Energy Forum Papers
SUMMARY
Concerns about reliability in electricity supply and failure of the market to invest have already called forth some interventions by the authorities. These do not augur well for a market designed to operate with minimal intervention.
It may be that certain unique facets of the electricity supply industry require a departure from a pure market that is similar to other commodity markets. The upshot of regulatory override measures need to be thoroughly examined. Regulatory interventions that prevail over outcomes based on the mutual interests of willing buyers and willing sellers will create other distortions. On past experience, many such distortions are more harmful than the deficiencies they seek to correct.
For these reasons the best approach, providing we can be assured that monopoly is absent (or at least is only transient) is to rescind any distortions that the market rules themselves have put in place but to do so in ways that do not disturb commercial decisions taken in good faith. Should interventionary measures be considered unavoidable, these are best handled by using market mechanisms. This makes it preferable to seek bids for additional supply/voluntary load shedding rather than requiring firms to operate.
THE ISSUES
There are concerns that the "energy only" market that has been established, together with the $5,000 price cap on VoLL, puts at risk the reliability of the electricity supply system. These concerns may be addressed in a number of ways, although we cannot be clear about the outcome of such treatments. Possible approaches are:
- to accept a greater level of unreliability than appears to be offered by the present market structure;
- to raise the price of VoLL so as to encourage a greater availability of flexible, high energy cost plant that will expect to run only occasionally;
- to introduce provisions, similar to the England and Wales LoLP*VoLL payments, under which consumers are required to make payments for reliability;
- for the market manager to bid for additional plant availability with the price paid for that additional plant being confined to that plant only (the Reserve Trader provisions and the administrative arrangements required for the current summer by the Victorian ORG are variations of this);
- for the market manager to require plant to operate at an administered price when the system is envisaged to be under stress.
COMPETITION AND MARKET FAILURE
These proposed measures are often said to be required because of market failure. Market failure is a precise term in economics that refers to the inability of markets to provide the lowest cost solution because of the occurrence of monopoly. It is not a situation which occurs when a market outcome does not accord with what regulators expect to occur.
A form of market failure also may occur because of failure of governments to ensure stability in contractual arrangements and certainty over property rights. This is more correctly a form of government failure due to distorted incentives. In such situations markets may not operate efficiently. The market may also fail as a result of such interventions if price restraints prevent a supply and demand equilibrium. In such cases rationing must be employed.
The events in Auckland and Queensland testify to the deficiencies of government operated and owned systems. Governments are likely to overbuild -- as they have in the past in NSW and Victoria -- or underbuild and stint on maintenance.
The introduction of a market for electricity is among the most radical changes in economic management. Not only do we have the wide Government ownership but we have:
- monopoly aspects of the system,
- a non-storable good,
- an inability of many customers to receive and take short term actions based on price information
- a shared distribution system, which impedes the wide variation in user demand profiles from being registered; as a consequence free rider aspects that might rule out a market free of all intervention.
Competition is one essential condition to market efficiency. Efficient markets also require secure property rights and rules that change only by mutual consent or with long lead times that allow investment decisions and contracts to be unwound. Changes in rules or regulatory seizures of property add risks that will reduce the investments firms make and cause commercial activities to be conducted in ways that are less than optimal. They may, for example, lead firms to concentrate on short term contracting because of concerns that longer term contracts will be overridden.
It is these twin provisions of requiring minimal government intervention in markets with the requirement of stable regulatory framework that presents dilemmas for the operations of the electricity market. Changes in market rules will reduce the value of certain contracts that were undertaken in good faith, yet if the market rules are themselves bringing inefficient outcomes, some changes would appear to be necessary.
The interventions in the market that have been seen to date are an unfortunate start to a system designed to be free of Government interference. These include the requirement by the Victorian Regulator-General that retailers contract for reserve power, the commissioning of QNI as a regulated link and the on-going debate on this issue about Riverlink.
While such decisions as these doubtless pollute the notion of an electricity market that is no less free than other commodity markets, interventions along these lines may still prove to be inevitable. Alex Henney in a recent report for the UK Minister for Energy and pool members envisages a major role for a variant of the NEMMCO powers over spinning reserve, continued (though changed) payments for capacity and possibly some reserve trader powers.
A key issue highlighted by Henney's report is the need for owners of rarely run plant to receive adequate remuneration. The UK capacity payments associated with LoLP are not considered a success. But the question is what is to replace them in a structure where, as Henney defines it, "The majority of customers buy energy PLUS generation reliability. Many customers either cannot exercise choice in generation reliability by responding to price and many do not wish to exercise choice because they have bought electricity on fixed price terms and expect a reliable supply."
One market rule that may be impeding the adequate availability of reliable power supply is the cross-ownership rules that prevent distributors, in Victoria at least, from owning power plant. For a retailer, owning some power plant is equivalent to taking out insurance or to self insuring by accepting the risk of very high prices. Of course such an outcome may be achieved by taking a long term hedge contract with an existing generator but the retailer may see ownership as providing additional security or a lower cost option.
ADDRESSING THE OPTIONS
RELIABILITY STANDARDS
Present standards based on the outage level due to lack of generation require reserve capacity of 500 MW in the Victorian region, 831 MW in NSW and 250 MW in South Australia. As the NEMMCO analysis has shown, considerably greater outages are likely to result from distribution line failures than from shortage of generation. It has been over 12 years since the power supply failed in Victoria because of lack of generation. No system can ever be 100 per cent secure.
In Victoria in 1997 some $20 million was spent at the regulator's direction on reserve power that has proved unnecessary. If firms and consumers are being required to expend additional sums for reliability the regulator should be certain that they actually value that trade-off and that the money is spent in the best way to avoid the failure.
REMOVAL OF THE PRICE CAP
The price cap on electricity sits ill with the notion of a free market. Price restraints are among the most egregious of regulatory instruments Unlike other interventions, they may prevent allocation of products to the parties valuing them most. However, the complications of the shared nature of electricity distribution/transmission systems may make this less important than in other markets.
Furthermore, any early moves to remove, or markedly increase the price caps could give rise to other structural instabilities. While market participants could reasonably expect the price cap to increase, total removal would not have been anticipated. Those generators that signed long term contracts expecting a maximum price of $5000 per MWh would incur costs of insurance far in excess of what they anticipated against their being unable to operate. Retailers would incur similarly high costs.
In this respect, there have been estimates of $250,000 per MWh as the price that electricity must reach in order to justify a plant operating to meet a 10 per cent probability of demand requirement of 5-7 hours.
INTRODUCE A CAPACITY PAYMENT
In the design of the Victorian and National Market, the twin component payment for energy and reliability was rejected. While many consumer markets with high fixed costs, for example telephonic services, have two part tariffs, the view was taken that the outcome would be most efficiently achieved if the market were to be one of energy only. In this respect, the relatively high (8% plus) payment for capacity in the England and Wales market was a consideration.
There are continued concerns that such a high payment in the UK may be due to generators gaming market rules that are unnecessarily vulnerable to such activity when capacity payments are involved. In particular, a capacity payment is best designed for long term availability rather than the simple day-ahead basis as used in the England and Wales market. But it is difficult to devise longer term capacity payments so that there are the appropriate premia, for example to fast start-up plant.
Moreover, a capacity payment involves a government agency making forecasts and the aim of the market is to avoid this. All that said, the interventions regulators have deemed to have been necessary to date indicate weaknesses in the existing approach.
RESERVE TRADER APPROACHES
A superficially attractive route to ensuring greater system security is to buy top-up energy at a premium price without that price being reflected in the price for all energy. This involves segregating the top-up energy from that traded in the main market.
One extreme variation of this is to have a market where all suppliers are paid the price they bid rather than SMP. In the long run it can be demonstrated that the outcome from this approach for the market price as a whole will be the same as the single price outcome. But to arrive at this outcome is likely to involve suppliers in considerable expense as they sift through the capabilities and market strategies of their competitors.
Whether a more limited version of this approach through a reserve trader will prove a practicable alternative is untested. Such measures were generally found to be offensive by the ACCC and other parties because they involved governments determining needs rather than the needs being resolved by the atomised interactions of the many market participants. As was addressed above with reference to capacity payments, in general, the new market seeks to escape intervention by the authorities because of the sort of "government failure" which is endemic with such intervention.
PLANT BEING REQUIRED TO RUN
When the market manager requires plant to run under terms its owners do not find satisfactory, this indicates deep-seated problems in the market structure. There may be occasions in conditions of extreme emergency where such actions are unavoidable, but these should generally be confined to conditions like the total breakdown that has occurred in Auckland.
Aside from such situations, high prices may be demanded by a provider with some monopoly powers in the market. Requiring such a provider to reduce the prices demanded is an extreme step and one likely to bring counter-productive responses.
Requiring a plant owner to operate is expropriation. As a short term fix it can be highly effective but such measures totally undermine the incentive structure on which free markets are based. Unless the target business was previously earning super profits, the firm owning the units targeted will seek to move them to other uses (perhaps overseas) where they can earn a higher reward. At the very least such moves will deter maintenance on the units and prevent any further units being commissioned.
Market power is best combated by having the structure arranged so that monopoly is avoided. But as long as there is freedom of entry (and investments are not so lumpy as to prevent small scale entry) and/or there is an ability of customers to react to high prices, there can only ever be a transient monopoly. The high prices will stimulate activity on the supply and/or demand side which will prevent the monopoly recurring. There is evidence to suggest considerable potential flexibility in electricity demand and supply sides, although this is not yet conclusive.
CONCLUDING COMMENTS
The market as presently designed may or may not be incapable of providing the degree of generator reliability demanded by consumers. If it is deficient in this respect, this may reflect either residual regulatory measures like cross ownership rules or the price cap, or some intrinsic deficiencies as a result of the shared nature of electricity supply.
Any measures to correct possible deficiencies should be taken with the knowledge that regulatory interventions will spawn market based reactions that could lead to even more interventions. Changes to market rules should also be taken so that they do not disturb commercial decisions taken in good faith.
A review of the market rules will shortly be underway. In the interim, any market interventions that are contemplated are best taken within a framework that makes use of the market system. In other words, if supplementary power is to be required, this is best obtained by a reserve trader seeking bids for reserve power and voluntary load shedding rather than by direction.
