Conversion from Regulation to a Competitive Power Market
Explaining the purchase and sale of electricity used to be easy. Utilities produced electricity at their own generating plants. They transmitted that electricity over their own transmission and distribution facilities. And they sold their electricity to their customers at regulated rates. The three components of electric service – generation, transmission and distribution – were referred to as a single “integrated” or “bundled” service.
Explaining the purchase and sale of electricity is no longer that easy. The following have made it much more difficult:
- The “unbundling” of the generation component of electric service; and
- Changes in the relationship between utilities and their end-use customers.
The Unbundling of the Generation Component of Electric Service
In 1995 the Federal Energy Regulatory Commission issued its Open Access Orders requiring utilities:
- To unbundle their generation service from their regulated transmission and distribution services; and
- To provide open access transmission service to all generation owners.
Since that time many utilities have operated their generating facilities in new unregulated affiliates. Other utilities have completely exited the generation business and sold their generating plants to unregulated Independent Power Producers (IPP). As a result, many end-use customers no longer purchase generation produced by their utility as part of the utility’s integrated service.
Customers now purchase the generation component of service under one of the following alternatives:
- In some states (mostly in the Northwest and Southeast where Independent System Operators (ISOs) have not been formed) customers still purchase generation produced by their utility as part of a single integrated service. The cost of that generation is included as part of the regulated rate for the single integrated service.
- In states where customers have been given the option to purchase generation from a competitive non-utility retail supplier customers can purchase their generation either from such a supplier or from their utility. Both the competitive supplier and the utility will obtain their generation supply on a wholesale basis either from an IPP or from a power market.
- In states where ISOs have been formed but customers have not been given the option to purchase from a competitive retail supplier generation will remain part of the integrated service provided by the utility. The utility may provide the generation either from its own facilities. However, it may also obtain generation from an IPP or the regional power market. The cost of generation and/or the cost of purchases will be included in the utilities’ regulated rate for the single integrated service.
Relationship Between Utilities and Their End-Use Customers
No matter where their generation service comes from end-use customers can be assured that their utility will continue to provide transmission and distribution of that generation. And those services will be regulated as they have been for over 100 years.
Where customers have been given the option to purchase from a retail supplier they may be dealing with two entities for their electric service. The utility will send an invoice for the delivery service and the retail supplier will send an invoice for the generation service. However, in some cases the utility has been made the collection agent for the supplier and will include a supply charge line on its invoice to collect the retail supplier’s charge.
Where customers decide not to take advantage of the competitive retail supply opportunity they rely on their utility to purchase their generation component from the competitive power market. The utility will typically include a separate line on its invoice to show the cost of the generation that it purchases in the competitive power market.
The ISOs Each Manage a Power Market
As explained above, much of our generation is now bought and sold in power markets. But how does such a power market work? And how are the competitive prices determined?
The power markets are operated by the regional ISOs. Those markets generally consist of two products – capacity and energy. The ISOs operate their markets in accordance with rules approved by the Federal Energy Regulatory Commission (FERC). The FERC expects its market rules to result in prices for capacity and energy that will result in reliable and affordable electricity for end-users in both the near term and the long term.
Retail suppliers – that is, both competitive retail suppliers and the utilities that provide the generation component from the market as part of their bundled service – are the buyers in the ISO auctions. They buy the capacity and energy needed to meet their end-users’ needs.
Generation plant owners (including some utilities that continue to own generation facilities) are the sellers in the auctions. They own the hundreds or thousands of generation sources that are interconnected to the ISOs and submit bids in the auctions for the sale of capacity and energy. Unlike a regulated utility, generation plant owners operating in a power market are not guaranteed a return on investment. They rely on the auction clearing prices for the possibility of a profit.
The Capacity Auction
Capacity represents the generating resources required to ensure that there will be adequate electricity available to meet end-use customer requirements. Capacity is measured in megawatts (MW).
Retail suppliers purchase capacity to ensure that there are adequate resources interconnected to the ISO to meet their end-use customers’ share of the maximum demand on the system. Generation plant owners sell capacity in the form of a promise to generate electricity when called upon to run by the ISO.
Because capacity is a promise to generate electricity rather than the actual generation of electricity it is sometimes referred as iron in the ground. The ISO rules are intended to ensure that there is adequate iron in the ground to meet end-use customer requirements.
By definition, capacity is a product that ensures the availability of electricity in some future time period. ISOs will conduct an auction for a future period to determine the price for capacity in that period. PJM, for example, conducts its capacity auction for a period three years into the future.
Because the supply and demand balance may vary throughout any ISO’s system there may be different settled capacity prices for different points on the system. Any plant that clears the capacity auction – in other words, whose bid (in $/MW/month) for the promise to deliver electricity has been accepted – will receive the cleared price for their capacity in the future time period whether or not they are asked to produce any energy.
Plants that have promised to generate electric will actually generate electricity only if and when, based real time demand and their operating costs, they clear the energy market and are directed to operate. However, if a plant receiving capacity payments fails to operate when called upon it will be subject to a severe penalty. See GAO’s Report to Congressional Committees on Electricity Markets for a detailed discussion and review of capacity markets.
The Energy Auction
Electrical energy is the ability to do work by the movement of charged particles through a wire. Energy is what is actually produced at a generating plant at the time it is needed by end-use customers. While capacity represents the ability to do work and is measured in MW, energy is the actual performance of that work and adds a time element to capacity. Energy is, therefore, measured in megawatt-hours (MWh).
Retail suppliers purchase energy to meet their end-use customers’ real time energy requirements. Generation plant owners sell energy to meet the retail supplier requirements.
The ISOs conduct auctions for each hour of the day to determine the settled price for energy (in $/MWh) at multiple locations on their systems. The settled prices in the auction will determine which plants are dispatched in each hour and what price they will be paid for their production.
Plants will, in general, only operate when the settled price exceeds their operating costs. To keep the cost of electricity as low as possible the lowest cost plants will clear first – in other words, when demand is low – and the higher cost plants will clear only in hours when demand increases. The following graph shows how different plants may be dispatched on the PJM system throughout the day as demand varies:
Plant dispatch then translates to energy prices. Thus, when usage is high, and the ISO dispatches the more expensive plants, the price of electricity to retail suppliers will be highest. The highest cost operation and the highest priced energy usually occurs during late afternoon hours in the summer months when air conditioning use peaks. The following graph shows a typical difference in electrical energy prices across the hours of a typical day in summer and non-summer months:
I. David Rosenstein worked as a consulting engineer and attorney in the electric industry for 40 years. At various times during his career he worked for utility customers, Rural Electric Cooperatives, traditional investor owned regulated utilities and deregulated power generation companies. Each of his posts in this blog describes a different aspect of the past, present or future of the electric industry.