Guest Commentary: Market flaws challenge energy policies

Vito Stagliano, Contributing Editor

The political consensus for restructuring the energy sector was premised on the widely accepted view that markets allocate resources more efficiently than do governments. In the last decade, structural changes in the U.S. energy sector have exposed flaws in each of the major energy markets. These market flaws constitute serious policy challenges for the Bush Administration that, if unresolved, will serve to undermine its policies on energy.

U.S. power markets

Restructuring of the electric industry has proven more complex and more costly than comparable efforts in other industries. The complexity is understandable, given the requirement of the power sector to balance its supply and demand functions instantaneously. Markets in the power sector, though in their infancy, show signs of fatal flaws in design, as in California’s experimentation with a model in which all energy was traded in the spot market and all hedging instruments were prohibited. More workable has been the market structure in the PJM Interconnection, which is among the most transparent in the nation, but does not quite rise to the level of a commodity market. Power markets, designed by grid operators and by regulators in conjunction with the organization of regional transmission organizations (RTOs), do not look promising, among other reasons because the geographic and operational scope of even the largest RTOs appears insufficient to ensure competition.

FERC should re-evaluate every aspect of power market evolution, including the delegation of responsibility for market design to the RTOs, the size and scope and functionality of all current markets, the linkage of market-based rates for energy to the competitiveness of the markets in which those rates apply, regulation of the markets beyond the monitoring functions that FERC provides, and the extent to which new policies could stimulate formation of multiple markets -physical and financial, spot, forward and future-to serve the power industry.

International petroleum market

Over 75 million barrels of oil are traded worldwide each day in the physical market and perhaps 10 times the volume in the derivative financial markets. These markets would be intensively competitive were it not for the role that OPEC plays in seeking to micromanage supply and demand balances, by fine tuning members’ production quotas. As the world’s marginal producer, and as supplier of over 30 million barrels/day, OPEC behavior is usually decisive in either oversupplying or undersupplying the market and creating price volatility.

Solutions to this problem are complex because OPEC’s behavior also serves the interests of non-OPEC market participants. All oil producers, public and private, benefit from OPEC-induced incremental rents. However, given the certainty of long-term and very significant U.S. reliance on imported oil, it should be U.S. policy to ensure a fully competitive international oil market.

U.S. gasoline market

U.S. demand for gasoline rose to the current 8.6 million barrels/day during a decade in which gasoline quality underwent a profound transformation. More than a dozen types of gasoline are now required to address winter and summer air quality problems in three dozen metropolitan areas. The reformulation of gasoline was induced by the Clean Air Act Amendments (CAAA) of 1990. EPA regulations to implement CAAA have had the effect of fragmenting what used to be a national market for gasoline into a multiplicity of local, economically unviable markets for customized reformulated products. As a consequence, the micro gasoline markets cannot be adequately supplied except at high cost.

EPA has it in its power to rationalize the gasoline market by undertaking a regulatory negotiation process with stakeholders in order to achieve a single national reformulated gasoline for summer use and a second one for winter use. A consensus on this very objective was nearly achieved during the last Bush administration. EPA should now re-animate the process and be motivated by the great stakes involved: a dramatic simplification of refinery operations and very substantial price relief for consumers.

Editor’s Note: EL&P welcomes Stagliano as a contributing editor. He served as DOE’s Deputy Assistant Secretary of Energy for Policy Analysis and is the author of A Policy of Discontent: The Making of a National Energy Policy (PennWell, 2001), a comprehensive analysis of 65 years of energy policy-making with an insider’s view of the four-year effort under the first Bush administration to craft the Energy Policy Act of 1992.

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