[BETA] Fortnightly

THE LIST OF COMPANIES STUNG BY RECENT ELECTRICITY. price spikes in he Midwest continues to expand, as cries for price caps grow loader. Much has been said of the dollar amounts lost and who has incurred those losses; yet few have questioned the fundamentals driving this market. Understanding what's behind the recent market uproar is the first step in deciding how well the market functions.

Regulators should be careful not to slow the restructuring process simply because of this price volatility, but they should pay very close attention to its causes.

In many ways, the market appears to be functioning properly. Electricity is unique in that it cannot be stored economically and its difficult to transport over long distances. These characteristics contribute to electricity's status as the most volatile commodity (five times more volatile than gas, the next most volatile commodity).

Marginal-cost pricing provides another indication of a properly functioning market. Pricing is no longer based on average utility costs. Instead, each individual plant must become its own profit center or shut down. With the exception of peak periods, the market faces excess generating capacity with prices based on variable costs. Since revenues based on variable generation costs are normally not enough for a plant to earn back its total costs, it must capture the higher revenues resulting from any peaks in market prices.

For example, using information from Pasha Publications, the average price over the past year is $24 per megawatt-hour if $1,000+/MWh days are excluded, but the average price rises to $34/MWh if price-spike days are included. Thus, without these two days there is little incentive for new market entrants to build additional generating capacity. Generators are only able to earn a full return on their investment when market prices include a "scarcity premium," such as that seen during the price spikes.

Electricity demand changes little in response to changes in wholesale market prices. Because of their obligation to serve, utilities short power during peak hours were forced to buy power no matter the price. Most electricity consumers are unconcerned with the price associated with their electricity consumption during peak demand because they are still paying average rates. Thus, consumers have no incentive to respond to price. Therefore, while markets seem to be working properly, current trends may not continue in the same fashion when retail choice is introduced.

The factors just noted lend credibility to the argument that electricity will sometimes be very expensive. The critical question, however, is: Did these prices result from market power abuse? Given utilities' historic geographic monopoly service area and the rapid consolidation in the industry, it is possible that market power is being exercised. Few details have leaked out concerning who was selling power at such high prices. One entity or many? Utility or marketer or both? This could signal that regulators should greatly emphasize market power analysis.

Christopher Seiple is a principal, Albert Pearson is a consultant, and David Wagman is an editor with RDI.

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