Thomas Walkom
The Star
April 1, 2001

CALGARY – When Alberta first announced it would open up its electricity system to the free market, Harry Irving was thrilled.

Irving’s family-owned Foothills Steel Foundry makes steel castings for the gravel crushing industry. Under the province’s decades-old regulatory system, the Calgary manufacturer paid between $15,000 and $20,000 a month for power. Competition in the electricity industry, he figured, would surely lower his costs.

“I’d be the first one to say deregulation should work,” Irving says.

Now, huddled over his computer screen in the early morning gloom, he is decidedly less enthusiastic.

Since Jan. 1, when Premier Ralph Klein’s Tory government officially threw open the province to free-market electricity, Foothills’ power rates have quadrupled. Irving has laid off half of his production workers and put the rest on a four-day week.

To take advantage of cheaper night rates, he and his entire staff now work the graveyard shift. They go to work at 11 p.m.; they clock out sometime after 7 a.m.

“It’s a different world,” he says. “I call it the dark ages.”

Most nights, he spends glued to a computer watching the price of electricity dip and surge at the whims of the market. So volatile is this price that it can triple within the space of a few minutes.

If it does jump dramatically, Irving has less than an hour to shut his entire plant down or face ruinous losses.

One night, the price suddenly leapt wildly. “I sent everyone home, but even then we didn’t get off fast enough.”

Harry Irving’s story is repeated throughout Alberta. In Lethbridge, John Davies, vice-president of Lethbridge Iron Works Co. Ltd., tells of leaving his computer screen briefly one night to take a quick shower. When he returned, the price had doubled.

“The regulatory system wasn’t perfect,” Davies tells a reporter. “But it sure looks good compared to what we’ve got today.”

Unlike Ontario, Alberta has always had a mixed, public-private electricity system.

Three large firms – two private, one a municipal utility owned by the City of Edmonton – dominated the generating field, each operating as a regulated, local monopoly.

As in Ontario, the regulated price charged to consumers was based on the actual cost of producing, transmitting and distributing power.

And, as in Ontario, the regulatory system worked. Alberta’s electricity prices were among the lowest on the continent.

In fact, Alberta even had one leg up on Ontario. Having never invested in nuclear plants, its generators were not burdened with the billions in debt that Ontario Hydro has incurred.

In hindsight, says Dan Macnamara, the old regulatory regime was nirvana.

Macnamara looks ever so slightly rueful when he says this. He is executive director of the Industrial Consumers and Cogenerators Association of Alberta, a big-business lobby that was the prime mover behind electricity deregulation.

“It proves what they always say,” he says over lunch. “You should be careful what you wish for.”

In the mid-’90s, Alberta big business was wishing for a free market in electricity.

New technology had made it easier to build smaller generating turbines. Petrochemical, forestry and big manufacturing firms found they could generate power cheaply themselves.

These firms didn’t just want to supply their own electricity through this so-called cogeneration process. They wanted to be able to sell any excess to someone else.

By 1995, the industrial consumers association – made up of 30 giant firms which use half of Alberta’s electricity and represent some of most powerful economic interests in the province – was pushing the Klein government hard to deregulate.

“We didn’t like the regulatory environment,” says Macnamara. “We thought it gave too much to the generators.”

At the same time, other forces were at play. Southern Albertan businesses resented a government policy requiring electricity to be sold at the same price throughout the province. Power was cheaper to produce in the south. Businesses in Calgary and Lethbridge didn’t see why they should subsidize their competitors in Edmonton.

As for the private utilities, they saw the writing on the wall. Deregulation seemed inevitable. Even British Columbia’s New Democratic Party government was talking of going to a competitive electricity market.

“We didn’t think regulation was going to last forever,” explains Dick Way, vice-president for TransAlta Utilities Corp. which, under regulation, had been one of the province’s big three generating firms.

“It was a matter of helping it to end in away that was not damaging to us.”

In 1995, the government announced it would take the plunge. Business and consumers would be given six years to prepare for the new world of electricity competition. D-Day would be Jan 1, 2001.

Now, six years later, many of the same business interests that first promoted electricity deregulation say it has been a disaster.

“The current mess just isn’t sustainable,” sighs Macnamara, digging into his pizza. He says two of his association’s members (he won’t say which) have quietly shifted production out of Alberta.

In Taber near Lethbridge, the Lamb Weston french-fry plant has put a $50 million expansion plan on hold, citing high electricity prices.

“Look,” Macnamara says, putting down his fork. “My members will be all right. They’ve got ways to protect themselves. What the government doesn’t realize though is that in the end, the people who really will be screwed are the small residential, industrial and commercial customers. . . .

“If you’re not going to get to a competitive environment, it is absolutely insane to deregulate. People forget why we regulated in the first place.”

But isn’t it just that Alberta screwed up its move to the free market? Can’t a deregulated electricity system be designed which will produce competition and lower prices?.

Macnamara ponders the question. “I’m not aware of any electricity market in the world that’s working,” he says finally.

In theory, Alberta’s deregulation scheme plan should have worked. It resembles the one Ontario plans to introduce later this year. In fact, on paper it looks better.

As in Ontario, the hallmarks of Alberta’s market opening were competition and choice. Ontario’s scheme requires Ontario Hydro to sell or lease two-thirds of its generating capacity within 10 years. Alberta’s plan required the three big generators to sell off, not their plants, but the output from those plants – for periods ranging up to 20 years.

The idea was that those who bought this output would compete with one another to produce a low basic electricity price.

Middlemen would then buy this electricity and compete with one another to provide final consumers, residential and business, with the cheapest possible power.

As in Ontario, consumers would be able to sign long-term, fixed-rate contracts for their power. Those who didn’t would, as in Ontario, pay the spot market price.

This spot price would be not be set by government regulators but by the impersonal forces of supply and demand operating through the Alberta Power Pool (the equivalent of California’s now-disbanded Power Exchange and Ontario’s Independent Market Operator).

Those who controlled the output from generating plants would offer electricity to the pool, indicating how much they were willing to sell and at what price. Utilities and other large consumers seeking to buy electricity would make bids, indicating how much power they wanted and how much they were willing to pay.

When bids and offers were matched up, the theory went, a single price would emerge – one satisfactory to both sellers and buyers. This was the spot price, the key to the whole system. Even those selling power through long-term contracts would take their cue from the spot market

There was, however, one big difference between Alberta’s scheme and Ontario’s. In Alberta, residential and small business rates were to remain capped for up to five years after the market opened to competition. In Ontario, there are to be no formal caps on prices.

To market purists, Klein’s decision to cap electricity rates for the majority of the population represented a loss of nerve.

In the end, though, it probably saved him from a humiliating political defeat.

By Jan. 1, as Alberta formally opened up its electricity system to market forces, almost nothing had worked out as planned.

Under regulation, three firms dominated the province’s supply of power. Under deregulation, the number had barely nudged up – to five.

These five, including the municipal utilities of Calgary and Edmonton, bought most of their power through a government-run auction last August, paying about four cents a kilowatt-hour.

Now they are selling this same electricity through the power pool at anywhere from eight to 25 cents a kilowatt-hour.

Similarly, Alberta’s promised retail competition has not materialized. Edmonton Power, now called EPCOR, controls the northern half of the province, Calgary’s public utility, ENMAX Corp., controls the south.

Like Toronto Hydro, both EPCOR and ENMAX are municipally-owned. Like Toronto Hydro, both have taken their provincial government’s advice to heart.

In the world of electricity deregulation, they are as hard-nosed, secretive and profit-driven as their private-sector counterparts.

Last December, as Harry Irving prepared to meet the Jan. 1 deadline for market opening, he was desperate. Since 1996, the power pool had been listing a kind of shadow price for electricity – the price consumers would have to pay if there were no regulation.

By December that shadow price was high and rising. Even the government was forced to admit that power prices would skyrocket once the market regime was instituted.

The utilities feared they would be caught in a California-style squeeze, forced to buy high but required – because of the residential rate caps – to sell low. To appease the utilities, Klein increased the regulated rate cap for residential and small business consumers. Their electricity prices would now almost double.

But to appease voters on the eve of a provincial election, he also announced $2.3 billion in temporary subsidies to these same residential and small business consumers.

The result: most voters will not see their electricity bills rise significantly until the end of this year.

Thanks to the subsidies, Klein easily weathered the election. Most voters were like the Premier himself who, in the final days of the campaign, acknowledged that he didn’t “know a damned thing about generating electricity.”

All that most Albertans knew was that, in the end, their rates were stable.

“I don’t really know if (deregulation) is a good idea,” Calgarian Peter Tworow told a reporter who knocked on his door during the campaign. “It probably is. I mean government shouldn’t really be involved in the free market, should it?”

Among residential consumers, Tworow’s comment was typical.

However, medium-sized businesses like Harry Irving’s Foothills were not as sanguine. Their electricity rates were not protected by either caps or subsidies.

Under regulation, Irving had been paying ENMAX 5.6 cents a kilowatt-hour for power. In late fall, the Calgary utility offered him a one-year contract, at more than triple the old price. EPCOR, the only other major retailer in Alberta refused to offer him anything.

Suddenly, in early December, ENMAX pulled its offer from the table. It was no longer interested in across-the-board, long-term contracts.

“Our (long-term) offerings are now limited,” Kevin Willerton, ENMAX’ director of market development, explained later to The Star. “We now only offer these contracts to certain customers.”

Irving stills buys his power from ENMAX. But the price he pays is set by the power pool spot market and is well above 18 cents.

Bill Pastoor, whose Big M factory in Lethbridge makes plastic bags for supermarkets, is in a similar situation.

“When the government first announced electricity deregulation, I never thought about it, . . .” he says.

“I thought it would be like when they deregulated the telephone, with Telus, Sprint and AT&T falling all over each other to get our business.”

Instead, he was faced with only one electricity supplier: ENMAX. The company offered Pastoor a one-year contract at roughly triple what he was paying. EPCOR offered nothing.

In December, ENMAX abruptly pulled its offer from the table. Like Harry Irving in Calgary, Pastoor is now at the mercy of the spot market.

Pastoor says he competes with manufacturers from British Columbia and Manitoba, where – thanks to regulation – power prices are still cheap. He has already lost two plastic bag contracts and fears he will lose more.

Would he like to go back to the old regulated system?

“You bet,” he says.

Supporters of market opening argue that Alberta – like California – simply blew it.

Both these jurisdictions, free market supporters say, didn’t have sufficient reserves of generating capacity when they deregulated.

The fact that prices went through the roof, they argue, reflected shortages and the high cost – particularly with natural gas prices up – of producing power.

“The conditions in Ontario, including the way the market is being set up, are quite different from California and Alberta,” Dave Goulding, president of Ontario’s Independent Market Operator, told the Toronto Board of Trade recently.

“(In Ontario) I expect to see far more stability in prices.”

In particular, Goulding noted that Ontario has plenty of excess generating supply.

However, so did Alberta and California when they first embarked on the road to deregulation. California had access to about 30 per cent more electricity than it used. Alberta had a 35 per cent cushion.

Ontario’s power reserves, according to Pat McNeil, a vice-president of Ontario Power Generation (one of Ontario Hydro’s successor companies and the main generator in the province) are now only about 15 per cent.

But even that figure is optimistic, says Tom Adams, head of the public interest group Energy Probe and until recently one of the directors of the Independent Market Operator.

“No one can say with any kind of certainty that something like Alberta won’t happen here,” Adams says.

There is one glaring similarity between the two provinces. Like Ontario today, Alberta before deregulation had some of the lowest electricity generating prices in North America, roughly four cents a kilowatt hour.

The market price in Alberta now is between double and six times that.

Severin Borenstein is director of the University of California’s Energy Institute. Like many economists, he is sympathetic to the idea of deregulation. His scholarly articles on the subject have been published by the Washington-based Cato Institute, a rightish organization devoted to market principles.

But Borenstein says he is less confident about deregulating electricity. The problem with electricity, he says, is that it isn’t a commodity like any other.

Unlike grain, it cannot be easily stored. Moreover, demand and supply must always be in exact equilibrium. Send too much power down the lines and everything may blow out. Send too little and the system may collapse.

Equally troubling, Borenstein notes in his paper “The Trouble with Electricity Markets,” is that electricity has unusual economic characteristics. Both supply and demand are inflexible. An economist would call them inelastic.

What this means is simple: No matter how much the price of electricity goes up, neither the quantity demanded nor the quantity supplied varies much.

Demand is inelastic because, to most people, electricity is a necessity. Even if the price of power rises, most Torontonians will still have to run their furnace motors in winter.

Supply is relatively inelastic because it takes years to build a new generating plant.

The result is that electricity markets are more vulnerable than most to manipulation by suppliers. Economists call it exercising market power. In the industry, it’s called gaming.

According to experts, gaming is a characteristic of every deregulated electricity market. Any generators that don’t game, write Borenstein and fellow University of California academic James Bushnell, are doing so “out of the goodness of their hearts and against the interest of their shareholders.”

In California, the Independent System Operator, the government-appointed body charged with overseeing the electrical system, concluded last week that gaming has cost the state a stunning $5.5-billion (U.S.) over the past 10 months.

That figure, the report says, represents the excess profits generators who have been able to manipulate the electricity market have extracted from consumers and utilities.

In Alberta, the government’s former market surveillance administrator, Howard Ward, suggested that the same kind of manipulation may have occurred there.

“The circumstances or level of market maturity may be such that the essential elements for workable competition are not there,” Ward wrote last October.

(Tom Cumming, Alberta’s current market surveillance administrator, says he is working on rules to curb the improper use of gaming, if it indeed exists).

While some, including Klein, have argued that high electricity prices in California and Alberta are solely attributable to rising natural gas prices, evidence shows otherwise.

In California, a government report issued last August pointed out that natural gas prices did rise 200 per cent in the first few months of last year. But over the same period, electricity prices jumped 700 per cent.

Alberta’s Ward made much the same point in October. “The fundamentals (rising gas prices) do not of themselves explain the price levels experienced,” he wrote.

Indeed, according to the Industrial Association of Southern Alberta, so weak is the correlation between natural gas and electricity prices that, at times, they move in different directions: power prices can rise even as gas prices decline.

If gaming is endemic to deregulated electricity markets, can it be controlled by encouraging more competition? Not necessarily, says economist Borenstein. He says gaming happens even when deregulated electricity markets aren’t dominated by a handful of players.

Nor is collusion required. All that’s needed is for one significant generator to suddenly shut down one turbine – allegedly for unscheduled repairs.

If the market is already tight, as it is in California and Alberta – and as it may be in Ontario – this reduction in supply can send prices shooting up astronomically.

The gaming generator will then be able to make super profits on the units it has left in service, so much so that the extra money it makes will more than compensate for any revenue it has lost by shutting down the one turbine.

Best of all, it is virtually impossible to catch gaming. Who can question a generator that says it has to shut down for maintenance?.

And even if gaming is detected, it isn’t illegal. In a free market, no one is compelled to sell electricity. If a seller can make more by creating artificial shortages, what’s wrong with that? It’s free enterprise.

“Businesses are going to do what businesses are going to do,” sighs Dan Macnamara of Alberta’s industrial power consumers association.

There is one area, though, where the competitive market works exactly as predicted.

Under most regulated systems, including those of Alberta, Ontario and California, electricity costs were based on the average cost of production.

If Ontario Hydro used a mix of low-cost hydro plants, medium-cost nuclear plants and high-cost natural gas plants to generate power, the price the regulator would allow it to charge consumers would be based on an average of all three.

Under a competitive market model, however, price is set by the so-called marginal cost – the cost of producing the last unit of power brought on line.

In the world of theoretical economics, this would make no difference. Average and marginal costs are equal. But, as Borenstein points out, in the real world of electricity, this equivalence rarely holds. Marginal cost – and hence the price charged – can be either higher or lower than average cost.

When this price is below average cost, Borenstein says, the utilities will complain, threaten bankruptcy and demand to be bailed out by government.

But when it is above, the utilities will reap super profits.

Even without gaming, this is what is happening in Alberta. Utilities are producing the vast bulk of their power in low-cost hydro and coal-fired plants.

But they are able to sell all of this cheap power at the price determined by the province’s small number of high-cost natural gas plants.

Why? Because those are the rules of the marketplace. That’s the way it works