R Street’s Electricity FAQ

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See also R Street’s Electricity Glossaryas well as the following entries in R Street’s Electricity 101 series:

  1. Federal Power Act and organized electricity markets
  2. Physical characteristics of energy
  3. Economic characteristics of electricity
  4. Traditionally regulated vs. competitive wholesale markets
  5. Types of organized electricity markets

Physical System

  • What is electricity?

Electricity is the flow of electrical charge. It occurs naturally, but must be created and distributed in particular ways to make it useful to people. Electricity is a “secondary” energy source, which must be derived from a primary source like coal, wind, nuclear, natural gas, oil or solar energy. Primary sources are used to spin or rotate magnets around wire coils to induce electrical currents and voltages.

  • What is the “grid?”

The grid, or transmission system, is a network of power lines and equipment used to transport electricity in bulk from power plants to communities. At the local level, distribution lines and equipment transfer power from the transmission system to end-use customers.

  • How did the modern electricity system come about?

In the late 1800s, the electric system began with isolated generators serving dedicated customers. Utilities gradually began to interconnect their transmission systems in response to a variety of policies. This led to improved reliability and more cost-effective use of generation assets. For example, utilities could share backup generation in times of equipment failure or unexpected increases in demand. By the 1960s, the once-fragmented system had completed the transformation to interregional grids.

  • How much electricity does an average home use and how much does an average power plant produce?

In 2014, the average electricity consumption for a residential customer was about 900 kilowatt-hours per month, according to the U.S. Energy Information Administration. A commonly sized power plant (500 megawatts) utilized at 60 percent of its maximum would produce enough electricity for about 250,000 residential customers (note: power plants vary greatly in size and utilization rates).

  • How many power plants does the United States have?

In 2014, the United States had more than 7,500 operational power plants with nearly 20,000 generators, according to the Energy Information Administration. Power plants each have one or more generators. For example, nuclear plants usually have one or two generators, while coal plants often have several.


Concepts

  • Why is electricity sometimes considered a “natural monopoly?”

Certain economic characteristics of electricity led to the conclusion that electricity service could only be provided on a ‘least-cost’ basis by a single entity. This ‘vertically integrated’ monopolist would own all of the generation (power plants), transmission (high voltage) and distribution (low voltage) facilities in the service area. Today, we know that at least the generation function can be provided in a competitive market, allowing customers to choose their electricity supplier. Competitive reforms are known as ‘restructuring.’

  • What types of entities provide electricity and serve customers?

The ‘natural monopoly’ perspective supports four forms of utility ownership: public (government-owned); cooperative (member-owned); private (investor-owned); and not-for-profit. In a restructured market, a utility only owns the distribution facilities, while separate entities own the generation and transmission facilities. These entities are deemed independent transmission companies and independent power producers, also known as merchants.

  • What is an independent system operator (ISO) or regional transmission organization (RTO)?

RTO/ISOs are independent, nonprofit organizations responsible for wholesale grid reliability and transmission planning and operation. They administer organized markets for wholesale electricity. RTO/ISOs are necessary for restructured areas in order to operate the grid reliably and facilitate competition. While unnecessary for areas with vertically integrated utilities, RTO/ISOs generally can operate the grid in a more cost-effective way.

  • How much of the United States is under an RTO/ISO and how many are there?

States and industry participants have voluntarily formed seven RTO/ISOs. Six fall under the jurisdiction of the Federal Energy Regulatory Commission, while Texas’ falls only under state jurisdiction. Today, RTO/ISOs manage more than two-thirds of the nation’s electricity volume and they continue to expand.

  • What types of organized wholesale-electricity markets exist?

All RTO/ISOs use energy and ancillary-service markets to value and arrange the short-term services needed to operate the grid. Four of these RTO/ISOs use capacity markets to ensure adequate resources exist to meet future needs.

  • What is the benefit of organized wholesale electricity markets?

The alternative to organized markets is bilateral-only markets, where utilities trade electricity services through customized deals or through a broker. Organized markets use well-defined, standardized products to lower the transactions costs of trading electricity services. This results in more liquid markets and better gains from trade. These organized platforms better reflect the economic characteristics of electricity, such as capturing the value of transmission congestion, and allow for lower-cost grid operation and planning.

  • What is locational marginal pricing (LMP)?

LMP is the cornerstone of energy markets. It reflects the marginal cost to provide electricity at a specific time in a particular location. Three elements comprise LMP: the energy component (system supply-demand baseline); transmission congestion (when a transmission constraint requires operating a higher-cost resource); and transmission-line losses. This is similar to the economics of ridesharing, where the supply and demand for rides fluctuates based on the time of day. Traffic congestion can affect the supply of rides and increase prices. As with electricity, the market fundamentals and resulting prices are very location-specific and can change in minutes.

  • How do competitive wholesale markets ensure there are sufficient resources to maintain electric grid reliability?

Private actors in a marketplace cannot capture the full benefits of resource adequacy, which is the state of having sufficient resources to meet maximum demand. This means a market will underprovide those resources. Competitive wholesale markets use one of two ways to provide extra revenue to resource providers to ensure they retain enough systemwide resources. They either use scarcity pricing, which elevates markets prices when a shortage of supply exists, or create a new market (capacity market) that procures resources for the future.


Policy

  • How can Congress and the Federal Energy Regulatory Commission address state policy implementation that affects interstate wholesale electricity markets?

The federal government can proactively engage states to understand their concerns and motivation, such as electric reliability and environmental considerations. A change in federal policy or better explanations of how wholesale electricity markets work often can be enough to avoid the need for state interventions. Where this is not the case, states can cooperate with the federal government to develop policy that addresses state concerns without adversely affecting wholesale electricity markets.

  • How do organized wholesale electricity markets account for environmental considerations?

RTO/ISOs do not have an environmental mandate. Changing that would require extensive regulatory and institutional reorientation without any clear benefit, compared with the alternatives. Federal and state agencies already exist to implement federal and state environmental laws. RTO/ISO markets accommodate federal and state environmental policies. Electricity markets are best suited for market-based policies, such as those that internalize the social cost of pollution (e.g., pricing emissions). Generators include these pollution costs in the offers they submit into the organized markets, and the results reflect the private and social costs of operating power plants. Other policies may affect the frequency or duration that a power plant can operate on a particular fuel source, which generators reflect in the physical parameters of their offers. These are accounted for in the least-cost operation of organized markets.

  • How do out-of-market interventions intended to boost resource adequacy (e.g., subsidies for a new power plant or natural gas pipeline) affect wholesale electricity markets?

Interventions may boost resource adequacy in the short term, but generally undermine it in the long term. This occurs because actions that impact resource adequacy suppress market prices. This drives down the value of merchant investment in resource adequacy. If merchants believe market signals are strong enough to make such an investment, but are concerned that political intervention may undercut the value, then the threat of political intervention may cause them to forego the investment and compromise resource adequacy. At the least, it increases the risk of investment and raises investor costs. Thus, political discipline is essential to facilitate an investment climate where markets deliver low-cost resource adequacy.

 

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