sealPurdue News

November 7, 2001

Electricity prices could rise if wholesale markets function poorly

WEST LAFAYETTE, Ind. – A new report cautions that a lack of sufficient competition in electricity wholesale markets could result in high prices during times of peak demand, when electricity is most scarce.

The price spikes could be an unintended consequence of a 1996 change in federal guidelines that allowed small, independent power producers to sell electricity to utilities, according to the report prepared for the Indiana Utility Regulatory Commission. The report was written by analysts at the State Utility Forecasting Group, a state-funded panel of researchers headed by Tom Sparrow, a professor of industrial engineering at Purdue University.

Sparrow will discuss the report at 9 a.m. Thursday (11/8) during the 2001 Indiana Energy Conference: Indiana's Energy Future in a Changing World. The conference will be at the University Place Conference Center at Indiana University-Purdue University in Indianapolis.

Before 1996, utilities purchased electricity strictly from other utility companies because federal regulations prohibited independent power producers from entering the wholesale market. But since that restriction was removed, many so-called "merchant plants" have been springing up in the Midwest and across the nation. In Indiana alone, six such plants have come online since the federal change and another 14 new plants have been proposed so far, Sparrow said.

Electricity from merchant plants is especially needed during the hottest summer months, as the power grid strains to meet energy demands, he said.

If enough of the producers that sell wholesale electricity to utilities merge in the near future, the result could be drastically higher peak-demand prices. That's because the fewer, merged companies that remain could, independently of each other, decide to withhold electricity during times of peak demand, increasing their own profits but causing the wholesale price of electricity to spike upward dramatically.

Withholding power to increase profits "was a sure factor in driving up prices" in California last winter, Sparrow said.

"There is no evidence that such withholding has taken place in the past in Midwest markets, nor is this report predicting that withholding will take place," he said. "However, it must be recognized that in open market situations when only a few competitors have power for sale, there is a strong economic incentive to withhold power, particularly when users have few options to avoid purchasing the electricity."

The report was written by forecasting group analysts Sparrow, Douglas Gotham, Forrest D. Holland, Zuwei Yu and David Nderitu. Its findings were made possible by a sophisticated price-forecasting system that uses a mathematical model developed by Yu and Nderitu. The model simulates the possible impact of power providers withholding electricity in a Midwestern region that includes Indiana, Illinois, Ohio, Michigan, Kentucky and portions of Wisconsin, Iowa, Pennsylvania, West Virginia, Maryland and Missouri.

The region currently has 28 power providers, which includes both large utilities and smaller independent merchant plants. If the number of providers shrank to eight due to mergers and other factors, the price of wholesale power would increase an average of 20 percent. But, reduce that 28 to only five providers, and the price of electricity would spike by 100 percent during times of highest demand, the analysts predicted.

Indiana has no authority to approve or deny corporate mergers of electricity providers. Such mergers must be approved by the Federal Energy Regulatory Commission and the Securities and Exchange Commission.

The report, "Factors Affecting Indiana Electricity Prices in Competitive Markets," also contains findings about three other issues:

• Whether changes brought about by the wholesale electricity market will cause an increase of "congestion" on the high-voltage lines that transmit electricity between power providers.

• How the addition of plants that generate low-cost energy will impact electricity prices during times of peak demand.

• How electricity conservation measures and strategies to reduce industrial usage during times of peak demand would impact electricity prices.

Analysts used models to study how changes in the transmission capacity – or the amount of power the lines can carry – will impact electricity prices.

The study focused on lines that carry electricity from one power provider to another, a system that was not designed for the wholesale market environment, said Gotham, associate director of the utility forecasting group.

"The development of the wholesale market means that, instead of the old way of doing business where the utility generated its own power and distributed it to its customers, there will be a lot of buying and selling between utilities or between a merchant plant and a utility, and that will cause more usage of the transmission system," Gotham said.

The increased electricity transmission could approach the transmission capacity limits, causing traffic jams in the system.

The congestion could cause prices to spike by restricting how many power providers can compete in the market just when the lowest-cost electricity is most needed, during times of peak demand. The report, however, found that Indiana is not particularly vulnerable to congestion because the state has adequate transmission lines and enough competition to keep prices from spiking.

The report also found that energy conservation and strategies to reduce electricity consumption during times of peak demand could have a significant impact on prices.

The forecasting group does not make recommendations. Its findings are used as a resource for policy-makers in state government. The studies are done in accordance with a state law enacted in 1985 to provide the Indiana Utility Regulatory Commission with an impartial projection of electricity consumption and peak demands.

The annual energy conference is sponsored by energy companies, government agencies and Indiana Industrial Energy Consumers Inc., a private group that is an advocate for industrial energy users. The conference keynote speaker will be Nora Mead Brownell, commissioner of the Federal Energy Regulatory Commission. Other speakers will include Anne E. Becker, who heads the Indiana Office of Utility Consumer Counselor; William D. McCarty, chairman of the Indiana Utility Regulatory Commission; State Rep. Craig Fry, D-Mishawaka; and state Sen. Thomas Weatherwax, R-Logansport.

People interested in attending the conference may call (317) 639-1210, or they may register on line. The cost is $175 per person or $75 for government employees.

A copy of the report is available on the Web.

Writer: Emil Venere, (765) 494-4709,

Sources: Tom Sparrow, (765) 494-7043,

Douglas Gotham, (765) 494-0851,

Mary Beth Fisher, IURC public information director, (317) 232-2297,

NOTE TO JOURNALISTS: A copy of the report is available online. A hard copy is available from Patricia Bridwell at the State Utility Forecasting Group, (765) 494-4223, Copies also are available from Mary Beth Fisher, public information director of the IURC, (317) 232-2297,

Related Web sites:
Indiana Industrial Energy Consumers Inc

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