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ISO Economics: How California Flubbed It on Transmission Pricing

Fortnightly Magazine - October 15 1998

Instead, let the ISO accept more imaginative bids for redispatch

IN THE TWO YEARS FROM MID-1994 TO MID-1996, CALIFORNIA undertook an intensive and acrimonious debate on how to set up its new competitive electricity market. The main issue was how much to centralize market decisions. Those favoring a relatively large role for an independent system operator emphasized efficiency and safe operation of the power system. Those favoring a relatively small role for the ISO wanted maximum freedom for market participants to strike power deals.

In the end, the debate went to the power marketers and large industrial consumers, who suspected that a strong ISO might simply perpetuate the monopoly power of the incumbent utilities. The deal they struck (which became ensconced in law in Assembly Bill 1890) was as follows: First, the power marketers and industrials got the weak ISO that they wanted. Second, the incumbent utilities were guaranteed recovery of their stranded costs. Third, environmentalists got many hundreds of millions of dollars for energy conservation. In exchange, however, California will be stuck for many years with a market that is very expensive to administer and that gets prices wrong.

Using a simple numerical example - with a clearly correct answer - this article will explain how the California market sets the wrong prices for grid congestion, leading not only to faulty transmission prices but also wrong prices for electric energy. The bottom line is that California's transmission pricing makes it needlessly difficult for its ISO to relieve congestion and makes consumer prices needlessly high.

Dealing With Congestion:

An Efficient Model

Suppose that three merchant firms (in California called "scheduling coordinators") have all of their generation to the west and their entire load to the east, linked by a constrained transmission interface. Suppose further that, as shown in Figure 1, these three merchants (M1, M2, and M3) together want to transport eastward 6,000 megawatts over that interface, which can carry only 2,000 MW. Under these circumstances, two-thirds of the proposed schedules must be curtailed. How should the market allocate these curtailments?

To assess the efficiency effects of different methods for alleviating the transmission constraint, we need to know about the cost of supply and the value of demand. This information is presented in Figure 2, which depicts supply and demand curves for each merchant (shown as straight lines for the sake of simplicity). The curves show that M1 has the highest-valued loads but also the most costly supply. M3, by contrast, has the cheapest supply but also the lowest-valued loads. M2's loads and supply fall in the middle.

It should not prove too difficult to find the most efficient use of the constrained transmission interface. First, add together the demand curves for the individual merchants shown in Figure 2 to derive a single demand curve for the entire market. That curve will show the total market demand at each price level. Do the same for the individual merchant supply curves. These two new total market curves for demand and supply, based on the curves of Figure 2, appear in Figure 3. The