July 1, 2001
L.A. Loves a Loophole
There's no getting around it...
Energy Retailing: Setting a Standard Offer for Every Season
For deregulation to work, consumers must see the real price-- including all utility costs.
Summer is back, and with it, concerns that not enough power will be available to meet critical peak demands in the Northeast, Mid-Atlantic, Midwest, and California. Why potential shortages when capital is abundant and deregulation and competition are supposed to make the industry work better? Because regulators, with the best of intentions, are setting the wrong prices for power sold by the regulated utilities in competitive markets.
Establishing electricity and gas prices charged by the regulated utilities has been a key consideration for policymakers in deregulating states. Set properly, such prices, referred to as "standard offers," "prices to beat," or "default prices," enable consumers to make choices that force electricity providers to become more efficient and offer better service. Properly set prices also protect regulated utilities. Set improperly, prices inhibit competition and encourage consumers to make uneconomic choices about when to buy power and from whom. Those choices can have dramatic consequences, including lack of sufficient generating capacity during summer peaks.
Prices in free markets reflect the full cost of a company offering a product or service, including fluctuations in wholesale costs. "Full cost" includes three items:
- PRODUCT COSTS (electricity or gas commodity and transportation, in this case);
- ALL ASSOCIATED DIRECT COSTS (purchasing, scheduling/load forecasting, accounting, legal, etc.); and
- FULLY ALLOCATED CORPORATE OVERHEADS (general administrative expenses).
Every business must recover all of these costs in its pricing in order to remain in business. The same approach is the right one for deregulating energy markets: Regulated utilities should set prices for electricity and gas including all three cost areas, as well as reflecting fluctuating wholesale costs, which should be reflected monthly.
Regulators may choose from three options in setting standard offer prices: forecast low, use actual costs, or forecast high. Unfortunately, the most common regulatory approach to date, that of forecasting wholesale prices and setting low regulated utility prices, is probably the worst possible. That hurts not only consumers, but also the utilities. The perceived benefit is short-term political: reduced, stable prices. However, history has shown that such artificial price caps are followed quickly by dramatic negative results. Examples range from the collapse of the Soviet economy to the natural gas shortages and high prices in the late 1970s and early 1980s in the United States (prices were capped at the wellhead, not to end-consumers).
As with most things in life, simplicity and common sense yield the best result when it comes to pricing energy sold by regulated utilities in deregulating markets. Only two things are necessary: First, reflect the utility's full cost of the product or commodity, acquiring the power, and operating that portion of the utility's business (in a separate business unit, ideally), and, second, pass on price fluctuations to the consumer, so consumers can make informed choices. (If consumers demand flat pricing, competitive suppliers will offer it; the difference is that those prices will reflect actual wholesale costs and the risks associated with offering flat pricing.)
The result will be what policymakers and consumers have