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Article Excerpt
Electricity markets are an anomaly in a world where many energy markets are global or at least continental. Oil is traded at a single price in world markets; natural gas is traded at single prices in continental and increasingly global markets. Other commodities like wheat, nickel, copper and steel are traded on international markets. With respect to manufactured goods, such as automobiles, computers, footwear and clothing, post-war trade liberalization has meant that markets for most of these goods are increasingly international. The reason: international markets enable producers to exploit their comparative advantage; increase returns to scale, specialization and hence productivity; and increase consumer welfare by increasing choices and reducing costs and prices (Trebilcock and Howse 2005). In contrast, many electricity markets have historically been largely local in nature and have entailed very limited trading of electricity across jurisdictions within federal states or across national borders. This paper explores why this has been so and makes the case for greater regional integration of electricity markets in the future.
In Part I, we discuss the effects of greater regional integration of electricity markets. We conclude that greater integration has the potential to improve the performance of electricity markets in many ways. The expected benefits include: reducing the total costs of electricity; improving the efficiency with which generating and transmission resources are used; reducing consumers' costs; reducing price volatility; and mitigating market power by dominant players. Further integration would also increase competition, improve reliability, create better incentives for making optimal investments in generating and transmission assets, and reduce the adverse environmental effects of generating and transmitting electricity. We also identify and discuss several potential, or perceived, adverse effects of increased integration. We conclude that each one is non-existent, exaggerated, susceptible to effective mitigation, or avoidable through careful market design.
In Part II, we present a diagnostic tool-kit for assessing electricity markets in diverse jurisdictions. We identify and discuss seven preconditions for success in designing and implementing a large regional market. They are: (i) vertical separation of functions (between generation and sales on one hand, and transmission and distribution on the other); (ii) horizontal integration (of transmission and network operations, and reliability standards); (iii) nondiscriminatory access to the transmission grid; (iv) an effectively functioning spot market; (v) consumer incentives to respond to price changes; (vi) a mechanism for allocating scarce transmission capacity; and (vii) mechanisms that induce or require adequate investment in transmission capacity.
In Part III, we provide an overview of the present electricity market in Canada, and analyze the situation in Ontario, with reference to the seven preconditions for the creation of an efficiently functioning regional electricity market. We conclude that Canada can enhance the performance of its electricity market by increasing the size of the market and increasing the degree of integration, both within the Canadian market and with the adjacent, electrically interconnected United States market. Because of the geographic and demographic characteristics of North America, we conclude that increased north-south integration is more promising than increased east-west integration. Within Canada, we urge the National Energy Board to begin to take a much more active role in the process of increasing the degree of regional integration of the Canadian electricity market.
Part I: The Benefits of Greater Market Integration
A market is integrated in an economic sense if the prices at each location in the market differ only by the cost of transactions between the various locations. (1) In an integrated market for electricity, the difference in the price of electricity in one physical location should only differ from that in another by the cost of transmitting electricity between those two locations. An obvious requirement for economic integration of markets is the physical interconnection of the regions in which those markets exist.
Even if regions are interconnected, however, transmission costs, congestion costs, transaction costs and the exercise of market power by a dominant firm may cause differences in the prices observed. Transmission costs are due to line losses (losses due to electrical resistance) and can be significant when electricity is transmitted over long distances. Congestion costs occur when there is no available capacity on the interconnection between regions, in which case the prices in each regional market will be determined separately. (2) The difference in prices in the markets reflects the opportunity cost of congestion; that is, the lack of available transmission capacity. Even in the absence of transmission congestion, however, prices in interconnected regions may diverge due to economic factors such as the exercise of market power and transaction costs for importing and exporting electricity.
The purpose of greater market integration is therefore to reduce or eliminate the physical and economic factors that prevent prices in interconnected regional markets from converging and accurately reflecting the true marginal cost of generation--the added cost for added generation--within the integrated markets. Besides affecting prices, however, integration can also have significant effects on costs, competition, reliability, investment, consumption, the environment and health, and the scope for government policy. We consider the impact of greater integration below.
Reduced Costs
Greater market integration can reduce the total cost of electricity by reducing transaction costs, reducing certain operational costs and increasing the optimal use of generation and transmission resources. First, electricity market integration may reduce the transaction costs of importing and exporting electricity. Transaction costs--that is, the costs that electricity traders must bear in order to import and export electricity--prevent complete integration, as traders will only engage in such trade as long as expected profits from trading electricity are greater than the transaction costs. (3) If transaction costs are reduced, either by merging markets entirely or reducing the differences between market interfaces and rules, more trade can take place, increasing the gains from trade and driving prices in different locations closer together.
Second, greater integration can also reduce operational costs incurred by system operators and market participants who generally pass these costs on to the consumers of electricity.
In order to preserve the stability of a control area, a system operator usually schedules all imports and exports to and from the area in advance of when the actual power flows will occur. (4) Imports and exports must therefore be treated differently from other types of transactions in real-time markets for electricity, and the system operator must incur costs in scheduling the transaction from one control area to another. Furthermore, once flows are scheduled across an interconnection, they cannot be adjusted in real-time. (5) The transmission operator must therefore reserve some capacity on interconnections to account for unscheduled flows, which implies that there may be times when interconnections are not used most efficiently (Hunt 2002). By improving the coordination between system, market and transmission operators in different regions, greater integration can reduce the operational costs associated with the import and export of electricity.
Third, greater market integration can permit generation resources within a larger region to be used more efficiently. As demand for electricity varies greatly depending on, among other factors, the weather, the time of day and the season, system operators must have sufficient generation capacity available at all times to satisfy load during peak periods. System operators must also be able to adjust the total amount of generation output as load changes second by second. These constraints require a mix of generation technologies in an electricity system, each with different technical attributes and economic costs. Greater market integration provides system operators with a wider array of generation resources to draw on in order to match generation against load, increasing efficiency. Similarly, regions that have different load patterns can share capacity that would otherwise go unused during peak periods.
There is evidence that the cost savings from greater market integration can be substantial. A recent study (Hunt 2005) showed that the elimination of "seams" among and between three control areas in the Pennsylvania/New Jersey/Maryland (PJM) electricity market in 2004 resulted in savings of approximately US$29.5 million for PJM and $36.4 million for the Eastern Interconnection. On an annualized basis, the savings for PJM and the Eastern Interconnection were $69.8 million and $85.4 million, respectively. Reduction in costs due to greater integration can have a significant impact on prices. PJM found that, after adjusting for rising fuel costs, prices in the PJM market declined by 4.2 percent between 2003 and 2004.
Reduced Price Volatility
Greater market integration can reduce the volatility of wholesale electricity prices, which is a significant risk for consumers, who may be unable to adjust their consumption in response to price spikes. Price volatility may also be a political concern where retail prices are tied to wholesale prices, as high volatility will periodically result in high prices. By increasing the available capacity in the market and by making the supply more responsive to price changes, greater market integration can reduce the volatility of electricity prices. This would reduce consumers' costs of managing price risk and potentially make deregulated electricity markets more politically acceptable.
Some critics of electricity market integration have argued that greater integration of electricity markets will necessarily disadvantage those regions with historically lower electricity prices (Cohen 2003). Greater integration, it is said, will result in increased exports to higher-priced regions, raising prices for consumers in lower-priced regions. This claim ignores one of the basic lessons of trade theory; namely, the gains from specialization and exchange. Where a region has a comparative advantage in the generation of electricity (i.e., it can generate electricity at lower cost), it is in its interest to trade that electricity (as with oil and gas) with other regions (Boyer, 2005). While electricity prices may rise in a region following greater integration, it is not the case that the region is economically disadvantaged. As trade theory tells us, regions that trade with other regions gain more than they lose, though it is important to note that one group within the region may receive the gains while another bears the costs.
More specifically, those critics making this argument usually emphasize the distributive effect of greater market integration by noting that consumers bear higher prices while generators earn greater profits. This concern is misdirected, however, as other policies exist to redistribute wealth in such cases. Moreover, unless a region has a comparative advantage in the generation of electricity (due to the availability of resources such as rivers, coal or natural gas), the only way for a region to keep its electricity prices lower than those in other regions is to make socially excessive investments in generation. However, this implies that taxpayers, not private investors, will bear the costs of these investments. Thus, consumers may not, in fact, be better off in the long run without greater market integration; they may be able to avoid higher electricity prices, but they will still bear the cost in the form of...
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