Making Competition Work in electricity SALLY HUNT John Wiley & Sons, Inc. Making Competition Work in electricity Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, please visit our Web site at www.WileyFinance.com. Making Competition Work in electricity SALLY HUNT John Wiley & Sons, Inc. This book is printed on acid-free paper. ➇ Copyright © 2002 by Sally Hunt. All rights reserved. Published by John Wiley & Sons, Inc., New York. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products visit our Web site at www.wiley.com. ISBN 0-471-22098-1 Printed in the United States of America. 10987654321 foreword ere is the book I’ve been looking for to guide me through the devilishly Hcomplicated experience of electric industry deregulation, drawing on the author’s direct involvement in this process in several of the countries that have undergone it—none of which, significantly, has seriously considered reversing the process. Some of its judgments are wondrously pithy. California allowed itself to get into the dreadful position of designing its trading arrangements so as to rely on demand response, and then hav- ing customer prices frozen. There was no transition: it went cold turkey into a world of no installed reserve requirement, no demand response, no intelligent price caps, no anything. Equally, some of its recommendations: FERC should just hire Bill Hogan to set out the coherent set of trading arrangements that he has been advocating indefatigably for a decade, and drop all the paraphernalia of wheeling. More important, she explains why. Most valuable of all, she presents a clear, explanatory road map, a de- tailed exposition of the order in which to proceed, step-by-step, which steps are essential, which optional, which worth taking whether or not we pro- ceed to the next one, which not. Some of the essential steps, such as pricing transmission services efficiently, are elegantly described; some, such as the overwhelming importance of instituting efficient pricing, amazingly simple. An admirable and indispensable guide; detailed, annotated and au- thoritative. ALFRED E. KAHN Former Chairman, New York State Public Service Commission Former Chairman, Civil Aeronautics Board Professor Emeritus, Cornell University v preface wanted to write this book. It seemed a fitting way to begin retirement, al- Ilowing me the luxury of concentrating on one thing, discussing complex issues with many really smart people, pulling together everything I have learned about the electric industry for nearly 30 years, and expanding it to develop a workable solution to the current impasse in the United States. It has been more difficult than anything I have ever done, but I have enjoyed it immensely. The Edison Electric Institute (EEI), at the behest of its then chairman, John Rowe, requested the book and partially supported the writing of it, but this is not an industry position paper. The members knew my views on the issues, which I had expressed in speeches and in a previous book. No EEI member was ever going to agree with everything I would say, and they do not; but the feeling was that the country needed a coherent intellectual framework to work from, and no one but the industry was going to take on the task of providing one. There are so many people to thank for their knowledge, their detailed attention, and their prose. Paul Joskow, who has been a demanding and generous colleague for a quarter century, read two of the early drafts and commented extensively. His intellectual contribution to the book is so great that it dwarfs all others. It was he who suggested dividing it into two parts, which made it a much better book although it killed three weeks. Alfred Kahn, everyone’s favorite guru, and mine, lent his time to reason with me about the federal/state question. Graham Shuttleworth of NERA London, the coauthor of my previous book, and now sadly too far away for contin- ued collaboration, read and improved it; he also provided information for the U.K. appendices. Among my NERA U.S. colleagues, the most special thanks must go to Hamish Fraser who worked with me constantly during the writing of the book. I no longer know which paragraphs he wrote and which I did. He has done a sterling job of keeping me honest, cutting the waffle, also drafting the trading arrangements and transmission sections. (Hamish’s training ground was in the New Zealand and the New York trading arrangements— two success stories; while I participated in the design of old U.K. Pool, now vii viii PREFACE regrettably demised, and in the contorted California process, which nearly demised me.) Hethie Parmesano drafted the retail sections and, as always, returned comments and provided examples each time I changed my mind about what I thought. Jeff Makholm explained gas deregulation, which was a turning point in the analysis. Carolyn Berry and Kristina Sepetys provided information on California. Jonathan Falk is my source for analogies, and also for market power and environmental issues. Gene Meehan, Kurt Strunk, Karl McDermott, Oscar Arnedillo, Chantral LaCasse, and Andy Joskow helped with the thinking, and Veronica Irastorza, Willis Geffert, and Veronica Lambrechts filled in many of the details. Stephanie Godkin did the graphics, David Tabak taught me about liquid and efficient markets, Bill Taylor about telephone, Lou Guth about alcohol, and Fred Dunbar about roads. Dick Rapp, the president of NERA, originally suggested writ- ing the book and has provided moral support, office space, and the time of the NERA staff. David Owens of EEI offered valuable assistance and provided Mathew Morey and Ken Linder as readers. They discussed it with me chapter by endless chapter, but they never tried to censor. Elizabeth Moler, the former Chair of FERC, provided detailed and illuminating comments; Tom Rose and Mike McCall filled me in on Texas. In these restructuring matters, working with clients on real problems has always been my major source of learning. Since 1996 when my last book was published, I have collaborated principally, and over long periods, in New Jersey with the two Franks—Cassidy and Delany—at PSE&G, in Mexico with the Energy Ministry under Luis Tellez, and in China with Noureddine Berrah for the World Bank. Thanks also to Robert Marritz, Charles Stalon, Laura Manz, Tony Robinson, Jose-Luis Aburto, Larry Ruff, Fiona Woolf, Jim Barker, and Daniel Fessler. My son, Mark Streiter, acted as a target reader on the early drafts, forcing me to greater clarity. And finally, sincere acknowledgments to Bill Hogan, who has made his thinking available to all of us, both on his Web site and in person, and has shaped so much of the progress in this area. Thank you all very much. SALLY HUNT contents CHAPTER 1 Introduction 1 The Electric Industry 2 The Case for Competition 3 The United States 9 PART ONE The Standard Prescription 15 CHAPTER 2 The Essential Aspects of Electricity 17 Functions of the Electric Industry 17 Traditional Organization of the Industry 24 Key Factors Specific to the Electric Industry 29 CHAPTER 3 Reforming the Industry 37 Candidates for Competition 37 Other Objectives and Constraints 38 Four Models for Industry Structure 41 Restructuring Existing Companies 59 Ensuring Competitive Markets 67 CHAPTER 4 Requirements for Competition: Demand Side 71 The Role of Demand in Markets 71 Demand Responsiveness 74 Inelastic Demand and Price Caps 85 CHAPTER 5 Requirements for Competition: Supply Side 89 Many Sellers 89 How Does Market Power Work? 90 ix x CONTENTS Newly Deregulated Markets 95 Market Power Solutions 96 Price Caps, Bidding Restrictions, and Profit Controls 101 Small Markets, Big Plants,