Creating electricity markets is not so obvious
This is the first installment of the Topic of the Month: Thirty years of electricity markets
Thirty years of electricity markets
After 30 years of open electricity markets, an assessment of their achievements and current challenges is appropriate, particularly given the significant impact of decarbonisation and digitalisation on the industry. The upcoming Handbook on Electricity Markets, edited by Jean-Michel Glachant, Paul Joskow and Michael Pollitt, makes such an analysis.
In this Topic of the Month, we will convey the key messages outlined across the handbook's 22 chapters, providing you with a comprehensive picture of the state of the art in electricity markets. This first instalment will focus on the introduction of competition in the electricity industry and the main lessons that have been learnt. Next week, we will look at a few concrete experiences with electricity markets in Europe, the US and Australia, while the subsequent two instalments will consider more closely the current challenges that electricity markets face and their future role in the transformation of the industry.
Competitive markets, both at the wholesale and retail level, are not a spontaneous feature of the organisation of electricity industries worldwide. For decades electricity systems have been based on local or national monopolies, vertically integrated from generation to final supply, and from transmission to distribution. These traditional arrangements, which supported the exploitation of significant economies of scale and scope and the expansion of electricity grids to ensure almost universal access to electricity in developed countries, have been replaced by competitive markets only quite recently and not everywhere. In the 1990s and early 2000s, innovations in technology and developments in economics, together with a political landscape more favourable to market forces, promoted the restructuring of the electricity industry in large parts of Europe, North America and beyond. The ownership and operation of networks have been separated from competitive activities (unbundling) and a new type of economic regulation – the so called “incentive regulation” – applied to network companies. Legal barriers for enterprises to enter the generation and supply segments have been broken down; in some cases, incumbents have been dismantled and privatised as well (for more information on the traditional arrangements for electricity supply and the industry restructuring, look at Chapter 2 by Richard Schmalensee).
From a theoretical point of view, the reliance on competition for the generation and supply of electricity rests on the idea that open markets provide an economic incentive to operate existing power plants efficiently and to invest in an optimal generation fleet over the long term. Under certain conditions, competition then ensures the same outcomes as a centrally planned monopoly. Importantly, this holds in the case of multiple generation technologies and an inelastic electricity demand function. Economic theory also says that price spikes are an essential element in this picture: it must be possible for prices in peak hours to be several times larger than prices in off-peak hours for market forces to convey adequate incentives to producers and consumers (for more information on optimal wholesale pricing and investment in generation, look at Chapter 3 by Paul Joskow and Thomas-Olivier Léautier).
The specific features of electricity call for significant attention being paid to the details of market design. To date, different countries and regions have adopted different market designs, typically due to political factors and diverse initial conditions in the industry. However, the experience accumulated in the past three decades suggests some important principles to consider when designing an efficient electricity market. First, short-term markets used to dispatch generation assets and set electricity prices must properly consider the physical attributes of the electricity system and its real-time operation. Second, incentives to the market entry and exit of generators must be consistent with the achievement of long-term system adequacy criteria. Third, appropriate mechanisms that monitor and mitigate the market power at the local and system-wide levels are necessary to prevent inefficient prices that penalise consumers. Fourth and finally, the active involvement of demand in wholesale markets should be promoted as a means to address market power concerns and to use supply-side resources more efficiently (for more information on wholesale electricity market design, look at Chapter 4 by Frank Wolak).
Competition at the wholesale level does not fully ensure an efficient supply of electricity. Some form of competition at the retail level can also help facilitate the entry of new generators, as well as providing producers, both new and old, with stronger incentives to invest and operate their assets efficiently, in addition to innovating processes and products (see again Chapter 4 for a detailed explanation). However, while there is a wide consensus on the merits of retail choice for industrial and large commercial customers, the benefits of letting residential customers freely choose their supplier are much more debated. After a first liberalisation wave in the 1990s and 2000s, recent years have seen a growing number of interventions by governments, limiting the freedom of retailers and small electricity customers. This trend has not spared the UK, the cradle of retail choice, and might even affect another champion of free markets, Texas, as a consequence of the February 2021 crisis. Despite these changes in the direction of policy, it can be argued that retail competition will be more, not less, relevant in the coming years. Given the ambitious decarbonisation targets adopted by governments and the opportunities offered by the digitalisation of electricity infrastructure, energy customers and retailers must be actively involved and encouraged to innovate and use resources efficiently. Market forces are likely to be more effective in this regard than pervasive regulation (for more on the evolution of competitive retail electricity markets, look at Chapter 5 by Stephen Littlechild).
If you want to hear more on what we have learnt about electricity markets over the past 30 years, or if you would like to pose questions to some of the contributors of the handbook, join the open access webinar jointly hosted by FSR and IAEE on 11 October 2021.
Electricity markets in times of (climate) change (event recording)