Electric system reliability is a political necessity. The reverberations from
California’s rolling black-outs have stalled the trend towards generation market
deregulation, which seemed so inevitable just two years ago. The seismic waves
even threaten to cause states which have initiated deregulation to reverse that
process. After California’s recent experience, the many investment opportunities
that were created by the utility industry deregulation are now in jeopardy.

Most of the North American electric industrybusiness opportunities depend upon
continuing the process of electric generation deregulation, and a trend toward
stability and predictability in the electric markets. State legislatures and
Congress need to facilitate such market deregulation with legislation. However,
they also need to exercise discipline by keeping their hands off the competitive
markets and let them work efficiently.

Unless public policies are adopted which ensure that electric reliability will
co-exist with competitive markets, competitive markets will be the political
victims. This article discusses a policy initiative which would allow electric
system reliability and substantially unfettered competition in the generation
market to cohabit. Policy answers to this reliability issue will be necessary
to sustain, for the long run, the restructured industry’s investment opportunities.
Supply equals demand in a competitive market equilibrium. This is the formula
for an efficient market mechanism, but is it also the formula for an unreliable
electric energy market?

When supply just equals an electric market’s coincident peak demand, there is
no room for error in the marketplace. If the coincident market peak demand exceeds
projections, or if generating plants are not available, electric shortage results.
Such events are absolutely likely to occur, and in a large, regionally interconnected
electric grid, it is difficult to isolate the effect of electric shortage just
to the piggies who build their houses out of twigs or straw. The voltage drops
that occur when use exceeds supply at a material level affects the entire grid.
Saving the grid from rolling blackouts has more to do with controlling loads
than it does with the firmness of service contracted for the retail providers.

Reliability Based on System Reserves

In each of the state jurisdictions regulating electric utilities and in the
nation’s several reliability councils, this problem was solved by requiring
firm, system electric generating supply reserves ranging from 15 to 20 percent
above the forecast, coincident, non-interruptible demand peak for the portion
of the electric grid served by each retail electricity supplier. The cost for
this reserve capacity — which, if maintained, reduced the risk of actual
shortage to a near zero probability — was borne as an insurance premium
against interruption in the rates paid by retail customers. Through paternalistic
regulation, electric shortage became a theoretical, latent risk.

Reliability an Externality

As the nation came to count on and even expect excess generating capacity,
the political dynamic in some jurisdictions began to focus on the relative cost
of electricity — and, of course, carrying reserve capacity to insure against
shortage exerts upward pressure on costs. When the political world (and the
regulatory world under its thumb), began to take the excess generating capacity
of the 1990s for granted, the standard short political attention span turned
to its normal inquiry, “What have you done for me lately?” The answer to that
question in a number of states (at least New York, California, Massachusetts,
Illinois, Pennsylvania — not insignificant jurisdictions) was disproportionately
high rates in a generation market with excessive system reserves. Supply exceeded
demand, and prices were high.
Unlocking that generation market — which was no longer an apparent natural
monopoly — to competition seemed the logical and all-too-simple answer.
Competition is efficient. It drives the market to the cheapest marginal cost
solutions. It equates supply and demand … it equates supply and demand … it
equates supply and demand. …

Equating supply and demand is a double-edged sword. It removes the latency of
electric shortage and creates a shortage risk that is allocated by the marketplace.
The participants in the marketplace operate in an interconnected electric grid.
The piggies build separate houses of brick, twigs and straw, with each to his
own fate. But in the interconnected electric grid, the piggies build a condominium,
and the piggy using straw would build the foundation. Decisions by separate
consumers cannot necessarily be insulated from having a collateral affect on
other consumers served by that grid — an externality of the competitive
generation market, in economic parlance.

So, is reliability an externality to the competitive market? If it is, even
Adam Smith might urge its regulation. But can you regulate the system reserves
without ruining the efficiency of the marketplace? Following is a proposal to
deal with system reserves as a market externality by assuring its existence
extrinsic to the generation supply provided by the competitive market. These
system reserves are assumed to be the necessary bedrock of reliability. The
need to keep the system reserves outside the supply that is perceived to exist
in the competitive marketplace is driven by the efficiency of the market’s ability
to equate its perceived supply with demand. Perceived capacity in excess of
demand will beg the reserve supplies to be sold, possibly twice (if they are
available to the market). Suppliers will gamble with shortage, and the market
will be left with economic sanctions — and economic sanctions cannot be
delivered at 120 or 220 volts.

Utility Regulation’s Darwinian Evolution

What many legislators seem to have forgotten is that utility regulation evolved
in a Darwinian manner, adjusting to cope with the Great Depression, World War
driven shortages, runaway inflation, and the constant specter of political tinkering
in response to populist or Wall Street pressures. The regulation evolved to
compensate for the famous populist, Huey “the Kingfish” Long, who ruled the
Louisiana utility regulation from the Governor’s mansion — and also to
avoid the machinations of Wall Street illustrated by the likes of Insul.

In this evolution, utility commissions became quasi-judicial bodies subject
to restraints on ex parte communications and staffed by civil servants. Politicians
grew wary of “tampering” with utility regulatory commissions, based on the flak
they might get from civil servants for political meddling — and out of
their recognition that the decisions they made were mostly political no-wins.
The three “R’s” — rates, reliability and (financial) ratings — all
had to be balanced, and politicians were better off taking neither credit nor
blame for the outcome.
That was the situation until 1995. Then, blinded to the risks of tinkering with
excess electric generating capacity, and seduced by the political pressure to
reduce high electric rates (or otherwise punish the unpopular utilities), legislatures
and political leaders in California and elsewhere jumped into the utility regulation
pool. The changes they made demonstrated the short institutional memory of legislatures
and their short institutional planning horizon. Having legislatures rewrite
utility regulation in one term is like handing a platinum credit card to a teenager
— instant gratification wins out over long-term planning.

The legislatures forgot why certain provisions in the regulatory schemes had
existed at all. For instance, purchased power adjustment clauses or periodic
rate cases are important financial pressure release valves. When they are eliminated,
financial explosions can occur (i.e., PG&E’s bankruptcy).

Basic Changes of Incentives

The old regime rewarded investors only for building so-called “rate-based”
generation, transmission and distribution assets — so the equity owners
had incentives to build reliability-enhancing assets. Utility regulatory commissions
were charged with ensuring adequate service, but spent as much time ensuring
that utilities did not overbuild or unnecessarily gild the reliability lily.
When legislatures changed the regulatory game from rate-based returns to performance-based
rates, the owner’s incentives were turned upside down — but the regulatory
process was not ready to become the police force for adequate electric supply
and electricity service reliability.

Frequently, an organism doesn’t understand why it evolved all of its parts —
but the spleen and appendix can seem awfully important when they are damaged.
The sophistication and effectiveness of the old regulatory processes (at least
from a system reliability standpoint) is much more obvious in retrospect, now
that the system that was perceived to be broken has not been properly “fixed.”

Now that the legislatures and politicians seem to be in charge of regulation
and we can again understand the problems created by giving them the credit cards,
maybe the strategy to follow is the one that minimizes the amount of state regulation
needed. This could be accomplished with an authentically competitive and robust
generation market, coupled with a situation in which the 15 to 18 percent generation
reserve is controlled and operated by a regional transmission organization outside
of the generation market — deployed in a disciplined manner simply to avoid
shortage and support reliability in the RTO’s grid.

Another Job for the RTO

Will a competitive wholesale market that includes a robust spot market provide
15 to 18 percent system capacity reserves? Will the electric retail service
providers selling firm service be required to have term, firm contracts covering
a full 115 percent of their firm service capacity requirement, 100 percent of
the time? If not, the market will not provide that 15 percent reserve.
And even if there is a regulatory process which sets a 115 percent of firm service
capacity control requirement, if the players in the electric grid in which the
market is located do not all play by the rules of the game, the 15 percent reserves
will not exist. Assume Oregon and Nevada have assured 15 percent system reserves
in their service areas, but California has not. A collapse of the electric grid
due to a substantial supply shortage in California will not easily be isolated
to the retail suppliers without firm contracts covering 100 percent of their
capacity requirement.

In order for there to be system reserves, either the market — or regulation
as a market surrogate — must demand and be willing to pay for and maintain
as ready 15-18 percent more capacity than is likely to be used at any time.
If all firm service suppliers were required to have 115 percent of their firm
service demand covered by long-term capacity contracts, this would help support
adequate capacity reserves, but probably would not ensure them.

Who would regulate this requirement? Effective regulation requires watching
both the retail sales contracts and the underlying wholesale market. Would all
of the players play by the rules? Such a regime would minimize the value of
the spot market, and would substantially limit its use to interruptible service
users and providers.

Is there electric system infrastructure switching capabilities that can restrict
the effects of system shortages to just those customers whose electric supply
purchasing decisions failed to assure against shortage? Probably not for a long
time, and these electric circuits/markets are frequently interstate.

Experience and intuition suggests system reserves in the range of 15 to 18 percent
are an externality to a competitive market. In the competitive market, attention
to costs will cause all participants to test just how thinly they can cut the
size of fixed carrying costs attributable to reserving firm generation capacity.
Suppliers will attempt to sell a given unit of capacity as many times as possible.
Suppliers will make dispassionate, economic decisions about the risk of shortage
to their customers. If there is only a competitive wholesale market, or if that
wholesale market is dominant in the generation market, the wholesale buyer with
an absolute supply obligation that suffers the supply shortfall becomes a desperate
market participant on the demand side. California, here we come.
If adequate system reserves are an externality, they need to be provided for
the electric system by a supplier, and with costs borne, outside the market.
How could this be done?

The RTO Solution

An RTO scaled to the geographic size of the electric circuit (grid) defining
the generation market, is in a position to:
1. Know the system demand requirements, and to reasonably forecast that electric
system’s demand and capacity requirements
2. Collect transmission tariffs from all participants in that electricity market
who benefit from the existence of a competitive market and the reliability afforded
by 15-18 percent system capacity reserves
3. Own, and withhold from the market except only as necessary to support system
reliability, 15-18 percent generating reserves in excess of that system’s forecast
peak — which a competitive market would be expected to supply, and
4. Ensure that the cost of assuring reliability with such system reserves could
be borne by the beneficiaries of that reliability for that electric circuit
grid/market through inclusion in trans mission tariffs.

Will policymakers focus upon the need for system reserves, conclude that this
is best treated as a market externality, and put the job of assembling, carrying
the costs, and levying charges into the hands of the RTO? The RTO is currently
charged with providing the electric transmission infrastructure necessary to
support that competitive generation market. Who else has a jurisdiction, and
interest, and a “taxing” method, which is co-extensive with the electricity
circuit and marketplace? Another job for the RTO!
Without the RTO doing this job, there is an inherent disconnect between the
regulation of firm capacity sales from the generator (as done, say, by Pennsylvania-New
Jersey-Maryland requiring that capacity reserves be added into and paid for
in that sale) and the sale of firm power at retail (by a regulated or a direct
access provider). An unregulated market might replace actual physical capacity
reserves with economic sanctions and contract remedies as the answer to the
risk of shortage.

Will the political will tolerate actual shortage, albeit offset by economic
remedies? Or will the longevity of competitive generation markets be better
sustained by actual physical system generating reserves of 15 to 18 percent
above the demand and supply as equalized by the competitive marketplace, who
are financed through RTO tariffs levied upon the market participants realizing
the benefits of that reliability insurance against shortage?

As states now implement policies which foster competitive electric generation
markets, and as those markets become efficient, supply will rather quickly match
demand. But the interconnected electric grids typically span several state jurisdictions.
The grid might be comprised of various institutional electric market outcomes
— ranging from true open access, to traditional regulation. It is hodge
podge of brick, twig and straw solutions to the reliability issue. The overall
result is that electric demand will not include a 15 percent excess capacity
reserve, the electric market will operate continuously at the ragged edge of
shortage, and shortage will remain a real (and not merely latent) risk for the
whole grid — even those portions that do not contribute to the problem.

If the wholesale purchasers themselves operate in competitive markets (and are
not required by regulation to maintain 15 percent capacity reserves), they will
cut costs and test the market’s willingness to endure shortage. Even normal
commercial sanctions applicable to suppliers who fail to meet their contractual
supply obligations will replace the necessity — electricity — with
dollars of liquidated damages. And dollars can’t run computers or escalators
or surgical rooms.

So, can a robust, competitive electric market achieve reliability for an inter
connected electric grid with a hodgepodge of institutional policies regarding
competition? Probably not. At least, not without a very intrusive level of regulation
of both wholesale suppliers, wholesale purchasers, and retail providers —
regulation which is likely to severely compromise the benefits of competition.
Absent policing the whole supply chain throughout the grid (the reliability
region) to assure 15 percent reserves up and down the supply line — the
free market will push the system towards zero reserves.

What system could avoid continuing, pervasive regulation to assure reliability
creating system reserves? If the RTO, co-extensive with the electric grid which
constitutes the market, owned or otherwise controlled generating capacity equaling
15 percent of the coincident peak for the market covered by the RTO — and
reserved in a disciplined manner that capacity outside the competitive market
for use only in time of shortage — reliability might be assured.