The RTO Endgame – Slower and More Political Than Once Thought by Chris Trayhorn, Publisher of mThink Blue Book, January 15, 2002 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. 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.