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Hybrid Finance

A solution to high electricity prices in restructured states.

Fortnightly Magazine - September 2010

be divested or transferred to an unregulated subsidiary;

• The cost of energy and capacity was eliminated from the retail rate such that retail suppliers could compete directly in supplying electricity to the consumer;

• At the end of the phase-in period, electricity was bought or sold in the wholesale market either through an auction process or through bilateral contracts;

• Transmission and distribution continued to be regulated under traditional rate-of-return regulation; and

• The issuance of rate-reduction bonds was authorized to cover stranded costs.

Restructuring allowed producers to keep the profits from efficiency gains, resulting in a dramatic increase in capacity factors at existing coal and nuclear plants. The efficiency gains were especially pronounced at nuclear power plants. Significant new sources of supply, primarily combined-cycle gas ( i.e., both energy efficient and environmentally acceptable) were brought on-line, as price signals from the wholesale market encouraged new investment. Absent from the market, however, was significant construction of new baseload electric generation in restructured states.

The issuance of rate-reduction bonds was authorized to cover stranded costs and deferred balances. Without this mechanism, the rate reductions associated with restructuring would have been more difficult to achieve.

High Wholesale Prices

The increase in wholesale electricity prices has been dramatic, with rate increases exceeding 50 percent or more in some markets. These price increases have occurred in both restructured and traditional markets, but are more noticeable in restructured markets. The primary reason that vertically integrated states have lower electricity prices is the prevalence of coal units, especially older units without advanced pollution controls.

In the initial years of restructuring, the marginal cost-based pricing of competitive markets led to a decrease in electricity prices compared with the average costs, which would be charged under rate-of-return regulation. Recently, as a result of demand growth, inefficient natural gas-fueled combustion turbine units are on the margin more of the time, causing electricity prices to surge. In addition, the price of natural gas also has increased substantially, which has compounded the problem. In effect, less-efficient units burning increasingly expensive natural gas are setting the price of electricity more of the time. 1 Some of the factors that contributed to the increase in electricity prices include: rising prices for key production inputs, such as coal, oil and natural gas, because of scarcity, production constraints, weather, OPEC, etc. ; high real rates of economic growth and the rise of the information economy have led to increased demand, i.e., a data center can use as much electricity as a steel mill; and increased demand has led to the use of less efficient generation units because new baseload capacity hasn’t been built. Additionally, utilities have responded to state and federal incentives to install new generating technologies, such as wind and photovoltaics, at a higher cost than traditional baseload generation.

Electricity prices increased in most markets despite the implementation of various strategies to ameliorate the price increases, such as real-time pricing, first for large customers and eventually for other customers; 2 demand-side management and energy efficiency programs; and additional market monitoring to assure wholesale