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Ensuring an adequate power supply
Robert J. Graniere
Five courses of action will ensure an adequate and reasonably priced supply of electric power.
et's be accurate. Wholesale and retail electricity markets are not new. It is the full or partial deregulation of these markets that is new. During the last five to six years, we have experimented with the deregulation of these markets. Not one deregulation effort in the United States is exactly the same as another. Each has a common factor, however. Not one has yielded the expected results.
Although unregulated companies have entered and profited in the deregulated wholesale energy market, wholesale prices have risen dramatically and unexpectedly. Meanwhile, unregulated companies have entered and left the retail market because they could not earn their desired profit margins.
And the disappointments with deregulation are getting worse. Rolling blackouts persist in California despite the best efforts of its policymakers. To cast further doubt on these experiments, the new wholesale and retail services have not exactly benefited consumers--they generally ask customers to voluntarily curtail electricity usage. But perhaps most disappointing of all, the promise of lower prices has given way to the reality of higher prices.
It is tempting to ask how we missed the mark so badly. This is a mistake, however, because we quickly descend into a quagmire of recriminations. It is much more productive to ask what courses of action might ensure an adequate and reasonably priced supply of electric power. I believe there are five.
The first falls to the electricity industry, which must accept that electricity is an unusual commodity. The second lies in the hands of retail customers, who must accept that real-time (fluctuating) prices (RTPs) are not optional. The third responsibility belongs to our political leaders, who must reevaluate their belief that deregulating the wholesale electricity market will not ensure an adequate supply of electricity. The fourth involves a commitment by regional transmission providers to cooperate closely. The fifth requires universal acceptance that new power plants have to be built.
Electricity, an unusual commodity
widely held belief is that electricity is a commodity. If it is a commodity, however, it is not a typical one. It cannot be stored in large quantities, and its constant flow must be kept in continuous balance to avoid blackouts. Yet, the New York Mercantile Exchange (NYMEX) has elected not to account for these physical quirks of electricity in the design of its commodity contracts. By so doing, this major commodity exchange has turned its back on standardized contracts, which are the essence of commodity trading. This decision is puzzling because NYMEX already has rejected the naive belief that coal is a typical commodity. It made this choice on the strength of two facts: A ton of coal varies in quality and the cost of its transportation.
Like coal, electricity varies in quality. Its standard for quality is reliability, which is measured by "loss of load probability," or LOLP. Electricity becomes Transmission tower in Fairfax County, Virginia: Electricity is transferred from the source of generation to the area of use through vital points such as this. less reliable as the LOLP increases. The LOLP, in turn, increases as the transmission network becomes more congested. Congestion can cause significant increases in the costs of transmitting electricity. If the locations of congestion could be predicted accurately, then the standardization of transmission costs would be manageable. Unfortunately, such predictions do not fall within the required range of accuracy. Consequently, a standard transmission cost cannot be obtained. The absence of this cost calculation makes electricity an unusual commodity. Perhaps electricity can be a commodity only in an idyllic world where there is no congestion. If this conjecture turns out to be true, then the trading of electricity can be relied on only to make money, not to ensure its adequate supply.
Real-time prices are not optional
onceptually, RTPs are recalculated each instant of every day. Practically speaking, electricity prices are calculated each hour and may vary each day. For example, the RTP for 2:00 p.m. to 3:00 p.m. today may or may not be the same as the RTP for 2:00 p.m. to 3:00 p.m. tomorrow or the next day. An energy RTP may be regulated or unregulated. If it is an unregulated price, then the local utility or retail marketer will have the option of passing along to the consumer its actual hourly wholesale electricity costs, its actual hourly transmission and distribution costs, and its preselected hourly markups for marketing costs and profits. If an RTP is a regulated price, then the utility may not have this option; instead, it may be forced by state public utility commissions to smooth out its hourly fluctuations in these five cost categories before passing on these costs. Clearly, RTPs make us aware of when the costs of producing electricity are high and low. But are RTPs a necessity for this reason? The blunt answer is no. So, why should RTPs be mandatory? The short answer is that RTPs send three signals that help to ensure an adequate supply of electricity. The first and strongest signal is sent to us directly. It alerts us to the possibility that it may be profitable to alter our daily pattern of electricity usage. The changes that we typically make are to decrease electricity use when prices are high and to increase it when prices are low. With the precision of high technology, these changes always result in reductions in the peak-period demand for electricity, which in turn always reduce the pressure on the power industry to build new plants. Investors in the power industry receive the second signal. Using varying RTPs means that the local utility and retail marketers will remain financially solvent over the long term because they will be able to recover their wholesale costs from retail customers. The investors, therefore, are reassured that they will be able to profit from building new power plants, which, in turn, helps to ensure an adequate supply of electric power. Investors and consumers receive a third (and weaker) signal. It is the most complicated one: RTPs mitigate the market power that is held by the power industry. Why? RTPs always provide us with an incentive to shift our electricity consumption to hours of the day when electricity is more plentiful and less costly. To the industry, this means that the economic benefit of keeping generation capacity short (scarce) has dried up. As a result, it is more likely to build new power plants to earn more profits, which, in turn, help to ensure an adequate supply of power.
Expose customers to competition
he vast majority of state public utility commissions taking the treacherous roads of wholesale and retail competition faced retail electricity prices that were above the national average for a variety of reasons. The California Public Utility Commission, for example, was forced to approve above-average retail prices because of the state's stringent environmental laws and aggressive energy conservation programs. Other U.S. public utility commissions had to approve higher retail prices because of tax policies. These prices were deterring economic growth and becoming burdensome to consumers. In a politically charged environment such as ours, politicians usually promise lower prices. This is exactly the promise that has been made about energy prices. Unfortunately, it was a promise that could not be kept. Having, in their opinion, exhausted all available administrative means to lower electricity prices, politicians reasoned that their only recourse was the marketplace. They embraced it wholeheartedly, and why not? The experts had told them that competitive markets always lower prices. Competition induces efficiency. Efficiency induces lower costs. Lower costs induce lower price. Of course, the fly in this ointment is that the retail electricity market might not be competitive. The experts told the political leaders not to worry, however. Even if the retail market is not yet fully competitive, the wholesale electricity market surely is, they said. Therefore, to fulfill their promise of lower prices, all politicians had to do was unleash the competitive power of the market. How? They simply had to deregulate it. But well-argued plans can be fatally flawed. This was one of those times. The fatal flaw is that the wholesale market is not competitive. A market does not become competitive as a matter of choice; it is a matter of technological innovation that is capable of altering the existing market structure.
What did this flaw mean to our economic welfare? Political leaders exposed us to the rigors of competition for the wrong reasons. We should not have been asked to assume these risks on the basis of promises of lower prices and more choices of electricity suppliers. The rapid and continuous availability of new electricity services made possible by technological innovation is the only proper reason. The great economist Joseph Schumpeter had it right all along. Technology is the engine that drives competition, not vice versa.
Fortunately, distributed generation, which is the most active source of technological innovation in the electricity industry, is suitable for use in the retail market. Distributed generation places a power source (e.g., solar panels or fuel cells) at or near users to provide emergency and supplemental generation. Thus far, the most innovative use of distributed generation is to improve power quality at universities and other high-tech businesses.
Close cooperation a necessity
holesale and retail energy competition requires a very specific infrastructure to support it. A critical piece of this infrastructure is the transmission grid, which is the primary vehicle for keeping the supply and demand of electricity in continuous balance. But the U.S. transmission grid is not a stand-alone, integrated network of high-voltage lines. Rather, it is a patchwork of individually owned transmission systems that are interconnected at specific interfaces.
An important task of the Federal Energy Regulatory Commission (FERC) is bringing these individual systems together into a regional transmission organization (RTO), which will be the single transmission provider for a region. Two objectives will be achieved by forming RTOs: increasing the efficiency of existing transmission facilities and increasing the accessibility of current -------------------------------------------------------------------------------- In a politically charged environment such as ours, politicians usually promise lower prices. This is exactly the promise that has been made about energy prices. Unfortunately, it was a promise that could not be kept. -------------------------------------------------------------------------------- power plants. More efficient transmission facilities will lower transmission costs, while the accessibility of power plants will increase the supply of electric power without building new power plants. Both these outcomes will help ensure an adequate supply of power for regional customers.
Still, the benefits of regional integration are confined to each region. FERC wants these benefits to spill over to adjoining regions. It can achieve this by prescribing the optimal size of an RTO and then ordering the affected transmission owners to join it. Or it can encourage close cooperation between RTOs that have been formed voluntarily. FERC has chosen close cooperation because it has already decided that membership in an RTO should be voluntary.
Close cooperation between RTOs depends on a continuous flow of information between them. The information is used to minimize costs and reduce transmission congestion. Less congestion increases the output of power plants. Lower transmission cost increases the feasibility of transmitting electric power from a region with surplus capacity to a deficient one. Both these outcomes increase the supply of electricity.
Build new power plants
here are limits to how far electricity can be carried over transmission lines, which restricts the supply made possible by close cooperation between RTOs. Distributed generation also has limited economic applications. Plain old price increases and RTPs are best suited for reducing and redistributing the electrical demand; they have only a limited capability to increase the power supply. Treating electricity as a commodity can increase power supply only if it reduces the market power of the existing generators. Therefore, there can be no doubt that new power plants have to be built.
The appropriate state agencies have approved the construction of new power plants. The California Energy Commission, for example, has authorized the construction -------------------------------------------------------------------------------- Treating electricity as a commodity can increase power supply only if it reduces the market power of the existing generators. Therefore, there can be no doubt that new power plants have to be built. -------------------------------------------------------------------------------- of plants capable of generating approximately 6,000 megawatts over the next five years. But there is a problem. All these plants use natural gas as their base fuel for generating electricity, and the price of natural gas is increasing substantially.
On average, the price of natural gas in 1999 added between two and three cents to the retail price of electricity. Currently, it adds five to seven cents. If natural gas prices remain at these levels, then it will not be economically advantageous to build all these authorized power plants. The most likely replacements are coal-fired plants, but they would expose California to additional environmental dangers.
Energy security may become an issue in California and elsewhere. If the gas-fired power plants are built, then it is a virtual certainty that domestic supply will not meet the demand. If new natural gas fields are not opened offshore or in Alaska, then we will have to increase our imports of natural gas from Canada and Mexico. But then, we expose ourselves to additional problems. We will not only have to worry about the decisions made by a faraway oil cartel; we will also be dependent on our neighbors for our natural gas supply. Consequently, we must make reasoned choices in this area to ensure a balanced mix, which means a rosier future for coal and clean-coal technologies.
America's energy future is not as dark as it may seem at present because of the imbroglio in California, but at the same time it is far from bright. Fortunately, the five courses of action discussed here, if properly balanced, have a strong potential to ensure an adequate supply of reasonably priced electricity for all of us. -------------------------------------------------------------------------------- Robert J. Graniere is the senior institute economist at the National Regulatory Research Institute at Ohio State University.
-- Martin Thompson (email@example.com), June 01, 2001
This is a very enlightening piece of writing. Thanks for posting it, Martin.
-- Uncle Fred (firstname.lastname@example.org), June 01, 2001.