An overview of electricity market reform
and deregulation
1
C.K. WOO
D EPARTMENT OF E CONOMICS
HONG KONG BAPTIST UNIVERSITY
Objective
2
 Present an overview of electricity
market reform and deregulation
 Offer a list of key questions to
help frame the discussion and
guide the decision-making
process
Why should we care?
3

Electricity cannot be economically stored and
must be supplied in real time to meet
fluctuating demand

Real time demand can sharply spike due to
extreme weather and is price insensitive

Electrical equipment can fail unexpectedly

Renewable generation (solar and wind) is as
available, intermittent, and non-dispatchable

Reliable supply can only occur with capacity
reserve and backup facilities


More volatile total demand, more total capacity
Higher failure rates, more facilities
Why should we care?
4
 Electricity has no close substitutes
for many end-uses (e.g., motor,
lighting, cooling, electronics)
 Electricity can only be produced
and delivered with equipment
already in place
 Electricity requires capital-
intensive investments with long
lead time
 Electricity service disruption can
have large economic consequences
Though dangerous, electricity theft does occur,
at times with fatal consequences (e.g., KFC
thief)
Transformative events
5

Electricity market reform and deregulation
results in (a) competitive wholesale energy
markets with hourly prices by location; (b)
inter-regional trading; and (c) retail
competition for customers

Large-scale renewable energy development
requires flexible generation and load to
accommodate intermittent, unpredictable
and as-available generation (e.g., wind)

Smart grid, smart meters and smart
appliances enable electricity product
differentiation and responsive/flexible
loads

What’s next for Israel?
What is a desirable outcome?
6
Safe, reliable, and environmentally friendly service at just, reasonable and
stable rates, which requires:
 Least-cost investment and operation
 Diversified demand-supply mix for energy security, including reliable
integration of renewable resources
 Efficient pricing of differentiated services to meet diverse customer needs
 Investment and pricing decisions sensitive to unpriced environmental factors
 Recovery of reasonable risk-adjusted return on and of investments
Market organization options
What are the drivers for change?
7
Government
ownership
Privately owned
integrated utilities
Market reform
and deregulation
North America:
California,
Texas, PJM,
Pre-reform: Europe,
Ontario, China,
Rate of return
Performance based
Australia, New
(ROR) Regulation:
Regulation (PBR):
Zealand, Singapore
North America
UK and Australia
New York,
New England
Canada: Ontario and
Alberta
European Union
Australia
New Zealand
Degree of decentralized decision making
Stylized model
8
Wholesale Generation Market
(Pool Structure)
Bilateral
Market
Distribution
Companies
Financial
(Contracts)
Market
Retailers
Customers
Path to success
9
Market
design
Design
stage
Good design
Implementation
stage
Operation
stage
Successful
implementation
Bad design
Unsuccessful
implementation
(e.g., few sellers)
Existing capacity
Existing capacity
surplus, fast market
shortage, slow market entry,
entry, and elastic demand
and inelastic demand
Gains: Lower costs, lower prices,
more choices, better reliability
Losses: Higher and more volatile prices,
capacity shortages, lower reliability
Status in the US
10
Source: http://www.eia.doe.gov/cneaf/electricity/page/restructuring/restructure_elect.html
Anticipated challenges
11
 Electricity deregulation is complicated, with many under-estimated challenges
 The cost of setting up and operating an Independent System Operator (ISO) is
substantial
 Marrying competitive generation with grid operation leads to many markets: (a)
energy markets (e.g., forward, day-ahead, hour-ahead, real-time); and (b)
ancillary service markets (e.g., spinning and non-spinning reserves, regulation,
voltage support, real power loss, energy imbalance)
 Electricity spot prices are highly volatile due to random demand, fluctuating fuel
cost, unpredictable equipment failure, and intermittent renewable generation,
necessitating risk management by market participants
 Market power abuse is common in deregulated markets

When supply is short, even minor capacity withholding can be highly effective
and profitable, at the expense of consumers
Anticipated challenges
12
 Electricity deregulation may cause insufficient investment because price and
revenue volatility discourages investment, even in the face of capacity shortage
 Renewable energy development erodes the incentive to invest in flexible
generation critically needed for reliable grid operation
 Deregulation can jeopardize reliability: merchant generation investments do
not always occur in the right place at the right time
 Deregulation seldom reduces generation cost

While competition reduces labor and O&M costs, generation cost may not
fall because merchant generation’s capital cost exceeds a regulated utility’s
capital cost
 Dysfunctional input markets may preclude an efficient output market because
of vertical market power abuse
 Contract breach can occur, especially when the wholesale market price explodes
Key questions
13
Question
Remarks
What are the key drivers for
change? And what does one
ultimately want?
As in a medical case, not knowing what’s wrong with the patient, it is
difficult to find a fix. Answering these questions sharpens what one
wants from deregulation.
Will there be adequate capacity
after the reform?
Adequate capacity provides the reserve required for reliable service,
stable price, and market power mitigation.
Will many price-taking sellers
A few dominant sellers can abuse their market power to raise prices.
compete for sales to many buyers? However, too many sellers can result in fierce price competition,
rendering the industry financially unstable.
Will efficient investment occur?
Deregulation replaces centralized planning with decentralized
decision-making driven by market prices. To date, market
competition, absent long-term contracts, has failed to induce much
merchant generation in the US.
Will there be sufficient
transmission available under open
access?
Transmission congestion limits trading that would have caused
electricity to flow from low-cost areas to high-cost areas. As well, it
creates load pockets and exacerbates market power.
Will the input markets be
competitive?
A dysfunctional input market can compromise the economic
performance of a wholesale generation market.
Key questions
14
Question
Remarks
Will electricity end-users see and
respond to wholesale price
changes?
Demand response reduces market power and improves reliability.
However, electricity consumers, especially households, prefer rate
stability and are insensitive to hourly price variations.
Will there be strong and
enforceable rules and laws?
They are required to prevent gaming, market power abuse, and
contract breach.
How will open access occur?
Generation competition cannot occur without open access. If
transmission is publicly owned, open access can be more readily
implemented than otherwise. The US achieves open access via Order
888 that preserves the rights of transmission owners and allows for
stranded cost recovery.
Will transaction costs be large?
Large transaction costs dissipate potential benefits from deregulation.
Moreover, some transaction costs (e.g., ISO and market set up) must
be committed upfront.
Will the post-reform spot price be
reasonably stable?
High and volatile prices can doom a market reform because of
unstable bills that force politicians “to do something” like price capping
which discourages investment.
Will deregulation harm
reliability?
Centralized planning and investment have yielded highly reliable
service, which may not be the case under decentralized decisionmaking.
Key questions
15
Question
Remarks
Will there be active forward
trading?
Forward trading facilitates market power mitigation, price discovery,
and risk management.
Will deregulation adversely affect
income distribution?
Even if deregulation can produce positive net benefits, electricity
producers and large customers are likely to receive the benefits,
while households and small business customers pay higher rates.
Will there be commitment to
deregulation?
If voters and politicians would reverse deregulation after the
inevitable price spikes, deregulation should not have occurred in the
first place.
Will electricity consumers be
made better off?
Deregulation should be based on a careful cost-benefit analysis, not
an ideological belief in competition.
Can the projected benefits of
deregulation be obtained via other
means?
Deregulation is not the only mechanism to improve the performance
of an electric sector. Competitive procurement and performance
based regulation is a less risky alternative.
If deregulation fails, can it be
reversed?
Deregulation often entails divestiture of the integrated utility’s assets.
Once done, it is almost impossible to put the pieces back together
again.
C.K. Woo, Ph.D. (Economics, UC Davis)
16

Dr. Woo is Professor and Head of the Economics Department of HKBU and Senior
Partner (now on leave) of Energy and Environmental Economics, Inc.
(www.ethree.com), a consulting firm located in San Francisco

He specializes in energy economics and applied microeconomics. With 30 years of
industry experience, he has participated in electricity market reform in California, Texas,
British Columbia, Ontario, Macau and Hong Kong

He has co-authored 12 papers with Professor Asher Tishler on the Israeli electricity
industry

He has over 100 papers in such scholarly journals as Energy Policy, The Energy
Journal, Energy, Energy Economics, Journal of Regulatory Economics, Journal of
Public Economics, and Quarterly Journal of Economics

Recognized by Who’s Who in America, he is (a) a senior fellow of the US Association of
Energy Economics; (b) an associate editorial board member of Energy and The Energy
Journal; (c) a guest editor for a special issue of Energy Policy on renewable energy