Customers pay too much for reliability, study says, urging more use of non-supply options

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Electric Utility Week
January 24, 2005

By virtually ignoring the demand side of the supply/demand equation in the electric utility industry, regulators are causing consumers to pay far too much to ensure generating reserve margins are adequate, according to a new study.

The study, from the Center for the Advancement of Energy Markets and the Distributed Energy Financial Group, said a market-based approach to ensuring resources are sufficient would produce a $19 billion benefit to retail customers each year.

Too often regulators believe supplies are the problem and that a capacity reserve margin is the best way to ensure reliability, but “a well functioning electric system will see investments in generation, transmission and distribution, and customer premises solutions, such as distributed generation, energy storage, advanced metering, sensors and controls,” said the report.

Reserve margins are maintained all year long and they are usually set above a peak generating level or peak demand day, meaning for most of the year “there is an enormous amount of unused capacity” that is being paid for by all ratepayers, said Ronald Sutherland, one of the authors of the study. “The value of improved reliability due to reserve generating capacity is much less than the cost of providing this capacity,” Sutherland said.

Relying on the competitive market and more efficient pricing for capacity would reduce the average cost of electricity by more than 1 cent/kWh in certain parts of the country, the study said. “This price reduction would produce a $19 billion annual benefit to ultimate U.S. customers. The benefit would result from avoiding unnecessary capacity reserves, and encouraging price-demand response,” said the study.

The study recommended that demand-response initiatives, distributed generation or other mechanisms such as loadshifting and curtailment should be pursued more aggressively, rather than trying to ensure generation levels are adequate for reliability purposes. “We’re saying there’s a cheaper way of doing business,” and rather than prescribing means to achieve reliability the best way is to “let the market figure it out. … The same level of reliability could be obtained at a much lower cost,” Sutherland said in an interview.

“As reliability and confidence in the market increase, the capacity reserve margin can be eliminated. The application of a competitive approach will reduce cost, and will enable the private markets to provide reliability services. A competitive approach will enable electric restructuring to provide the benefits to customers that we have observed in other deregulated markets,” according to the report.

Many states or regions of the country have reserve margins or resource adequacy requirements, but the study said such a prescriptive regulatory approach undermines the goals of a competitive market, treats all consumers the same regardless of their preference for more or less reliability and results in considerable costs being passed onto consumers.

Any generating reserve requirement should be limited in scope, planning horizon and duration because an annual requirement that doesn’t change while demand drops during off-peak periods is inefficient, the groups maintained.

Focusing resource adequacy on generation is inappropriate because most electrical outages result from transmission and distribution system failures, not insufficient capacity, the groups said. Today’s industry relies on “an increasingly brittle and aging T&D system” that could use more investment, not more generation, said Jamie Wimberly, president of CAEM and CEO of DEFG. “The least reliable link in the electricity network is the distribution system, not generating capacity,” the report said.

Inadequate investments in T&D results in “load pockets” that limit the ability of existing generation to reach customers, meaning a reserve margin is almost useless in such situations. Reliability is enhanced “by the use of price demand-response. Historically, the electric sector has considered load a given, and not subject to efficient pricing and demand response. All three resource options need to be considered and optimized in order to achieve an economically efficient system,” the report said.

The groups are not advocating a certain type of demand response, such as time-of-use rates or payments for customers curtailing or shifting load, but rather they believe the market will provide such services if the regulatory picture allows them. “We’re saying open the market up to other possibilities. If the price signals are there, people will respond,” Wimberly said.

He added that “there needs to be more work done” on how best to incorporate demand response in today’s markets, and CAEM has a proposal to examine the issue. The focus of the current report, however, was to say resource adequacy rules can kill any effective demand-response program. “If you maintain a constant amount of capacity month in and month out, wholesale prices will be relatively constant and those inefficient costs are passed through to retail customers,” Sutherland said.

Projections by the North American Electric Reliability Council and the Energy Information Administration document that future generating capacity is likely to be more than adequate, yet regulators in Texas are considering adopting a reserve margin for that state, said Nat Treadway, the other principal author of the report and managing partner at DEFG. Texas has plenty of generation and is seeing relatively new plants mothballed, yet staffers at the Texas Public Utility Commission have said they intend to have a rule establishing a reserve margin approved by the end of the year to avoid a crisis a few years down the road, said Treadway, a former staffer with the PUC.

“They need to take a more market-oriented approach” to avoid excess costs and market inefficiencies seen in other parts of the country, he said.

At the retail level, the current regulatory model focusing on generation adequacy and flat-rate prices from utilities also hinders any real benefit from retail restructuring because competitive retail markets are designed based on an inefficient wholesale market model, according to the report. “Flat-rate prices preclude the development of efficient wholesale and retail markets,” so while deregulation in other industries has produced enormous benefits where prices to consumers have dropped more than 50%, “benefits of this magnitude do not characterize any electric restructuring effort in the U.S.”

Retail restructuring efforts “include the use of auction markets and retail access to power suppliers, but some such efforts are superimposed on the old regulatory model of flat-rate pricing and large reserve margins. The inefficiencies inherent in the regulatory model preclude restructuring efforts from providing the potential benefits to customers,” the report said, suggesting that the transition to a truly competitive electricity market may take a decade or longer.

CAEM is a non-profit think tank based in Washington and DEFG is a financial services firm that provides consulting and other services to energy clients. The report, “Resource Adequacy and the Cost of Reliability: The Impact of Alternative Policy Approaches on Customers and Electric Market Participants,” is available for free by contacting Jamie Wimberly by e-mail at jwimberly@defgllc.com.