The American State of California has been experiencing severe difficulties with its electrical power system for the past year. The end effects of these have been threefold -
1. Huge increases in retail prices in some areas (as much as threefold)
2. Power outages in other areas.
3. Threatened bankruptcies of distribution companies, possibly requiring state intervention.
The causes of the problems are a matter for discussion, but most commentators concentrate on the regulatory structure of electricity provision in California. Historically, power has been provided by vertically integrated private monopoly utilities, tightly regulated with permitted prices linked to costs. Since 1996, this system has been replaced by a network of independent generating companies and distribution companies, mediated by a transmission board, and operating a real-time market in electricity.
At a glance, the new system appears very similar to that in force in the U.K. I will therefore look into two questions.
1. Could what is happening in California happen in the U.K.?
2. If not, why not, and could California benefit from looking at the U.K. model?
The present organisation of power provision in California is based on a 1996 law "AB1890". This set up the Independent System Operator (ISO), a private, not-for-profit organisation charged with running the transmission system (that is, the high-voltage lines connecting power stations with the local power distribution companies' networks.
It also created the Power Exchange (PX), a daily market in which distribution companies, and the ISO, bid for power from the generating companies, either for the following day, or for the current day.
The major way in which the practice of the electricity market has deviated from what the planners expected is in the volume of electricity traded in the "spot" market. The idea of this was that when distributors have been unable to buy enough power in advance, they fill the gap by buying at the last moment. It was expected that this market would not handle more than 5% of the daily power demand, but the figure has been on occasion as high as 30%. When these circumstances arise, the ISO has to buy the electricity to keep the grid stable and avoid blackouts - and this is where the very high prices have come from.
The effect of this has varied depending on the retailer (distributor). Of the three main private retailers, one (San Diego Gas&Electric) is not subject to price capping. It has passed these high wholesale prices to its customers, resulting in two or threefold increases in bills. The other two are subject to price caps, and are therefore running up debts in the billions of dollars. It is unclear who will eventually pay for these.
It seems to me that the crisis has been brought about by the interaction of three relatively small mistakes.
1. There is a power shortage
In 1996, California had 30% surplus capacity. The system is supposed to run with a 7% reserve over predicted demand hour by hour. There is not actually a shortfall now, but compared to the situation when deregulation was being planned, supply is very tight. This has the two effects of making the system vulnerable to exceptional peaks of demand or generating equipment failures, and of reducing competition among generators. The causes of this shortage has been failure to build new capacity over the five to ten years prior to deregulation, and a strong increase in demand as the Californian economy boomed. On top of this, the transmission network is also limited in capacity, and this restricts how much power can be moved around the state and from outside to meet demand.
2. Retailers were forced to get all their power through the PX.
In order to get the system going, the main distributors of power were prohibited from buying power in deals outside the PX mechanism. Had this not been the case, these retailers would probably have bought a significant proportion of their power in longer-term deals at relatively stable rates, thus diluting the effect on overall prices of short-term fluctuations in day-ahead and spot markets.
3. The third mistake in my view is that no company with investors' funds to spend has been given the duty under the system of making supply reliable. As far as a business is concerned, a little undersupply is no worse than a little oversupply, and both tend to happen at different times in most industries. If reliable supply is considered essential as a matter of policy, at least one of the players in the system must have both the responsibility of ensuring it, and the means to fulfil that responsibility. In fact, the only body which has the duty of ensuring reliable supply is Cal-ISO, a legal charity with no capability to actually achieve that end by, for instance, securing long-term committments from generators to supply at given prices, or obtaining extra generation capacity of its own to be used in emergencies when other sources fail.
Two things that have not caused the crisis are increased I.T. usage and high natural gas prices. Reports of skyrocketing demand due to increased use of computers seem to be exaggerated - the demand increase has been due to more offices and factories running, and more people living in California to work in them. Natural gas prices have risen sharply, and that would have caused significant electricity price increases - but not the scale of increases that have occurred. They are incidental to the whole problem.
It is worth adding that these mistakes in the design of the system are aggravated by separate mistakes made by both producers and consumers. In the case of producers, prospective generators held back from building plant to enter into the new deregulated market, preferring to wait and see how it worked out. They must be kicking themselves when they see what profits the generating companies that bought the existing plants have made over the past two years.
In the case of consumers, what is striking is the extreme inelasticity of demand. A doubling of electricity rates in the San Diego area has produced an enormous amount of debate, news coverage and political blustering, but almost no reduction in demand. Government TV adds have appeared pleading with people to unplug spare refrigerators, but if a huge price hike had caused people to reduce consumption by even 5%, the near-breakdowns in the grid that caused the price spikes might have been averted.
In a functioning market, there are two forces working to keep down prices asked by suppliers. The first is that, if the supplier charges too much, consumers will buy from other suppliers instead. The second is that, if prices are too high, people will do without. The second seems not to apply in electricity - the vast majority of electricity use seems to be on things that consumers refuse to do without. The first reason appears to be working, except when demand is so close to the maximum available supply that it is obvious that no significant generator can be excluded from the market for being to expensive.
Over the next few years, the problem is likely to be resolved as the high profits made by generators pull more producers into the market. The time taken to build new power stations, though, means that even without deliberate ( and illegal ) collusion, generating companies could charge pretty much what they like for power on numerous occasions over the next couple of years. To deal with the short term, the State of California has entered into long-term contracts to buy electricity at fixed (and fairly high) rates for up to the next five years from suppliers in other states.
I will examine the U.K. arrangements in my next article, but at a glance, I would say that the problems that California has experienced might possibly happen here, but almost certainly not so severely. Currently, the U.K. has adequate surplus capacity to enable competition among generating companies to function. There is a significant level of capacity which is more expensive to produce than the bulk of plants, so that if a generating company priced its main plant output too highly, the market could take those other plants' output instead. For a California-type situtation to develop, that surplus capacity would have to be taken up. This is particularly unlikely because the U.K. equivalent of Cal-ISO, the National Grid Company, is a fully privatised company with freedom to take whatever steps it chooses to secure adequate supply for the future and thus meet its own contractual obligations - it is currently considering such things as building interconnects with the Netherlands and Norway, for example.
Even if a squeeze in power did come about, I believe that the UK power companies are able to sign long-term contracts for part of their supply, thus insulating themselves against sharp short-term increases in prices. This would not prevent a California-type situation, but it would reduce the magnitude of its effects.
Copyright © Andrew McGuinness, March 2001