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Hybrid Finance

A solution to high electricity prices in restructured states.

Fortnightly Magazine - September 2010

market competition.

Significantly lacking from restructured markets has been the construction of new baseload generation capacity.

Regulated vs. Competitive Market Pricing

The same economic dispatch of generating units applies under both cost-of-service and market-based pricing. Utilities run generators with the lowest marginal costs first and start more expensive units as power demand increases, so as to maximize economy of service. When demand for electricity is low, the grid is supplied by hydro, nuclear and coal baseload power plants, which have low marginal costs. When demand for electricity is high, in addition to baseload units, the grid is supplied by combustion turbine plants, which have high marginal costs due to the price of natural gas and the high heat rates associated with these less efficient units.

Prices under the rate-of-return model are set to cover the utility’s cost of service including fuel, appropriate operating expenses, depreciation and taxes, plus a fair return on invested capital. The price or average cost of electricity normally is expressed per unit of output, which is obtained by dividing the cost of service by output. When restructuring first was proposed, average costs of generation exceeded marginal costs, which was a strong argument in favor of deregulation; customers didn’t want to pay for excess capacity and utility inefficiency. Cost-of-service regulation imposed the majority of cost overruns directly on captive retail customers. Most existing baseload generation was financed under rate-of-return regulation.

Under a market-based pricing model, prices are based on the marginal cost of electricity produced by the last generating unit dispatched. When demand is low, prices also are low because they are based on the marginal cost of coal and nuclear units. When demand is high, prices are correspondingly high because they are based on the marginal cost of combustion turbines, which burn expensive natural gas. Unlike rate-of-return pricing, which provides for a fair return on invested capital, return on investment under market-based pricing depends on the market producing prices that exceed the marginal costs of some generating units. Prices haven’t risen high enough to incentivize the construction of new baseload generation, possibly because prices in these markets often are priced-capped during periods of the highest demand.

Owners of existing baseload generation are realizing significant profits from the present state of the market because prices reflect the marginal cost of the producer with the highest cost whose output is necessary to meet demand. If new baseload generation was to be constructed, the price of electricity would fall and the profits being realized by the owners of existing baseload generation would be reduced.

Supply Growth Reduces Prices

New baseload generation will be needed despite the increased use of energy efficiency, conservation and renewables. The construction of new baseload capacity is especially important given the decline in reserve margins. If reserve margins shrink more than expected, system reliability would be affected, with a deleterious impact on the economy.

The new baseload technology likely will be either nuclear power or clean coal; the latter might be the appropriate technology in areas with accessible coal resources and the geology to accommodate carbon sequestration.