Wholesale Electricity Markets and Policy: An Overview
By Tim Brennan
April 6, 2005
Opening electricity markets follows a deregulatory trend going back to at least the Carter administration. Economists long had recognized that regulation was handicapped by the difficulty faced by the government in getting the information necessary to set reasonable prices. In addition, the process tended to respond more to the needs of the regulated firms rather than to those of the customers.
Replacing regulation with competition has been very successful in sectors that are workably competitive, most notably airlines, trucking, and banking. In other sectors, such as telecommunications and now electricity, introducing competition has been more difficult because segments within those industries retain tendencies toward monopoly. Generation (the production of electric energy) and marketing (the sale of electricity to final users) have become amenable to competition, but long-distance transmission systems and local distribution grids used to move electricity from generators to users, however, remain regulated monopolies.
This web feature is adapted fromMaking Electricity Markets Competitive: How Fast and By Whom?
by Tim Brennan
(Chapter 7 in New Approaches on Energy and the Environment: Policy Advice for the President).
The stakes are high. The electricity sector constitutes about 2 to 3 percent of the gross domestic product in the U.S. economy, comparable to, if not exceeding, the sizes of the automobile manufacturing, agricultural, or television industries. But this 2 to 3 percent figure, large as it is, vastly understates electricity's importance. As the August 14, 2003, Northeast blackout reminded us, our economy and society grind to a halt absent electricity to provide light, refrigeration, heating and cooling, communications, transportation, and the energy to power our factories, businesses, and homes.
The intricacy of the puzzles presented by this sector follows from electricity's inherent nature. Unlike virtually all products, at any moment the amount of electricity consumed must just equal the amount produced, neither exceeding nor falling short. Imbalances are costly, in that they lead not to minor inconveniences, but to blackouts. Moreover, because the grid is interconnected, a failure of one supplier to meet demands from its customers leads to a blackout for everyone. This makes the reliability of the electricity system a "public good" that an unregulated market is unlikely to provide adequately.
Competition in wholesale markets for electricity sold for distribution to industrial, commercial, and residential customers began as an unintended by-product of the 1978 Public Utility Regulatory Policy Act (PURPA), passed to promote alternative sources of energy by requiring utilities to purchase electricity from a limited set of approved generators. Despite flawed implementation, PURPA showed that the grid could work with non-utility generators. Congress enacted the Energy Policy Act in 1992 to open access to the transmission system to any independent power producer wishing to compete in the wholesale market. Four years later, the Federal Energy Regulatory Commission (FERC) issued its Orders 888 and 889, the first of many enabling regulations toward this end.
To facilitate competition among generators, monopoly transmission needs to be independent from the generation sector. Otherwise, a generator that owns transmission may have the means to stifle competition from new entrants into its traditional markets. Whether so-called "functional unbundling" suffices, or whether a more radical full divestiture and creation of a stand-alone transmission company are required, remains contentious. Through its Order 2000 (issued in 1999) and more recent proposals to standardize wholesale markets, FERC has encouraged the development of independent and geographically expansive regional transmission operators (RTOs). RTOs should at minimum have the geographic scope necessary to match the size of the wholesale markets they manage.
Transmission expansion is a particularly difficult matter. High prices on congested lines desirably encourage shifting the generation of electricity to sites where transmission capacity is available, but allowing high prices for congestion can create perverse incentives to limit capacity. RTOs may need the ability to require investments to expand the grid in one state in order to facilitate competition some distance away. However, if expansions need to be coordinated with specific generation investments, the latter sector may be unable to act with the independence necessary for competition to work.
Another issue is market power, the ability to profit by withholding output in order to raise price. Although the magnitude of the problem remains controversial, it is widely agreed that at peak demand times, when electricity capacity is stretched to the limit, individual generation companies may find it profitable to cut energy supplies even without colluding. The profitability of withholding will be even greater in some settings, as in California during its crisis, when retail prices were largely fixed, ensuring that the public would continue to demand electricity regardless of its wholesale price.
This leads to the fundamental and crucial issue of reliability. Traditionally, reliability has been promoted through voluntary standards. Such processes, however, may not suffice as we move from an era in which utilities had geographically separate monopolies to one in which utilities compete against each other to sell electricity to load serving entities (LSEs). The North American Electric Reliability Council (NERC) may continue to play the major role, but independent RTOs or FERC may need to step in. Whether reliability can be achieved without so much central planning that competition is thwarted remains a debated question.
The choice of competition over regulation should be a matter not of ideology, but of the degree to which one or the other better serves consumers and the economy. The jury remains out on whether transmission and distribution grids can be managed apart from generation to achieve cost recovery, ensure reliability, encourage short-term supply-and-demand response to congested lines, and provide appropriate incentives to increase generation, transmission capacity, and the use of innovative control systems. Effective counters to the incentive to withhold power at times when demand stretches generation capacity to the limit, especially solutions that do not involve reregulation of wholesale markets, remain elusive. While reasons for optimism exist, policymakers should always keep in mind that electricity's crucial nature and unique characteristics may render it unsuitable for extensive competition.
 Whether and how to open retail electricity markets, involving competition for direct sales to end users, involves additional policy considerations. For reviews of some of the important issues, see Douglas R. Bohi and Karen L. Palmer, "The Efficiency of Wholesale versus Retail Competition in Electricity," Electricity Journal 9(8): 12-20 (1996); Timothy J. Brennan, Karen L. Palmer, and Salvador A. Martinez, Alternating Currents: Electricity Markets and Public Policy (Washington, D.C.: RFF Press, 2002), especially chapters 4, 9, and 12.
Tim Brennan is a senior fellow at Resources for the Future, an independent energy and environmental research organization in Washington, D.C., and a professor of Public Policy and Economics at the University of Maryland, Baltimore Campus.
RFF is home to a diverse community of scholars dedicated to improving environmental policy and natural resource management through social science research. Resources for the Future provides objective and independent analysis and encourages scholars to express their individual opinions, which may differ from those of other RFF scholars, officers, and directors.