on Energy: shortages, surplus and the search for value

03 06 14 24 38
Introduction Reaping the benefits Generation asset Comparing approaches Liquefied natural gas
of electricity industry ownership: the more to promoting renewable is more flexible than
reform: defining and things change the more energy: prospects for pipeline gas: but can
limiting the use of they will remain the wind energy in the UK this value be extracted?
price controls same and the US
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Contents
Introduction 03

Reaping the benefits of electricity industry reform: 06

defining and limiting the use of price controls

Generation asset ownership: 14

the more things change the more they will remain
the same

Comparing approaches to promoting renewable 24

energy: prospects for wind energy in the UK
and the US

Liquefied natural gas is more flexible than 38

pipeline gas: but can this value be extracted?
Viewpoint on Energy

Reaping the benefits of electricity industry

reform: defining and limiting the use of price
controls

By Edward Kee

O
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 start-
up 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.

07
Viewpoint on Energy

Electricity sector reform Markets in the electricity

driven by benefits sector
Reform of the electricity sector – replacing All markets are defined by prices, with market
traditional electricity industry regulation with prices providing information about the relative
competition and markets – is largely driven by scarcity of products to buyers and sellers. Buyers
the promise of benefits. Regulation of electric and sellers in a market act on this price information
utilities has been the norm over most of the last to coordinate their economic activity.
century and has resulted in well-developed power
Electricity markets are no different. Electricity
systems in most developed countries. However,
market prices provide important information on
electric utility regulation results in higher prices
relative scarcity to buyers (both wholesale and
and lower levels of service than markets might
retail electricity users) and sellers (generators).
provide because:
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

08
 Viewpoint on Energy

more investment and behavior changes to when they wanted it, for a relatively fixed (and
increase this) 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 Electricity market prices may exhibit
fixed prices for electricity, as seen in regulation. large and frequent swings, largely
When electricity market participants understand
and even expect volatile prices, they will act to driven by hourly, daily, weekly and
manage the risk presented by volatility. This risk
is managed by entering into hedging arrangements,
seasonal movements in demand.
by changing use or production patterns to
benefit from price swings (eg, interruptible load The result is that most electricity markets have
and peaking plants), or by physical hedging had price controls and intervention even before
through vertical integration between loads and the markets were established. These price controls
power plants. will make electricity markets less effective and will
reduce or even remove market benefits.
However, some market participants respond
to volatile electricity market prices by seeking
government or regulatory intervention. Price controls reduce market
benefits
Electricity market price When market prices are controlled or capped,
controls the resulting price information (ie, about
relative scarcity) does not reflect actual market
Regulatory intervention and price controls in
conditions and may lead buyers and sellers to take
electricity markets may be seen as normal, even
inappropriate and inefficient actions.
though market prices are an important part of
electricity markets. 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.

09
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 pre-
empting 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.

10
 Viewpoint on Energy

In the short term, price controls may lead to 1. Understand markets, accept price
shortages at times of peak demand under capped volatility and manage expectations
prices or the need for extensive intervention
of system/market operators. In the long term, Accept that electricity market prices will be
price controls may lead to inappropriate levels of volatile, with variations over time and across
investment. locations. The important information in these
prices is needed to allow participants to take
Most markets provide system/market operators
actions to manage the market. Prices should be
with tools (eg, reserves, emergency powers to
high when supply is short and low when there is
direct operation, etc) to manage the market in the
excess supply, both in the short term (ie, in hourly
short term with price controls. When the level
spot prices) and in the long term (ie, in long-term
of intervention is high, intervention may replace
hedging arrangements and the annual average
market prices as the primary tool for managing
spot price). Some actions:
the system.
• 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
market prices with some artificial signal. that demands for price controls or intervention
will succeed.
Electricity markets with price controls or other
intervention may produce outcomes that are • Strive for stability and predictability. Electricity
worse than the outcomes in a well-run, regulated, markets are a unique mix of short-term activities
vertically integrated industry. (demand and generation must be matched in
each second) and long-term assets (power plants
take years to build and last for many decades).
Limit price controls and Participants will not undertake long-term
investment and operating strategies that are
intervention to preserve needed to achieve short-run efficiency unless
market benefits there is the expectation that the market is here
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
distortion of these price signals by price controls intervention to manage other problems
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
these price signals. from occurring. Some examples:

1
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 market to work much of the time, than to
solutions (eg, requiring divestiture of assets set price controls that are in effect much of
by dominant participants) and by aggressive the time. An example is a Value of Lost Load
legal action against participants that take (VoLL) price cap.2 Such a cap might be a
illegal actions. substitute for demand response that is set at a
high level that increases over time (see case study
• A lack of real-time demand response can best be
on Australian market that follows.)
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
consequences: By following these guidelines, governments and
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

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.
3
Offering a subsid�fered.
4
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.
5
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.

12

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.
6
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).
Viewpoint on Energy
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 market-
based 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.
13