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Energy Retailing: Setting a Standard Offer for Every Season

Sending Price Signals, Without Illegal Tying
Fortnightly Magazine - August 2000

of regulation is that, in return for requiring a company to provide a service, regulators agree to allow that company to charge rates (prices) that enable the company to recover its full cost of providing the service (including associated direct costs and corporate overhead). Similarly, competitive markets, by their nature, require that a company charge prices that recover its full costs (direct, associated direct, and corporate overheads); otherwise, that company will go bankrupt. The right price for deregulated utilities to charge for electricity and gas is the same: full cost.

Not only is full cost the right way to set prices for regulated utilities to sell energy, it is simple: (1) Add up the costs of acquiring and transporting wholesale power, (2) add all internal associated costs, and (3) allocate corporate overheads.

Because wholesale gas and electricity prices fluctuate daily, even hourly, setting the regulated utility's price also requires that such fluctuations be addressed. Ideally, prices to the consumer would reflect the variations as daily or hourly prices. (Again, knowing the true economic cost of energy enables consumers to make informed decisions about when and how to use energy most efficiently, given that consumer's desires and needs.) But since usage data is collected monthly (via monthly meter reads) and bills are issued monthly, the simple solution is to reflect such variations on a monthly basis. Indeed, California has adopted this approach.

Various other ways of handling wholesale price fluctuations are available. The problem with these methods is they send the wrong price signals to either consumers or the wholesale markets, creating distortion. In almost all cases, peak energy prices are set too low, causing generators to build too few plants--hence the danger of electricity shortages during peak times this summer. On the consumer (demand) side, peak prices set too low exacerbates the problem by encouraging consumers to use too much energy during peak hours. In deregulated wholesale markets, the combination of too little supply and too much demand has led to dramatic price spikes--though even these are hidden from consumers through averaged prices.

Regulators historically have responded to price spikes with regulation and price caps. Unfortunately, the result is to make the problem worse. Notable examples in the United States were the wage and price controls enacted during the Nixon administration, and, even more relevant, natural gas price regulation. In the early 1980s, before price deregulation at the wellhead, extreme shortages occurred and prices spiked in much the way electricity markets have responded to price caps and the absence of price signals. Forecasters said natural gas no longer would be available by the year 2000. But following deregulation, the competitive market eliminated both problems: Higher initial prices led to widespread exploration, resulting in huge increases in the availability of natural gas, and, in the end, plummeting prices.

The Standard Offer: State-by-State Evolution

A look at the various approaches regulators have taken to pricing energy in competitive markets, and how some are rethinking those plans.

By Paul Gromer

The states that have implemented electric competition have taken very different approaches to the pricing