This white paper reviews the restructuring experiences in three New England
states – Massachusetts, New Hampshire, and Maine – and their trials and
successes. Additionally, the paper considers the role of the New England
Independent System Operator in establishing free and open power markets
and the disconnect between the development of the retail and wholesale
electric markets in the region. The New England experience demonstrates
the difficulty in creating competitive markets for an essential commodity
that has historically been subject to command and control regulation and
used as a vehicle to support numerous social programs. The tension between
the popular desire to create a free market and the political will to shield
consumers from the risks inherent in such markets has created distorted
price signals and dampened the growth of a once promising retail electric
market in the region.

Three Different Approaches

By 1997 a number of New England states were fully engaged in the race
to restructure their electric utilities and provide consumers with retail
access to third-party suppliers of electricity. The discrepancy between
low wholesale electric prices and high retail electric rates spurred state
utility regulatory commissions and legislators to find a way to bridge
the gap. States competed to be the first to create new markets that would
hopefully reduce the traditionally high New England energy rates and make
their state more attractive to economic development. The California experiment
with retail access, the Federal Energy Regulatory Commission’s action
to provide open access transmission and competitive wholesale markets,
and the desire to attract new competitors and capture a “first-in” premium,
quickly produced an almost unanimous political groundswell for electric
industry restructuring.

Before any markets were opened and the rules established, eager marketers
from all parts of the country converged upon New England in hopes of capturing
market share and getting a jump on the learning curve that could be used
in other regions opening up their retail electric markets. Three years
later, after the scheduled “customer choice” dates have come and gone
in all three states, many retail energy sellers have abandoned New England.
In several states, retail customers granted “customer choice” in open
access states have no options to choose a third-party supplier because
the marketers have fled, unable to compete with the mandated standard
offers or transition service made available through electric distribution
utilities. All three of the New England states discussed here adopted
distinctively different approaches to introducing competition, and each
achieved varying success in attracting new market entrants.

Massachusetts

Massachusetts was one of the first states in the nation to embark on
electric industry restructuring when the Massachusetts Department of Public
Utilities opened an investigation into the matter in February, 1995. In
a number of decisions over the next two years the Department announced
its general principles for restructuring and concluded that there is a
strong public policy basis for providing electric utilities a reasonable
opportunity for recovery of non-mitigatable stranded cost. While the Department
did not accept the utilities’ legal arguments that they were absolutely
entitled to such recovery, based upon exclusive franchises, it recognized
that lengthy litigation over the matter could derail efforts to introduce
competition.

While developing rules and requiring utilities to file restructuring
plans, the Department encouraged stakeholders to negotiate settlements
as the most efficient means of moving forward. In October, 1996, Massachusetts
Electric Company (MECo) filed a settlement with the Attorney General and
numerous other parties, under which MECo agreed to provide retail access
to its customers, divest its generating assets, and implement an immediate
10 percent discount in its rates. The parties also agreed that MECo should
be allowed to recover all of its non-mitagatable stranded costs through
a Contract Termination Charge over a 12-year period.

The MECo settlement provided a framework for the Department’s Electric
Industry Restructuring Plan issued in December 1996. The Department concluded
that it required legislative authorization to implement its plan, which
would provide immediate consumer benefits through mandatory rate reductions,
allow utilities an opportunity for full-stranded cost recovery, and prevent
vertical market power by encouraging voluntary divestiture of utility-owned
generation. The Plan also provided that distribution service would remain
a monopoly service and postponed consideration of whether to allow competition
in metering, billing, and information services (MBIS).

After the filing of several other utility restructuring settlements,
and approval by the Department of the MECo proposal, the Massachusetts
Legislature enacted restructuring legislation in November 1997. The legislation
embodied most of the principles in the Settlements and the Department’s
Plan, and mandated rate decreases of 10 percent in 1998 and 15 percent
in 1999. The Legislation also included adders to distribution rates for
energy efficiency programs and to support renewable sources of generation.

The compromise reached by the legislature on stranded cost recovery and
rate reductions produced an immediate barrier to market entry entitled
Standard Offer Service. All customers would be eligible to continue to
take service through the standard offer which would include three parts:
the stranded cost recovery charge, the distribution charge, and the Standard
Offer for generation. In order to ensure the mandated discounts, utilities
were to price their “standard offer” at a rate below wholesale prices
and could defer for collection in later years, the difference between
the wholesale price and the artificially deflated Standard Offer.

All of the Massachusetts electric distribution companies filed restructuring
plans or settlements and opened up to competition on March 1, 1998. Unfortunately,
the below-market standard offer made it extremely difficult for new market
entrants to offer a “competitive” price without taking the risk of a large
loss leader in the early years and gambling that the new markets would
eventually reduce wholesale prices to the levels of the standard offer.
Two years after open access, only 0.2 percent of Massachusetts residential
customers are buying competitive supplies, and only 19 percent of industrial
customers have switched. By comparison, in Pennsylvania, almost 10 percent
of residential customers and 56 percent of the industrials are buying
competitive supplies. 1

New Hampshire

New Hampshire, which was paying the highest electric rates in the country
to one electric utility serving over two-thirds of the state, took a decidedly
different tack than the Massachusetts negotiation and settlement strategy.
After attracting significant market interests in 1996 with an electric
competition Pilot Program, the legislature provided the Public Utilities
Commission with a broad outline for electric industry restructuring and
directed them to implement that plan in short order. Encouraged by the
flood of marketers participating in the Pilot Program, the legislature
and Commission focused on creating a truly “competitive” market, and included
no hard and fast requirements for immediate rate reductions or discounted
standard offer service.

The Commission’s Final Plan sought to impose a new regulatory regime
by which any stranded costs recovery would be tied to a comparison of
a utility’s rates with a regional average. Utilities with rates at or
below the regional average would have an opportunity for 100 percent recovery
of their standard costs, while those above the regional average (i.e.,
Public Service Company of New Hampshire) would not be allowed to recover
that percentage of their stranded cost equal to the percentage by which
their rates exceeded the regional average. This recovery mechanism was
based, in part, upon the Commission’s determination that as a matter of
state and federal law, utilities had no legal right to stranded cost recovery,
even if they purchased the power under federally approved wholesale rates
that have traditionally been found to preempt any state attempts to disallow
those costs in retail rates.

The Commission’s Final Plan led to immediate litigation in the federal
courts and a stay of the state’s restructuring plan. While the MECo affiliate,
Granite State Electric, was able to develop a settlement along the same
lines as the Massachusetts plans, the other utilities in the state have
been involved in the federal lawsuit for over three years, including five
interlocutory reviews by the 1st Circuit Court of Appeals.

In August 1999, PSNH filed a comprehensive settlement that provided for
implementation of electric retail choice in 2000, an 18 percent electric
rate reduction for standard offer (transition) service customers, divestiture
of PSNH’s generating assets, a write-off by PSNH of $367 million in stranded
costs, and securitization of up to $725 million of PSNH’s stranded costs.
In conditionally approving the settlement, the Commission required PSNH
to absorb additional stranded costs and increase the transition service
rates in order to bring them closer to wholesale prices and avoid creating
large deferrals for later recovery.

In June 2000, the New Hampshire Legislature passed, and the governor
signed, new legislation authorizing securitization of PSNH’s stranded
costs, establishing transition service rates and requiring a system benefits
charge. The law required certain revisions to PSNH restructuring settlement,
which are currently under consideration by the Commission. Assuming those
modifications are approved, most of New Hampshire is now open to competition
– over three years after the originally mandated customer choice date.
It may be too early to predict whether marketers will return to New Hampshire,
but at this time there is only one registered competitive supplier in
the state.

Maine

The Maine legislature also passed electric restructuring legislation
in 1997, but provided for a three-year implementation period culminating
with retail choice in March, 2000. The extended period for accomplishing
restructuring provided the Commission with an opportunity to conduct numerous
rulemakings and consider stranded cost recovery and restructuring plans
for each of the electric utilities in the state. The Maine restructuring
statute includes a requirement for standard offer service through at least
2004, divestiture of generation assets by March 1, 2000, and stranded
cost recovery determined by the Commission, with true up at least every
three years.

During 1998 and 1999, prior to the start of retail access, all of the
Maine electric utilities sold their fossil fuel generation assets through
auctions, which proceeds allowed them to mitigate their stranded costs
and reduce rates or deferrals. The Commission also completed proceedings
on establishment of stranded cost recovery for each of the electric utilities.
These proceedings culminated in settlements or stipulations establishing
not only stranded cost recovery, but also the unbundled transmission and
distribution rates and new rate designs.

The one area in which Maine has encountered difficulties is in the solicitation
of Standard Offer suppliers. The Maine Commission, like several other
states, has conducted auctions for standard offer service from third-party
suppliers. The intent of bidding out the right to serve customers is to
counteract any advantage of the incumbent utility. Commission mandated
auctions in 1999 for standard offer supply yielded bids which the Commission
ultimately determined were too high for two of the three participating
utilities. The Commission has sought to balance the need to keep rates
down with desire to make the Standard Offer as close as possible to actual
market prices so as to encourage new market entrants.

The standard offer rates in Maine are move “competitive” than those adopted
in Massachusetts, and the impact of these prices can be seen in the greater
migration of customers to competitive electric providers. In the first
four months of open access in Maine, a large portion of industrial customers
have switched to competitive suppliers, though there has been little movement
of residential customers.

The Power Markets: Price Administration or Reregulation

In attempting to design a market structure for competitive retail markets,
all of the states recognized the importance of creating a workable wholesale
market as a key ingredient to restructuring the electric industry. The
New England wholesale market operates over a coordinated transmission
grid or power pool known as NEPOOL. In 1997, NEPOOL which was formerly
controlled by the integrated utilities which were the major transmission
owners, restructured to create an Independent System Operator (ISO-NE).
The ISO-NE is a not-for-profit, private corporation charged initially
with management of the regions electric bulk power generation and transmission
systems and ensuring open access. As of May 1999, the ISO-NE also administered
the restructured wholesale electricity marketplace for the region. Market
participants buy and sell seven electricity products through an Internet-based
market system.

In New England, and more recently in California, the price spikes in
the volatile new wholesale electric markets have collided head on with
the desires of end users, regulators, and legislators to shield consumers
from such risks. After all, the intent of restructuring the electric industry
is to harness the forces of competition to reduce overall prices to consumers,
not enrich marketers and generators. Electricity’s unique characteristics,
however, make price volatility inevitable in a free market.

Electricity can not be economically stored, creating a need to constantly
balance supply and demand.2 Moreover, demand for electricity is extremely
inelastic during the short run, and there is a constant need to ensure
reliability of the grid.3 Thus, when demand rises above production, the
inelastic demand results in higher prices, which prices do not necessarily
produce increased supply or decreased demand, but rather can result in
extreme price spikes.4

In May 2000, an unseasonably hot day in New England coincided with a
number of planned and unplanned outages of generating units. The resulting
demand and price escalation was from $10 per megawatt to $6,000 per megawatt.
The reaction of the ISO-NE to a comparable price spike in the previous
year was to seek a retroactive price cap. While the ISO-NE is now investigating
the cause of this year’s spike, many parties are seeking imposition of
price caps to protect against such price volatility.

The issue has not attracted the same attention as in California, however,
in part because consumers in states like Massachusetts are protected from
any short-term impacts. Under the retail regulatory regime, utilities’
standard offer and default service rates are capped to ensure the mandated
15 percent discount. To the extent the utility is purchasing supplies
that reflect the volatile market rates, any increases in the actual cost
of standard offer or default service above the overall rate ceiling are
deferred for future recovery. Thus, consumers are shielded from the actual
market prices today, but they face prospects of paying for those increases
somewhere down the road when the utilities’ combined rates fall beneath
the overall price cap. The danger is that these artificial upfront discounts
will create growing deferrals that will continue for years to prevent
imposition of accurate price signals.

Conclusion

Replacing regulated electric prices, subject to command and control regulation
for over 100 years, with competitive retail and wholesale markets can
not be achieved overnight. Decision-makers may have to choose between
guaranteed price reductions, which will inhibit market entrants and postpone
the development of a viable market, and exposing consumers to the risk
that the market may not produce savings in the short run and will inevitably
be volatile. A structured timetable, rather than a rush to the finish
line, allows opportunities for consensus-building, negotiation, and settlement.
Postponing the scheduling of retail choice may provide sufficient time
for divestiture of utility assets and market development, so that customers
actually have competitive options on the date retail access occurs.

Imposition of artificial rate reductions through retail price caps may
be the price to be paid for gaining a political consensus to accomplish
restructuring. While such compromises may be preferable to attempting
to achieve immediate rate reductions through litigation, they create a
potential for ever-increasing deferrals of costs that will eventually
be passed onto consumers. These artificial discounts also prevent accurate
price signals that are essential to a fully operational market.

The issue of price volatility in wholesale electric markets will likely
be addressed in multiple forums in the coming months and years. Shielding
customers from these impacts and deferring the recovery of market increases
for years will not allow for an informed debate. A viable and competitive
market is one in which customers are to be provided an opportunity to
choose, even if they do not exercise that option.

Footnotes

1 Admittedly, Pennsylvania has taken the opposite approach and instituted
“shopping credits” at prices above the utilities’ cost of supplying power,
thus providing an incentive for migration.

2 Severin Borenstein and James Bushnell, Electricity Restructuring: Deregulation
or Reregulation, Regulation, Vol. 23, No. 2, 2000, pp. 48-49.

3 Ibid

4 Ibid