Alberta now finds itself nearly three months into the operation of an electricity market where prices are determined through market forces rather than regulation. While the Power Pool of Alberta has been in operation since 1996, prices for the majority of electricity volumes were determined by regulated contracts. As of 2001, however, this is no longer the case. Recent high Power Pool prices have some observers wondering if the expected benefits of deregulation will materialize.
We submit that the underlying realities of Alberta's electric power sector made higher prices inevitable, even if it had preserved its system of regulation. Comparisons with neighboring regulated jurisdictions are misplaced, as are comparisons with the regulated rates of old. The hard reality is that Alberta needs to develop significant new generating resources in order to meet its growing needs. Such new investment will always be expensive, no matter if it is financed through regulated rates or through market prices.
Perhaps more importantly, recent prices must not distract policymakers from the need to continue to develop the Alberta marketplace. The focus must be firmly on attracting private investment in new capacity through market means. Most importantly, the government cannot appear to undermine the free market process, as few things alienate investors quite as effectively as the specter of regulatory intervention.
In the coming months, several issues will require responsible guidance from policymakers, including the development of forwards markets and a market for ancillary services. Sound market design, of the kind that has characterized reforms to date, will do the most to create an attractive place for investors to do business, and for the benefits of deregulation to materialize.
Hardships Stemming From Current Market Prices
This is not to say that we should not be concerned with the hardships stemming from current market prices. Some customers will be better able to avail themselves of opportunities created by deregulation than others, and it is the proper role of government to assist the most vulnerable consumers. This can be achieved through programs such as rebates and the use of deferral accounts to offset current high prices against future expected lower prices. Carefully designed programs can provide protection to eligible consumers without distorting the underlying market.
The real benefits from deregulation will be realized when new plants are necessary to meet the needs of a growing system. This is precisely the case in Alberta, where the need for new generating capacity has been widely acknowledged for several years. A new plant that is built in the province no longer has any assurances that it will realize a return on its investment. It is therefore incumbent upon the private investor to carefully analyze the need for new generation, as due diligence will be its only assurance of a good investment.
From the point of view of consumers, the new deregulated environment means that they are no longer the captive guarantors of new investments. A firm making a poor decision will no longer have recourse to consumers' pocketbooks to recover their costs. While this protects consumers from bearing the costs of poor decisions, they also benefit from the competitive pressure created as multiple firms pursue good investments. Firms will try to develop the most cost-effective projects possible, as this maximizes their profits. In the course of doing so, the combined effect is to reduce prices overall.
The key benefits to deregulation arise not because it fundamentally lowers the cost of doing what has been done for decades, but because it alters the nature of new investment.
Comparing Apples and Oranges
Two common refrains in newly deregulated markets are to compare electricity prices to those in neighboring markets, and to compare them to what they used to be. Both such comparisons are potentially misleading. It is wrong to compare Alberta's energy prices to those in British Columbia, for example, because the prices reflect fundamentally different situations, not only in terms of regulation but also in terms of historic investment, system needs, and available resources.
B.C. is fundamentally different from Alberta. Its extensive endowment and development of hydro resources is the mirror opposite of the thermal system in Alberta. More importantly, B.C. does not currently face a capacity shortage, so its rates will be driven by an asset base of depreciated investments. Alberta cannot hope to see the rates faced by B.C. consumers because Alberta is not B.C.
The appropriate comparison for gauging whether deregulation offers benefits to consumers, then, is to ask how Alberta would have met its current challenges under the old system of regulation. Given the realities of the Alberta electric system, the real question should not be to lament its situation -- as comparisons to other jurisdiction or to the past do -- but to ask how these challenges can be best met.
Rise in Prices Reflect Changing Market Conditions
Room for Improvement
Consumer Protection
Conclusions and Recommendations
An obvious first question is to ask whether recent market prices make sense. These prices must be viewed in the context of various factors that influence electricity prices:
- Hydro generation was nearly 20 per cent below 'average' levels during 2000, increasing the reliance on thermal generation in the province, just as this thermal generation was getting more expensive.
- Imports fell over 35 per cent while exports tripled, reducing net imports by 70 per cent compared to 1999. This was due primarily to the surge in prices in the Pacific Northwest, in turn influenced by rising California prices. This increased competition for importing sources while also increasing the demand for exported power.
- System load grew by approximately 5 per cent in 2000.
Every one of these factors indicates a tightening in the supply/demand balance, from a system that had been generally regarded as being in need of new capacity for several years. While we have not undertaken a complete study to determine if these factors explain the higher Power Pool prices during 2000, we would have been very surprised if prices in 2000 had not been significantly higher than in previous years.
We stated previously that the real benefits from deregulation stem from the shift of risk and responsibility for new investment away from regulated utilities and into the hands of private investors. One seemingly obvious test, then, would be some sort of measure of private-sector interest in investing in new capacity. We would argue that this is the ultimate test; no other benefits of competition are as valuable as getting government out of the business of building new power plants. If Alberta's electricity policy fails to get new capacity built by private investors, the entire effort will have been for naught.
At first glance, it would appear that Alberta is successful in this regard. The initial market reforms have led to nearly 1,000 MW of new independent power capacity to enter service. With over 4,000 of planned and announced new generation, there is at least an indication of strong interest, even if such announcements are not exactly commitments. Another positive sign in the $1.1 billion of revenues raised by the PPA auction; this is revenue in addition to shouldering the obligation of making fixed and variable payments to the plant owners for up to 20 years.
These promising signals aside, it is probably too soon to tell how much private capital Alberta's market will ultimately attract.
Nevertheless, there are aspects of the Alberta market that raise some concern:
- The Power Pool rules were amended to prevent imports from setting the Power Pool price. This is pure price discrimination, and weakens the price signals within the Province.
- The Balancing Pool has become an active market participant, directly controlling one of the key plants in the system. There is a legitimate concern about a market where a dominant participant has poorly defined operating incentives. The offer strategy adopted by the Balancing Pool - in which Clover Bar was offered below its properly defined marginal cost during peak hours -- was regarded by many as a deliberate attempt to manipulate Power Pool prices.
- The precise interaction between ancillary services and the Power Pool price is not clear. In particular, how is energy dispatched from a unit providing reserves priced? If these reserves are tapped to prevent rationing, prices should reflect the compromised nature of reserves. As far as we are aware, however, reserves do not affect Pool prices, even when called to deliver energy.
The rule changes and actions of the Balancing Pool do not inspire complete confidence in this market. Imports continue to be an important source of power for Alberta, yet the Power Pool no longer reflects this. In January and February, there were 38 and 35 hours, respectively, in which imports were procured even though they were more expensive than the Power Pool price.
If the true price of electricity is not reflected in the Power Pool price, consumers will have insufficient incentive to conserve, and generators will have insufficient incentive to increase production through improved operations or through new investment.
The offer strategy adopted by the Balancing Pool is more disturbing. By improperly calculating the price paid for gas for Clover Bar, the Balancing Pool offered output from the plant below its economic marginal cost. On January 5, for example, Clover Bar set the Power Pool price in 16 hours at approximately $97/MWh. Its actual marginal cost was closer to $130/MWh, implying a distortion to market prices of 25 per cent in each hour it was setting the Pool price. The message to private investors, unfortunately, is that the Balancing Pool has the ability and demonstrated willingness to distort market prices.
If the government is concerned about high electricity prices, it has several options at its disposal that do not distort the market. The Regulated Rate Option is one such alternative, in which deferral accounts are established to smooth out the transition to deregulated prices for certain customers. It rightly provides price protection for the most vulnerable customers while not preventing those with the skills, desire and incentive to actively participate in the market from doing so.
Other options also exist; including fixed monthly rebates to customers. This reduces the cost of electricity while not distorting the marginal incentives for consumption. Consumer protection does not need to come at the expense of market transparency and credibility.
We have now experienced three months under the new market rules, where the price of all electricity is set by market forces rather than by regulation. It is tempting to look at Power Pool prices during this time and pronounce deregulation as an expensive proposition.
However, this would have been a period of rate increases even under regulation. If higher prices were inevitable -- as they necessarily will be in any system with a shortage of generating capacity -- then we must turn our attention to whether new supply is best developed under regulation, or under competition. The key concern must be to look forward, to ensure new supply is attracted by creating and fostering a credible marketplace where companies will want to invest.
Several developments will need responsible guidance in order to fortify the Alberta electricity market. Some issues in particular will need attention:
- Control of the PPAs held by the Balancing Pool must be transferred to private entities with commercial incentives. Despite its best intentions, having a quasi-public entity control a large fraction of generating capacity will always be viewed with suspicion. Competition on a level playing field was a central tenet of the Electric Utilities Act; active participation of the Balancing Pool in the market offends this principle.
- Emerging forwards markets will play a key role in providing price signals over different time frames. Both over-the-counter and exchange -based trading is developing, and at least two Binding Day-Ahead Markets are expected. It will be critical that the choice of markets not be distorted by such issues as allocation of uplift costs.
- A market for ancillary services is being developed to replace the RFP process currently being used. Considerable effort will be required to design the rules that govern this market, as well as how it will integrate with the real-time energy market.
- Much of how the Alberta market currently functions depends on the ability of the transmission grid to operate as a single provincial system. If this ability is eroded, significant issues will arise, such as the need for location-based prices and the allocation and use of transmission rights. Experience in the American markets shows it is difficult to 'fake' a one-zone system. Either a commitment must be made to maintaining an uncongested transmission system, or work must begin on considering designing a market that reflects the limitations of the grid.
- Large industrial load could well make Alberta the first electric market to truly involve load in the price-formation process. The resulting 'Alberta model' may become the leading example of a complete electricity market.
In general, Alberta has developed a very attractive market. The fundamental design is transparent, the relevant institutions are well established, and there is a large volume of information available about how the market functions. A renewed commitment to 'letting the market work', while pursuing minimally distortionary consumer protection programs, should encourage the private investment the sector so obviously needs.
Seabron Adamson is President of Frontier Economic Inc. and directs the firms North American energy practice. Mr. Adamson made this presentation to last month's annual meeting of the Independent Power Producers Society of Alberta. ET