Industry

Electricity Markets: The Pre-Restructuring Era

It all dates back to the year 1879 when Thomas Edison patented the first incandescent light bulb and began commercializing it a year later. But apart from “removing darkness from people’s lives”, it proved to be one of the first practically available uses of electric power. It changed the way we design buildings, increased the length of an average work day and boosted many businesses. Electrification’ was a major engineering achievement in the 20th century leaving behind spacecraft, automobile and computers. Electric utilities thus began to spring up in major cities and have been growing since then.

Traditionally, the electric utilities have been regulated by the state and federal governments. There are two fundamental reasons for this. First, it is seen as an industry aimed at the well-being of both businesses and individuals, becoming an industry “affected with the public interest”. Second, the technological and economical dynamics are such that it is more economical to cater to the demand by one operator rather than multiple smaller units. Competition can’t strive and eventually only one operator would survive. Such operators are often termed as natural monopolies or local monopolies. Such monopolies would then dictate the terms and set prices which would be economically unjustifiable. Owing to these two reasons there is an intervention required from the government explicitly to protect the public interests which the markets would fail to achieve on their own.

The public interest has many variables. Any individual willing to accept the terms of service and pay the regulator-approved price must be provided by the regulated local monopoly. The service must be the same throughout all customers. Since the utilities would have to run their “wires” through the communities there needs to be standards in place to avoid the wires sagging down and adhere to the “right of way” or in other words the clearance criteria. Moreover, generating electricity may pollute the environment given that the majority of power is produced by burning the fossil fuel. The regulators thus impose the environmental responsibilities on the utilities. Lastly, since the very nature of the industry (local monopolies) doesn’t allow consumers to choose their own operator the government should have an oversight so that the utilities act responsibly.

But the basic question that remains unanswered is: how the prices are determined? By a basic economics principle, the price of any commodity is set at the equilibrium – the point where the marginal price (cost of producing one more unit of commodity at a given production level) of producing that commodity is equal to the benefits received by the consumer groups as an aggregate or simply the point where the supply and demand curves meet. But such pricing mechanism exists where there is an open competitive market structure. The market forces determine the price rather than an external force or a regulator. In regulated markets, since the markets by themselves can’t determine the price, the regulator is the entity responsible for the pricing. Generally the pricing is done based on “cost of service” approach, where fair prices are determined by taking into consideration the costs incurred to supply the specific group of consumers (residential, commercial, industrial) plus a reasonable rate of return on investments done. The state, federal and local regulating agencies determine the price, lay down the terms of services and make the budgets and construction plans.

Is regulation an agreement between the utilities (who are obliged to provide the services) and government? The answer to this question is no. Regulation is an exercise of the power by the state over industries “affected with public interests” and not a binding agreement. The need for regulation arises because of the monopolistic nature of the industry and its only objective is to “keep the lights on” adhering to security and reliability standards.

Vertically integrated utilities became a famous term and refer to a geographical monopoly which takes care of all the three components – generation, transmission and distribution of electricity in their respective areas of operation. All activities like generation planning & scheduling, other operation related activities, short-term maintenance activities, future generation and transmission expansion planning etc. were then taken care by one such big utility adhering to the regulations from the state and federal agencies. Engineers treated managing this industry as a set of challenging optimization problems. These problems grew in complexity and size, creating newer algorithms. Such vertically integrated utilities lasted for about a century and operated just fine. But what happened then? What were the driving forces that changed the way and structure of the electric power industry? How does the industry look like now?

 

6 thoughts on “Electricity Markets: The Pre-Restructuring Era

  1. Power Generation and Distribution industry is required to be regulated because society and industry need power 24×7. If left to market forces, many plants would shut down disrupting our lives. If they are not assured reasonable return on investment, no body would invest. In view of these peculiar features, regulation of power prices with certain pre-defined norms is the only practical way for ensuring dependable power supply.

     
    1. Thanks for the comments! I think all your questions on introducing competition will be answered in next blog. But, countries like USA, Canada, whole of Europe and many others have competitive markets since late nineties and they function just fine. The competition came into being with the reasoning that it’s only the “wires” (transmission and distribution) that have the monopoly and not generation. Regarding your question on “keeping the lights on” , they have reliability standards they need to abide by which basically takes care of this problem. But stay tuned for the next blog and I will try answering all your questions specifically there.

       

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