Solutions for Advancing Electricity Market Reform

(Paris) — 24 November 2003

Most IEA countries are liberalising their electricity markets, shifting the responsibility for financing new investment in power generation to private investors. No longer able to automatically pass on costs to consumers and with future prices of electricity uncertain, investors face a much riskier environment for investment in electricity infrastructure. Two new books published today by the International Energy Agency (IEA) provide some practical strategies to help move the liberalisation process forward.

Power Generation Investment in Electricity Markets
examines how market forces are reshaping the roles of investors and governments. “Electricity markets have in general, encouraged adequate investment,” said Ambassador William C. Ramsay at the launch of the book. “But governments remain concerned about the performance of electricity markets and the reliance on volatile electricity prices to bring forward that investment.”

While liberalisation was intended to limit government intervention in the electricity market, volatile electricity prices have put pressure on governments to intervene and limit such prices. This report looks at several cases of volatile prices in IEA countries’ electricity markets, and finds that while market prices are a necessary incentive for new investment in peak capacity, but government intervention into the market to limit prices may undermine such investment. For investment to thrive, the government’s role in electricity market reform needs to be more carefully defined. Its role should include monitoring the level of investment, and being able to respond effectively to threats of market manipulation.

This report looks at how investors have responded to the need to internalise investment risk in power generation. While capital and total costs remain the parameters shaping investment choices, the value of technologies which can be installed quickly and operated flexibly is increasingly appreciated. Investors are also managing risk by greater use of contracting, by acquiring retail businesses, and through mergers with natural gas suppliers.

Another key finding is that while price fluctuations are intrinsic to well-functioning markets, these can be reduced by encouraging greater response of demand to prices. The second publication launched today, The Power to Choose – Demand Response in Liberalised Electricity Markets draws on the experience of IEA Member countries and demonstrates the benefits of demand response. That is, providing electricity users both the incentive and the ability to vary their demand for electricity in response to changes in electricity prices.

Electricity markets are inherently volatile. Demand for electricity rises and falls on a daily and seasonal basis and is highly sensitive to weather. Supply has to be continually varied to match these changing demands, and that drives up costs. In extreme cases, where there is not enough supply (or transmission and distribution) capacity, and brown-outs or black-outs can occur.

By increasing demand response, price and demand peaks can be clipped and reliability improved. The “response” involves voluntary changes in consumer behaviour – deferring power demands around the house such as hot water heating, clothes washing and drying, dish-washing, for example, or by reducing demands through installing more efficient air conditioners, heating or lighting systems.
In the business sector, demand responses can include deferring demand to off-peak times for systems which store energy, such as freezers, cool rooms, or high-temperature processes such as aluminium smelters.

For this to occur, electricity users must have an incentive to change their usage patterns. Often, households and smaller companies have to pay regulated prices which may be fixed for periods of up to a year or more. This, combined with bills that might arrive months after the electricity was used, means that these customers have no incentive to vary their electricity demands at times of peak demand and prices. With demand response, customers will be offered the choice of moving to dynamic tariffs, which typically involve short periods of higher prices (during which consumers are encouraged to reduce consumption) in return for lower prices at other times.

Providing customers actually respond, demand response results in lower electricity costs for consumers. This effect is reinforced by the fact that demand response reduces peak loads and prices and over time reduces the system-wide costs of generating electricity, and hence average prices. Many electricity distributors and governments may wish to retain the option of offering customers fixed price tariffs. This can be compatible with effective demand response, since only a relatively small percentage of users need to respond in order to have a significant impact on peak prices.

Another key requirement for successful demand response is that customers must have the ability, as well as the incentive, to respond to changing prices. This involves the use of sophisticated systems for communicating real-time price information to customers, and also for metering and monitoring demand in real-time. A new generation of smart meters and internet or power line communication systems are necessary.

The Power to Choose shows that the economic benefits of demand response are large – between $10 – 15 billion for the US market alone. Given the additional benefits of improved reliability of electricity markets, reduced investments in peak capacity, more efficient energy use and associated reductions in greenhouse gas emissions, the incentive for governments to act to encourage demand response in strong. An electricity market with active demand response is a more efficient market.

Journalists may obtain review copies of Power Generation Investment in Electricity Markets and/or The Power to Choose – Demand Response in Liberalised Electricity Markets from the IEA Public Information Office in Paris.

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