August 2000

Demand Common Sense

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2000/08)

By the time this column is published, it will be time for post mortems on the "great legislative fix" of 2000. One may have a certain confidence, however, that however substantial or modest or non-existent that fix may turn out to be, it will be at best ameliotory and likely addictive (i.e. necessitate more fixes to come).

The reasons are simple: Deregulation is not as great a thing in the electric industry as it has been (at least by some key criteria) in other formerly regulated industries. To the extent deregulation is going to be made to work, the key lies in the substantial physical revamping and upgrade of the grid on a national basis and emphasis on demand management breakthroughs. While the best aspects of the proposed legislation would create a better regionally based infrastructure to oversee "reliability," it at best offers an improved long-term institutional approach to a market that is physically discontinuous.

A key data point which supports this observation is the great price cap war currently raging. Regulator after regulations in the Deregulated States of America now has sought to address the summer shortage and price spiking phenomenon by one of the most ancient of means: fiat, California has been the most visible battleground. There, the godfather of that state’s mother of all deregulation bills – paradoxically surnamed "Peace" - now wrestles with the ISO over whether it should have price control power. The debate is framed in classic economic terms – but unfortunately without reference to the unique characteristics of the commodity in question. It runs like this, distorted markets produce unjust and unreasonable pricing. Would be suppliers are diverted to more attractive markets. The prospects of shortage and rationing are induced. The wraith of reregulation unleashed on the land by pusillanimous populists.

To which the aforesaid populists respond by arguing that California’s so-called deregulation which effectively preserved incumbent utilities market shares – thereby permitting stranded cost recovery – is not a true deregulated "open market" at all. They then go on to challenge deregulation as being supported on the flawed premise that raising prices now somehow will lead to lower prices. They further point out that this proposition represents the abandonment of the rationale for deregulation when it was originally proposed: that it would lower prices, because, that is simply what competition necessarily does.

Insight into the merits of the argument may be gained from a recent article. "Electricity Restructuring: Deregulation of Reregulation" which appeared recently in Regulation, a publication of by the generally pro free market Cato Institute. Focusing on consumer price response to market price signals as the likely best source of the beneficial efficiency desired from industry deregulation, it reaches the following empirical conclusion which lies at the crux of the debate described above: 

"Thus far in the United States, real time consumer price response has not developed either in regions that have restructured or in those that have remained under traditional regulation… (T)he need for price responsive demand is made greater in a less regulated environment." (emphasis added) 

The article then emphasizes the potential adverse effects of deregulation unaccompanied by consumer price signal response. While electric generation may have become a commodity (and one that has been underdeveloped in recent years), it is a commodity marked by a high-cost of storage; for which there is a need to balance supply and demand on a second-for second basis; and for which (at this stage of technology development), end use consumer demand price observation and response capability is minimal. The result is a situation where producers can, at certain times, command extremely high prices (particularly as reserve margins shrink). This is because the electric good is not storable to defend against vulnerability and because, market demand cannot shift to other willing suppliers. Under these circumstances, there are times when even firms with small market share can exercise significant power. Concentration measures suitable to measure market power in other industries may well not be suitable to electric power. 

Moreover, "free trade" scenario which is supposed to accompany deregulation, i.e. power flowing competitively among markets, is a partial fiction. Analyses of prices under "free trade" and "regulated trade" in the Northeast in this regard, to determine if interregional power movement will respond to deregulated market opportunities is revealing in this regard. Application of optimal computer flow (OCF) algorithms produce conclusions like the following: in a scenario where more power is freed up in ECAR and PJM to be made available to NEPOOL, nevertheless calculated NEPOOL prices actually may rise as a result of the operation of transmission constraints. 

This analysis in Regulation suggests that the great price cap war ought to be understood by regulators to suggest a need for a larger number of more specific demand side oriented solutions than are being proposed in the "comprehensive" standards presently being proposed on the Hill. Some recent examples illustrative of the directions which, if properly coordinated and writ large, might begin to address the difficulties electricity deregulation has presented include the following: 

• PJM’s initiative to make it easier for distributed generators to hook up to the grid and to encourage large users to generate onsite during peak demand periods (the Customer Load Reduction Pilot Program);

• Proposals by EEI to encourage investors to enter the transmission business (e.g. risk adjusted returns on equity to attract capital to profit-making incentives to encourage transmission operators to reduce congestion).

• Emergence of e-commerce web clearinghouse end-to-end load management service for utilities and aggregators to sell to commercial and industrial customers,  e.g. sell excess onsite generation and curtailed load to utilities, retail energy service companies and aggregators when prices spike. 

It is measures like these which will enable the industry to get beyond rhetorical battles of "freedom of choice" versus "people power."  Electricity is a sophisticated commodity; facilitating meaningful market demand response to price signals is the  key to common sense. We should demand common sense.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.