Summary ofAlternative State Approaches
The 1990s: Growing Enthusiasmfor Restructuring
About one half of the statesin the United States embarked on the process of electricrestructuring during the 1990s. There was a rising tide of enthusiasmfor restructuring through 1999, and it seemed likely that otherstates would join in the process. At the Federal level, there wastalk of mandating restructuring, and the Federal Energy RegulatoryCommission (FERC) came to be increasingly committed to competition inwholesale electric markets and fair access to the transmission gridby independent power producers.
Reassessment in2000/2001
In 2000/2001, however, theunexpected and severe California electricity crisis was dramaticproof of the dangers of embarking on restructuring in unfavorablecircumstances and without a well-designed market structure. Thewholesale electricity price increases in California and otherregions, combined with delays in forming regional transmissionorganizations (RTOs), and difficulties in getting the retail marketestablished for residential and small business customers, sobered upthe enthusiasts, and led to a nationwide reassessment ofrestructuring.
Variety of StateResponses
This survey is intended todocument the responses of different states across the country tothese developments. We have selected 15 states &endash; some of whichwe have discussed in detail, others in a more summary or focusedfashion. The states have been selected to show a variety ofresponses, and to attempt to explain why the responses havediffered.
Some states had alreadyestablished workably competitive wholesale markets with direct accessby large business customers and even some residential and smallbusiness customers, and it is not surprising that most of themdecided to stay the course. In our survey, Illinois, Maine, Ohio andPennsylvania are in this group.
On the other hand, somestates that had not yet embarked on restructuring, including Floridain our sample, decided to wait and see. Colorado, which is also inour sample, had already decided not to restructure. Others, includingVermont in our sample, had come close to restructuring, but have alsodecided to wait and see.
Of particular interest forstates like Arizona that have gone some distance towardrestructuring, but have not yet reached the point of no return, arethose states that were in the process of restructuring, or were onthe verge of restructuring. What have they done, and why?
We have picked one state,Texas, that has remained totally committed to restructuring, andopened up its retail market to competition on schedule on January 1,2002. The Texas authorities believe that the experience of the firstmonths of retail access is bearing out their optimism...
Few if any other states thatare on the brink of restructuring have remained quite as sanguineabout the prospects as has Texas. In our sample, Montana, New Mexicoand Oregon have all delayed the process in one way or another, andretained the protection of utility regulation for an extended period.Two states &endash; California itself and its neighbor Nevada&endash; have completely abandoned restructuring, and one, Arkansas,which has already decided on a two-year delay, is considering aprolonged delay.
Lessons from the MoreSuccessful States
Broadly, certain lessons canbe learned from those states that had already undergone electricrestructuring &endash; more or less successfully &endash; before theCalifornia crisis erupted. In these states &endash; includingIllinois, Maine, Ohio and Pennsylvania in our sample &endash; thewholesale market is functioning better in states with establishedregional ISOs, such as Maine and Pennsylvania. And even in thesestates, their ISOs and related power pools &endash; NEPOOL and PJMrespectively &endash; have seen unjustifiably high prices at times,barriers to merchant power interconnection, and transmission pricingand congestion problems. In Illinois and Ohio, it is provingdifficult to get the Midwest RTO off the ground and approved by FERC.This could result in shortfalls of supply or transmission inadequacywhich could undermine competition and lead to unreasonable priceincreases.
In all of these four states,it is proving difficult to get retail competition established in theresidential and small business market. There is considerablevariation between different parts of each state, e.g., in Ohio, thenorthern Ohio service territories of Cleveland Electric IlluminatingCompany and Toledo Edison account for almost all the switching in thestate. The utilities' high prices provide the motive, and theformation of large governmental aggregators provides the means.Governmental aggregation is made relatively easy in Ohio because itcan be of the opt-out variety &endash; customers in a municipal areaare included unless they choose to opt out.
In Illinois, the Chicago areaserved by Commonwealth Edison Company (ComEd) accounts for most ofthe state's switching. Again, the motive is provided by ComEd's highrates. In Illinois, aggregation has not been a factor; rather, itseems that the sheer concentration of customers in Chicago makes itfeasible for marketers to sign them up without incurring excessiveacquisition costs.
In Maine, the legislationprovides an alternative, indirect, means of bringing competition tosmall retail customers. Standard offer service is not part of thedistribution utility's scope; it is put out to bid and awarded tocompetitive providers. Maine regards this approach assuccessful.
In Pennsylvania, the "posterchild" for retail restructuring, the development of the small retailmarket is also very uneven. Pennsylvania's reputation was based onthe adequacy of its "shopping credits" &endash; the credit given byutilities to customers who no longer take generation service. Thededuction of a relatively low exit fee for utility stranded costs,and the inclusion in the shopping credit of a retail adder to reflectalternative providers' retail overhead and marketing costs, are amongthe methods for increasing shopping credits. However, Pennsylvania'sapproach has not proved that much more successful in the face ofmarket price increases than the.. approaches of other states. Fully30% of the customers who had switched to the competitive market inPennsylvania have returned to utility standard offer service in thepast year or so.
Optimism in Texas andPessimism Elsewhere
Why did Texas go ahead onJanuary 1? The authorities checked through the problems of Californiaand decided that their own situation, and the structures that thelegislature and commission had put in place, would prevent anythinglike that from happening in Texas. Perhaps the most significantdifferences are in the wholesale generation market. The Texas marketbenefits from having state control of its own independent systemoperator, and the state commission can accordingly develop consistentpolicies for the wholesale and retail markets.
Texas prizes the isolation ofits electric system, which protects it from being drawn into marketcrises in neighboring states. The ERCOT-ISO is encouraging the timelyand adequate construction of new power plants and transmission lines,and there appears to be sufficient generation capacity.
The Texas legislation alsofavors the creation of a workably competitive wholesale market byrequiring utilities to auction off 15% of their generation tocompetitive providers, and by limiting the ownership of generationassets by any one corporation to no more than 20% of themarket.
Regarding the Texas retailmarket, it remains to be seen whether it develops for residential andsmall business customers as well as for large business customers.However, early signs are promising: a number of customers appear tobe switching suppliers, and governmental aggregation has alreadysucceeded in gaining a foothold in the market.
By contrast with Texas,Nevada, which had come close to allowing its two principalinvestor-owned utilities to divest their generation assets, abandonedits restructuring effort. The wholesale market simply wasn't readyfor it. Similar considerations led to a successful effort by Montanato retain effective jurisdiction over the generation assets ofMontana Power Company, even though those assets had already beendivested to PPL Montana, a non-affiliated company. And in Virginia,fearing that loss of jurisdiction would result in higher prices&endash; Virginia utilities having low embedded costs that wouldlikely remain below the level of market prices &endash; theCommission is trying to maintain jurisdiction by restrictingtransfers to utility generation divisions, not separate corporateentities.
Summary andRecommendations
In summary, there are veryfew states that can clearly demonstrate benefits from retailcompetition to date &endash; and very few small customers have seensignificant, lasting benefits.
Experience has shown thatthere are risks associated with retail competition &endash; risks ofmarket power and increased electricity prices, risks associated withthe loss of state regulatory jurisdiction, and even risks ofelectricity market failure. How states are responding to thischanging situation depends as much on their views regarding marketsversus regulation, as on the evidence provided by the experience todate. In looking at emerging competitive markets, state authoritiesseem to be able to see the glass as either half empty or halffull...
Our foremost recommendationis that the risks must be carefully weighed against the potentialbenefits before taking irrevocable steps to restructure electricutilities. Restructuring should only be pursued if it can bedemonstrated that the benefits outweigh the risks. A smoothlyfunctioning, well-designed, competitive wholesale electricity marketis the most important condition necessary to reduce the risks andincrease the potential benefits of retail competition. Theappropriate design and structure of the retail market is alsonecessary to achieve the benefits of retail competition; includingthe design of the shopping credits, the availability of competitivemarketers, and provisions for aggregation or competition to providestandard offer service. If these conditions are not in place, therisk may not be worth taking...
III a. Lessons of theCalifornia Electricity Crisis
California is not a model ofwhat to do, it is an example of what notto do. Here, we listsome of the electricity restructuring features and developments thatresulted in the state's electricity crisis, and the lessons that canbe learned.
A tight power supplysituation resulted in a malfunctioning of the poorly designedCalifornia ISO, and in opportunistic behavior by suppliers whichenabled them to manipulate prices. Prices rose far above productioncosts.1Similar, though lessextreme, price spikes have occurred in other parts of the country. Ifthe supply of power becomes tight in the bulk power market, it isdifficult to avoid extreme price spikes. This is perhaps the mostwidely applicable lesson of the California electricitycrisis.
In California, demand washigher than expected, and supply was less than expected. On thesupply side, hydroelectric generation was low, owing to lowprecipitation. Also, owing to environmental concerns, it has beendifficult for generators or IPPs to site new plants in California,and for a long period, which ended only recently, no new plants wereconstructed in the state. Siting needs to be made consistent withdemand growth, and someone needs to plan and build enough newcapacity.
There are features of aderegulated power supply market that can avoid or at least mitigatesupply shortfalls. Some planning and/or pricing mechanisms are neededto ensure the adequate construction of new power plants andcoordinated expansion of the transmission system.
The RTO may be theappropriate agency for planning and coordination. This is the view ofPatrick H. Wood III, the FERC chairman. In a striking admission thatgeneration markets need some kind of regional (and state) planning,he said recently, "The RTO is a recognition that the power businessmust be planned and operated regionally...The RTO ought to be therespected body that initiates regional planning by saying, ‘Inthis large area we need these four projects to be built.’ Thenit becomes the states’ responsibility." (BusinessWeek, March 4,2002, p 30B)
Wood also recognizes thatprice caps may be necessary to deal with price hikes; FERC respondedslowly to the need for a price cap in the West in the wake of theCalifornia crisis, but finally imposedone.3
California's chaoticregulatory structure probably contributed to the generationdeficiency; investors in new generation capacity need a favorablereturn on investment with regulatory and market certainty. It isreported that belatedly several new plants are coming on-line, butthere is no guarantee that the cycle may not repeat itself, with aglut of power followed by a shortage later.
2. ISO/RTO design.
The California crisis wasexacerbated by poor design of the California ISO. The problemsoccurred in the functioning of the California Power Exchange'sday-ahead market and the ISO's real time purchases (to make up, on anemergency basis, any remaining power shortfall on the day itself).For example, when prices rose in May and June 2000, the ISO cappedthe price of power, but this cap did not apply to the ISO's emergencypurchases in the real-time market. The result was that supplierswithdrew power from the day-ahead market, forcing the ISO to purchasemore and more "emergency" power at higher prices in the real-timemarket.4This aberration peaked onJuly 28, 2000, when fully 28 percent of load was met on the real-timemarket. But even in November and December 2000, the ISO was stilldeclaring emergencies when the generating reserve margin wasapparently around 40 percent.
FERC’s ongoing task isto encourage the creation of more effective ISOs or RTOs. The West islagging behind some other regions in this regard. Even in thoseregions that had a head start, because they already had tight powerpools, ISOs are still undergoing evolution.
3. Market power.
The California experience ofmarket manipulation &endash; strategic withdrawal of capacity fromthe market and opportunistic pricing &endash; shows that market poweris an ever-present concern in deregulated bulk power supply markets,especially when supplies are tight. Wholesale markets need to becharacterized by adequate supplies, as noted earlier. They also needto have a number of effective and independent suppliers and lowbarriers to entry by new generators.
4. Retail versus wholesaleprices.
The combination of regulatedlow retail prices and high and volatile wholesale prices had twounintended effects. First, it made the retail market unprofitable forthird-party suppliers.
After some initial skirmishesin the retail market, they withdrew and concentrated on sales in thewholesale market.5The lesson is that if andwhen states wish to make the retail market attractive to suppliers,they need to allow a differential between wholesale and retail pricessufficient to cover retail marketing costs. Looked at from anotherperspective, states need to allow customers a sufficient shoppingcredit to make shopping pay.
Second, the rise in wholesaleprices put extreme financial pressure on the distribution utilities,who could not pass the price increases on to their standard offercustomers in the retail market. (When suppliers became afraid thatthe utilities would go bankrupt and not be able to pay, they withheldsupplies. Their fears were justified: California's largest utility,Pacific Gas & Electric, filed for Chapter 11 bankruptcyprotection from its creditors in April 2001.)
5. Demand-sideinflexibility.
The protection that retailcustomers initially had against wholesale price increases inCalifornia made demand less responsive than it could have been. Asretail markets develop and real-time pricing becomes more economicaland widespread, energy conservation and load management are likely tomitigate supply shortfalls.
6. Poorly planneddivestiture.
In California, utilitiesdivested most of their power plants into an imperfectly competitivemarket. The retail market design favored standard offer service, andthe utilities were required to purchase power for standard offerservice on the Cal PX spot market. This was a recipe for disaster.Utilities were dependent on the PX for more than half of theirpurchases, contrasted with less than 20% in most other divestituresituations, like that in New England, where utilities rely for themost part on bilateral, long-term purchased power agreements.Limiting the utilities’ ability to prudently purchase energy isnever sound regulatory policy. It is especially imprudent when theutilities are forced to rely on an untested and flawed entity likethe PX. Utility divestiture of generation assets needs to becarefully planned. The California experience in this regard can beavoided by ensuring that the wholesale generation market iscompetitive before divestiture takes place, that divestiture itselfcontributes to the competitiveness of the market (e.g., by assetsales to several separate unaffiliated generators), and thatUtilities are able to make better arrangements for utility buy-backof power for standard offer service, such as a mix of spot marketpurchases and contracts of different duration.
7. Natural gasdependence.
High gas prices and gaspipeline bottlenecks, allegedly exacerbated by market power in thegas market, contributed to California's electricity crisis. Perhapsthere is over-dependence on natural gas among electricity generatorsin California, who use gas to generate more than half of theirpower.
The potential problem of lackof fuel diversity is difficult to avoid in deregulatedmarkets; thereis a tendency for most or all generators to build gas-fired plants.The solution could be for a regional entity such as the RTO tomonitor this issue and provide incentives for fueldiversity.
8. Clumsy and belated stateintervention.
State (and Federal)authorities were slow to respond to early warning signs of theCalifornia crisis. FERC finally responded by instituting region-wideprice caps. However, California, through its Department of WaterResources, has now entered into long-term purchased power agreements(which its utilities had foolishly been prohibited from doing) athigh prices, and is considering buying the transmission grid from theutilities to help them overcome their financial crisis.
9. Stranded costrecovery.
The mechanism by which thestranded cost recovery charge was set in California was defective.Instead of a fixed per-kWh charge on the rates for delivery service,the charge was variable. The higher the wholesale market price, thelower the charge, and the lower the wholesale market price, thehigher the charge. This variation had the result of undermining theretail supply market, because suppliers who offered customers a fixedprice never knew what revenue they would be getting on anet-of-stranded cost basis.
1
There is a disputeabout whether or not supply was actually deficient in California, orwhether the whole crisis was created by manipulative suppliers. Here,we assume that there was market manipulation, but that it would nothave been so prevalent if supplies had not been at least somewhattight (in the sense of capacity reserve margins being narrow) in thefirst place.
2
Contributing to theCalifornia crisis was the way in which both California and thePacific Northwest came to rely on power imports from each other inthe late 1990s. When hydroelectric capability was reduced in 1990,while the regional economies were booming, a tight supply situationdeveloped. Throughout, California relied upon power from theSouthwest, and its increased dependence in 2000/2001 put pressure onthe market in Arizona and the rest of the Southwest.
3
Partial or regionalprice caps can distort the market or lead to gaming. It has beennoted earlier that suppliers sold power to out-of-state marketers,who then resold it in-state. Another result of California-only pricecaps was that power which might have been available in-state flowedout-of-state, period. There was a resulting loss of supply inCalifornia which contributed to make the market there tighter. Thesestatements refer to price caps in general and should not be construedto indicate that Staff supports the price caps ultimately implementedby the FERC.
4
There were othertwists. One was that the ISO could purchase power from out-of-stateat higher prices than it could pay to in-state suppliers. Thisresulted in "laundering" of power when suppliers sold it toout-of-state marketers who then resold it into the California market.Another maneuver was for generators with market power on the exportside of a bottleneck to game the ISO's congestion pricing scheme byover-scheduling capacity. The ISO would then be forced to buydecremental generation, which the same generators would offer at lowprices, enhancing their net revenues.
5
Green power was anexception, owing to a special customer credit for greenpower.