Report from New England: Lessons Learned on the Road to Competition by Chris Trayhorn, Publisher of mThink Blue Book, November 15, 2000 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 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.