CSEM WP 106R Investment Efficiency in Competitive Electricity Markets With and Without Time-Varying Retail Prices

The standard economic model of efficient competitive markets relies on the ability of sellers to charge prices that vary as their costs change. Yet, there is no restructured electricity market in which most retail customers can be charged realtime prices (RTP), prices that can change as frequently as wholesale costs. We analyze the impact of having some share of customers on time-invariant pricing in competitive electricity markets. Not only does time-invariant pricing in competitive markets lead to outcomes (prices and investment) that are not first-best, it even fails to achieve the second-best optimum given the constraint of time-invariant pricing. We then study a number of policy interventions that have been proposed to address the perceived inadequacy of capacity investment. We show that attempts to correct the level of investment through taxes or subsidies on electricity or capacity are unlikely to succeed, because these interventions create new inefficiencies. We demonstrate that the most common proposal, a subsidy to capacity ownership financed by a tax on retail electricity, is particularly problematic. An alternative approach to improving efficiency, increasing the share of customers on RTP, has some surprising effects. We show that such a change lowers the equilibrium price to flat rate customers and makes them better off, but it makes incumbent RTP customers worse off. Also, an increase in RTP customers, does not necessarily reduce equilibrium capacity investment. If the equilibrium flat rate is higher than optimal, then an increase in RTP customers improves welfare. However, if the equilibrium flat rate is lower than optimal, such an increase does not necessarily improve welfare. We present an example in which welfare decreases, but the construction of the example suggests it is not likely to be policy relevant. Finally, we demonstrate that the analysis is robust to inclusion of a simple form of reserve capacity. 1 Borenstein: Director of the University of California Energy Institute (www.ucei.org) and E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business, U.C. Berkeley (www.haas.berkeley.edu). Email: [email protected]. Holland: Visiting Researcher, University of California Energy Institute. Email: [email protected]. Our thinking on this topic has benefitted a great deal from discussions with Jim Bushnell and Erin Mansur. In many industries, retail prices do not adjust quickly to changes in costs or market conditions. Restaurants keep stable menu prices even when ingredient prices fluctuate. Service providers, from house cleaners to veterinarians, regulate fluctuating demand with non-price mechanisms (usually queuing) rather than by adjusting price to clear the market in times of excess demand. Perhaps nowhere is the disconnect between retail pricing and wholesale costs so great as in restructured electricity markets. In the last decade, it has become apparent that wholesale electricity price fluctuations can be extreme, but retail prices have in nearly all cases adjusted only very gradually. Typically, wholesale electricity prices vary hour by hour, while retail prices are adjusted two or three times per year. Because electricity is not economically storable and fixed retail prices create price inelastic demand, it is not uncommon for wholesale prices within one day to vary from five cents to twenty-five cents or more per kilowatt-hour while retail prices do not adjust at all. Economists, recognizing the potential inefficiencies when prices do not reflect production or wholesale acquisition costs, have been among the most vocal proponents of realtime pricing (RTP) of electricity, under which retail prices can change very frequently, usually hourly. With the 2000-01 California electricity crisis, many market participants also expressed support for more responsive retail prices. RTP has been explored in economics in what is commonly referred to as the peak-load pricing literature. That literature, however, has focused almost entirely on time-varying pricing in a regulated market. Much of what is known from that literature carries over immediately to a deregulated market if all customers are on RTP, but that situation is unlikely to occur in any electricity system in the near future. While many deregulated (and some regulated) electricity markets are considering implementing RTP for some customers, nowhere is RTP likely to encompass all, or even most, of the retail demand. In all cases, the outcome is likely to be a hybrid in which some customers see realtime prices and others see time-invariant prices, more commonly called flat-rate service. In this paper, we examine such a structure under deregulation, where competitive generation markets develop time-varying wholesale prices, but competitive retail sellers still charge some customers flat retail rates. Closely tied to time-invariant retail pricing is the issue of investment adequacy. Many participants in the electricity industry have argued, generally without an economic explanation, that deregulated electricity markets will result in inadequate investment in 2 See Steiner (1957), Boiteaux (1960), Wenders (1976) and Panzar (1976).