Static in the electricity market

July 24, 2013
Edward Hadas

Let me start with a confession. I do not fully understand what the Federal Energy Regulatory Commission says Barclays did wrong in the U.S. electricity market, and I am not entirely sure about the claimed misdeeds of JPMorgan. But my inability may well have less to do with my inadequacies than with the fundamental futility of trying to use financial markets to set the price of electricity.

Very approximately, FERC says Barclays sold electricity in order to manipulate a price index in ways that created profit on related positions in a related financial market. The UK bank plans to contest the $453 million judgment. According to news reports, JPMorgan is about to agree to pay almost as much to settle charges that it unfairly solicited "make whole" payments, which compensate utilities for setting up but not actually running power plants on a particular day.

I am not competent to judge the banks' legal and moral culpability, because the details are little short of diabolical. The jargon includes the "volume-weighted average price of the dailies' trading", not to mention spot markets, day ahead markets, physical positions, fixed-to-floating contracts and nodes. Still, FERC's summary of electricity trading in its latest annual review suggests there is problem. Purely financial strategies can easily play an unhealthily large role in a market where, according to the watchdog, financial volumes represented about 100 times the physical volumes.

These bank-regulator disputes are arcane, but they are evidence in a basic debate about whether market thinking is appropriate for electricity. The argument has been going on for several decades. On the winning side are the enthusiasts for competition, liberalisation and the use of supply and demand to set prices. On the other side, in my view, are almost all the facts.

Competition makes little sense in electricity. The transmission and distribution of power are what economists call "natural monopolies" – it is ridiculously expensive to have more than one set of power lines. It is less ridiculous to consider different power plants as competitors, but it is much more sensible to think of an integrated system which includes everything from huge nuclear facilities down to rooftop solar units.

Free market prices are also an unhelpful idea in this sector. For the industry to be viable, the price of electricity should be high enough to pay for the total cost of past and future power plants (including capital costs, in the argot, which are typically very high). Prices will often drop well below this level, because generators will sell power at any price which covers the daily bills (variable costs) for such things as fuel, payroll and taxes. Prices can also jump too high when there is even a small shortage, since most customers cannot easily reduce their demand (or, as economists say, there's low price elasticity).

What's more, the trading markets that FERC regulates – and there are similar arrangements in most European countries – cannot easily address important non-financial concerns (externalities) such as damage to the environment, the long-term availability and cost of fuel, and the need for capacity which is usually unused but available for especially hot days when air conditioners run flat out or periods when too many other plants are shut down.

The overseers of the electricity business seem to have some sense that free market economics do not fit. That's why the rule books for the so-called deregulated industry are much longer than for the previous system of tightly regulated monopoly suppliers. Energy policy continues to matter; it is just surrounded by misleading market rhetoric and distracting financial activity.

The market veneer confuses policy debates. Experts, not the market, will have to decide whether nuclear power is a good option, and whether the advantages of renewable energy sources justify their perhaps temporary additional cost. It is policy that will determine the balance between investment in energy-saving technology and in new generating capacity. It is politicians, not the market, who will decide whether residential customers should pay more or less than commercial users.

For all these problems, liberalisation of the electricity industry was useful. It challenged sleepy companies, swept away unhelpful practices and poked holes in obsolete prejudices. The credit, though, does not go to the new ideology, but to the power of change. New rules often help shake up organisations which have become stultified and complacent. The matrix of electric utilities and their regulators qualified as both.

The rethink brought benefits, but as the novelty wears off the sad truth is becoming clear. The convoluted rules of the spurious market model have made big policy decisions more difficult. The pretence of competition has handed more influence than ever to lobbyists and financial interests.

I will end with another confession. I almost hope that Barclays and JPMorgan fight off the charges. If their behaviour is judged to be legal, it will be a little bit harder for defenders of the system to claim that it works well.

<- Go Back