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PoolCo, Bilateral Trading, and Technology

Fortnightly Magazine - March 15 1995

balancing and ancillary services on efficient terms, allowing no free riders.

Clearly, a well-designed PoolCo will provide the most efficient and equitable market framework, reducing the opportunities to profit from market imperfections.

Professor Hogan was correct to argue that the debate is something of a distraction. A number of other significant and tricky issues, which add up to fair sums of money, should be sorted out if "competitive" power markets are also to be reasonably efficient. For example, How do you charge for voltage and frequency regulation and make them transparent and competitive? Also, How do you charge for the costs of constraints and provide the proper incentives for reducing these costs? Incentives interact with both PoolCo (or the spot market) and transmission pricing in complex ways and, as we found to our cost, it is not difficult to build in perverse incentives.

The design of electricity markets will in practice be based not upon the theoretically desirable, but upon the institutional framework and characteristics of particular electricity market areas. Perhaps the debate has missed the most fundamental point. Namely, the appropriate means of trading is influenced by industry structure: Bilateral trading may be more appropriate than PoolCo with an integrated structure. (Consider that oil spot and futures markets developed hand in glove with the "unbundling" of the oil majors into upstream and downstream activities.) A PoolCo is definitely likely to be easier to implement with a vertically fragmented structure and an independent grid. Indeed, the effect of the Federal Energy Regulatory Commission's Order 636 on gas industry structure suggests that such a structure may well lead that way in the long run.

Further, a PoolCo is complex to negotiate (the English pooling agreement runs to 1,000 pages). Thus, it is key that an electricity market area be under a single jurisdiction, one that has sufficient authority to force agreement if necessary. In practical terms, bilateral trading will likely be available as the default mode, particularly in a vertically integrated industry, and each major company has its own area of control over ancillary services and constraints. Finally, the physical characteristics of a particular system will play a role. For example, large thermal plants are not as flexible to operate as reservoir and pumped-storage hydro, and those with less nimble plants will soon realize they do not want a system whose market rules disproportionately benefits flexible plants.

The likely evolution of competition in many, if not all, parts of the United States will be bilateral trading between utilities, larger customers, and perhaps some retail merchants who will try to package a portfolio of smaller customers. This type of competition will reduce some of the grosser distortions (em such as blatant cross-subsidization and crude mispricing of transmission services (em leaving the integrated utilities with numerous modest areas of market power over ancillary services and constraint costs at the generation level. Merchants may profit from trading on the artificial inefficiencies resulting from the jurisdictional and regulatory failures to resolve issues. A series of regulatory cases will erode these advantages, and calls for complete separation of