Monday, March 22, 2010

A new view on electricity market reforms

I recently went through a thought exercise on how the electricity market might look like if it had:
  • been developed under a more commercial framework for customers,
  • achieved sensible commercial terms despite aspects of natural monopoly,
  • due to the different dynamic imperatives created above developed new technology.

My conclusion from this experiment is it is the retail electricity market that is badly broken, but this causes significant problems upstream particularly with lines businesses (including Transpower). In fact all problems with all aspects of the market stem from a key primary problem - property rights (or rather absence of).

My contentious starting point is that the early mid twentieth century's preoccupation with socialising everything is the source of a great deal of current woe when it comes to infrastructure generally, and particularly electricity. Now for the avoidance of doubt I see absolutely no problem with the cooperative model for developing local electricity supply. This is how electricity reticulation started and I believe a co-op was the only way that this could have begun.

The co-op wasn't the problem, the problem was these co-ops were given local authority state monopoly status, which immediately made the management of them extremely attractive to politicians, control freaks and meddlers. Rather than granting these statutory monopolies for misguided reasons of efficiency they should have had to compete with rival networks. The regulatory effort should have gone into mediating the disputes between rivals to ensure that economic terms were met for connection and interconnection. I must admit it is here that my thought experiment is a bit idealistic. I am assuming that economic terms for connection and interconnection would, ultimately, have been reached if the regulatory effort had been directed at preventing monopoly barriers and pricing.

The key thing that I think should have been different is that the connection of a new customer should have been a negotiation. The new customer should have been allowed to negotiate for terms. Even if the new customer chose the vanilla offerings then this should have been established by contract that specified capacity, volume, price, reliability and quality. If these property rights had been established from the outset then we would not have the mess we now have.

Immediately the argument usually comes back that this is too complex for consumers but this is clearly self-aggrandising b-grade ollux. It is obvious that consumers are easily able to come to terms with capacity limits, pricing plans for off-peak minutes, prepayment options that variablise everything at a higher rate, differentiated service for capacity (base capacity or excess) and different quality options. They are just as clearly (in aggregate) able to optimise their own values and preferences when given the chance (we've only being doing it for 5,000 years).

Some engineers will often tell you that the technology doesn't exist to do such things but this is not true, and a failure of imagination and innovation. Load control (for example) is a form of differentiated capacity service with differentiated reliability standards. If property rights had been established and respected from the outset then all the useful technology would already exist.

Here, then, is my thoughts on what needs to happen to properly reform electricity markets (notwithstanding that I don't believe that this would ever happen):

  1. Make the customer's retailer the agent for all aspects of their electricity supply, including capacity, energy, price, reliability and quality (and guarantees and warranties).
  2. Establish the implied contracts with existing customers and establish their existing property rights (this includes standard contracts that all parties must accept).
  3. Allow customers (through their chosen retailer to negotiate new terms - ie, capacity, quality, reliability); but the retailer and the customer must establish the technology to enforce the new terms.
  4. Completely redesign the registry to provide a central record of these property rights for lines service and energy service.
  5. Transition to the point where a retailer can negotiate with any potential provider of energy or lines service where the incumbent lines company can only require that reasonable standards are met for connection and interconnection.
  6. Establish methods to aggregate the consumer contracts to establish the bulk energy and capacity requirements of the retailers.
  7. Require the retailers to establish that they have sufficient access to capacity and energy to meet their obligations (remember this is back to back with contractual limits on customers).
  8. As part of 7 require Transpower to make available the implied capacity rights for the grid and define the standards of reliability and quality.
  9. Only allow Transpower to recover revenue through negotiated contracts for capacity, reliability and quality (yes, they must take risk).
  10. Allow any alternative provider of transmission service to connect to Transpower's network subject to meeting reasonable standards for connection and interconnection (but they must also contract to meet service specifications)
  11. Redesign the wholesale electricity market (including hedging platforms) to ensure purchasers can meet and manage their obligations to their customers.
  12. Otherwise leave the wholesale market to optimise efficient generation dispatch.

I know this is hard to do and would require significant transition planning. And great care would be needed to ensure that customers aren't immediately disadvantaged (although customers would have to accept that the established property rights are also obligations on them).

Despite this being hard I am firmly of the view that until customers are enabled to make their own trade-offs and select their own preferences for service, volume and price rather than being at the whim of central planners, control freaks, politicians, vested interests and meddlers then electricity will always be a mess.

I think some people believe smart metering is the answer but, unless property rights are first established, then smart metering will be just like all the other reforms so far. Overlaying economic incentives on a badly designed retail electricity market (actually never designed retail electricity market) is like tying a horse's legs together and then whipping it until it goes faster. The whip may be a good incentive to go fast but the biggest gain is achieved simply by untying the horses legs. The problem is, of course, the horse is going to be very angry as you try to let him go.


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