The winds of competition are blowing. Some find them chilling; others find them exhilarating. Deregulation calls on competitive markets to stand in for regulatory decisions, giving more choice to customers, reducing costs dramatically, and requiring new capabilities.

Competition is already transforming major portions of the electric industry. Changes in federal and state regulation have introduced competition from independent power producers, and the 1992 Energy Policy Act (em

requiring open access to the transmission grid for wholesale transactions (em has aided competition in the bulk-power markets. High-cost electric utilities can no longer exploit their geographic market power by denying reasonably priced access to their transmission assets. Competition has also entered retail markets in the form of cogeneration, self-generation, district heating and cooling, industrial plant siting, municipalization, and demand-side management (DSM). Customers clearly have competitive options and they want more.

Competition will unbundle electricity into energy, reliability, coordination, transmission, and distribution services. Deep, liquid, pool-based spot markets will price commodity energy on an hourly basis; generation will become fiercely competitive. Customers will enter long-term capacity contracts for base-load reliability and may bid short term to determine peak interruptibility thresholds. The marketing business will package energy, capacity, DSM, and related services tailored to address specific customer needs. System control and coordination services will be provided by an independent system operator for a regulated fee. Transmission and distribution services will continue to be regulated, but regulators will introduce market incentives to enhance market efficiency.

The micromarket segmentation that reshaped banking, telecommunications, and other services will come to the electricity industry. Customers will then choose from a menu of fixed, floating, and indexed price combinations. They will be able to select desired reliability levels for each load segment. They will have the choice

of multiple electricity products (price, reliability, service packages) from competing marketers, reaping lower costs and better service.

Electricity service companies will need to develop new risk management tools in this competitive market. With unbundled products and services, both customers and electricity service providers will need to find new ways to price risk (such as futures) and respond to risk (such as adjusting demand to real-time pricing). These risk-management tools will allow companies to capture the full benefits of market competition.

The Power of Paper:

The Role of Futures

Futures markets in grains, metals, flowers, livestock, money, oils, and other commodities have flourished and perished since at least the 15th century. New futures contracts for housing prices, advertising space, computer chips, insurance, and pollution emissions allowances are under consideration or newly operating as futures markets around the world compete to bring new risk-management tools to market.

Futures can accelerate industry restructuring. Treasury, currency, and stock index futures now strongly influence macro-economic policy. Crude oil futures helped revolutionize the oil industry in the 1980s, inviting upstart Wall Street refiners into the oil business. Natural gas futures accelerated the development of a fiercely competitive natural gas industry, made spot contracts more efficient, encouraged the development of storage, and enabled new product development (such as capped gas prices to industrial customers).1 Likewise, electricity futures could help remake the electricity industry.

The proposed New York Mercantile Exchange (NYMEX) electricity futures contract will help electricity sellers and buyers manage business risk. Under a NYMEX futures contract, a buyer could purchase 1,500 megawatt-hours at a constant 5 megawatts (Mw) (plus or minus 2 percent) an hour for 20 business days, during peak hours (7 a.m. to 10 p.m.). The power would be deliverable at 500 kilovolts at the Palo Verde, AZ, bus or the California/Oregon border under Western Systems Coordinating Council rules.

Futures could change electricity industry structure, products, and language. Generators could use a combination of natural gas futures and electricity futures to lock in a "combustion spread" between fuel prices and electricity prices. Electricity marketers or brokers could use electricity futures to lock in a margin between their energy-purchase and -sales contracts. Marketers or buyers' agents could use futures to offer customers electricity with designer prices (em such as fixed prices, capped prices, and collars (fixed-price ranges). End-use customers with heavy electricity requirements and fixed output prices (such as aluminum smelters) could use electricity futures to fix electricity input prices. Futures would allow market participants with different risk preference profiles to buy just the right amount of low-cost price-risk insurance.

Electricity futures and/or other electricity forward markets could provide increased price transparency, accelerating deregulation. Futures could provide important market information (for example, futures would provide a more efficient price index than the surveys used today). Strong futures or forward prices could provide clear signals to de-bottleneck the transmission system. Futures market information should also reduce the need for regulatory oversight of prices.

Futures price signals could provide a clear, measurable incentive for DSM. The market for avanced telecommunications-based personal demand-management products (such as PowerView from First Pacific Networks) should boom. Futures would also provide better supply-management signals. Futures prices could allow companies to finance short-term technological innovation to improve electricity production efficiency, extend asset lives, and enhance distribution efficiency at lower capital costs. Futures price signals could reshape hydropower storage and production patterns. Futures could become the most visible symbol of the new competitive electricity market.

Unfortunately, developing a successful electricity futures market will not be easy. Electricity faces much higher market structure and technological hurdles than natural gas. Moreover, the market may not need electricity futures.

The Challenge:

Why Futures Fail

At first glance, electricity looks like a perfect match for a futures contract (em electrons are completely homogeneous and price volatility is high. However, electricity fails important market tests. Most notably, electricity lacks a deep, highly liquid spot market.

Even though the U.S. electricity industry is highly fragmented, local control areas remain highly concentrated. Open-access rules have only begun to increase trading. Electricity futures will have a better chance if deregulation reduces local market concentration (perhaps by encouraging generation asset swaps and sales and increasing market size or participation through pools) and encourages transmission congestion pricing.

Asymmetric regulatory compacts have limited the incentive for utilities to trade electricity on a spot basis (em losses typically accrue to the shareholders while gains go to the ratepayers. Performance-based ratemaking represents a step in the right direction, but electricity futures would depend on allowing returns to match the risks companies choose to take.

Regulatory boundaries have inhibited trading (em state commission jurisdictions are often too small to build competitive structures. Ultimately, the markets would evolve to create larger, deeper, spot markets with competitively defined boundaries. Strong market reform must pave the way for an electricity futures market. Power pools offer a smooth, but rapid market reform path.

Electricity does present significant technological challenges. For example, electricity requires much stronger system control than either natural gas or oil. Electricity remains difficult and expensive to store. Electricity travels faster than traders can think, making it difficult to rely on unstructured, real-time market clearing mechanisms. Loop flow matters. Electrons stubbornly refuse to follow contract paths, choosing instead the laws of physics. System controllers must have instant access to generation ancillary services (e.g., spinning reserves, reactive support) and transmission control technology (e.g., reactors, capacitors). Electricity system stability depends on instantaneously balancing voltage, amperage, wattage, and frequency across all nodes in an interconnected power grid using advanced telemetry (em

cavalier free-riders can cause cascading blackouts, costing billions.

Finally, the market may not need electricity futures. Many competitive markets exist without futures. Electricity swaps and forward markets or natural gas futures might provide a more efficient substitute. Since few electricity industry participants have developed trading skills, futures liquidity might be low. Extended periods of low price volatility, delivery disputes, and bad luck might also derail a contract.

The Solution:

Deep, Liquid Pools

A well-structured power pool like the one proposed by San Diego Gas & Electric (SDG&E) could become the cornerstone of a competitive electricity market and provide a foundation for electricity futures. A deep, liquid pool with broad participation, flexible rules, and low barriers to entry certainly will not restrict the development of futures. The highly restrictive U.K. pool that originally granted market power to the generators and excluded traders is the exception that proves the rule (em a power pool should be a mechanism to promote competition, rather than reinforce oligopolistic behavior. A robust futures market can exist side by side with a forward contracts for differences (CfD) market. Many existing markets, including the New York Stock Exchange, testify that bilateral and auction markets can exist side by side.

Most who criticize the ability of a power pool to promote futures trading seek to undermine the power pool for other reasons (for example, speculators seek less

efficient markets to enhance trading profits). Power pools offer market efficiency, technical control, and fairness advantages over a pure bilateral approach.

The basic power pool model2 requires an independent system operator (ISO) to provide system control services, operate the transmission grid, and manage bidding markets. The ISO will have instant access to a pool of flexible generating capacity, transmission control technologies, and advanced DSM tools to maintain system reliability.

The ISO will create an energy bidding market to ensure economic dispatch. The pool will be open to all market participants on a real-time basis (em the depth and liquidity of the pool market will determine its success. Generators, traders, and DSM sources will bid a price to supply the system on a day-ahead, spot, hour-by-hour basis. The ISO will provide detailed market information to support market efficiency. The bidding results will determine the dispatch sequence. Actual demand requirements will determine the market clearing price. Prices should approach marginal cost. The pool and its CfD market will operate in coordination with a bilateral contract market. Structured appropriately to ensure broad participation among market participants with diverse risk preferences and market positions, the pool should become a deep, liquid spot market.

The ISOs will create a bidding market for reliability. Today, most regions carry expensive and excessive spinning, load following, and planning reserves due to inadequate coordination among control areas and inefficient price signals. The ISO would provide excellent reliability at a lower cost. Longer term, the ISO may facilitate the development of forward pricing mechanisms to provide appropriate market signals when new capacity is needed. The shape of the intersection between the supply and demand curves should provide an appropriate signal about the type of new capacity the market requires (see Exhibit 1).

Futures Can Swim

in Power Pools

Once a competitive pool spot market is well established, a strong electricity futures market could emerge. An efficient network of electricity pools, much like the network of natural gas hubs, could provide deep market liquidity, with prices highly correlated to a central futures market delivery point. The pool would provide cash-market price transparency, futures deliverability, and contract homogeneity. Futures could swim quite well in power pools.

Competition will reshape the electricity industry structure. Electricity futures could provide important market efficiency and risk management roles, but first the industry must address unique market structure and technological challenges. A well-structured power pool can provide the foundation for an effective cash market, while addressing these challenges. Power pools could provide a fertile ground for the development of electricity futures.

SDG&E has designed a power pool which allows for a competitive generation market and open access to transmission on a comparable basis for all generators. With this solid foundation in place, the market should have a key tool from which it can shape and structure an electricity futures market. t

Stephen Baum is an executive vice president with San Diego Gas & Electric Co. He has led SDG&E's efforts to design a new regulatory model. John Treat is a vice president with Booz-Allen & Hamilton's global energy practice in San Francisco. Mr. Treat was formerly president of the New York Mercantile Exchange. He introduced the crude oil futures contract and wrote the natural gas futures contract. The authors gratefully acknowledge the input of Bill Reed, director of strategic planning, and Ed Lucero, financial analyst, both of SDG&E; as well as that of Matt Rogers, principal, and Dana MacLaurin, consultant, from Booz-Allen's San Francisco energy practice.

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