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Power Procurement: What's in Your Mix?

Why competitive markets are scaring regulators.

Fortnightly Magazine - November 2006

being overlooked. 10

The competitive-solicitation approach has resulted in a new group of wholesale electricity suppliers that have developed approaches for pricing electricity that manage price and volume risk in a competitive environment. These competitive suppliers make use of many of the same analytical tools as utilities using IRPs, but these competitive suppliers also have developed various internal proprietary systems to compete as risk managers. Unlike utilities with some degree of regulatory protection, these suppliers have strong incentives to get the analysis right because if they are wrong, competition will drive them out of business. Moreover, competitive wholesale suppliers continually will refine their analytical tools precisely because their livelihoods depend on it. 11 Thus, the introduction of retail competition along with the introduction of transparent wholesale spot markets has created the means by which competitive suppliers can evaluate supply risks and provide numerous different products to utilities and individual customers on a competitive basis. We believe the underlying issue of this approach is assessing the risk-management costs of these shorter-term supply arrangements. 12

The ability of the portfolio-resource-mix approach to manage risk more successfully over the long run, as compared with the risk management of competitive suppliers under the competitive-solicitation approach, is uncertain as well. One major concern flowing from the use of often very long-term supply commitments ( e.g., 10 to 20 years) is that the price at which these supplies have been obtained may, over time, become significantly different from the realities of supply and demand. 13 Indeed, this concern cannot be overstated. The portfolio-resource-mix approach, instead of taking advantage of market price signals that will change year-to-year, is precisely the kind of framework that can be far out of step with the economics of energy markets. Moreover, historically there has been a propensity to “overshoot” and end up with excess capacity that takes significant time to absorb. The costs associated with these excesses will be passed through as fixed-generation charges as opposed to proper electricity price reductions in times of excess supply. Meanwhile, the costs of balancing supply and demand and the benefits of responding to seasonal and daily changes must all be tracked and ultimately passed through to customers.

Thus, a major difference between these two procurement approaches is the cost of managing the risks of changes to supply-and-demand conditions and the associated change in prices. Procurement policies in states that have introduced retail competition often directly request pricing that incorporates the management of these risks. That is, prices are fixed over various terms depending on product. In states that have not introduced retail competition, utility customers are charged fixed rates, but are subject to true-up mechanisms that allow for recovery of fuel costs and purchased-power costs associated with the management of price and volume risk. The key question is, Which approach results in lower risk-management costs over time?

Unfortunately, there is no easy way to quantify the risks involved in electricity procurement. It often is argued that utilities using the regulated portfolio-resource-mix approach enjoy the benefit of lower costs of capital and subsequently have lower investment