FERC's Standard Market Design: Too Detailed To Evolve

The Federal Energy Regulatory Commission's standard market design (SMD) proposal states objectives that are important and supportable, both theoretically and empirically. Uniform rules and business practices reduce transaction costs and limit opportunities for institutional arbitrage, increase the extent of the market, and increase market liquidity and investment. In fact, the goal of unleashing market incentives for transmission investment is prominent in the SMD, and that goal is correct and crucial for continued dynamism and value creation in the electricity industry.

The current SMD proposal, though, is too mired in details to be a good blueprint for institutional change in electricity regulation. The SMD proceeds on the assumption that mandating a single, uniform set of detailed rules is preferable to mandating simple, general rules across the country and letting the parties figure out the details that suit them best. Such detail will make the SMD static and costly to change as the industry evolves. FERC faces the problem of walking the fine line between uniform general rules to reduce transaction costs and top-down imposed, detailed rules that will create advantages for some market participants. To be robust and create the most possible value, the SMD should comprise simple rules that will adapt to the unknown, not dictate the specifics to the extent contained in the current proposal.

One simple rule that would accomplish much of what the SMD proposes regarding transmission investment and congestion pricing would be to reduce entry barriers in transmission. The proposed SMD recognizes that improved transmission coordination and investment can make wholesale generation markets more competitive, but does not recognize that the reverse is also true. Changes in generation regulation and technology can make transmission more competitive, and therefore indicate that transmission is no longer a natural monopoly. The proposed SMD does not reduce the artificial barriers to entry that restrict our ability to put transmission to a market test. In the absence of these barriers, transmission is contestable, or faces potential competition. An approach likely to create real benefits and dynamic efficiency would be to reduce artificial barriers to entry in transmission and see the extent to which transmission really can be contestable, and the timeframe over which that contestability evolves. Furthermore, reduced entry barriers would enable investors to create beneficial redundancy and increased grid security. Such beneficial redundancy does not exist with transmission regulated as a natural monopoly.

Market-based retail pricing is another simple rule, which would obviate the need for FERC and ISOs to perform market monitoring. Market-based retail pricing connects demand and supply, maximizing information transmission in markets and disciplining supplier exercise of market power better than any other known institution. However, the bifurcated legal jurisdiction between federal/wholesale and state/retail prevents FERC from determining retail-pricing policy. States are only slowly moving toward market-based retail pricing and retail choice. Thus, we are going to have market monitoring for the foreseeable future, but it should have sunset provisions as the percentage of retail load on competitive contracts increase. Market-based retail pricing is more likely than market monitoring to create