Coordination and Pricing On An Open Transmission Network
by Arthur S. De Vany
Arthur S. De Vany, Department of Economics Institute for Mathmatical Behavioral Sciences University of California at Irvine.
Letting go is hard to do. State Public Utility Corporations (PUCs) have spent the last fifty years carving out and protecting their piece of the nations power transmission grid. They are reluctant to change. There is real danger that they will sabotage competition in electricity even as they ostensively redesign the industry to let competition flourish. Many state regulators would try to create competition with top-down designs, in part as a means to protect the interests of the PUCs. But competition will come only when the interstate power market is open. State boundaries must be eliminated.
State regulators believe electricity markets are different from markets for donuts or carpets and cannot be given autonomy. They believe that electricity transmission is a natural monopoly. They also believe that the physics of electricity transmission requires centralized coordination. Those beliefs are mistaken.
Five arguments will demonstrate that state efforts to "design" deregulated electricity markets are not supported by theory or evidence:
1. Markets are never designed; they evolve as a manifestation of supply and demand.
2. Similar arguments were used over a decade ago by those who maintained that it would be impossible for natural gas to be deregulated. Such arguments were wrong then and are wrong now.
3. The investment losses associated with so-called stranded assets (power generators whose local market is eliminated by deregulation) would be rectified if artificial local-market boundaries were eliminated.
4. Electricity transmission is not a natural monopoly, even in theory.
5. Data from current interstate electricity markets suggest that prices effectively coordinate transactions between generators and consumers of electricity. Prices signal opportunities for profit, exactly the same as in other markets whose existence is questioned by no one.
Regulators Designing Markets
State utility regulators and industry lobbyists are preoccupied with the design of intrastate electricity markets. Distracted by the details of developing competing market designs within states, policymakers might miss the real issue: the need for exchange of power among all states in a diverse and highly competitive interstate market. Markets are not designed. They evolve naturally as customers and suppliers make exchanges free of government direction. Contracting and trading opportunities are exploited. Contract standardization and market institutions evolve to cope with problems and exploit new opportunities. Markets grow from the bottom up. The evidence is all around: the EuroBond market grew out of informal interest rate swaps and the New York Stock Exchange evolved from an informal curb market.
The Natural Gas Example
The most pertinent example of how markets self-organize is the natural gas market. Until a decade ago, the gas transmission grid was balkanized, much as the power grid is today. Now, natural gas flows over an integrated network of pipelines whose connection structure emerged through decentralized interactions among traders seeking profitable opportunities. Arbitrage drove prices to a narrow range. Natural gas is now priced so accurately across all points of the pipeline network that prices everywhere fall within arbitrage limits.
Several critical judicial decisions were instrumental in opening access to gas pipeline transmission, the critical point in the transformation of the natural gas industry. Natural gas trading began when suppliers gained some freedom to contract directly with large customers. Usually the customers would then make transmission arrangements with pipeline owners. From that small beginning, a market in gas and transmission developed.
The problem of regulators designing markets can be understood in the context of electromagnetic spectrum markets. In an article to appear in the Journal of Law and Economics, this author writes:
Rather than attempt to design a policy for implementing a market-based spectrum policy, we should just let it happen. Explicit attempts to implement markets will coalesce interests against them, but if we let each of the diverse interests play their own strategies in the prisoners dilemma game of deregulation, the system will unravel by itself . . . an evolution of spectrum allocation to a market system will happen more rapidly than trying to plan it and make it happen. The idea that markets are implemented or designed is the same old mentality that gave us planning and regulation in the first place.
To most utility executives and to the regulators listening to them, the major downside of complete deregulation of the electricity market is the issue of stranded assets. Behind every stranded asset stand many stranded customers whose fates are bound with the fate of the asset. Deregulation releases the captive customers. If the current state reform models indicate properly, few if any state regulators intend to let the interstate power market compete for their captive customers. If they cannot block it outright, they are likely to load obligations onto interstate suppliers and raise hurdles against their full participation in the market.
That view of stranded assets misinterprets the risks that arise from closed rather than open markets. There are no stranded assets or customers in an open market because electricity generation assets are no longer specialized to a particular service or set of customers. In general, specialized assets are illiquid in markets, and lack of liquidity severely affects value. An open transmission grid and a free generation market releases resources for deployment over the whole interstate grid. Since they are no longer bound to an area or use, they become liquid assets. Transaction costs fall when assets become deployable at low cost and can be traded in an active and deep market. The decrease in transaction costs, in turn, increases liquidity and value, contrary to the view currently held by those resisting true deregulation.
Not a Natural Monopoly
Natural monopoly arguments are used to justify the necessity of electricity market regulation. Traditionally, justification for regulation relied on the existence of economies of scale in generation of electricity. Certainly, that argument no longer applies in light of the low costs of small natural gas turbine plants relative to the cost of large, base-load coal plants. But more importantly, the argument was not true even when large coal plants had the lowest costs. The traditional economies-of-scale argument confuses the coordination of generating resources with the control of generated output. The confusion arises from the belief that there must be a single owner of the output in order to achieve coordination.
Without regulation, the industrial organization of electricity generation might well have resembled the organizational form found in housing markets. Each facility would have many owners, each of whom controlled a part of the electricity output similar to the way large owners control separate condominiums in a large apartment building. The owners would appoint someone, often one of the larger owners with generating capacity, as coordinator of the electric generation facility. But each owner would individually sell the electricity output they control, the same way condominium owners might sell their unit without checking with the other owners. Without regulation, the pricing and allocation of electricity generation would be decentralized; no single entity would decide how much output to put on the market.
The economies-of-scale argument becomes a self-fulfilling prophecy. By equating the simple managerial job of coordinating use with the power to control the amount of output going onto the market (the only source of monopoly power when entry is also blacked, as in a regulated natural monopoly) the standard model becomes a blueprint for creating monopoly. A blueprint of virtually every regulated, large scale activity follows.
The basis for regulation has shifted to the transmission grid. The concerns are two-fold: the transmission grid is a natural monopoly and the physics of electricity transmission require central coordination. Both arguments are false theoretically and empirically.
The arguments are wrong theoretically because of confusion over how complex systems coordinate. In a complex system, many simple components interact to produce aggregate behavior that cannot be comprehended by simply understanding the simple components. There is order in complex systems; it emerges from the components interactions. Think of how a crowd leaves a football stadium after the game. The flow is not centrally planned yet the stadium empties very efficiently. It is as though the crowd had instructions to minimize the total time it takes to empty the stadium. An overhead observer would witness what F.A. Hayek called spontaneous order: social order emerges from the decentralized decisions of many agents interacting in simple ways and whose aggregate behavior exhibits emergent, dynamically organized behavior.
Market Coordination of Electricity Transmission
Studies by this author and colleague David Walls suggest that the active wholesale market for electricity in the Western region of the United States effectively coordinates transactions between generators and consumers. The Western electricity transmission system is a complex network that interconnects the entire western United States, from Canada to Mexico, and as far east as Montana, Utah, and New Mexico. Within that complex regional network, electricity is free to follow alternative paths, each path offering varying degrees of resistance. Each paths transfer capability changes as generators place more or less electricity onto the network and as consumers take more or less electricity off the network. The group relies on "rules of the road" and decentralized coordination to govern transmission and to direct power flows. The structure of the Western grid is a model of how a decentralized and deregulated transmission grid might be organized.
Matching Contract and Power Paths
To understand the economics of electricity, it is necessary to understand some of the technical issues involved. Power flows depend on voltage parameters and resistance. When power is injected into the network at one point and withdrawn at another, line obstructions change over the network and flows are redirected. Total energy inflows and outflows must balance, but the paths that achieve balance change dynamically. The stability of the network requires that power pulses be kept near 62 Hz. Consequently, transmission pricing and arbitrage cannot be conducted as though electrons will flow solely along a contract-determined path.
Power injections and withdrawals must balance and their distribution over the network must be consistent with load balance and flow constraints on the network arcs. In the absence of any constraints on flows over any of the arcs in the network, the prices paid to generators will equal the prices paid by consumers. Both sets of prices will be the same everywhere in the network, subject to positive transaction costs and information constraints.
During peak periods, flows through many paths or arcs on the grid will reach capacity, with resulting constraints and bottlenecks. During peak periods, both generation capacity and transmission are constrained. Hence, peak prices will be higher than off-peak prices and the differences among them will widen. The price spreads between what generators are paid and what consumers pay (the economic profits that accrue to owners of the transmission network) will be larger and more volatile during the peak periods.
Network Integration and Stability
To maintain network stability, power pulses over the network must be dampened so that they remain in a narrow frequency range near 62 Hz. That is the job of the network coordinators who manage flows to meet arc constraints and maintain stability while meeting energy demands. The Western Systems Coordinating Council (WSCC) governs trading of electricity in the Western grid. The WSCC establishes "rules of the road" for addressing the problems of coordinating generation and demand problems.
How well do the rules and the prices that accompany them work? During off-peak hours, there are no physical barriers to the free flow of electricity on the grid. Thus, one would expect that the price of electricity during such periods would be the same throughout the grid. In a similar manner, the price of a particular corporate stock, for example for General Motors, should be the same in New York, San Francisco, and Tokyo at any given time.
To determine the presence or absence of arbitrage opportunities in the Western grid, economists use statistical techniques. The techniques test the network for pricing stability and thus implicitly test the effectiveness of decentralized coordination and markets in maintaining a stable power grid.
If arcs of the network overload, the network degenerates into isolated components, global trading breaks down. One would expect price differences or arbitrage opportunities during peak use periods in certain parts of the system as a result of the physical limitations. One would expect prices in the grid to separate into subregions. The integration of prices across subregions, therefore, is a good indicator of the stability of the network.
In an adept competitive market, prices paid by consumers and prices paid to producers contain the same information. They do not offer pure arbitrage opportunities to make money just by buying and selling against the price spreads. A price analysis conducted by the author and David Walls used daily spot prices for electricity in the WSCC trading area from December 1994 until April 1996 to discover the difference between the prices paid to electricity generators and the prices paid by electricity consumers. The patterns observed in those price differences suggest the degree to which the Western electricity market is one market with no arbitrage rather than a balkanized market with prices that vary across space and time.
The results of the examination showed that off-peak prices were consistent with an integrated market. They were essentially equal on average, with few arbitrage opportunities. Many arbitrage opportunities would indicate that the Western grid arrangement suffered serious economic inefficiencies.
Prices during peak periods were strongly integrated with exceptions in certain sub-markets. Prices varied during peak periods because transmission capacity became scarce. That would be expected in a properly functioning market.
The wholesale power market performed impressively. If retail power markets were to operate with comparable efficiency, customers in a seven state region in the trading area would save about $13 billion a year.
Persistent price differences between buyers and sellers suggest the need for the entry of new supply. During off-peak hours, there is no transmission charge because there are essentially no price differentials between trading points. Transmission should be priced accordingly when capacity is unconstrained. During peak hours, the structure is weakened, partly isolated subcomponents begin to form because of transmission constraints. The inability of arbitrage to fully exploit price differences among the isolated components lets price dispersion drift upward and transmission rates rise to equalize delivered prices.
The market is efficiently pricing transmission in the SCC grid. The few persistent differentials found suggest a demand for new transmission capacity along the southern and eastern boundaries and a new tie between the outer perimeter and the central portion.
The Western electricity grid is a coordinated efficient and stable transmission network. The characteristics have been achieved through a mixture of decentralized "rules of the road" and prices, rather than central regulation. The impressive efficiency and stability of pricing indicate that the decentralized coordination employed by the WSCC is highly effective. The potential gains from opening power grid access to distributors and end-users seem to be enormous. If every utility, distributor, marketer, and end-user had access to the wholesale power market, the potential gains would be over $13 billion per year in the seven western states alone.
De Vany, Arthur and David Walls. The Emerging New Order in Natural Gas: Markets Versus Regulation. Westport CT: Quorum Books, 1995.
De Vany, Arthur and David Walls. "The Triumph of Markets over Regulation in Natural Gas," Public Utilities Fortnightly, April 15, 1995.
De Vany, Arthur, Ross Eckert, Don OHara, and Charles Meyers. "A Property System for Market Allocation of the Electromagnetic Spectrum," The Cato Papers. Washington, DC: The Cato Institute, 1980.
De Vany, Arthur. "The Emergence and Evolution of Self-Organized Coalitions." In Computational Economic Systems: Models, Methods and Econometrics, edited by Manfred Gilli. Norwell, MA: Kluwer Scientific Publications, 1996.
De Vany, Arthur and David Walls. "Open Transmission and Spot Markets for Power: Models of Power and Transmission Pricing on the Western Network." Institute for Mathematical Behavioral Sciences working paper MBS97-07, University of California, Irvine.
De Vany, Arthur. "Information, Chance, and Evolution: Alchian and the Economics of Self-Organization." Economic Inquiry 34: 427-443, 1996.
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