Providing for Default Service in Retail Natural Gas and Electricity Markets
<a href=www.energypulse.net>Energy pulse 5.14.03 Ronald Sutherland, Consulting Economist and Adjunct Professor of Law, George Mason University, School of Law
A crucial issue facing states that are in process of deregulating retail markets for electricity and natural gas is how to provide default service to customers who may be abandoned by suppliers, or who otherwise may be unable to obtain service. The approaches to this issue involve light handed regulation and reliance on market forces, and heavy handed regulation that ignores market incentives. The former approach is certainly preferable, but many states appear to apply the latter approach. The light handed approach involves developing a competitive market with incentives to service to all customers. The heavy handed regulatory approach involves promulgating regulations that encourage suppliers to exit the market, and then additional regulations that require a provider of last resort (POLR). Understandably, states that follow the regulatory approach find it particularly challenging. The website material from the Texas Public Service Commission indicates the substantial effort required to establish a POLR.
This article explains that the key to providing default service is a robust wholesale market with transparent and floating prices. The best way to provide for default service is to develop a competitive market where providers have an incentive to serve customers. Competitive retail markets require a wholesale market with price adjustments that equate supply and demand. Given a robust wholesale market with floating prices, commodity will be available at a price and there is unlikely to be a need for default service. However, utility commissioners and state legislators will require the security of a designated POLR. Establishing such a POLR should be relatively simple, when such services are unlikely to be required and are easily met by spot transactions.
Default service has two commonly accepted definitions. In the transition to a competitive market, some customers choose to remain with their current service provider, instead of choosing an alternative provider. In this use of the term, the current service provider is the default choice. Default service is also viewed as a backup service provided to customers who are abandoned or refused service. In this definition, a default service provider is a provider of last resort (POLR).
In regulated electricity and gas markets, the utility has an obligation to serve customers. In competitive markets, customers are ensured service by having a choice between numerous service providers. In the transition from regulation to competition, there may be no obligation to serve, nor a well developed market that ensures service. The uncertainties of this transition, plus the need to serve all customers, apparently require a provider of last resort. This argument, although advanced frequently, is actually quite weak because several markets are deregulated without the need for a POLR.
If state legislators and utility commissioners are to deregulate these markets, they must have assurances against failures in the form of abandoned customers. The need to obtain support from these public officials requires some light handed regulation that ensures a POLR, in addition to reliance on market forces.
In some states, marketers have exited the retail market, raising the serious issue of ensuring service to their former customers. The most frequent need for a POLR results from a regulatory distortion, such as a price cap, that discourages marketers and utilities from serving customers. Given that default customers arise from a regulatory failure, the heavy handed regulatory approach imposes even more regulations in an effort to reverse the effects of the initial regulatory change.
States have adopted different approaches to providing for default service. States that allow the local utilities to retain their merchant function typically require the utility to be the provider of last resort. In states where the utility exits the merchant function, an alternative provider becomes the POLR. The risk of abandoned customers appears greatest where the local utility exits the market, however the risk is actually greatest where regulatory failures encourage suppliers to exit the market and leave customers without service.
The key to ensuring service to all customers is a robust wholesale market with continuously adjusting prices. Such prices are referred to as floating prices, real time prices, and current spot prices. Continuously adjusting wholesale prices bring supply and demand into balance. The critical feature of floating prices is its assurance of supply at a price, as opposed to supply rationing. In such a robust wholesale market, a merchant can purchase gas or electricity at spot and provide retail service to customers at spot plus a service charge. In such a market, suppliers have every incentive to provide service and customers are unlikely to be abandoned. If marketers leave the market, customers can readily obtain service from another service provider. When a market has incentives to serve customers, POLR service is unlikely to be required. Designating an official POLR is relatively simple under these conditions.
Some gas and electricity markets have long-term fixed-price contracts in the wholesale market, and price caps in the retail market, or other supply constraints that discourage reliable supply. With these regulatory failures, customers are abandoned, and such customers may be unable to find an alternative supplier at a current market price. These conditions require a provider of last resort (POLR). However, the POLR task now becomes complicated because the POLR may have difficulty in obtaining the commodity in a supply constrained market. For instance, most states that are deregulating their gas and electricity markets are imposing price caps as part of a standard offer service. When wholesale fuel prices increase and price caps become binding, there is both an increasing need for POLR service, and a difficulty in providing it. Heavy handed regulation is an apparent necessity when previous regulatory failures contribute to customers being abandoned. The preferable solution is not new regulations for POLR service, but allowing efficient wholesale to provide reliable retail service.
Providing the best value to customers requires the development of a wholesale market that reveals floating prices. Providing service for abandon customers is almost trivial when such customers can readily obtain service on their own. Service providers – the utility or marketers – will readily provide service if they can buy at spot and sell at spot plus a service charge. Providing for service for abandon customers is a serious challenge only when regulatory failures preclude service providers from obtaining the commodity in the wholesale market.
Empirical evidence confirms the critical nature of the wholesale market with floating prices. Imagine an energy market with a small number of suppliers where one or more supplier may leave the market abruptly. Suppose further a robust wholesale market characterized by floating prices. At issue is how to ensure reliable service to those customers who may be abandoned by their service provider. Given these assumptions, including a robust wholesale market, the answer is that no special provision is required for default service.
World oil markets are characterized by a small number of influential suppliers, termed OPEC, and in early 2003 there was serious concern over supply disruptions. The threat came from Iraq, other regional suppliers, and from Venezuela, which was experiencing different issues. There was no concern for a POLR; I do not recall the issue even being raised. If large producers exited the market, the world oil price would increase to again equate supply and demand. There is no need for a POLR, because a robust wholesale market ensures that commodity will be available at a market clearing price.
If marketers or other suppliers of electricity and natural gas abruptly exit the retail market, will customers immediately be able to obtain service, in the absence of a POLR? If the wholesale market is robust with floating prices, all customers should be able to obtain service at these floating prices. However, if the wholesale market does not have market clearing prices, and is instead characterized by shortages, customers could also experience shortages and lack of service provider. States that are encouraging retail competition can ensure service reliability by encouraging the development of a well functioning wholesale market, where designating a POLR is not a regulatory challenge.
Phone: 703-323-5815
Do you agree or disagree with this article? If you disagree, send in a rebuttal piece.
Readers Comments
Bill Mueller 5.14.03 Dr. Sutherland describes many of the aspects of a functioning market. The description can apply very well to large consumers: businesses and industrials. The large customers have enough at stake to actually pay attention to the problem of getting the best price. They can afford the five or ten (or more) hours a year required to manage the problem.
Small consumers aren't very active because it is too expensive to care. If they get involved with their electric purchases, they will save perhaps $50 per year (assuming they save a full cent per kWh and use 500 kWhs per month). So a good market system needs to give them a choice that provides $5 per month. Anything less than that isn't worth the time and mental energy to learn about and decide.
Keep in mind that almost half of all consumers use less than 500 kWhs per month. They’ll never save enough to take on the decision hassle of choosing hassle. If you’ve ever tried to correct a billing error by phone – one incident can offset any small monthly savings.
And keep in mind that most alternative prices don't provide a full cent of price choice. The electricity markets have very thin margins, on the order of 1/3rd of a cent. Suppliers exit the market because the margins are thin – there’s not a lot of money in the business. The commodity is undifferentiated, after all if the products were differentiated, the market would be less efficient. The price pressures results from a short term market structure, marginal pricing, and long-term investments and mortgages to be paid. It’s unlikely that the markets will ever be inefficient enough to support price differentials over 1 cent per kWh, large enough to provide consumers enough value to worry about choosing suppliers.
And even $5 per month is "below the radar screen" of many consumers. (Have you saved your $5 by installing compact fluorescents?)
Our dilemma is that the political definition of a successful deregulation tacitly involves the active participation of many consumers, especially voters. It is unlikely that any deregulated market will ever have enough consumer participation to eliminate “heavy-handed” regulation. It is unlikely that there will ever be enough participants to fund an active market of many suppliers competing for business of active consumers who revisit their electricity choice annually.
Bill Mueller Principal Number Four Associates Cambridge, MA