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Introduction

1.1 Why Competition?

For most of the twentieth century, when consumers wanted to buy electrical energy, they had no choice. They had to buy it from the utility that held the monopoly for the supply of electricity in the area where these consumers were located. Some of these utilities were vertically integrated, which means that they generated the electrical energy, transmitted it from the power plants to the load centers, and distributed it to individual consumers. In other cases, the utility from which consumers purchased electricity was responsible only for its sale and distribution in a local area. This distribution utility in turn had to purchase electrical energy from a generation and transmission utility that had a monopoly over a wider geographical area. In some parts of the world, these utilities were regulated private companies, while in others they were public companies or government agencies. Irrespective of ownership and level of vertical integration, geographical monopolies were the norm.

Electric utilities operating under this model made truly remarkable contributions to economic activity and quality of life. Most people living in the industrialized world have access to an electricity distribution network. For several decades, the amount of energy delivered by these networks doubled about every 8 years. At the same time, advances in engineering improved the reliability of the electricity supply to the point that in many parts of the world the average consumer is deprived of electricity for less than 2 min per year. These achievements were made possible by ceaseless technological advances. Among these, let us mention only the development and erection of transmission lines operating at over 1 000 000 V and spanning thousands of kilometers, the construction of power plants capable of generating more than 1000 MW and the on-line control of the networks connecting these plants to the consumers. Some readers will undoubtedly feel that on the basis of this record, it may have been premature to write the first paragraph of this book in the past tense.

In the 1980s, some economists started arguing that this model had run its course. They said that the monopoly status of the electric utilities removed the incentive to operate efficiently and encouraged unnecessary investments. They also argued that the cost of the mistakes that private utilities made should not be passed on to the consumers. Public utilities, on the other hand, were often too closely linked to the government. Politics could then interfere with good economics. For example, some public utilities were treated as cash cows, others were prevented from setting rates at a level that reflected costs or were deprived of the capital that they needed for essential investments.

These economists suggested that prices would be lower and the overall economy more efficient if the supply of electricity was subjected to market discipline rather than monopoly regulation or government policy. This proposal was made in the context of a general deregulation of Western economies that had started in the late seventies. Before attention turned toward electricity, this movement had already affected airlines, transportation and the supply of natural gas. In all these sectors, a regulated market or monopolies had previously been deemed the most efficient way of delivering the "products" to the consumers. It was felt that their special characteristics made them unsuitable for trading on free markets. Advocates of deregulation argued that the special characteristics of these products were not insurmountable obstacles and that they could and should be treated like all other commodities. If companies were allowed to compete freely for the provision of electricity, the efficiency gains arising from competition would ultimately benefit the consumers. In addition, competing companies would probably choose different technologies. It was therefore less likely that the consumers would be saddled with the consequences of unwise investments.

If kilowatt-hours could be stacked on a shelf - like kilograms of flour or television sets - ready to be used as soon as the consumer turns on the light or starts the industrial process, electricity would be a simple commodity, and there would be no need for this book. However, despite recent technological advances in electricity storage and microgeneration, this concept is not yet technically or commercially feasible. The reliable and continuous delivery of significant amounts of electrical energy still requires large generating plants connected to the consumer through transmission and distribution networks and careful attention must be paid to reliability.

In this book, we explore how various aspects of the supply of electricity can be packaged into products that can be bought and sold on open markets. Because these products cannot be fully separated from the supply infrastructure, we also discuss how their trading affects the operation of the power system and, in turn, how operational constraints impinge on the electricity markets.

In the long run, the need always arises to invest in new facilities, either because a new technology holds the promise of greater profits or simply because equipment age and need to be replaced. Here again we will need to examine the interplay between market-driven behavior, physical constraints, and the need for reliability.

1.2 Market Structures and Participants

Before we delve into the analysis of electricity markets, it is useful to consider the various ways in which they can be structured and to introduce the types of companies and organizations that play a role in these markets. In the following chapters, we will discuss in much more detail the function and motivations of each of these participants. Since markets have evolved at different rates and in somewhat different directions in each country or region, not all these entities will be found in each market.

1.2.1 Traditional Model

In the traditional market model (Figure 1.1), trading is limited to consumers purchasing electricity from their local electric utility. This utility has two main characteristics. First, it has a monopoly for the supply of electricity over its service territory. If consumers want to purchase electricity, they do not have a choice: they have to buy it from this utility. Second, the utility is vertically integrated. This means that it performs all the functions required to supply electricity: building generating plants, transmission lines and distribution networks, operating these assets in a reliable manner, and billing the consumers for the service provided.

Figure 1.1 Traditional model of electricity supply.

In a fairly common variant of the traditional model (Figure 1.2), the vertically integrated utility is split in two parts. One organization generates and transmits electricity over a fairly wide area and sells it to several distribution companies (Discos), each of which has a local monopoly for the sale of electricity to consumers.

Figure 1.2 Variant on the traditional model of electricity supply.

Because monopolies could take advantage of the fact that their customers do not have a choice to charge them extortionate prices, they must either be government entities or be subject to oversight by a government department, which we shall call the regulator. In the traditional model, the regulator enforces what is called the regulatory compact. This is an agreement that gives a utility a monopoly for the supply of electricity over a given geographical area. In exchange, the utility agrees that its prices will be set by the regulator, that it will supply all the consumers in that area, and that it will maintain a certain quality of service.

This model does not preclude bilateral energy trades between utilities operating in different geographical areas. Such trades take place at the wholesale level, i.e. through interconnections between transmission networks.

The problem with the traditional model and its variant is that monopolies tend to be inefficient because they do not have to compete with others in order to survive. Furthermore, because their operations are rather opaque, regulators have difficulties assessing where improvements could be made.

1.2.2 Introducing Independent Power Producers

A first step toward a more competitive industry structure consists in allowing other companies (called independent power producers or IPPs) to produce part of the electrical energy that the incumbent vertically integrated utility must supply to its customers. Figure 1.3 illustrates this arrangement. While this model introduces a degree of competition at the generation level, it does not provide a mechanism for discovering cost-reflective prices in the same way that a free market does (see Chapter 2). The incumbent utility would like to pay as little as possible for the energy produced by the IPPs to discourage them from expanding their generation capacity. It must therefore be forced by law to buy the power produced by the IPPs. Given this guarantee that their production will be purchased, the IPPs will try to get as high a price as they can. This leaves the regulator with the task of deciding what an equitable price would be. In the absence of detailed and reliable information, the result will often be economically inefficient.

Figure 1.3 Incumbent vertically integrated utility with independent power...