Electric Market Restructuring in the 21th Century trading old for new shibboleths Richard O’Neill Chief Economic Advisor Federal Energy Regulation Commission Regulation, Industry Structure, and Market Power Conference Gold Coast, Australia 1 August 2003
Transitioning from Transitioning from planning and planning and dispatch to auction dispatch to auction and market power and market power mitigation models mitigation models December 11, 2008 2
Cultural Shibboleths Shibboleths Cultural � It takes a decades to change a cultural paradigm � Old timers are hard to convince but they often have good insights � Don’t let the model dictate the answer � Hammer looking for a nail � Assume Nash (no collusion) behavior when there is collusion � Jargon traps you in the old system � Use cost-based approach language in a auction based model � Small rules matter; all are not written � Mafia and the insurance � Culture matters � competition between gov’t corps (New Zealand ) � Utility execs become non-utility execs � Crown corp. becomes private corp.; buy corp jet and raise salary � Analogies often are often self-serving December 11, 2008 3
Fool me once shame on you fool me twice shame on me � Old culture: � government control of commanding heights (Lenin) � Sunk-cost-based pricing becomes costly � Transition paradigm: Thatcher-Reagan-Hayek � Laissez faire (almost) for commanding heights � Weak institutions lead to outlaw culture and abuse � New paradigm: where is the Tipping Point � market-based regulation for commanding heights � Keep prices in competitive range; Ignore sunk costs � Deal with externalties; transition to less regulation December 11, 2008 4
All markets are regulated the policy question is how? ☯ Contracts and Property rights : common law ☯ eminent domain ☯ Institutional rules: SEC, CFTC, … ☯ Antitrust (monopoly): collusion ☯ Does Nash behavior violate antitrust law? no ☯ Utility regulation: just and reasonable prices ☯ Punishments for illegal behavior ☯ Restrictions on behavior ☯ disgorgement of profits ☯ compensation of harm ☯ Fines and jail time December 11, 2008 5
Twenty-first century Luddites � Old testament: vertical integration with cost-of- service regulation is efficient � Technology innovation � Scale economies in generation have declined � Information technology has lowered scope economies � New testament: market structure amenable to more competition � Requires shift in regulatory authority from � Cost-based to market-based regulation � State to federal December 11, 2008 6 � Luddities stand in the way
Market-based v. cost-based regulation: it’s all about incentives � Imperfect regulation v. imperfect markets � Hayek/Lerner debate: which is more efficient � $200 billion in stranded cost � Cost-benefit test is soft � Tipping point for market-based regulation? � Market structure determines the tipping point � Market structure is dynamic � Depends on concentration, supply and demand � therefore the mitigation tools are dynamic � Dynamic mitigation has dynamic guard rails December 11, 2008 7
Cost-based v. market-based regulation approach Cost-based Market-based Fixed costs Allocated to Recovered in customers the market Variable Allocated to Used in bid costs customers caps market Discounting Market clearing design auctions Negotiated rates Recourse rate Bid cap Market power mitigation (rate cap) December 11, 2008 8
Market structure dictates efficient regulation ☯ Concentration ☯ Supply functions depend weather, e.g., precipitation ☯ Demand functions depend on weather, heat and cold ☯ Market mechanisms ☯ Contract structure ☯ credit December 11, 2008 9
The 20 th century utility regulation in a nutshell � FPA (1935) and NGA (1938): ‘just’ rates � Must give the opportunity to recover prudently (efficiently) incurred costs � Until late 1980s, cost-based regulation � Markets grow geographically � Scale economies decline � Franchised monopolies/fiefdoms � Late 1980s, tipping point switch to market- based regulation � jurisdictional turf: states v. feds December 11, 2008 10
. Analogies usually fail . Analogies usually fail not air traffic, natural gas or telephone electricity is not electricity is air traffic, natural gas or telephone � telephone: hush-a-phone and spectrum � air traffic controller: � no Kirchhoff laws � a reservation changes seats available on all other flights � natural gas: no valve; no storage � lead to a socialization of the market � subsidize real-time market � subsidize congestion December 11, 2008 11 � subsidize trading
The Enron phenomenon � Wall Street encourages Enron clones � Instead of a measured transition in California, we jumped to reasonably unfettered markets designed by Enron and its aspiring clones with intense lobbing and without any transition mechanism. � Result: Rube Goldberg market rules � Memo to Cal. strategies � Enron online: Enron told the Comm it was a bad idea? December 11, 2008 12
Market operator for system operator RTO commodity security coordinator capacity tariff administrator tx rights Transco/ gencos LSEs/discos Gridco/Isos What did we do before we went back to the drawing board? iou ENRON creates ether money; ENRON creates ether money; December 11, 2008 13 wall street believes! wall street believes!
� Pre-day-ahead markets � for transmission rights: CRT/TCC/TRCs/FGRs � for generation capacity/resevres (ICAP) � market power mitigation via options contracts � day-ahead market for reliability(valium substitute) � simultaneous nodal market-clearing auctions for energy, ancillary services and congestion � allow multi-part bidding � higher of market or bid cost recovery � allow self scheduling � allow price limit bids on ancillary and congestion � Real-time balancing myopic market December 11, 2008 14 � markets are nodal-based LMP with fish protection
Role of Transmission in Electric Markets � Traditional approach: Integrated Resource Planning � Plan system � Build assets � Add costs to rate base � Roll-in the costs � Order 888 � Rolled in v. incremental � ‘And’ v. ‘Or’ the ‘but for’ for cheap expansion � SMD and Merchant transmission December 11, 2008 15
Merchant expansion Merchant expansion � Public good: Eminent domain and environment � Test: contestability or no withholding � Operation under control of RTO/ISO: � open breaker option � system is no worse off � TX property rights without withholding � FTR and Flowgate rights � Choice seems to be DC subnetworks December 11, 2008 16
Transmission rate design and Transmission rate design and revenue requirement revenue requirement � Transco/Gridco does revenue requirement � Cost-based: traditional v. PBR � Incentive compatible � Benchmarking (EU): percent availability � RTO does rate design � Total revenue requirements via access charge � TX rights auctions for forward rights � Congestion fees � system expansion must go thru planning process � transmission property rights via RTO auction December 11, 2008 17
TX rights auctions TX rights auctions � Joint TX and generation auctions � San Fran nomogram � Hedging phase shifter settings � Point(s) to Point(s): FTR/TCC/FCR/CRT � “perfect” hedge except losses � If constraint set is nonlinear, no options contracts � Flowgate rights: elements or combinations � Option v. obligation contracts � Approximations � Linear: PTP decomposable � Nonlinear: PTP not decomposable; no PTP option December 11, 2008 18
ELECTRIC WHOLESALE MARKET PLATFORM FERC White Paper Issued April 29, 2003 � Why Issue A White Paper? � Let the industry, states, and others know Commission views about the scope and direction of a final rule � Explain changes in the proposal based on the comments and our outreach � Address legitimate concerns while moving forward to better wholesale markets December 11, 2008 19
The Commission Rule That Would � Establish a wholesale market platform with good market design and market power mitigation � Require public utilities to join an RTO or ISO � Allow regional flexibility in policies & timelines � Establish regional state committees to provide state input on FERC issues � Not require an element of the wholesale market platform if its costs outweighs its benefits � Not set retail rates, irrigation, flood control, … � Bottom up approach December 11, 2008 20
Wholesale Market Platform Goals Wholesale Market Platform Goals � improved wholesale competition � Reasonable transparent prices � Prevent market manipulation � Prevent transmission owners from favoring their own wholesale power sales � Encourage needed investment � Improve reliability � Recognize the regional character � Provide for federal and state cooperation December 11, 2008 21
MARKET PLATFORM ELEMENTS MARKET PLATFORM ELEMENTS � Market Power Mitigation and Monitoring � Regional Independent Grid Operator � Regional Transmission Planning Process � Fair Transmission Cost Allocation � Spot Markets � Efficient Grid Congestion Management � Firm Transmission Rights � Facilitate Resource Adequacy Approaches December 11, 2008 22
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