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The Fallacy of High Prices

We are better off under restructured electric markets.

Fortnightly Magazine - November 2006

best a temporary protection as world energy prices continued to rise. Moreover, those price caps, however well-intentioned, prevented consumers from gradually adjusting to market fluctuations typical of any industry. Not surprisingly, as if a dam burst, the end of those price caps, coupled with the sharp increases in fuel prices, has led to large price increases.

Market Timing

One of the difficulties in demonstrating the benefits of wholesale competition today is the high cost of fossil fuels, especially natural gas. In fact, the impetus for retail electric competition was, in large measure, low fossil fuel prices: Large commercial and industrial customers, in particular, sought to avoid paying higher rates based on utilities’ embedded costs by gaining access to low-cost, gas-fired generation.

As the saying goes, “timing is everything.” The gas glut of the 1990s, coupled with an inability to build any other type of generation because of environmental opposition in the Northeast, led to an increased reliance on new gas-fired generation to meet growing electric demand. When gas prices shot up beginning in 2002, so did wholesale market prices. Yet, despite the large fuel price increases, the data reveal that there have been tangible benefits from wholesale competition.

Fig. 1 presents fossil fuel trends between 1996 and 2005. Natural-gas prices (city gate) remained below $4.00/MMBtu through 1999 and have been above that level since, with a rapid rise to near $9.00/MMBtu in 2005. 7 Fuel oil prices have followed a similar pattern, reaching above $13.00/MMBtu in 2005. Coal prices, while rising far less than either oil or natural gas, have nevertheless increased steadily since 2000. 8 Higher fossil-fuel prices have translated to an increase in wholesale electric prices. For example, in PJM, wholesale electric prices rose from about $30/MWh in 1999 to above $60/MWh in 2005.

Yet, despite that increase in electricity prices, competition has wrung out significant benefits. Consider Fig. 2, which compares actual rolling 24-month average prices in PJM (adjusted for inflation) and prices “de-trended” to remove the impacts of higher fossil-fuel prices. (The de-trending analysis also controls for the effects of generation capacity reserve margin, peak demand, and extreme summer weather.) Wholesale electricity prices excluding the effects of fuel cost have decreased significantly since the inception of the PJM wholesale market in 1998. The average de-trended price for the last 24 months of the data period is 9 percent lower than that for the first 24 months. The restructuring process effectively has motivated power suppliers, now faced with the full force of competition, to operate far more efficiently.

To address possible arguments that an over-supply of generation caused these de-trended price decreases, our analysis also controlled for the impact of increasing generation capacity. Moreover, even if we had not controlled for this effect, if energy prices were indeed depressed by oversupply— i.e., by the inability of some generators to sell at prices that covered their fully allocated costs, plus a return—this outcome nevertheless represents a dramatic change that is unequivocally a benefit of competition. Just as increased supply benefits consumers in other markets—whether groceries or automobiles—aggressive competition in