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The Structural Shortcomings of Retail Provider Choice in Distribution

Alberto Ramirez Orquin's picture
Professor of Electrical Engineering, University of Puerto Rico at Mayaguez and co-founder of Resilient Grids, LLC. University of Puerto Rico at Mayaguez & Resilient Grids, LLC.

Dr. Alberto Ramirez Orquin is an energy expert with industrial experience encompassing a vast international utility engineering practice, including extensively the US and Canada; he held the...

  • Member since 2003
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  • Jul 16, 2004
As well known, generation was the first business segment where deregulation was attempted. The approach was fostered at the turn of the century by both US federal policy and technological development; a contributing factor to this emerging competition could also be found in the progress of integrated systems such as combined cycle, cogeneration, and trends toward smaller modular units, demand-side management, distributed utility generation, fuel cells, solar, etc.. In this context the idea of economies of scale and ‘natural monopolies’ very much advocated in the past became obsolete. But distribution has become at present the challenge where deregulation efforts are being carried out; it is now where the real test for the goodness of any reform resides, and it is also where the results on record are far from impressive. An explanation for this disappointing outcome can be a task involving substantial research; what has become apparent is that at the end-use level there is as a phenomenon that tends to amplify overall system flaws. It does not seem to have trickled down to this level the economic benefits of wholesale market competition. Some of the fundamentals of this problem hinge around intricate new issues, for instance the regulatory philosophy evolving from the traditional cost-of-service/rate-of-return to a likely performance-based price/quality standpoint. The potential unbundling of the distribution grid and energy services segments will only exacerbate this predicament. Rate issues may also become a very complex proposition particularly under retail wheeling, load aggregation, demand charges, energy efficiency guidelines, demand-side management programs, customer benefit function behavior, etc. Cost pass-through criteria can also become controversial and conflictive, being closely related to grid congestion allocation and development.

Field Results
The UK model has been frequently used as a reference because of its pioneering nature (April 1990). Here the Regional Electricity Company (REC) framework had given an early indication of serious consumer welfare problems, rate inconsistencies, trial and errors and flip flops; in sum, the somewhat competitive wholesale system efficiency has not been reflected at the retail level. On the other hand the California crises have dramatically reasserted the fact that deregulation was not necessarily conducive to lower rates; where only scattered new Load Serving Entity (LSE) entrants could play the market with the incumbent utilities to render any demand benefit at all. Among the other few States where deregulation has been implemented, Texas has captured attention with its ‘choice’ program. This reform has been characterized as an instant success. The model has been laid out within a bulk bilateral context. In this market it is important to comment that the affiliate utility establishment (a derivative from the regulated era) is very much present with three major players. The system operator, ERCOT, is also the electric reliability council and requires from its qualified scheduling entities (QSE) balanced schedules, which in practice forces the unaffiliated players to face the burden of securing both ancillary and balancing services; these have been known to experience volatility. The independent Retail Energy Provider (REP) thus has in both energy and capacity markets an inherent risky short position. Their potential penalty for scheduling errors or departures can be substantial.

Economies of Scale
In general the typical distribution sector has configured a bundled product having both the grid and the retail energy provision. From this standpoint a misconception regarding the notion of economies of scale can take place; while it was accepted that subadditive costs exist at the transmission level, it was widely accepted this was not the case at the distribution one. But this assertion is questionable and stems from bundling the network and retail services, looking solely to the lower voltage grid characteristic. As it turns out it can only apply to the relationship between load carrying capacity and topology/density of the grid; but in no case to the retail service for the end user. Here the diversity of the demand function is a fundamental consideration. Also the concept of economies of scope has also become significant, particularly with the current relevance of CIS issues.

The Statistics of Aggregation
The demand of a single customer of a generic Retail Energy Provider is a random variable, typically assumed normal; ?this function shows some conditionality from a very complex set of other random processes, notable weather. But the total demand facing such a retail player comes from the aggregation of its demands; it is also a random variable exhibiting basically a normal probability distribution. Making the assumption that for any particular customer class the individual variances are similar allows proving that the normalized standard deviation of the aggregate demand is equal to the one for the individual demand, divided by the square root of N, the number of customers per firm. This result reveals a major shortcoming to the whole notion of retail competition; the microeconomic definition of pure competition calls for a large number of players. This assumption causes N to be relatively small, having the effect of making the aggregate demand’s volatility to be larger as the number of players grows. This antithetic tradeoff can be formulated also from an Industrial Organization standpoint, as the market structure can be ascertained by estimating the Herfindahl-Hirschman Index HHI. Looking at reasonable index ranges in terms concentration may purport a sound competitive industry. But again N for a fair market share distribution tends to be as low as possible, setting the perverse trend on volatility. A load serving entity must secure both capacity and energy ahead of time lines for its customers; as previously stated this sets a short position that must be hedged against. For instance in ERCOT it means at least an ancillary and balancing service requirement. The know how and transaction costs facing a small or even medium player can be significant and very much correlated to their demand volatility, since the departures from programmed schedules generate a definite financial liability. These potential surcharges would fall into the demand side (and possibly to rates by a pass-through mechanism), causing a loss of consumer surplus.

The classical model of pure (perfect) competition postulates a marketplace that ideally sets a random process phenomenon capable of sustaining a sort of convolution between supply and demand stimuli. These functions are understood to exist in electric energy system segments that cannot be construed as natural monopolies. In any event, the presence of natural monopolies is dynamic in time and dependent on the state of the art in technology and on the relative business sizes of the attendant service segments. For the price-clearing process and in order to have well-behaved functions there must be ‘reasonable’ distributions; in general this means a minimum threshold in the number of players (and size) all things considered. Failure to achieve this objective may lead to market power and distinctive societal deadweight loss and corruption of the whole process. Furthermore the Retail Choice proposes a model based on a pure competition paradigm, similar to the one achieved at the wholesale level seeking to establish a sizable number of retail providers. This approach however may render such providers with a substantial risk exposure that increases with the number of firms, setting thus a conflictive tradeoff. Yet it is conceivable that a feasibility band or interval could be defined for each specific implementation, indicating a viable number/range of LSE firms. In any event it is clear that considerable R&D efforts must be devoted to address this complex issue.

Alberto Ramirez Orquin's picture
Thank Alberto Ramirez for the Post!
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