Fortnightly
New England Power Pool: A Bridge to Competition
July 01, 1995By Gunnar E. Jorgensen and Frank A. Felder
As the debate over restructuring the U.S. electricity industry moves forward, there comes a host of new theoretical models. Two proposals in particular serve well to frame the debate. The PoolCo proposal emphasizes reliable system operation, short-term efficiencies through central dispatch, and a single market price; the bilateral contract model stresses competition, multiple dispatches, and customer choice.
How can policymakers choose intelligently between these two dramatically opposed models? Are there advantages to either or both? If so, should policymakers implement a compromise solution? Might a compromise bring out the worst of both? Or, could they be made to strengthen each other? Consider also that the electric power grid is a large-scale, interrelated system. Serious policymakers simply cannot approve and implement significant change based solely on theoretical proposals and expect them to be instituted immediately.
Nevertheless, there is a way to navigate these waters. Rather than opting now for PoolCo, physical bilateral contracts, or a compromise, policymakers should consider an incremental or bridging approach that can advance the objective of restructuring while also resolving technical, economic, and regulatory uncertainties along the way. In New England, the starting point is the New England Power Pool (NEPOOL), which already meets the short-run objective of minimizing the fuel cost of producing electricity while maintaining a reliable regional system and allowing contract flexibility.
Markets Don't Happen Magically
The electricity industry's transition to a more competitive structure, beginning with the wholesale arena, is not to be confused with a "free-for-all" based on that oft-quoted promise, "Out of chaos, comes order." The "magic" of the marketplace does not just happen. To function properly, markets require an appropriate structure coupled with a mechanism to maintain that structure, so that participants realize the benefits and bear the consequences of their decisions \(em and their decisions alone. Absent this direct accountability, competition does not achieve economic efficiency.
Yes, the fundamental economic structure of wholesale electricity production has changed. Generation is no longer considered by most a natural monopoly. But the underlying economics of the electricity network remain the same. The operation of generators and transmission facilities affects system reliability and the economics of other power plants. This network interaction creates both positive and negative externalities. (In this economic framework, reliability can be viewed as a network externality.) In the past, with few players operating under cost-of-service ratemaking, utilities accounted for network externalities on a quid pro quo basis \(em a.k.a., "gentlemen's agreements" or "good engineering practice." To realize the benefits of competition, instead of merely shifting costs among various market players, any market structure must account for such externalities.
Improving economic efficiency at the expense of system reliability, as the Federal Energy Regulatory Commission has recognized, does not represent progress. From a policy point of view, there is no doubt that the existing level of reliability must constrain the restructuring process \(em unless the policy is to reduce reliability. But the concept of reliability should not be considered a constraint that lies outside the efficiency discussion. Market participants must have the resources necessary to serve their customers reliably, as well as the flexibility to enter into contracts that best meet their obligations. We believe this can be accomplished in a fully competitive, but also accountable and efficient marketplace.
Internalizing Reliability
NEPOOL, now serving 20,000 megawatts of load, was formed in the early 1970s in response to an Northeastern Seaboard blackout \(em by all definitions a significant, negative externality \(em that left 30 million people without power on November 9, 1965. NEPOOL instituted a two-part system of accountability: First, and most easily understood, is the notion that members with load-serving obligations must have sufficient capacity \(em physical or contractual resources \(em to meet their customers' load reliably. Second, and more complicated, is the idea of a central but independent institution to sort out costs, benefits, and accountability.
This second dimension of accountability includes three components:
s Dispatch. A central (regional) dispatch for NEPOOL-member generation facilities to meet poolwide demand at the lowest total regional short-run fuel cost, without regard to ownership.
s Settlement. An after-the-fact "accountability" settlement that determines how members would have dispatched their system to serve their individual loads on a stand-alone basis.
s Forwards. A bilateral forward market in which members can optimize their power-supply mix by selling, purchasing, or exchanging resources with members and nonmembers.
NEPOOL energy transactions are governed by interchange procedures based on the difference between how a member's system actually operated as part of the central dispatch and how it would have operated if each member dispatched its system on a stand-alone basis \(em what might be called an "accountability dispatch."1 If members' resources in the central dispatch produce less physical energy relative to their stand-alone dispatch, it means that others have supplied them with energy at a lower production cost. Those who receive the energy pay their avoided replacement energy cost (short-run marginal cost) for power via NEPOOL. Whenever members are net providers of physical electricity relative to their own load dispatch, they are compensated at their replacement energy cost. The difference between the replacement costs of net users and net providers creates a NEPOOL savings fund, which is then allocated among interchanging members according to their respective contributions (see sidebar).
Members continuously enter into and modify bilateral contractual arrangements with other members and nonmembers to meet changing market conditions, and NEPOOL adjusts its members' own load dispatch to reflect these contractual arrangements. For example, if a NEPOOL member "sells" a slice of a unit to another member, the member's accountability dispatches are performed as if the buyer "owned" the slice, and that member is then held accountable for that decision. This potent combination of accountability and central dispatch gives NEPOOL members strong incentives to plan adequately for their individual energy needs by using their own resources or entering into bilateral contracts. Over the long term, new resource additions are incorporated into the central dispatch \(em by definition improving efficiency in the region \(em but only the owners of these resources are held responsible for their resource decisions. Members do not rely on NEPOOL for their energy needs because they prefer to transact in the bilateral market; the pool is only a place for trading surplus energy as a last resort.
Whether energy is transacted among the members via NEPOOL's interchange structure (about 5 percent of the time), via bilateral contractual arrangements, or within a participant's own system, the central physical dispatch does not change. Here lies the "magic" of the NEPOOL marketplace: Central dispatch ensures reliable energy production at the lowest cost, the forward bilateral market determines cost responsibilities, and the NEPOOL interchange method provides an accountable and disciplined market of last resort, thereby ensuring that all potential fuel-cost savings are captured.
Invoking Accountability Dispatch
At first glance, NEPOOL accountability dispatch and the sharing of savings may seem confusing and contrary to the spirit of competition: Low-cost producers do not share their margins with their high-cost competitors. In fact, though, accountability dispatch and its associated rules enhance New England's competitive wholesale electric market and provide a framework for future competition, permitting a wide range of large and small members to pursue strategies consistent with their individual mandates.
NEPOOL members are solely responsible for their own energy decisions, such as unit characteristics, operational restrictions, transmission limitations, self-nominated power, environmental restrictions, scheduling problems, contractual arrangements, and so on. Further, the fact that NEPOOL has 100 members but only 60 or so accountability dispatches suggests that members are engaging in portfolio management. All this is accomplished under the auspices of competition and customer choice, the driving forces behind the bilateral contract model.
The combination of central and stand-alone settlement dispatch frees market participants to engage in mutually beneficial, competitive, and confidential bilateral (or multilateral) paper transactions, leaving NEPOOL to worry about the physical operation of the system. Decoupling physical and financial transactions ensures system reliability, facilitates innovative bilateral paper contracts, and creates a forward market. NEPOOL members enter into a variety of financial contracts \(em
including unit contracts, joint ownership arrangements, energy-exchange agreements, system power-sales agreements, and interruptible loads \(em all to meet their own system needs, without having to address how such deals might affect the central dispatch.
The key advantage of NEPOOL is that it separates the physical supply from the financial products and services associated with electricity. Efficient markets can have different structures, ranging from commodity-based models to those that involve extensive tailoring of products and services. Markets for electricity are no different. On the physical side, electricity is much like a commodity; in the presence of a network, centralized economic dispatch achieves in the short run the same efficiency outcome as a marketplace that has successfully internalized any externalities. Essentially, this is what the PoolCo model does. Although PoolCo is bid-based and NEPOOL at present is based on marginal costs, there is no reason why NEPOOL could not also implement a bid-based approach. This option, in fact, is currently being explored in NEPOOL's ongoing review process, attended by members and nonmembers alike.2
Other products associated with electricity \(em such as reliability, ancillary services, and risk management \(em require a market in which participants can fashion contracts confidentially to meet their individual needs. This is what the bilateral model stresses. For these products, commodity-type arrangements are not always sufficient to account for situations where one participant has excess peaking load, others have unique financial needs, and so on. Those with efficient surplus energy automatically interchange bilaterally with those who have inefficient energy resources.
Clearly, an extensive forward market has developed around NEPOOL. First, the NEPOOL savings fund is, for all practical purposes, zero. NEPOOL members have arbitraged away any savings, as would be expected in an efficient market. Second, the number and frequency of bilateral transactions have increased dramatically over time, with power marketers and brokers conducting more business, another indication of a well-developing wholesale market. Literally thousands of active financial transactions occur at any given time. Figure 1 plots the number and duration of financial contracts that were active on January 26, 1995.
Bridging the Transition
Municipal systems were not originally members of NEPOOL when it was formed. Instead, municipals bought full-requirements power as customers of the local utilities, just as retail customers buy today from their host utility. The NEPOOL accountability structure, however, enabled municipals to change their status from full-requirements customers to entities that could use the New England regional wholesale market for supply \(em not just the local utility company. Over 40 municipals are now members of NEPOOL. As the pool prepares itself for even more wholesale competition \(em perhaps including load aggregation \(em members recognize that the NEPOOL structure should be able to facilitate this change without adversely affecting the central dispatch, and as before, only the expanded bilateral financial transactions will have to be sorted out via the accountability dispatch.
Except for the two other major integrated power pools in the United States (New York Power Pool and Pennsylvania-New Jersey-Maryland [PJM] Interconnection), a large portion of the U.S. electricity system today is operated primarily as large electrical control areas without central economic dispatch. There are approximately 140 control areas, mostly dominated by one or several large companies. In a control area approximately the size of NEPOOL's, a few companies manage the central economic dispatch and provide power at times to others, such as municipalities, on a full-requirements basis. These control areas are similar to what NEPOOL was over 20 years ago, when NEPOOL consisted primarily of eight major investor-owned utilities serving municipals and other small entities on a full- requirements basis. By following in NEPOOL's footsteps, these areas could achieve the benefits of competitive markets and financial independence for all parties.
Over its 25-year history, the NEPOOL agreement has been amended and interpreted to meet the changing needs of its 100 members, some of whom are independent power producers. NEPOOL is committed to increasing its membership even further. Power marketers and brokers are participating in NEPOOL's reform efforts to broaden competition and member categories while maintaining the advantages of the dispatch system.
As its track record with municipals demonstrates, NEPOOL also provides the necessary foundation for increased choice, should this become the policy of the six New England states. Future independent load aggregators could combine retail and wholesale customer load as long as they also acquire enough resources, either via bilateral contractual arrangements or through their own facilities, to meet their capability responsibility and energy needs. Market participants could also serve as load and supply aggregators. In fact, the NEPOOL mechanism of requiring independent supply procurement and charging its members their own replacement cost, should they require energy from the pool, disciplines market participants: They may end up buying energy at their selling price,3 depending on actual load conditions.
As is the rest of the country, so the New England states are debating the public policy issues on various forms of industry restructuring. These policy issues will take time to sort out. Meanwhile, NEPOOL will enable wholesale competition to move forward. With some enhancements, the NEPOOL structure can provide the bridge between now and an even more competitive environment. t
Gunnar Jorgensen is manager of wholesale market development at Northeast Utilities Service Co. Frank Felder is a consultant with The Economics Resource Group, Inc., a consulting firm based in Cambridge, MA.
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