Kevin Li

Mrs. Michelle Bagley

Intern/Mentor GT
15 January 2016
In Defense of Decentralized Electricity Markets
The lives of 97,000 San Franciscans ground to a halt as rolling electricity blackouts hit
the bay area on a muggy, hot June 14th. While customers sweltered in overheating homes and
berated San Diego Electrics call center, they must have asked what went wrong. Most thought
that a power plant exploded or the grid must have shorted circuited, but in truth, the blackout was
caused by financial traders playing with spreadsheets. In the months preceding the blackout,
generator market monopolist Enron had manipulated electricity prices upwards by cutting
electricity future generation and sales. The result was a 300% price spike in electricity price that
made it impossible for intermediary retail electricity companies to power consumers and
business. As federal and state regulators scrambled to find a solution to the power outages,
California declared a state of emergency that would only end three years later. This Californian
Electricity Crisis demonstrated the inherent danger and volatility in a monopolized electricity
market. Enrons position as a government protected monopolist allowed it to inflate prices and
become a crucial lynchpin of the system, damning the market to instability when it collapsed
during the 2002 Skilling scandal. To prevent a monopolist from creating similar disasters in the
future, electricity markets from the PJM (Pennsylvania, Jersey, Maryland) to the Midwest began
instituting competition laws and systems. The Federal Electricity Regulatory Commission
(FERC) and state legislators created regional wholesale and retail markets which allowed a

competitive ensemble of firms to generate, trade, and sell electricity. Electricity generators sell
electricity to wholesale which is then transferred to the retail and consumer market by a central
grid dispatcher. Although many federal regulators predicted financial catastrophe as a result of
decentralization, competitive wholesale and retail markets enjoy cheaper prices, lower volatility,
and a more diverse set of services relative to their regulated counterparts. This success of the
decentralized markets can mainly attributed to the benefits of competition within both markets
and the distribution of risk among sellers through new financial instruments (PJM 1).
The unifying characteristic within the various regional regulation laws has been the
liberalization of wholesale/generation markets. Traditionally, generation units (e.g. coal fired
plants, solar farms, and nuclear generators) were controlled by a limited group of energy
generation companies subject to price controls. Historically, price ceilings were set by algorithms
that considered fuel prices, empirical price volatility, and generation capacity. The system usually
worked, but regulatory algorithms were circumvented by companies possessing extreme trading
leverage in electricity and fuel markets. For example, taken to extreme pricing and market
conditions created by Enrons massive cuts in energy supply, the Californian automated price
ceiling collapsed. Clearly, the price setting power of a monopoly was the problem (Bushnell
245). To solve this market vulnerability, the latest movements towards decentralization split and
liquidized generation units to the public market. Ownership of generation units has been
devolved to shareholders who purchase parts of the generation units generation capacity and
collectively decide the volume and price of the units electricity. Combined with competition
laws that prevent the formation of monopolies, changes have created a wholesale environment
that resembling perfect competition, especially in the PJM market. The number of wholesale
traders in the PJM market with market share over 6% quadrupled from 2 in 2005 to 8 in 2012.

Absolute number of sellers increased by ten times. These various controllers of generating units
must now individually bid to a regional grid dispatch organizer to sell electricity. If they bid to
sell their electricity at too high a price, their bid will be placed at low priority compared to the
bids of other units and their plant will not be used on the grid. If they bid too low, they will
produce underneath marginal cost and therefore incur lost (Eydeland 23). Therefore,
shareholders are incentivized to invest in cheaper generation methods and bid lower prices. This
contrasts the incentives of the monopolized electricity structures where firms such as Enron
stood to profit by disrupting business-as-usual operations to circumvent price ceiling algorithms.
Advocates for deregulation credit the change in incentive structures as a cause of increased
investment in generation efficiency, but the effects of market structures cannot be separated from
the ramifications of anti-climate change investment tax breaks. Thus, the overall general
decrease in price should be attributed to the inability for any individual firms to set supply in an
open market. However, the definite extent of the price decrease relative to monopolized markets
cannot be determined due to difference in regional fuel, transmission, and regulatory costs
(Hogan 14).

These

changes in wholesale market structure have been complemented with horizontal changes in the
retail market. The retail market in both the decentralized and monopolized markets serves as an
intermediary between the wholesale market and the final customer. Through a mercantile
exchange, retailers purchase electricity futures and sell the electricity product to customers in the
form of supply contracts. A central grid dispatcher then feeds then the grid according to those
contracts with the lowest bid electricity sellers from wholesale, and from that point, the
electricity acts as a physical commodity. It is the retailers responsibility to measure the
electricity consumption of its customer and set individual prices. Prior to 2000, most retail

markets limited the entry of firms into the markets through licensing fees and minimum
investment size requirements. Liberalization trends removed these barriers to entry in multiple
markets by 2005. As such, the electricity retail business has exploded to dozens of firms from the
previous three monopolists in PJM (Eydeland 33). This has somewhat split the monopolized
structures vertical integration, where monopolists wholesale trading group would sell solely to
their own retailer. Substantial literature argues that this vertical market structures decreased
prices, but it is worth noting that the decentralized market retains the capability for larger firms
to vertically integrate wholesale and retail capabilities. The decentralized market only forces
larger retail firms to consider the possibly cheaper options of other wholesale agents. This
diversification and competition between retailers to obtain final electricity users have
revolutionized the electricity business. Because large firms must now compete instead of
restricting the market through wholesale protectionism, electricity companies find creative
methods to attract customers, minimize cost, and stabilize volatility (Bushnell 256). Companies
have begun offering businesses customized energy reporting and generation-specific allowances.
For example, the French conglomerate lectricit de France (EDF) offers dynamic price
predictions that consider yearly climate trends in PJM and California. Other firms such as NRG
and Vanguard offer peak electricity time monitoring and on-demand load modifications. These
new tools allow customers to plan for electricity price fluctuations, and therefore decrease their
overall electricity costs. By comparing various price points and services, customers now have the
freedom to choose the plan best suited for their energy needs. This diversity of services exist
only in decentralized retail markets such as PJM, California, and MISO (Midwest) and not in the
monopolized Northwestern and Southwest markets. Providers in centralized market have no
incentive to provide these services as they have no competitors and can therefore pass costs on to

the consumer (PJM 55).

In addition to service creativity, decentralization of markets has allowed the emergence of
new financial risk management tools and an era of electricity service stability. Competition has
forced firms to introduce new electricity derivatives including put options, spark options, and
swaps to help distribute risk and attract investment (Deng 1). Retailers can now buy electricity
futures from the exchange at whatever time they choose in whatever volume. This introduces the
possibility for dollar-cost averaging, where retailers can procure a time periods electricity load
in separated intervals to mitigate temporal risk. Additionally, because lawmakers have
deregulated trading of electricity futures, firms can freely choose how they can hedge their
portfolio. If an electricity firm decides that its winter portfolio contains too much risk, it can
hedge by buying summer load futures beforehand. Electricity companies can even hedge
electricity futures using gas derivative swaps, where firms may swap income flows with another
commodity in case their current portfolio becomes untenable due to low prices. Spark options
allow retailers to minimize the effects of input generation volatility on prices by allowing firms
to purchase the electricity future minus fuel input price (Deng 6). These tools have allowed
companies such as Entergy, Exelon, and EDF to maintain stable service to their customers and
guarantee they will not dip below a defined bottom line. As such, companies have been able to
survive the recent 60% drop in electricity prices because of their safe risk distribution in the
decentralized markets. The dynamic nature of financial markets has also helped limit the effect
of volatility. In the California Crisis, the lack of other trading firms allowed the collapse of Enron
to destroy the entire Californian market. In contrast, the collapse of Constellation Energy in
2008 had little long term effect on electricity trading because its electricity portfolio was quickly
dumped onto the electricity exchange and bought by other retailers. Other retailers took

management over Constellations customers so consumers barely noticed the change. Therefore,
despite the demise of the largest electricity trading company, the market remained stable because
of other financial actors who absorbed Constellations load (Eydeland 232).
Decentralization of electricity markets has allowed the invisible hand to stabilize
electricity markets. As the California crisis demonstrated, government micromanagement warped
economic incentives for the electricity industry, exacerbating the very volatility it aimed to
control. But by removing restrictive anti-competition laws, regulators have returned incentives
for firms to innovate technologically and financially to create better electricity products. Instead
of finding new ways to manipulate federal regulations and market irregularities, wholesalers now
compete with each other to find the most cost-efficient methods for electricity generation.
Similarly retailers have pioneered new tools for consumer electricity management in response to
the dozens of new firms that vie for market share. Tied together by a competitive exchange
market, the firms in these two markets constantly innovate in the life or death struggle of
competition. Any fluctuations in the market are spread across multiple firms and financial
derivatives, alleviating volatility in the short run. But most importantly, the introduction of a
diversity of firms into the industry means that death for a single firm need not be death for the
overall market. With these new systems developed by the free market, regulators can finally
leave the failures of over management behind and welcome a new era of innovation in the
electricity industry.

Works Cited
Bushnell, James. "Vertical Arrangements, Market Structure, and Competition: An Analysis of
Restructured US Electricity Markets." American Economics Review 98.1 (2008): 237-66.
Print.
Competitive Electricty Markets. Baltimore: PJM ISO, 2012. Print. PJM Workshop.
Deng, Seth. "Electricity Derivatives and Risk Management." Energy 31 (2006): 940-53. Print.
Eydeland, Ayson. Energy and Power Risk Management. Hoboken: Wiley, 2003. Print.
Hogan, Warren. Competitive Electricity Markets: A Wholesale Primer. N.p.: n.p., 2006. Print.