America''s Next Nightmare: SMD by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 Reliable, low-cost electric energy makes the American economy go. It is the essential service, so necessary to modern life that its momentary absence defines a disaster. After every hurricane or earthquake, the critical question always is how many households are without power. Electric utilities used to be called public service companies because that is what they did — provided an essential public service. Enron, Enron wannabes, and Enron disciples at the Federal Energy Regulatory Commission (FERC) would turn this on its head. In their view, the public exists to serve the marketer, which turns out the lights if its economic demands are not met. In California, we had a contrived cataclysm of epic proportions: Tens of millions of California residents and businesses were threatened every day with rolling blackouts and service curtailments while Enron and other merchants of doom offered to avert disaster for payments at levels that plundered utility bank accounts and the state treasury. It was unconscionable. FERC stood by and watched while it happened. California’s cataclysm was made possible by an ill-considered experiment in deregulation that opened the door to the rapacious traders and merchant generators. California has now spent two years and billions of dollars trying to recover from that cataclysm. FERC’s Standard Market Design (SMD) obstructs California’s recovery effort by promoting an illegal and ill-considered federalization of retail service that would impose the worst features of the California experiment on the nation. It would bring Enron’s dream — and California’s nightmare — to America’s power business. FERC’s Illegal Plan For 70 years, the statutory division between state and federal jurisdiction in electricity regulation has been between retail and wholesale service. Federal regulation is devoted exclusively to wholesale electric service in interstate commerce, while the states regulate service both in interstate and intrastate commerce. FERC’s SMD proposal obliterates the line carefully drawn by Congress in the Federal Power Act. It usurps state authority to regulate retail service. While Congress may choose to give FERC such authority, it has not yet done so. In proposing SMD, FERC not only has exceeded its statutory authority but cannot implement its plan. During the years it will take the courts to confirm the invalidity of SMD, the entire industry — consumers, providers, investors, regulators, and pundits — will be mired in confusion rather than addressing real issues and problems. The Federal Power Act authorizes FERC to regulate wholesale electricity sales in interstate commerce and electricity transmission in interstate commerce. Congress has not authorized FERC to regulate electric generation facilities and facilities used to provide retail service, whether or not they are “in interstate commerce.” The United States Supreme Court confirmed this dichotomy in Connecticut Light and Power v. Federal Power Commission, 324 U.S. 515, 530 (1945): “Congress is acutely aware of the existence and vitality of these state governments. It sometimes is moved to respect state rights and local institutions even when some degree of efficiency of a federal plan is thereby sacrificed. Congress may think it expedient to avoid clashes between state and federal officials in administering an act such as we have here “Congress may think complete centralization of control of the electric industry likely to overtax administrative capacity of a federal commission. It may, too, think it wise to keep the hand of state regulatory bodies in this business, for the ‘insulated chambers of the states’ are still laboratories where many lessons in regulation may be learned by trial and error on a small scale without involving a whole national industry in every experiment.” Truer words have seldom been spoken. Proponents of deregulated electricity trading, like Enron, have been trying for years to ease the “bright line” between wholesale and retail regulation. They have consistently been rebuffed by Congress. State Jurisdiction In the 1992 Energy Policy Act, Congress added specific language to the Federal Power Act that reinforced state retail jurisdiction: “No order may be issued under this chapter which is inconsistent with any state law which governs the retail marketing areas of electric utilities.” This explicit restriction on FERC regulation is reinforced by an original Federal Power Act provision that denies FERC any ability to encroach upon the states’ reserved authority: “Federal regulation of the transmission of electric energy in interstate commerce and the sale of such energy at wholesale in interstate commerce is necessary in the public interest, such federal regulation, however, to extend only to those matters which are not subject to regulation by the states.” During March 2002, for the first time, the Supreme Court blurred slightly the wholesale-retail distinction by authorizing FERC to remedy discrimination in transmission service, including discrimination affecting retail transmission service, where a state had voluntarily “unbundled” transmission from energy supply for retail customers. The decisions of some states, such as California, Pennsylvania, and New York, to permit so-called “retail choice” of electric suppliers are examples of this unbundling. The court held that FERC had the authority under the Federal Power Act to issue its Order 888 regulating transmission in interstate commerce, including voluntarily unbundled retail transmission. The Supreme Court specifically rejected Enron’s argument that FERC should take control of the entire national grid to facilitate trading, whether or not a state had unbundled under state law. However, FERC has adopted Enron’s suggestion through the creation of an astonishing fiction that a utility “discriminates” whenever it uses its transmission systems to serve its own customers with its own power plants (i.e., provide “bundled” retail service), rather than serve wholesale generators. This astonishing notion, which flies directly in the face of the 1935 Federal Power Act and 1992 amendments, supplies the legal underpinnings for SMD. Ill-Considered A group of regulators representing 15 states recently signed an “Alliance Statement,” which opposed SMD and called on FERC to withdraw it. Specifically, the statement calls on FERC to: • Refrain from asserting jurisdiction over the transmission component of bundled retail sales. • Refrain from asserting jurisdiction over power supply planning functions. • Refrain from asserting jurisdiction over demand-response functions. • Refrain from imposing highly complex, untested market mechanisms throughout the nation. • Focus on improving the wholesale electricity market through monitoring and better enforcement. • Return to regional transmission system discussions. • Identify on a regional, cooperative basis, real (not theoretical) problems, and fashion practical, evidence-based solutions. • Before implementing any new programs or market designs, subject them to a rigorous cost-benefit-risk analysis that measures net benefits to consumers. The statement catalogs both what FERC is doing wrong and what FERC should be doing but is not. FERC is attempting to promote investment in electric transmission upgrades that have significant environmental and cost consequences. Congress has consistently withheld this authority from FERC, in clear contrast to its allowing FERC to regulate interstate gas pipelines. FERC is attempting to accomplish by indirection what it cannot do directly, by mandating the creation of regional transmission organizations (RTOs) that would have planning authority. FERC is also pushing a variety of devices to permit electricity day traders to use deception — such as “virtual bidding” of electricity they do not actually have — to confuse grid operators and make money. We have had a terrible experience with this type of deceptive behavior in California, but FERC would require it nationwide. Problems Ignored Equally important is what FERC is failing to do, particularly in the area of market manipulation and abuse. Since Spring 2002, when FERC proposed SMD, almost daily revelations are uncovered about the way gas and electricity marketers manipulated and abused California during the energy crisis. Sadly, it appears that in some instances FERC had information that it ignored or suppressed. FERC took action only when that evidence was publicly disclosed through other means. In April 2000, California parties complained that El Paso Natural Gas was using its market power to raise gas prices in California. In August 2002, 28 months and many billions of dollars later, FERC’s chief administrative law judge agreed. (At press time, the case was pending before the full commission.) In May 2000, fraudulent arrangements to illegally withhold electric supply were made between two FERC-regulated wholesale generators and marketers. California authorities informed FERC of this illegal conduct in February 2001. FERC settled the case and suppressed the information until it was disclosed in October 2002 in litigation between California agencies and one of the perpetrators. FERC has subsequently expanded the types of evidence it will consider in calculating refunds for California consumers, but it waited more than 18 months after receiving this evidence. In August 2002, FERC staff issued a report detailing reasons why certain natural gas price indexes that FERC had been using to calculate refunds were unreliable and vulnerable to manipulation. Since that time, the Commodity Future Trading Corporation (CFTC) has issued subpoena to gas traders, and a number of gas marketers have terminated employees for erroneous reporting that might have influenced the indexes and financial statements and skewed arrangements premised on the indexes. FERC has not even commented on these revelations, much less pursued them. “Horrific” Outcomes The deregulated wholesale market that FERC is promoting with SMD has serious problems, one of which continues to be FERC’s unwillingness or inability to police deceptive and fraudulent behavior. Instead of pushing SMD, FERC should rein in the cowboys in those wholesale markets for which FERC clearly has responsibility. Deregulation’s consequences for consumers have been horrific. The consequences for investors and employees have been equally horrific. The intellectual bankruptcy of FERC’s approach is best understood in the actual bankruptcies, valueless stock, and business collapses of the electric and gas traders. An innkeeper in Greek mythology had a bed that fit every traveler — those who were too tall had their heads and feet chopped off; those who were too short were pounded with an iron club and stretched out to fill the dimensions. FERC’s one-size-fits-all SMD is a “bed of Procrustes” that would ruin the American economy. Instead of allowing FERC to strap each state into that bed, we should try to solve real problems and make real improvements both in federal regulation of wholesale services and in state regulation of retail services. As the alliance statement from state regulators concludes: “There may well be problems to solve and improvements to be made both in federal regulation of wholesale services and in state regulation of retail services. We are convinced that consumers will benefit if both the Commission and the states focus on identifying and solving real problems, whether through RTOs or other means. “But the Commission’s unprecedented and aggressive jurisdictional reach, which shifts the ground rules and undermines trust at many levels, disrupts useful aspects of the process and the ability to make informed decisions. “We urge the Commission to recognize the limits of its own reach and respect the partnership it must forge with the states, and to withdraw the proposed rulemaking.” FERC should withdraw SMD and return to the voluntary, incremental approach to regional development that has served the nation well for almost 70 years. The last five years of deregulation are a nightmare that we should never dream again. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.