The thrust of the anti-ISO argument rests on two flawed and interrelated
propositions: (1) that, incentivized by the profit motive and market-based
transmission pricing, transcos will necessarily be more efficient than
not-for-profit ISOs1 and (2) that ISOs are little more than surrogates
for self-interested stakeholders and thus not capable of neutral administration.2

Problems of the Market

ISOs are not organized for profit but instead address vertical and horizontal
market power problems in the electric industry while, in certain instances,
also coordinating a spot market in wholesale power. In the words of one
commentator, “Without regional ISOs, the performance of wholesale markets
will be plagued by a combination of self-dealing and suspicions of self-dealing
between owners of transmission lines and their generating, distributing,
and power marketing affiliates.”3 Vertically integrated utilities that
control transmission can favor their interests in generation, resulting
in abuses of native load preference and manipulation of posted available
transmission capacity. They may also exercise horizontal market power
through rate pancaking and high transaction costs.

For-profit transcos, it is argued, can cope with these problems better
than ISOs since, as owners, they are alleged to have “the incentive to
increase overall use of the transmission system, whether through upgrades,
new facilities, or operating efficiencies.”4 By contrast, ISOs, which
exercise control over transmission assets without ownership, “must rely
on the transmission owners to make any necessary investment in new transmission
facilities.”5 Transco advocates also argue that transcos are better able
to take advantage of performance-based transmission pricing.6 Transco
proponents thus enshrine “the profit motive as the main engine of the
success of free enterprise”7 and claim that not-for-profit entities have
no place in transmission, “a private business that requires large expenditures
and risk-taking.”8

Real-World Results

To their critics, however, for-profit transcos are monopoly enterprises
that own essential facilities and have a fiduciary obligation to maximize
profits for shareholders, whether or not maximization will result in least-cost
solutions to transmission and generation requirements.9 Notwithstanding
transco advocacy, such concerns have prefigured regulatory decisions,
measured by filings at FERC. Consider, as a prime example, FERC’s order
late last year conditionally “approving” the Alliance Companies’ application
for a for-profit transco.10 Although case-specific, the order addresses
nearly intractable problems that will affect any transco application.

The Alliance Companies contemplate formation of two companies, Alliance
Publico and Alliance Transco. Alliance Publico, a registered public utility
holding company with publicly traded shares and a board of directors unaffiliated
with the Alliance Companies, would be the managing member of Alliance
Transco, to which members of the Alliance11 could transfer high voltage
transmission facilities. To address implicit control issues, no Alliance
Company would own more than 5 percent of Alliance Transco’s stock.

Pinpointing structural inadequacies in the Alliance Companies’ scheme,
FERC found:

• Alliance Transco fails Order No. 888’s independence standard because
  the Alliance Companies could control it through stock ownership of
  Alliance Publico and thus veto the addition of new members or facilities.
  In addition, Alliance Transco’s ostensibly independent board would
  owe fiduciary duties to the Alliance Companies as owners.12

• Alliance Transco fails Order No. 888’s financial interest standard
  because Alliance Publico’s directors, officers, and employees “may
  perceive career-preserving value in protecting or preferring the interests
  of [the Alliance Company] stockholders over other market participants.”13

• Alliance Transco fails Order No. 888’s non-discriminatory single-system
  tariff standard because it perpetuates rate pancaking and continues
  a “preference for the transmission owners’ generation resources.”14

• Alliance Transco fails Order No. 888’s relief of system constraints
  standard because it cannot facilitate re-dispatch for new service
  given the lack of generator obligations to submit bids, coupled with
  pancaked rates.15

• Alliance Transco fails Order No. 888’s efficient management and administration
  standard because it is under “no prohibition or limitation on …
  contracting with market participants.”16

• Alliance Transco fails Order No. 888’s pricing policies for transmission
  and ancillary services, both as to rate formulas and non-rate terms
  and conditions.17

FERC’s conditional “approval” thus proves, on closer reading, to represent
a massive rejection.18 In view of the transco-ISO debate, FERC’s rejection
is all the more interesting because coupled with a suggestion that the
applicants form or join a regional transmission organization satisfying
the scope and configuration requirements of the Final Rule, i.e., that
the Alliance Companies’ transmission facilities be run by an ISO. FERC
suggests, for example, that “Alliance, Midwest ISO, and PJM could negotiate
procedures and rate treatments that would eliminate the toll-gate aspect
of Alliance’s configuration, deal with loop flow issues, and eliminate
concerns about reliability impairment …”19 FERC’s suggestion speaks
volumes about the relative positions of ISOs and transcos in today’s industry.

As FERC’s Final Rule recognizes, electricity is a network industry. Efficient
transmission embraces more than electric throughput. It is instead a complex
service with substantial network interactions.20 In the words of one observer,
“[t]he network consists of subcontractors, vendors and competitors, emerging
standards for exchanges, the technical infrastructure of commerce, and
the web of consumers and clients.”21 In a network industry the focus of
an individual firm necessarily shifts from maximizing the firm’s value
to maximizing the network’s value. The transmission provider’s profit
motive does not necessarily drive the network. Efficient market design
does.22

Seen generically, any network is an expanding web of relationships regulated
by standards.23 FERC’s Final Order confirms this as to the transmission
network and seeks to codify the standards necessary to maximize its efficiency.
In doing so, FERC has properly focused on optimum development of the network
itself rather than profitability of the transmission provider. To this
end, it is ISOs, not transcos, that have emerged as network facilitators
by enhancing access, promoting short-term spot markets, defining a workable
system of transmission rights and thereby encouraging opportunity and
innovation.

Governance and Structure

Such considerations still do not persuade ISOs’ institutional critics,
who contend that “a nonprofit ISO will make its decisions by counting
the votes of heterogeneous interests whose numbers are apportioned on
non-economic criteria.”24 This assertion – which totally discounts several
ISOs’ independent, non-stakeholder boards – assumes governance by shifting
coalition, where the “winning policy is more likely to depend on its value
to the coalition rather than its value to the group as a whole.”25

Linked to this argument is the conclusion – factually groundless – that
the ISO is a more likely transmission monopolist than the for-profit transco
“since regulation may be unable to reach or even estimate the profits
earned by non-utilities that succeed in bending policy to favor themselves.”26

One example of such alleged policy distortion concerns expansion of the
grid. As a “collectively-governed non-profit entity” operating a grid
of independently owned systems, an ISO is presumed to “face problems in
inducing [transmission] investment” since “[i]ncumbent generation owners
and others may have incentives to foreclose or delay the new construction,
and the votes to carry the day with the ISO.”27 In short, its principal
critics view the ISO as a political institution, dominated by interests
that will “impede competition, shift costs, and operate inefficiently.”28

PJM: The Little Engine that Could

The most effective response to such theoretical critical assaults is
the ISO track record to date, particularly PJM’s.29

As the nation’s most fully realized and successful ISO, PJM is a limited
liability company with an independent, non-stakeholder board of managers.
PJM’s board members are not affiliated with or controlled by market participants,
whether generation interests or transmission owners; its non-stakeholder
board therefore makes unbiased decisions that address the market as a
whole. The PJM Board has demonstrated its independence by taking unilateral
action to interpret and amend the PJM Tariff, for example by proposing
to add a market monitoring plan without market participants’ support.

The PJM board’s primary fiduciary duty is to maintain a safe and reliable
system; operate competitive and nondiscriminatory markets; and ensure
that no member or group of members exercises undue influence.30 Unlike
a for-profit transco’s corporate board, which must answer first to shareholders,
the PJM Board adheres to a public interest standard, whatever the commercial
interests of its members. Stakeholder concerns are channeled to the PJM
Board through members’ advisory committees, which have input into but
cannot dictate a decisional outcome.

PJM makes scheduling, re-dispatch and maintenance decisions independent
of members’ commercial interests; is the sole administrator of its open
access tariff; has implemented a queue system to handle interconnection
of additional generation; and has clear authority to direct transmission
owners to construct upgrades or additional facilities if necessary to
accommodate such generation interconnections.31 PJM’s reliance on locational
marginal pricing eliminates any requirement to negotiate and manage re-dispatch
with its generator members on a bilateral basis.

PJM also monitors energy markets to assure non-discrimination and efficiency.
It is uniquely able, in FERC’s words, to “develop or receive information
on quantities of bulk power and transmission services bought and sold
by different market participants, expected and real transmission system
conditions, planned maintenance of both generation and transmission facilities
and anticipated and real time patterns of load and generation.”32

In addition, PJM administers both a spot market and bilateral schedules;
maintains reliability through economic dispatch; offers a balancing service;
and has implemented a system of tradeable fixed transmission rights as
a means of hedging congestion costs. PJM thus promotes the long-run competitiveness
of the marketplace but does not seek to maximize either its own profitability
as ISO or that of any market participant. PJM also has primary responsibility
for transmission planning in the PJM control area and is free to solve
transmission constraints by building additional transmission or interconnecting
new generation.

None of the foregoing remotely suggests that PJM is a captive of its
members or that its decisions are political compromises, worked out to
serve a coalition of interests. Nor is there a shred of fact to support
the contention that PJM would be more efficient if its ISO functions were
driven by a profit motive. On the contrary, PJM qua ISO is the precise
institutional expression of disinterested and efficient operational authority
in a dynamic networked electricity market.

The Essential Banana

In his comments on FERC’s notice of proposed rulemaking leading to its
Final Rule, Professor Hogan refers to complex network interactions in
the electric grid that presuppose the existence of an entity, as system
operator, able to provide certain critical coordinating services. With
due deference to politicization of the ISO/transco debate and Alfred Kahn’s
nomenclature, Professor Hogan calls that entity a banana.33

To provide the required services,

• The banana must maintain a continuous aggregate balance of production
  and consumption within the limits of the transmission system. To achieve
  reliability, the banana must coordinate and monitor spinning reserve
  and reactive support. When the transmission system is constrained,
  the banana must arrange economic (i.e., least cost) re-dispatch, subject
  to applicable security constraints.

• The banana must apply marginal cost prices for power provided through
  the dispatch, thus determining the locational marginal costs of additional
  power and providing the foundation for a non-discriminatory transmission
  tariff.

• The banana must offer the coordinated balancing market on a voluntary
  basis, allowing market participants to choose whether or not to respond
  to the operator’s economic dispatch or to find similar services elsewhere.

In providing these services, the banana must run the balancing market
as a bid-based, security-constrained economic dispatch with voluntary
participation by generators and loads. Prices in the system must reflect
the marginal cost of meeting load at each location. Whatever its organizational
form or name, the banana must serve as system operator and perform its
functions consistent with the public interest in a competitive market.

Conclusion

Whether the banana is called an ISO or a transco, therefore, it must
perform minimum indicated tasks. The mere establishment of a for-profit
transco will not “dispense with the difficulties of evaluating the pricing
and access rules for transmission and system operations.”34 Nor will for-profit
status ensure short-term reliability, which turns instead on such factors
as the efficacy of market rules and authority of the system operator to
arrange energy transfers during emergency conditions. Like ISOs, for-profit
transcos will have no choice but to serve network requirements. It is
naive to suppose that the profit incentive will liberate transco management
from these requirements or accord it comparative advantage in meeting
them. To the contrary a transco that fits the Hogan criteria may end up
looking a lot like today’s ISOs.

It is ISOs, not transcos, that have emerged as regional transmission
organizations in today’s interconnected, unbundled and market-based environment.
As the Alliance order shows, for-profit transcos cannot readily do so
without satisfying an array of conceptual, regulatory and organizational
concerns. Despite imperfections and regional variations, ISOs embed a
consistent market design for operation of the grid. The Final Rule has
further articulated that design, and there can be little doubt as to FERC’s
chosen instrument for its implementation.

Footnotes

1 See, e.g., Michaels, op. cit. at 233-34; Hebert, “The Quest for an
Inventive Utility Regulatory Agenda,” 19 Energy L. J. 1 (1998); Angle
and Cannon, “Independent Transmission Companies: The For-Profit Alternative
in Competitive Electric Markets,” 19 Energy Law Journal 229 (1998); ComEd
Petition, passim.

2 Michaels, op. cit. at 233-34.

3 Pierce, “Why FERC Must Mandate Efficiently Structured Regional ISOs
– Now!,” The Electricity Journal, January/February 1999, p. 50.

4 Angle and Cannon, op cit. at 266. See also Final Rule (mimeo. p. 125)
and ComEd Petition (Attachment 1), which contemplates operating performance
incentives, congestion management incentives and expansion incentives.

5 Angle and Cannon, op. cit. at 264.

6 Hebert, op. cit. at 9; ComEd Petition (Attachment 1).

7 Hebert, op. cit. at 9.

8 Ibid.

9 See, e.g., National Association of State Utility Consumer Advocates’
Comments on Regional Transmission Organizations Notice of Proposed Rulemaking
filed in FERC Docket No. RM99-2-000 on August 26, 1999 (mimeo, p. 19)(“Faced
with the alternative of interconnecting new generation (which the for-profit
Transco does not own) to remedy transmission constraint problems, or the
prospect of either constructing new transmission assets on which the for-profit
Transco would earn a return, or reaping additional transmission revenues
through monopoly pricing of transmission services, the for-profit Transco’s
financial self-interest will prefer the most profitable outcome even if
such outcome is not justified from an economic efficiency or societal
cost standpoint. If the for-profit Transco is the RTO, decisions based
on self-interest factors rather than economic efficiency and public interest
factors could cost ratepayers significantly more than would be the case
if the RTO was not controlled by such self-interested parties.”)

10 See FERC Order on Proposed Disposition and Related Rate Filing issued
December 20, 1999 in Docket No. ER99-3144-000 and EC99-80-000 (hereafter
“Alliance Order”).

11 The Alliance Companies are: American Electric Power Service Corporation,
Consumers Energy Company, Detroit Edison Company, FirstEnergy Corp. and
Virginia Electric and Power Company.

12 Alliance Order (mimeo, pp. 11-12).

13 Alliance Order (mimeo, p. 14).

14 Alliance Order (mimeo, p. 18).

15 Alliance Order (mimeo, pp. 24-25).

16 Alliance Order (mimeo, p. 26).

17 Alliance Order (mimeo, p. 27).

18 On January 19, 2000 the Alliance Companies filed requests for rehearing
and clarification in Docket No. ER99-3144-01 et al. and on February 17,
2000 submitted a compliance filing in response to FERC’s initial Alliance
Order. The compliance filing was not deemed persuasive. FERC continued
to view the Alliance Companies’ proposed transco as flawed, because it
failed to embody FERC’s ISO principles with respect to independence and
governance; financial interests; pancaked rates and rate design; scope
and configuration; open access transmission tariff provisions; and operational
requirements. Specifically, FERC found that the filing did not remedy
the pancaked rate structure rejected initially in the Alliance Order;
did not comply with FERC’s independence standards as to governance; did
not address FERC’s concerns regarding exercise of voting interests in
the Alliance transco; did not modify the initial proposal to require that
withdrawal of transmission facilities from the Alliance ISO would require
FERC pre-approval; did not adequately limit the ability of the Alliance
companies to contract with market participants, including transmission
owners; did not improve the Alliance transco’s scope and configuration
or develop specific proposals to manage “seams” issues; and permitted
the Alliance Companies to exercise discretion in requiring generators
that interconnect with the Alliance transco to bid to provide redispatch
service. On the most central and crucial issue, FERC determined that the
“Alliance Companies have not adequately addressed independence issues,
which they must before we will issue a final ruling on their proposal.”
Alliance Companies, 91 FERC, paragraph 61,152 (May 18, 2000), (mimeo,
p. 24).

19 Alliance Order (mimeo, p. 32).

20 See William W. Hogan, FERC Policy on Regional Transmission Organizations:
Comments in Response to the Notice of Proposed Rulemaking, filed at FERC
in Docket No. RM99-2-000 on August 16, 1999 (mimeo at pp. 15-16) (hereafter
“Hogan Comments”).

21 Kelly, New Rules for the New Economy (1998), p. 66.

22 Hogan Comments (mimeo at p. iv).

23 Kelly, op. cit. at p. 72.

24 Michaels, op. cit. at p. 242.

25 Id. at p. 253.

26 Id. at p. 256.

27 Id. at pp. 258-59.

28 Id. at pp. p. 261.

29 See Comments of PJM Interconnection L.L.C. filed at FERC in Docket
No. RM99-2-000 on August 16, 1999 (hereafter “PJM Comments”).

30 PJM Comments, p. 32.

31 Id. at p. 65.

32 Id. at p. 71.

33 Hogan Comments, pp.3-8, passim.

34 Hogan Comments, p. 15.