[BETA] Fortnightly

As the debate over restructuring the U.S. electricity industry moves forward, there comes a host of new theoretical models. Two proposals in particular serve well to frame the debate. The PoolCo proposal emphasizes reliable system operation, short-term efficiencies through central dispatch, and a single market price; the bilateral contract model stresses competition, multiple dispatches, and customer choice.

How can policymakers choose intelligently between these two dramatically opposed models? Are there advantages to either or both? If so, should policymakers implement a compromise solution? Might a compromise bring out the worst of both? Or, could they be made to strengthen each other? Consider also that the electric power grid is a large-scale, interrelated system. Serious policymakers simply cannot approve and implement significant change based solely on theoretical proposals and expect them to be instituted immediately.

Nevertheless, there is a way to navigate these waters. Rather than opting now for PoolCo, physical bilateral contracts, or a compromise, policymakers should consider an incremental or bridging approach that can advance the objective of restructuring while also resolving technical, economic, and regulatory uncertainties along the way. In New England, the starting point is the New England Power Pool (NEPOOL), which already meets the short-run objective of minimizing the fuel cost of producing electricity while maintaining a reliable regional system and allowing contract flexibility.

Markets Don't Happen Magically

The electricity industry's transition to a more competitive structure, beginning with the wholesale arena, is not to be confused with a "free-for-all" based on that oft-quoted promise, "Out of chaos, comes order." The "magic" of the marketplace does not just happen. To function properly, markets require an appropriate structure coupled with a mechanism to maintain that structure, so that participants realize the benefits and bear the consequences of their decisions (em and their decisions alone. Absent this direct accountability, competition does not achieve economic efficiency.

Yes, the fundamental economic structure of wholesale electricity production has changed. Generation is no longer considered by most a natural monopoly. But the underlying economics of the electricity network remain the same. The operation of generators and transmission facilities affects system reliability and the economics of other power plants. This network interaction creates both positive and negative externalities. (In this economic framework, reliability can be viewed as a network externality.) In the past, with few players operating under cost-of-service ratemaking, utilities accounted for network externalities on a quid pro quo basis (em a.k.a., "gentlemen's agreements" or "good engineering practice." To realize the benefits of competition, instead of merely shifting costs among various market players, any market structure must account for such externalities.

Improving economic efficiency at the expense of system reliability, as the Federal Energy Regulatory Commission has recognized, does not represent progress. From a policy point of view, there is no doubt that the existing level of reliability must constrain the restructuring process (em unless the policy is to reduce reliability. But the concept of reliability should not be considered a constraint that lies outside the efficiency discussion. Market participants must have the resources necessary to serve their customers reliably, as well as the