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Fortnightly Magazine - November 15 2002

value for consumers, and one reason for that advantage is that market monitoring is almost certain to suppress dynamic investment incentives.

The SMD abounds with excessively detailed rules, including mandatory use of locational marginal pricing (LMP) to value congestion. Why specify that all market participants use LMP, rather than stipulating that transmission providers must offer clear and transparent transmission congestion pricing methods to purchasers? Then, with legal recourse serving as a deterrent to keep transmission providers from being opaque, the differences among different congestion pricing systems would not be an impediment to exchange, as long as the participants face clear and transparent congestion prices. Such a straightforward approach is also consistent with rules by which open access problems have been addressed relatively well in other industries. This approach would also be more effective if transmission entry barriers were reduced, because dissatisfied purchasers would have choices.

Redispatch tariffs and congestion revenue rights (i.e., firm transmission rights) are also stipulated in great detail in the SMD. Why do they have to be so extensively specified? Are there more parsimonious ways to bring about reliability-based redispatch? Again, FERC could implement simpler, more flexible redispatch rules if transmission entry barriers were lower, because transmission owners would have increased incentives to offer attractive redispatch terms to their customers. Similarly for congestion revenue rights: simply require that the transmission provider adhere to and enforce congestion revenue rights, based on the stipulation that there must be defined congestion property rights. "Offering several different types of Congestion Revenue Rights would make the system more flexible and better able to adapt to the needs of specific customers," (SMD, p. 139) but why not let the participants figure out the details for themselves? Financial markets typically work that way, which is how new and innovative approaches are discovered.

Detailed rules run the risk of regulatory path dependence and lock-in. What if FERC mandates LMP for everyone, and some technological or contracting innovation makes LMP superfluous or obsolete? The new institutional structure in the SMD should be flexible and reversible, with clear, credible phase-out provisions as market-based retail pricing expands and technological change happens. Regulatory lock-in and ratchet effects are large potential problems in institutional change, and in the case of moving away from LMP in the future, regulatory lag could result in substantial lost profits due to delays in the process of shifting from old regulations to new ones. The amount of time and effort going into this institutional change should encourage us to consider the costs of changing the institutions in the future.

Robust institutions that will stand the test of time and create value for consumers must be able to adapt to the unknown. And there is a lot that is unknown in electricity, particularly in the regulatory, financial, and technological future. Market design that focuses too much on precise details and not enough on simple rules that will adapt flexibly to changes in the environment will be ineffectual at best, and counterproductive at worst.

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