Restructuring as Erosion by mThink, May 23, 2005 Throughout 2005, five anniversaries will mark mileposts in public powers pursuit to protect electricity consumers and strengthen the value of community ownership of electric utilities. The first is the 125th anniversary of the institution of public power. Butler, Mo., has the longest- serving public power system. It was established in 1880 to provide arc lighting in the village square. As electricity quickly went from phenomenon to necessity, thousands of communities created their own municipally owned electric utilities, in many cases because the market wasnt meeting their needs quickly or cheaply enough. The number of public power systems reached its apex in 1923 with a total of more than 3,500. Thereafter, the numbers declined as hundreds of smaller public power systems and smaller IOUs were acquired by the ever-expanding utility holding companies controlled by Samuel Insull and other industry leaders. The vast majority of those that survived until the utility holding companies were brought under control continue to serve their communities today. Another anniversary is the creation of the American Public Power Association 65 years ago. Today, the APPA is the national voice for the interests of nearly 2,000 publicly owned, locally controlled electric utilities. Collectively, public power systems provide electricity to more than 14 percent of the nations ultimate retail customers, yet the systems own only about 10 percent of the nations installed generation capacity (see Figure 1). It is obvious from these figures that we are net purchasers of wholesale power, and equally obvious why we have a very keen interest in properly functioning wholesale markets that meet our needs. Public power systems range in size from quite large, such as the Los Angeles Department of Water and Power with 1.5 million metered customers, to Radium City, Kan., with 23. Some are vertically integrated; some are distribution-only companies. All were created to serve their communities and all share the characteristics of public ownership and public service orientation. There are some legal anniversaries that need noting, too. Seventy years ago, Congress enacted the Public Utilities Act. Title I became the Public Utility Holding Company Act of 1935 while Title II contained the Federal Power Act. Both statutes remain on the books, although the Securities and Exchange Commission, which has pleaded for PUHCA repeal, now acts as though it has been repealed despite the lack of congressional action. These statutes and the principles underlying them have served the public well over the last seven decades. We debated over the promised benefits of deregulation and restructuring. Remarks about the failures of regulation have also been prevalent over the last few years. What is gradually displacing those comments is the realization of how horrendously complex (and easily corrupted) the restructuring process has turned out to be. Indeed, the process of deregulation is proving to be more corruptible than the process of regulation. The just and reasonable wholesale rate requirement embodied in the Federal Power Act continues to be the law of the land and critical to protecting electric consumers from the abuses of market power. The acts prohibition against undue discrimination is the foundation on which open access to transmission facilities has been built. Finally, the last anniversary is that of the Federal Energy Regulatory Commissions Notice of Proposed Rulemaking (NOPR) that 10 years ago resulted in FERC Order No. 888. This anniversary, and more specifically the lessons learned through our experiments with open transmission access and industry restructuring over the last decade, provides an opportunity to notice what has worked (and what hasnt) and what needs to be done. Where Weve Been The journey toward restructuring and open access has been both fascinating and frustrating. Weve put on a lot of miles. Unfortunately, we havent made much progress toward the goals we embraced at the outset. When it all began, our goals were lower rates, better service and greater innovation through markets and competition. New transmission organizations that would provide nondiscriminatory access, eliminate rate pancaking and engage in regional planning (and possibly construction) of transmission facilities were a means to these ends. For the most part, public power systems were enthusiastic supporters of these new transmission organizations. While we were perhaps more skeptical (some would say more realistic) about the probability of successfully restructuring this industry all the way down to retail choice, we did look forward to the benefits of displacing regulation with competition where that could occur without losing focus on the real beneficiaries of the process the end user or consumer. Sadly, we have yet to see these predictions come true or the new institutions perform the functions as they were initially envisioned. The regional transmission organization (RTO) and independent system operator (ISO) institutions sanctioned by FERC to date are quite different from the ones we initially visualized, and all are blemished by spiraling costs, unaccountable governance, and most important, service offerings that do not meet transmission customer and end-user needs. Hiding Behind FTRs Public power systems are load-serving entities with the sole mission of meeting the electric service needs of their customers and communities as cheaply and reliably as possible. Most depend to some extent on the wholesale power market to serve their retail load. Long-term assured access to transmission at stable and predictable rates is essential to meet this mission. RTOs and ISOs are not helping to meet this mission, and are actually impeding us. In the RTO world of today, APPA members are being forced to exchange their physical firm long-term transmission rights (often hard-won through litigation) for financial transmission rights (FTRs) that are inadequate in quantity and term. An RTOs idea of a long-term FTR is one to five years, while public powers idea of long term is measured in decades. The ability of public power systems to plan for and procure long-term generation resources to serve load is being hindered. Credit rating agencies, which have liked our business model and consistently given us high ratings despite the financial meltdown of others in our industry, have taken note of this problem, and that, too, concerns us. Not only do public power systems need long-term assured access, they need reasonable stability in pricing. Access to the transmission system in RTO regions is being rationed by price under the locational marginal pricing (LMP) construct. Rate pancaking, one of the ills that was to be eliminated through RTOs, has been replaced by LMP differentials that often have the same (if not worse) economic effect. Leave It to the Market We do need a more robust transmission grid. However, the LMP/FTR system taken alone does not ensure the construction of adequate transmission infrastructure. At best, it shows which source and sink pairings create congestion with the hope that this information will be sufficient for the market to develop economically efficient solutions. For the most part, merchant transmission companies have not formed. And incumbent transmission owners have reasons of their own for not being eager to build new transmission facilities. Complicating this problem is the fact that some RTO transmissionplanning regimes have focused on the artificial distinction between new transmission needed for reliability and that needed for economic purposes. Where new transmission is deemed necessary solely for economic reasons, construction is being left to the market with less than optimal results. As Professor Paul Joskow of the Massachusetts Institute of Technology noted in a recent analysis of PJM transmission additions, Economic transmission investments can also often confer reliability benefits as well. Thus reliability and economic transmission investments are interdependent. At worst, the distinction between them is analytically arbitrary. There is no bright-line distinction, and rather than focusing on transmission to enhance reliability or transmission to enable transactions, we should be looking for an adequate transmission infrastructure that meets societys needs for electricity at reasonable cost. These developments inevitably lead to the perverse result that many APPA members are not looking to the wholesale power market but are instead either renewing power supply contracts with their existing IOU suppliers, or building their own generation as close to their own loads as possible all to reduce transmission-related risk and uncertainty. These decisions may not produce the most economically efficient generation resource results, but they are being driven toward these outcomes by the RTO/LMP market construct. What is not developing is a well-functioning wholesale power market with many healthy competitors. Worse yet, we are paying for living in this frustratingly complex RTO environment because RTO administrative costs have climbed with little apparent accountability for or appreciation of the impact of these outlays on electric consumers. This problem is additionally aggravating for the mostly small public power systems within the RTO footprints that must add staff, hardware and software simply to cope with these new markets, protocols and requirements. Getting a Good Rate The other shoe on FERCs policy foot is its market-based rate regime. FERCs market-based rate policy until now has assumed that competitive markets (supplemented in RTO regions by RTO market monitoring and mitigation regimes) will produce just and reasonable rates for wholesale power supplies. In many real-world instances, in the organized markets and elsewhere, this has proven not to be the case. Prices for generation charged in the organized markets are often substantially above what would result if cost of service regulation were used. It is clear that many suppliers in these markets are not bidding their marginal costs, as the theory underpinning centralized single price clearing markets posits, but instead are charging what they think the market will bear. What the market will bear often does not pass the Federal Power Acts just and reasonable smell test, especially in periods of high demand. Moreover, the price volatility in these short-term markets does not match up with the steady stream of long-term revenue that investors in new generation facilities now like to see. Sale of power at market-based rates is a privilege, not a right. To obtain FERC permission to sell wholesale power at market-based rates, the seller must demonstrate that it does not possess, or has mitigated market power. There is, as well, a continuing obligation on FERCs part to ensure that market-based rates remain just and reasonable. If that obligation was not clear before, it was made crystal clear last fall by the 9th Circuit Court of Appeals decision in State of California, ex rel. Bill Lockyer v. FERC. FERCs assumption that the entire footprint of an RTO constitutes the relevant geographic market, and that the RTOs mitigation regime is sufficient to counteract any generation market power as seller, may have to be examined carefully, as does the actual performance of market monitors. They are the first line of defense in ensuring that market-based rates continue to be just and reasonable. FERC is increasingly relying on market monitors, who are either employees of or contractors to the RTOs, to assess whether the wholesale energy and transmission prices reflect those of competitive markets. But the recent decision of the United States Court of Appeals for the District of Columbia Circuit in Electric Power Supply Association v. FERC calls this continued reliance into question. As FERC Commissioner Joseph T. Kelliher has noted, it may not be appropriate (or legal) for FERC to delegate determination of just and reasonable rates to market monitors. The APPA has recently commissioned an assessment of RTO and RTOsponsored empirical studies on how restructured wholesale power markets in the mid-Atlantic and Northeastern U.S. are performing. The preliminary results are not comforting. The analysis is not yet final, but suggests there is good cause to be concerned over abuses of market power, strategic behavior on the part of suppliers intending to raise prices and the lack of competitive market forces to constrain anticompetitive behavior of market participants. Anecdotally, many APPA members face threats to their viability because of the lack of availability of long-term firm transmission and increasing generation consolidation. They get few if any viable bids from suppliers in response to their RFPs, cant obtain transmission to reach alternative sources of power and suffer dramatic price increases from local suppliers with market power. Little wonder, then, that we look with alarm at more consolidation within the industry, such as the recently announced gigamerger of Exelon and PSEG, which will create a company controlling more than 50,000 megawatts of generation. Industry observers assume this marriage will be blessed by FERC because any possible anticompetitive problems will be mitigated simply by membership of the merged utility in PJM. That assumption must be validated. Calling All Cops As noted earlier, this is the 10th anniversary of the FERC NOPR that produced Order No. 888. The Open Access Transmission Tariffs (OATTs) required by Order No. 888 to ensure transmission access on a nondiscriminatory basis were a behavioral remedy intended to address the exercise of market power. To work, they require policing by FERC. Some police work is occurring, and some bad guys are being caught. We learned at the end of last year, for example, that random audits by FERCs Office of Market Oversight and Investigations found that both Arizona Public Service and Tucson Electric Power had failed to make timely data postings and had provided favorable treatment to their merchant power subsidiaries. The existence of these anticompetitive practices should come as no shock. Utilities have been using their transmission assets to disadvantage competitors for decades. It seems likely that APS and TEP are not isolated incidents, and in fact FERC Chairman Pat Wood III recently suggested that we could see additional violations uncovered as a result of other random audits. However, just these two examples suggest refinement and improvement of Order No. 888. FERC, unfortunately, issued Order No. 888, then quickly shifted its focus to RTO activities. Unless a transmission customer called the hotline or filed a complaint, FERC generally assumed all was well with OATT administration. FERC should undertake a comprehensive look at ways its OATT regime could be improved. Anniversaries A lot has happened in 10 years. While things have not turned out as the APPA and its members had planned, at least we seem to be taking the lessons learned. The debates on how to move forward are shifting away from blind faith in markets to consideration of actual facts on the ground. The proposition that public sentiment will trump economic theory, especially misguided theory, also appears to be affecting current thinking about restructuring. In 2005, there will be a new Congress, a new secretary of energy and possibly changes in personnel at FERC. We have the benefit of a decade of experience from which we can measure the successes and failures of restructuring against the successes and failures of regulation. All of this sets the stage for 2005, which looks to be a watershed year. This paper was adapted from a speech delivered at the American Antitrust Institute in January 2005. Filed under: White Papers Tagged under: Utilities