By Jan Carr
Merging an organization that is mandated to ensure there is adequate investment in generation – OPA – with one charged with ensuring generators compete – IESO – raises concerns about conflicts of interest. From the perspective of basic market dynamics, new investment in supply is inherently counter to the interests of existing suppliers. But from the perspective of customers, inadequate investment leads ultimately to lower reliability and higher prices.
Both the IESO and the OPA have mandates to balance short-term price and long-term reliability but their mandates are based on different philosophies which must be reconciled for a successful merger. Under the IESO’s mandate, the balance is achieved through market forces where the higher prices resulting from inadequate supply incent the necessary new investment – short-term pain for long-term gain.
But the OPA was put in place precisely because this balancing mechanism was not working. Specifically, the sudden freezing of market prices in November 2002 due to a few months of high prices (and a new and confusing billing format) destroyed investor confidence that market forces would be allowed to work. OPA’s original mandate revolved around price being set through suppliers competing for the opportunity to sign long-term off-take contracts which provided more certainty on prices.
Along with parallel functions of smoothing prices paid by consumers and measuring adequacy based on central planning, the OPA mandate seeks long-term gain without short-term pain – the antithesis of IESO’s mandated mechanism.
With their merger into the OESO as proposed in Bill 75, it is clear that these two mandates have the ability to collide head on. Alternatively, a new mandate could be structured which is better than the sum of the two parts. After all, it is becoming clear to many that in their purest forms, neither competition nor central planning is a panacea for getting electricity “right”.
In the 1990s double digit rate increases and spiraling debt caused Ontario to abandon central planning and Ontario Hydro as a publicly owned monopoly in favour of open competition. However, the pendulum swung back a few years later as impending supply shortfalls and the lack of conservation and renewable energy responses from market forces resulted in the formation of OPA with its mandates for central planning and managed procurements.
There are parallels in other jurisdictions. Having recognized that an open and competitive market without long range planning is driving generation to a gas-fired monoculture, the UK is introducing OPA-like measures to ensure that new nuclear generation gets built. At the same time, many US markets have become progressively less market-like with the growing adoption of rules which allow the market operator to restate or override competitive bids and offers.
So before we all spend too much effort on ensuring separation of church and state within OESO, perhaps we should reflect on exactly what we want from a competitive marketplace and therefore exactly what internal walls and shared courtyards are needed. For example, it is not clear that the preservation of the existing IESO market should be the highest priority. For all its sins, nobody ever accused Ontario Hydro of dispatching the system in an uneconomic manner yet the focus on virtually all our market design and implementation efforts to date has been around optimizing dispatch.
The criticism of Ontario Hydro was that it was making poor investment decisions. The investment program was dominated by ever larger generating stations with their corresponding longer lead times which resulted in rising commercial risks. In contrast, advances in gas turbine technology driven by the burgeoning commercial aviation sector had created smaller scale, faster in-service generation options that were being overlooked. At the same time, capital markets had become more sophisticated and allowed investors to hedge risks that a century earlier, at Ontario Hydro’s birth, could only be taken under monopoly protection. Opening up Ontario electricity to competition promised more benefit from improved capital allocation than it did from improved dispatch.
This is not to be dismissive of the need for competition in real-time – the dispatch market – because it can facilitate the longer-term competition that lies above it in the broader marketplace. But separation of functions within a new OESO is surely the least of Ontario’s challenges to the efficacy of real-time markets and efficient dispatch. The current IESO administered market is after all stumbling toward irrelevance under assault from administered priority dispatch rights of renewable generation and the price discovery deadweight of the Global Adjustment. The bigger challenge to real-time markets and efficient dispatch in Bill 75 is not the merger to form OESO but the further entrenching of government’s micromanagement through directives.
So how might we take advantage of the new thinking around a new OESO to deliver the really substantive benefits available to society from competition in electricity? The general direction would seem to be in building robust forward markets that move the competition away from a centralized real-time market and toward a greater reliance on decentralized buying and selling of longer term contracts. A marketplace concerned more with the next 60 months than the next 60 minutes.
A forward market requires buyers interested in hedging their future risks. Of course, any market requires buyers as well as sellers but our focus on the real-time spot market clouds this simple fact because buyers are essentially automatically looked after by the IESO’s short-term operational forecasts. Buyers in the real-time market are passive price takers and make no commitment to buy even though it is known with certainty that they will consume and pay the bill. A forward market simply takes that certainty and turns it into a buying commitment with a binding commercial contract against which investment in new generation can be committed. Under such a market, investment in new generation occurs without customers taking investment risk – see “Debt Retirement Charge”.
A forward market does not imply that each individual household or industrial customer must be active in the market. In a robust forward market, various intermediaries aggregate the requirements of individual customers and turn them into significant forward positions against which new investment in generation can be made. For example, coordinated action by OESO and OEB could leverage the buying power of the RPP load to build a forward market.
Instead of OEB forecasting the cost of RPP in the real-time market and setting RPP rates to cover that cost, OESO could actually purchase the requirements ahead of time and the procurement cost would dictate the RPP rates. (OPA’s original mandate is not confined to buying electricity from new generators in order to incent investment but allows for buying in the open market in and beyond Ontario.) This need not be an all-or-nothing arrangement and in fact it would be necessary to start by purchasing, say, 10% of total RPP needs so that the RPP price would be a blend of 90% forecast real-time pricing and 10% actual forward costs. In fact, it will be necessary to gradually grow the proportion of RPP purchased forward to stay in step with the willingness of generators willing to sell forward.
Of course, this is really just a proposal to allow OESO to operate as a “load serving entity” (LSE) – an entity that takes commercial responsibility for meeting the electricity needs of passive electricity customers. In most jurisdictions this role is filled by either the distribution utility (e.g. Québec, British Columbia) or an appointed retailer (e.g. Alberta, UK). Since Ontario has no provision for appointing retailers and has a large number of relatively smaller LDCs, each with correspondingly limited financial and energy management resources, the standard LSE arrangement is not commercially practical. Should the panel currently studying rationalization of the LDC sector recommend moving to a few large distributors, the new LDCs would have scale and financial resources sufficient to be LSEs. In time, they could displace OESO’s role in supporting forward market evolution by buying in the wholesale marketplace on behalf of RPP customers.
What is needed is feeding just enough buying requests to attract sellers but not so much or so little that prices are too far depressed or elevated. This is a balancing act where the measure of success is how well the public interest is served in managing risk and the cost of that management. That such an arrangement could be made to work is demonstrated by Bruce Power’s recent initiative of offering contracts that include the Global Adjustment, as would be the case for RPP.
One of the values of a combining IESO and OPA into OESO will be the enhanced ability to manage the progressive development of a forward market by keeping the buy and sell sides in reasonable balance. Even if both OPA and IESO favour such an initiative, their separate mandates and governance structures require consensus to move forward. While the IESO and OPA might agree on the ultimate objective, their different mandates create differences in the immediate steps each see as necessary to begin the journey. OESO’s single mandate, one board of directors and a unified senior management team will facilitate progress.
Jan Carr is one of the leading authorities on Ontario’s electricity system. He has worked on power issues as a private consultant, as a regulator and as a public official, including as a member of the Macdonald Committee which first recommended restructuring Ontario's electricity system. He was the first CEO of the OPA and is currently a board member of the Alberta Electric System Operator.