Electricity and Markets – Have Customers Benefited?

Presentation by

John Kelly

MMEA Fall Conference

September 20, 2007

Five Questions

1. Why did we move to choice (price deregulation)?

2. Why have rates gone up?

3. Why has choice/LMP lead to (a) high prices & (b) not induced new investment?

4. Have consumers benefited?

5. Going forward, what will happen?

APPA Electricity Market Reform Initiative (EMRI)

APPA Supported Original Vision of RTOs/ISOs:

Non-discriminatory transmission access;

Elimination of transmission-rate pancaking;

Coordination of regional transmission planning

APPA Electricity Market Reform Initiative (EMRI) APPA Anticipated:

Continuance of Bilateral Markets/Contracts Small Short-term Balancing Market

Instead: Expansion of RTOs/ISOs from grid operators

and police to “market makers” FERC is allowing market-based rates subject

to price cap and selective market power mitigation.

APPA Electricity Market Reform Initiative (EMRI) – Sponsored Studies1. Evaluate Evidence of Consumer Benefits

(Restructuring the U.S. Power Sector: A Review of Recent Studies, John Kwoka)

2. Causes of High Rates (Increasing Electricity Prices: Are Fuel Costs the Only Explanation, Ken Rose)

3. Utility Profits (The Electric Honeypot: The Profitability of Deregulated Electric Generation Companies, Ed Bodmer)

4. Lack of Investment/Reliability (Investment Performance in Deregulated Markets, Timothy Mount)

APPA Electricity Market Reform Initiative (EMRI) – Sponsored Studies5. Locational Marginal Pricing (LMP) and Short-Run

Marginal Costs (Comparative Analysis of Actual Locational Marginal Prices and Short-Run Marginal Costs, London Economics International)

6. LMP and Bidding (LMP Electricity Markets: Market Operations, Market Power, and Value for Customers, Synapse Energy Economics)

7. RTO/ISO Costs (Analysis of RTO Operational and Administrative Costs, GDS Associates.

1. Why did we move to choice (price deregulation)?

Belief that wholesale power markets can be competitive;

Markets – imperfect or not – are always better than price regulation;

Monopoly Firms/Power Eventually Destroyed – just wait;

Markets do better job allocating investment than regulators or central planers;

1. Why did we move to choice (price deregulation)? (cont.) Inherent Inefficiencies of Price Regulation

(construction, operation, innovation);

Inefficiency in utility rate designs

Worked in other industries (airlines, etc.)

Lower prices (But being questioned now)

2. Why have rates gone up?

First, not largely because of fuel costs Rose study – movement of fuel prices and rates In PJM – MD & DE versus Carolinas & GA, w/

essentially the same fuel mix (Hogan Comment)

Rather: (1) Relaxed price deregulation and

(2) Absence of competitive entry in

base-load capacity markets – too few

players

2. Why have rates gone up? (cont.)

Evidence from EMRI Studies:

LMPs well above relevant costs (LEI)

Reg. v. Dereg. States (Rose, Lave)

Profits of companies & implication of (values of companies, profits=p-c) (Bodmer)

Profits in capacity markets, e.g., New York (Mount)

3. Why has choice lead to high prices and failed to induce investment Simple answer is that that’s what happens in

monopoly (oligopoly) markets;

Two basic requirements for competitive prices are: Allowing prices to vary Low barriers to entry

3. Why has choice lead to high prices and failed to induce investment (cont.)

The economic characteristics of electricity markets are very different from other markets – significant barriers to entry for base load;

Not an excuse for continued regulation; rather, an economic reality that can’t be ignored

Plus, of course, it is an essential service.

Importance of industry characteristics for competitiveness

Capital intensiveness

Financial capital requirements

Scale economies

Lumpiness of investments

Location of facilities

Technology

Product durability

Sunk costs

Substitutes

Seasonality

Product differentiation

Vertical integration

Number of sellers and buyers

Mobility of resources/ Asset specificity

Foreign competition

Network industry

VerySomewhatNot Very

3. Why has choice lead to high prices and failed to induce investment (cont.)

Warren Buffet:

Investing in electric utilities is “not a way to get rich, it’s a way to stay rich.”

“Most of deregulation was a mistake” because, in a deregulated market, “generators have a clear incentive to reduce power reserves.”

Owners of generating assets want the market to be tight

“The last thing in the world an unregulated operator wants is excess capacity.”

Graphic Description (A): Initial Case

Graphic Description (B): Strict Price Regulation

Graphic Description (C): Relaxed Price Regulation

Evidence: Company Profits

ROE (%) Cash Flow to Equity (%)

2005 5-Year 2005 5-Year

Exelon 19 18 33 33

Constellation 13 13 28 25

PSGE 14 16 27 24

PPL 16 20 32 50

Allegheny 10 -1 30 11

Summary of Stock Holding Period Returns (%)

10 yrs. 5 yrs. 3 yrs. 1 yr.

Regulated 10 9 9 12

S&P 500 7 5 10 15

Exelon 22 27 30 26

Constellation 13 22 19 11

PSGE 19 13 20 4

PPL 17 18 23 15

Allegheny 7 3 60 49

Evidence: Company Profits

Evidence: Prospective Profits

Year ROE (%)

Exelon 2008 22

Constellation 2008 17

PSGE 2009 22

PPL 2010 23

Allegheny 2010 26

4. Have Consumers Benefited?

According to some prominent economists – Yes

“There is growing evidence and convincing studies that show that consumers have saved billions of dollars in energy costs as a result of competitive markets.”

“Open Letter to Policymakers,” Compete Coalition, Washington, D.C., June 26, 2006

4. Have Consumers Benefited? (cont.)

According to Prof. John Kwoka:

Methodologies used in the studies that showed benefits “consistently [fell] short of the standards for good economic research.”

“In particular, despite much advocacy there is no reliable and convincing evidence that consumers are better off as a result of restructuring of the U.S. electric power industry.”

4. Have Consumers Benefited? (cont.)

Specifically in regard to the “Open Letter …”:

“… Existing studies do not support that proposition.”

“Indeed, … there is no credible and convincing economic evidence that consumers have been made better off by electricity restructuring.”

4. Have Consumers Benefited? (cont.)

Further …

Unsupported conclusions should not

serve as the basis for further ill-defined

deregulation

4. Have Consumers Benefited? (cont.)

Items cited above in 2 and 3 demonstrate that

consumers haven’t, on average, benefited.

Final Thoughts

Threshold question is not about markets v. regulation, as such; rather it’s about competition v. monopoly.

“Imperfect information, imperfect capital markets, imperfect competition: These are the realities of market economics – aspects that must be taken into account.”

Final Thoughts

“The advocates of deregulation say it was not done perfectly.

They would have us compare an imperfect regulated

economy with an idealized free market

… Rather than an imperfect regulated economy with an even more imperfect unregulated one.”

Joseph Stiglitz

Final Thoughts

Economic Analysis v. Value Judgments (what is an acceptable degree of competition/monopoly, how long to wait, etc.)

As much about economic ideas as about vested interests

Important to understand economic ideas and question assumptions that underlie them, “So,” as one prominent economist warned, “not be duped by economists.”