Avoiding the Boom and Bust Cycle in Electricity Trading

I have posted the following comment under the EnergyPulse article Avoiding the Boom and Bust Cycle in Energy Trading, posted on 10/31/06, By John Sheely , Trading Manager, Sheely Capital Management

I understand that it is impossible to avoid altogether the boom and bust cycle in energy trading. What is needed is to mitigate the amplitude of the cycles. As electricity growth is greater than total energy growth, there is a need for power sector structures that will help decrease said amplitude. If large scale transportation becomes a reality, the mitigation opportunities for electricity will further increase.

Vertical integration is not such a mitigation structure, because fuel clauses simply transfer volatility to the utility, which in turn is transferred to the customers after a time delay. The time delay depends on the regulation procedures, where customers cannot do anything about to avoid – a systemic time delay – except paying sooner or later whatever it costs. Some countries use taxes to cover part of the increases, but I think that is or soon will become irresponsible with todays and tomorrow technology and possibilities of innovations. The result is no mitigation whatsoever.

Neither is a mitigation structure centered on transmission access and generation competition, while distribution remains a retail monopoly –kept alive and protected as native load on the 2005 Energy Bill - under inefficient price controls (none or very little demand response to increase short run price elasticity). The problem experience so far is that spot prices amplify fuel volatility. That is one of the reasons of the failure of deregulation. The explanation is that as power systems get close to capacity limits in time and space, system risk of failure increase at the same time spot prices increases. The result is amplification instead of mitigation together with opportunities to game the system, as the Enron case showed. From this standpoint, Enron was just a casualty in the making.

What is needed is a structure where fuel volatility is transformed into spot prices with much less volatility. That was what the late M.I.T. professor Fred C. Schweppe worked very hard to envision during the 80s, and that resulted in the book "Spot Pricing of Electricity." The idea being that with a reduction of the systemic time delay, customers with the aid of new interface technology will be able to become responsive and mitigate random short run volatility. That is what now is called demand response, still an immature but highly promising technology.

Professor Schweppe explained how to adapt the vertical integrated utility to demand response, without deregulation. However, he explained that it would be easy to deregulate once the electricity marketplace was operating under the utility. The problem with deregulation was that his suggestion was bypassed. A quote from the EnergyPulse paper “An Alternative Business Case for Demand Response,” repeats his suggestion:

Most wholesale deregulation efforts have been a failure. Professor Schweppe had a different idea. He and his colleagues wrote in the book "Spot Pricing of Electricity": "We believe the deregulation which considers only the supply side of the supply-demand equation is dangerous and could have very negative results." It has taken a long time and a lot of value destruction to understand the above insight. The doors to innovative solutions in the power industry will be wide open when these concepts are finally understood.

I have been working on an extension of Professor Schweppe's work and have come to the conclusion recently that there are a great opportunities to develop the resources of the demand side. That is what I have call Electricity Without Price Controls in the blog of Grupo Millennium Hispaniola. At the center of the structure is a transmission and distribution natural monopoly, which is also the agent that controls physical electricity systemic risk, in the short and long run. That is a new paradigm of the power industry leading to its end state for the foreseeable future.

Electricity trading works on a new value chain which is wholesale, retail, customer, as explained in the article already mentioned. This is a more modest kind of deregulation than the earlier, which is not exclusive for the benefit of large industry, but for the benefit of the small guy. An inclusive, innovative, 21st century electricity industry will be the result. This is what the market at the Bottom of the Pyramid is waiting for. For further information please take a look at comments posted earlier on EnergyPulse that I have compiled 12 Selected 2006 Posts on Electricity Without Price Controls.