november 2008 update: why are electricity prices in rtos increasingly expensive?

8/14/2019 November 2008 Update: Why are Electricity Prices in RTOs Increasingly Expensive?

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MCCULLOUGHRESEARCHROBERT F.MCCULLOUGH,JR.MANAGING PARTNER

6123REED COLLEGE PLACE PORTLAND OREGON [email protected]

Date: March 3, 2009

To: McCullough Research Clients

From: Robert McCulloughTony BaderTolga Yilmaz

Subject: Why Are Electricity Prices in RTOs Increasingly Expensive? Novem-ber 2008 Update

For the last several years we have been reviewing the electricity cost and revenue dataprovided by the U.S. Energy Information Administration.1 Our purpose is to ob-serve the advantages, if any, of markets administered by governments (e.g., Texas andCalifornia) over open markets (e.g., WSPP).

As of November 2008, the differential between RTO states and non-RTO states is$.020 per KWh on a twelve-month basis. With fuel costs removed, however, the dif-

ferential is even greater $.024 per KWh.Since April 1, 1998, the markets administered by RTOs (also called ISOs) have lostground compared to open markets.2 The difference between the average wholesalecost of electricity in RTO states and in non-RTO states peaks in the summer.

As is easily seen from the chart below, RTO prices are consistently much higher thannon-RTO prices:

1 U.S. Department of Energy, Energy Information Administration, Electric Power Monthly, November 2008.2 For a map of the states, see http://www.ferc.gov/industries/electric/indus-act/rto.asp#skipnavsub.


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MCCULLOUGH RESEARCHWhy Are Electricity Prices in RTOs Increasingly Expensive?March 3, 2009Page 2

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Texas and Louisiana

The next chart compares Texas with Louisiana, where generation is far more suscept-ible to natural gas price increases than Texas, yet Louisianas electricity is now lessexpensive than Texas.

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BetweenRTOandNonRTOElectricRatestoConsumers


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Higher fuel costs do not explain this price discrepancy. Even when we remove fossil

fuel costs, average prices in Texas are significantly higher:

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EIAElectricPowerMonthly

Texasaveragepric e Louisianaaverageprice


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Is the high price of natural gas to blame?

Despite extensive data to the contrary, advocates of placing markets under the con-trol of RTOs continue to argue that the problem is high natural gas prices.

This argument is puzzling since the differential has increased when natural gas pricesincreased and when natural gas prices fell. For example, natural gas fell after Katrina,but the differential increased. More recently, natural gas prices have fallen significant-ly, and the differential remains quite high.

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EIAElectricPowerMonthly

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The pricing differential of RTO states is even greater when fuel costs are removedfrom the calculation, and explains why RTO prices have continued to diverge fromnon-RTO prices even though natural gas prices declined from highs in mid-2007. Weare unaware of any current research undertaken on the basis of natural gas prices toexplain the differential. The usual approach is to submit the question to standard sta-tistical tests.

If the increasing difference between RTO and non-RTO states rates is the result ofthe increasing cost of procuring natural gas, the two series should have a significantpositive correlation. A simple plot showing the relationship between natural gas pric-

es and the RTO/non-RTO differential shows that this is not the case.

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To conclude that natural gas is a good candidate for an explanation of the differential,we need to show that the correlation between the differential and natural gas is statis-tically greater than zero.

A frequent concern in the use of simple linear regressions using time series data isthat the error terms in the statistical procedure are correlated. This is the case here.Correcting for the serial correlation using the Hildreth-Lu procedure yields resultsthat are statistically efficient:

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RTO/NonRTODifferentialandU.S.NaturalGasPrices Linear(RTO/NonRTODifferentialandU.S.NaturalGasPrices)


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Prais-Winsten AR(1) regression -- SSE search estimates

Source | SS df MS Number of obs = 71

-------------+------------------------------ F( 1, 69) = 3.23

Model | .10715732 1 .10715732 Prob > F = 0.0766

Residual | 2.28850443 69 .033166731 R-squared = 0.0447

-------------+------------------------------ Adj R-squared = 0.0309

Total | 2.39566175 70 .034223739 Root MSE = .18212

------------------------------------------------------------------------------

differential | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

gas | -.049815 .0253367 -1.97 0.053 -.1003604 .0007303

_cons | 2.174093 .608114 3.58 0.001 .9609384 3.387247

-------------+----------------------------------------------------------------

rho | .9743416

------------------------------------------------------------------------------

Durbin-Watson statistic (original) 0.217539Durbin-Watson statistic (transformed) 1.861020

This technical analysis reveals that the impact of natural gas prices on the RTO/non-RTO differential is statistically indistinguishable from zero. While this does not meanthat natural gas may not be a factor, it certainly contradicts the argument that naturalgas is a major explanation behind the increasing differential.

Is it possible that the differential is due to higher than normal profits for firmsspecializing in RTO power markets?

A relatively small set of firms have profited from the change to administered markets.These include Exelon in Illinois; Public Service Electric and Gas; the former TXU;and Constellation. Although the situation is different company by company and stateby state, a clear picture has emerged over the past six years:


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One important reason for their enhanced profitability has been the transfer of exist-ing plants from regulated pricing to market pricing. This shows up as a windfall forthe owners of existing units. A secondary reason is the relatively higher wholesaleprices as noted above that have occurred under administered markets.

Conclusion

Our comparison of EIA electricity price, load, fossil fuel costs, and quantities forRTO and non-RTO states shows us that consumers in states with markets adminis-tered by RTOs continue to pay higher electric rates than consumers living in non-

RTO states. Fossil fuel costs, in particular natural gas costs, do not explain the diffe-rential between electricity prices in RTO and non-RTO states.

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Return

onEquity

RTOProducers'ReturnonEquityVersusTraditionalUtilities

RTOProducers TraditionalUtilities

november 2008 update: why are electricity prices in rtos increasingly expensive?

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