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More Price Elasticity Desirable Charles G. Stalon everal states have taken dramatic steps to S create efficient electricity markets. How- ever, some, perhaps all, of these markets tend to retain features that keep the efficiency of such markets significantly below their potential. In fact, it appears that some beneficial characteris- tics of the old system may have been eliminated before market substitutes were in place. Many of the features were essential parts of the regulated electric industry. Some of these undesirable features are scheduled to be phased out and others may fade to insignificance under market pressures, but on the other hand they may not. Until they are eliminated, they complicate an already complex transition problem. . . . beneficial characteristics of the old system may have been eliminated before market substitutes were in place. Many market demands in the new electric- ity markets are presently relatively insensitive to prices. This insensitivity constitutes a serious structural deficiency in the electricity and ancil- lary services markets. In particular, price vola- tility in these markets is unnecessarily and inefficiently large. These inelastic demand curves arise for many reasons: First, most users, even large ones, continue to buy electricity from their distribu- Charles G. Stalon, a consultant in St. Charles, Mis- souri, is a former commissioner of the Federal Energy Regulatory Commission and of the Illinois Commerce Commission. tion utility (disco) at a “rolled in” price. Thus, they do not see the high and low prices being created in the free markets. In effect, in periods of peak demands, the disco may buy electricity for a real-time price of 25 cents a kilowatt-hour and resell to its users at 6 cents a kilowatt-hour. In off-peak periods the same disco may buy for 2 cents a kilowatt-hour and sells for 6 cents a kilowatt-hour. (In fact, in some hours in the spring of 1998 the California energy market generated zero prices for energy.) The 6-cents- a-kilowatt-hour given here represents the aver- age cost of the electricity to the disco over some period, usually a past period, perhaps a week or perhaps a month, depending on the agreement between the disco and the its regulator. Such a pricing policy fails to provide users with incentives to decrease the quantity de- manded during “high price” periods or to in- crease the quantity demanded during “low price” periods. Because the disco is required to satisfy the demands of its customers at the regulated price, it must submit bids into the market to buy what it expects its customers to demand at that regulated price, that is, the 6 cents a kilowatt-hour in the previous example. Logic dictates that the disco’s market demand curve for serving users entitled to the rolled in price be perfectly inelastic with respect to the market price. Such a demand curve does not reveal anything of value about the preferences of users served by the disco. Second, some large users that might enter the short-term electricity market and confront “spot”prices seem to have managed to negoti- ate special deals in the multilateral negotiations leading to industry restructuring. Thus these 24 NATURAL GAS OCTOBER 1999 0 1999 John Wiley & Sons, Inc.

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More Price Elasticity Desirable Charles G. Stalon

everal states have taken dramatic steps to S create efficient electricity markets. How- ever, some, perhaps all, of these markets tend to retain features that keep the efficiency of such markets significantly below their potential. In fact, it appears that some beneficial characteris- tics of the old system may have been eliminated before market substitutes were in place. Many of the features were essential parts of the regulated electric industry. Some of these undesirable features are scheduled to be phased out and others may fade to insignificance under market pressures, but on the other hand they may not. Until they are eliminated, they complicate an already complex transition problem.

. . . beneficial characteristics of the old system may have

been eliminated before market substitutes were in place.

Many market demands in the new electric- ity markets are presently relatively insensitive to prices. This insensitivity constitutes a serious structural deficiency in the electricity and ancil- lary services markets. In particular, price vola- tility in these markets is unnecessarily and inefficiently large.

These inelastic demand curves arise for many reasons: First, most users, even large ones, continue to buy electricity from their distribu-

Charles G. Stalon, a consultant in St. Charles, Mis- souri, is a former commissioner of the Federal Energy Regulatory Commission and of the Illinois Commerce Commission.

tion utility (disco) at a “rolled in” price. Thus, they do not see the high and low prices being created in the free markets. In effect, in periods of peak demands, the disco may buy electricity for a real-time price of 25 cents a kilowatt-hour and resell to its users at 6 cents a kilowatt-hour. In off-peak periods the same disco may buy for 2 cents a kilowatt-hour and sells for 6 cents a kilowatt-hour. (In fact, in some hours in the spring of 1998 the California energy market generated zero prices for energy.) The 6-cents- a-kilowatt-hour given here represents the aver- age cost of the electricity to the disco over some period, usually a past period, perhaps a week or perhaps a month, depending on the agreement between the disco and the its regulator.

Such a pricing policy fails to provide users with incentives to decrease the quantity de- manded during “high price” periods or to in- crease the quantity demanded during “low price” periods. Because the disco is required to satisfy the demands of its customers at the regulated price, it must submit bids into the market to buy what it expects its customers to demand at that regulated price, that is, the 6 cents a kilowatt-hour in the previous example. Logic dictates that the disco’s market demand curve for serving users entitled to the rolled in price be perfectly inelastic with respect to the market price. Such a demand curve does not reveal anything of value about the preferences of users served by the disco.

Second, some large users that might enter the short-term electricity market and confront “spot” prices seem to have managed to negoti- ate special deals in the multilateral negotiations leading to industry restructuring. Thus these

24 NATURAL GAS OCTOBER 1999 0 1999 John Wiley & Sons, Inc.

users can buy from their local disco at prices that are lower than the expected average of spot prices. They are also entitled to buy from the disco at a price pegged to the rolled-in price. Consequently, their skills and bargaining abili- ties are removed from the market, and the disco’s market demand curve does not reflect the preference of these users, only the terms of their contracts with the disco.

. . . pricing policy fails to provide users with incentives

to decrease the quantity demanded during “high price”

periods - . . Third, direct-access customers who do buy

from an energy service provider other than the disco may also be “protected” from the price volatility of the market. Direct-access customers in California are of two types: those that have time-of-use meters and those that do not. Mem- bers of the latter group are charged a rate that depends on the “usage profile” of the group of which they are a part. Direct-access customers with time-of-use meters receive credits from their disco based on their load and power exchange prices. In effect, the Big Three Califor- nia IOUs’ pay credits to direct-access custom- ers, credits that tend to offset market price volatility. A direct-access customer who buys electricity based on the profile of his class will receive a credit based on the load and load profile of his class, not on his actual usage.2

Fourth, the quantities of many of the ancil- lary services the independent service operator (ISO) purchases are defined by reliability stan- dards that do not distinguish between periods of high and low prices. Consequently, market participants, particularly ISOs, are expected to buy specified quantities of these generating services regardless of price.

Promise of Competitive Market Prices One of the benefits expected from the

development of competitive electricity markets that cover large geographical areas and many users is that the resulting efficient, robust elec- tricity markets will permit all users to see the free market price of electricity each hour of the day. This might allow and encourage all users with access to the hourly electricity markets to “self-

interrupt” and expand usage when they choose. In effect, the promise is that efficient electricity markets can obtain every objective sought by utilities and utility regulators in creating com- plex categories of service and complex rules for service interruptions.

Free markets will generate relatively high prices when demands are high and relatively low prices when demands are low. Thus, it is to be expected that when users can see such hourly prices, many of them will respond by increasing the amount of electricity used in off- peak periods and decreasing the amount used during on-peak periods. Furthermore, it is to be expected that some users, especially large ones, will invest in control equipment that will facili- tate such electricity management practices. These buyers’ responses to prices will tend to reduce price volatility in the market. The resulting efficiencies will be higher capacity utilization rates for existing equipment, lower average costs for the sellers and lower average prices in the market for buyers.

Current Market Deficiencies Because of transition compromises, it ap-

pears that many of the expected benefits of competition are not forthcoming. In particular, because old methods of exploiting users’ de- mand elasticities are being weakened and mar- ket forces to exploit those elasticities are being suppressed, the peak-demand problem may be intensifying.

Because of transition compromises, it appears that many of the expected benefits

of competition are not forthcoming.

In the long run, the most disturbing conse- quence of the current faulty price signals may be faulty investment incentives. It cannot be ex- pected that discos will continue to cultivate interruptible users. They are no longer in the business of planning generation capacity. They now expect the free market to provide appropri- ate expansion incentives to generating compa- nies. However, demand projections based on current market performance cannot be seen by rational investors as indicative of what users will buy at market-determined prices. This lack of

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knowledge adds risks to investment decisions, and added risks means added costs.

It cannot be expected that discos will continue to

cultivate interruptible users.

Special Contracts for Large Users Some of the expected efficiency improve-

ments from competitive markets depend upon some users, large ones in particular, confront- ing hourly prices in electricity markets and responding to these prices by increasing usage in low-price periods and decreasing usage in high-price periods. Those users best able to respond quickly to daily and seasonal cycles in electricity prices are large ones. Their electric- ity bills are large, by comparison to the bills of most residential and commercial users, and many of them employ professional energy managers. They, furthermore, are already fa- miliar with the issues involved in buying and selling energy and in investing in energy man- agement assets. Many large firms are participat- ing in the competitive market, but many are not, and their absence from the free electricity markets reduces the price elasticity of demand.

Reasons for the reduced participation of large users are known only in part. Some large users, for example, seem to have used the negotiations over restructuring to gain such favorable contracts that the average price under the contracts is below the expected average price of the hourly electricity markets. For example, the Big Three IOUs in California report that they are not allowed to interrupt for economic reasons. Given the reliability of the expanded control system created to facilitate efficient markets, interruption for reliability rea- sons has a very small probability. As a result, these firms seemed to have gained firm service at interruptible rates.

Reconciling Reliability Standards and Competitive Markets

When two control areas interconnect, each loses its sovereign control over its economic performance. Each becomes dependent on the other for efficient and reliable delivery of power to its customers. Creating efficient, com- petitive power markets in an electric industry composed of interconnected control areas re- quires the existence of some agency with

authority to define, impose, and enforce rules for the operation of all control area operators (system operators [SOsl or independent system operators [ISOsl) so interconnected. The North American Electric Reliability Council (NERC) is that agency for the North American electric industry. However, its rules have evolved over decades, which means the rules were created to serve a regulated industry.

In designing these rules, the NERC and its affiliated regional reliability councils func- tioned under a principle of doubtful validity for a competitive electric industry. That prin- ciple is that government regulators will deal with economic issues, the NERC and its affili- ate organizations will deal with the technical issues of reliability, and there is a bright line separating the two responsibilities. Be- cause the NERC is an industry-created, self- regulating organization, its existence has depended on all parties respecting this prin- ciple. Furthermore, because the objective of reliability rules is to deter self-interested utilities from free-riding on the system, the rules tend to be fairly explicit and are ex- pected to apply in all economic circumstances.

- I - the NERC is an industry- created, self-regulating

organization - . . As customarily defined in the North Ameri-

can electric industry, reliability requires control area operators to, among other things, “provide ancillary services.” In vertically integrated utili- ties, the needed ancillary services were pro- vided by the SO as it dispatched all the company’s generating plants, so as to satisfy the reliability standards and minimize the cost of delivered services. In making these decisions the SO coordinated its actions with those of intercon- nected SOs, sharing reserves as was in their collective interests. In the California market, ancillary services are essentially privately pro- duced services that the I S 0 purchases as inputs (and/or mandates that generators provide as inputs as a part of their transactions) to produce the public good called “bulk power system reliability.” As any public good, such as national defense, “bulk power system reliability” cannot be denied to parties that benefit, even if they insist they do not want it and claim that it does not benefit them.

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Spinning Reserves as an Example of an Ancillary Service

One enlightening example of an ancillary service is “spinning reserves.” This example can also serve to demonstrate the lack of price sensitivity in determining the quantity of the service provided. Reliability standards are designed to preserve service when the largest generator in the control area fails. Such a standard requires each control area operator, or two or more cooperating control area operators, to run one or more generators synchronized with the grid with productive capacity to replace the largest generator in the control area(s) on very short n ~ t i c e . ~ A gen- erator owner, for example, might be capable of producing 500 megawatts of output from a generator, but limit its output to only 100 megawatts. If the generator can expand out- put from 100 to 500 megawatts in 10 minutes and is contractually committed to do so at the call of the control area operator, the generator is said to be providing 400 megawatts of 10- minute spinning reserve to the system.

In effect, the I S 0 pays some gencos (gen- eration companies) not to produce for the current energy market but to be ready to pro- duce on short notice. In so doing, the SO increases the probability that other parties to transactions will be able to implement those transactions as planned. Other generators will simultaneously be paid by the I S 0 to be pre- pared to produce with other, longer prior no- tices, perhaps 30 or 60 minutes. The continuous provision of spinning reserves, and other ancil- lary services, is expensive, but such practices have long been essential elements in the provi- sion of reliable power supplies in the United States and Canada.

Price Inelasticity of Demands for Ancillary Services

When the California and New England mar- kets were designed, the many ancillary services were categorized into commercially definable ones, but the practice of ignoring prices of each defined service when specifying the quantity of each service the I S 0 was required to purchase was carried over from utility operations. One consequence was that sellers of generating services were presented with a set of perfectly inelastic demand curves.* Not surprisingly, inef- ficiently high prices for some ancillary services

markets became a troublesome problem. Furthermore, the demand for generating

services for reliability needs increases as user demands for energy increase. The quantity of the public good “bulk power system reliability” may be measured by the quantity of inputs purchased to provide it. Additionally, we may recognize that the reliability standards require that some reliability inputs be purchased in proportion to total generation output. It then follows that the quantity of “bulk power system reliability” produced by the SO is expected to increase when total demand for electricity in- creases. Because the price of power and the price of the inputs to “bulk power system reliability” tend to go up when the demand for electricity goes up, current reliability standards require the SO to increase its output of “bulk power system reliability” when the cost of doing so increases.

. . . the demand for generating services for reliability needs increases as user demands

for energy increase.

Substantial improvements in the efficiency of the California ancillary services markets is promised by the implementation of the “rational buyer” principle proposed by the California I S 0 Market Surveillance Committee in its report to FERC. Using this principle, the I S 0 is called upon to substitute some services for others. In particular, “superior services” can be substituted for “inferior ones.” Such a principle will allow the I S 0 to recognize price and respond to it to minimize the total cost of ancillary services. This practice will replace four thin markets with one much more robust market. Price volatility can be expected to diminish.

. .) - replace four thin markets with one much more robust

market.

Further Thoughts About Reliability in Competitive Electricity Markets

The electric industry is moving from one dominated by vertically integrated, regulated monopolies to one in which generating ser- vices are provided in competitive markets by unregulated firms. In this process, it is essen- tial that the acceptable level of reliability be

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maintained and the efficiency objective de- mands that the target level of reliability be gained at minimum cost.

The economic characteristics of ancillary services deserve recognition. In the best of circumstances, the California IS0 and other ISOs are attempting to facilitate efficient mar- kets for generating services while simulta- neously paying some generators not t6 produce. Obviously, the less-defined the obli- gations of gencos, the greater the quantity of ancillary services the IS0 must purchase. For example, in California many gencos insist that all accepted offers to supply power are merely financial obligations and not obligations to supply power. In such a case, other things being equal, the I S 0 will be required to buy more ancillary services, that is, to pay gencos more not to produce for the energy market, than it would if all accepted offers to supply were obligations to produce power.

Furthermore, if one accepts the proposition that reliability is an economic good, it becomes plausible to argue that the quantity of it pur- chased should decrease as its cost increases. Arbitrage between electricity markets and ancil- lary services markets can be expected with the result that when the market price of electricity is “high” the costs of ancillary service will be “high.” This suggests that the amount of reliabil- ity services purchased during high-price periods might rationally be less that the amount pur- chased in low-priced periods.

Many Regulatory Efforts to Exploit Price Elasticity

An examination of the role of demand elasticity in the “old” electricity industry serves to highlight the difficulty of and the economic importance of exploiting price elasticity of de- mand in the “new” industry.

Regulators of the “old” electricity industry and executives of regulated electric utilities tended to assign a high value to price stability. This policy reflected their view that the public also assigned price stability a high value. It probably also reflected their view that public irritation when prices increased was distinctly more pronounced than public approval when prices decreased. The general attitude of both regulators and utility executives seemed to be that a price increase from the average, followed by a decrease to below the average, followed by a return to the average did not result in a net

political gain of zero. Instead, such a policy resulted in a net loss of political support for the utility and its regulator.

. - . regulated electric utilities tended to assign a high value

to price stability.

Role of Interruptible Demands in the Old System

The demand for electricity shifts dramati- cally from hour to hour, day to day, and from season to season. In most areas of the United States, the quantity demanded is normally much greater in midsummer days than in postmidnight hours at all prices, much greater on business days than on weekends, and much greater in hot summer days than on cold winter days or night^.^

Pursuing price stability in the presence of such volatile demands posed several prob- lems for utility executives and their regula- tors. Building and maintaining the generation and transmission capacity needed to satisfy all on-peak demands at average prices would cause significantly higher utility costs and prices than would an alternative policy in which some users could be “denied” service during peak-demand periods. Furthermore, the rate of use of the utility’s assets would be relatively low if all demands were always met at an average price. This is because some assets would be fully used only during the highest of peak demand periods, which might occur for only a few hours once every few years. The consequence would have been relatively high costs and relatively high prices. A better alternative, one that recognized de- mand elasticities, existed.

The regulatory solution to the problem was to create a multiplicity of classes of services. Of major importance was the distinction between firm and interruptible services. Firm demands were to be satisfied at all times. However, interruptible demands could be interrupted during peak demand periods if capacity was not adequate to serve all demands reliably. Users who permitted the utility to interrupt service were granted a discounted rate. Because meter- ing abilities were limited, the utilities focused their efforts to reduce demands in peak-demand periods and to increase demands in off-peak periods on large users, primarily large industrial and commercial users6

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Of major importance was the distinction between firm and

interruptible services.

Because interruptible demands did not have to be served during peak-demand peri- ods, the utilities did not have to plan and build generating plants and transmission lines to serve them. Consequently, the existence of interruptible users permitted the utility to keep its total costs and the average price to firm users lower than it would have been if all users were firm ones. The discounted rates permit- ted the utility to use the assets it did construct more intensely.

Although all firm users were entitled to similar service, interruptible users were cat- egorized in many ways. Some could be inter- rupted on very short notice, a few without notice, but most with notice of one or a few hours. Still others might require much longer notice so assembly lines could be closed and work shifts eliminated. Some could be inter- rupted for many hours in a season, while others could be interrupted for only a few. Some could be interrupted for many hours at a time and other for only a few. Some could be interrupted when the utility’s cost became very high, but most became interruptible only when reliability standards were constraining, that is, the service was denied only when the utility would infringe on accepted reliability stan- dards if the user were not denied service. Some users had interruptible contracts that permitted them to buy continued service at an increased rate rather than accept interruption.

. .. - the user was free to compare the price of

electricity hour by hour and to “self-interrupt” when it

so chose.

The desires of the utility and the utility’s regulators to gain a large stable of interruptible users and the consequent need to satisfy the special circumstances of many different users led to very complex rate structures and to many special contracts between utilities and their large users. The policy standard that insists that discrimination between members of a class is

unacceptable but that discrimination between classes is acceptable if the regulator finds it a “due” form of discrimination led inevitably to a large number of customer classes.

As metering and communication technolo- gies improved, a few utilities arranged for some large users to replace traditional forms of utility pricing with a system that changed the price to selected users frequently, perhaps every hour. The expected hourly price was usually announced a day in advance. This represented a fine-tuning of the interruption process. Instead of the utility deciding to inter- rupt the user, the user was free to compare the price of electricity hour by hour and to “self- interrupt” when it so chose. In effect, the utility administered an internal market. Clearly, as with interruptible services, users that had the capability to expand usage in off-peak periods and/or to contract usage in on-peak periods had an opportunity to use this more sophisti- cated pricing system to lower their average kilowatt-hour cost.

Notes 1.

2 .

3.

4.

5 .

6.

San Diego Gas and Electric, Southern California Edison, and Pacific Gas and Electric. A profile customer that has installed a time-of-use meter and pays the energy service provider for the actual amount of energy used in each hour has a different incentive environment. This customer can reduce use during on-peak periods and save while receiving a credit based on the usage profile of his group. Consequently, this customer has an incentive to reduce the use of electricity during high-price periods. A more precise statement would recognize that the ability of the IS0 to import power from neighboring control areas reduces the amount of generating re- serves the IS0 must buy to provide the needed level of reliability. Ancillary services are defined in California as Regula- tion, Spinning Reserves, Nonspinning Reserves, Re- placement Reserves, Voltage Support, and Black Start capability. The IS0 purchases the last two by contract; the first four are purchased in the free market. There are areas of the nation in which the seasonal peak occurs in the winter rather than the summer. The Northwest is one such area. The rewards to firm users for “shaving peak demands” and encouraging usage in off-peak periods were so large that regulators and utilities continuously experi- mented with programs to create interruptible services for residential and small commercial customers. Inter- ruptible home hot water heaters and home air condi- tioners are part of the demand management programs of many utilities. However, the ability of these pro- grams to shave peaks pale in significance when com- pared to the ability of interruptible programs for industrial and large commercial users.

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