Electricity Deregulation: Balancing Risks and Rewards in Today’s Electric Utility Markets

How big is the electricity deregulation in the U.S.? Well, nationally, electric utility revenue was over $270 billion in 2004*.  One-third of the country – 17 states - and the District of Columbia have deregulated the sale of electricity and nine of those states and DC have active energy markets.  Among them are some of the largest population centers in the nation, including New York, California, Texas and Illinois.

By Thomas W. Loria, Director of Research, Utilities Analyses, Inc.

How big is the electricity deregulation in the U.S.? Well, nationally, electric utility revenue was over $270 billion in 2004*.  One-third of the country – 17 states - and the District of Columbia have deregulated the sale of electricity and nine of those states and DC have active energy markets.  Among them are some of the largest population centers in the nation, including New York, California, Texas and Illinois.

From nothing in 1996, in only 10 years sales from energy-only service providers (ESPs) have grown to 18% of the total in the deregulated states, with California leading the way with 30% of all sales from ESPs**.  And there is a bottom-line, dollar impact: According to the U.S. Government’s Energy Information Administration, “Industrial and commercial end-use customers of ESPs generally obtained lower average prices than customers choosing to remain with traditional bundled service in the deregulated States.***”

With the explosive growth of this area of the market, can you afford to pay higher costs with a utility while your competitor across the street is paying less through a power marketer?  If not, how can you get the best price for the energy you need to make your product or provide your service?

From the customer’s point of view, the development and history of deregulation by state is not greatly important.  The important aspect is how the deregulation of electricity affects you, the customer.  However, a bit of background may help in better understanding and operating in this new arena.

In  1997, California was the first state to restructure their electricity utilities to create a deregulated power market for retail customers.  In the California Energy Crisis of 2001, the California power market failed, ending California’s experiment in deregulation.  However, with less national fanfare, many other states have quietly continued deregulation efforts.

Many people not in the industry or in the deregulated states assumed that the power industry returned to pre-California regulation.  However, many states have deregulated the retail sale of electric energy, and some states are ending multiyear rate freezes and transition plans.  In these states, marketer-supplied power will soon be the only procurement option available to most large commercial and industrial customers.

Technically, “deregulation” is a misnomer.  Governments are not abandoning their authority and throwing consumers into a Caveat Emptor (“Let The Buyer Beware”) situation in purchasing utility service. The more proper description is “market restructuring.”  However, the term “deregulation” has stuck, so we will use it here.  In deregulation, states establish a new regulatory framework for the retail sale of electricity, covering, among other things, the method of coordinating the production of power, the availability of operating reserves, the alternatives offered to retail customers by marketers, and by the transporting utilities.

In all cases, the sale of energy or generation is separated from the service of delivery, called distribution and transmission.   Transmission gets the power from the generating facility across the miles; distribution delivers it from the transmission system down to your meter.  Private entities, known as marketers, provide generation on a competitive basis.  A regulated utility offers transmission and distribution services.  In most cases, a regulated utility will also offer generation services on a regulated basis.  So the first element of deregulation from a consumer’s standpoint is to “shop” the marketers and the utility for the “best deal” for the price of electricity and the level of service desired.

Another aspect of purchasing power from marketers is the management of risk.  Typically, marketers will offer fixed price contracts or market index-priced contracts over a number of years.  The index-priced contracts typically offer a discount to the index.  In rising markets, fixed price contracts are more popular.  In stable or falling markets, indexed price contracts tend to be favored.

Commodity risk analytics can assist in selecting a fixed or index priced product, but, in general, if fixed price contracts are available at a reasonable price, the perception of trend dominates commodity risk.  Over the last few years, the price of power has greatly increased due to hurricane damage to natural gas production last year, and, in the longer term, failure to find significant new natural gas in the Gulf of Mexico; so fixed price contracts are increasingly more popular in most markets.  The most notable fact is that marketers give customers the chance to manage risk in ways not available before deregulation.  The onus is on the energy manager (and his or her advisors) to try and project where prices will go, and when to “float” with the market and when to “lock-in” a fixed price.  Not an easy task, but a vital one.

The admitted failure of the California deregulation effort halted additional states from starting the deregulation of electricity.  In those states that continued deregulation, the rules have progressed to make customers more reliant upon the market for power.

Customers of utilities have been given the option of buying power from marketers with a chance for savings, and with greater risk management options.  Here are some options available across the United States in deregulated markets.

Texas
Texas will soon have a fully deregulated market for electric generation.  Through the end of 2006, regulated utilities offer power under “price to beat” tariffs, which allow adjustments as often as every 6 months.  In January 2007, those tariff offerings will no longer be available, and all power must be purchased from a marketer. 

These marketers offer an index product; based upon ECAR (East Central Area Reliability coordination agreement) Local Marginal Price (LMP), and fixed price products for varying term.  The only offering from a regulated entity will be POLR (Provider Of Last Resort) service, at a very high price for temporary service.  In most instances, customers can and should avoid POLR service by selecting a new marketer at the end of each contract term.

Massachusetts
Massachusetts has a deregulated market also.  Marketers offer an index product based upon the New England Power Pool LMP, and fixed price products for varying terms, usually a minimum of 6 months to a year.  Regulated utilities offer Basic Service.  The price of Basic Service is fixed through auctions held every quarter, which makes comparison with marketer offers difficult because of differing terms.  The regulators in Massachusetts intend to continue offering Basic Service for the foreseeable future.

New York
The New York Market is changing in a subtle way.  In the ConEd area, larger customers will be forced to buy power priced on an hourly incremental basis, rather than pay based on the average of monthly incremental prices.  The effect will be to make load shape more important in determining power cost, and indexing options will reflect such pricing.  Historically, the New York market is notable for the spread between index-pricing and fixed pricing, so that customers are motivated to take index priced offers.

The New York market usually offers savings over the alternative of buying from the regulated utility, but does not afford the economical fixed price options available elsewhere.

Illinois
The Illinois market is starting to resemble the Texas market in the following way:  In 2007, the option to stay on traditional utility tariffs or an indexed purchase power arrangement will disappear.  Replacing the utility tariff will be Basic Service, which will be more directly linked to market prices.  Basic Service will only be available in areas not served by marketers.  All customers with marketers available must buy power from marketers, or take Interim Supply Service (ISS), which corresponds to POLR in the Texas market.

Conclusion

For the markets surveyed, the deregulated states are requiring customers to deal with marketers and market risk to a greater and greater extent.  The evolution of these markets has been uneven over the years, and not without some pullbacks to more regulated environments at times.  However, the general trend is towards more reliance on marketers for power.

The question that remains is:

Which model will control the U.S. power market in the next decade, deregulation or regulation at the retail level?

At the moment the question is far from answered, as both deregulated and regulated models continue across the United States.

The question for the energy manager is: how do I manage and minimize my utility costs under either the deregulated or regulated model?  Hopefully, this has given you some signposts pointing in the right direction.

About the Author
Thomas W. Loria is Director of Research at Utilities Analyses, Inc. (UAI).  Since 1972, UAI’s utility rate consultants have helped large utility customers reduce their costs.  UAI offers a full spectrum of services, including utility rate consulting, utility bill audit, utility bill processing and energy procurement: solutions and strategies to produce guaranteed increase in our clients’ ROI.

*Energy Information Administration website www.eia.doe.gov 2004 Electric Power Annual Review 8/18/06 p.7.

**Ibid