Competitive Electricity Markets

Design, Implementation, Performance

Fereidoon Sioshansi

• Publisher: Elsevier Science
• Year: 2011
• ISBN:
  9780080557717
• Topic: Technology & Engineering
• Subtopic: Electrical Engineering & Telecommunications
• Index: Technology & Engineering

After 2 decades, policymakers and regulators agree that electricity market reform, liberalization and privatization remains partly art. Moreover, the international experience suggests that in nearly all cases, initial market reform leads to unintended consequences or introduces new risks, which must be addressed in subsequent "reform of the reforms." Competitive Electricity Markets describes the evolution of the market reform process including a number of challenging issues such as infrastructure investment, resource adequacy, capacity and demand participation, market power, distributed generation, renewable energy and global climate change.

• Sequel to Electricity Market Reform: An International Perspective in the same series published in 2006
• Contributions from renowned scholars and practitioners on significant electricity market design and implementation issues
• Covers timely topics on the evolution of electricity market liberalization worldwide

Part I

Market Reform Evolution

Outline

Chapter 1: Reevaluation of Vertical Integration and Unbundling in Restructured Electricity Markets

Chapter 2: Hybrid Electricity Markets: The Problem of Explaining Different Patterns of Restructuring

Chapter 3: Achieving Electricity Market Integration in Europe

Chapter 1

Reevaluation of Vertical Integration and Unbundling in Restructured Electricity Markets

HUNG-PO CHAO¹, SHMUEL OREN² and ROBERT WILSON³, ¹ISO New England, USA; ²University of California, Berkeley, USA; ³Stanford Business School, USA

Publisher Summary

This chapter critically reviews the argument for vertical integration in the electricity industry. It also reviews the argument for restructuring based on unbundling of its products and organizations in favor of market mechanisms. It concludes that both arguments are deficient and that a balanced mixture of vertical integration and liberalized markets is superior to the extremes. Their central conclusion is that efficient management of the risks inherent in the electricity industry requires that restructuring retain universal service for the core of non-industrial customers who rely on regulated rates smoothed over time to recover the costs of service. It addresses basic economic issues posed by restructuring. The central issue is whether the overall technology of the industry—wholesale generation, transmission, and retail service—necessarily implies more or less vertical integration. It was long thought and is still being argued by many that vertical integration of retail utilities was essential for efficient investments and operations. On the other hand, restructuring has often been motivated by the view that the purported advantages of vertical integration are obsolete, that liberalized markets can work well, and that they bring stronger incentives that are likely to result in more efficient investments and operations. The argument presented in this chapter is that neither view is conclusive that pros and cons can be mustered on either side without any clear indication that one or the other extreme is better.

Summary

This chapter critically reviews the argument for vertical integration in the electricity industry, and also the argument for restructuring based on unbundling of its products and organizations in favor of market mechanisms. The authors conclude that both arguments are deficient, and that a balanced mixture of vertical integration and liberalized markets is superior to the extremes. Their central conclusion is that efficient management of the risks inherent in the electricity industry requires that restructuring retain universal service for the core of non-industrial customers who rely on regulated rates smoothed over time to recover the costs of service.

1.1 Introduction

This chapter addresses basic economic issues posed by restructuring. The central issue is whether the overall technology of the industry – wholesale generation, transmission, and retail service – necessarily implies more or less vertical integration. It was long thought and is still being argued by many that vertical integration of retail utilities was essential for efficient investments and operations (e.g., see Michaels, 2006). On the other hand, restructuring has often been motivated by the view that the purported advantages of vertical integration are obsolete, that liberalized markets can work well, and that they bring stronger incentives that are likely to result in more efficient investments and operations (e.g., California Public Utilities Commission, 1993). The argument presented here is that neither view is conclusive – that pros and cons can be mustered on either side without any clear indication that one or the other extreme is better.

In prior work (Chao et al., 2006) the authors argued that restructuring of the electricity industry should develop along a middle path between the extremes of vertical integration and liberalization of wholesale and retail markets. This middle path establishes the boundaries of the firm – the extent to which a retail utility should retain some degree of vertical integration. A key element of this choice is the make-or-buy decision about whether to own and manage supply resources, or to rely on wholesale markets via either spot purchases or longer-term contracts. A middle path also requires restructuring of regulatory policies and redefinition of the regulatory compact to recognize the effects of investment, purchasing, and contracting decisions by utilities in the context of liberalized wholesale markets, and to strengthen incentives for efficient operations and demand response. Moreover, the optimal extent of vertical integration is ultimately determined by the requirements for efficient allocation of risk bearing. After restructuring, the most important determinants of the optimal degree of vertical integration concern risk management, which affects the cost of capital – the ultimate measure of financial risk – and supply reliability and resource adequacy – the ultimate measures of physical risk. (See also Correljé and De Vries, Chapter 2 in this volume.)

From the perspective of risk management, the mutual interests of suppliers of generation and retail service enable risk sharing that mitigates financial risks. Depending on local circumstances, their shared interests imply a greater or lesser degree of reliance on markets and contracts, or on direct ownership that perpetuates some degree of vertical integration. For example, a utility might meet some resource adequacy requirements by contracts or by purchases in capacity markets, and also own generation facilities that serve its core retail customers within a regulatory scheme that continues the traditional regulatory compact, albeit with stronger incentives from market forces and performance-based regulation.

Section 1.2. begins by reviewing the case for vertical integration of utilities that prevailed through most of the twentieth century. Section 1.3. examines anew these arguments in the current context and finds them greatly altered – in part by the evident successes of some aspects of restructuring. The discussion of economic issues in Section 1.2. includes a summary of explanations of vertical integration in the literature. This discussion is necessary because ideas from this debate have greatly influenced restructuring decisions by regulators and legislators, especially in Europe recently. It also clarifies the distinction between financial and organizational “unbundling” of a utility’s vertical components – wholesale generation, transmission, and retail service – and unbundling of the corresponding products. In the regulated era, the organization of the electricity industry stemmed from vertical integration of utilities in all respects, while in the past decade much reorganization aimed at segmenting utilities into their vertical components in conjunction with unbundling of their products. In several cases, organizational unbundling of firms was seen as a necessary or desirable complement to unbundling of products to facilitate liberalized wholesale markets. Although organizational disintegration was rejected in most other liberalized industries (transport, telecommunications, etc.), regulators and legislators favored dissolution of vertical organization in the electricity industry for reasons that are reviewed.

Section 1.4. reviews some of the unsolved problems of liberalized markets, including both those that cannot be solved efficiently by market processes and those that have not yet been solved adequately by market restructuring. Section 1.5. develops the case that risk management considerations are major determinants of the degree of vertical integration in terms of organization and ownership and vertical contracting. Section 1.6. concludes by outlining some implications for the evolution of restructuring. This discussion introduces scenarios in which a desirable degree of vertical integration coexists within liberalized wholesale markets for unbundled products, and which allow a utility to serve core customers at regulated rates while others opt to purchase from competing suppliers.

1.2 The Historical Mo...