Lessons from Electricity Market Restructuring

David Newbery Cambridge University

Dublin Electricity Workshop

Dublin, 25 November 2004http:// www.econ.cam.ac.uk/electricity

D Newbery Dublin 2

Lessons from Britain

• Importance of market structure: – Unbundling: England vs Scotland– Competition in England and Wales: Pool to NETA

• BETTA, locational signals and losses

• Security of supply and investment

• Environmental issues: ROCs and ETS

• Liberalizing domestic supply

D Newbery Dublin 3

British contrasts

• England and Wales 1989– unbundle CEGB into 3Gencos, Transmission– privatise Regional Electricity Companies +NGC– privatise National Power, PowerGen– Electricity Pool as gross wholesale market

• Scotland– privatise 2 unchanged vertically integrated co.s

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Audit of CEGB: first five years

• labour productivity doubled• coal prices fell 20% real• coal sales fell from 74mt to 30mt• CCGT rose from 0 to 25%• fossil fuel cost/kWh fell 45% real• nuclear fuel cost/kWh fell 60% real• emissions/kWh fell dramatically

D Newbery Dublin 5

Productivity of CEGB and successor companies

compared to UK manufacturing industry

10

79/8081/8283/8485/8687/8889/9091/9293/9495/96

Financial years April-March

Index numbers 1989/90=

100 (log scale)

IndustryCEGBNPPGNENGC

100

150

200

300

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Generation in England and Wales by fuel type

TWh

1990 1992 1994 1996 1998 20000

50

100

150

200

250

300

350

Nuclear

Coal

other steam

CCGT

hydro+other

imports

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Generation in England and Wales by fuel type

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Generation in England and Wales

0

50

100

150

200

250

300

89/9090/191/292/393/494/595/696/797/898/999/0000/01f'cast

TWh

PSB /

Mission

PG

NP

Mis'n

AES

Eastern

IPP

Import

NE

Magnox

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Generation in England and Wales

0

50

100

150

200

250

300

89/9090/191/292/393/494/595/696/797/898/999/0000/01f'cast

TWh

PSB /

Mission

PG

NP

Mis'n

AES

Eastern

IPP

Import

NE

Magnox

D Newbery Dublin 10

Net benefits of privatizing CEGB

Cost savings: PDV at 6% £ billion $ bill.net fuel switching 3.6 5.8

efficiency gains 8.8 14.1

restructuring costs -2.8 -4.5

Total privatising gains 9.6 15.4

Environmental gains:

SO2 (£1b) CO2 (£1.4b) 2.4 3.8

levellised reduction per kWh 5.7%

D Newbery Dublin 11

CEGB costs/unit equivalent output

at 1994/5 prices

Note: includes transmission costs*corrects for changed balance gen:trans

-2

-1

0

1

2

3

4

5

6

7

79/8081/8283/8485/8687/8889/9091/9293/9495/96

p/equivalent* kWh

staffG&Sfuelprofits-taxtaxesdeprec

D Newbery Dublin 12

Who gained, who lost?

£ billion $ bill.

Consumers -1.3 -2.1

Govt. excl sales -8.5 -13.6

After-tax profits 19.4 31.1

Net benefits 9.6 15.4

Govt. sales proceeds 9.7 15.5

Net govt. position 1.2 1.9

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Electricity prices by town: 3,300 kWh at 2000 prices excl VAT

7

8

9

10

11

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

pe

nc

e/k

Wh

(2

00

0 p

ric

es

)

Edinburgh London

D Newbery Dublin 14

Who gained, who lost in Scotland?

£ billion $ bill.

Consumers -1.5 -2.4

Govt. excl sales -5.2 -8.3

After-tax profits 6.7 10.7

Net benefits -0.09 -0.14

Govt. sales proceeds 3.6 5.8

Net govt. position -1.6 -2.5

D Newbery Dublin 15

Subsequent developments• Initial market power raised profits

• Offer imposes price control until plant sold

• Market structure encourages IPP entry

• Incumbents must sell plant to buy retailing

• excess capacity, low concentration => price collapse, bankruptcy

• Pool abolished as “manipulable”, NETA

• prices recover after plant withdrawal

• NETA cost over € 1 billion

16DublinD NewberySource: John Bower (Oxford Institute for Energy Studies)

Capacity Ownership of Coal Generation 1990-2002

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

MW

ALCAN

Innogy

National Power

British Energy

AES

TXU/Eastern

Edf

International Power

AEP

Edison

EdF

Powergen

NETAlive

Offer “encourages” sales

Gencos trade horizontalfor vertical integration

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Real electricity and fuel costs 1990-2003

0

5

10

15

20

25

30

35

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

£(20

01)/

MW

h

0

1000

2000

3000

4000

5000

6000

7000

HH

I

Electricity

coal cost

gas cost

Coal HHI

NETA

Price control Profit maximisingTacitCollusion

Restraint

plantwithdrawal

D Newbery Dublin 18

Structural reforms

• initial choice of unbundling unsatisfactory– caused excess entry

• Licences help negotiated restructuring

• MMC can investigate structural problems

• divestiture “encouraged” by threat of MMC

• Mergers with retailing require plant sales

• After 10 years competition finally arrives

• and with it bankruptcy, sales to foreign co.s– caused by excess entry?

D Newbery Dublin 19

Lessons from Britain

• Competition improves performance

• Unbundling needed for effective competition

• Competition requires privatization?

• Privatization precipitates further reforms?

• But better to get it right at start

BETTA, locational signals and losses

Changing transmission pricing is difficult

D Newbery Dublin 21

Transmission charging

• CEGB took account of losses in dispatch

• losses socialised in Pool, annual grid charges spatially differentiated to guide G– Offer fails to get T losses charged to G

– small gains overall associated with large transfers of income from N to S

– NETA fairs no better

– BETTA no better

Security of supply

Recent British experience

D Newbery Dublin 23

Reliability and Security in Electricity

• Reliability is a system-wide property: G, T and D– G adequacy: balancing supply and demand

• Short run: balancing; long run: capacity adequacy

– T and D system reliability depends on:• standards (n-1), timely information, response to problems

• Importance of regulatory incentives for maintenance, investment

• Security of supply has a broader meaning– Includes strategic risks

• From overseas: fuel import dependency

• Internal: protests or strikes, terrorism

– addressed by diversity, redundancy, storage, spare capacity

D Newbery Dublin 24

The British experience

• competition lowers prices

– lower prices lead to plant withdrawal

– price-cost margin then stabilises?

Does competition threaten security of supply?

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Electricity plant margins in England and Wales

0%

10%

20%

30%

40%

forecast plant margins

NGC planning margin (20%)

Source: NGC

D Newbery Dublin 26

Impacts of restructuring on investment risks

• Vertically integrated franchise monopoly (e.g. CEGB)– investment risks passed on to ‘captive consumers’– investment planned by engineers, subject to energy policy

• In liberalised electricity markets– unbundling and competition shift investment risks to generators– investment decisions profit driven– network investments affected by regulatory incentives– reliability depends on short-run SO, longer run capacity

D Newbery Dublin 27

Security of supply

• Central question: can liberalised markets deliver secure supplies at acceptable prices?

• Transmission adequacy is test of regulation– do price caps lead to under-investment?

• Reserve margins depend on market design

• Import availability depends on actions abroad– from which information may be inadequate

D Newbery Dublin 28

Transmission adequacy• NGT has incentives to deliver reliability

– embarrassing London power cut 28/8/03– NGC restored within 31 minutes– has invested £3.5 billion since 1990– distribution+transmission investment = £16 billion– VOLL = 724 MW x £3532 x .5 = £1.32 million

• but does this adequately measure cost?

• Continent: poor incentives for interconnection– reduces interdependence and risks?

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Network investment looks fine but generation falls with price

• Source: JESS Report Nov 2003

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T & D Reliability

DNOs supply interuptions (min/year)Source: OFGEM

60

110

160

210

260

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Average Security Average Availability

Average Transmssion System Availability (%)Source: National Grid

93

93.5

94

94.5

95

95.5

96

96.5

92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03

D Newbery Dublin 31

Reliability of the regulated network

• OFGEM provides incentives for timely expansion of network capacity and efficient system operation

• Quality incentives– OFGEM is investigating the introduction of quality

incentives for the next Price Review (2005)

• Financial stability– DTI is consulting on the introduction of a ‘special

administrative regime’ for energy network co.s

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UK Electricity Winter ‘03 Base-load Forward Prices

• NGC reserve margins was expected to be as low as 16.5 % winter 03/4

• Markets reacted by an increase of 20 % of forward electricity prices since last spring

• However prices on the order of £22/MWh were still insufficient to allow new entrants to recover fixed costs

Source: OFGEM press release

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British Generator CCGT Gas Spark Spread under NETA

0

10

20

30

40

50

60

70

80

90

100

Mar-

01M

ay July

Sep Nov

Jan-0

2M

arM

ay July

Sep Nov

Jan-0

3M

arM

ay July

Sep Nov

Jan-0

4M

arM

ay

£/k

W/y

ear

spark spread Annual MA return to capital high

Annual MA return to capital low required return on capital

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Spark spread GB CCGT Winter 03-4

0

1

2

3

4

5

6

7

8

9

10

11

12

16-A

p...

17-Ju

l-04

17-O

ct-04

17-Ja

n-05

19-A

p...

20-Ju

l-05

20-O

ct-05

20-Ja

n-06

22-A

p...

23-Ju

l-06

£/M

Wh

0

7

14

21

28

35

42

49

56

63

70

77

84

£/kW

/yea

r (7

000

hour

s/ye

ar)

03-Nov-03

15-Apr-04

required spread poor locations

required spread good location

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Supply and Generation in Great Britain, 2002

0

50

100

150

200

250

300

350

supply generation

TWh

Others

Scottish Power

London (EdF)

AEP

Scottish & Southern Energy

AES

PowerGen

BNFL

Centrica (British Gas)

British Energy

Innogy (Npower)

(2001/2 estimates, adjusted for the London/Seeboard, Innogy/Northernand PowerGen/TXU mergers) Source: Richard Green

Vertical integration: solution to investment but at expense of supply competition?

Investment behaviour

Evidence of price responses

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Rate of profit for new South Australian generators

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1999 2000 2001 2002

Ret

urn

on c

apit

al c

ost

0

500

1000

1500

2000

2500

3000

3500

4000

MW

cap

acit

y

peaking OCGTmid-merit CCGTbase-load brown coalinstalled capacity

Returns fall asnew capacity comes on line

D Newbery Dublin 39

Assessment on generation investment

• Investors are attracted to profitable markets

– provided market design stable, accommodating

– regulatory risk of price caps low

– and no threats from dominant state-owned co.

• Problems:– obtaining suitable sites with consent– predicting future carbon price– predicting future capacity (renewables, interconnex)

Environmental issues

ROCs, ETS and the cost of wind

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CO2 emissions per kWh 1971-2000

0

100

200

300

400

500

600

700

800

900

1000

1970 1975 1980 1985 1990 1995 2000

gm/k

Wh

USA

Italy

UK

Europe

France

D Newbery Dublin 42

Efficient carbon taxes/prices

• damage independent of location and ~ time– costs and benefits uncertain: but MC steeper that

marginal damage => fix price not quantity

• EU Emissions Trading System:– makes CO2 price depend on supply and demand

– unstable, hard to predict– investments in low-C energy need more predictability

=> Governments to offer long-term contracts for CO2?

D Newbery Dublin 43

Current EU low-C policy

• Consider 20 €/t CO2 = 73 €/tC = 7.3 €/MWh CCGT, 20 €/MWh coal

– UK renewables premium: 60-75 €/MWh = 220-750 €/tC (estimate 450 €/tC)

– Irish estimate 2010 138 €/tCO2 = 506 €/tC

– contains large but unstable subsidy for R&D

• How to charge for C and subsidise learning-by-doing to make renewables commercial?– Quotas solve public good problem?

=> Pay-off if other countries then adopt technology

D Newbery Dublin 44

Incidence of ETS on ESI

• ETS prices carbon

• raises MC of marginal fuel

• more likely to be coal

• gives windfall to intramarginal plant

• SB or CTC markets can claw this back

45

£0

£10

£20

£30

£40

£50

£60

£70

£80

Old Nuclear Old CCGT Old Coal New CCGT New OnshoreWind

New Nuclear New Coal New OffshoreWind

Mar

gin

al C

ost

(£/

MW

h)

Fuel O&M LCPD EUETS Capital

EXPECTED MARGINAL COST OF GENERATION IN 2005 - 2010

Key question: when to invest in new CCGT and retire old coal

Source:John Bower www.oxfordenergy.org Oxford Energy Comment “UK Offshore Wind Generation Capacity: A Return to Picking Winners”

John Bower’s estimate of relevant medium term marginal cost

2003/4 price

Liberalising domestic supply

The British Experience

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Switching shares in electricity

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03

switch then return

to others

to British Gas

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Ownership of Supply Businesses Great Britain 1988-2003

0

5000

10000

15000

20000

25000

Dom

esti

c cu

stom

er n

umbe

rs

SWALEC

Southern

ScottishHydroManweb

ScottishPowerYorkshire

Northern

Midlands

SWEB

SEEBOARD

London

Norweb

Eastern

EastMidlands

PowerGenTXU

EdF

NPower

Scottish and Southern Energy

Scottish Power

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Domestic liberalisation

Real domestic electricity prices 1990-2002

100

150

200

250

300

350

400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

£/ye

ar/3

,300

kWh

incumbentcompetitorrescaled extra large customerscounterfactual

Supplyliberalisation

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Domestic Electricity Prices London Region (3,300 kWh)

£200

£210

£220

£230

£240

£250

Months

An

nu

al B

ills

(£

)

London Electric

British Gas

Eastern Energy TXU

Norweb energi

Powergen

Energy supplies Uk

Northern elec and gas

Npower

Scottish power

Scottish and Southern

Basic Power

Swalec

Seeboard

Yorkshire Electricity

Atlantic Elec and gas

Amerada

Independent Energy

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EdF (London) DD prices

150

155

160

165

170

175

180O

ct-0

0

Dec

-00

Feb-

01

Apr

-01

Jun-

01

Aug

-01

Oct

-01

Dec

-01

Feb-0

2

Apr

-02

Jun-

02

Aug

-02

Oct

-02

Dec

-02

Feb-

03

Apr

-03

Jun-

03

Aug

-03

Oct

-03

Dec

-03

Feb-

04

Time

Nom

inal

Price

(£)

In Area Out Area

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Breakdown of domestic Direct Debit electricity bill

2003

D Newbery Dublin 53

Cost-benefit analysis of supply competition

• Green and McDaniel (1998) criticise Offer’s SCBA– Offer’s benefit = consumer gain; co. losses ignored

– initial costs: £276 million

– extra on-going costs £36 m/year

• consumers gain £285 m/y, co.s lose £415m/y

• removing regulation allows margins to widen

Expensive and unattractive solution?

D Newbery Dublin 54

UBS Warburg Research 2002

• Sep 2001 81% of switchers to Dual Fuel

• 67% of Dual Fuel supply by British Gas

• Value of customers:– BG: dual fuel = £458/customer– Elec incumbent dual fuel = £444– Out-of-area dual fuel = £375– Elec incumbent elec only = £295

D Newbery Dublin 55

Research results

• Giulietti, Waddams Price and Waterson (2001)– survey of 692 domestic gas consumers – 20% had switched (same as nat. average)– determine profit-max behaviour of incumbent

=> profitable to maintain price £100/yr above entrant

= 33% above competitive level

=> would result in market share of 55%

Domestic retail market not very competitive

D Newbery Dublin 56

Conclusions on supply competition

• ending the franchise widens supply margins

• but avoids the need for regulation

• dual fuel offers reduce costs and prices

• but incumbents capture most DF market

• and keep prices considerably higher

• social benefits probably negative for ending franchise

Conclusions• Structure matters: easier to get right

– starting from state ownership– in large/well interconnected systems,

• Wholesale competition delivers gains– not clear this extends to domestic franchise

• Security of supply– market signals work in competitive markets– problematic in distorted markets

• Environmental policy: can be costly – needs careful market design and cost-benefit tests

Lessons from Electricity Market Restructuring

David Newbery Cambridge University

Dublin Electricity Workshop

Dublin, 25 November 2004http:// www.econ.cam.ac.uk/electricity