The Dawn of Electricity Competition: Efficient Prices and Efficient Choices

At first glance it seems contradictory that an issue that discouraged energy efficiency programs in the 1980’s would still be an issue that discourages economic efficiency.   After all, energy efficiency programs were labeled “social engineering” by some; in contrast today’s retail electricity choice is all about the “free market.”  How could these two activities be more different and yet affected by a similar problem?

In my mind, the issue that binds old energy efficiency programs with new retail choice is regulated ratemaking.  The practice of average-cost ratemaking skews the economics of peak load shaping and energy use during expensive peak periods.  What value is there in saving an expensive unit of power if you do not pay the full cost – or pay until much later – or if that cost is spread to non-peak hours?  Like a coat of plaster on a cracked wall, average cost pricing hides a problem, but just for a while.  Regulators have their hands full with different approaches to hold the wall together.

Assessing retail competition

A recent study by the Alliance for Retail Choice (ARC, http://www.allianceforretailchoice.com) identifies regulated pricing as a key barrier to retail electricity choice.  If that sounds like a contradiction, then read on.  Recall that energy efficiency program advocates have long recognized that regulated rates removed or dampened incentives for economically efficient price response, such as efficient consumer behavior in appliance purchases decisions, or in time-differentiated price response.  Then as now, regulated prices cause people to behave inefficiently.  Regulation typically emphases cost recovery (the past) for a utility (or for a default service provider), rather than risk management and efficient behavior (the future) by the customer.

“ARC’s Baseline Assessment of Choice in the US” (ABACUS) considers the market structures, business practices and regulatory policies that support choice for residential electricity consumers. ABACUS was designed to assess US states on their progress in implementing retail electricity competition.  One of the topics considered was the structure of the regulated transitional rate or “default service” that most states adopted.

ARC determined that a dozen states and two Canadian provinces continue to make progress in restructuring their electricity markets, addressing problems and moving forward.  Retail electricity choice thrives in Texas and New York because the market structure has advanced sufficiently for competitive markets to work effectively.  Residential consumers in Texas and New York have a choice of suppliers and a choice of products and services.  Unlike traditional regulation’s “one-size-fits-all” tariff, consumers can choose a contract period of one month or one, two or three years to lock in today’s prices; they can select green power that is backed by production from renewable resources such a wind and solar energy; they can bundle appliance maintenance costs into the electricity bill.  Consumer preferences differ, and competitive markets satisfy these diverse needs and wants.  Competitive markets are a mainstay of the US economy precisely because suppliers respond to consumers who shop – consumers who choose among products, services and suppliers.

The design of default service (also called basic or standard service or provider of last resort) was identified as the most significant determinant of the success of retail electricity choice.  A poorly designed default service undermines competition.  If default service is designed to satisfy all residential consumers’ needs, or if it bundles and spreads risks among all consumers, or if it is priced below market, then it is unlikely that new retail electricity providers will enter the market. With few choices, consumers are left with only the poorly designed default service, and with limited benefit.

ARC determined that to encourage the development of a competitive retail market, default service must be a more market reflective rate in the near term and it must provide opportunities to retailers.  The following principles were set forth:

• Default service is a transitional service with a clear ending date for the majority of consumers.
• Default service is easy to understand and meets only a consumer’s basic needs.
• Default service closely tracks the cost of power in the wholesale power market.

Texas was cited for excellent progress toward the achievement of a competitive market for residential electricity consumers.  This was due, in large part, to the decision to end the five-year rate transition for residential consumers.  Let’s examine how that worked.  Customers who did not immediately select a competitive retail service provider received the “price-to-beat” service from January 1, 2002 through December 31, 2006.  The price to beat met their basic needs, and retail providers began to offer competing services.  A variety of products and services were offered to take advantage of the new market structure.  Today, more than 50 products are available from nearly 20 retailers.

Additional products and services will arise in the competitive end-user marketplace.  Ground-source heat pumps, for example, will allow Texans to use the natural warmth of the ground in winter as a heat source, and the same earth as a heat sink in the summer.  The upper layers of the earth store solar energy and maintain a fairly constant temperature throughout the year.  Recovery of this solar energy by efficient heat pumps will lower heating costs.  Pumping heat into the earth will lower cooling costs, reduce the summer peak capacity requirements, and reduce natural gas usage in peaking generation units.  Hundreds of products and services are developing or will now spread to a state that was never considered a leader in energy efficiency.

Other products and services will target the retailers, providing them with tools to manage their customers’ energy usage.  As the intermediary, electricity retailers develop expertise in marketing products and ideas to consumers that lower the retailer’s exposure to price volatility.  Power plant owners now have increased incentives to manage costs, particularly fuel costs.  Armed with knowledge of what consumers want (based on contract length and terms), markets will develop the appropriate mix of high-fuel-cost power plants (like those that consume natural gas), and low-fuel-cost plants (like wind, and those fueled with uranium and coal).  This can only really begin to happen when consumers exercise their choices through the marketplace.

Price signals in Texas

Back in the 1980’s, energy efficiency program advocates worked to “get the prices right” so that consumers could make energy efficient choices.  They tried to eliminate the pass-through of fuel costs.  They tried to institute integrated resource planning.  Regulation in Texas proved too resilient and well established.  It took statutory reforms in 1995 and 1999 to open the markets to competitive forces and begin to get price signals that would result in efficient behavior.  However, even wholesale competition initiated in 1995, and with market restructuring to allow retail choice in January 2002, Texas maintained its “price-to-beat” with a fuel cost adjustment every six months. That is, most small end users, such as residential customers, continued to rely on regulatory decisions about costs that were incurred in the bulk power market – a market which many observers already considered competitive. 

In January 2007, the “price-to-beat” ended, and retail customers are now exposed to market prices.  Here is why that is important: The five-year transition allowed retailers to develop products and services that provide Texans with alternatives to the volatile wholesale market prices.  Perhaps more importantly, the owners of power plants in Texas now take full responsibility for managing the cost of fuel.  (Who better to do that job?)  The retailers who provide services between the bulk power market and the retail consumer must manage a portfolio that matches the needs of their customers.  (Who better to do that job?)  Customers are free to sign contracts of one or several years to lock down prices.  Customers are also free to take on some the price volatility and install devices in their homes and businesses that will allow them to control their exposure to that volatility.  Some customers will welcome that opportunity; others want the certainty of constant prices and “flip the switch” electricity service.  It’s their choice now.

An appropriate alignment of responsibility and reward is fundamental to the efficient functioning of an economy.  For this reason, it’s worth taking a look at electricity markets to determine where customers are allowed to make choices and where they are locked into accepting and paying for a choice made through regulatory processes.  The ABACUS study considers default service in detail because default service is deemed to be quite important to the success of retail markets in North America.  (For a copy of the report, go to http://www.allianceforretailchoice.com or http://www.defgllc.com.)  Several jurisdictions that claim to have retail electricity choice have policies that require customers to bear the cost of others’ decisions.  It’s a choice in name only.

With foresight in 2007 we should be able to identify the problems that remain with default service in each jurisdiction.  Regardless of whether you are motivated by the success of new energy efficiency programs or the success of retail electricity choice, there is a need for regulatory reform so that pricing is more efficient.  The market participants most capable of managing a risk – like fuel price risk – are the ones who ought to take responsibility for it.  Energy efficiency program advocates have been making this point for decades.

In Texas, the fuel factor is history in much of the state, and competition can proceed with full vigor.  For that reason alone, I believe it is appropriate to declare that electricity competition has just begun in Texas!  Retail services should continue to flourish as Texans look for ways to manage risk.  All eyes are on the future, and less time is now spent looking at (and allocating) last year’s costs.  In other states, the gradual phasing out of regulated prices will allow a fuller and more intense degree of competition to take place, and with it will come new products and services.