The Broken “E” Bubble

Being both a student of history and a participant in the recent events in California,
it’s with some reluctance that I undertake the task of outlining a view of the
future of RTOs. After all, the widely-held view in the not-too-distant past
was that we would now be at the threshold of an entirely new era of open and
competitive electricity markets.

The reality is that the e-bubble has broken. Not the Internet frenzy that has
been well documented, but the bubble in the electric markets. The FERC’s December
2001 time line for operational RTOs will not be met, and the promise of open
and competitive wholesale and retail electric markets seems as distant today
as when the idea was first contemplated. Just as the “irrational exuberance”
surrounding the Internet propelled many to dismiss the fundamentals of economics,
the promise of electric deregulation propelled regulators to quickly get on
the deregulation bandwagon in some cases without careful examination of the
fundamental implications of truly open markets.

Although many would like to deny it, the events in California have forever influenced
the pace and direction of deregulation nationally. California’s crisis has already
clearly slowed the pace of deregulation across the country. Even those who would
want to dismiss the California crisis as an isolated incident must admit that
it has highlighted the importance of ensuring that the entire deregulation mechanism
(wholesale through retail) is viable and sustainable. The upshot is that state
regulatory entities will not as easily be influenced by the mass excitement
for opening electricity markets as they might have been in the past. They are
now intensely interested in ensuring that the California experience is not repeated
in their states.

Given what we know today, what will be the future of RTOs (and electric markets
as whole) and what will be required to get there?

The Multifaceted RTO

As a framework for focusing on these questions, one needs to consider that
creating RTOs (or their ISO and Power Pool ancestors) is a multifaceted undertaking.

The Stable Past

First, at their core, RTOs are an engineering enterprise with the mission of
reliably controlling the electric grid. Before deregulation it was a well-understood
engineering problem. Daily life proceeded with the expectation that the lights
would always be on and that power would be available whenever and wherever it
was required.

Blackouts and the sort were rare events in the industrialized world and were
almost always the result of a rare confluence of unfortunate events. All this
was accomplished through the discipline and structure of decades of engineering
knowledge and experience.
Second, the regulatory (and political) framework for governance of electric
supply was stable, albeit an esoteric process largely transacted outside the
eye of public interest. Except for consumer advocate organizations most citizens
trusted that the regulators were acting in the public interest requiring that
the utilities operated under strict guidelines.

Third, participants (utilities) operated under the assumption that as long as
they could demonstrate their actions were prudent and within the regulatory
framework, they were entitled to full and fair cost recovery plus a negotiated
return to their shareholders. The utilities over the decades had become masters
of the rate-making process. Although the rate-making process did not always
yield the full results they desired, they generally knew what to expect. Now,
of course, things have changed.

The Dark Ages of Deregulation

From an engineering perspective, RTOs and their associated operations present
significant challenges to reliable grid operation. They are technically and
operationally larger and more complex than the single power control operations
historically managed and operated by each utility within its operating area.
Today, they must create reliable dispatch within the constraints of bids from
generators and execute this dispatch per the merit order of the bids. This process
frequently results in the utilization of transmission assets in ways that were
not contemp lated when they were designed and con structed. This element of
the current situation is broadly documented and discussed by appropriate authoritative
sources. Most conclude that the situation poses a significant risk to the reliability
of electricity supply nationally.

From a regulatory perspective, the well-known structure of jurisdiction and
appropriate authority has been thrown into turmoil by the RTO paradigm. Who
has, and who should have, authority to create and enforce the going forward
regulatory framework is very unclear. Uncertainty and/or disagreement at the
political level of the process abounds. RTOs represent a subtle but important
shift in the regulatory structure that strikes at the heart of the balance between
state and federal authority. It only adds to the turmoil that the process increasingly
is being carried beyond regulatory proceedings, into state, federal, and bankruptcy
courts.

Participants are, of course, seeking to ensure that the transition to new markets
is a safe harbor for their shareholders and provides a competitive advantage
to their enter prises going forward. However, they now face a regulatory process
that is far more unpredictable and less straightforward than in the past. Not
only must they navigate new regulatory processes, but they also must increasingly
deal with a legislative process as states seek to create a new structure for
dereg ulated markets that does not repeat the miscues of recent events. Now
it is also clear that fundamental conflicts in the new structure could potentially
threaten the sustain ability of participant’s core businesses. They need look
no further than the bankruptcy proceeding of PG&E to become aggressively diligent
to ensure shareholder value is not destroyed by the constructs of a dysfunctional
market.

Achieving the Vision

Given this current state, what are the key issues that must be addressed to
realize the RTO vision?

First is stability in the regulatory and market structure. This is, of course,
no small order. Compounding the difficulty is the fact that recent events challenge
not only the pace of transition to a new market framework (i.e. full wholesale
and retail competition), but also put into question what the actual endstate
will be. True, the FERC has become more prescriptive in each subsequent ruling,
but there are limits to its authority and jurisdiction. Stability also requires
clarity outside the Federal domain, notably in the frameworks for both future
retail markets and the disposition of utility transmission assets. Because both
of these issues are primarily state issues, the resolution could theoretically
have 50 different solutions.

Second is investment. There is no one in the industry that does not understand
or support the fact that the U.S. transmission infrastructure requires significant
investment. All the analysis arrives at the same conclusion — the current
situation threatens the reliability of the U.S. electric system. It does not
take a lot of business acumen to understand that such investment will not be
undertaken until the aforementioned stability is achieved. The required investment
is predicated on such stability.

Challenges

One could catalogue a long list of challenges that need to be overcome to drive
stability and thus investment. However four seem critical:

Bigger is Better — But Slower

First, the pace of implementing a few large RTOs needs to be carefully examined.
The intent and value of such a framework has been well-documented and articulated
by the FERC. Many agree with the framework in the abstract, but the devil is
always in the detail. The devil in this case is wildly inconsistent interests
and approaches to deregulation among various state political and regulatory
entities, operational and planned ISOs, and even market participants. A few
large RTOs nationally will necessarily force these various entities to form
consolidated governance structures and operations. The current state of affairs
is that there are significant differences in philosophy and implementation among
the various venues. Forging these consolidated entities will likely be a protracted
and difficult process. One need only examine recent news reports from New England
and California to understand the complex issues in play.
Compounding this complexity is the diversity in approaches to retail deregulation
among the various geopolitical regions of the country. RTO market mechanisms
cannot operate properly unless there is support and agreement among the various
states regarding retail deregulation under any single RTO span of control. The
recent events in California have clearly illustrated that a single wholesale
mechanism operating over a flawed retail mechanism can wreak havoc on those
market participants caught in the middle. Although a proper mechanism certainly
can be created to eliminate a California-type problem, it is not a requirement
that each state under a RTO have the same mechanism. States will become even
more interested in ensuring that their retail mechanisms will work in an open
wholesale market, thus drawing the process out longer than the current FERC
mandate envisions.

Independence in Policy and Action

The second challenge is independence of RTOs. The FERC has made this concept
a cornerstone of the RTO framework. The FERC defines this independence in the
context of market participants. RTO governance should not allow RTO actions
to be considered or undertaken with the interest of market participants as part
of the process. Otherwise, the logic goes, market participants will use their
position and information to exercise market power to the detriment of competition.

But this definition does not cover independence in the context of political
or reg ulatory agendas that can be in conflict with the overall agenda of the
Federal RTO mandate. Again California illustrates the point. The current in-force
mitigating legislation designed to stabilize the California market specifically
disallows the California ISO from joining the RTO West, and the current members
of the CAISO governing board are appointees of the Governor.

The California situation may be unique. But as various state policy makers examine
the acceptable quid pro quo for supporting an RTO that integrates the supply
and transmission of electricity among their neighboring states, it could be
that a place at the governance table of the RTO will become a requirement for
their support. To the extent that the policy philosophies of the various states
are inconsistent with federal direction, the potential for significant conflict
and “grid-lock” exists.

Be Careful What You Ask For — You Just Might Get It

The third challenge is the notion that electricity is a public good. Under
the old regime, electricity was a public good provided by private entities under
a strictly-defined reg ulatory framework. The long-standing debate within the
industry regarding the “duty to serve” and the balance between shareholders
and ratepayers are evidence of this fact.

In the extreme, the notion of an open market for electricity necessarily alters
this construct. Does a generator in a free market have an obligation to produce
no matter what? Is it improper that when a supply/demand mismatch in the market
creates an opportunity for a generator to command $1000/MW that they seek such
a price? Certainly the issue of market power makes the answer to this question
difficult, and one’s view of electricity, from different points in the spectrum
of public to private good (from consumer to policy maker), results in different
answers.

The salient point is really that the public still perceives electricity as a
public good. Throughout the process of deregulation it was led to believe that
they were getting the same good — only cheaper. However, the basic law
of supply and demand can yield a different result in a true market. It is speculation
whether the public would have supported deregulation if this point was fully
understood. But policy makers now understand it — perhaps all too clearly.

The Great Schism

The last challenge is likely the most critical to RTO success in the future.
For deregulation to work, there cannot be a regulatory schism between wholesale
and retail market pricing signals to the end customer. One need only cite the
recent California experience as clear evidence for this fact. Simply put, if
the wholesale markets are truly free and are driven by the law of supply and
demand, but retail markets cannot pass on these price signals to the consumer,
then the entire process is dysfunctional.

It is not necessarily a requirement that each state have the same retail mechanism
for the RTO paradigm to work. But if wholesale prices are free to move based
on supply and demand, an appropriate process for recovery of the price fluctuations
by the retail provider must be in place. Of course, the best mechanism would
be freely-floating retail prices, but it is unrealistic to assume that all states
will pursue such an aggressive retail strategy. The real point is that whatever
mechanism is put in place by the states, it must contemplate how retail providers
can fairly pass fluctuations in wholesale costs onto the customer. Only with
such a mechanism will the proper price signals be sent to the ultimate end customer
while providing a sustainable business model through which providers can make
the right business decisions regarding investment.

A Clearer View of the Endgame

So what end state for RTOs does a synthesis of the current situation suggest?
Among the key points:
• The extent of retail market openness will vary considerably from state
to state. Factors such as the current regional price of electricity, supply
sufficiency, and political agenda will be evaluated differently by each state.
• It is unlikely that the current view of the FERC — that four is
the magic number of RTOs nationally — will be achieved. It could easily
be double the current FERC vision.
• Independence across all domains is a strict requirement for success.
This issue will likely require an even more intrusive regulatory agenda on the
part of the FERC, and will test both its strength and authority.
• The public will not relinquish the view of electricity as a public good.
This view will drive regulatory direction and limit the extent of deregulated
structures.
• The entire process of creating RTOs and restructuring the market will
clearly take longer than anticipated. 2003 to 2005 is a more realistic implementation
goal.
• The various regulatory positions will harden as various policy makers
seek to mitigate problems like California’s.

If today one re-reads the foundation documents that were the basis for deregulation,
one finds a different picture — and indeed a different promise — for
electric market restructuring than we really see. Today there is much uncertainty
and some retrenchment regarding electric deregulation. It is entirely unclear
when the required stability will emerge to provide a foundation to make the
RTO and deregulation vision a reality. But one thing today is for certain: the
entire process of creating RTOs and deregulating electricity markets has become
significantly more complex politically. Not being at the vanguard of the electric
deregulation bandwagon is now more virtue than vice.