Electricity Deregulation in New Jersey
The road to hell is paved with good intentions
More often than most would like to believe, regulation or laws that are enacted in an uncertain environment can lead to unforeseen consequences that are more detrimental than the initially desired objectives of those regulations. Take the Volsted Act for instance which brought about the 18th amendment and the situation better known as “prohibition”. While the initial hope was the elimination of alcoholism and its adverse social byproducts, it instead resulted in the rise of organized crime, unforeseen economic losses from the elimination of jobs, public health hazards like blindness and death from bathtub gin and shifts in the belief of many who were previously law-abiding, but who now had no problem breaking laws they viewed as unnecessary and oppressive.
With an objective retrospective analysis, we may draw similar conclusions on the results of deregulation of the electricity industry.
History of Utility Regulation and Deregulation
Prior to the 1970’s electric service for generation, transmission, distribution, and retail supply to the end-use electrical customer were all provided by utilities. State regulators granted exclusive rights in specific geographic franchises to utilities to take advantage of economies of scale. In return utilities agreed to be regulated and managed by a state regulator and recognized that they had an “obligation to serve” electric customers and could not deny them service.
Utilities set their pricing to cover their variable and overhead costs and recovery of their investment in infrastructure with a reasonable profit margin, all reflected in transparent and published tariffs for various rate classes. Utilities were regulated primarily by locally based public utility commissions.
Around the mid 70’s arguments began to emerge promoting generation and retail supply to end use customers as competitive markets. The beliefs were:
· Increased supplier and generator competition would result in lower pricing for consumers
· Consumers would have greater choice as to who they wanted to deal with
· Private investment would find its way into generation markets, offloading this burden from utilities and their customers
· Technology would advance at a much greater rate with non-utility R&D investment in a manner similar to what happened with cellular communications
· Pricing would be logical and market driven
· Generators would have greater flexibility in their fuel mix, providing a boost to evolving and desirable renewable sources such as solar and wind
· New business models would emerge such as demand response and other ancillary services which would improve grid efficiency and offer new revenue streams for generators and transmission operators
In the face of such persuasive and attractive arguments, what wasn’t to like? As a result, New Jersey, and many other jurisdictions deregulated both generation and retail supply services, decoupling an electric value chain that had been in effect and working well for the preceding half a century or more.
While transmission and distribution can easily be envisioned as processes that lend themselves to their highest and best organization as monopolies, generation and retail supply appeared to offer many opportunities for economy and efficiency if operated to a competitive market. Deregulation efforts included restructuring measures to introduce competition into the upstream generation market and the downstream retail market.
What has the change wrought?
While the rationale for deregulation on the surface would appear to make sense, one can never anticipate every contingency which may arise as a result of change. This is especially true when the case for deregulation was based on restructuring analogies from other industries which in retrospect, were not applicable to a vertically integrated industry like electricity.
Electricity is not inventoriable. In other industries, a manufacturer may sell to a wholesaler, who takes ownership of the product and either stores it, or sells it to a retailer, who takes ownership and then peddles the product to end-use consumers. The ability to inventory a product allows market participants to decide when to make it, when to sell it, when to buy from suppliers, and when to hold, driven exclusively by market conditions that produce the best option for themselves. There is no oversight as to the effect of these decisions on the end-use consumer.
The history of vertical integration for electric utilities was based on the unique physics of electric production and delivery. With very few exceptions, electricity cannot be stored and needs to be generated at the time when needed. For electricity to be transmitted from generator to consumer, supply and demand must remain in precise balance at all times across a large geographic area. This suggests that a central authority should govern both the supply and demand of electricity along with the carriers that operate on the power grid.
With generation and retail supply, separated from transmission and distribution, authority for governing each link in the value chain is scattered among multiple control entities, inevitably producing troublesome supply and demand imbalances driven by the differing business objectives of each participant in the value chain.
In New Jersey, the generation segment of the electricity value chain has multiple generators who make their decisions without the oversight of an authority charged with protecting consumer interests. The free-market dictates when generators run, how much they make, and when they add production capacity. Pricing and investment decisions are based solely on achievable profit.
Similarly, the retail marketer buys electricity from another party, the newly hatched middleman, or wholesaler, who will buy and release it to market only when he can make a profit on his merchant operations.
Wholesale energy markets can be thought of as two distinct markets, physical and financial, when it comes to the buying and selling of power. The financial market is the market most causing disruptions to equilibrium in the demand/supply balance required for stable electric markets:
Physical Electricity Markets
· The physical electricity market involves the actual generation and transmission of electricity from generators to the grid. RTOs and ISOs in these markets are tasked with balancing real-time and day-ahead supply and demand, making markets through an auction-based model. Since electricity cannot be stored in bulk efficiently, these markets are instant and ever-volatile
· Essentially “inventory” is not an option for the product (electricity) being purchased
Financial Power Markets
· Financial electricity markets include forward contracts, swaps, and futures contracts that allow participants to hedge against price volatility or speculate on future price movements, with or without involving physical delivery. Retail energy suppliers and their wholesale trading partners often engage in these markets to offer fixed pricing to customers outside of physical real-time or day-ahead hourly rates
· Transactions occur sometime in the future and provide the option of a “virtual” inventory of electricity
The generator, wholesaler, and retailer do not have the “obligation to serve” as former regulated utilities did. All three make self-serving business decisions on pricing, resource adequacy, and resource planning in response to market dynamics which do not involve balancing supply and demand to best serve consumers.
Transmission and distribution (T&D) operators, the remnants of the old vertically integrated utility, are both accountable to different masters. They are not synchronized in their resource planning. Transmission operators are accountable to the Federal Energy Regulatory Commission (FERC) and their respective Regional Transmission Organization (RTO) or Independent System Operator (ISO). While distribution is still overseen by local Public Utility Commissions in a specific geographic territory.
Communication between T&D entities and their regulators is fraught with fragmentation, often accompanied by lags in actions that would normally be required to ensure smooth coordination and handoff between two essential carriers. These essential carriers and their regulators are being “whipped sawed” in a constant state of confusion, caught between the bungling incongruence of their bilateral relationship, and the obvious disregard for their business objectives from fellow generators, wholesalers, and retail suppliers.
What is the market telling us?
Opening generation to participants other than regulated electric utilities began the transition to the situation we now face of high prices, shortages, and reduced reliability. In many instances, states forced regulated utilities to either sell their generating assets, or to place them in unregulated subsidiaries where decisions on capacity and operation were no longer overseen by local regulators.
Eighteen states plus the District of Columbia have deregulated retail electricity markets. The result of this restructuring has been universally disappointing.
According to a study by MIT’s Center for Energy and Environmental Policy Research:
“Prices have risen faster and remain higher in deregulated states, than in traditionally regulated states. While proponents promised that market competition would lower costs, structural market mechanisms and higher wholesale markups have instead resulted in residential consumers in deregulated states paying significantly more on average per kilowatt-hour. Importantly, the impact of deregulation on prices is theoretically ambiguous. Market-based prices provide incentives for profit-maximizing firms to reduce costs, but firms that have market power also have an incentive to increase markups. When cost efficiencies from deregulation are outweighed by an increase in markups, market-based prices can be higher than regulated rates. Thus, without efforts to protect and strengthen competition, such as regulatory oversight and antitrust enforcement, markets may be worse for consumers.”
The problems precipitated by market power exasperate adverse conditions. Market power appears in several forms. The first is the withholding of generation capacity where an owner of generation intentionally shuts down a power plant or reduces generating capacity in order to raise pricing on other plants they own in a given region. They base plant expansion decisions on high investment hurdles versus having adequate capacity to service consumer demand. Market power is also present in the form of strategic bidding, otherwise known as collusion, where accepted bids in the market are higher than they would be if generators competed directly with each other in a true free market.
In New Jersey, the unanticipated effects of deregulation are the principal cause of rising energy prices.
Who could have imagined:
· That merchant generators would manipulate production?
· That ROI’s for merchant generator investment would far exceed the allowed regulated rates of return on utility investment?
· That generators, transmitters and distributors of electricity wouldn’t play nice in the same sandbox with similar obligations to the consumer when it came to resource planning?
· That the introduction of wholesale middlemen and retail marketers would have incentives to sell power not in local markets near power plants, but to highest bidders resulting in transmission grids originally designed to service local monopolies, now being used for “wheeling” and movement of power over longer distances, underserving customers in the original local utility area?
· That deregulation participants in an uncertain market would not upgrade or maintain transmission and generation infrastructure in a timely manner, leading to reliability and resilience limitations?
· That Independent System Operators would be unprepared to efficiently approve hookups of new generation to the grid resulting in lengthy delays in responding to market conditions?
· That an ongoing imbalance in supply and demand, and continuing non-coordination of critical infrastructure resource decisions, would result in shortages and higher prices?
How can this situation be corrected?
So how can we put the genie back in the bottle? Concisely, the solution is re-regulation and the return of the vertically integrated electric utility. Economists believe that vertical integration is the most efficient organizational approach when several conditions are present:
· Infrastructure assets are highly specific to a given use or location
· Infrastructure assets are utilized in activities that must be coordinated
· Infrastructure assets are dependent upon contingencies that are hard to predict
When these conditions are considered for the electric utility industry, the advantages of vertical integration are indisputable.
What needs, or can be, done?
· Let owners of transmission and distribution also own generation
· Let state regulators oversee, plan for, and regulate generation, transmission and distribution in a synchronized manner which will induce coordination of resource decisions
· Let existing non-utility generators continue to compete with all generators in the marketplace
· Revert to regulated rates of return on new investment by utilities for generation and for acquisition of existing non-utility generation
· Consider establishment of a New Jersey Power Authority modeled after NYPA
· Consider an “eminent domain” approach for public or utility acquisition of existing generation if transition to a more stable electric marketplace doesn’t occur fast enough
There comes a time when one must admit mistakes and take corrective action. The federal government came to this conclusion after a failed experience with prohibition, and the government of New Jersey should do the same with their failed experience with electric deregulation.