converted into an output; a ratio of two quantities.For example, one definition of efficiency is the ratio of work done toenergy input. The ratio is less than’ one, because some energy isdissipated in the form of waste heat during the process thatconvertsenergy into work. A process is said to be more efficient than another(see Heyne 1987: chap. 6) if, in the first process, ahigher proportionofpotential energyis converted into kineticenergy than in the secondor, equivalently, if the first process generates less heat loss than thesecond process.

On that definition, the most technologicallyefficient means of pro-ducing electricity would be the method that converted the highestproportion of the potential energy of its fuel into electrical energy.

31n a fascinating discussion, FriedrichA. Hayek (1964) traces the intellectual roots ‘ofthisapproach to policy enØneeringto theEcole Polytechnique (see his The Counter-Revolutionof Science, especially Part 1, chap. X, and Part 2, chap. IV.).

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By that criterion, nuclear plants are more efficient than coal-firedplants, and coal-firedplants are more efficient than are hydrogenerat-ing stations.

If electricity were the only commodity of economic value, thetechnological and economic concept ofefficiency would come downto the same thing. But of course, literally tens of thousands of goodsandservicesare valuable. The inputs, including fuel, that are necessaryto generate electricity are scarce resources in the sense that they havemany alternative uses—alternative uses thatalso satisfyhuman wants.Thus, the most efficient way to produce electricity, from society’spoint of view, is the method that maximizes the difference betweenthe value of output and the value of inputs.

The objective data of the engineer (conversion rates) is only onefactor in the determination of the subjective values that measureeconomic efficiency. Hydroelectric power plants, the leasttechnologi-cally efficient plants, may be the most economically efficient meansof producing electricity when the value of the resources consumedin production and the environmental consequences of hydropowerare taken into account.

Writing 70 years ago, the engineer Otto Goldman (1923: 84), usingdifferent terminology, makes the same argument,

It seems peculiar and indeed is unfortunate that so many authorsin their engineering books give little, or very little, consideration tocosts in spite of the fact that the primary dutyof the engineer is toconsider costs in order to obtain real economy—to get the mostpower, for example, not from the leastpounds ofsteam, but from theleast number of dollars and cents: to get the best financial efficiency.

Absent technological change, objective engineeringdata on energyconversion rates remain constant andprovide an unambiguous rankingofthe differentmethods for producing electricityaccording to techno-logical efficiency. By contrast, the ranldng of production methodsaccording to economic efficiency can change as the result of either atechnological innovation or a change in the relative value of inputs.An example ofthe latterwould arise if the market valuationof nuclearfuel rose and the price of coal dropped. Under such circumstances,the value of the resources consumed by coal-fired plants might dropbelow that of nuclear plants, per unit of electricity produced, andcoal-fired plants would become more economically efficient thannuclear plants.

A shift in subjective valuation changes the measure of economicefficiency while having no effect on the measure of technologicalefficiency. The twin measures of efficiency are fundamentally differ-ent. In terms ofhuman welfare, themost efficientmeans ofproduction

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is always gauged in terms of economic efficiency, the ratio of thesubjective value of output to the subjective value of inputs.

The concepts of engineering and economic efficiency diverge fortwo reasons. First, there are different methods ofproducing electricity,each of which uses a different combination of inputs. These inputsare scarce; theyhave alternative uses. Which use is the morevaluabledepends on subjective assessmentsrevealedonly by market exchange.Second, electricity is not a single good but a multiproduct havingmany characteristics includingpeakandoff-peak timingofproductionand consumption, and reliability of service. A method of productionthat is efficient for producing a base load may be inefficient formeetingpeak-load demands. Narrow technical efficiency provides nomeaningful criterion for ranking production methods when inputshave alternativeuses or when productioninvolves complex goodswithmultiple characteristics. Electricity is just such a good. The higherdimensionality of the concept of economic efficiency and the greaterinformation costs of measuringeconomicefficiency present a problemthat is best solved by voluntary market exchange.

What makes the notion of objective technological efficiency socongenial to the idea of state ownership and operation of this vitalindustry is that it avoids the necessity of’ obtaining and acting oninformation about market valuation. Technological efficiency seemsto point to the way of generating and distributing electricity. All theinformation necessary to do so is known by the civil servants actingon behalf of the public interest.

The natural monopoly thesis and thenotion thatproducing electric-ity is a purely technical matter are powerful ideas that die hard; theyhave shaped the structure and governance of the electricity industrythroughout this century. This paper argues that, to the contrary, theefficient use ofresources to produce anddistribute electricityrequiresinformation about relative valuations that can be generated only bymarket exchange.

Competitive GenerationTheoretical arguments, statistical evidence, and—ofincreasing

importance—experience favor theviability of competitive markets forthe generation ofelectricity. In general, reform meansthesubstitutionof market competition for state ownership or government regulationto ensure good performance. The nature of the particular reformnecessary to introduce competition into the electricity industrydepends, of course, on the current structure of the industry. If theindustry is a state-owned monopoly, as, for example, in the case of

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Electricité de France (EDF), then reform means full privatizationand the separation of generation from transmission and distributionfunctions. If the industry consists of investor-owned utilities, subjectto government regulation, as in the United States, then deregulationof generation capacity coupledwith the separation of generation fromtransmission and distribution is required.

Elements of ReformThoroughgoing reform has four major elements: (1) private owner-

ship of electricity industry facilities; (2) open access for generators totransmission facilities; (3) a minimum of three independently ownedgenerating stations that could potentially compete for consumerswithineach regional electricity marketor service area;4and (4) separa-tion of generation from transmission and distribution.5 More radicalreform would be difficult because privatization, restructuring, and~complete deregulation of transmission and distribution facilitiesremain controversial.

By contrast, decentralized, competitive markets at the generationstage are not only conceptually desirable, but are becoming increas-ingly important in the United States. John Tschirhart (1991: 27)observes, “Entry of new firms into the electric power industry isbecoming commonplace. The entrants typically are unregulatedfirmsthat compete with regulated electric utilities only in the generationstageof the latter’s integrated structure.” By 1990, adecade after thereform movement got under way in the United States, cogeneratorsand unregulated IPPs were building more generating capacity thanwere traditional utilities. For example, Southern California Edisonbuys 30 percent ofits power from NUGs. The Midland Co-GenerationProject in Michigan consists of 12 gas turbines with a generatingcapacity of 1,343 megawatts. In New York State, construction ofnewgenerating capacity is determined bycompetitive bid with manycontracts being awarded to NUGs (Tschirhart 1991). The AlamitaCompany, in Arizona, is an independent power company that sellselectricity to bulk customers, Tucson Electric Power Company, andSouthern California Edison (Herriott 1989a).

4Producers need not be locatedwithin the region, but only interconnected to themarketvia transmission lines. Independent producers. in some instances, could be created bybreaking up existing generatingcapacity Into a (relatively small) number of companiesthatwould compete to sell electricity. Other competitors in a regional market could includeIPPs and cogenerators.5One approach is to treat the transmission grid as aregulated common carrierprovidingaccess and central dispatch to all power producers. Distribution companies could be regu-lated as regional (private) monopolies.

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Compared with the deregulation of lOUs, privatization of astate-owned monopoly requires acomplete and fundamental change in thestructure of ownership and property rights in the electricity supplyindustry in order to obtain the benefits of increased efficiency andinnovation. A shift from public to private ownership refocuses thegoal of the producer toward profits. Pursuit of the latter provides astrong economic incentive, in acompetitive environment, to improveand maintain the quality of customers services, monitor costs moreclosely, and invest in productivity-enhancing technologies. Theseincentives are blunted by state ownership. With respect to privatiza-tion, the British experience since 1989 seems more germane thandoes the regulatory reform the United States has been undergoingsince 1978.

The Advantages of Competitive GenerationCompetitive generation envisions a market within which indepen-

dent firms compete on the basis of price to sell electricity directly tolarge industrial customers (bulk wheeling), and to supply electricity,via common carrier transmission, to distributors who in turn sell powerto final users (Rozels 1989, Bushnell and Oren 1994). Producers mayspecialize or diversif~tby load characteristic. For example, some mayprefer to compete for long-term base-load contracts. These firms arelikely to own hydro and nuclear power plants. On the other hand,firms with fossil fuel plants might seek to supply base and cyclingloads. Finally, producers with gas combustion turbines and cogenera-tors couldcompete to meetpeak loads. Other firms maydiversify andbe ready to compete for base, cycling, andpeak loads. Peak and off-peak loads are defined by day, week, and season.

Prices charged for each type of service (peak and off-peak load,daily to seasonal) could be established by contract, 24-hour advancenotice, and in spot markets. Unit prices could vary by the amount ofelectricitypurchased perperiod (Wilson 1993). As a result, customerswould face more service options and amore complex pricingscheme.

There are a number of advantages to having a variety of types ofgenerators linked to the transmission grid. The first major advantageinvolves cost savings. At any given moment, power is supplied to thetransmission grid by the firmwith the lowest marginal costs. Dispatchaccording to merit (from lowest to highest marginal cost includingline loss6) savesresourcesandreduces the costofgenerating electricity.

°Typicalline loss approximates 1 percent per 100 kilometers. Line loss limits the extent ofthe market, because the loss rate is anonlinear Increasing function of distance.

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Because the different plants may have different load characteristics,peak and load duration curves, generating capacity can be more fullyutilized and additional capital resources saved.

Moreover, thevariety ofgenerating equipment and the largernum-ber of independent producers adds diversity to the system, loweringthe probability ofwidespread equipment failure, and, thereby, reduc-ing the amount of excess capacity required to provide a given levelof service reliability. The availability of electricity from alternativesuppliersmeans thatgenerators can coordinate routine plant mainte-nance. The added flexibility in scheduling repairs lowers plant mainte-nance costs. These four sources of cost savings mean lower prices tothe consumers of electricity (Herriott 1989b).

The second advantage of competitive generation is that a spotmarket for electricity will develop. The ability to sell electricity onthe spot market increases the generator’s fiexibthty in schedulingproduction. Consider the position ofthe monopolyproducer. The firmmust waitfor customers to “ffip the switch” anddemandelectricity. Inorder to meet fluctuating demand, the monopolist must maintaincostly“spinning”capacity as areserve. Bycontrast, competitive gener-atorscan sharply reduce their idle spinning capacity and simplysched-ule efficient production. They need not wait for customers becausetheycan sellpower on the spot market at any time. Efficient schedulingreducesproductioncosts.The dynamismandflexibility ofthecompeti-tive market is the antithesis of the passive waiting game that themonopolist must play.

Moreover, the presenceofa spot market means that less idle capac-ity must be maintained in order to provide a given level of servicereliability. Shortfallsandemergenciescan be metby purchasingpoweron the spot market. Demand and supply are equilibrated by flexiblespot prices.

The third advantage of competitive generation is that the marketwill provide an arrayof service standards that more closely match themosaic ofconsumer preferences (Caves, Herriger, and Kuester 1989).It is a shibboleth of the industry that a utility must stand ready tosupply electricity to all demanders at all times. But of course such astandard ofreliability ismet and maintainedonlyat highcost. Verticallyintegrated utilities invest in expensive excess (off-line) capacity to

ensure a high degree of reliability. For example, gas combustion tur-bine plants make up much of the spinning standby capacity in theUnited States.

Not all consumers seek such a high quality of service all of thetime. With the option of choosing among competitive generators,distributors have an incentive td discover the level of reliability

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demanded by differentconsumers. Consumers could be offeredprior-ity service with a schedule of electricity rates increasing with the levelof reliability. Customers upon whominfrequent but uncertainserviceinterruptions impose relatively low costs could save (with certainty)by subscribing to lower priced, lower priority service. Conversely,customers for whominterruptions imposehigh costs would subscribeto higher priced, more reliable service (Smith 1989).

Interruptible service does not mean customers are without servicealtogether. Rather interruptions involve a reduction in power. Typi-callyinthe UnitedStates, forexample, interruptible residential servicemeans that the consumer’sheai~yappliances (air conditioner,hot waterheater, or space heater) are turned off when the utility sends anelectrical impulse that trips a circuit breaker. Full power is restoredafter the emergency or peakloadhaspassed. In other systems,custom-ers purchase a fuse that guarantees a minimum level of power notsubject to curtailment; power use above that level can be interrupted.The higher the minimum level of service chosen by the consumerthe higher the price of electricity (Wilson 1989, Woo 1990).

By offering such choices, distributors obtain information aboutconsumerpreferences for reliability. With this informationdistributorsknow, for instance, how much andat what prices electricity should bepurchased on spotmarkets during peakperiods or emergencyoutages.

In spite ofcostly excess capacity, outages occur. Unexpected equip-ment failure or peak demands temporarily greater than generatingcapacity cause blackouts or rolling brownouts. The resulting randomrationing is inefficient because it represents an arbitrary distributionof an unpriced resource—reliable service. By contrast, during anemergency shortage with priority service, consumer service is inter-ruptedin order of ascendingpriority, from lowest to highest reliability.Because consumers have revealed their preference for service reliabil-ity, a priority system reduces the aggregate cost to consumers ofinterruptions, compared with random rationing.

According to Hung-Po Chao and Robert Wilson (1987), priorityservice offers significant efficiency gains over random rationing withfixed electricity rates. The authors argue that advances in the micro-electronic technologies of metering and control make selective,ordered rationingeconomically feasible, Similarly, AbrahamGrosfeld-Nir and Asher Tishler (1993) found variations in outage costs for asample of Israeli industries, which suggested to them that there is apotential for large savings ifpriority service is offered.

Priority service reduces costs in three ways. First, it reduces theexcess capacity carried in order to provide the reliability demandedby consumers. Second, when outages occur and service is rationed,

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priority service minimizes thecosts ofinterruptions borne by consum-ers. Third, because consumers have revealed their preferences forboth the quantity andreliabilityof electricity service, long-run capitalplanning is more efficient, hence more cost effective.

Priority service can be fine-tuned by offering rate schedules basedon both the frequency and average duration of service interruption,andonwhether service would be interrupted only upon priornotifica-tion. Those willing to bear the risk of uncertain interruption wouldpaylower electricity rates. Finally, as Shmuel S. Oren and Joseph A.Doucet (1990) suggest, suppliers can provide interruption insurancewith premiums based on the probability of rationing and compensa-tion specified.

A competitive market in electricity generation would offer a muchbroaderarrayofservices than do statemonopolies or regulated genera-tors. Perhaps it is not surprising that 70 percent of United Statesprivate utilities, facing new competitive pressure at the generationstage, now offer some form ofvoluntary interruptible service (Straussand Oren 1993).

Such services are less likely tobe offeredbyeither state monopoliesor heavily regulated private utilities than by competitive generatorsprecisely because priority service economizes on capital capacity.For a state monopoly, offering priority service would reduce thesize of the enterprise and budget, the level of employment, andultimatelypower within thebureaucracy. For privateutilities operat-ing under cost plus pricing regulation, more capital means higheraccounting profits. Moreover, for both state andprivate monopolistssystem reliability is apowerful hook on which to hang a request fora larger budget or rate increases. Tailoring service standards tocustomer demands is the last thing to expect from a state or pri-vate monopoly.

The fourthadvantage ofcompetitive generationis innovation. Expe-rience in the United States with deregulation of transportation andtelecommunication and, on a more limited basis, the electric powerindustry suggests that competitive pressure tends to make industriesmore innovative. Competition not only leads firms to be more respon-sive to consumer demands, monitor costs more closely, and competeon thebasis ofprice, it provides an incentive to be innovative becausethatmaybe the onlyway toget atemporaryjumpon rivals. Developinganew consumer service, abetter method ofreducing costs, or a fasterway of dealing with problems promises the innovator a competitiveedge. Because research and development is risky and offers littlereward to state enterprises or utilities with monopoly franchises, evi-dence suggests that the latter organizations are less innovative.

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Competitive Pricing of ElectricityPrivate producers of electricity seek to earn profits. If their opera-

tions are regulated by market competitionrather thanstate regulationsgoverning prices and rates of return, producers will monitor costsmore closely at all margins and, further, offer electricity at pricesdetermined by marginal costs. Becausethe cost of generating electric-ity varies by reliabilityof service andwhether demand falls on a peakor off-peak period, we expect a more elaborate pricing system toemerge under competitive conditions.

Industrial CustomersWith competitive generation, industrial customers can purchase

electricity from the regional distributor or directly from a generatorvia bulk wheeling. Industrial users can shop for electricity. Servicestandards and prices ‘would be negotiable and subject to long-termcontract, Unanticipated requirements can be met on spot markets(Schweppe et al. 1988). Retail spotmarket prices for industrial userswould equal wholesale spot prices (determined by competitionamong generators) plus transmission and distribution charges. Theregulatory authority would guarantee open access for generators tothe grid, approve transmission and distribution charges, and requirethat distributors base retail spot prices on prevailing wholesalespot prices.

Itmaybe thecase that few, ifany, industrial or commercialcustom-ers, would want to purchase power on the spot market. Buying andselling electricityatvolatile spot prices involves relatively high transac-tion costs and risk. The point remains that competitive generationmakes retail spot markets viable. Also note that with competitivegeneration, an industrial customer who is buying electricity from asupplier at 11:00 a.m. may be selling electricity to thatsame supplierat 7:00p.m. (Rose andMcDonald 1991). In competitive markets, theroles of buyer and seller can change periodically.

Residential ConsumersResidential consumers too are in a position to contract with any

producer on the network andthus can shop for the most desired typeofservice and prices. Residential consumers.might pay setprices froma menu establishing time-of-dayandtime-of-yearrates, andpremiumsand discounts based on reliability of service. Prices for interruptibleservice would vary depending on probability and expected durationofoutages andwhether ornot priornotificationis specified. Residentialconsumers are unlikelyto want to purchasepower onthe spot market.Fluctuating spot prices would generate too much uncertainty for the

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typical residential user. The vast majority of households are likely toopt for menu prices, based on service characteristics, in part,becausesuch a pricing scheme makes estimating expenditures on electricityeasier.

Distribution CompaniesWith competitive generation, distributors have many options.

Indeed, distributors become the most important shoppers for electric-ity in the system. Depending on the quality of service demanded bytheir customers, distributors’ degree of risk aversion, and their abilityto diversify, distributioncompanies seem likely topurchase their baseand expected peak loads by long-term contract with shorifalls andemergency requirements met in the spot market (Doucet 1994). Forexample, Florida Energy Brokers operate a wholesale spot market forelectricitywhich posts prices hourly.

Transmission Sert~lces

An analysis of the pricing oftransmission service is beyond the scopeof this paper, but a few comments are in order. Private transmissioncompanies would be regulated as common carriers that guaranteeopen access to all potential suppliers ofelectricity. The transmissioncompany’s role is pivotal as it performs central dispatch. Operatingthegrid involves establishing network policies andprocedures, assign-ingload to each generating station, maintaining network lines, schedul-ing energy transfers, and accommodating bulk wheeling.

Transmission rates should be set so that (1) all transmission costs,discussed below, are covered; (2) short-run demand equals the short-run supply of electricity, and (3) price provides guidance for optimalinvestment in future transmission capacity.

The transmission of electricity is governed by certain physical laws.These should be interpreted as technical constraints within which themarket determines the quantity and price of electricity supplied atany given time by any given generator. Thermal and voltage limitsdefine transmission capacity (Hogan 1993). Moreover, electricityplaced on thegrid flows according to Kirchoff’s laws—forthepurposesof this paper, electricityflows along the path of least resistance. Thus,for example, electricity sold by Generator A to Industrial CustomerB may not travel along the “contract path,” that is, the shortest linewithin the network that directly links the buyerandseller. Dependingoncircumstances, electricity introduced into thenetwork at any pointmay give rise to loop flow” affecting all suppliers to the grid. Loopflow can disrupt the quality and reliability of service to everybody

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taking electricity from the grid at the moment additional power isintroduced.

While conceptually loop flow can be a problem, central dispatchis designed to direct traffic so as to avoid problems associated withthese technical constraints. Linking anumber of independent powerproducers increases the load diversity of the system and the numberof energy transfers per period thus reducing the significance of loopflow (Walters and Smith 1993). As William W. Hogan (1992: 216)argues,

When loop flow is a small part of power economics then informalswaps can balance out the effects over time, and when all partiesare members of the same transmission club, it is reasonable toemploy the contract path fiction as a practical accommodation incrafting power contracts.

Network rules would, of course, establish minimum technical stan-dards for putting electricity onto the grid: long-term contracts settingforth transmissionrights for each generator, andfees for transmissionservices. Transmission fees might consistof a two-part tariff: an accesscharge covering capital costs and a fee set equal to the marginalcost of providing transmission service. Because the latter includesmaintenance and congestion costs, fees would vary with the volumeand distancepower is transferred. When appropriate, a higher conges-tion fee would be charged short-term users because of the highertransaction costs of arranging dispatch on short notice (Doyle andMaher 1992).

The Market Response to RiskIt is important to understand themarket response to the increased

risk associated with the introduction of competition into the marketfor generating electricity. Before discussing this issue, however, it isdesirable to outline the sources of risk thatare independent ofmarketstructure. The production and distribution of electricity is subject topredictable time-of-day and seasonal variations in demand and inputprices. In addition, it is subject to stochastic equipment breakdown,unexpected fluctuations in demand that must be accommodatedinstantaneously, and unexpected changes in input prices, particularlythose for fuel.

Typically a vertically integrated state monopoly deals with fluctua-tions in demand and random equipment failure by carrying excesscapacity, including redundant backup capacity. It may also addresspredictable fluctuations in demand by offering peak-load pricingschemes, although the incentive to do so is weakened by state owner-

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ship or regulation. Installing excess capacity is more attractive to thebureaucracy. Peak-load pricing waswell understood long before stateor franchise monopolies implemented time-of-day service.

Competitive generation produces at least two additional sources ofrisk: a more complex pricing structure (discussed above), and loopflow problems when independent producers put electricity into thetransmission network. But if decentralized markets introduce addi-tional risk, they also provide a broad array of ways of dealing with it.All of these sources of risk potentially influence the quality of serviceto the final consumer of electricity. In general, the market offersmethods to reduce risk and to price risk so that it can be spread orshared optimally.

Fluctuations in electricityprices andinterruptions inservice generaterisk for the buyer and seller. In the case of price variations, the payerfinds it more difficult to forecast expenditures and plan accordingly.The seller finds it more difficult to forecast gross receipts. Uncertaininterruptions of service complicate consumer andproducer planning.The risk borne by a given party depends on the probability of anuntoward event (an outage), the magnitude of the event (extent anddurationof an outage or the magnitude of an unexpected price change),the costs imposed by the event, and the degree of risk aversion of theaffected party. Because reducing risk, transferring risk to parties willingto bear it, and spreading risk among allparties are valuable activities,it is not surprising that the market provides for all three.

Consider how a generator faces the risk of uncertain prices forelectricity. First, theproducer can sell power by long-term contract tolarge industrial customers and regional distributors. Contracts specif~’prices and adjustment clauses. Thus, only a small proportion of itsoutput may even be exposed to unknown price fluctuations (Jaskow1988). Second, selling on the spot market on a regular basis offersnormal returns because prices regress toward the mean over a largenumber of sales, By selling regularlyin the spot market, theproduceris reducing risk through diversification, Third, theproducer can hedgespot market sales in the futures market.

The futures market for electricity is really a market for futuregenerating capacity, not future electricity. The generator is said tobe “long on capacity”; therefore, the firm hedges by selling futurescontracts for the amounts and periods corresponding to its desiredsales proffle. On the other side of the market is a distributor whowishes to hedge against uncertain future prices, so he purchases thefutures contract on a take-or-paybasis. (With a take-or-pay contract,thedistributor commits himselfto purchasea given amount ofelectric-ity during specified periods on specified dates; failure to take results

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in paying the supplier a fee.) Standardized futures contracts reducetransaction costs and are highly liquid. For example, contracts in theUnitedKingdom’sElectricityForward AgreementMarket setquantityat a minimum of one megawatt, duration at weekdays or weekends,delivery in four-hour intervals, and settlement terms (Amundsen andSingh 1992).

Suppose today’s future price for one megawatt of electricity deliv-ered in two weeks from 2:00 pm until 6:00 pm is 10.8 cents perkilowatt-hour (kwh). Assume that, in twoweeks, the spot price duringthatperiod is 10.4 cents. The distributor can either take delivery andpay theagreedupon 10.8 centsor decline deliveryandpay thegenera-tor four mills per kwh for the amount of power specified in thecontract. The distributor can then purchase his power requirementson the spot market at 10.4 cents. In the latter case, the generatorreceives four mills per kwh from thedistributor who declines deliveryand10.4 centson thespot market for its power. For boththegeneratorandthe distributor, there is no uncertainty about thepriceofelectricityfor that future period—it is 10.8 cents perkwh. The hedge is exactlythe same if the spot price rose to 11.3 cents.

Futures prices are determined hourly in open auctions conductedby brokers for generators, on the one hand, and distributors andindustrialusers, on the other. The presence of speculators, who nevertake delivery on take-or-pay futures contracts, only adds bidders andsellers on both sides of the market—which serves to deepen the’market and increase its liquidity and efficiency.

Electricity generators already have experience making spot marketpurchases of fuel, principally natural gas and petroleum, andhedging‘those purchases in the futures market. The combinationofcontractingand hedging reduces the risk born by the generator. That, in turn,reduces the risk facing the final consumer of electricity.

Similarly, distributors and large industrial users can mitigate thefinancial consequences of uncertainelectricityprice changes by enter-ing into long-term contracts, andby hedgingspot market purchases ofpower. Take-or-paycontractsare ideallysuited for such circumstances.Futures markets already exist in Norway and the United Kingdom.New England and Mid-Atlantic power pools, in the United States,are investigating establishing futures markets.

To reduce or spread the risk associated with stochastic equipmentfailure or unexpectedfluctuations in demand, the distributorwill havesigned contracts with a competitive producer carrying appropriategenerating capacity. Moreover, the distributor is in a position to pur-chase electricity to meet service requirements on the spot market.Because the ability to obtain electricity literally on an instantaneous

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basis is a major characteristic of service quality, it has a market price.In addition, the distributor has an incentive to discover the finalconsumer’s demandfor reliabilityby offering discounts for interrupt-ible service. The added flexibility of priority service reduces the riskto the distributor that an unexpected spike in demand or equipmentfailure might otherwise cause.

To reiterate, the ability of a distributor to obtain electricity from anumber of suppliers under long-term contract and on spot marketstends to ensure thatelectricity is made available at lower competitiveprices, and that risk-reducing system diversity is enhanced. Intertem-poral price risk arising from spot market transactions can be hedgedin a futures market for electricity. At present, the development of afutures market for electric power is just beginning, but long-termcontracting for electricity, spot market bids and sales, and energywheeling are a growing part of the market for electricity in theUnited States.

ConclusionThe technical andeconomic knowledge exist to permit thesubstitu-

tion of market competition for stateownership or government regula-tion in the electricity generation industry. The chief advantages ofmaking that substitution include a reduction of costs and lower finaluser prices, closer alignment between the array of services offeredandconsumer preferences, and greater incentives forongoing discov-ery and innovation.

Generating electricity is capital intensive. Economizing on capacitydedicated to meeting peak-load demand can be a significant sourceof saving. Potential savings are far greater than those offered by peak-load pricingalone. Competition in generation increases load diversity,thereby reducing the inventory of standby capacity necessary to meetpeak loads. The development of spot markets for electricity meansthatgeneratingcapacity can be more fullyutilized and less idle reservesneed be maintained. In addition, competition provides an incentiveto discover thedemandfor reliabilityamongdifferent customer classi-fications. Meeting thatdemand more closely byoffering interruptibleservice saves additional capital resources.

The first principleof competition is marginal costpricing. Competi-tive generation provides an incentive for producers to reexamine theircost structure at every margin. Expected cost savings are greater ina competitive environment than are likely to exist under a regime ofeither state ownership or regulation. Under state ownership, bureau-cratic self-interest runs counter to efficient, innovative operation. Reg-ulation entails costlybureaucratic monitoring and politicalnegotiation.

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The market is an engine of discovery. Without the informationabout relative valuations that can only be revealed by market-deter-mined prices, the electricity industry has no meaningful guidance forplanning investment, siting plants, deciding on the array of servicesto offer, or reducing the effects of uncertainty. The structure andgovernance of the electricity industry today leadsto a situationwherenew plants are built when demand for electricity, atpolitically deter-mined prices, systematically outstrips capacity and the political willis found to proceed with construction. Siting of plants is reduced topolitical negotiations. Such negotiations often pay little heed to theimplications ofmarket location, fuel transportation costs, andtransmis-sion costs. Beyond time-of-day and seasonal rates, little attention isgiven to the quality of service. Nor is there any surprise in this. Todaythe industry’s stated goal is to offer only the highest standard ofreliability for all consumers, whether they want it or not,

Risk management in the electricity industry is synonymous withcarrying enough excess capacity to meet any peak load or temporaryequipment failure.Whether this approach is economic or not is neveraddressed. Economicvaluations, reflecting consumers’ choices regis-tered in open markets, play almost no role in the decisions reachedby governments, state-owned electricityfacilities, or regulatedutilities.

Bycontrast, thecompetitive market reduces risk byoffering achoiceamong alternative suppliers of power, by creating spot markets, andincreasing load diversification; it allows for the transferof risk throughthe creation of futures markets, through prior notification of serviceinterruption, and interruption insurance;andit spreads risk by increas-ing the number of producers and transactions.

The introduction of nonutility, independent power production 16years ago in the United States, aspart of a larger energy conservationpolicy, unleashed the forces of competition at the generation stage.The gradual spread of competitive pressures within the industry wasnot anticipated. Industry spokesmen and academicians have consis-tently missed the implications of these changes. Many have been fartoo cautious in estimating the efficacy of competition in enhancingthe economic welfare of consumers of electrical power.7 But perhapsthis is not surprising. Market processes are discovery processes. Eveninformed commentators may not be very good at predicting howthe market will solve many of the problems confronting an industryin transition.

7An influential example of such reticence is Jaskow and Schmalensee 1983. For a more

recent example see Cegax and Nowotny 1993.

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