Competitive Electricity Prices: An Update
Release date: 1998
Historically, electricity prices in the United States have not been set by market forces. Consumers’ electricity supply choices have been limited to the utilities franchised to serve their areas. Similarly, electricity suppliers have not been free to pursue customers outside their designated service territories. Utilities have built generation, transmission, and distribution capacity only to serve the needs of the customers in their service territories, and the price of electricity has been set administratively, based on the average cost of producing and delivering power to customers.
The regulatory structure of the U.S. electric power industry evolved from the belief that the supply of electricity was a natural monopoly, and that one supplier could provide services at the lowest cost. For a variety of reasons, both economic and technological, that view has changed. Today, the relationship between consumers and suppliers of electricity is poised for change. Most States plan to implement significant changes in the procurement and pricing of electricity between now and the first few years of the 21st century. Thus, in the near future, some of the services currently provided by local utilities will be available from other suppliers.
The electricity business is made up of three major functional service components or sectors: generation, transmission, and distribution. The generation sector is the production arm of the business—the power plants where electricity is produced. The transmission sector can be thought of as the interstate highway system of the business—the large, high-voltage power lines that deliver electricity from power plants to local areas. The distribution sector can be thought of as the local delivery system—the relatively low-voltage power lines that bring power to homes and businesses. While it is expected that most consumers will continue to purchase distribution services from their local utilities and buy transmission services from a centralized pool, generation services are expected to be available from many sources.
For the most part, the prices for transmission and distribution services are expected to continue to be set administratively on the basis of the average cost of service. Some alternative approaches for pricing transmission services are being considered. In contrast, competitive market forces will set generation prices. Buyers and sellers of power will work together, through power pools or one-on-one negotiations, to set the price of electricity. As in all competitive markets, the supplier in the market who has the highest costs will determine the price at any level of demand. During most time periods, the generation price of electricity will be set by the operating costs of the most expensive (in terms of operating costs) generating unit needed to meet demand, or what in economics is referred to as the “marginal cost” of production. When consumers’ demand for electricity rises (for example, on a hot summer day), the generation price will rise as units with higher operating costs are brought on line. Conversely, on cool spring weekends when air conditioning is not needed and many businesses are closed, prices will be relatively low
The movement toward competitive pricing of generation has several implications. Generation prices are likely to become more volatile, changing as consumers’ needs move up and down across seasons and from hour to hour during the day. For example, as the temperature rises on a hot summer day, the use of air conditioning will increase, and the price of electricity will rise as plants with higher operating costs are used to meet demand. Competitive prices based on marginal costs will also be more sensitive to any factors that affect the operating costs of the marginal generators. For example, if the cost of fuel to marginal generators rises unexpectedly, the impact on prices will be readily apparent. With traditional cost-of-service pricing, these impacts are muted, because the costs for all plants are averaged together.
Both of the above characteristics of competitive prices were illustrated by national-level model results in the Annual Energy Outlook 1998 (AEO98). This report illustrates a third impact of the move to competitive generation pricing—the narrowing of the range of prices across regions of the country. Concentrating on the period 2005 to 2020 (after competition has been phased in), electricity prices are presented regionally for the generation component, the combined transmission and distribution component, and generation sector taxes