Physical Demands of the System: Is Electricity Different?
Proponents of electricity markets point to gains from restructuring in the airline industry, trucking, telecommunications and natural gas to support their cause [Malloy 2005], but electricity has several characteristics that make it stand out. Since electricity cannot be stored, demand must match production at any given moment in a manner that keeps voltage and frequency stable across the whole network [Joskow 2003a; Sioshansi and Hamlin 2004]. Sprawling transmission networks help achieve this task by providing scale over which to smooth supply and demand; network congestion reduces the efficiency of the network at performing this role. Moreover, the AC transmission network is like a gigantic commons, in which bilateral contracts between two parties can introduce externalities through loop flow effects [Joskow 2003a; Van Doren and Taylor 2004]. The balancing task is further complicated by slow supply responsiveness because generation capacity has a long lag time, and low system elasticity of demand because consumers tend not to be price responsive. Congestion in transmission networks can shrink the geographic scope for competition, exacerbating the problem of matching demand to supply. For several of these reasons, system reliability requires provision of "ancillary services" and complementary, and complex, markets for these services [Joskow 2003a; Lave, Apt, and Blumsack 2004].
On the generation end, the capacity mix matters to how electricity markets work. For example, in hydropower based systems, reservoir discharge along a river has to be coordinated to maximize production, which may result in dispatch quite inconsistent from the demands of market competition.
In brief, electricity systems are machine like in their nature. Under vertical integration, coordination is achieved through direct control, while electricity markets have to indirectly ensure technical coordination through economic relationships. Commenting on this challenge, U.S. deregulation guru Alfred Kahn, has observed "I am worried about the uniqueness of the electricity markets. I've always been uncertain about eliminating vertical integration. It may be one industry in which it works well" [quoted in Kahn 2001].