America”s Next Nightmare: SMD

Reliable, low-cost electric energy makes the American economy go. It is the essential
service, so necessary to modern life that its momentary absence defines a disaster.
After every hurricane or earthquake, the critical question always is how many
households are without power.

Electric utilities used to be called public service companies because that
is what they did — provided an essential public service. Enron, Enron wannabes,
and Enron disciples at the Federal Energy Regulatory Commission (FERC) would
turn this on its head. In their view, the public exists to serve the marketer,
which turns out the lights if its economic demands are not met.

In California, we had a contrived cataclysm of epic proportions: Tens of millions
of California residents and businesses were threatened every day with rolling
blackouts and service curtailments while Enron and other merchants of doom offered
to avert disaster for payments at levels that plundered utility bank accounts
and the state treasury.

It was unconscionable. FERC stood by and watched while it happened. California’s
cataclysm was made possible by an ill-considered experiment in deregulation
that opened the door to the rapacious traders and merchant generators. California
has now spent two years and billions of dollars trying to recover from that
cataclysm.

FERC’s Standard Market Design (SMD) obstructs California’s recovery effort
by promoting an illegal and ill-considered federalization of retail service
that would impose the worst features of the California experiment on the nation.
It would bring Enron’s dream — and California’s nightmare — to America’s
power business.

FERC’s Illegal Plan

For 70 years, the statutory division between state and federal jurisdiction
in electricity regulation has been between retail and wholesale service. Federal
regulation is devoted exclusively to wholesale electric service in interstate
commerce, while the states regulate service both in interstate and intrastate
commerce. FERC’s SMD proposal obliterates the line carefully drawn by Congress
in the Federal Power Act. It usurps state authority to regulate retail service.

While Congress may choose to give FERC such authority, it has not yet done
so. In proposing SMD, FERC not only has exceeded its statutory authority but
cannot implement its plan. During the years it will take the courts to confirm
the invalidity of SMD, the entire industry — consumers, providers, investors,
regulators, and pundits — will be mired in confusion rather than addressing
real issues and problems.

The Federal Power Act authorizes FERC to regulate wholesale electricity sales
in interstate commerce and electricity transmission in interstate commerce.
Congress has not authorized FERC to regulate electric generation facilities
and facilities used to provide retail service, whether or not they are “in interstate
commerce.”

The United States Supreme Court confirmed this dichotomy in Connecticut Light
and Power v. Federal Power Commission, 324 U.S. 515, 530 (1945):

“Congress is acutely aware of the existence and vitality of these state governments.
It sometimes is moved to respect state rights and local institutions even when
some degree of efficiency of a federal plan is thereby sacrificed. Congress
may think it expedient to avoid clashes between state and federal officials
in administering an act such as we have here …

“Congress may think complete centralization of control of the electric industry
likely to overtax administrative capacity of a federal commission. It may, too,
think it wise to keep the hand of state regulatory bodies in this business,
for the ‘insulated chambers of the states’ are still laboratories where many
lessons in regulation may be learned by trial and error on a small scale without
involving a whole national industry in every experiment.”

Truer words have seldom been spoken. Proponents of deregulated electricity
trading, like Enron, have been trying for years to ease the “bright line” between
wholesale and retail regulation. They have consistently been rebuffed by Congress.

State Jurisdiction

In the 1992 Energy Policy Act, Congress added specific language to the Federal
Power Act that reinforced state retail jurisdiction:

“No order may be issued under this chapter which is inconsistent with any state
law which governs the retail marketing areas of electric utilities.”

This explicit restriction on FERC regulation is reinforced by an original Federal
Power Act provision that denies FERC any ability to encroach upon the states’
reserved authority:

“Federal regulation … of the transmission of electric energy in interstate
commerce and the sale of such energy at wholesale in interstate commerce is
necessary in the public interest, such federal regulation, however, to extend
only to those matters which are not subject to regulation by the states.”

During March 2002, for the first time, the Supreme Court blurred slightly the
wholesale-retail distinction by authorizing FERC to remedy discrimination in
transmission service, including discrimination affecting retail transmission
service, where a state had voluntarily “unbundled” transmission from energy
supply for retail customers. The decisions of some states, such as California,
Pennsylvania, and New York, to permit so-called “retail choice” of electric
suppliers are examples of this unbundling.

The court held that FERC had the authority under the Federal Power Act to issue
its Order 888 regulating transmission in interstate commerce, including voluntarily
unbundled retail transmission. The Supreme Court specifically rejected Enron’s
argument that FERC should take control of the entire national grid to facilitate
trading, whether or not a state had unbundled under state law.

However, FERC has adopted Enron’s suggestion through the creation of an astonishing
fiction that a utility “discriminates” whenever it uses its transmission systems
to serve its own customers with its own power plants (i.e., provide “bundled”
retail service), rather than serve wholesale generators. This astonishing notion,
which flies directly in the face of the 1935 Federal Power Act and 1992 amendments,
supplies the legal underpinnings for SMD.

Ill-Considered

A group of regulators representing 15 states recently signed an “Alliance Statement,”
which opposed SMD and called on FERC to withdraw it. Specifically, the statement
calls on FERC to:

• Refrain from asserting jurisdiction over the transmission component
of bundled retail sales.
• Refrain from asserting jurisdiction over power supply planning functions.
• Refrain from asserting jurisdiction over demand-response functions.
• Refrain from imposing highly complex, untested market mechanisms throughout
the nation.
• Focus on improving the wholesale electricity market through monitoring
and better enforcement.
• Return to regional transmission system discussions.
• Identify on a regional, cooperative basis, real (not theoretical) problems,
and fashion practical, evidence-based solutions.
• Before implementing any new programs or market designs, subject them
to a rigorous cost-benefit-risk analysis that measures net benefits to consumers.

The statement catalogs both what FERC is doing wrong and what FERC should be
doing but is not.

FERC is attempting to promote investment in electric transmission upgrades
that have significant environmental and cost consequences. Congress has consistently
withheld this authority from FERC, in clear contrast to its allowing FERC to
regulate interstate gas pipelines.

FERC is attempting to accomplish by indirection what it cannot do directly,
by mandating the creation of regional transmission organizations (RTOs) that
would have planning authority.

FERC is also pushing a variety of devices to permit electricity day traders
to use deception — such as “virtual bidding” of electricity they do not
actually have — to confuse grid operators and make money. We have had a
terrible experience with this type of deceptive behavior in California, but
FERC would require it nationwide.

Problems Ignored

Equally important is what FERC is failing to do, particularly in the area of
market manipulation and abuse.

Since Spring 2002, when FERC proposed SMD, almost daily revelations are uncovered
about the way gas and electricity marketers manipulated and abused California
during the energy crisis. Sadly, it appears that in some instances FERC had
information that it ignored or suppressed. FERC took action only when that evidence
was publicly disclosed through other means.

In April 2000, California parties complained that El Paso Natural Gas was using
its market power to raise gas prices in California. In August 2002, 28 months
and many billions of dollars later, FERC’s chief administrative law judge agreed.
(At press time, the case was pending before the full commission.)

In May 2000, fraudulent arrangements to illegally withhold electric supply
were made between two FERC-regulated wholesale generators and marketers. California
authorities informed FERC of this illegal conduct in February 2001.

FERC settled the case and suppressed the information until it was disclosed
in October 2002 in litigation between California agencies and one of the perpetrators.

FERC has subsequently expanded the types of evidence it will consider in calculating
refunds for California consumers, but it waited more than 18 months after receiving
this evidence.

In August 2002, FERC staff issued a report detailing reasons why certain natural
gas price indexes that FERC had been using to calculate refunds were unreliable
and vulnerable to manipulation. Since that time, the Commodity Future Trading
Corporation (CFTC) has issued subpoena to gas traders, and a number of gas marketers
have terminated employees for erroneous reporting that might have influenced
the indexes and financial statements and skewed arrangements premised on the
indexes. FERC has not even commented on these revelations, much less pursued
them.

“Horrific” Outcomes

The deregulated wholesale market that FERC is promoting with SMD has serious
problems, one of which continues to be FERC’s unwillingness or inability to
police deceptive and fraudulent behavior. Instead of pushing SMD, FERC should
rein in the cowboys in those wholesale markets for which FERC clearly has responsibility.

Deregulation’s consequences for consumers have been horrific. The consequences
for investors and employees have been equally horrific. The intellectual bankruptcy
of FERC’s approach is best understood in the actual bankruptcies, valueless
stock, and business collapses of the electric and gas traders.

An innkeeper in Greek mythology had a bed that fit every traveler — those
who were too tall had their heads and feet chopped off; those who were too short
were pounded with an iron club and stretched out to fill the dimensions. FERC’s
one-size-fits-all SMD is a “bed of Procrustes” that would ruin the American
economy.

Instead of allowing FERC to strap each state into that bed, we should try to
solve real problems and make real improvements both in federal regulation of
wholesale services and in state regulation of retail services. As the alliance
statement from state regulators concludes:

“There may well be problems to solve and improvements to be made both in federal
regulation of wholesale services and in state regulation of retail services.
… We are convinced that consumers will benefit if both the Commission and the
states focus on identifying and solving real problems, whether through RTOs
or other means.

“But the Commission’s unprecedented and aggressive jurisdictional reach, which
shifts the ground rules and undermines trust at many levels, disrupts useful
aspects of the … process and the ability to make informed decisions.

“We urge the Commission to recognize the limits of its own reach and respect
the partnership it must forge with the states, and to withdraw the proposed
rulemaking.”

FERC should withdraw SMD and return to the voluntary, incremental approach
to regional development that has served the nation well for almost 70 years.
The last five years of deregulation are a nightmare that we should never dream
again.