- Email: [email protected]
Fixing the California Pricing Mess
GUEST EDITORIAL
Steven Braithwait and Ahmad Faruqui
Fixing the California Pricing Mess
T
hese comments, occasioned by the latest round of rolling blackouts in California, focus on a question and a comment in columnist Paul Krugman’s provocative op-ed piece on California’s electricity crisis, “The Unreal Thing,” in the Feb. 18 edition of The New York Times. His question and comment were: “Would it really have made a big difference if those [retail] prices had not been fixed?” and “All the evidence suggests that to reduce demand enough to eliminate today’s shortages retail electricity prices would have to rise enormously . . .” Our response in brief is yes, allowing retail prices to better reflect wholesale costs would have made a big difference, and no, prices overall would not have to “rise enormously” to solve the shortage problem.
The issues concerning the state’s fixed retail prices are best dealt with in two parts. One has to do with the overall level at which the prices are fixed. The other has to do with whether retail prices are allowed to vary over different time
Steven Braithwait is a Vice President at Christensen Associates, Madison, Wisconsin, where he focuses on electricity pricing and measuring customer price responsiveness. He may be contacted via email at [email protected]. Ahmad Faruqui is an economist with EPRI (formerly the Electric Power Research Institute), Palo Alto, California. He manages a portfolio of research dealing with retail and power markets. He can be reached at [email protected].
I. Overall Prices
June 2001
periods to reflect the underlying wholesale cost of power.
Regarding the overall price level, it is evident that, since last summer, regulated retail prices in California have been maintained at a level far below the cost of power in the wholesale market; this is the cause of the debt crisis facing the major utilities (i.e., the utilities paid out much more to buy power in the wholesale market than they
were allowed to recover in revenue through rates). Under either true deregulation or traditional regulation, retail prices would normally have been raised (as they have been recently in numerous other states) to account for factors that have increased utilities’ costs, such as recent natural gas price increases, higher emissions credit payments, and the effect of low hydro conditions in the Pacific Northwest. Wholesale prices in California have soared beyond the levels suggested by those factors, reflecting a combination of scarcity rents as the independent system operator (ISO) scrambled to buy scarce power, possible market power manipulation by the current owners of generating units in the state, and risk premiums due to nonpayment concerns. Since retail prices remain fixed, however, the utilities’ debt, and now that of the state government, continue to grow, and hundreds of small generators have not been paid for power that they produced (a rate increase was scheduled to take effect June 1). Our understanding is that “today’s shortages” (i.e., those leading to the 32 days of Stage III alerts during January and February, and to rolling blackouts on Jan. 17–18 and the week of March 19, even at
© 2001, Elsevier Science Inc., 1040-6190/01/$–see front matter PII S1040-6190(01)00209-3
71
relatively low demand levels) have largely been the result of the financial crisis brought on by the major utilities’ debts, and generators’ consequent reluctance to sell power without being paid (reports at the time suggested 3,000 MW of independent power generation held out of the market). Thus, a modest overall retail price increase last summer or fall, designed to recover costs and relieve at least part of the debt problem, would likely have prevented much of the “shortage” experienced during the past few months.
ing most summer days range from below-average to average levels. The important thing to understand, however, is the beneficial effect of connecting the wholesale and retail markets by allowing at least some large customers to face hourly real-time prices (RTP) that reflect wholesale costs on the highest-cost days. Many consumers who face such high hourly prices will reduce their consumption in those hours substantially (historical evidence from RTP rates elsewhere indicates that customer price response is consistent and predictable). This “demand response” will
II. Real-Time Pricing The shortage issue for the upcoming summer is more serious, with estimates of supply falling short of likely maximum demand levels by as much as 5,000–7,000 MW. This leads to our second point, that overall retail prices do not have to “rise enormously” to solve the short-term shortage problem. Occasional capacity shortages and high prices in regional power markets are not unusual. They typically occur during the afternoon hours on only a few days in summer, in which demand is unusually high or capacity is unusually constrained. The total number of such hours typically ranges from 1 to 2 percent of all summer hours, depending upon several factors, including weather conditions, the overall business climate, availability of generation, and, in California, drought conditions in the Northwest. During those relatively few hours, wholesale prices may rise to levels as much as 10 to 100 times normal. In contrast, “peak period” prices dur-
72
help bring the aggregate demandsupply equation into balance. It will also reduce the effectiveness of bidding strategies of generators that are designed to raise wholesale prices above competitive levels. These effects, in turn, will produce substantially lower wholesale prices than if retail prices were held fixed, and demand were completely unresponsive. Our analysis of a hypothetical RTP program in California (reported in the March 15, 2001, issue of Public Utilities Fortnightly) sug-
© 2001, Elsevier Science Inc., 1040-6190/01/$–see front matter PII S1040-6190(01)00209-3
gests that demand response during supply constraints and high wholesale prices would produce state-wide load reductions on the order of 2.5 percent, and lead to wholesale price reductions of 24 percent. Thus, unfreezing retail prices for some customers during the occasional periods of supply constraints would have gone a long way toward both relieving those constraints and reducing the market prices that all customers must eventually pay. ome are concerned that exposure to high hourly prices will lead to large and unstable customer bills. “Two-part” rate-design mechanisms, based on forward contracts for baseline levels of usage, are available to stabilize monthly bills for RTP customers at amounts no larger than under the fixed, regulated prices. In practice, customers’ actual bills are likely to fall when they reduce usage during very high-cost periods, as they effectively sell power back into the system. (This two-part mechanism can also be used with simpler pricing designs, such as time-of-use prices that reflect average wholesale market prices; such designs provide incentives for load reduction while maintaining bill stability.) In summary, “enormous price increases” are not required to resolve the state’s shortage problem. Common sense suggests that some overall price increase is needed to get close to covering utilities’ costs, and put a dent in the debt problem. Finally, some large price increases during a relatively few hours of tight supply will go a long way toward relieving the demandsupply imbalance until new capacity is brought on line. j
S
The Electricity Journal
Steven Braithwait and Ahmad Faruqui
Fixing the California Pricing Mess
T
hese comments, occasioned by the latest round of rolling blackouts in California, focus on a question and a comment in columnist Paul Krugman’s provocative op-ed piece on California’s electricity crisis, “The Unreal Thing,” in the Feb. 18 edition of The New York Times. His question and comment were: “Would it really have made a big difference if those [retail] prices had not been fixed?” and “All the evidence suggests that to reduce demand enough to eliminate today’s shortages retail electricity prices would have to rise enormously . . .” Our response in brief is yes, allowing retail prices to better reflect wholesale costs would have made a big difference, and no, prices overall would not have to “rise enormously” to solve the shortage problem.
The issues concerning the state’s fixed retail prices are best dealt with in two parts. One has to do with the overall level at which the prices are fixed. The other has to do with whether retail prices are allowed to vary over different time
Steven Braithwait is a Vice President at Christensen Associates, Madison, Wisconsin, where he focuses on electricity pricing and measuring customer price responsiveness. He may be contacted via email at [email protected]. Ahmad Faruqui is an economist with EPRI (formerly the Electric Power Research Institute), Palo Alto, California. He manages a portfolio of research dealing with retail and power markets. He can be reached at [email protected].
I. Overall Prices
June 2001
periods to reflect the underlying wholesale cost of power.
Regarding the overall price level, it is evident that, since last summer, regulated retail prices in California have been maintained at a level far below the cost of power in the wholesale market; this is the cause of the debt crisis facing the major utilities (i.e., the utilities paid out much more to buy power in the wholesale market than they
were allowed to recover in revenue through rates). Under either true deregulation or traditional regulation, retail prices would normally have been raised (as they have been recently in numerous other states) to account for factors that have increased utilities’ costs, such as recent natural gas price increases, higher emissions credit payments, and the effect of low hydro conditions in the Pacific Northwest. Wholesale prices in California have soared beyond the levels suggested by those factors, reflecting a combination of scarcity rents as the independent system operator (ISO) scrambled to buy scarce power, possible market power manipulation by the current owners of generating units in the state, and risk premiums due to nonpayment concerns. Since retail prices remain fixed, however, the utilities’ debt, and now that of the state government, continue to grow, and hundreds of small generators have not been paid for power that they produced (a rate increase was scheduled to take effect June 1). Our understanding is that “today’s shortages” (i.e., those leading to the 32 days of Stage III alerts during January and February, and to rolling blackouts on Jan. 17–18 and the week of March 19, even at
© 2001, Elsevier Science Inc., 1040-6190/01/$–see front matter PII S1040-6190(01)00209-3
71
relatively low demand levels) have largely been the result of the financial crisis brought on by the major utilities’ debts, and generators’ consequent reluctance to sell power without being paid (reports at the time suggested 3,000 MW of independent power generation held out of the market). Thus, a modest overall retail price increase last summer or fall, designed to recover costs and relieve at least part of the debt problem, would likely have prevented much of the “shortage” experienced during the past few months.
ing most summer days range from below-average to average levels. The important thing to understand, however, is the beneficial effect of connecting the wholesale and retail markets by allowing at least some large customers to face hourly real-time prices (RTP) that reflect wholesale costs on the highest-cost days. Many consumers who face such high hourly prices will reduce their consumption in those hours substantially (historical evidence from RTP rates elsewhere indicates that customer price response is consistent and predictable). This “demand response” will
II. Real-Time Pricing The shortage issue for the upcoming summer is more serious, with estimates of supply falling short of likely maximum demand levels by as much as 5,000–7,000 MW. This leads to our second point, that overall retail prices do not have to “rise enormously” to solve the short-term shortage problem. Occasional capacity shortages and high prices in regional power markets are not unusual. They typically occur during the afternoon hours on only a few days in summer, in which demand is unusually high or capacity is unusually constrained. The total number of such hours typically ranges from 1 to 2 percent of all summer hours, depending upon several factors, including weather conditions, the overall business climate, availability of generation, and, in California, drought conditions in the Northwest. During those relatively few hours, wholesale prices may rise to levels as much as 10 to 100 times normal. In contrast, “peak period” prices dur-
72
help bring the aggregate demandsupply equation into balance. It will also reduce the effectiveness of bidding strategies of generators that are designed to raise wholesale prices above competitive levels. These effects, in turn, will produce substantially lower wholesale prices than if retail prices were held fixed, and demand were completely unresponsive. Our analysis of a hypothetical RTP program in California (reported in the March 15, 2001, issue of Public Utilities Fortnightly) sug-
© 2001, Elsevier Science Inc., 1040-6190/01/$–see front matter PII S1040-6190(01)00209-3
gests that demand response during supply constraints and high wholesale prices would produce state-wide load reductions on the order of 2.5 percent, and lead to wholesale price reductions of 24 percent. Thus, unfreezing retail prices for some customers during the occasional periods of supply constraints would have gone a long way toward both relieving those constraints and reducing the market prices that all customers must eventually pay. ome are concerned that exposure to high hourly prices will lead to large and unstable customer bills. “Two-part” rate-design mechanisms, based on forward contracts for baseline levels of usage, are available to stabilize monthly bills for RTP customers at amounts no larger than under the fixed, regulated prices. In practice, customers’ actual bills are likely to fall when they reduce usage during very high-cost periods, as they effectively sell power back into the system. (This two-part mechanism can also be used with simpler pricing designs, such as time-of-use prices that reflect average wholesale market prices; such designs provide incentives for load reduction while maintaining bill stability.) In summary, “enormous price increases” are not required to resolve the state’s shortage problem. Common sense suggests that some overall price increase is needed to get close to covering utilities’ costs, and put a dent in the debt problem. Finally, some large price increases during a relatively few hours of tight supply will go a long way toward relieving the demandsupply imbalance until new capacity is brought on line. j
S
The Electricity Journal