Restructuring as Erosion

Throughout 2005, five anniversaries will mark mileposts in public power’s 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 wasn’t 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 nation’s ultimate
retail customers, yet the systems own only about 10 percent of the nation’s
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

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which has pleaded for PUHCA repeal, now acts as though it has been repealed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 act’s 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 Commission’s
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
hasn’t) and what needs to be done.

Where We’ve Been

The journey toward restructuring and open access has been both fascinating
and frustrating. We’ve put on a lot of miles. Unfortunately, we haven’t 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

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

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 RTO’s idea of a “long-term” FTR is one to five years, while public
power’s 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

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
society’s 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 FERC’s policy foot is its market-based rate regime. FERC’s
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 Act’s “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 FERC’s 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.

FERC’s assumption that the entire footprint of an RTO constitutes the relevant
geographic market, and that the RTO’s 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, can’t 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 FERC’s 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.


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.