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Overview

A lucid and up-to-date introduction to understanding electrical power utilities in an era of change

Electric utilities worldwide are undergoing profound transformations: nationally owned systems are becoming privatized, privately owned systems that were previously regulated are becoming deregulated, and national systems are becoming international.

Professionals in the power sector must now work in a new world in which an understanding of the principles of markets and how to evaluate investment projects under competition are essential.

This text was written as a manual for the Russian Federal Energy Commission to train regional electricity rate regulators in the principles of economics and finance involved in regulating electricity markets and deregulating electricity generation. Requiring no familiarity with economics and using a minimum of mathematics, this book provides professionals in the power sector with the tools to face the new realities of electric utility operation.

Designed both as a reference for practicing professionals and as a textbook for university and continuing education programs, Electricity Economics: Regulation and Deregulation discusses:

  • The lessons learned from international experiences
  • Competitive versus noncompetitive markets
  • Cost and supply, profit, and economic efficiency
  • The cost of capital, including net present value, discounting, and risk and return
  • Wholesale power markets, generation expansion, and customer choice
  • Specific international examples including the Californian, Norwegian, Spanish, and Argentine power sectors
  • Plus numerous exercises to help clarify and support absorption of the concepts
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Editorial Reviews

From the Publisher
"This training guide requires no familiarity with economics and uses a minimum of mathematics to provide power sector professionals with the tools to face change." (Business Horizons, September-October 2004)

“...this collection is devoted tot he challenges that lie ahead in this area.” (Business Horizons, Vol. 47, No. 2, March/April 2004)

"...a useful addition to the introductory literature on electricity market deregulation..." (The Journal of Energy Literature, Vol.1X, No.1, 2003)

"...produced for...the thousands of professionals…who need to understand the underlying changes that are occurring...the value of this primer is that it covers many topics of regulatory economics...applicable to restructured electricity markets and introduces the reader to electricity markets..." (Energy Journal)

"This book, sponsored by the Institute of Electrical and Electronics Engineers, is really an economics tutorial. It could well be worth millions of dollars to the right industry niche players... I highly recommend this title for anyone playing in this niche financial and energy market." (Business Information Alert, Vol. 15, No. 9, October 2003)

"…I would recommend this book for self-study for any engineer…" (IEEE Power & Energy Magazine, July/Aug 2003)

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Product Details

  • ISBN-13: 9780471234371
  • Publisher: Wiley
  • Publication date: 2/14/2003
  • Series: IEEE Press Series on Power Engineering Series , #12
  • Edition description: New Edition
  • Edition number: 1
  • Pages: 304
  • Product dimensions: 6.48 (w) x 9.61 (h) x 0.78 (d)

Meet the Author

GEOFFREY ROTHWELL is a senior lecturer in the Department of Economics at Stanford University and a senior research associate at the Stanford Institute for Economic Policy Research. He received his MS and PhD at the University of California, Berkeley. 

TOMÁS GÓMEZ is a professor of electrical engineering at Universidad Pontificia Comillas, Madrid, Spain. He is currently Vice Rector of Research and formerly was the director of the Instituto de Investigación Tecnológica at the same university.

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Read an Excerpt

Electricity Economics: Regulation and Deregulation


By Geoffrey Rothwell Tonmas Gomez

John Wiley & Sons

ISBN: 0-471-23437-0


Chapter One

ELECTRICITY REGULATION AND DEREGULATION

1.1. THE ELECTRICITY INDUSTRY: RESTRUCTURING AND DEREGULATION

During the 1990s, a deep transformation in the electricity industry took place in many countries. This sector is moving from a monopoly structure to a more competitive one, as are the transportation and telecommunications sectors. For example, in Latin America, Chile was a pioneer in the early 1980s with the development of a competitive system for electricity generation based on marginal prices. In 1992, Argentina privatized an inefficient government-owned electricity sector, splitting it into generation, transmission, and distribution companies, and introduced a competitive generation market (see Chapter 9). These experiences were repeated in other countries in the region, such as Bolivia, Peru, Colombia, Guatemala, El Salvador, Panama, and, to a limited extent, Brazil and Mexico.

In Europe, Scotland and Northern Ireland followed the experience of England and Wales (Littlechild and Beesley, 1989). The Scandinavian countries, following Norway, have gradually created a Nordic wholesale electricity market (see Chapter 7). In the European Union in 1996, the European Parliament and Council issued the Internal Electricity Market Directive 96/92/EC that set goals for a gradual opening of national electricity markets and rules for transmission access in the 15 member states (European Parliament and Council, 1996; Schwarz, Staschus, Knop, and Zettler, 2000). Spain in 1998 and Netherlands in 1999 created fully competitive generation markets (see Chapter 8). The rest of the members are adapting to the new regulations. For an international comparison of transmission grid access, see Gronli, Gomez, and Marnay (1999). For other international comparisons, see Gilbert and Kahn (1996).

In New Zealand, Australia, and some provinces of Canada (Alberta and Ontario), deregulation of the electricity industry is being introduced as a way of increasing efficiency and reducing prices. This is also true in some states of the United States (US); restructuring legislation has already been enacted in half the states, with California and Pennsylvania-New Jersey-Maryland (PJM) in the lead. See Stoft (2002). However, the California electricity crisis of 2000 and 2001 has slowed the move toward electricity deregulation in the United States (see Chapter 6).

Under restructuring and deregulation, vertically integrated utilities, in which producers generate, transmit, and distribute electricity, have been legally or functionally unbundled. Competition has been introduced in the wholesale generation and retailing of electricity. Wholesale electricity markets are organized with several generation companies that compete to sell their electricity in a centralized pool and/or through bilateral contracts with buyers. Retail competition, in which customers can choose among different sellers or buy directly from the wholesale market, has also been implemented. This was done instantaneously for all customers (as in Norway), or progressively, under a multiyear program, according to different customer sizes (as in England and Wales, Australia, Argentina, etc.).

Transmission and distribution are still considered natural monopolies (see Chapter 2 for the economics of monopolies and natural monopolies) that require regulation (see Chapter 4 on the regulation of natural monopolies). To achieve effective competition, regulation is still needed to ensure open, nondiscriminatory access to the transmission grid for all market participants.

1.2. FROM MONOPOLIES TO MARKETS

Restructuring and deregulation involve a transformation in the structure and organization of electricity companies. Traditionally, a single utility, vertically integrated, was the only electricity provider in its service territory and had the obligation to supply electricity to all customers in its territory. This provider could be

Owned by a national, regional, or local government

Owned by a cooperative of consumers

Owned privately

Because of the monopoly (single seller) status of the provider, the regulator periodically sets the tariff to earn a fair rate of return on investments and to recover operational expenses; see Chapter 3 on determining the rate of return and Chapter 4 on rate-of-return regulation. Under this regulated framework, firms maximize profit subject to many regulatory constraints. But because utilities have been allowed to pass costs on to customers through regulated tariffs, there has been little incentive to reduce costs or to make investments with due consideration of risk.

Under perfect competition, in theory, the interaction of many buyers and sellers yields a market price that is equal to the cost of producing the last unit sold. This is the economically efficient solution. The role of deregulation is to structure a competitive market with enough generators to eliminate market power (i.e., the ability of a firm or a group of firms to set prices "a small but significant and non-transitory amount" above production cost; see DOJ/FTC, 1992). (See the Glossary for the definitions of words and phrases in bold italic type.)

With deregulation, electric utilities must split regulated from deregulated activities and compete with new firms originating from other energy businesses or retail services (see Chapter 5). The economic decision-making mechanism, under competition, responds to a decentralized process whereby each participant maximizes profit equal to the difference between total revenue and total cost. However, under competition, the recovery of investment in new plant is not guaranteed. So, risk management becomes a crucial part of the electricity business.

1.3. WHY RESTRUCTURING AND DEREGULATION NOW?

There are many forces driving electricity restructuring around the world. These forces are

1. New generation technologies, such as combined-cycle gas turbines (CCGT), have reduced the optimal size of an electricity generator. 2. The competitive global economy requires input cost reduction; electricity is a primary input for many industries. 3. The State, as owner and manager of traditional infrastructure industries, cannot respond as quickly as private owners to economic and technological change, prompting privatization. 4. Information technologies and communication systems make possible the exchange of huge volumes of information needed to manage electricity markets.

CCGT manufacturers have been racing to achieve (1) technical efficiencies close to 60%, (2) short power plant construction periods (less than 2 years), and (3) low investment costs (around U.S.$500/kW). These technical developments (along with low natural gas prices and new natural gas transportation networks) have made this technology the dominant choice for new investment in competitive generation markets.

Even before the opening of generation to competition, CCGT technology was being built by independent power producers selling electricity to traditional utilities under different types of regulated agreements. The efficient size of these power units is currently between 150 and 300 MW. This is much smaller than efficient scales for traditional fossil or nuclear power stations.

Global competition promoted by international firms is emphasizing international price comparisons and, consequently, inducing nations to reduce electricity costs to be globally competitive. Restructuring and deregulation processes are carried out by governments through the introduction of electricity markets to increase efficiency and reduce prices. Markets also promote participation of external agents and neighboring countries with lower production costs as a way to achieve lower prices.

After World War II, in many countries, for strategic reasons, the electricity industry was gathered in a single, nationalized company. This situation was common in Europe and Latin America. But public ownership has been in crisis during the last decade for various reasons. For instance, in Latin American countries that had high rates of electricity demand growth, the State, with a significant external debt, was unable to carry out the needed generation investments. This situation, plus the recommendations of international financial institutions, such as the World Bank and the Inter-American Development Bank, led governments to initiate privatization and restructuring.

Also, the internationalization of fuel markets called into question national subsidies to specific primary energy sources. For instance, in several countries in Europe, the State has been subsidizing the coal industry. Low international coal prices (and the usual environmental problems associated with burning low-quality domestic coal) prompted governments to progressively abandon this type of intervention. Similarly, the nuclear power industry was developed with a high level of State support. However, political opposition has undercut this support, postponing or stopping new investment in nuclear plants.

Finally, information technologies and communication systems are making possible day-ahead and on-line electricity markets with multiple agents and multiple types of transactions. Further, metering, billing, quality control, and load management options based on new information technologies and communication systems are being offered under restructuring and deregulation. Also, retail competition and customer choice based on these technologies encourages entry of new electricity service providers with new commercial relationships, offering attractive prices, high quality, and other integrated services.

1.4. REGULATION IS STILL REQUIRED

Although regulators' objectives differ across countries and sectors, their primary objective is to protect the short-run and long-run interests of consumers by promoting economic efficiency. The most direct way to achieve efficiency is to encourage or mimic competition. However, economic regulation must be used where competition is not feasible, for example, in sectors that have natural monopoly characteristics or in situations where externalities have not been internalized.

Traditionally, the electricity industry has been dominated by monopolies. Under restructuring, only high-voltage transmission, distribution, and system operation exhibit natural monopoly characteristics. Achieving economic efficiency in natural monopoly industries requires regulation. In these industries, the largest firms can charge the lowest prices, driving rivals from the market. Once there is no competition, the surviving firm can charge monopoly prices, reducing quantity and social welfare (see Chapter 2). There are several solutions to this problem, including

1. Government ownership of the industry, with a mandate to provide adequate output at reasonable prices 2. Private ownership with government regulation to ensure adequate output and a reasonable return on private investment

The economic theory of regulation (see overview in Joskow and Noll, 1981) attempts to predict which institutional arrangement is preferable as a function of the comparative social costs and benefits of

Private monopoly without regulation Government monopoly Private monopoly with regulation

Each solution involves costs, including (1) the social cost of the monopolist using its market power, (2) the cost of maintaining a regulatory agency, and (3) the costs imposed on the monopolist by the regulator. Besides the administrative costs associated with regulation, another potential cost arises from misguided regulatory interventions that can create social welfare losses. Therefore, the regulator must carefully consider the costs and benefits of each regulatory requirement on the regulatory agency and the regulated utility (see Chapter 4).

The role of regulation is to encourage enough investment to meet customer demand and to compensate investors with a reasonable rate of return. There are several ways of accomplishing regulatory goals in the electric power industry. Two basic regulatory forms are (1) Rate-of-Return (ROR), also known as Cost-of-Service (COS), regulation, which requires the regulator to actively monitor the electric utility; and (2) Performance-Based Ratemaking (PBR), which requires much less regulator intervention. Under ROR or COS regulation the regulator determines

1. Appropriate expenses 2. The value of invested capital 3. The allowed rate of return on invested capital

This process requires a costly exchange of information between the regulator and the electric utility. PBR involves mechanisms that attempt to reduce the cost of regulation by allowing utilities to keep profits resulting from efficient operation.

As an electricity industry is restructured, the role of the regulator becomes one of setting market guidelines to yield competitive conditions in which prices and quantities are similar to what they might be under perfect competition (see Chapter 5).

Establishing competitive electricity markets requires a reduction in the market power that could be exerted by the formerly integrated utilities. In some cases, the regulator has obliged these utilities to divest their generation assets. Economic efficiency gains from deregulation can disappear if there is no real competition at the wholesale level.

On the other hand, usually, retail competition is initially dominated by the utilities that formerly distributed electricity to customers. They can also create their own retail or service provider companies as deregulated firms. The role of the regulator in this area is crucial to ensure fair competition. Regulated distribution companies, as former vertically integrated utilities, will provide preferential treatment to their own spin-off retailers rather than to new entrants. The regulator should establish clear rules to avoid this discriminatory behavior, while actively promoting the entrance of new participants.

Where regulation is maintained or introduced after privatization, regulators should adopt open, transparent, and objective decision-making procedures (i.e., observable data sources, replicable methods, open debate, and reasoned decisions). This is because regulatory decisions are always a part of an ongoing regulatory regime. Electricity companies will continue to be regulated where capital-intensive investments can lead to monopoly conditions. In the current environment, these conditions clearly apply to investments in transmission and distribution.

In a regulatory regime that sets revenue for an industry characterized by assets with long lives, the credibility of regulatory commitments is extremely important. Before investors will commit funds to such investments, they must be convinced that the regulator will allow future revenues that provide reasonable assurance of cost recovery. For example, preventing the recovery of stranded costs or assets (see Chapter 5) associated with past investments would allow the regulator to make an immediate price reduction, but also reduces the necessary credibility that future investments might be recovered. Therefore, the regulator must consider both consumers' short-run interests in low-price, high-quality service and their long-term interests in continued maintenance and investment in the electric power sector.

1.5. WHAT LESSONS CAN BE LEARNED FROM INTERNATIONAL EXPERIENCES?

The economics of natural monopolies, markets, and regulation are not enough to understand the complexities of real regulatory reforms. There are many issues of practical implementation that should be analyzed through case studies to obtain a clearer understanding of electricity restructuring. For that purpose, we have selected four restructuring experiences to describe in detail in this book. These experiences correspond to the cases of California, Norway, Spain, and Argentina. This complexity is portrayed in Table 1.1, which compares the institutional, regulatory, organizational, and technical issues of the four case studies.

We begin with California because of the problems during its transition from regulation to deregulation. In the late 1990s, California tried to ensure compatibility between bilateral trading and a centralized pool. In addition, California addressed the issue of the stranded costs of the former investor-owned regulated utilities. To recover these stranded costs, electricity tariffs were frozen at a regulated tariff 10% below 1996 levels and a competition transition charge was added to them. Consequently, when the stranded costs were recovered and regulated tariffs disappeared, customers faced the high prices of the wholesale market. See Chapter 6 on this and other issues associated with the California "electricity crisis."

(Continues...)



Excerpted from Electricity Economics: Regulation and Deregulation by Geoffrey Rothwell Tonmas Gomez Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Preface.

Nomenclature.

Electricity Regulation and Deregulation.

Electricity Economics.

The Cost of Capital.

Electricity Regulation.

Competitive Electricity Markets.

The California Power Sector (Ryan Wiser, et al.).

The Norwegian and Nordic Power Sectors (Helle Grønli).

The Spanish Power Sector.

The Argentine Power Sector.

Glossary.

References.

Author Index.

Subject Index.

About the Authors.

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