Moving to Competitive Utility Markets:
Parallels with the British Experience
by
Dr. George Backus
Policy Assessment Corporation
Denver, Colorado, USA
and
Susan Kleemann
Systematic Solutions, Inc.
Dayton, Ohio, USA
Introduction
Although the UK privatization and the US deregulation of the electric industry
start out from different places, comparative historical and simulation analyses
show they will tread similar economic paths and quickly develop into dynamic
industries characterized by gaming, volatile prices, overbuilding and eventual
consolidation.
The British Experience with Privatization
The official UK deregulation is considered to have begun on March 1, 1991. As of
summer 1996, privatization of the nuclear components and the National Grid
Company (NGC) appeared imminent. With an average load of 50,000MW, the UK
capacity mix includes both old and new, nuclear, hydro, pumped storage, combined
cycle, gas, oil, waste, coal, and wind generation. At the initial break-up, the
UK system was comprised of 12 Regional Energy Companies (RECs), three primary
generators, independent power producers (IPPs), "special" entities such as
pumped storage facilities owned by the NGC (National Grid Company), and two
vertically integrated Scottish companies.
Unlike the US, the UK government owned the original Central Electricity
Generating Board (CEGB) whose break-up and privatization led to the current
system structure. The CEGB components were sold for less than 20% of their
estimated book value. The RECs are regulated via prices that escalate with
adjusted inflation. Under-priced assets along with the new flexibility to
control costs, naturally led to impressive profits. Because most of the US
system is privately held, this mechanism for profit-taking will not be part of
the US market dynamic - other than possibly through the acquisition of
municipal, cooperative and large federal PMA assets.
The British system is essentially a spot market pool where all participants must
bid in the day before. The NGC then determines a least-cost dispatch based on
anticipated load, merit order (bid prices), and plant availability. For the next
day's dispatch all generators are paid the current system marginal price (the
bid price of the most expensive generation unit needed to operate). System
operations and load following may require some higher costs plants to be
dispatched early (constrained-on). Some lower cost generation may not be
compatible with current load conditions and could be constrained-off. All
available generators, running or not, receive a capacity payment (called the
LOLP) which is the LOLP*(VOLL-max(SMP,bid price)), where the LOLP is the loss of
load probability and VOLL is the value of loss of load.
The Phases of Deregulation
Transient disequilibrium conditions are forced on US and UK electric markets
going from a regulated to a deregulated environment and they last until existing
power plants, transmission lines, and customer equipment convert to a
configuration appropriate for the new environment. During transition, market
distortions necessarily exist which provide opportunities to the clever and
catastrophe to the unwary.
2
The six phases of deregulation are arbitrary, overlapping classifications. The
last phase may begin before the first phase ends; some phases may dominate the
market for years while others may be passed through before they are recognized.
Growing evidence from both the British experience and simulation modeling
suggests that the US system will pass through all the phases without exception
and reach the final phase as its still dynamic endpoint. The six phases are:
Transitional Market, Massive Restructuring, System Divestiture, Market Gaming,
Re-regulation, and Industry Consolidation.
Phase 1 - Transitional Market
The transition phase corresponds to regulators' attempts at "giving" up control
while controlling the consequences. The changes between the FERC Open Access
Ruling and the original Mega-NOPR alone substantiate this premise. The Open
Access Ruling really had little to do with transmission - transmission simply
provided the last vestiges of control. This control is needed as regulators
continue to respond to complainants who want a level playing field that tilts in
their favor. As each rule affects a new set of constituents, more rules are
invoked in the name of "fairness." Ultimately the rules increase to the point
where compliance becomes an overwhelming task and a collective solution that
removes direct responsibility must found - in this case usually an Independent
System Operator (ISO). Although an ISO will work, secondary dynamics result in
excess capacity, non-converging higher prices and gas market consolidation.
Volatdle, Non-convergingPrices
As the UK utilities have learned, "optimal" analyses don't work in a competitive
environment with physical constraints, because any "gamed" action makes the
optimal plan less than optimal, and the competitor's loss is the game player's
win. Further, this "gaminge advantage provides economic motivation to avoid the
"market clearing price" and to keep the market volatile - just like in any other
commodity market. Evidence of this gaming behavior is found in UK bulk power
markets - a highly volatile market where provisional pool purchases prices have
varied from lp/kwh to 1 .11/kwh. Figure 1 displays the dynamics of the bid price
for aggregations of plant-types that should have similar, consistent avoided
costs. "The message from the UK is clear. It was incorrectly assumed that the
new commercial entities would continue to operate by the intent of the rules,
even if not formally stated, when the new structure began. But commercial
markets are commercial markets, profits are profits and any commercial advantage
will be taken." (Tabors 1996, p. 49)
Comnparison first incremiental bids
[GRAPHIC OMITTED]
Figure 1: Bid rice Dynamics By Pant Type (OFFER 1992)
An historical analysis of independent power production i the US indicates that
deregulation will not produce generation marginal cost pricing either. In
regions where IPPs are common prices were neither falling not converging to a
single value; the prices from one of the operating PPs could be twice that of
the least expensive operator. (Comnes 1996)
Fipgre 2: Declared Capacity Vaiation (OFFER 1992)
Excess Capacity
In the UK, the "books" show roughly a 20% reserve margin, but that neglects 8GW
of disconnected capacity. If all this capacity were included, the reserve margin
would approach 40%. If all planned capacity is considered, including 24.4GW of
CCGT, then the reserve margin approaches 50% by 2000 and subsequently declines
as more plants retire. (NGC 1995) Figure 2 illustrates the "hold-back" dynamics
of capacity in the UK electricity market. In the US, electric utility analysts,
competing in a competitive market simulation game (CIGMOD) routinely built CCGTs
based on economic considerations, raising already high reserve margins.
Natural Gas Market Consolidation
IPP's in the UK see the gas spot market "as an attractive option to burning
contracted gas for electricity generation, thus effectively raising the expected
profits of an IPP with a gas
Total available capacities
[GRAPHIC OMITTED]
1991 1992
contract, as he can choose whether selling electricity or gas is more
profitable." (Newbery 1995a, p. 15) While TransAlta in Canada must decide
between building generation plant in the US and transporting gas or building
plant in Canada and transporting electricity to the US, US utilities are busy
deciding which gas companies would make good partners (such as Texas Utilities
and Houston Light & Power mergers with large gas utilities.) Additional
perspective of the US potential of multi-fuel arbitrage is provided by Vu and
Denard. (Vui 1996) They show that the current "gaming" conditions in the NW are
an "arbitrageurs dream." The price of gas and electricity fluctuate by factors
of 6 as seen in Figr 3.
5
DAILY PRICE OF ELECTRC#TY AND GAS
[GRAPHIC OMITTED]
Figure 3: Arbitrage of Gas and Electricfy in the US Northwest (Vu 1996)
Phase 2- Massive Market Restructuring
Within the context of partial deregulation, a number of problems take oot in the
definition of who has what rights. Reallocating these ights then undermines the
justification of previous positions. In speaking about the early days of the UK
deregulation, Hunt notes that: "Despite its many virtues, there are many reasons
to believe that the generally wholesale competition will be merely a way station
and testing ground for fuldl retail competition. Probably the main reason is
that both in the United Kingdom and in the United States, when authorities have
tried to grant some types of customers open access to sellers while excluding
others, the problems of definition have become acute." (Hunt 1996a, p. 22)
TIhe power of the deregulation dynamics indeed shows itself in US movement
toward retail wheeling. One description of the process: "Deregulation in one
state puts pressure on its neighbors to follow suit, often from major industrial
end-users concerned about losing a competitive edge through having to pay higher
prices." (Trader 1996, p.8)
Phase 3 - System Divestiture
Once deregulation achieves retail wheeling, conflicts among generation,
marketing, transmission and distribution widen. Generation struggles in the
market place every moment of every day balancing high risks and high potential
gains. It has strong cash flow requirements and must behave in a competitive
fashion by targeting markets and restricting access to information. Because
transmission is still regulated, it has "an obligation to serve with minimal
chance to earn significant returns. If transmission expansion is required, the
assets of the generation would be needed to s ecure investment finds and support
the project putting further economic pressure on the generator. This conflict of
interest requires the two to severe all ties.
6
In addition, the distribution portion of the utility experiences regulatory
pressures to minimize cost. If marketing is part of distribution, it must find
low cost suppliers to maximize its market shares. The associated generator would
then need to negotiate contracts under competitive bids with other generators.
Further, the distribution company may find the generation supply the
transmission topology allows is more expensive than that from a CCGT plant it
could build nearby on its own. The pressures to divest become acute.
As mentioned before, the creation of an ISO critical. The abundance of
operations problems and conflict-of-interest transactions find generic solutions
only within the confines of a unbiased third party such as an ISO. But the
market-forces creation of the ISO also adds pressure to separate distribution
from transmission.
In the US, the temptation to game the transmission system is strong. The
multiple connection points of unequal capacity can generate loop flows on a line
with limited capability. Most NERC reliability regions require line load relief
even if only the contingency is threatened. Generation representing as little as
5% of the line flow will be forced to reduce power or come off-line. In general,
100MW of required line load relief typically causes 400 to 600 MW to come
off-line. (Hogan 1995, p. 35) The gaming of a small amount of generation in one
area can have major impacts in another; there is no static competitive circle or
a local generation market in the US One has only to remember July 2nd and August
12th 1996, when huge power outages occurred on the robustly designed Pacific
Intertie transmission lines. This massive loss of power in the Northwest
indicates the far reaching impacts of local phenomena.
With a leverage as high as 7 to 1, the monetary value of such transactions
becomes hard to resist. Excessive operational rules to prevent such
possibilities would limit flexibility and, therefore, cause added system
reliability and stability problems. New legal methods just create new pressures
(loop holes) at the limits of the new law.
Phase 4 - Market Gaming
The'physical constraints on the system as well as payment rules, cause market
distortions that can be gamed. Additional rules designed to avoid excessive
profit taking are merely new distortions causing new, albeit different, gaming
tactics. This gaming option makes optimal, equilibrium-pricing an outmoded
concept because any gaming causes a loss from the competitor's optimal plan to
benefit the game player. Volatile pricing and rewards for "surprise" tactics
constitute the preferred market condition.
Gaming Generation Plant Availability
With variable costs dominating the spot market, capacity costs need to be
included elsewhere in the price to make generation financially viable. In the
UK, capacity payments are made to all available plants running or not. The
capacity charge (LOLP) is a strong function of available capacity versus
expected demand. By making plants "unavailable," generators can dramatically
affect the value of this capacity charge. The capacity charge plus the System
Marginal Price (SMP) determines the pool purchase price (PPP). Adding the
average cost of transmission, including losses, plus payments to constrained-off
generation, gives the pool selling price (PSP) that RECs would experience.
Newbery shows the
7
relationship between peak reserve margin versus LOLP/SMP and indicates the
dramatic exponential growth needed in capacity charge to "clear the market" for
capacity. A 20% variance in reserve margin produces a thousand-fold increase in
capacity charges! This dramatic price response can cause generators to remove
plants as the price increases, knowing that remaining plants will be worth even
more. (Newbery 1995, p. 50)
Early into the UK deregulation, the generator PowerGen, learned to make plants
unavailable for maintenance and then make them suddenly available when its own
unavailability had caused the capacity charges to rise substantially. Because of
this practice, new rules require a plant to be out seven days before its absence
affects capacity charges. With new rules, come new games. Now a plant that goes
off-line because of failure may be better off to wait until its outage has
driven up the capacity charge before coming back online. (Newbery 1995, p. 57)
Further, when a significant plant does become unavailable for cause it may
signal other plants to go off-line to increase the capacity charges. In fact
when the LOLP is almost unity, the reward for making capacity available may be
zero or negative because of its impacts on reducing capacity charges.
Gaming Transmission Constraints
Generators remain successful at "gaming the transmission constraints to increase
profits (via increased uplift payments).." (Newbery 1996, p. 63) The UK is
winter peaking and had abundant transmission capacity prior to deregulation.
Generators appear to have learn how to improve their ability to produce
constraints even in shoulder periods as shown in Figure 4. Note also that both
low and high voltage lines undergo constraint activities.
Cost of transmission constraints
[GRAPHIC OMITTED]
Figure 4: Learning to Constrain (OFFER 1992)
Because of local transmission constraints, plants that would minimize overall
system generating costs may have to be "constrained-off" and plants on the other
side of the
8
constraint "constrained-on." The constrained-off plant obtains the revenue equal
to the difference between the SMP and the bid price. Thus, if the plant expects
to be constrained- off, it will bid in a low price. (Helm 1995, p. 5)
Conversely, a plant constrained-on receives its bid price. (If it had bid lower,
it would be already running and not constrained-on.) If a generator expects to
be constrained-on, it naturally bids higher than it would otherwise. In 1991, a
95 MW load-following plant received L60M for playing the "constrained-on" game.
Although its normal bid was C25/MWhr, its bid for this period was Ll20MWhr. It
also increased its start-up and no-load charges plus increased its minimum
stable load requirement to 95MW.
Constrained-on and constrained-off charges are added to the price of electricity
as uplift. Note that by this definition, "all transmission constraints therefore
contribute to uplift [and price]." (Hunt 1996, p.175) If a generator bids low to
come on-line in a way that creates a transmission constraint that forces another
plant to be constrained-off, the uplift prevents a legal issue by rewarding both
parties. Figure 5 shows how dramatic of an effect these constraints (noted as
operational outrun) can be. The tallest peaks are due to declaring an
unscheduled unavailability and forcing several small-capacity increasing-cost
units to replace the generation from a large low-cost unit.
Figmre 5: Components of Uplift Dynamics (POOL 1996)
[GRAPHIC OMITTED]
Figure 6 shows the "ups and downs" of uplift as generators utilize their
capacity options. "Many of the RECs argue that the generators are attempting to
recover the cost for constrained plant twice: once through Vesting CfDs and
again via uplift revenues." (OFFER 1992a, p. 94)
9
Average daily Uplift payments
April - September, 1992
[GRAPHIC OMITTED]
01-Apr 15Apr 29-Apr 3-May 7-MAy a-J 24-Jun 08-Jul fl-Jul 05-Aug 19-Aug
02-Sep 6SEp 30-Sep U Other components [l Operational Outturn
FRpgure 6: Uplift Volatility Under Non-Peak Conditions (OFFER 1992)
Blocking Entry
Free market entry is supposed to discipline competitive markets by removing
incentives to raise price. One way to limit entry is to add price volatility to
the market and make IPP entry riskier and more expensive. Although price
volatility is certainly present, in the long term a stable average price may
appear that provides a solid price signal fordecisions..j-owever there is a
second entry limiting tactic: bringing higher cost, mid-merit plants into play.
Baseload is bid low to make the average price of baseload power below the entry
price. High-cost mid-merit plants are then bid in above cost to compensate
because generators know that few if any IPP would risk entering that market. The
added profits in the mid- merit market then defray any losses in the baseload
market.
Examples of gaming can already be found in the US Although the actual prices
used in the example below are only approximate, both involved parties have
verified the phenomena happened. Suppose BPA sells energy to a municipal or
large industrial customer for say 25 mills/kWh. Now suppose PacifiCorp goes to
the customer with a promise to supply energy at 22 mills. The customer is aware
that PacifiCorp may not have this power, but PacifiCorp insures that the deal
would be honored. Abruptly, BPA loses possibly a few hundred MW of load. The
waters still run, so BPA puts the excess hydro power on the spot/economy market
for say 18 mills. Any guess on who buys the power for 18 mills and sells it for
22 mills?
Phase 5 - Reregulation
10
The gaming of phase 4 quickly separates the weak from the strong. The weak
demand "fairness" through regulatory changes. The inevitable regulatory response
forces the strong to act collusively, which further excludes the weak from
market participation.
Although electric prices fell in the early part of the UK deregulation, they
fell at a rate lower than the decline in fuel costs. Regulatory review led to
price caps. These in turn forced collusion among generators to simulate
compliance while maintaining profit margins and keeping new entrants out.
Phase 6 - Industry Consolidation
Once the market starts to stabilize, participants will attempt to lock-in
advantageous situations. Generators will find themselves regularly selling to
the same distribution companies. The increased profits from further reducing
uncertainty force reintegration creating economies of scope. The impetus for
re-regulation implies that many participants have reached the "end" of their
gaming days, therefore, sweep-up acquisitions surge. A handful of national
vertically integrated utilities form accompanied by small market niche
utilities. Transmission assets lose market value and a single national
transmission company, probably with quasi-public ownership takes shape. The
storm of deregulation has finally subsided.
In the UK, over 800 miles of transmission line is needed to connect the north to
the south. In the US, BPA can and has transmitted power across the continental
US to TVA. These two facts make any argument that a small group of
trans-national utilities could not compete in the national market indefensible.
The reduction in coipanies does not signal the end of competition. In the UK
where there are two large conventional generators, a nuclear utility, (soon)
only one Scottish utility and minor IPP players, the analysis of the market
indicates functioning competitive conditions.
(Newbery 1994)
Analyses with CIGMOD indicate that existing large US utilities would not
necessarily be the survivors after consolidation. IPPs could easily win the game
because accumulating large cash reserves is a winning strategy. Thus, companies
such as Enron and banks involved with mergers and acquisitions appear more
likely to succeed than US utilities.
Conclusion
The dynamics of deregulation appear inevitable. The final market, although
bearing little resemblance to regulated utility markets, appears
indistinguishable from many other commodity markets. The transition from a
regulated to a deregulated market is one where the former relationships of
generation, demand, markets, delivery, and pricing become burdens, yet slow to
change because of the constraints of past long-lived investments. For a period
of time the system is out of balance with the new forces of supply and demand,
however, at the end of the transition, the "equilibrium" condition that
dominates mature commodity markets comes to pass. The system is still dynamic,
but those dynamics are no longer its defining characteristic. Critical to US
utility thinking is the rather poignant evidence that indicates this tumultuous
time period spans only five to seven years. Given
1 1
the changes that occurred between the Mega-NOPR and the Final Open Access
Ruling, the US transition appears to be running right on schedule.
12
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