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The Market Transition: Is FERC Pricing Policy on the Wrong Side of the Road?

Fortnightly Magazine - February 15 1995

right quadrant), and the regulated price falls below the market price. Those IPP fans of the free market suddenly turn schizophrenic. They begin expounding the obvious principle that a utility should never earn more than its cost of service. Their speeches sound so good, they bring tears to regulators' eyes. These regulators view with dismay and consternation even the possibility that a utility could ever charge rates above embedded cost. (And yet they remain silent when utilities must sell capacity or economy energy below embedded cost rates because "that's where the market is.")

FERC's Double Standard

In the electric power industry, deregulation is a story of double standards. The FERC created this double standard by forcing utilities to charge market rates only when embedded cost is higher (em for instance, in economy energy sales. In a vacuum, each FERC order may well fall within the bounds set out in the Supreme Court's famous 1941 Hope case. But the overall effect forces utilities to operate only in the upper left and lower right quadrants of the Figure. Unless the rules are changed, this internally inconsistent deregulation will deny utilities the opportunity to earn a fair return on assets, forcing rate confiscation that violates the U.S. Constitution (see sidebar).

The first pages of the policy statement on transmission pricing imply that the FERC is adopting an economically sound position:

"To the extent practicable, transmission rates should be designed to reflect marginal costs, rather than embedded costs, in a manner consistent with the remaining principles. We favor marginal cost prices in order to promote efficient decisionmaking by both transmission owners and users.... In our view, this means that transmission pricing should promote good decisionmaking."

The FERC adds that its policy should foster efficiency in:

s expanding transmission capacity

s locating new generators and load

s using current transmission facilities (and allocating constrained capacity through appropriate market-clearing mechanisms)

s dispatching generating resources.

The actual test of the FERC's intentions will come in the pricing orders, but the language of the policy statement suggests that economic efficiency will take a back seat to traditional regulatory principles.

The FERC is attempting to combine the free-market system with the traditional regulatory system. In the latter system, regulators must balance admittedly incorrect price signals by allocating resources using mechanisms such as certificates of convenience and necessity or integrated resource planning. But the FERC's new system sets a regulated price and then relegates allocation to the free market. It won't work! It cannot work. When a regulated price is "let loose" in the free market without the correct allocation signal, it creates a shortage or surplus with economic inefficiency, as surely as night follows day. New York's 6-cent rule offers a prime example.

Because the regulated price for transmission falls below the marginal price in most cases, power producers and wheeling customers will tend to demand too much transmission capacity. Some power plants might be built too far from loads simply because the transmission rate is too low. Transmission is a scarce asset, one that lies at the heart of the