by Zero Hedge
By Kathryne Cleary and Karen Palmer, from Resources for the Future
In the United States, how electricity is bought and sold varies by region of the country. While many cities, including Austin, Texas, Los Angeles, California and Nashville, Tennessee are served by municipally owned utilities and some rural areas are served by customer-owned rural cooperatives, the majority of electricity customers in the use are served by utilities that are owned by investors. These investor-owned electric utilities can be either regulated and operate as vertically integrated monopolies with oversight from state public utility commissions, or they can operate in deregulated markets where electric energy prices are set by the market with some federal oversight of wholesale market operations. These regulatory constructs determine how retail and wholesale electricity prices are set and how power plants are procured. This explainer discusses the different types of US electricity markets, how they are regulated, and implications for the future given ongoing changes in the electricity sector.
For definitions of bolded terms and other concepts related to the electricity grid and industry, check out “Electricity 101.”
Traditional Regulated Markets
Prior to the 1990s, most investor-owned electric utilities were regulated and vertically integrated, which means they own electricity generators and power lines (distribution and transmission lines). Today, while many states have abandoned this system in favor of deregulation, utilities that serve about one third of US electricity demand still operate under this construct.
Utilities in these traditionally regulated regions operate as a monopoly in their territories, which means that customers only have the option to buy power from them. In order to keep electricity rates reasonable for customers, state regulators oversee how these electric utilities set electricity prices. Retail electricity prices in these areas are set based on recovering the utility’s operating and investment costs including a “fair” rate of return on those investments (collectively called a revenue requirement). This revenue requirement must be approved by the state’s public utilities commission, which prevents utilities from overcharging customers for electricity.
Regulated utilities must also seek state approval for investments in power plants. Vertically integrated utilities decide which generators to build and then recover the costs of these investments through electricity rates. Because a utility’s investments determine its revenue requirement and thus its potential profit, many state regulators require utilities to demonstrate the necessity of future investments through an integrated resource planning (IRP) process. This process is used for long-term planning and requires each utility to demonstrate how it plans to meet customer electricity demand going forward and to justify any future investments. Notably, under this structure, customers bear the risk of investments because utilities can recover their costs through rates, regardless of how the power plant performs (for example, South Carolina electricity customers paid for nuclear plants that were never constructed).
Even though vertically integrated utilities generate their own electricity, many trade with other utilities during times of need. For example, during certain times of the year it may be cheaper for some utilities to purchase excess hydroelectric power from others rather than generate power using their own facilities. This type of wholesale bilateral trading is especially common in the west and southeast where most utilities are still regulated. These wholesale market transactions are subject to regulation by the Federal Energy Regulatory Commission (FERC).
Beginning in the 1990s, many states in the US decided to deregulate–also known as restructure–their electricity systems to create competition and lower costs. This transition required electric utilities to sell their generating assets and led to the creation of independent energy suppliers that owned generators. Because power lines are a natural monopoly, electric utilities held onto these assets to become transmission and distribution utilities, and those natural monopoly functions continue to be regulated.
The biggest impacts resulting from deregulation were changes to retail and wholesale electricity sales, with the creation of retail customer choice and wholesale markets.
Retail Deregulation: Customer Choice
In deregulated areas, electricity customers have the option of selecting an electric supplier (known as customer choice) rather than being required to purchase electricity from their local electric utility, which introduces competition for retail electricity prices. Since many electric suppliers can exist within a region with customer choice, electric retailers offer competitive prices in order to acquire customers (contracts with generation suppliers typically offer the customer a fixed charge—dollars per kilowatt-hour of power—over a certain amount of time).
For consumers, there are pros and cons to selecting a supplier other than their local utility company. Retail competition can help lower a customer’s electric bill and also allow them to tailor their energy to their preferences, such as selecting a clean energy supplier. However, independent companies often require customers to sign contracts, which can lock them into a set electricity price for multiple years. While fixed rates could be beneficial for some customers, they could also negatively impact others if the rate they agree to ends up being more expensive than the rate set by the local utility. Also, it is important to note that customer choice is only applicable for the generation portion of a customer’s utility bill because transmission and distribution services are still provided by the local utility company, since these services are a natural monopoly (as discussed above). Consequently, only a portion of electric rates in these areas are set competitively.
For customers who choose not to select an independent power supplier, their local utility is still obligated to provide them with electricity that the utility will purchase from generators.
Wholesale Deregulation: Creation of Competitive Wholesale Markets
Unlike regulated states that plan for investment, deregulated states use markets to determine which power plants are necessary for electricity generation. As utilities and competitive retailers in deregulated regions do not generate their own electricity, they must acquire power elsewhere for their customers. Centralized wholesale markets—in which generators sell power and load-serving entities purchase it and sell it to consumers—provide an economically efficient method of doing so (discussed more in the next section). Notably, under this structure, investment risk in power plants falls to the electric suppliers and not to customers, unlike in regulated markets.
Following deregulation, regional transmission organizations (RTOs) replaced utilities as grid operators and became the operators of wholesale markets for electricity. These RTOs have evolved over time.
Regional Transmission Organization Map
Since many RTOs operate wholesale markets that encompass multiple states, they are regulated by FERC (with the exception of ERCOT, the Texas RTO). FERC has oversight of all wholesale power transactions on the two large interconnected grids: the eastern and western interconnects.