The Economists: On the Future of Energy Markets


Uncertainty clouds direction of FERC’s market engineering.

Fortnightly Magazine - April 1 2002

A boom-and-bust cycle has struck the electric power industry and economists are worried about its effect on industry restructuring. Many believe the latest boom period in power generation construction will now be followed by a period of insufficient generation capacity additions. If this prediction proves accurate, certain regions of the country could get hit with another generation capacity shortage in a couple of years, similar to the one that helped spark the price spikes and turmoil in California's electricity markets in 2000 and early 2001.

"The concern that should be on people's minds is whether we've set up a system that has an inevitable boom-bust cycle in it where we get these periods of demand growth, very tight markets and very high prices," says Paul Joskow, a Massachusetts Institute of Technology professor of economics and director of the MIT Center for Energy and Environmental Policy Research. "We see an over-investment in generation, so the market collapses. We then see companies going out of business and periods of no investment. I think that kind of a boom-bust cycle, as it emerges, is not going to be politically acceptable to many consumers and legislators."

Enron's meltdown also has had dramatic effects on the entire independent power industry in the United States. The independent generators' stock prices and credit ratings have declined and an enormous amount of capacity that has been in the development stage has been canceled. Joskow says he hopes the collateral damage to the independent power companies from Enron's collapse recedes and those companies can go back to doing their business.

"I'm now concerned that they are pulling back too much and that we're going to find ourselves in 2004 and 2005 back in a situation where we have too little generating capacity and find ourselves with price spikes again," Joskow explains. "I hope we can stabilize these markets so that investors can take a longer-run view and can respond to opportunities to enter into longer-term contracts and provide a more stable supply."

Marce Fuller, president and chief executive officer of Mirant, concedes the fallout from Enron has had a much bigger impact on the market than the California electric power industry restructuring fiasco. Enron "damaged confidence" in energy markets, she said at the CERAWeek 2002 conference in Houston in February.

The electric power industry isn't alone in its vulnerability to these types of cycles. Any other capital-intensive industry, including the automobile and steel industry, will go through cycles and will be dependent on general economic growth. Whether the electric power industry can avoid these types of cycles is open to debate.

"Very few industries can evolve out of a boom-and-bust cycle," says Mary Tolan, managing partner of the Resources Global Market Unit at Accenture. "And the bust part of the cycle tends to last two or three times longer than the boom periods." Tolan recalls that the most recent boom period in the electric and gas industry was very brief, lasting only two or three years.

Joskow contends the real question is how much of that cycle and the associated variance in spot prices are going to be borne by consumers-residential and small commercial consumers-and how much is going to be hedged away with longer-term contractual arrangements.

For most customers, Joskow explains, they're going to want to hedge much of the market volatility. "That's the job of retailers and utilities if they still have retail service obligations to try to come up with a portfolio of contracts that match consumers' risk preferences and balance the costs and benefits of shorter and longer-term commitments at fixed prices," he says.

Joskow predicts that one of the problems that might emerge in the Northeast United States, if a clear plan for retail competition is not developed, is many customers will be moving straight into the spot market. When a large percentage of customers are in the spot market, the industry begins to see bad investments and opportunities to exercise market power.

"I think the natural equilibrium for end-use customers is one where the vast majority of demand-85 percent to 90 percent-is forward contracted out for periods of one to five years," Joskow says. "And the spot market is primarily a balancing market that allows generators to trade with one another when they have lower cost power."

In New England, most utilities agreed to a default service obligation at a fixed price for a number of years during restructuring negotiations with state public utility commissions. But these service commitments end in two or three years, and there's little hope retailers will be able to grab many of these customers if the trouble they've had attracting residential and small commercial customers during the transition phase is any indication.

"The question is, what happens when these standard offers come to end?" Joskow asks. "Do we just throw the customers out in the spot market? What's going to happen? As of now, the answer is, there is no answer. That seems to be an agenda item that states like my own, Massachusetts, and Rhode Island, New York, New Jersey and Pennsylvania really need to focus some attention on."

The Power of Price Responsiveness

Bruce Humphrey, an economist and vice president of Xenergy Inc., suggests all parties involved with retail restructuring need to look for ways to obtain price-responsiveness on the consumption side. "Without price responsiveness, and if it's only quantity and not price adjusting, you get the behavior you got first in the Midwest and then out in the West," Humphrey says. "The big hurdle to overcome is creating mechanisms and technologies that allow consumers of whatever size to react to short-run prices in the marketplace. As long as consumers are facing some version of average cost, then the benefits of competition will be difficult to achieve."

Behind the California and Enron events, though, Humphrey sees a big story in the background where as many as 50 million customers accounts "are now nominally free to choose their supplier. "As we come out the end of this transition process, which is not that many years away, that is quite a large number of customers and more are coming," he says. "I think the transition pricing issue will resolve itself over time, both through market forces and regulatory decisions. I think new entrants will be attracted to the market once the customers begin to move."

Economists agree that San Diego's foray into retail electric power choice during the summer of 2000 was a disaster. San Diego residents were the first customers in the United States to be granted the freedom to choose their electricity supplier without the backstop of price caps, frozen rates, or standard offer service at guaranteed prices.

When electric bills more than doubled with the lifting of price regulation, San Diego residents, who had grown accustomed to steady electric bills on a year-round basis, revolted and the state's regulators were forced to put a cap back on the price of the commodity. Because of the dramatic spike and subsequent political reaction, little was learned from the first full retail electric unbundling episode in the United States.

"I can't say whether we saw any significant response on the demand side or not," says Charles Stalon, an independent economist and a former FERC commissioner. "What we did see was this quick response on the political side. What we also saw then was a revelation of the absurdity of the political compromise that had been put together in California in the early days."

One of the realities of a market system is that price volatility plays a very important role in guiding use of scarce resources, Stalon explains. "But one of the first rules of politics is people hate price volatility. Reconciling those two conflicts is a large part of what we're all about. I don't think the kind of volatility we had in California is necessary for efficiency. But some price volatility is."

Humphrey says he has no problems with what happened in San Diego in terms of the economics of allowing the electricity prices actually to track what was going on in the marketplace. "But the education on the part of San Diego Gas and Electric, even more so on the part of the political powers that be there, were probably inadequate," Humphrey adds.

Joskow agrees that the electric power industry learned that neither politicians nor consumers in California were prepared for the market conditions that emerged in San Diego during the summer of 2000 and the subsequent market turmoil up and down the state. "All of these retail competition programs and industry restructuring programs in California and the Northeast were sold aggressively as programs that would reduce the price of electricity," Joskow says. "The proponents of these programs, especially the marketers, the independent generators and the industrial customers, never entertained the possibility the prices would go up."

Now that politicians have seen that prices can go up or down in a competitive market, they will need to re-educate themselves and consumers about the implications of restructured energy markets, he says.

Joskow also emphasizes that developing a system that benefits consumers should be a high-priority item. "I think that's the primary focus that people's minds should be on," he says. "It's not a question of creating opportunities for marketers or for other entities."

States in the Northeast as well as Texas, Michigan and others, appear committed to trying to make the new approach to organizing the electric power industry work. "I think it's too late in many cases for them to easily put the toothpaste back in the tube," he says.

Appreciating Vertical Integration

That's not to say the vertically integrated utility doesn't have any merits. "I think that the traditional, vertically integrated utilities that emerged in the United States in the 20th century have been unfairly maligned," Joskow argues. "By international standards, on average overall, the U.S. electric power industry has performed very well. I think it's a mistake and it's actually inaccurate to characterize the old system as being grossly inefficient."

Stalon notes that the traditional utility companies that have yet to be broken apart continue to get stronger. Provisions in the Energy Policy Act of 1992 that altered the Public Utility Holding Company Act provided many benefits to electric utility companies, including the chance to invest more liberally on the international scene. "You can't walk in a foreign airport these days without bumping into somebody from Southern Co. or Duke. If you look at the AEP merger with [Central and] South West, and you think, that's an integrated utility? And yet the courts seem to be saying, that's okay. Well, what isn't okay? It strikes me at this point that any kind of merger is permissible under the law."

Efforts to create efficient energy markets similar to systems in place in PJM, New York and New England are not a top priority for large utility companies, Stalon contends. "If you're big, you don't have to have an efficient energy market because you can satisfy your contracts out of your great diversity of capacities. It's only the small generator who knows he is totally dependent on a free market."

The large utilities certainly have no right being unhappy with the way policy has evolved, Stalon says. "They've gotten bigger and bigger all over the world, bigger inside the United States. They have created new definitions of what constitutes competition and integration of markets. They've gotten what they've wanted out of this delay. I'm not at all sure what they would want at this point, and I think the last thing they would want would be someone saying we're going to spread PJM nationwide."

And yet, Stalon isn't convinced FERC's inclination toward larger transmission organizations is the right path to follow. "I guess I am a little skeptical about the wisdom of pushing for bigger and bigger RTOs," he says. "I thought it would be easier to create smaller-sized ISOs and then work on the seams issues than it is to create these giant organizations. FERC gave up what I thought was a tough issue for one that was twice as tough."

The goals of power merchants and generators often have conflicted with the development of efficient ISOs. These players have preferred a bilateral market and have not wanted an ISO that would manage the spot market at all, Stalon notes.

ISOs always will be an extension of FERC because the commission, with its limited manpower, can never police all of the markets across the United States without bringing in the ISOs as their agents, Stalon says. "That offended many of the big generating companies and the big generating wannabes," he notes. "After all, you don't make a lot of money in a highly efficient market. You make money, both as a trader and as a speculator, in an inefficient market."

Stalon says the push for an efficient market always was hounded by those who wanted "all of the emphasis placed on removing all the regulation and letting the parties that now exist trade power, which means, let all the big guys control this market and don't allow anybody to come up unless it's a private enterprise group, unregulated in any dimension, to create a spot market."

Flaws with the RTO Model

Joskow says he has sympathy for the need to have reasonably standardized wholesale markets in large regions with a transparent and flexible transmission platform that overcomes the problems associated with balkanized ownership and operation of transmission. But he also has concerns about FERC relying on institutional structures that are non-profit, quasi-government agencies that don't own assets and inevitably are going to be highly politicized.

"If I had my way and I were the benevolent dictator, I think we could meet FERC's goals by creating regional grid companies like in England and Norway and Sweden, New Zealand, Australia, Argentina, almost every other country that has done this that are independent of market participants, that own assets and that can be operated under performance-based regulatory mechanisms and really do a good job on focusing on the provision of transmission," Joskow says.

There are serious questions, he says, as to whether regulators are setting up a system that will lead to adequate amounts of investment in transmission capacity in the right places. He's discouraged that FERC hasn't focused on providing transmission owners financial incentives to reduce congestion and invest in new transmission capacity.

"We have models around the world that work," Joskow says. "I'm a big fan of looking at things that work in reality, not just looking for them to work in theory. We are adopting a set of institutions that exist nowhere else on Earth. I think American regulators on the incentive front are 25 years behind the times."

Joskow believes there are serious risks in separating the operation of the electric power network from the ownership of the assets and in not having an appropriately structured performance-based regulatory system that is viewed as a necessity rather than a privilege for companies.

"Performance-based regulation isn't a bribe you give to companies," he says. "It's a way of establishing what your expectations are for providing financial incentives to align the incentives of the owners of the assets with the goals of the regulators and policymakers."

Stalon believes there's often an element of luck in creating successful markets. "There are very powerful interests involved in creating systems of regulation and in changing it," Stalon says. "You have to be lucky and find the right time. So far we don't seem to have found it in electricity."

A coalition on Capitol Hill hasn't existed to move forward with creating a viably efficient and competitive electric power system. "Enron was one that was trying to provide leadership," Stalon says. "Now that its leadership will be dissipated, it's not clear who is going to take the leadership in restructuring. After all, if you are a large generating company, it is not a competitive market you want. It is a market in which you can exercise monopoly power in an unregulated environment."

While concerned about how Enron's collapse damaged certain segments of the industry, Joskow also believes the company's demise has taught policymakers and regulators to keep an eye on the problems of corporate governance and disclosure, instead of focusing only on market structure.

"It turns out many of their investments were unsuccessful," Joskow says. "They went to great efforts to hide that. It looks like what Enron was most innovative in was cooking the books and avoiding responsible disclosure."

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Discouraging Results Not Enough to Deter Leading Academic

Policymakers tend to forget how all of the pieces of an electric power system need to fit together properly for electric markets to work with the least amount of friction, says Paul Joskow, the noted professor of economics at the Massachusetts Institute of Technology, who has authored a number of books and scholarly papers on the electric power industry.

In Britain, for example, regulators kept track of the relationship between all of the different segments of the electric power industry, to an extent that, when regulators did identify mistakes in the system, they were able to remedy the problems before restructuring was thrown completely off track. "I think the British did it the right way in the sense that they took a long-term view," Joskow says. "The most important part of the British system is they structurally set it up in a way that was very conducive to competition, to creating a very smooth and efficient platform for trading energy on the network, for eliminating congestion."

The success that other countries are experiencing with electric industry restructuring is exacerbating Joskow's frustration with the turn of events in U.S. electric power markets. Given his long career working on electric industry issues, Joskow expresses a certain sense of duty to prove that electric power markets in the United States are capable of functioning efficiently and smoothly.

"I've been working on electricity regulatory and deregulatory issues for 30 years and events of the past two years have been very disappointing to me," he says. "I feel like I have a responsibility to consumers in the United States and to people who've read what I've written and listened to what I've said to work with responsible regulators to make markets work and to find the best solutions."

Joskow, who joined the faculty at MIT in 1972, the same year he earned his Ph.D. in economics from Yale, says things are happening too fast in the industry to consider writing another book on electric power anytime soon.

But Joskow says he's looking forward to the next couple of years so that he can provide a "public interest voice" to assist FERC and state commissions. Later this year, he plans to file comments on FERC's anticipated "giga-NOPR" on standard power market design.

As for California, Joskow laments that if only the state had followed the British model, the electric power industry may not have received such a black eye.

"Initially, they were on the path of replicating the U.K. system and I think if they had done that, they'd be a lot further along," Joskow says. "One of the things that the U.K. system had when they divested the generation is they set up vesting contracts, which were forward contracts. If California had done everything they've done in the U.K., they wouldn't have had these problems." -MH

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Veteran Regulator Finds California Behavior Strange, But Clean

Charles Stalon has worn many hats during his long career in the electric and gas industries. Aside from serving as a FERC commissioner in the 1980s and as an Illinois Commerce Commission member prior to that, Stalon has sat on the boards of ISO New England and New Jersey Resources, and has served as a member of the advisory council of the Gas Research Institute and on the Harvard Electric Policy Group.

After retiring in 1993 from his position as director of the Institute of Public Utilities and Professor of Economics at Michigan State University, Stalon moved to Cape Girardeau, Mo.-a scenic riverboat town along the Mississippi River and only 40 miles north of the New Madrid Fault-where he set up his own private consulting practice.

Undeterred by spring flooding of the Mississippi or speculation about an earthquake striking the biggest fault line in the United States east of California, Stalon has spent the last decade in southeastern Missouri examining the best methods for designing and implementing competitive electric power markets. Included among his many tasks was serving on the first market monitoring committee of the California Power Exchange, prior to the eruption of the state's electric restructuring program.

Consistent with statements by generators operating in the state, Stalon says he never saw any evidence of manipulation in the market. "Let's draw a distinction here between raising the price of energy in that market versus raising prices in a forward market temporarily that do not cause any increase in the price of energy. People bet wrong all the time," Stalon says. "There were no real signs of market manipulation by any significant player."

Stalon, described by former FERC commissioner Oliver "Rick" Richard as the most intellectual of the members to serve on the commission, says the monitoring committee did notice some strange bidding behavior. "When we would challenge the industry on the bidding behavior, we would get explanations that would send cringes up and down the back of anybody who had been through sophomore economics," he remembers.

In theory, Stalon says, all competitive generators bidding into such a spot market as California would bid their short-run marginal cost curve. "But we would go into meetings with the industrial groups and somebody in the group would stand up and make the argument, 'you can't possibly make any money just bidding your short-run marginal cost curve.' And many of them were not."

They would bid into the market, he says, as if they were trying to game the system. "And yet it didn't make any sense to be gaming. It wasn't in their interest to be gaming. They were not raising the price by gaming," he explains. "But we would see them bidding higher than their short-run marginal cost curve. It was a puzzle. I never really figured out why they were doing it. We couldn't deduce any pattern of price increases because of this behavior." -MH