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ID: E000242

electricity markets

In many parts of the world buyers and sellers now trade electrical energy in liberalized markets. These markets have partially replaced cost-based regulation and government ownership.

Since the 1980s, governments in many countries have privatized and restructured their electricity industries. Liberalized electricity markets now operate in much of Europe, North and South America, New Zealand and Australia. These changes were primarily motivated by the perception that the previous regimes of either state ownership or cost-of-service regulation yielded inefficient operations and poor investment decisions. Liberalization of the electricity industry also reflected the progression of a deregulation movement that had already transformed infrastructure industries, including water, communications and transportation, in many countries. Although electricity shares many characteristics with other deregulated industries, the differences have proven to be more important than the similarities. Electricity has been one of the most challenging industries to liberalize and in most places new layers of regulations have replaced the old.

Historically, electricity was viewed as a natural monopoly. Typically, a single utility company generated, transmitted and distributed all electricity in its service territory. In much of the world, the monopoly was a state-owned utility. Within the United States, private investor-owned companies supplied the majority of customers, although federally- and municipally-owned companies played an important minority role. These companies operated under multiple layers of local, state and federal regulation.

Restructured electricity markets share a common basic organization. The three segments– generation, transmission, and distribution – have been unbundled. Wholesale generation, no longer viewed as a natural monopoly, is priced through a market process. Transmission and distribution remain regulated, although in many cases some form of incentive regulation has replaced cost-of-service regulation or stateownership.

Most wholesale electricity is traded through long-term (a week or longer) forward contracts. Many markets also feature day-ahead auction-based exchanges. Because supply and demand must be continually balanced to preserve transmission stability, transmission system operators run real-time balancing markets. Prices in these high-frequency markets can be highly volatile since electricity is non-storable and real-time demand fluctuates dramatically. To meet unforeseen contingencies, transmission system operators also contract for and occasionally use standby or reserve generation services. Many markets reflect price differences across geographical locations when parts of the transmission grid are congested (Schweppe et al., 1988; Chao and Peck, 1992). Game theorists and experimental economists are involved in the ongoing process of designing electricity markets (Wilson, 2002), while empirical researchers have used detailed auction data to estimate how well predictions from theoretical models describe firm behaviour (Wolak, 2000; Hortascu and Puller, 2004).

At the retail level, the vision of liberalization was to provide customers a choice among competing retailers who would operate as either resellers or integrated providers with access to customers through a regulated common-carriage distribution network. In most restructured USmarkets, retail competition for residential customers is very weak (Joskow, 2005). Retail competition is more advanced in the United Kingdom, although evidence suggests that customers have been slow to take advantage of the ability to switch to a lower-priced retailer (Waddams, 2004). Several authors have noted the economic benefits of allowing retail prices to vary to reflect real-time changes in the wholesale prices, although this sort of real-time retail pricing has been slow to take hold in practice (Borenstein and Holland, forthcoming; Joskow and Tirole, 2004).

Oligopoly simulation analysis indicates the potential for serious market power problems because suppliers face extremely inelastic demand and entry requires long lead times (Green and Newbery, 1992). Empirical work has indicated that market power has indeed been present, although to varying degrees in different markets. Wolfram (1999) found that prices in England and Wales were lower than static oligopoly models would suggest. By contrast, extreme levels of market power in California contributed to record high prices in 2000–1 (Borenstein,Bushnell and Wolak, 2002). The explanations for these differences have focused on variations in the threat of future regulation and in the extent of long-term fixed price contracts (Bushnell, Mansur and Saravia, 2005).

Although the main motivation for market liberalization was to improve economic efficiency, there have been few attempts to measure efficiency changes. Newbery and Pollitt (1997) and Fabrizio, Rose and Wolfram (2004) find modest positive effects of market liberalization on, respectively, industry efficiency in the United Kingdom and plant-level efficiency in the United States.

As electricity industry restructuring moves forward, the major unresolved question is the degree to which public policy will influence investment decisions. Electric generating plants are long-lived, so while operating efficiency gains appear to be real, the potential gains from improved investment stand to be larger. Also, policies to limit the environmental impact of electricity generation could affect the types of technologies in which we invest.

James Bushnell and Catherine Wolfram

See alsocompetition; energy economics; industrial organization; industrial organization: empirical studies; privatization; privatization impacts; regulation and government policy; regulation of natural monopolies

Bibliography

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