Commentary: Electricity: Reforms That Will Save Money

By Peter Coy

With California in an electricity crisis and other regions facing the risk of summer blackouts, politicians are warning darkly of chronic shortages.

But the real problem is not a long-term lack of generating capacity. In fact, high electricity prices are stimulating such a boom in power-plant construction that the current capacity shortage could become a glut in just a few years. According to Henwood Energy Services Inc. of Sacramento, close to 100,000 megawatts of generating capacity are under construction and another 300,000 Mw are in planning stages. Some plants won't be built. But if all of them were, and on schedule, it would increase U.S. generating capacity 50% by 2004. "This construction is way beyond what would be economic," says Richard Lauckhart, a senior project manager at Henwood.

The real problem is that while high prices are working their magic in generation, they still aren't functioning as they should in two other crucial parts of the business: the consumption and the transmission of electricity. Consumers aren't seeing the true cost of the electricity that they use. And transmission prices aren't reflecting the actual costs of getting electricity across the grid from point A to point B.

As a result, Americans could end up wasting a lot of money. They could build plants in the wrong places, where they're not needed. Or they could build too many plants when it would be more efficient to reduce peak demand by shifting consumption to other times of day.

Let's start with consumption. Today, most consumers have no incentive to turn down their air conditioners when the system is gasping to meet demand because they pay the same prices regardless of generating costs. The obvious solution is time-of-day pricing, in which prices are highest during hours of peak use because that's when the costliest plants must be fired up to satisfy demand.

Time-of-day pricing would encourage people to shift consumption by, say, running their dishwashers late at night. Consumers don't know it, but the overnight price for electricity at wholesale can be practically zero. Utilities and other power producers are sometimes actually forced to pay industrial customers to use electricity in the early morning hours--because it's too expensive to shut down the power plants at night. Eastman Kodak Co. (EK ), for instance, got paid for consuming electricity this spring. "We love it," says Joseph Sherman, Kodak's heat-balance engineer. With time-of-day pricing, consumers would pounce on such bargains and demand would even out.

GRIDLOCK. Prices for the transmission of electricity over long distances are equally illogical. They don't rise and fall based on demand. When everyone wants to use the same power lines to get electricity from some low-cost generating plant, the congestion can ripple outward like gridlock on city streets. To prevent that, system operators have to arbitrarily deny some transactions. The solution, again, is basing prices on costs--in this case, the cost of congestion. Such a system has been used successfully since 1998 by PJM Interconnection LLC of Valley Forge, Pa., which runs the grid for Pennsylvania, New Jersey, Maryland, Delaware, the District of Columbia, and part of Virginia. New England and New York, among others, have adopted versions of PJM's system.

With congestion-based pricing, consumers in cities like New York must pay high prices for electricity because the lines delivering power to them are constantly congested. Result: Entrepreneurs are building plants close to the cities to fetch the high prices, and that itself is easing the problem. Without the clear signal provided by congestion pricing, people might build plants in places where new production doesn't really help, says Craig Glazer, PJM's regulatory affairs manager. The question, says Glazer, is: "Where do you get the most bang for the buck?"

Right now in most parts of the country, only one part of the electricity system--generation--responds to high prices. Prices must be aligned with costs for consumption and transmission as well. The market only does its work if you let it.

Coy is associate economics editor.

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