Wholesale electricity markets in the technological age
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Executive Summary
The U.S. power industry, a major underpinning of the national economy, has experienced significant regulatory and market transitions over its long history. The unique nature of electricity provision is one susceptible to various forms of market failure, giving rise to a complex regulatory structure. Some failures are sufficiently pervasive as to support the widespread view that the industry is a “natural monopoly.” Thus, the industry’s early development included utilities being granted exclusive franchises in exchange for tight state regulation.
In the 1990s, efforts to introduce competition into the electricity industry reached full-swing, giving rise to organized wholesale markets operated by independent system operators (ISO) and regional transmission organizations (RTO). RTO/ISOs developed complex market rules to account for systemic market failures. The performance of RTO/ISOs continues to be affected by this confluence of evolving market rules, market conditions and technological development.
Some observers are critical of the performance of organized markets. Market outcomes have sometimes proven politically unpopular or prompted interventions from states to “correct” for perceived deficiencies. These include actions to subsidize construction of new power plants or keep unprofitable power plants online. Some parties also charge that organized markets do not evolve with technological change.
Despite these criticisms, the development of organized markets has brought large economic efficiency gains compared to the “unorganized” model. RTO/ISOs have exhibited strong reliability performance and provide incentives for market participants to engage in reliable behavior. The open-access organized market model is better positioned to reduce barriers to entry, lower transactions costs, provide clear investment signals to investors that spur innovation and compensate resources fairly and efficiently in a manner consistent with market fundamentals. RTO/ISOs in states that have restructured or replaced monopoly regulation of generation with independent merchant ownership have seen more efficient behavior from market participants than RTO/ ISOs areas with predominantly regulated monopoly utilities.
While organized markets offer a substantial upgrade in electricity-system structure, significant performance challenges remain. Compared to a perfectly designed market, this paper finds that current organized markets can be improved in ways that enhance market performance.
- Enhancing price formation. Improvements in organized market design can ensure prices better reflect market fundamentals. This can reduce the need for RTO/ISOs to take “out-of-market” actions – that is, administrative mechanisms designed to deal with constraints that aren’t represented in the commercial network model – that distort price signals, as well as the need for side payments with such payments known as “uplift.”
- Reducing artificial barriers to entry and exit. Administrative barriers to entry preclude the full participation of all resources. Removing these would bolster competition. Market-design improvements also could better reflect resource needs at local levels, which would avoid administrative barriers to exit that currently compensate for market deficiencies.
- Remedying incomplete markets. Certain ancillary services are not fully represented in existing markets. Creating market products that match discrete services would value these services more appropriately. Similarly, transmission-planning processes can hinder effective competition from transmission substitutes or advanced transmission technologies. Reforms should allow all capable products to compete to supply transmission-system needs.
These market-design reforms could yield substantial market-efficiency gains. Much of this benefit would derive from taking better advantage of the value of advanced energy technologies. Achieving these goals would require proactive leadership from the Federal Energy Regulatory Commission, the RTO/ISOs and their stakeholders, as well as constructive engagement from the states through a form of “cooperative federalism.”
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