An overview of electricity market reform and deregulation

1. An overview of electricity market reform and deregulation C.K. Woo Department of Economics Hong Kong Baptist University

2. Objective • Present an overview of electricity market reform and deregulation • Offer a list of key questions to help frame the discussion and guide the decision-making process

3. Why should we care? • Electricity cannot be economically stored and must be supplied in real time to meet fluctuating demand • Real time demand can sharply spike due to extreme weather and is price insensitive • Electrical equipment can fail unexpectedly • Renewable generation (solar and wind) is as available, intermittent, and non-dispatchable • Reliable supply can only occur with capacity reserve and backup facilities • More volatile total demand, more total capacity • Higher failure rates, more facilities

4. Why should we care? Electricity has no close substitutes for many end-uses (e.g., motor, lighting, cooling, electronics) Electricity can only be produced and delivered with equipment already in place Electricity requires capital-intensive investments with long lead time Electricity service disruption can have large economic consequences Though dangerous, electricity theft does occur, at times with fatal consequences (e.g., KFC thief)

5. Transformative events Electricity market reform and deregulation results in (a) competitive wholesale energy markets with hourly prices by location; (b) inter-regional trading; and (c) retail competition for customers Large-scale renewable energy development requires flexible generation and load to accommodate intermittent, unpredictable and as-available generation (e.g., wind) Smart grid, smart meters and smart appliances enable electricity product differentiation and responsive/flexible loads What’s next for Israel?

6. What is a desirable outcome? Safe, reliable, and environmentally friendly service at just, reasonable and stable rates, which requires: • Least-cost investment and operation • Diversified demand-supply mix for energy security, including reliable integration of renewable resources • Efficient pricing of differentiated services to meet diverse customer needs • Investment and pricing decisions sensitive to unpriced environmental factors • Recovery of reasonable risk-adjusted return on and of investments

7. Market organization optionsWhat are the drivers for change? Government ownership Privately owned integrated utilities Market reform and deregulation Pre-reform: Europe, Ontario, China, Australia, New Zealand, Singapore Rate of return (ROR) Regulation: North America Performance based Regulation (PBR): UKand Australia North America: California, Texas, PJM, New York, New England Canada: Ontario and Alberta European Union Australia New Zealand Degree of decentralized decision making

8. Stylized model Bilateral Market Wholesale Generation Market (Pool Structure) Financial (Contracts) Market Distribution Companies Retailers Customers

9. Path to success Market design Design stage Good design Bad design Implementation stage Successful implementation Unsuccessful implementation (e.g., few sellers) Operation stage Existing capacity surplus, fast market entry, and elastic demand Existing capacity shortage, slow market entry, and inelastic demand Gains: Lower costs, lower prices, more choices, better reliability Losses: Higher and more volatile prices, capacity shortages, lower reliability

10. Status in the US Source: http://www.eia.doe.gov/cneaf/electricity/page/restructuring/restructure_elect.html

11. Anticipated challenges • Electricity deregulation is complicated, with many under-estimated challenges • The cost of setting up and operating an Independent System Operator (ISO) is substantial • Marrying competitive generation with grid operation leads to many markets: (a) energy markets (e.g., forward, day-ahead, hour-ahead, real-time); and (b) ancillary service markets (e.g., spinning and non-spinning reserves, regulation, voltage support, real power loss, energy imbalance) • Electricity spot prices are highly volatile due to random demand, fluctuating fuel cost, unpredictable equipment failure, and intermittent renewable generation, necessitating risk management by market participants • Market power abuse is common in deregulated markets • When supply is short, even minor capacity withholding can be highly effective and profitable, at the expense of consumers

12. Anticipated challenges • Electricity deregulation may cause insufficient investment because price and revenue volatility discourages investment, even in the face of capacity shortage • Renewable energy development erodes the incentive to invest in flexible generation critically needed for reliable grid operation • Deregulation can jeopardize reliability: merchant generation investments do not always occur in the right place at the right time • Deregulation seldom reduces generation cost • While competition reduces labor and O&M costs, generation cost may not fall because merchant generation’s capital cost exceeds a regulated utility’s capital cost • Dysfunctional input markets may preclude an efficient output market because of vertical market power abuse • Contract breach can occur, especially when the wholesale market price explodes

13. Key questions 13

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16. C.K. Woo, Ph.D. (Economics, UC Davis) • Dr. Woo is Professor and Head of the Economics Department of HKBU and Senior Partner (now on leave) of Energy and Environmental Economics, Inc. (www.ethree.com), a consulting firm located in San Francisco • He specializes in energy economics and applied microeconomics. With 30 years of industry experience, he has participated in electricity market reform in California, Texas, British Columbia, Ontario, Macau and Hong Kong • He has co-authored 12 papers with Professor Asher Tishler on the Israeli electricity industry • He has over 100 papers in such scholarly journals as Energy Policy, The Energy Journal, Energy, Energy Economics, Journal of Regulatory Economics, Journal of Public Economics, and Quarterly Journal of Economics • Recognized by Who’s Who in America, he is (a) a senior fellow of the US Association of Energy Economics; (b) an associate editorial board member of Energy and The Energy Journal; (c) a guest editor for a special issue of Energy Policy on renewable energy