Summary of Alternative State Approaches
The 1990s: Growing Enthusiasm for Restructuring
About one half of the states in the United States embarked on the process of electric restructuring during the 1990s. There was a rising tide of enthusiasm for restructuring through 1999, and it seemed likely that other states would join in the process. At the Federal level, there was talk of mandating restructuring, and the Federal Energy Regulatory Commission (FERC) came to be increasingly committed to competition in wholesale electric markets and fair access to the transmission grid by independent power producers.
Reassessment in 2000/2001
In 2000/2001, however, the unexpected and severe California electricity crisis was dramatic proof of the dangers of embarking on restructuring in unfavorable circumstances and without a well-designed market structure. The wholesale electricity price increases in California and other regions, combined with delays in forming regional transmission organizations (RTOs), and difficulties in getting the retail market established for residential and small business customers, sobered up the enthusiasts, and led to a nationwide reassessment of restructuring.
Variety of State Responses
This survey is intended to document the responses of different states across the country to these developments. We have selected 15 states &endash; some of which we have discussed in detail, others in a more summary or focused fashion. The states have been selected to show a variety of responses, and to attempt to explain why the responses have differed.
Some states had already established workably competitive wholesale markets with direct access by large business customers and even some residential and small business customers, and it is not surprising that most of them decided to stay the course. In our survey, Illinois, Maine, Ohio and Pennsylvania are in this group.
On the other hand, some states that had not yet embarked on restructuring, including Florida in our sample, decided to wait and see. Colorado, which is also in our sample, had already decided not to restructure. Others, including Vermont in our sample, had come close to restructuring, but have also decided to wait and see.
Of particular interest for states like Arizona that have gone some distance toward restructuring, but have not yet reached the point of no return, are those states that were in the process of restructuring, or were on the verge of restructuring. What have they done, and why?
We have picked one state, Texas, that has remained totally committed to restructuring, and opened up its retail market to competition on schedule on January 1, 2002. The Texas authorities believe that the experience of the first months of retail access is bearing out their optimism...
Few if any other states that are on the brink of restructuring have remained quite as sanguine about the prospects as has Texas. In our sample, Montana, New Mexico and Oregon have all delayed the process in one way or another, and retained 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 a prolonged delay.
Lessons from the More Successful States
Broadly, certain lessons can be learned from those states that had already undergone electric restructuring &endash; more or less successfully &endash; before the California crisis erupted. In these states &endash; including Illinois, Maine, Ohio and Pennsylvania in our sample &endash; the wholesale market is functioning better in states with established regional ISOs, such as Maine and Pennsylvania. And even in these states, their ISOs and related power pools &endash; NEPOOL and PJM respectively &endash; have seen unjustifiably high prices at times, barriers to merchant power interconnection, and transmission pricing and congestion problems. In Illinois and Ohio, it is proving difficult to get the Midwest RTO off the ground and approved by FERC. This could result in shortfalls of supply or transmission inadequacy which could undermine competition and lead to unreasonable price increases.
In all of these four states, it is proving difficult to get retail competition established in the residential and small business market. There is considerable variation between different parts of each state, e.g., in Ohio, the northern Ohio service territories of Cleveland Electric Illuminating Company and Toledo Edison account for almost all the switching in the state. The utilities' high prices provide the motive, and the formation of large governmental aggregators provides the means. Governmental aggregation is made relatively easy in Ohio because it can be of the opt-out variety &endash; customers in a municipal area are included unless they choose to opt out.
In Illinois, the Chicago area served by Commonwealth Edison Company (ComEd) accounts for most of the state's switching. Again, the motive is provided by ComEd's high rates. In Illinois, aggregation has not been a factor; rather, it seems that the sheer concentration of customers in Chicago makes it feasible for marketers to sign them up without incurring excessive acquisition costs.
In Maine, the legislation provides an alternative, indirect, means of bringing competition to small retail customers. Standard offer service is not part of the distribution utility's scope; it is put out to bid and awarded to competitive providers. Maine regards this approach as successful.
In Pennsylvania, the "poster child" for retail restructuring, the development of the small retail market is also very uneven. Pennsylvania's reputation was based on the adequacy of its "shopping credits" &endash; the credit given by utilities to customers who no longer take generation service. The deduction of a relatively low exit fee for utility stranded costs, and the inclusion in the shopping credit of a retail adder to reflect alternative providers' retail overhead and marketing costs, are among the methods for increasing shopping credits. However, Pennsylvania's approach has not proved that much more successful in the face of market price increases than the.. approaches of other states. Fully 30% of the customers who had switched to the competitive market in Pennsylvania have returned to utility standard offer service in the past year or so.
Optimism in Texas and Pessimism Elsewhere
Why did Texas go ahead on January 1? The authorities checked through the problems of California and decided that their own situation, and the structures that the legislature and commission had put in place, would prevent anything like that from happening in Texas. Perhaps the most significant differences are in the wholesale generation market. The Texas market benefits from having state control of its own independent system operator, and the state commission can accordingly develop consistent policies for the wholesale and retail markets.
Texas prizes the isolation of its electric system, which protects it from being drawn into market crises in neighboring states. The ERCOT-ISO is encouraging the timely and adequate construction of new power plants and transmission lines, and there appears to be sufficient generation capacity.
The Texas legislation also favors the creation of a workably competitive wholesale market by requiring utilities to auction off 15% of their generation to competitive providers, and by limiting the ownership of generation assets by any one corporation to no more than 20% of the market.
Regarding the Texas retail market, it remains to be seen whether it develops for residential and small business customers as well as for large business customers. However, early signs are promising: a number of customers appear to be switching suppliers, and governmental aggregation has already succeeded in gaining a foothold in the market.
By contrast with Texas, Nevada, which had come close to allowing its two principal investor-owned utilities to divest their generation assets, abandoned its restructuring effort. The wholesale market simply wasn't ready for it. Similar considerations led to a successful effort by Montana to retain effective jurisdiction over the generation assets of Montana Power Company, even though those assets had already been divested 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 would likely remain below the level of market prices &endash; the Commission is trying to maintain jurisdiction by restricting transfers to utility generation divisions, not separate corporate entities.
Summary and Recommendations
In summary, there are very few states that can clearly demonstrate benefits from retail competition to date &endash; and very few small customers have seen significant, lasting benefits.
Experience has shown that there are risks associated with retail competition &endash; risks of market power and increased electricity prices, risks associated with the loss of state regulatory jurisdiction, and even risks of electricity market failure. How states are responding to this changing situation depends as much on their views regarding markets versus regulation, as on the evidence provided by the experience to date. In looking at emerging competitive markets, state authorities seem to be able to see the glass as either half empty or half full...
Our foremost recommendation is that the risks must be carefully weighed against the potential benefits before taking irrevocable steps to restructure electric utilities. Restructuring should only be pursued if it can be demonstrated that the benefits outweigh the risks. A smoothly functioning, well-designed, competitive wholesale electricity market is the most important condition necessary to reduce the risks and increase the potential benefits of retail competition. The appropriate design and structure of the retail market is also necessary to achieve the benefits of retail competition; including the design of the shopping credits, the availability of competitive marketers, and provisions for aggregation or competition to provide standard offer service. If these conditions are not in place, the risk may not be worth taking...
III a. Lessons of the California Electricity Crisis
California is not a model of what to do, it is an example of what not to do. Here, we list some of the electricity restructuring features and developments that resulted in the state's electricity crisis, and the lessons that can be learned.
A tight power supply situation resulted in a malfunctioning of the poorly designed California ISO, and in opportunistic behavior by suppliers which enabled them to manipulate prices. Prices rose far above production costs.1 Similar, though less extreme, price spikes have occurred in other parts of the country. If the supply of power becomes tight in the bulk power market, it is difficult to avoid extreme price spikes. This is perhaps the most widely applicable lesson of the California electricity crisis.
In California, demand was higher than expected, and supply was less than expected. On the supply side, hydroelectric generation was low, owing to low precipitation. Also, owing to environmental concerns, it has been difficult for generators or IPPs to site new plants in California, and for a long period, which ended only recently, no new plants were constructed in the state. Siting needs to be made consistent with demand growth, and someone needs to plan and build enough new capacity.
There are features of a deregulated power supply market that can avoid or at least mitigate supply shortfalls. Some planning and/or pricing mechanisms are needed to ensure the adequate construction of new power plants and coordinated expansion of the transmission system.
The RTO may be the appropriate agency for planning and coordination. This is the view of Patrick H. Wood III, the FERC chairman. In a striking admission that generation markets need some kind of regional (and state) planning, he said recently, "The RTO is a recognition that the power business must be planned and operated regionally...The RTO ought to be the respected body that initiates regional planning by saying, ‘In this large area we need these four projects to be built.’ Then it becomes the states’ responsibility." (BusinessWeek, March 4, 2002, p 30B)
Wood also recognizes that price caps may be necessary to deal with price hikes; FERC responded slowly to the need for a price cap in the West in the wake of the California crisis, but finally imposed one.3
California's chaotic regulatory structure probably contributed to the generation deficiency; investors in new generation capacity need a favorable return on investment with regulatory and market certainty. It is reported that belatedly several new plants are coming on-line, but there is no guarantee that the cycle may not repeat itself, with a glut of power followed by a shortage later.
2. ISO/RTO design.
The California crisis was exacerbated by poor design of the California ISO. The problems occurred in the functioning of the California Power Exchange's day-ahead market and the ISO's real time purchases (to make up, on an emergency basis, any remaining power shortfall on the day itself). For example, when prices rose in May and June 2000, the ISO capped the price of power, but this cap did not apply to the ISO's emergency purchases in the real-time market. The result was that suppliers withdrew power from the day-ahead market, forcing the ISO to purchase more and more "emergency" power at higher prices in the real-time market.4 This aberration peaked on July 28, 2000, when fully 28 percent of load was met on the real-time market. But even in November and December 2000, the ISO was still declaring emergencies when the generating reserve margin was apparently around 40 percent.
FERC’s ongoing task is to encourage the creation of more effective ISOs or RTOs. The West is lagging behind some other regions in this regard. Even in those regions that had a head start, because they already had tight power pools, ISOs are still undergoing evolution.
3. Market power.
The California experience of market manipulation &endash; strategic withdrawal of capacity from the market and opportunistic pricing &endash; shows that market power is an ever-present concern in deregulated bulk power supply markets, especially when supplies are tight. Wholesale markets need to be characterized by adequate supplies, as noted earlier. They also need to have a number of effective and independent suppliers and low barriers to entry by new generators.
4. Retail versus wholesale prices.
The combination of regulated low retail prices and high and volatile wholesale prices had two unintended effects. First, it made the retail market unprofitable for third-party suppliers.
After some initial skirmishes in the retail market, they withdrew and concentrated on sales in the wholesale market.5 The lesson is that if and when states wish to make the retail market attractive to suppliers, they need to allow a differential between wholesale and retail prices sufficient to cover retail marketing costs. Looked at from another perspective, states need to allow customers a sufficient shopping credit to make shopping pay.
Second, the rise in wholesale prices put extreme financial pressure on the distribution utilities, who could not pass the price increases on to their standard offer customers in the retail market. (When suppliers became afraid that the utilities would go bankrupt and not be able to pay, they withheld supplies. Their fears were justified: California's largest utility, Pacific Gas & Electric, filed for Chapter 11 bankruptcy protection from its creditors in April 2001.)
5. Demand-side inflexibility.
The protection that retail customers initially had against wholesale price increases in California made demand less responsive than it could have been. As retail markets develop and real-time pricing becomes more economical and widespread, energy conservation and load management are likely to mitigate supply shortfalls.
6. Poorly planned divestiture.
In California, utilities divested most of their power plants into an imperfectly competitive market. The retail market design favored standard offer service, and the utilities were required to purchase power for standard offer service on the Cal PX spot market. This was a recipe for disaster. Utilities were dependent on the PX for more than half of their purchases, contrasted with less than 20% in most other divestiture situations, like that in New England, where utilities rely for the most part on bilateral, long-term purchased power agreements. Limiting the utilities’ ability to prudently purchase energy is never sound regulatory policy. It is especially imprudent when the utilities are forced to rely on an untested and flawed entity like the PX. Utility divestiture of generation assets needs to be carefully planned. The California experience in this regard can be avoided by ensuring that the wholesale generation market is competitive before divestiture takes place, that divestiture itself contributes to the competitiveness of the market (e.g., by asset sales to several separate unaffiliated generators), and that Utilities are able to make better arrangements for utility buy-back of power for standard offer service, such as a mix of spot market purchases and contracts of different duration.
7. Natural gas dependence.
High gas prices and gas pipeline bottlenecks, allegedly exacerbated by market power in the gas market, contributed to California's electricity crisis. Perhaps there is over-dependence on natural gas among electricity generators in California, who use gas to generate more than half of their power.
The potential problem of lack of fuel diversity is difficult to avoid in deregulatedmarkets; there is a tendency for most or all generators to build gas-fired plants. The solution could be for a regional entity such as the RTO to monitor this issue and provide incentives for fuel diversity.
8. Clumsy and belated state intervention.
State (and Federal) authorities were slow to respond to early warning signs of the California crisis. FERC finally responded by instituting region-wide price caps. However, California, through its Department of Water Resources, has now entered into long-term purchased power agreements (which its utilities had foolishly been prohibited from doing) at high prices, and is considering buying the transmission grid from the utilities to help them overcome their financial crisis.
9. Stranded cost recovery.
The mechanism by which the stranded 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, the lower the charge, and the lower the wholesale market price, the higher the charge. This variation had the result of undermining the retail supply market, because suppliers who offered customers a fixed price never knew what revenue they would be getting on a net-of-stranded cost basis.
1
There is a dispute about whether or not supply was actually deficient in California, or whether the whole crisis was created by manipulative suppliers. Here, we assume that there was market manipulation, but that it would not have been so prevalent if supplies had not been at least somewhat tight (in the sense of capacity reserve margins being narrow) in the first place.
2
Contributing to the California crisis was the way in which both California and the Pacific Northwest came to rely on power imports from each other in the late 1990s. When hydroelectric capability was reduced in 1990, while the regional economies were booming, a tight supply situation developed. Throughout, California relied upon power from the Southwest, and its increased dependence in 2000/2001 put pressure on the market in Arizona and the rest of the Southwest.
3
Partial or regional price caps can distort the market or lead to gaming. It has been noted earlier that suppliers sold power to out-of-state marketers, who then resold it in-state. Another result of California-only price caps was that power which might have been available in-state flowed out-of-state, period. There was a resulting loss of supply in California which contributed to make the market there tighter. These statements refer to price caps in general and should not be construed to indicate that Staff supports the price caps ultimately implemented by the FERC.
4
There were other twists. One was that the ISO could purchase power from out-of-state at higher prices than it could pay to in-state suppliers. This resulted in "laundering" of power when suppliers sold it to out-of-state marketers who then resold it into the California market. Another maneuver was for generators with market power on the export side of a bottleneck to game the ISO's congestion pricing scheme by over-scheduling capacity. The ISO would then be forced to buy decremental generation, which the same generators would offer at low prices, enhancing their net revenues.
5
Green power was an exception, owing to a special customer credit for green power.