Why electricity markets go haywire

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McKinsey quarterly

Why electricity markets go haywire: title image

Generators, retailers, customers, and regulators alike must get used to the idea that electricity is a special kind of commodity.

The McKinsey Quarterly, 2002 Number 1

The deregulation of electricity generation around the world was thought to be good news for customers. In place of government agencies compelling them to pay for capacity that far exceeded any imaginable need, markets would more closely and cost-effectively match supply to demand. If any party suffered, it would be the generators, forced to surrender the guaranteed profits that carried them through the industry s cycles.

At first, deregulated electricity markets followed that script: wholesale prices went down by 20 to 50 percent, service improved, and the generators profits fell. However, recent events suggest that electricity markets don t necessarily behave like other commodity markets. In California, for example, electricity wholesale prices in 2000 01 were five times higher than they were in 1998 despite the advent of a competitive generation market. Expecting wholesale prices to fall further, industry analysts that year advised utilities to sell their generation assets.

Meanwhile, in the Netherlands, wholesale prices have on average been 30 percent higher than expected over the past two years notwithstanding significant oversupply. In Sweden the universal model of successful deregulation the peak price in 2001 actually reached almost ten times the normal one. And in Brazil, a drought that reduced hydropower output has resulted in skyrocketing prices and widespread rationing. There too, most analysts were preoccupied, only a few years ago, with the risk of oversupply.

Two problems

These unexpected and extreme events raise the possibility that a California-style crisis could erupt almost anywhere (Exhibit 1). Temporary regulatory flaws, which are certainly an important element of the problem in many cases, usually get most of the blame. For example, high and volatile prices in the Netherlands where a capacity oversupply of 20 to 30 percent should logically have forced prices down to the operating costs of the country s generating plants are partly the result of a failure, in the aftermath of deregulation, to introduce more competition among the four generators. A drought in Brazil had dramatic repercussions because supply was already falling short as a result of a slow and uncertain deregulation process that discouraged investment in new capacity.Chart: Not just California’s problem

In California, the flaws include a bureaucracy encompassing many regulatory bodies rather than a single authority responsible for overseeing the whole system. One result of this proliferation is a long and complicated process for gaining permission to build new plants. Another regulatory flaw was the deregul ation of the wholesale price but not the retail price. An increase in the former and an inability to raise the latter led to bankruptcies among suppliers. (For a solution,seePower by the minute.”)

Although such flaws made things much worse, the root of the problem in California and other liberalized markets was the intrinsic nature of electricity as a commodity:

  1. Demand for electricity, whether to run air conditioners or electric heaters, varies daily and seasonally. Since no economically viable way to store it in large quantities exists, substantial reserve generation capacity is required.
  2. For most applications, electricity has no substitute, and the cost of shortages to the economy, to local and national security, and to the health of the public is very high. As a result, short-term demand is inelastic.
  3. Like demand, supply varies with weather conditions: in systems that depend on hydropower, droughts can dramatically reduce it.
  4. Power generation is usually subject to tight environmental regulation.

These characteristics produce two unexpected and unwanted effects in deregulated markets: supplies can become excessively tight, and, partly as a result, prices are highly volatile. When supplies run short, there is almost no limit on what can be charged.



For more on California s regulatory flaws,seeJames B. Robb and Anthony Sugalski, “The deregulation that wasn t,”The McKinsey Quarterly, 2001 Number 3, pp. 164 7.


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