What is wrong with the Wholesale Electricity Spot Market?

by Dean de la Paz, as originally posted at What is wrong with the Wholesale Electricity Spot Market? at the Philippine Online Chronicles/Blog Watch Channel

 

When we last looked at the raging controversy over the recent power generation tariff increases that electricity distributor Manila Electric Company (Meralco) is compelled to include in their billing statements we discovered some of the substantial causes for the inordinate hike as well as at least one arena where tariffs went through the roof. While the usual critics and anti-capitalist rhetoric have centered on Meralco and the independent power producers (IPPs), blaring as loud an accusation as an indictment of criminal collusion and cartelized pricing, Malaca?ang, through Presidential Communications Group head Sec. Herminio Coloma says that the increase was simply the result of economics and the laws that govern supply and demand.

He is right. It is about economics. But it may also be the inordinate application of the concepts of economics, specially in the choice of pricing models. With all due respect to the usual dyed-in-the-wool critics of Meralco and those who constantly hallucinate and imagine conspiracy theories under every rock as they turn to their cliché default and, in chorus, cry market abuse and collusion, we believe Sec. Coloma is squarely spot on. This is a question of economics and in discussing the issue we will, every so often along the way, invoke what economic concepts are operant.

First, the over-reaching and omnipresent law of scarcity which founds the economic objective to optimally allocate limited resources.

With respect to collusion, while that would explain most of the unexplainable, it is unnecessary in the scale many suspect. The Meralco franchise area is a limited marketplace afflicted with dangerously thin reserves, whether spinning or those requiring black starts, serviced as it is by a mere handful of often decrepit yet large base load capacity power generators. One of the most modern and state-of-the-art that feeds the franchise area is a medium-sized plant vintage 1980’s. That’s about as modern as it gets. It’s engines and boilers are way past useful lives, not to mention normal contractual obligations.While we are confident that the plant’s latest owners have retooled the vintage plant, its cumulative mileage is well over its depreciable accounting life.

Not only is supply scarce and fed from decrepit plants, some, for one reason or another, don’t even work. For instance, in the run-up to the recent price increase, a major yet aging thermal base load plant owned and operated by the state and managed by a twice-questionable government agency created by that poorly-crafted and failed Electric Power Industry Reform Act (EPIRA) mysteriously failed to dispatch as much as 650 megawatts of critical capacity.

Where such capacities are deliberately denied in a large market already fatally afflicted and under-supplied then a cartelized conspiracy among generators is not necessary to drive distributors, often in desperation, to the clutches of the marginally-priced WESM.

Before we proceed, just so we do not get our wires crossed and electrocute everyone, let us define that often-misconceived word “marginal”. In economics, marginal does not refer to “less”, “small”, or any of the usual connotations attached to the idea of diminution. Marginal means “incremental”, or “added”. When used to refer to the pricing activity, marginal pricing refers to the values charged for an “incremental” or added quantity. Thus a marginal price can either be high or low depending on a slew of factors. One is cost. If the quantity is small, a typical application of the supply and demand laws would imply that prices would naturally be high, specially where economies of scale exist and costs cannot be allocated over larger quantities. Thus prices rise relatively. More so when demand is similarly high.

It would be good to hold that thought for later use as we return to the concept of scarcity where quantities, or, as these are referred to in the energy industry, “capacities”, are sorely limited.

When even one engine of a base load power plant goes offline, the gap created is so large that it would take several smaller plants running at maximum if only to avoid a calamitous cascade tripping of the whole grid. Already we see the law of economic scarcity operating at its worst.

In fact, the generating environment within the Meralco franchise area is so volatile that cartelization is not necessary to create an undersupply. Any medium-sized plant generating 650 megawatts (MW) that goes offline when the Malampaya fueled-plants are operating on higher cost oils, diesels and petroleum condensates is enough to compel a distributor to fill demand peaks from available albeit marginally-priced capacities offered at the state-operated Wholesale Electricity Spot Market (WESM).

Let us then look closer at the WESM and see what economic concepts operate there that force an increase in power rates.

The first is the economic  principle of “low hanging fruits” where the cheaper fueled energy sources should not only be the more abundant and thus fill the WESM pool proportionately, but, as the principle implies, these will also be the first to go, dispatched or be picked as the allegory goes. Conceptually similar to the laws of diminishing returns and diminishing utilities, one aspect of these is the economies of scale that operate when quantity is abundant, diminishing relative returns or utility in the longer run as quantity depletes.

On a relative basis, ceteris paribus, the costs for the few fruits remaining on the higher branches would effectively be more expensive as scales decrease and quantities fall as the lower hanging fruits are picked first.

In other words, cheaper sourced fuel from the base load plants, once offered at the WESM, will enjoy dispatch priority, and as base load supply, they would be relatively cheaper. If the market’s capacities were adequate and where most power suppliers offered inexpensive energy, WESM would lead to lower rates.

Another critical condition would be the pricing mechanism where costs are substantially similar in a homogenous supplier’s market. Pricing based on weighted average costs, even where invoices are allocated individually, would be low and reasonable. Unfortunately, some generators have the most expensive oil fuel-fired, small capacity marine generators. So, if they wielded political power and influence when EPIRA was being written, they would have advocated for marginal pricing.

As WESM rules compel a strange “must-offer-lest-you-won’t-be-dispatched” supply in the WESM pool even where some bidders are contractually committed via bilateral contracts, employing a marginal pricing system, these enter as price setters at peak trading hours. Their astronomically ludicrous high bids become WESM’s pivotal clearing price – one eventually shared by all and benefiting even low-cost bidders offering base load capacities.

Bilateral pricing negotiated outside WESM should stay away from WESM. Should they enter and there act as pivotal price-setters then they infect the WESM. But since the marginal pricing model at WESM favors the last-minute, last kilowatt, small-capacity Php 62.00 ++/kWh  (the previous high was Php 63.00/kWh) high-priced bidder and everyone else at the lower branches of this poisoned tree, all that is needed is a situation that forces Meralco to purchase at the WESM.

Not dispatching a state-owned 650 megawatt plant would do it.

As small expensive generators are the last queued to fill unsatisfied demand, according to a London School of Economics colleague, players can game the market where “the game is to make room so they all come in” and, eventually, all and sundry earn a windfall.

And where the electric power industry is a small and overly cozy town populated by intimate bosom buddies who had worked together during the heyday of the independent power producers and the notorious take-or-pay PPAs (power purchase agreements), it only takes a duo to tango and bloat electricity tariffs.

Dean dela Paz is an investment banker. He is a consultant in the fields of finance and banking and has packaged some of the most prolific public offerings in the Exchanges. He is a member of the Executive Committee and sits in the Board of one of the oldest financial institutions in the country. He is likewise an energy consultant having served on the Boards of several foreign-owned independent power producers and as CEO of a local energy provider.

He is currently the Program Director for Finance in a UK-based educational institution where he also teaches Finance, Business Policy and Strategic Management. A business columnist for the last fifteen years, he first wrote for BusinessWorld under the late-Raul Locsin and then as a regular columnist for the Business Mirror and GMANews TV. He also co-authored a book and policy paper on energy toolkits for a Washington- based non-government organization. He likewise co-authored and edited a book on management.

Screencap from wesm.ph . Some rights reserved.