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Preliminary response to the EIA report
Will Electricity Competition Increase Northwest Electricity Costs? ?
Part II
This paper is written in response to recent headlines declaring that
prices in the Pacific Northwest could increase if a competitive retail
electricity market is created. The headlines were prompted by the recent
release of a preliminary analysis by the U.S. Energy Information
Administration (EIA). That study was based on a model of competitive
electricity markets, and concluded that electricity prices are likely to
increase in the Northwest under competitive markets. These concerns have
been expressed for some time here in the region and were addressed in an
earlier paper from the Council "Are customers of
Northwest utilities likely to pay higher rates due to competition?"
This paper addresses the EIA study specifically. Higher electricity
prices as a result of competition are a possibility the region needs to
consider, but it is not at all certain. To a significant extent, the EIA
study?s conclusion is the result of technical and, more importantly, policy
assumptions made in their analysis. Moreover, the analysis addresses only
one aspect of the effects of competition. The potential longer-term benefits
of competition are given little attention. This paper addresses three issues
related to the EIA study and retail competition: (1) The paper raises some
important technical concerns about the EIA analysis and its assumptions. (2)
It discusses the policy assumptions implicit in the EIA analysis and the
implications for regional electricity restructuring policy. (3) It
distinguishes the short-term electricity price effects that are the subject
of the EIA study from the longer-term reasons for encouraging competition.
In summary, our conclusions are:
- The EIA analysis incorporates a number of technical assumptions that
would lead to an overstatement of the competitive price of electricity.
- The EIA?s conclusion that electricity prices (or, more accurately the
cost of electricity to consumers) would go up in the Northwest under
competition (and down in many other parts of the country) is largely the
result of a policy assumption. That assumption results in shifts of the
benefits of existing low cost generation and the costs of existing high
cost generation from consumers to owners. Such shifts are not a given and,
in fact, are contrary to the restructuring policy decisions that have been
made around the country.
- The EIA analysis pays little attention to the long-term benefits that
many believe will result from competition. In the long run, competition
should lead to greater innovation in electricity services, greater system
efficiency, and, ultimately, lower power costs than would be the case in a
protected monopoly environment.
Technical Limitations of the EIA Study
Although not the main point of this paper, there are reasons to believe
that the results of the EIA study overstate the likely competitive price of
electricity. This would result in overestimation of the short- and
medium-term prices that could be expected in a competitive electricity
market and also overestimation of any increase in price that might be
experienced by Northwest consumers. The reasons are listed below:
- The estimated cost of a new combined-cycle combustion turbine, which
tends to become the marginal new power source and set electricity prices,
is one third higher in the EIA study than in the Council?s power plan. If
anything, the Council?s estimates have been criticized as being overly
conservative (i.e., higher cost).
- EIA?s estimates of competitive electricity prices in the Northwest are
more than double the prices that have been typically observed in the
competitive market at the California/Oregon border since that market has
existed. Comparing the EIA?s estimates of competitive market prices for
the California/Southern Nevada Power Area with other estimates for that
area show the EIA estimates to be from 1 to 2 cents/kwh higher. [ See the
LCG Consulting Report ]
- The EIA study assumes average water conditions in the Pacific
Northwest, but does not consider purchases of firm or secondary energy
from Canadian power markets. Northwest electricity exports to Canada were
assumed to double, presumably reflecting the return of the Canadian
entitlement, but because Canadian energy markets were not modeled, the
possibility that the power could be remarketed in the Northwest is not
reflected.
- The report underestimates the rate at which new, lower cost
electricity generating plants may replace older plants by assuming no
early retirement of existing generation.
We cannot, at the present time, assess accurately the extent to which the
EIA analysis overestimates market prices but we believe it does. The Council
will be undertaking analyses in the coming months that should provide better
estimates of the West Coast and Northwest markets.
Policy Assumptions and Their Implications
Regardless of these arguments about the specific results of the EIA
study, there is a great deal of uncertainty about future competitive
electricity prices. It is possible, even likely, that for many Northwest
utilities future competitive market prices could be above current costs.
That does not mean, however, that the existing customers of that utility
have to experience higher total electricity cost as a result of competition.
That is a policy choice for legislators and regulators. To a large extent,
the EIA study?s conclusion that the Northwest would experience higher costs
as a result of competition (and the conclusion that the other parts of the
nation would experience lower costs) is the result of implicit policy
assumptions made by the EIA. Those assumptions have to do with the treatment
of stranded costs and their mirror image, competitive "windfall profits."
Stranded costs occur when utilities cannot recover their fixed costs of
existing generation at competitive market prices. Much of the
restructuring debate has been on the question of stranded costs. In
virtually all cases, regulators and/or legislatures have decided that when
markets are opened up to competition, utilities are entitled to recover most
or all of their stranded costs from their existing ratepayer base ? their
distribution customers. [ In contrast, all the costs of new resources in a
competitive market are the responsibility of the owners. The owners bear the
risks of new resource decisions.] The policy rationale is that when those
investments were made, the utility owners had a reasonable expectation that
their monopoly customers would pay those costs. The EIA analysis, however,
ignores this policy reality. Consequently, in those areas with high cost
existing resources, the EIA analysis finds competitive prices to be
significantly less than the average costs that would be charged in a
monopoly environment. That is because those average costs include the
stranded investment and the competitive prices do not. It is an "apples and
oranges" comparison. The lower competitive prices are the result of shifting
existing fixed costs from the distribution customers to the owners.
Wind fall profits can be created when utilities with low cost resources,
who had previously been constrained to selling their power at average cost
based rates, are allowed to sell that power at market rates. This is the
situation that could exist for several utilities in the Northwest. This
issue has not yet been fully engaged because restructuring has been
advancing more rapidly in areas with high cost generation. When it is
engaged, the parallel with the recovery of stranded costs should be evident.
If it is reasonable policy for the distribution customers to pay a
significant share of the stranded costs of high cost utilities, an equally
reasonable and symmetric policy would be for distribution customers to
receive a significant share of the windfall profits from existing low-cost
resources. The EIA analysis ignored windfall profits as it did stranded
costs, and consequently their market prices are higher than current average
costs in areas where the consumers are currently enjoying the benefits of
existing low cost resources. The effect is to shift benefits of existing
generation from consumers to the owners.
While one reaction to the possibility of increased prices is to postpone
or limit competition in the region, this response would have serious
drawbacks. Delaying retail competition is likely to allow large electricity
users to capture any available low-cost electricity leaving captive
customers with higher costs. It would also delay the longer-term benefits of
consumer choice that are the real goal of restructuring.
There are better policy responses available to the region for dealing
with the risk that competitive market prices could be higher than current
average costs. In its latest power plan and in other places, the Council has
urged that the region?s utility regulators develop symmetrical
transition cost recovery methods that include the possibility of both
stranded costs and windfall profits.. Stranded costs and windfall profits
are simply mirror images of one another. During some transition period,
distribution customers of utilities should share symmetrically in
responsibility for paying stranded costs or benefiting from windfall
profits.
Developing stranded cost/windfall profit policies would be a positive
activity for regulators and legislatures in the region. Delaying retail
competition is only likely to result in policies being dictated at the
national level, cost shifting among consumers as customers with market power
get market access, and a delay of the long-term benefits of competition.
Short-term Versus Long-term Effects of Competition
Electricity prices will be affected by the change from regulated pricing
to market pricing. This change was described in the Council paper referenced
above, and would be the immediate short-term effect of deregulated
electricity generation. It is important to understand that such short-term
changes in electricity prices do not represent real gains in economic
efficiency. Absent policy action on transition costs, any immediate
reduction in price would just be a shift in costs from consumers to owners
of electricity generation. Losses suffered by electricity generation
companies and their stockholders would about equal the gains to consumers.
In areas where prices increase, the opposite would be true, consumer?s
losses would equal increased profits for owners of generation capacity.
Stranded cost/windfall profits policies simply mitigate for all or some part
of this transfer by adding a charge, or providing a credit, to the price of
electricity. For example, if full sharing of windfall profits were the
policy, and electricity prices increased, the consumer?s cost of electricity
would be unaffected because the price increase would be offset by a windfall
profit credit on the consumer?s bill.
The EIA study primarily addresses these short-term effects of competition
on electricity pricing. Likewise, most of the regional discussion about the
possibility of increased electricity costs has focused on this short-term
concern. In the areas of the country that have high electricity costs, these
potential short-term price reductions could be large. While the current
competitive pressures, even in this low cost region, tend to indicate that
there may be some short term price savings available, such benefits, if they
materialize at all, will be certainly be smaller for this region than for
many others.
In the longer term, there are more fundamental reasons to encourage
competition in electricity markets. The Comprehensive Review report put it
this way:
The goal of the Comprehensive Review Steering Committee
recommendations on retail markets and consumer choice is to encourage a
more efficient power system, lower electricity costs, increased product
choice and greater product innovation for all consumers.
The Comprehensive Review goals of greater efficiency, increased product
choice and innovation will lead to lower electricity costs over time.
However, these longer-term benefits of competition are more difficult to
quantify and have not been as prominent in regional analyses and
discussions. Nevertheless, the benefits of increased efficiency, innovation,
and product choice have been significant in other industries that have been
opened to increased competition.
These long-term benefits, as well as the shorter-term cost reductions
likely to occur in most parts of the country, have been driving the national
debate on restructuring. It was a widely held perception during the
Comprehensive Review that restructuring was likely to happen at the national
level and that this region needed to determine the best way to position
itself for the changing industry. Simply ignoring the changing electricity
industry is not an option for this region. Implementing restructuring
policies that are appropriate for the realities of this region is the only
option.
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