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By Kenneth Rose, Ph. D.
Senior Institute Economist

June 2000

When a state considers electric restructuring, a commonly expressed concern is that the introduction of retail choice should not leave residential and small business customers behind. In other words, while "big dogs" may "eat first" (and perhaps the most), these smaller customers should also benefit from retail choice. Some states have adopted policies that specifically target residential and small business customers, such as customer education programs and measures to prevent unscrupulous marketing tactics (for example, "slamming" and "cramming"). However, some policies, such as setting low generation standard offer prices and rate discounts, may appear to be beneficial, but can actually reduce the competitive options avaiiabie to these customers.
What has greatly complicated implementation of retail choice is the attempt to reconcile the consequential, but contradictory goals of: (1) making sure residential and small business customers benefit or are at least not harmed by competition, (2) encouraging the development of an efficient and competitive retail market (for example, policies aimed at limiting market power), (3) having broad customer participation, 94) protecting incumbent utilities from potential market losses (so-called "stranded costs"), and (5) maintaining "system benefits" that include system reliability, low-income assistance, and conservation and renewable programs. While every state has addressed, to varying degrees, each of these five overall goals, none has, or is likely to meet, all of them simultaneously.
These goals come into direct conflict when existing customer rates are unbundled into various price components. These include the following components: (1) a generation price, which has been given various labels such as standard offer, shopping credit, price to compare, backout rate, and other labels; (2) customer charges, which include charges for "stranded costs," low-income customer assistance, conservation and renewable programs, and other items; (3) transmission and distribution charges, for the "wires" that remain regulated; and (4) in many states, an automatic discount off the previously regulated rates.
Since states often also establish price ceilings during a transition period, all these price components must fit under the ceiling, which is the beginning of the practical difficulty. If the last three price components are established separately, this may mean that the generation component is set below what a competitive retail market would establish as its price. The result is insufficient "headroom" for competition to occur. As a result, few customers select an alternative supplier, as has occurred in several states, because few competitive options are being made available to them. The experience in the first states to adopt retail access indicates that, not surprisingly, there is a strong positive correlation between the economic incentive to select a supplier (the generation "price to compare" or standard offer relative to the retail market price) and the percentage of customers that have selected a supplier.
To avoid this problem, some states have established a generation price (or "shopping credit") that is set sufficiently high so that alternative suppliers are encouraged to enter the market. While this avoids the problem of insufficient "headroom," at least initially, the method is not without its problems. First, even with a generation price well above the retail market price, inducing many alternative suppliers to offer customers lower prices, and vigorous customer education to inform customers of their options, many or most customers remain at the established generation price. Preliminary evidence suggests that these customers may be disproportionately the elderly and low-income households. A second limitation, which is a limitation of any method that sets the generation price in advance without cyciic market adjustments, is that while there may be sufficient headroom initially, over time it may be eroded as market conditions change. Suppliers may abandon the area and try to "dump" customers back to the incumbent supplier at the established generation price.
There are two general categories of methods used by states to determine the generation price. The first is market-based methods, which inciude direct wholesale passthrough and standard offer auctions. The second is composed of administratively determined methods that include basing the price on the incumbent utility's generation costs or a market estimate. While there are advantages and disadvantages to the various methods, market-based methods are better able to reflect market conditions and, if periodic adjustments are made, can change as market prices change over time. Because of the numerous factors that determine a retail price, it is difficult for administrative methods to simulate a dynamic market price, particularly in advance of actual market experience. At best, administrative methods are only rough approximations of the actual market price. Another advantage to market-based approaches is that they spread the benefits of a competitive market to all customers, not just those savvy enough to select a supplier.
Because of the design of most transitional unbundling schemes, if upward pressure continues on wholesale prices, residential and small business customers may find themselves in an increasingly disadvantageous bind of higher prices, few or no competitive options, or both. For customers served by an incumbent supplier, the generation "price to compare" may either continue to be below a competitive retail price, so that few competitive options are made available to them, or, when the generation price is sufficiently high to allow competitive suppliers to enter the market initially, the situation does not remain that way as wholesale prices move above the set retail price. In addition to the low (or negative) retail margin, uncertain and unstable prices increase the risk for alternative suppliers and force them to charge higher prices, abandon retail markets, or never enter in the first place. There will be little complaint from the incumbent supplier about the generation price, at least during the transition period, since its total generation compensation also includes the payment for "stranded costs." Also, the incumbent supplier (or its affiliate) is able to maintain a dominate market share. When the incumbent utility has exited the generation business either mostly or entirely, upward pressure is placed on the generation price since it is now supplied by the new owner or owners of the existing generation resources or is purchased in the wholesale market. However, since the amount of the "stranded cost" payment was determined when lower prices were expected (either estimated or determined by generation asset sales), customers continue to pay for "stranded costs" that never materialize. The combined result is a higher price of generation and continued payment for "stranded costs" to the former owner of the generation assets.
Perhaps one of the most significant issues facing small customers is the possible impact of market power and price discrimination. Due to consumer demand characteristics, relatively concentrated retail markets, and generation and transmission constraints that limit retail customer access to alternative suppliers, there may be significant opportunity for suppliers to exploit market power and raise their price above what a competitive market outcome would be. Also, since suppliers will be able to segment groups of customers, the opportunity (and incentive) exists to charge a higher price to smaller customers and sustain the higher price for an appreciable period of time.
It is hoped over time, as transition periods end, more new generation enters the market, and transmission constraints ease, that prices should moderate and all customers should benefit. However, some transition periods run until the end of this decade and, at this time, it remains to be seen to what extent supplier market power (both wholesale and retail) will develop to obstruct or prevent the full development of a competitive generation market. At this critical stage of restructuring, states need to seriously consider policies that encourage the development of a competitive generation market and ensure the spread of the benefits to as many residential and small business customers as possible. If this does not occur, political support for electric industry restructuring may be undermined by a perception that the only beneficiaries are large customers and electric power suppliers.

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