on Energy: shortages, surplus and the search for value

03
Introduction

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Reaping the benefits of electricity industry reform: defining and limiting the use of price controls

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Generation asset ownership: the more things change the more they will remain the same

24
Comparing approaches to promoting renewable energy: prospects for wind energy in the UK and the US

38
Liquefied natural gas is more flexible than pipeline gas: but can this value be extracted?

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Contents
Introduction 03

Reaping the benefits of electricity industry reform: defining and limiting the use of price controls

06

Generation asset ownership: the more things change the more they will remain the same

14

Comparing approaches to promoting renewable energy: prospects for wind energy in the UK and the US

24

Liquefied natural gas is more flexible than pipeline gas: but can this value be extracted?

38

Viewpoint on Energy

Reaping the benefits of electricity industry reform: defining and limiting the use of price controls
By Edward Kee

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ver the last two decades, competition and markets have been introduced into the historically regulated electricity sector. This reform of the electricity industry, including newly established markets, has the potential to provide benefits compared to regulation. These benefits (see ‘Electricity market benefits’) are the reason that these reforms have been considered and implemented in many countries. However, these newly created electricity markets are often saddled with price controls and other interventions that have the potential to reduce or remove market benefits. PA believes that the benefits of electricity markets will only be possible when intervention in these markets (including price controls) is limited and well defined.

Viewpoint on Energy

ELECTRICITY MARKET BENEFITS
The reform of the electricity sector, including markets and competition, replaces regulation. Under this reform, participants respond to market prices to create benefits, as compared to regulation: • Investments – The largest benefits from electricity markets will come from a shift to market-driven investments that replace regulated utility expansion planning and rate-base additions. Investment-related benefits will not be seen for years due to the long life and long development cycle of electricity industry investments. The magnitude and timing of these investments is dependent on investors who will demand real electricity prices (ie, without price controls) in electricity markets that can be expected to continue into the future. • Operational improvements – Unregulated power plant operators will see increased profits if they reduce costs and increase output, while regulated electric utilities recover costs in rates and may have few incentives to reduce these costs or to increase output. In a reformed electricity sector, power plant operations are modified to increase the reliability and flexibility of power plants, lower fuel costs (eg, renegotiate fuel contracts or add on-site storage), increase thermal efficiency (eg, upgrade turbines to raise thermal efficiency), and reduce other costs. Owners of existing power plants that were built under regulation, but are now operating as unregulated participants in a market, have made modifications to increase maximum output and ramp rates, decrease minimum output, reduce startup times, reduce minimum downtimes and otherwise increase the power plant’s ability to profit in the market. Significant performance improvements have been seen when regulated utility plants are sold to unregulated owners and operated in a market. • Resource allocation – A regulated power plant that would be uncompetitive in a market might continue to operate, contributing to a regulated utility’s return and recovering fixed costs in rates. In an electricity market, the most efficient and productive power plants will take a larger share in a market, and a power plant that does not earn sufficient profits to cover fixed operating costs will face financial stress. Over the short term, power plants competing for market share in each hour will also ensure that an efficient use of fuels is made, based on the cost of producing electricity. • Innovation – Regulated cost recovery may blunt the incentives to undertake innovative approaches to reducing cost and increasing output. Market participants will try to maximize profits by pursuing innovations in investment efficiency, operational efficiency and productivity. A number of such innovations have been seen since the advent of unregulated independent power plants. • Demand-side response – Under electricity regulation, infrastructure is built to meet the projected peak demand, plus a margin for reliability under a defined set of contingencies. This regulated approach has the effect of maximizing the size and returns of regulated utility companies. The response of consumers to real (and real-time) market prices for electricity has the potential to: lower investment in supply side resources; lower market prices; reduce opportunities for generators to game the market; decrease price volatility; increase security of supply; and decrease environmental impacts.

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Viewpoint on Energy

Electricity sector reform driven by benefits
Reform of the electricity sector – replacing traditional electricity industry regulation with competition and markets – is largely driven by the promise of benefits. Regulation of electric utilities has been the norm over most of the last century and has resulted in well-developed power systems in most developed countries. However, electric utility regulation results in higher prices and lower levels of service than markets might provide because:

Markets in the electricity sector
All markets are defined by prices, with market prices providing information about the relative scarcity of products to buyers and sellers. Buyers and sellers in a market act on this price information to coordinate their economic activity.

Electricity markets are no different. Electricity market prices provide important information on relative scarcity to buyers (both wholesale and retail electricity users) and sellers (generators). The economic activity that is coordinated by the • Regulated utilities, without the incentives information in market prices includes real-time and disciplines (eg, higher profits, loss of dispatch of power plants, trading, consumption customers) imposed by the market, will have a and investment. reduced focus on customer service, productivity Electricity can be considered as another and efficiency commodity similar to wheat or oil, although • Operating and investment decisions under electricity markets are different from other regulation are made without market price commodity markets. The most important information, without the discipline of risk, difference is that electricity market prices may be and with the potential influence of special even more volatile than the prices in most other interest groups. commodity markets. Electricity market prices do not have the same buffering mechanisms that are The introduction of competition and markets in seen in most commodity markets, such as: the electricity sector has the potential to increase the focus on customer service, productivity and • Stored inventory (electricity storage is expensive efficiency, and to provide a market mechanism and difficult, so there is little of it) to govern sector investments. The result has • Ability of consumers to respond to prices by been a series of new electricity markets around limiting or deferring purchases (there are limited the world. opportunities to limit or defer electricity use; real-time pricing and metering might encourage

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Viewpoint on Energy

more investment and behavior changes to increase this)

when they wanted it, for a relatively fixed (and sometimes subsidized) price.

• Availability of good substitutes (there are few Governments, politicians, regulators and other products that can easily be substituted for customers may view an individual customer’s electricity). ‘rights’ to this regulated paradigm of on-demand electricity at fixed prices as paramount. Political The result, predictably, is the potential for highly intervention in electricity markets is helped by: volatile prices. Electricity market prices may exhibit large and frequent swings, largely driven • Timing: It is all too easy for government to by hourly, daily, weekly and seasonal movements intervene in the electricity market to produce in demand. Events on the supply side, such as immediate benefits (eg, lower and stable prices) power plant or transmission line outages, also for voters, especially when any detriments of cause price swings. the intervention (eg, lower investment, lower reliability and eventually higher prices) may not These volatile electricity prices provide useful be seen for years information to manage supply (and demand, where possible) on an hourly and daily basis in an • Status quo: This intervention is made simpler electricity market. In electricity sector reform, a because it can be characterized as a return to market-driven supply and demand process with the benign status quo ante of regulation, rather prices replaces the real-time system control and than intervention in an established and accepted dispatch process in a regulated system. market The change from regulation to markets in • Fear of failure: Some highly public (and little electricity involves significant changes in the understood) perceived failures of electricity way that buyers and sellers of electricity operate. markets (eg, California) allow intervention to be Electricity market prices that reflect real-time based on an expectation that electricity markets system information allow more parties to will fail. respond and take the actions that lead to benefits. However, electricity price volatility is unfamiliar and raises concerns with many buyers and sellers of electricity that have long experience with flat fixed prices for electricity, as seen in regulation. When electricity market participants understand and even expect volatile prices, they will act to manage the risk presented by volatility. This risk is managed by entering into hedging arrangements, by changing use or production patterns to benefit from price swings (eg, interruptible load and peaking plants), or by physical hedging through vertical integration between loads and power plants. However, some market participants respond to volatile electricity market prices by seeking government or regulatory intervention.

Electricity market prices may exhibit large and frequent swings, largely driven by hourly, daily, weekly and seasonal movements in demand.

The result is that most electricity markets have had price controls and intervention even before the markets were established. These price controls will make electricity markets less effective and will reduce or even remove market benefits.

Electricity market price controls
Regulatory intervention and price controls in electricity markets may be seen as normal, even though market prices are an important part of electricity markets.

Price controls reduce market benefits
When market prices are controlled or capped, the resulting price information (ie, about relative scarcity) does not reflect actual market conditions and may lead buyers and sellers to take inappropriate and inefficient actions.

Many of the benefits of electricity markets arise from the response of market participants to prices. Many electricity users, as a result of a century of Price controls short-circuit this market mechanism. regulated and cost-based rates, are uncomfortable Market prices under price controls or other with, and may be opposed to, the concept of intervention are not ‘real.’ These ‘unreal’ prices market-based electricity prices. Most electricity do not provide accurate signals of underlying consumers have consumed electricity under a market conditions, so that market participants political and regulatory paradigm that allowed will respond to these false price signals and market them to get as much electricity as they wanted, benefits will be blunted or even destroyed.

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Viewpoint on Energy

ELECTRICITY MARKET INTERVENTION
It is fairly easy to identify overt price caps, but there are other ways to intervene in electricity markets that may not be so easy to identify. Some examples: • Subsidies – In the move to encourage certain types of investment, some electricity markets have implemented rules and procedures that have the effect of intervening in the market. In the most benign case of subsidized entry, a certain type of investment is given money to overcome a real or perceived economic disadvantage in the market. This has the predictable effect of causing more investment in the subsidized investments than is warranted, with the potential to depress market prices. Some markets, worried that market investment will not occur in a manner that results in reliable service, offer special incentives to new generation entry. This has the predictable result of preempting market entry, lowering prices, and ensuring that any new entrant will demand similar treatment and incentives. • Skewed rules – Another approach to encourage certain types of investment is to insert special treatment for those investments into the market rules. An example might be a requirement that wind generators receive preferential dispatch, even though this might be accomplished only with some difficulty in a functioning electricity market. Similar rules might state that wind generators never see prices that are below zero. Such skewed rules may have similar effects in encouraging excess investment in the targeted generation, but may have more significant and unintended consequences in the market. One important issue in such rules changes is that potential for other market participants to be placed at a disadvantage as a result of the working of the rules. • Socialization of costs – A common approach to markets is using non-market approaches to recover some costs that would otherwise be part of real-time market prices. An example is the cost of managing congestion in the England & Wales market, where this cost is not seen in electricity market prices, but is recovered from customers in a more diffuse manner. The result is severe blunting of the price signals that would otherwise drive investment to reduce congestion. • Price formation that hides real prices – Another subtle form of electricity market price control is the use of uniform or zonal prices. Electricity prices may have strong locational differences that are not reflected in uniform or zonal prices. Ignoring locational electricity price differences leads to such things as regulatory ‘must-run’ power plants, constrained on/off payments to generators, rationing (eg, power outages), and non-market incentives aimed at power plant investment location decisions. A similar approach might set prices on an hourly basis, when actual market prices would have significant differences within an hour.

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Viewpoint on Energy

In the short term, price controls may lead to shortages at times of peak demand under capped prices or the need for extensive intervention of system/market operators. In the long term, price controls may lead to inappropriate levels of investment. Most markets provide system/market operators with tools (eg, reserves, emergency powers to direct operation, etc) to manage the market in the short term with price controls. When the level of intervention is high, intervention may replace market prices as the primary tool for managing the system.

1. Understand markets, accept price volatility and manage expectations Accept that electricity market prices will be volatile, with variations over time and across locations. The important information in these prices is needed to allow participants to take actions to manage the market. Prices should be high when supply is short and low when there is excess supply, both in the short term (ie, in hourly spot prices) and in the long term (ie, in long-term hedging arrangements and the annual average spot price). Some actions:

• Educate market participants about electricity The ultimate impact of price controls in electricity prices – that these prices will be volatile and markets may not be obvious for some time. Price will reflect underlying supply and demand. caps that seem harmless and even beneficial to Realistic expectations will help participants deal some participants in the short term may have with actual prices. a negative impact on the level, type and timing of new power plant investments that will not be • Encourage and assist participants to develop seen for years. These same price caps may lead appropriate hedging and risk management the owners of existing power plants to shut them approaches. down rather than continue with losses. • Implement transitional risk management Price caps will result in higher consumption and programs when moving from vertical less investment in power plants than an unfettered integration and regulation to electricity markets, electricity market. The increases in demand as using vesting contracts or similar approaches.1 consumers use more electricity are inconsistent This will serve to minimize the ‘price shock’ with lower investment in power plant capacity. factor and will have the effect of jump-starting This problem has led to a variety of capacity an active hedge market. mechanisms that are meant to maintain reliability by replacing the investment signals from ‘real’ • Ensure that market participants do not expect that demands for price controls or intervention market prices with some artificial signal. will succeed. Electricity markets with price controls or other intervention may produce outcomes that are • Strive for stability and predictability. Electricity markets are a unique mix of short-term activities worse than the outcomes in a well-run, regulated, (demand and generation must be matched in vertically integrated industry. each second) and long-term assets (power plants take years to build and last for many decades). Participants will not undertake long-term Limit price controls and investment and operating strategies that are intervention to preserve needed to achieve short-run efficiency unless there is the expectation that the market is here market benefits to stay. Electricity markets, like all markets, rely on price signals to participants. The benefits of electricity markets may not survive the 2. Do not use price controls and intervention to manage other problems distortion of these price signals by price controls and other intervention (see ‘Electricity market intervention’). Price controls and market It sometimes seems easy to address difficult intervention must be limited and well-defined problems in industry structure (eg, generator in order to ensure that the benefits of markets market power, lack of real-time demand response, are available. PA believes that the following or transmission congestion) with the use of price guidelines, for governments and regulators, will controls or other intervention. Price controls will help preserve real price signals and the market not solve these problems, only mask the effects of benefits that arise from participant response to the problems and prevent any market solutions from occurring. Some examples: these price signals.

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Vesting contract is a term used to refer to a range of transition instruments that are used to temporarily convey the benefits of vertical integration to disaggregated market participa� esting Contracts: A Transition Tool.’ The Electricity Journal, July 2001. 11

Viewpoint on Energy

• Market power is best addressed by structural solutions (eg, requiring divestiture of assets by dominant participants) and by aggressive legal action against participants that take illegal actions.

• A lack of real-time demand response can best be addressed by implementing real-time metering and educating users, not by putting automatic • Limit any price controls with explicit ‘sunset’ market price mitigation schemes in place that are provisions. Such provisions might include a supposed to be a proxy for demand response. price control mechanism that is due to expire on a fixed date or a VoLL price cap that is removed • Transmission congestion and local supply/ when an adequate level of market demand demand imbalances are best managed by response is seen. solutions that modify the supply/demand balance. Price controls through uniform or • Avoid other regulatory interventions that may zonal pricing will only mask the real problem, have the indirect effect of controlling prices, will prevent market solutions, and may even such as out-of-market incentives3 for new entry exacerbate the real problem. or demand rationing.4 • A need for more generation that leads to high • Demand clear thinking, wide consultation and market prices will best be managed by adding an ‘economic impact’ analysis that covers an more generation, not by putting price caps in appropriately long time period before adopting place. High prices are the market signal for new price controls. Recognize that the negative effects entry (and also for lower consumption). The of price controls may not be seen for years. use of non-market incentives (eg, subsidized • Do not let one side of the market (eg, consumers) power purchase agreements) will also corrode dominate the debate or drive intervention and the effectiveness of price signals and market price controls – electricity markets have buyers participant response to them. and sellers; both are necessary for the market to work and both have valid interests. 5 3. Adopt price controls and other • If some intervention is required, avoid the use of interventions carefully and with ex post facto price controls, such as those sought clear limits for the California market (eg, repayment by generators of revenues during periods when While the market will work best when left alone, prices were high in 2000). There are few things there may be times when there is no choice but that will undermine confidence in markets and to use some sort of price control or intervention. blunt participant activity in markets so much In such instances, the actions should be as limited as the possibility of ex post revisions to already in time and scope as possible, and should be settled market outcomes. carefully examined to minimize unintended By following these guidelines, governments and consequences: regulators can define and limit the use of price • Allow the market to work as much as possible. controls, thereby reaping the benefits of electricity It is better to have high price caps (and low industry reform. price floors) that allow the

market to work much of the time, than to set price controls that are in effect much of the time. An example is a Value of Lost Load (VoLL) price cap.2 Such a cap might be a substitute for demand response that is set at a high level that increases over time (see case study on Australian market that follows.)

Edward Kee is a Member of the PA Management Group. He works for the firm’s global energy team, based out of Washington, DC.
2

The Value of Lost Load or VoLL is a price that is meant to be reflective of the price at which consumers would shed load, if they could respond to price. In market designs, VoLL prices are� Also, when the market fails to clear so that load is shed involuntarily, the VoLL price is in effect for similar reasons. Offering a subsid�fered. In the summer of 1999/2000, the Victoria state government (Australia) responded to price spikes and the potential for outages following a large power plant outage by ordering that air conditioning be turned off. This had the effect of lowering demand significantly, so that Victoria electricity market prices were extremely low and power was exported to neighboring states where prices were at more normal summer peak levels. Subsequently, the Australian market rules were modified to invoke VoLL pricing when such government interventions occurred. Markets are defined by the interaction of supply and demand; all too often, electricity markets become an exercise in supplying an unresponsive demand that seeks protection from the market, rather than participating in the market. Sellers with large sunk capital investments may have few options and may be seen in the post-Enron industry as convenient political targets.

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Case study: Australian electricity market – VoLL price cap increase
Our thought-piece outlined some guidelines for price controls and market intervention. The Australian national electricity market provides an example of a price cap that is applied in a manner that is consistent with those guidelines, with the result that the market has not been harmed by the price cap.

The Australian national electricity market (NEM) is an energy-only market. There are no separate capacity payments or other market mechanisms to drive capacity investments. In the NEM, all generator revenue comes from sales at spot prices that may be supplemented by revenue from participation in the reserves market. Outside the NEM market, a wide range of contractual market arrangements also produces profits for generators. The NEM has a VoLL cap on spot prices that was initially set at AUS$5,000 per MWh and was raised to AUS$10,000 per MWh in 2003. While market prices rarely reach the level of these price caps, market participants expect that spot prices can and sometimes will reach the VoLL price cap. Investments that ensure reliability during system peaks may only earn revenue from an energy-only market such as the NEM for a few hours per year. The price that would be required to provide incentive for these peak reliability investments was considered in setting the level of VoLL. The high level of the VoLL price cap provides incentives for reliability of supply through investment in peak generation, demand-side facilities and network investment. In one form or another, the market will need to pay for peaking investments if reliability is to be maintained. In the NEM design and initial reviews, a number of alternative approaches to generation adequacy were considered and none was regarded as superior to the energy-only market with a VoLL cap. The VoLL cap approach allows spot prices to clear at a sufficiently high level to remunerate peak generation investments.

In the application to increase the level of the VoLL price caps, it was argued that increasing the level of the VoLL spot price cap would benefit the public by increasing the incentive for market responses by both the demand and supply sides, ensuring the future reliability of the system and reducing the price distortion introduced by a market cap.6 Interestingly, market participants were in favor of keeping the VoLL cap and increasing its level. Market participants have come to expect that prices may get very high at times and have developed strategies for hedging this price risk. The participants in the Australian market have high levels of coverage using contracts for differences. This high level of contract coverage, initially a result of vesting contracts that are now expired, is the result of a bilateral market between buyers and sellers that has developed with no intervention from outside. New generation entry, supported in part by market hedge contracts, has been seen in South Australia, Queensland and even in Victoria. South Australia and Queensland had tight supply situations and resulting high prices (occasionally at VoLL levels) when the NEM started in 1998. In both regions, new marketbased entry in base-load and peak-load power plants has significantly moderated prices in both regions, and in some hours, both regions are exporting to the rest of the NEM. Victoria had a surplus of base-load coal stations when the market started in 1998, but has recently seen price spikes in the summer peak months that led to recent market investments in peak-load power plants.

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For more information, see ACCC Determination, Applications for Authorisation, VoLL, Capacity Mechanisms and Price Floor, 20 December 2000, authorisation nos: A90711, A90712, and A90713; pages 6–7 (www.accc.com.au). 13

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