Monitoring electricity marketsWhat can we learn from

the economics of regulation?

Robert J. MichaelsCalifornia State University, Fullerton

rmichaels@fullerton.edu

Rutgers University Center for Research in Regulated Industries Annual Western Conference San Diego, California June 25, 2003

Market Monitors and Regulation

Power markets -- novel institutions and naïve expectations

Efficiency, cynicism and reality in the economics of regulation California was just “reregulating”

Market monitors: which story fits California?

Virtual bidding in three ISOs: a natural experiment

Whence the collective amnesia of economists?

Electricity’s new institutions Old federal and state regulation continues Bilateral contracts, energy markets, and ISOs Market Monitoring Institutions [MMI]

Observe and report to FERC on ISO energy markets Internal employees or appointed outsiders To observe market power and functioning of rules Vague responsibilities: “anomalies” and “gaming” Unclear investigative powers, abilities to levy

sanctions Order 2000 and SMD – FERC dodges the issues

No analogues of MMIs Not a regulatory body, never contemplated

in legislation Stock Exchanges as Self-Regulatory

Organizations In federal law Made up of market participants (NASD)

Electrical MMIs must have no market interests Have powers re new contracts, arbitration,

suspension of traders, circuit breakers Electrical MMIs have ambiguous powers

Due process for SRO prosecutions

Economists and regulation I Regulators inhospitable to economic

recommendations re efficiency But some headway in electricity – tariff

designs, peak pricing, rates of return Regulatory history – producer

protection and franchises Early studies: ineffectiveness,

producer protection, cross-subsidies “Capture” and more general models

Economists and regulation II Later studies: politics and economics v.

“public interest” Mostly reject public interest where tested

FTC, antitrust, etc. and politics The paradox: When MMIs arrived in

electricity, economists played dead Accepted feasibility of monitoring Viewed it as a useful supplement to regulation Despite past research and restructuring politics,

no economist on any side has questioned MMMIs No examination of their origins and performance

California’s Origins I State restructuring under AB 1890

Utilities must collect stranded cost in residual between market energy prices and frozen retail rates within deadline

Required to purchase all requirements day-ahead (PX) and real-time (ISO)

Political and economic rationales for separating PX and ISO

Required divestitures of major utility assets

California’s origins II PX and ISO are in FERC jurisdiction Can only have market-based rates if

concentration in relevant markets low Utilities’ studies all show concentration

screens violated at times Utilities propose mitigation

Further generation divestitures “Must-run” contracts Market monitoring

No other interested party proposes MMIs or questions why utilities have suggested them

California’s Origins III 1995- 1997: Utilities dominate PX/ISO design

“collaborative” Only parties allowed to vote All particulars of MMIs only formulated after FERC

irreversibly approves concept Result: four MMIs with vague responsibilities

PX and ISO get internal and external MMIs To examine “anomalies” and “gaming,” evaluate

protocols and report to FERC Anomalies: things that should not happen in competitive

markets – but no specification of what should Gaming: taking unfair advantage of rules

Will have data-gathering and investigative powers But are not to evaluate operation of the ISO

California’s monitors I Begin operation with markets opening

(4/1/98), soon face ancillary service thinness and must-run problems

Assertions re generators, reformation of must-runs, buyers’ market power no concern Nearly 90% of PX sales to 3 utilities “Hockey stick” supply means utilities can lower

total cost by demand shifts In [rare] discussions, MMIs excuse utilities’

conduct as “defensive” PX MMI shows utilities how to lower price further 2003: FERC says utilities exercised market power,

says refunds not required since no profit resulted

California’s monitors II Reconciling competitive west-wide markets

with market power in Calif. Beyond market analysis to calculating utility

stranded cost recovery shortfalls Market monitors calculate refunds, testify on

behalf of state in other FERC refund proceedings

No objection by monitors to active presence of CDWR representatives in ISO trading area FERC finally orders them out after petition from

generators

Virtual bidding

Arbitrage by bidding demand or supply into DAM and selling or buying it back in RTM Promotes efficiency and liquidity Helps ISO manage buyer load shifts to RTM In California, undoes misstated schedules

The comparison: RTOs and MMIs with differently-situated utilities will have differing policies re virtual bids

Case 1: PJM Pennsylvania utilities previously reached

settlements ensuring stranding recovery Other PJM states allow cost pass-through

Most PJM transactions are bilateral or self-generation, retail competition is a real threat to Penna. Utilities

Result: PJM opens virtual bidding without problems on same day DAM and RTM open

MMI views virtual bids as integral to success of regional markets

Case II: New York Utilities have unsettled strandings, but no

deadlines like Calif., retain generation and contract bilaterally, with small retail threat

Two-year delay in introducing virtual bids During interim, utilities can shift but others can’t NYISO MMI believes physicals suffice for

arbitrage and virtual bids can destabilize Result: convergence between DAM and

RTM prices, and between transmission-constrained areas MMI says that volume is sufficient to undo

moderate market power exercise by buyers

Case III: California California utilities faced short stranding

deadline, restricted to DAM and RTM for all power, retail rate freeze

MMIs reject virtual bid concept, view as generator market power Some Enron transactions are virtual bids

But today: utilities rescued, bilaterals feasible, retail competition in doubt

New ISO DAM/RTM proposal includes virtual bids, now supported by monitors on efficiency grounds

Rethinking monitoring Politics is trumping economics, like we said No MMI has ever produced a minority report

But economic experts in dockets have differing views and interpretations

Are MMIs unrepresentative? Or crafting compromise opinions of less value to FERC

Smarter experts not the answer, stakeholder experts may be Now a motive to explain differences of opinion

FERC’s majority and dissenting members can both put their differences on the record

Market monitoring – too important to be left to the market