Utilities expert Paul D. O’Rourke shares some lessons drawn from the establishment of competitive electricity markets in the US in the 1990s that can bear insight for energy policies today
By Nan-Hie In
Recently at the American Chamber of Commerce in Hong Kong, Paul D. O’Rourke, formerly the energy practice lead at Booz Allen & Hamilton, CRA International and Putnam Hayes and Bartlett, shared his experience of utilities reform in the US in the 1990s akin to a cautionary tale. Like everyone else, he thought deregulation of the electric market would work wonders, including various savings for customers. However, it didn’t achieve what many hoped for.
“The wholesale markets that were designed to be competitive are increasingly re-regulated,” he says. O’Rourke shares insight about this disruptive period, the implications as well as recommendations for Hong Kong’s energy future.
The Impetus of Market Liberalization in the 1990s
Many pressures contributed to electricity sector reform in the US at this time but the leading proponent was the high prices charged in some regions.
Since the 1970s, electricity prices were rising, but they did not spread uniformly across the US. “In Pennsylvania, even within the state, the price of energy in Pittsburgh were about 20 to 70 percent the price of energy in Philadelphia,” he says. Various reasons were to blame including the regulatory process. “A perceived lack of efficiencies in utilities were based on a bunch of benchmarking exercises and audits that were done rather carelessly in retrospect,” explains O’Rourke.
Large industrial customers saw the big price discrepancies and demanded better rates, which was a key driver to bringing competition in the industry. Meanwhile, deregulation in other industries such as natural gas and banking were successful. “There was this hope and dream that a competitive dynamic would reduce costs; it happened in other industries so it has to happen in electricity,” he says. But electricity is unlike other industries.
From the Generation Perspective
To create competition at the generation level, utilities were forced to sell their generation assets to merchant generators. Then they competed by bidding into an auction process. However, the initial design of the system created an incredibly gaming opportunity to manipulate the market prices. “The merchant generators inflated the prices bid in the process to earn more money,” he says, “Now it’s tougher.”
There is a day-ahead market and a real-time market. The day before the market opens, all the generators bid various prices (based on their start-up costs, minimum load costs and so forth).
Initially in the day-ahead market, the generators guessed the demand and what the generators would run to meet that demand. Sometimes the generators misforecast the supply and demand. For example, hot weather suddenly increased the generation required.
Due to potential generation scarcity, some participants bid not their cost but very high prices. “Some of them made their profits in 150 to 200 hours, a small slice of time compared to the number of hours in a year because of this issue of scarcity pricing,” says O’Rourke.
From a Wholesale and Retail Perspective
On a wholesale level, competitive markets were established but they were ill-prepared for other market forces that effected electricity: natural gas prices. O’Rourke explains: “[Electricity] market prices are driven by fuel prices. [Electricity’s] marginal cost’s primary component is fuel so if gas prices go up, the price of electricity goes up. Conversely, when natural gas price go down so does the price of electricity.”
When the markets were deregulated, natural gas prices were down. A few years later, gas prices arose as it entered a boom period. “Three years after competition was introduced in the retail sector, people got shocked – customers suddenly had to pay much more for electricity,” says the industry veteran.
Essentially installing competition in the electric market never met expectations for countless reasons.
The industry is highly complex and incredibly capital intensive to enter. “In California alone, the last number I saw was US$800 million dollars to create the IT infrastructure to run the competitive wholesale market,” reveals O’Rourke. Other high fixed costs include the customer information systems, customer call centers, billing systems among other upfront investments required.
Traditionally, utilities were a vertically integrated business which meant power generation, transmission, distribution and retail services were all in one entity, like Hong Kong today. Introducing industry competition meant unbundling these parts. O’Rourke says, for the distribution side especially, it led to a whole set of costs that had to be recovered from customers.
Furthermore, competition in the industry led to many consumers switching services but it mostly occurred amongst large users. “All the large customers negotiated very nice discounts with their suppliers, which pushed a lot of the cost back on the incumbent utility,” reveals the energy expert. To recover costs, the supplier redirected them to the remaining customers, notably small customers from lower income and elderly households for most.
So there were no savings on customers. “I thought competition would lead to technological innovation, in part greater efficiency, lower wholesale power costs, and greater consumer choice, but generally these things did not happen in the US.”
Recommendations for Hong Kong
In Hong Kong, opening the market to competition to break up the duopoly of Hong Kong Electric and CLP Holdings remains a continuing debate. The perceived outcomes include more consumer choices and environmental advantages as renewable energy providers may join the market.
However O’Rourke thinks these outcomes can be achieved without industry competition. “Creating a wholesale competitive market is going to be incredibly expensive and I’m not sure it can be done in Hong Kong because the market is not big enough,” he says.
The government has deferred the competition issue this year in its upcoming public consultation which focuses on the city’s electricity sector, which closes by June 30th. O’Rourke recommends three approaches for Hong Kong’s energy future.
Firstly, focus on the demand. Explore what can be done in the existing framework to encourage customers to reduce their electricity consumption – especially during peak hours, which cost the most – and encourage better energy efficiency and demand management.
“If consumers want lower costs give them the technology to get lower costs. Let them decide how much they want to lower costs by putting in Smart Meters or time based rates, for example,” advises the industry veteran.
Smart Meters connected to a Smart Grid are technologies that provide much data for users to monitor their energy consumption and how much it is costing consumers in real-time.
Secondly, on the city’s fuel diversity to shift away from coal to natural gas, O’Rourke recommends further gas development. In space-starved Hong Kong, one possibility is a storage scheme delivered offshore from a floating platform called FSRU or floating storage re-gasification unit. “This is a viable alternative for geographies that do not have sufficient land area.” Plus: explore wind farms offshore.
Thirdly, regulators can consider renewable energy incentives to encourage utilities to achieve certain public policy environmental goals. For example, make it explicit in the calculation of the rate of return so providers could earn more if they meet environmental goals, advises O’Rourke.
According to the energy expert, the big and growing renewable energy business in America was mainly driven by federal tax incentives for wind and solar energy. So government policies are the engine behind renewable energy growth including the nation’s objective to generate 25 percent of renewable energy by 2025. O’Rourke says this would have happened with or without competition.
Likewise, Hong Kong’s government can tell Hong Kong Electric and CLP Holdings to generate x amount of total kilowatt sales from renewable sources over x number of years. “That is a more direct and easier mandate than trying to create a competitive wholesale market,” says O’Rourke.