The boon and the bane of modern existence, markets have come under a lot of criticism lately. It’s painfully clear that even after a decade in which the markets appeared healthy and in which countries around the world took pro-market approaches to governance, the free operation of market systems has been powerless to prevent a major international recession.
Although markets were not the cause of the problem, the political philosophies that put market forces at the top of their priority list are clearly on the defensive and a wave of new regulation is expected. This should not be seen as a setback for markets in principle, and market mechanisms remain a big part of the solution to the current economic problems.
Given that the power sector is being affected by the economic turmoil, what lessons can be learned from the events of the last year, and what can the industry do to avoid similar messes in the future? It will almost certainly be necessary to move beyond the simple headlines of “too much regulation” vs. “not enough regulation” to determine which processes are actually working and which are allowing mismanagement and inefficiency to proliferate.
The traditional philosophies of politics are becoming less and less relevant. In the public debate one often hears allegations that the market is heartless, or that the single-minded pursuit of efficiency is used as a license to run roughshod over the needs of the vulnerable. These critiques almost always confuse the market system with political philosophies that stress the importance of markets. In fact, it is the market system that has allowed the creation of many of the social benefits that modern society takes for granted. The most successful economies in the world today seem to be those that are led by governments not caught up in the dogma of either extreme: They take the best of both worlds, being business-friendly and looking after the less fortunate. Such pragmatic governments frequently use the two commitments to reinforce one another. To hand out money, you need to make it first, and to make money, you need to look after your people. It may not be convenient as dogma but it’s becoming increasingly widespread in governance.
The common factor in almost all economic history is that markets have proven to be an essential underpinning to any kind of social development. Some markets are less perfect and some could be better managed, but there can be few doubts that markets are a fundamental part of modern life, and will be so for nearly every country in the world for the foreseeable future. The most relevant political debates are primarily about how to define the mandate and scope of market regulation, not whether markets are good or bad. And despite numerous aberrations, the overall direction of history is the reduction of central administration, and a gradual transition towards markets operating in more realms, rather than fewer. Such a statement does not mean that every pro-market initiative is sound, or excuse the market-related behaviours that contributed to the credit crisis, but it does mean that the market is more like the messenger than the source of the problem.
President Barack Obama, who has more reason and more power than anyone to limit the operation of markets in the near future, used his inauguration address to reinforce the universality of markets: “Nor is the question before us whether the market is a force for good or ill. Its power to generate wealth and expand freedom is unmatched, but this crisis has reminded us that without a watchful eye, the market can spin out of control.”
Amory Lovins, the renowned energy expert from the Rocky Mountain Institute, has eloquently summarized a realistic view of markets in his oft-quoted statement that “Markets are a good tool, but they are not a good master. And they are a lousy religion.” There are many day-to-day operations that are so effectively mediated by markets that to consider any other system of organization would be madness - consumer products being a good example. But it would be equally mad to think that markets could somehow dictate social policy, or set the mandate of the regulators that oversee them.
In fact, it is only at the most superficial layer of political discussion that choices appear to be as simple as the ideologues would suggest, as in someone being pro or anti-market, for example. In reality, and even in most political realms, once the speeches are over, the realistic choices focus on the nature and scope of regulation, and making markets work better, not whether markets should be expanded or cut back. For Canada in particular, despite a widespread sense that the approach to regulation needs fundamental review, changes made in response to the financial crisis could be very subtle, consisting mainly of technical rules and an expectation that there will be more care taken when issuing political directives to regulatory agencies. Markets are responsible for the great majority of the wealth and success of modern society, and although not a panacea, they are for all practical purposes indispensable.
The generation industry in Ontario has been positive about the wholesale power market, and has generally supported principled and cautious proposals to extend the reach of market forces in the sector. But it hasn’t been a walk in the park. To many in the Canadian power industry over the last ten years, assisting with market development has seemed like a labour of love, as so much of what is necessary to build and operate a power business has more to do with the intricacies of centralized administration than with markets. But the effort to gradually move to more comprehensive and more efficient markets in the power sector continues nonetheless, bolstered by the belief that as markets in the power sector grow, they will be able to demonstrate their value more and more convincingly over time.
It is this faith that time will prove the wisdom of the market system that has allowed generators to tolerate the many rules and regulations that complicate their work and reduce their returns. Although the wholesale market in Ontario has many admirable features, a raft of technical rules has the effect of suppressing price and reducing market efficiency. Such rules have had much the same effect since the market began. For example:
• Imports are over-scheduled from a cost perspective, and they are not factored into the wholesale energy price. Both the over-scheduling and the under-pricing lead to unnecessary inefficiencies in the market.
• Peak rather than average figures are used for the demand forecast in pre-dispatch, also leading to over-scheduling in advance and market inefficiency.
• The 3x ramp rate adjustment artificially suppresses price without commensurate compensation to generators. As many readers will know, it was for exactly for these reasons that the ramp rate adjustment was reduced from 12 to 3 times in 2007 after IESO stakeholdering, an OEB hearing and a court challenge.
• Ignoring the physical restrictions of the transmission system when determining price tends to present an unrealistically low reflection of market prices.
• As the volume of intermittent wind energy increases, the energy price is reduced as this energy is in effect placed at the bottom of the supply stack as it has no incremental energy cost. Thus the more wind that generates, the lower the energy price, while the additional revenue paid to the wind energy producers must be recovered through the Global Adjustment.
• A wide variety of wholesale services that consumers pay for through uplift charges, rather than being factored into energy prices, have the effect of making the commodity appear less expensive than it actually is.
• Setting an artificially low rate of return for OPG, less than the standard commercial rate of return. While this low “allowed” rate of return doesn’t prohibit OPG from achieving a higher return (by either producing in excess of forecast or by reducing its costs) it is indicative of the price suppression theme that appears to exist within the industry.
• The absence of any requirement to retire accumulated debt on a fixed schedule also reduces the apparent cost of power by postponing the timeline for recognizing legacy costs. Total stranded debt from the Ontario Hydro era has declined very slowly in the ten years since it was identified, with billions continuing to be held on the books of the Ontario Electricity Financing Corporation that are not recognized in prices.
The market price is insufficient to support new investment in power generation in Ontario. This has been acknowledged implicitly by the establishment of the OPA’s procurement programs for new generation, and explicitly by studies released last year. (See “Market revenue insufficient to support new investment, study finds,” IPPSO FACTO, March 2008.) Price-setting in Ontario, a key part of market processes, is clearly not achieving everything it could be expected to do in a more efficient market.
In Ontario, the IESO, the OEB and the regulatory system in general have reflected the view that the market should generally be allowed to operate without interference in the electricity sector, as long as reliability and environmental requirements are met. If there are social inequities that must be reduced, they are best addressed outside the power sector, with wealth transfers or similar, and as a matter of public policy. This view has been reviewed and reinforced through numerous stakeholder processes, and even in the courts as the 3X ramp rate decision was tested legally in 2007. In all cases it was concluded that the efficiency of the market should be the primary consideration in whether to change or maintain a market rule.
This circumstance, while seemingly modest in its impact, has a powerful effect on the investment climate. As years go by and the system demonstrates that through a wide range of efforts to remake rules and regulations, the same basic principles respecting the integrity of market processes are faithfully applied, investors take comfort in that, and start to view the sector as a safer place to put long term money.
Whatever else may ail the Ontario power sector, it has one solid force working in its favour: a regulatory system that has demonstrated over time a highly consistent approach to fostering open market processes. Such diligence, while almost invisible to most, builds the all-important factor of investor confidence. In case anyone doubts its significance, please note that’s the same investor confidence that recently went missing on Wall Street and led to the financial crisis.
It’s the maintenance of this kind of confidence that generators had in mind as they reviewed the January 2009 decision of the IESO to continue with the current system of using peak rather than average for pre-dispatch forecasts. (See “IESO nixes average forecast,” page 13.) Certainly, a decision to allow more accurate and efficient market signals to operate would have caused some short term price increases for Ontario consumers. But according to the IESO’s research, the change would have led to a more efficient market, likely with fewer imports and lesser uplift charges in future. Was this decision taken merely to protect consumers at the expense of the market as a whole? Make no mistake: The generation industry understands that the IESO has to consider non-market factors when it makes policy decisions. The concern in generator circles is whether its decisions are in danger of becoming politicized, captive to the most powerful interest group, and moving away from the consistent focus on market efficiency that has made them so dependable, and a source of confidence in the past. If that confidence begins to be frittered away through concessions to a squeaky wheel here or there, it may be very hard to win the confidence back, and there will be a lot more to squeak about in the years to come.
Ontario’s power industry, like most other sectors, operates under a combination of market forces and regulated systems. In principle, that’s not surprising or likely to change anytime soon. However, when one looks closer it’s apparent that the balance between market-driven processes and central administration varies from year to year, and oscillates almost as unpredictably as a stock market index. This kind of unpredictability is not necessary. It interferes with investment plans, and does nothing to improve accountability to the public.
The power sector and the rest of the economy, if they are to work efficiently, have an important need: To know with reasonable certainty the nature and scope of regulatory intervention that’s going to impact the viability of their investments. It’s a relatively simple prescription for improving the investment climate, and is by no means an obstruction to further regulation. Indeed, financing can be found for investment in heavily regulated markets. However, there is a universal aversion to putting money into a sector if it’s unclear if the whole system of oversight could be easily shaken up and basic principles upon which investments are based, left in the dust. A big part of the prescription for economic health in the sector is therefore a reinforced commitment to continuity of principles, including market principles, in the regulatory sphere.
The management and regulation of markets will probably absorb more and more of policy makers’ and the public’s attention. Like any powerful tool, the market should be respected, studied, and handled with great care. Although society should never let markets set the overall direction of public policy, allowing markets to assess value and mediate complex tradeoffs is not only the most efficient, but ultimately the fairest way to go.
— Jake Brooks, Editor