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Symposium 2010

Proposal - Global Electricity Market

The Challenge

In principle, solar and wind are more than enough to deliver any amount of energy that the world’s population might need. But these sources are usually best exploited in areas that are far from ce ...

In principle, solar and wind are more than enough to deliver any amount of energy that the world’s population might need. But these sources are usually best exploited in areas that are far from centers of demand. It is technologically challenging to transport electricity over large distances and even more to store it. As a consequence, electricity markets have tended to develop as regional markets.

In the long run, the most sustainable forms of power generation, solar and wind, will drive the electricity system. Achieving a system based on these resources will require an integrated network that delivers energy over transmission infrastructure from sources that are often far from demand centers. In broad scope, the technological requirements for such a system are readily identifiable. These include storage, improved transmission and increasing energy conversion efficiency. The system design challenges are not minor, however, and will engage the engineering community significantly.

I will focus my remarks on the institutional challenges. In one way or another, electricity has always been a regulated industry. While market forces have also played a major role in the development of the electricity industry, governments have had a strong hand in stabilizing and organizing investment and controlling prices. As the geographic scope and technological basis of electricity markets have grown, regulatory institutions have adapted to these changes and evolved. In the industry’s infancy, the municipality was the focus of electricity development. In recent years, national authorities have emerged to play the leading regulatory role, although more local factors are still a consideration to varying degrees. A global electricity market will require major institutional innovations.

There is already international commercial activity in electricity. The market for electric generating equipment of all kinds is global in scope. The largest vendors of all technology types operate internationally. There are also multinational companies with ownership interests in electricity assets in multiple countries. Transnational electricity trade, however, is still comparatively modest in scope.

I focus attention on two institutional issues that require attention to facilitate transnational electricity trade. First, building the transmission infrastructure necessary to enable global electricity trade will require cost-sharing arrangements. Many of the lines that will be built will rely on DC technology because it is most efficient for long distances. There are significant scale economies with DC technology. Therefore projects will most likely require multiple participants. Allocating the costs of large projects must be done before such projects are built. The second important institutional issue is dispute resolution. Although this issue addresses problems that will arise after infrastructure is built, resolving the framework for dispute resolution ex ante will encourage project development because it will reduce uncertainties about commercial operation. Finally, I address the question of how much global integration of markets is optimal.

Cost Allocation

Construction of new international transmission facilities will require a cost-sharing plan to facilitate investment. Relevant projects will often be too large for single buyers and single sellers alone. Diversifying the risks of large projects also argues for multiple owners. There are likely to be many parties who would benefit from large transmission projects, but some may seek to avoid or minimize their share of the costs. Such ‘free-riding” is a common problem in economics. Regulatory institutions must try to avoid this outcome. Even if there is agreement in principle for cost-sharing, there are many different ways in which this can be accomplished. Methods must be developed that allocate costs to beneficiaries in some roughly proportionate manner. It is more important that these allocations be robust rather than overly precise, since imprecision in estimation is inevitable.

One simple allocation rule that has worked well on the buyer side is the load share principle. Customers pay in proportion to their share of contracted capacity. In the case of wind energy, with its substantial and often random availability, there can be complications arising from how and when shares are measured. Despite such complications, load share cost allocation can be robust enough to facilitate commercial arrangements.

Additionally there are often “network externalities,” in which new projects require network upgrades in other parts of the system. This topic can be opaque because it involves network reliability issues are often not treated in a standard fashion. Therefore the opportunity for disagreement is correspondingly large. Here also, regulatory institutions have a role to play in defining which parties should be responsible for which costs.

Dispute Resolution

It is inevitable that under a regime of international electricity trade, commercial disputes will arise from one circumstance or another. Parties will disagree about the interpretation of events, unexpected circumstances will arise, disruptions of one kind or another will occur. It is essential, therefore, that dispute resolution mechanisms be established that will allow for the settlement of commercial disagreements in a mutually acceptable manner. There are already a variety of institutions that address commercial dispute resolution in the international context. These institutions are likely to need further development in the context of a global electricity market.

Regulatory institutions play a prominent role in the dispute resolution process in electricity, even if regulators are not the adjudicators involved. This is because regulatory standards help define the benchmarks for establishing a reasonable allocation of costs and benefits in a commercial context. Disputes in electricity commerce often reference regulatory rules, standards, decisions or common practices. Where regulatory standards differ, the resulting ambiguities and conflicts can impede rather than facilitate dispute resolution. Therefore, even if a commercial conflict does not directly involve regulatory authority, it is important for global electricity trade that regulatory standards and practices to be harmonized as much as possible.

The current regime for the arbitration of international commercial disputes has uneven global participation. Countries that are most likely to be electricity exporters in a global electricity market, many of which are now oil and gas exporters, have historically participated less in these procedures than countries that are likely to be importers. Cultural differences appear to be at the bottom of this difference in participation. Legal traditions are quite diverse, and this impedes a finding common ground for arbitration. For arbitration to be successful, the parties must agree on procedures to be used, standards of evidence, and enforceability of decisions among other factors.

In a global economy, trading partners need to have a common understanding of commercial contingencies. Cultural differences have historically deterred this to a certain degree. Energy officials from prospective electricity exporting and importing countries should include dispute resolution procedures in their negotiations over commercial arrangements to broaden the scope of electricity markets.

How Much Global Integration of Electricity Markets Makes Sense?

Economists typically see trade as a process that benefits all parties. Because electricity plays a somewhat special role in economies, however, there are potential concerns about security of supply that need consideration. Electricity is an essential infrastructure industry. Modern society depends upon a reliable electricity supply for the most mundane and most sophisticated tasks. The disruption of electricity service imposes disproportionate costs on society. There is some risk that a global electricity market could result in greater fragility, a less secure system of supply, at least under some conditions.

There are some technology solutions that could ameliorate the security risks of global electricity trade. The chief among these is large scale storage. Inventories buffer supply interruptions in all industries. Storage provides the inventory function. Electricity storage, however, has not been economic except for hydrologic reservoirs. These are too limited at present to provide much of a buffer on any large scale. Back-up thermal generation, based on existing technology, is a widely available alternative for hedging against supply interruptions. Regulators will have to decide how much back-up plant to support as a security of supply hedge.

It is likely that natural limits on global electricity trade will appear. The cost advantages of remote resources may not turn out to be so uniformly great to overcome the substantial costs of transmission, at least on a consistent basis. When security of supply costs are factored in as well, the cost advantages of trade will be further reduced. The current dependence of European countries on imported natural gas, for example, is likely to exceed the degree of integration of electricity markets.

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