When you plug your laptop into the wall outlet at home, work, or the local coffeeshop, you expect it to recharge without problems. That same electricity also reliably powers your lights, television, air conditioning, and washing machine at the mere flip of a switch. Yet, the simplicity with which we have access to electricity shrouds the complexity of the power system on the other side of the wall outlet. The ability to power a device using electricity requires coordination between large, synchronous machines connected across thousands of miles, and successful delivery of reliable electricity depends both on decisions that are made in real-time, and those made several decades in the past. This article provides a broad overview of how and why electricity markets came into existence, as well as how they operate to give us the source of power we so often take for granted.
Vertically integrated utilities
Before the early 1990s, vertically integrated utilities mostly operated electric power networks as regulated monopolies. These monolithic companies controlled everything on the other side of the wall outlet: they owned all of the generation and transmission assets within their geographic region, made short-term decisions about how to operate their power plants on a day-to-day basis, and made long-term decisions about future network and generation investments. Operating under “cost-of-service” agreements, these vertically integrated utilities were able to pass all of their regulator-approved costs to their customers. Given the relatively risk-free nature of their business model, most vertically integrated utilities tended to overinvest in their network and generation assets to ensure against the political and social impacts of failures such as blackouts. (California’s 2001 blackouts, provide a great example of the political and social consequences that come with electricity failures.)
While overinvestment usually provided greater protection against system failures, it also raised the average cost of electricity for consumers. To address this economic inefficiency, power systems around the world began transitioning to competitive electricity markets in the early 1990s. These transitions, often referred to as market “liberalization,” “deregulation,” or “restructuring” separated the monolithic, vertically integrated utilities into four main businesses: generation, transmission, distribution, and retail. Transmission and distribution remained regulated monopolies because of their inherent economies of scale; for example, power lines become less expensive per unit capacity as they grow larger. Rather than allow multiple companies to build small and less efficient networks that compete against each other, regulators allowed one organization to build and manage a single, regional network. The most notable change for liberalized power systems occurred at the generator level with the creation of new power markets. Individual generators and generation companies could now compete against each other for the right to sell electricity, and new entrants could enter the market with any technology of their choosing.
As with other markets, electricity markets operate on the economic principle that perfect competition will produce the most efficient outcome. With proper market incentives and “perfect” information about electricity prices, load trends, generation technologies, and other pertinent aspects of the power system, private entities should be able to compete with each other by making prudent investment and operation decisions. This competition should provide customers with an economically efficient supply of electricity.
However, in reality, many market failures exist that skew this result. For example, the oligopolistic behavior of generation companies allows price fixing, even if every company is “competing” to sell electricity. Electricity price caps are another example. Although electricity price caps prevent consumers from paying high prices, they also prevent investors from accurately assessing potential investment opportunities. Because of these imperfections, “liberalization” and “deregulation” efforts over the last two decades have led to a need for more (and better) regulation—not less.
Not all power systems in the world have electricity markets. For example, in the United States map shown below, only the regions highlighted in color have an independent system operator (ISO) that runs the electricity market; the remaining parts of the country continue to operate under vertically integrated utilities.
As concerns about global climate change drive the adoption of carbon markets and the integration of more renewable generation, electricity markets will adapt and adjust to accommodate these new elements. The overarching goal of electricity markets and liberalized power systems, however, remains the same: to steer power systems toward economically efficient and desirable outcomes via competition.