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 just and reasonable regulated rates. The sale of all three components of electric service – generation, transmission and distribution – was referred to as an “integrated” or “bundled” service.
The explanation is no longer than easy because of recent changes in:
- The relationship between utilities and their end-use customers; and
- The source of the generation component of electric service.
Change in the Relationship Between Utilities and Their End-Use Customers
The utilities are still responsible for providing the transmission and distribution components of electric service to their customers. And they provide those delivery services on the same regulated basis that they have been providing them for over 100 years.
But the generation, or commodity, component of electric service may have changed depending upon the utility and where it is located. In some states little has changed. The utility still sells the commodity component as part of its regulated bundled service.
In other states, the commodity component can be sold to end-use customers by unregulated competitive retail suppliers. In those states the utility remains responsible for delivering that commodity on behalf of the competitive retail suppliers. Where customers in those states opt not to purchase their commodity from an unregulated competitive supplier the utility will serve as the default supplier of the generation component.
Source of the Generation Component of Service
The source of the generation component also differs on a state by state basis. In some states, utilities continue to own their own generation plant and, where they include generation as part of the bundled service, the cost of that generation remains part of the regulated bundled rate. However, in most states, utilities no longer include the cost of their own generation as part of the regulated bundled rate. In those states, the utilities that still provide the commodity component of service (as well as the unregulated retail suppliers) obtain that commodity component from a competitive power exchange.
The ISOs Manage the Power Markets
But how does such a competitive power market work? And how are the competitive prices determined? Each competitive power market is operated by regional Independent System Operators (ISO). See Post entitled Who Controls the Electric Transmission Grid? for an explanation of the ISO. And the prices in those markets are determined in a competitive auction that the ISOs manage. The ISOs runs the auctions under sets of rules approved by the Federal Energy Regulatory Commission (FERC).
Retail suppliers – that is, both competitive retail suppliers and the utilities that provide the generation commodity component as part of their bundled service – are the buyers in the auction. They buy the products necessary to meet their end-users’ requirements.
Generation plant owners (including some utilities that continue to own generation facilities) are the sellers in the auction. They own the hundreds or thousands of generation sources that are interconnected to the ISOs. Unlike a regulated utility, generation plant owners are not guaranteed a return on investment. They rely on the auction clearing prices for the possibility of a profit.
Hopefully, the ISO power market rules will result in reliable and affordable electricity for end-users in both the near term and the long term. Most of the ISOs meet this goal by maintaining a competitive market for several products, the most important of which are capacity and energy.
The Capacity Market
Capacity is the amount of generating resources required to ensure that there will be adequate electricity available to meet end-use customer requirements. Capacity is measured in megawatts.
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.
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 the ISO 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 for the promise to deliver electricity has been accepted – will receive the cleared price for their capacity in the future time period.
Plants that have promised to generate electric will actually generate electricity only if and when, based on their operating costs, they clear the energy market and are directed to operate. However, they will receive the cleared price for their capacity even if they never clear in the electrical energy market and never sell any energy during that period. But, 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 Market
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 megawatts, energy is the actual performance of that work and adds a time element to the capacity. Energy is, therefore, measured in megawatt-hours.
Retail suppliers purchase energy to meet their end-use customers’ current energy requirements. Generation plant owners sell energy to meet the retail supplier requirements.
The ISOs conduct an auctions for each hour of the day to determine the settled price for energy at multiple locations on their system. 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 prices 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 end-use customers 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.