Electricity Markets

How wholesale markets affect retail rates

Every home, store, factory, office building, and hospital pays a regular bill for electricity. The cost of electricity that appears on the bill depends on a complex set of variables that are different across the country.

Electricity rates are set at a level to recover the utilities’ costs, including the cost to purchase or generate the electricity, the cost of delivering the power, and administrative costs.

One factor influencing the costs incurred by utilities, and thereby the retail rate customers pay, is the wholesale electricity market. The wholesale market is where utilities and alternative suppliers purchase electricity to supplement any power generated by utility-owned facilities. But the amount of power that utilities purchase from these markets can vary significantly. Some utilities purchase all of their customer load at wholesale, and others purchase power as a small supplement to their owned generation.

In regions covering about two-thirds of households in the United States, the wholesale electricity markets are centrally administered by regional transmission organizations or independent system operators (referred to collectively as RTOs). All RTOs operate energy markets that trade the electricity needed to meet demand.

Prices in the RTO markets need not be equal to the sellers’ costs. Sellers may offer to sell energy at a price above their actual costs. Moreover, the prices are established by the highest bid, which means all sellers submitting lower bids will receive that higher clearing price. That means wholesale costs might be greater in RTO regions, which is reflected in higher retail rates. This is especially true for areas where utilities purchase more power from the wholesale market.

Another factor influencing the markets is whether the utility is in a state that undertook retail restructuring. Retail restructuring affects investor-owned utilities (IOUs) and has generally not applied to public power and rural electric cooperative utilities.

IOUs outside of restructured states remain vertically integrated and continue to own generation. Almost all public power and cooperative utilities use some form of vertical integration, whether through generation ownership or bilateral contracts for electricity supply, to provide service to their end users. Some public power utilities and cooperatives own and operate their own generation and bulk transmission facilities, and others have banded together to form umbrella entities that build or purchase generation and transmission services for their customers (i.e., joint action agencies).

In the restructured states, some or all retail customers can choose their own energy supplier and do not have to purchase power from the utility. While a restructured utility still delivers the energy to the customer, the customer pays for the electricity from a separate company, known as an alternative retail supplier. These customers receive a bill that covers the IOU’s costs for the distribution of energy, metering, and billing of the customer, plus the generation charge paid to the alternative supplier. To avoid providing the IOU with a competitive advantage in the retail marketplace, states that undertook retail restructuring incented or required the IOUs to sell off their power plants. In these states, a significant share of power is provided by merchant generators whose profits are not regulated by the state utility commissions.

Within the RTOs, public power, restructured utilities, and alternative suppliers purchase power through bilateral contracts, with some remaining amount purchased directly from the RTO markets. In all retail access states but Texas, the restructured IOUs are still required to provide power to customers who do not buy electricity from an alternative supplier, known as provider of last resort or standard offer service. This service is typically provided through short-term contracts between the utility and power suppliers or brokers.

Contracts allow the utilities to lock in a price for a set period and minimize price volatility. But the prices of these contracts are likely to be influenced by current and projected RTO market prices, because sellers within RTO markets typically do not want to lock in a contract price below that which they expect to earn in the markets.

Therefore, customers of restructured utilities, which purchase a greater amount from the wholesale markets, end up paying rates that are more dependent on the wholesale costs. In 1997, the retail choice states had weighted average rates that were 2.3 cents per kilowatt-hour (kWh) higher than rates in the regulated states (8.1 cents vs. 5.8 cents). Two decades later, that gap has narrowed by only one-tenth of a cent (11.5 cents vs. 9.3 cents).