Energy Markets are Broken

The warped incentive structure that drives utility decision making and energy market operations several limits progress in the energy industry. It's hard to make a case for innovative new products that will improve efficiency, drive down costs, or improve customer satisfaction when a utility can't directly profit from those benefits. Reading about how California has to pay Arizona to take excess power, pretty frequently, really makes one feel like energy markets aren't working right.

In May 2017, Greentech Media published an article titled "Why There's No Such Thing As a Free Market for Electricity" by Julia Pyper.  It was based on an essay by Travis Kavulla, vice chairman of the Montana Public Service Commission, in the Summer 2017 edition of American Affairs. As Julia summarizes, he argues that there is no such thing as a free market for electricity because, even where there are competitive features, the marketplace is warped by government intervention. Read Kavulla's essay in full here.  My key takeaways are outlined here. This industry faces huge challenges given the energy revolution underway. Is it possible to change the business model and the markets to allow us to move to an energy future that is flexible and renewable? Leave me a comment below with your view.

Understanding the North American Regulatory Structure

In order to sell to utilities, it's important to understand their motivations.  One of the main challenges is how utilities are compensated. As Kavulla explains, due to how regulated utilities in the United States earn a return, innovation is at odds with their corporate motivation. "Innovative products often make the old ways of doing things cheaper, reducing a utility’s capital spending and thus its regulated earnings. Innovation and the utility’s profit motive are frequently misaligned."

The other complicating factor is that how utilities are regulated and structured varies across the country. "Even experts in certain places, such as New England, profess that they cannot understand the market rules for the product’s trade in, say, California." What a challenge for any startup trying to enter the industry! Even if you could master the details of each regions regulatory structure, the fact that there are major differences means that a compelling business argument in one won't necessarily work in another. "In about half the country, utilities are still vertically integrated monopolies; they own the grid and everything else it intermediates. But in the other half of the country, the utilities are structured as poles-and-wires firms across whose physical architecture unfolds a complicated auction process where power plants compete with one another upstream and customers downstream have a choice of retail supplier."

Typically, it makes sense to at least try to understand the motivations of the retail arms of utilities, who are focused on selling kW and kWh to customers, separately from the distribution network groups, who are focused on the poles and wires, separately from the bulk power teams, who are focused on generation and transmission. Even in vertically integrated utilities, these teams still exist, though they are all under the same roof. Understanding how your product impacts each of these areas is key to making an argument for its adoption.

Deregulated markets are typically seen as opportunities for newer, innovative products because they are supposedly competitive. "In these restructured marketplaces that stretch from the Rust Belt to the Mid-Atlantic to New England, traditional utilities retain ownership of the grid but have turned over the keys of daily operational control to an Independent System Operator (ISO). Power plants submit bids to the ISO, which acts as the traffic controller of the grid and the auctioneer for a market in electricity, accepting enough bids to meet projected consumer demand, and thereupon issuing instructions to generators to start up, shut down, ramp up, or ramp down. The highest bid sets the market clearing price, which all generators are paid, except that higher-cost bids can leapfrog lower-cost ones when the transmission grid in an area of high consumer demand is unable to receive imports from elsewhere, in which case a higher price prevails in that congested area." Having an ISO in place seems like it would provide more opportunity, but they too are subject to extensive regulations and rules that prevent new products from participating in the market at all. "The tariffs that govern the competitive ISOs are approved by the Federal Energy Regulatory Commission (FERC), which has responsibility for wholesale energy trading. The tariffs governing “market” relations are enormously complex, spanning several times the length of the tariffs that govern the vertically integrated monopolies, whose charges are regulated by state utility commissions. Monopolistic command-and-control regulation is rather simple by contrast: a utility spends money on a power plant, and the regulator fixes a price intended to recover those costs. The regulator of competitive markets, on the other hand, first has to describe what product is to be traded in the auction. These include, depending on which market one is operating in, day-ahead energy, real-time energy, capacity, flexible ramping, regulation and frequency response, congestion and transmission rights. Then the regulator must define the auction: when, how, and by whom is the product traded." Unfortunately, this regulation of the "competitive" markets has made it difficult for DERs by not including them in the "products traded." Just recently issued, FERC 841 is an example of a new rule in this category intended to allow new products to be traded, in this case energy storage. 

Even in regions with competitive wholesale markets, "customer-facing retailers have the responsibility of sieving this auction process into something that does not completely bewilder customers. They passively take the auction results, or rely on financial traders to hedge for them, and vend more easy-to-understand products (a service with a nighttime and a daytime price, for instance) to their customers." The fact that consumers are shielded from the true costs of electricity makes it very difficult for them to be correctly compensated when they use electricity in such a way as to benefit the grid. While this "shielding" does have benefits to consumers, in terms of protection against high wholesale price spikes, for example, it fails to give consumers any insight to or understanding of what's really happening on the grid.

All that being said, it does seem to be the case that customers in de-regulated markets have more opportunity to take advantage of innovation. "Customers in the sort-of-competitive markets are being served more cheaply than are those in similarly situated markets that did not introduce competition. More and more customers seem to be shopping around for suppliers, where choices exist. Importantly, when innovation in the sector has occurred, those innovations appear to take hold more quickly."

How to Sell Innovation in a Broken Market

Innovators in the energy space need to pay attention to the regulatory environment and become experts in the rules and regulations of their chosen markets. Companies, and even startups, will benefit by engaging in the regulatory process as much as possible because the process can be influenced. Typically, for those with limited resources, it makes sense for small companies in the same area to band together to make their arguments to regulators. It helps to get to know your regulators and market design officials. They know the future of the grid and energy is changing and are often trying to figure out how best to move forward. Be one of the voices they hear from.

Of course, it would be nice if the regulatory structure itself changed, but that's a heavy lift. Kavulla recommends:

"Stop the pernicious trend of a utility requesting permission for virtually everything it does and, at the same time, withdraw some of the protections of their exclusive franchise. Does a customer or a neighborhood want to withdraw from the utility? Perhaps it is time to let them exit, but also to give the utility the right to cut a deal with those defectors and offer something better (whether cheaper or of greater value) than the price-regulated service ordained by utility commissions."


"Supporting competitive auctions—even if they are just “sort of” competitive—is an important tool to rationalize the way power plants are built and operated. These auctions are the only thing standing in the way of outright government selection of power resources, and the cronyism that that entails. "

Keep pushing.

Read Kavulla's full essay here.