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Open Power Market Generates a Debate: Wholesale Market Sets Prices, but Critics Say System is Vulnerable

Posted on: Sunday, 16 April 2006, 06:00 CDT

By Paul Adams, The Baltimore Sun

Apr. 16--VALLEY FORGE, Pa. -- Though consumer anger is largely focused on BGE, some say the true origins of Maryland's rising electricity prices lie in a sedate office park in this suburban community 25 miles outside Philadelphia.

More famed as the place where George Washington's encamped army survived a brutal winter, this is also home to the PJM Interconnection, whose primary function is to act as the air traffic controllers of power for electricity providers in Maryland, Washington, D.C., and all or parts of 12 other states.

Twenty-four hours a day, monitors for the independent grid operator sit in a control room three stories underground and watch a giant, wall-sized screen that displays every major power transmission line stretching from Chicago on one end to New York on the other. Their job is to keep those lines from overloading and ensure the smooth delivery of electricity to 51 million residents who reside within the largest centrally dispatched power pool in the world.

But it's what happens upstairs that has millions of customers in Maryland and elsewhere reaching for their wallets.

Three flights up from the dimly lit control room is where staff of the PJM - named for the original grid of Pennsylvania, Jersey and Maryland - run the region's wholesale electric market, which has become ground zero in the debate over whether electric deregulation has helped or hurt consumers. Under deregulation, BGE and other utilities must buy their electricity from competitive wholesale suppliers, who take their cue from the PJM spot market when deciding how much to charge.

But critics say the roughly eight-year-old power market - a sort of stock exchange for electricity - might be vulnerable to a legal form of market manipulation by cagey power generators, who could withhold power supplies at key times and artificially drive up prices.

Also, they blame certain free-market trading rules for making some power generators rich during periods of peak demand while pushing electricity prices for consumers higher than they would be under a traditional regulated system.

"Are we worse off? I think the answer to that is 'yes,'" said Lester B. Lave, an economics professor at Carnegie Mellon University and co-director of its Electricity Industry Center. "To be more careful with it, I would say deregulation the way it was done in Pennsylvania and Maryland, and so on, certainly has been a failure."

PJM officials and many deregulation defenders dispute such claims. They point to several years of data that show the wholesale market has lowered generating costs while fostering a competitive trading system that results in extremely tight profit margins for power producers.

Those and other free-market benefits have been masked, they argue, by the soaring cost of natural gas, coal and other fuels burned to make electricity. Despite the recent political fight in Annapolis, those factors are beyond the control of both utilities and the PJM.

"The primary driver is just fuel [costs]," said Paul Joskow, an economics professor at the Massachusetts Institute of Technology and director of its Center for Energy and Environmental Policy Research. "There's nothing anybody in the legislature can do about that."

It's an academic debate that has raged for several years among economists and regulators, but it has largely been ignored by the public, which until now has been shielded from rising prices as a result of rate caps imposed as part of the transition to free markets.

With those caps expiring, consumers in Maryland, Delaware and other deregulated states are waking up to soaring energy costs, prompting a political outcry and calling attention to recent studies that argue deregulation has not benefited consumers.

Lave and his colleagues at Carnegie Mellon point to a number of flaws in the market, including a concern that large energy suppliers could withhold power from the market or demand higher prices during periods of peak demand. If enough suppliers followed that lead, utilities would be essentially blackmailed into paying stratospheric prices.

The group conducted simulations demonstrating how power suppliers could quickly learn to anticipate each other's moves, creating the temptation to collectively bid prices higher in what researchers termed a form of "tacit collusion."

So long as the suppliers aren't discussing their plans with each other, such behavior wouldn't violate antitrust laws.

PJM says its staff of 16 market monitors guard against such behavior, quickly investigating suppliers who act suspiciously. In instances when there are too few generators bidding to supply power, the PJM immediately caps prices at the cost of production. Suspected cheaters are referred to federal regulators.

"It keeps everybody honest," said Joseph E. Bowring, PJM's chief market watchdog.

The danger remains Lave and his colleagues agree that PJM monitoring has been effective, saying they have no evidence that suppliers have gamed the system. But they say the danger remains, and that such strict policing and other market administrative costs further burden consumers."The structure of the market leaves it vulnerable to that behavior," Lave said. "If you're walking around with a 'kick me' sign on your rear end and nobody kicked you, you'd feel good about that. But you'd still want to get rid of the sign."

Another chief complaint among market critics is that the highest-priced electricity dispatched to the grid on any given day sets the price that all power producers receive - regardless of their cost of production.

Because natural gas sets the price for all electricity, critics say, the result is windfall profits for owners of nuclear and coal plants, and higher costs for consumers. Under traditional regulation, they point out, utilities were only compensated for their actual fuel costs, which were passed to consumers without any markup.

"Our research shows that there is no evidence that restructuring has produced any measurable benefit to consumers or to the systems that have restructured," Carnegie Mellon researchers concluded in a recent paper published in the Electricity Journal, a trade publication.

A Cornell University study came to a similar conclusion. A report commissioned by Delaware Gov. Ruth Ann Minner went a step further, saying customers in that state are worse off.

The complaint resonates in Maryland and Delaware, where low-cost nuclear and coal-fired plants supply much of the region's power. Those power plants were paid for by ratepayers before deregulation, and used to be owned by BGE and other utilities.

As part of deregulation, BGE transferred those plants to an affiliate owned by its parent company, Constellation Energy Group, which sells its power to the highest bidder.

"They [Constellation] own this generation that ratepayers paid for under regulation, and now the customers have to buy [electricity] from those plants at the market price, which is often much higher than they would have paid ... under regulation," said Kenneth Rose, an independent energy consultant based in Ohio.

When natural gas was cheap, there was little controversy over this method of pricing. But weather-related supply disruptions, war and soaring worldwide demand for natural gas and oil have pushed prices for those fuels through the roof, taking electricity along for the ride.

Architects of PJM's wholesale market dispute claims that natural gas has an oversized influence on spot prices. They also point to flaws in the Carnegie Mellon paper and other studies that blame deregulation for consumer angst.

Andrew L. Ott, vice president of PJM's market division and the market's chief architect, said bids from natural gas-fired power plants set the PJM clearing price only about a quarter of the time last year.

That compared with about 67 percent for cheaper coal plants. However, the price of coal has roughly doubled in recent years, which accounts for some of the rise in electricity prices.

PJM officials also dispute that power generators are making windfall profits. Holding fuel costs constant, market data shows, the cost to generate electricity has actually declined slightly in the more than seven years in which the deregulated wholesale market has been operating. The reason, they argue, is competition and pressure from shareholders.

In contrast with conditions under traditional regulation, power plants are no longer guaranteed a profit. That has forced plant owners to cut staff, upgrade equipment and increase efficiency in order to extract more profit out of every megawatt sold. The drive for profits also has led to fewer and shorter plant outages, Ott said.

Bowring said PJM data also shows that over the past seven years, a new coal plant getting paid the PJM wholesale price for power would have recovered only about 70 percent of its total costs, which includes long-term debt and other capital expenses that older plants don't have. Gas-fired and other higher-cost plants would have netted only about 45 percent of total costs. That's one reason a number of power plant owners have gone bankrupt in recent years, he said.

'Might be too low' "If I'm worried about one thing it's not that prices are too high, but that they might be too low to attract enough investment [in new plants] going forward," said Joskow, the MIT economist, referring to the PJM data.

Jay Apt, one of the Carnegie Mellon researchers, concedes that energy consumers in Maryland would be seeing significantly higher rates regardless of whether the state had deregulated. But he says the structure of the PJM market is at least partly to blame. Also, the overall record on deregulation is at best murky.

"It's not obvious to me that there's anything in either the Cornell [research] or my paper that shows me that deregulated states are much worse off, but they're clearly not better off," he said.

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Source: The Baltimore Sun, Maryland

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