Do not mistake the FERC's professed neutrality on what works best for regional transmission organizations.

In its final rule on regional transmission organizations, known as Order 2000,[Fn.1] the Federal Energy Regulatory Commission said it would not dictate to the electric utility industry whether and how to form RTOs. Don't be misled. The FERC claims to be agnostic,[Fn.2] but it still has a vision. And that vision leads inexorably to one conclusion. The preferred form for an RTO is the independent system operator, or ISO.

That's the only structure designed to do what the commission clearly wants - to make the transmission network more efficient and more valuable.

Some investor-owned utilities prefer an independent transmission company, or transco.[Fn.3] Economics professor Robert Michaels apparently agrees. He criticized the ISO idea in a journal article published late last year.[Fn.4] Yet no viable transco, gridco or hybrid is now operating. The ISO is the only game in town, forming the unquestioned linchpin of electric restructuring. In fact, without the handful of ISOs already up and running, the FERC's Order 2000 would be little more than a theoretical exercise.

The critics offer two basic arguments. First, they say the profit motive will make transcos more efficient than ISOs. Second, they see ISOs as little more than surrogates for the real stakeholders and thus incapable of neutral administration.[Fn.5] However, these arguments ignore the plain truth of what the FERC sees as important, as revealed in both Order 2000 and in the commission's recent ruling on the proposed Alliance transco.

In reality, the electric transmission grid is a network asset that stands to gain more from efficient design than from a profit motive. The FERC clearly recognizes and endorses that principle in Order 2000. And, lest anyone remain in doubt, it reaffirmed its view last December in its Alliance decision. That decision gave a conditional "approval" to the Alliance transco, but a closer reading proves otherwise. In truth, the Alliance order stands as a clear rejection of the applicants' transco proposal and speaks volumes about the relative advantages of ISOs and transcos in today's industry.

The Transco-ISO Debate

FERC Commissioner Curt Hébert has often urged the presumed advantages of transcos. In a paper published in another journal, Hébert claimed that not-for-profit entities have no place in transmission. In his view the grid is "a private business that requires large expenditures and risk taking."[Fn.6] He suggests that transcos are better able than ISOs to take advantage of performance-based incentives in pricing and ratemaking.

Others also take up this theme. They allege that transcos have an "incentive to increase overall use of the transmission system, whether through upgrades, new facilities or operating efficiencies."[Fn.7] They contrast that case with ISOs, which exercise control over transmission assets without owning the assets. They say that ISOs "must rely on the transmission owners to make any necessary investment in new transmission facilities."[Fn.8]

Does an ISO threaten to abuse monopoly power? Professor Michaels says yes. He contends that an ISO will make its decisions "by counting the votes of heterogeneous interests whose numbers are apportioned on non-economic criteria."

Michaels cites grid expansion as an example. He sees the ISO facing problems in fostering grid investment, since generation owners may wish to foreclose new grid construction and may have "the votes to carry the day." As do other critics, Michaels views the ISO as a political institution, dominated by interests that will "impede competition, shift costs, and operate inefficiently." Thus he concludes that an ISO is a more likely transmission monopolist than a transco - "since regulation may be unable to reach or even estimate the profits earned by non-utilities that succeed in bending policy to favor themselves."

ISOs are not necessarily organized for profit but are intended instead to foster competition. They address problems in the electric industry arising from vertical and horizontal market power. Also, in certain instances, they coordinate a spot market in wholesale power.

In the words of one industry commentator, "[w]ithout regional ISOs . . ., the performance of wholesale markets will be plagued by a combination of self-dealing and suspicions of self-dealing between owners of transmission lines and their generating, distributing, and power marketing affiliates."[Fn.9] Vertically integrated utilities that control transmission can favor their interests in generation, resulting in abuses of native load preference and manipulation of posted available transmission capacity. They may also exercise horizontal market power through rate pancaking and high transaction costs.

The present debate therefore cannot mask an essential truth: A transco is a monopoly enterprise. It owns essential facilities. Meanwhile, it owes a fiduciary obligation to maximize profits for shareholders, whether or not that will lower costs for transmission and generation. This situation is inherently untenable, as was pointed out last year by the nation's utility consumer advocates in comments on the FERC's initial RTO proposal. They noted that a transco could choose not to upgrade a transmission line to relieve a constraint if that strategy would allow it to reap additional revenues through monopoly pricing of transmission services. That would put the transco's financial self-interest ahead of economic efficiency or costs to society. It could therefore cost ratepayers "significantly more than would be the case if the RTO was not controlled by such self-interested parties."[Fn.10]

The Trouble With Alliance

The advantages of the ISO structure can be seen clearly in the FERC's order[Fn.11] of late last year in response to the application of the Alliance companies to form a for-profit transco. On the surface, the FERC granted "conditional approval." On closer review, however, the ruling reveals the nearly intractable problems that will affect any transco application. It represents nothing less than a repudiation of the Alliance proposal and fair warning to any other would-be transco.

The FERC saw key problems in the ownership structure proposed for the Alliance transco. The plan entailed formation of two companies, Alliance Publico and Alliance Transco. The members[Fn.12] could transfer their high-voltage transmission facilities to Alliance Transco. No Alliance company would own more than 5 percent of Alliance Transco's stock. Alliance Publico, a registered public utility holding company with publicly traded shares and a board of directors unaffiliated with the Alliance companies, would operate as the managing member of Alliance Transco.

On reviewing the plan, the commission said the transco plan failed roughly half of the 11 standards for ISOs set down in its Order 888:

* Independence. Failed, because the members could control the Alliance Transco through stock ownership of Alliance Publico and thus veto the addition of new members or facilities. (Also, the board of Alliance Transco would owe fiduciary duties to the member companies as owners.)

* Financial Interest. Failed, because directors, officers and employees of Alliance Publico "may perceive career-preserving value in protecting or preferring the interests of [the Alliance company] stockholders over other market participants."

* Nondiscriminatory Tariff. Failed, because the Alliance plan would perpetuate rate pancaking and maintain a "preference" for the generation resources of transmission owners.

* Relief of Constraints. Failed, because the transco could not facilitate redispatch for new service given the lack of generator obligations to submit bids, coupled with pancaked rates.

* Efficient Administration. Failed, because the transco would have "no prohibition or limitation on . . . contracting with market participants."

* Pricing. Lastly, the transco would fail Order 888's pricing policies for transmission and ancillary services, both as to rate formulas and non-rate terms and conditions.

In the Alliance case, the FERC all but urged the member companies to have their transmission systems run by an ISO. For example, it suggested that "Alliance, Midwest ISO and PJM could negotiate procedures and rate treatments that would eliminate the toll-gate aspect of Alliance's configuration, deal with loop flow issues, and eliminate concerns about reliability impairment." The FERC's suggestion speaks volumes about the relative merits of ISOs and transcos in today's industry.

The Value of the Network

As the FERC recognizes in Order 2000, electricity is a network industry. Efficient transmission embraces more than electric throughput. It is instead a complex service with substantial network interactions, as recognized by Harvard professor William Hogan.[Fn.13] In a network industry the focus shifts from maximizing shareholder value to maximizing the network's value. The profit motive does not drive the network so much as an efficient market design.

Thus, the FERC's final order focuses on optimum development of the network itself rather than profitability of the transmission provider. To this end, it is ISOs, not transcos, that have emerged as network facilitators by enhancing access, promoting short-term spot markets, defining a workable system of transmission rights and thereby encouraging opportunity and innovation.

In his comments on FERC's notice of proposed rulemaking leading to its Final Rule, Professor Hogan refers to complex network interactions in the electric grid that presuppose the existence of an entity, as system operator, able to provide certain critical coordinating services. Hogan cites the various functions that this new entity must carry out:

* Load Balancing. Balance aggregate production and consumption continuously within the limits of the transmission system.

* Ancillary Services. Coordinate and monitor spinning reserve and reactive power support.

* Congestion Relief. Arrange economic (least-cost) redispatch when the grid is constrained, subject to security constraints.

* Congestion Pricing. Apply marginal cost prices for power provided through the dispatch, thus determining the locational marginal costs of additional power and providing the foundation for a non-discriminatory transmission tariff.

* Market Alternatives. Coordinate a voluntary balancing market, allowing participants to choose whether or not to respond to the operator's economic dispatch or to find similar services elsewhere.

In providing these services, Hogan says the grid manager must run the balancing market as a bid-based, security-constrained economic dispatch with voluntary participation by generators and loads. He adds that prices in the system must reflect the marginal cost of meeting load at each location. Whatever its organizational form or name, the RTO must serve as system operator and perform its functions consistent with the public interest in a competitive market.

The mere establishment of a for-profit transco will not dispense with the difficulties of the tasks cited by Professor Hogan. Nor will for-profit status ensure short-term reliability. That turns instead on such factors as the efficacy of market rules and authority of the system operator to arrange energy transfers during emergency conditions.

It is the ISO - not the transco - that has emerged as the practical form of RTO in today's interconnected, unbundled and market-based environment. As the Alliance order shows, transcos cannot readily perform this function without satisfying an array of conceptual, regulatory and organizational concerns. The Final Rule has further articulated that design. There can be little doubt as to FERC's chosen instrument for its implementation.

In fact, any transco will have no choice but to serve network requirements, just like an ISO. It is naive to suppose that the profit incentive will liberate transco management from these requirements or accord it comparative advantage in meeting them. To the contrary: A transco that fits the Hogan criteria may end up looking a lot like today's ISO.

Jeremiah D. Lambert is a partner in Shook, Hardy & Bacon L.L.P., of Washington, D.C. Among other clients, he represents the Pennsylvania-New Jersey-Maryland (PJM) Interconnection, approved by the FERC as independent system operator for the PJM Control Area. He can be reached at 202-783-8400, or by email at jlambert@shb.com.

The PJM ISO: A Model for RTOs

The PJM ISO, created by the Pennsylvania-New Jersey-Maryland Interconnection, illustrates how the ISO structure can avoid the potholes identified by the FERC in its Dec. 20 order that found shortcomings with the proposed Alliance transco.

* Independence. As the nation's most fully realized and successful ISO, PJM operates as a limited liability company with an independent board of managers that does not include stakeholders. PJM's board members are not affiliated with or controlled by market participants, whether generation interests or transmission owners.

The PJM Board has demonstrated its independence by taking unilateral action to interpret and amend the PJM Tariff, for example by proposing to add a market monitoring plan without the support of market participants.

* Public Interest Motive. The PJM board undertakes a threefold fiduciary duty: (1) maintain a safe and reliable system; (2) operate competitive and nondiscriminatory markets; and (3) ensure that no member or group of members exercises undue influence.

Unlike the corporate board of a transco, which must answer first to shareholders, the PJM Board adheres to a public interest standard, whatever the commercial interests of its members. Stakeholder concerns are channeled to the PJM Board through members' advisory committees, which have input into but cannot dictate a decisional outcome.

* Grid Management. PJM makes scheduling, redispatch and maintenance decisions independent of the commercial interests of members. PJM's reliance on locational marginal pricing eliminates any requirement to negotiate and manage redispatch with its generator members on a bilateral basis (though it does administer bilateral schedules in addition to a spot market).

Regarding transmission prices, PJM is the sole administrator of its open access tariff. It offers a balancing service. It has implemented a system of tradeable fixed transmission rights as a means of hedging congestion costs.

* Investment Incentives. PJM has primary responsibility for transmission planning in the PJM control area and is free to solve transmission constraints by building additional transmission or interconnecting new generation. To that end, PJM has implemented a queue system to handle interconnection of additional generation. Meanwhile, it enjoys clear authority to direct transmission owners to construct upgrades or additional facilities if necessary to accommodate such generation interconnections. - J.D.L.

1 Order No. 2000, FERC Docket No. RM99-2-000, issued Dec. 20, 1999 (hereafter, the "Final Rule").

2 ". . .[W]e do not propose to require or prohibit any one form of organization for RTOs or require or prohibit RTO ownership of transmission facilities. The characteristics and functions could be satisfied by different organizational forms, such as ISOs, transcos, combinations of the two, or even new organizational forms not yet discussed in the industry or proposed by the Commission." Final Rule (mimeo, p. 6).

3 See, e.g., Petition for Declaratory Order filed by Commonwealth Edison Company et al. at FERC in Docket No. EL00-25-000 on Dec. 13, 1999, seeking FERC's guidance as to an independent for-profit transmission company operating under the oversight of the Midwest Independent Transmission System Operator (hereafter "ComEd Petition," mimeo, p. 42).

4 See, e.g., Michaels, "The Governance of Transmission Operators," 20 Energy L. J. 234 (1999).

5 See, e.g., Michaels, op. cit. at 233-34; Curt Hébert, "The Quest for an Inventive Utility Regulatory Agenda," 19 Energy L. J. 1 (1998); Angle and Cannon, "Independent Transmission Companies: The For-Profit Alternative in Competitive Electric Markets," 19 Energy Law Journal 229 (1998); ComEd Petition, passim.

6 Hébert, op. cit. at 9.

7 Angle and Cannon, op cit. at 266. See also Final Rule (mimeo. p. 125). See also, ComEd petition, which contemplates operating performance incentives, congestion management incentives and expansion incentives.

8 Angle and Cannon, op. cit. at 264.

9 Pierce, Richard J., "Why FERC Must Mandate Efficiently Structured Regional ISOs - Now!" The Electricity Journal, January/February 1999, p. 50.

10 See, e.g., National Association of State Utility Consumer Advocates' Comments on Regional Transmission Organizations Notice of Proposed Rulemaking filed in FERC Docket No. RM99-2-000 on Aug. 26, 1999 (mimeo, p. 19).

11 See FERC Order on Proposed Disposition and Related Rate Filing issued Dec. 20, 1999 in Docket No. ER99-3144-000 and EC99-80-000 (hereafter "Alliance Order").

12 The Alliance Companies are: American Electric Power Service Corp., Consumers Energy Co., Detroit Edison Co., FirstEnergy Corp. and Virginia Electric & Power Co.

13 See William W. Hogan, FERC Policy on Regional Transmission Organizations: Comments in Response to the Notice of Proposed Rulemaking, filed at FERC in Docket No. RM99-2-000 on Aug. 16, 1999 (mimeo at pp. 15-16).

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