For deregulation to work, consumers must see the real price-- including all utility costs.
Summer is back, and with it, concerns that not enough power will be available to meet critical peak demands in the Northeast, Mid-Atlantic, Midwest, and California. Why potential shortages when capital is abundant and deregulation and competition are supposed to make the industry work better? Because regulators, with the best of intentions, are setting the wrong prices for power sold by the regulated utilities in competitive markets.
Establishing electricity and gas prices charged by the regulated utilities has been a key consideration for policymakers in deregulating states. Set properly, such prices, referred to as "standard offers," "prices to beat," or "default prices," enable consumers to make choices that force electricity providers to become more efficient and offer better service. Properly set prices also protect regulated utilities. Set improperly, prices inhibit competition and encourage consumers to make uneconomic choices about when to buy power and from whom. Those choices can have dramatic consequences, including lack of sufficient generating capacity during summer peaks.
Prices in free markets reflect the full cost of a company offering a product or service, including fluctuations in wholesale costs. "Full cost" includes three items:
- PRODUCT COSTS (electricity or gas commodity and transportation, in this case);
- ALL ASSOCIATED DIRECT COSTS (purchasing, scheduling/load forecasting, accounting, legal, etc.); and
- FULLY ALLOCATED CORPORATE OVERHEADS (general administrative expenses).
Every business must recover all of these costs in its pricing in order to remain in business. The same approach is the right one for deregulating energy markets: Regulated utilities should set prices for electricity and gas including all three cost areas, as well as reflecting fluctuating wholesale costs, which should be reflected monthly.
Regulators may choose from three options in setting standard offer prices: forecast low, use actual costs, or forecast high. Unfortunately, the most common regulatory approach to date, that of forecasting wholesale prices and setting low regulated utility prices, is probably the worst possible. That hurts not only consumers, but also the utilities. The perceived benefit is short-term political: reduced, stable prices. However, history has shown that such artificial price caps are followed quickly by dramatic negative results. Examples range from the collapse of the Soviet economy to the natural gas shortages and high prices in the late 1970s and early 1980s in the United States (prices were capped at the wellhead, not to end-consumers).
As with most things in life, simplicity and common sense yield the best result when it comes to pricing energy sold by regulated utilities in deregulating markets. Only two things are necessary: First, reflect the utility's full cost of the product or commodity, acquiring the power, and operating that portion of the utility's business (in a separate business unit, ideally), and, second, pass on price fluctuations to the consumer, so consumers can make informed choices. (If consumers demand flat pricing, competitive suppliers will offer it; the difference is that those prices will reflect actual wholesale costs and the risks associated with offering flat pricing.)
The result will be what policymakers and consumers have always wanted from deregulation: the reliability of adequate capacity, lower prices, and greater innovation. Even utility shareholders are better off, as their companies are removed from the untenable situation of buying high, selling low, and bearing risk.
Sending Price Signals, Without Illegal Tying
Regulators across the United States are deregulating electricity and gas markets based on two premises that guide market economies: First, individual customer choice is preferred to government selection of providers of products and services, and, second, competitive markets achieve more efficient outcomes, typically seen as lower costs and greater innovations. As recognized in U.S. anti-trust law and regulation by the Federal Trade Commission, the critical element in allowing competitive markets to work is to ensure that pricing is both transparent and free of cross-subsidization by monopoly products or services ( "illegal tying").1
Transparency enables consumers to select lower-cost goods and services that are provided more efficiently. Prohibiting cross-subsidization of competitive services by monopoly services enables consumers to choose freely. The combination provides proper price signals to consumers, because such prices constantly encourage consumers to make the right (more efficient) choices. Failure to provide proper price signals means encouraging consumers to make the wrong choices.
In all deregulating states so far, rates charged by regulated utilities are a major part of the deregulation equation. These regulated utilities are allowed or required to continue selling electricity or gas, at least during a lengthy transition period. Because the regulated utility starts out with 100 percent of the customers, its price becomes the target against which consumers judge all competitive offers. Energy pricing is complex and unfamiliar to consumers (with customer charges, per kilowatt-hour or British thermal unit rates, and so on), so it is simplest for competitive entrants to express prices in comparison--typically a percentage discount--to the regulated utility's price.
Because the regulated utilities retain a monopoly on distribution service, policymakers must exercise special care in setting energy prices for them. That is because regulated utilities have a natural financial incentive to include all possible costs in monopoly distribution rates. Customers are forced to pay those rates, so regulated utilities are guaranteed to receive those revenues. In addition, some utilities believe there may be greater assurance of stranded-cost recovery if the customer remains with the regulated utility, even though regulations typically are designed to guarantee such recovery independent of whether the customer selects a competitive supplier.
Where there are elements of both competitive and monopoly markets, price-setting becomes more complicated. In the competitive world, federal anti-trust laws exist that, for example, prohibit one company from charging below-cost prices to force a competitor out of business, then raise prices dramatically once the company dominates the market (becoming an actual or monopoly). The same danger exists for regulated utilities selling energy, except that it is exacerbated by the utility's ability to collect its below-cost amounts through monopoly distribution rates.2 Moreover, since regulators approve the regulated utility's energy price, competitive providers have no access to the protection of the laws normally preventing such anti-competitive behavior.
Including Overhead, Flux Lends Transparency
The fundamental principle of regulation is that, in return for requiring a company to provide a service, regulators agree to allow that company to charge rates (prices) that enable the company to recover its full cost of providing the service (including associated direct costs and corporate overhead). Similarly, competitive markets, by their nature, require that a company charge prices that recover its full costs (direct, associated direct, and corporate overheads); otherwise, that company will go bankrupt. The right price for deregulated utilities to charge for electricity and gas is the same: full cost.
Not only is full cost the right way to set prices for regulated utilities to sell energy, it is simple: (1) Add up the costs of acquiring and transporting wholesale power, (2) add all internal associated costs, and (3) allocate corporate overheads.
Because wholesale gas and electricity prices fluctuate daily, even hourly, setting the regulated utility's price also requires that such fluctuations be addressed. Ideally, prices to the consumer would reflect the variations as daily or hourly prices. (Again, knowing the true economic cost of energy enables consumers to make informed decisions about when and how to use energy most efficiently, given that consumer's desires and needs.) But since usage data is collected monthly (via monthly meter reads) and bills are issued monthly, the simple solution is to reflect such variations on a monthly basis. Indeed, California has adopted this approach.
Various other ways of handling wholesale price fluctuations are available. The problem with these methods is they send the wrong price signals to either consumers or the wholesale markets, creating distortion. In almost all cases, peak energy prices are set too low, causing generators to build too few plants--hence the danger of electricity shortages during peak times this summer. On the consumer (demand) side, peak prices set too low exacerbates the problem by encouraging consumers to use too much energy during peak hours. In deregulated wholesale markets, the combination of too little supply and too much demand has led to dramatic price spikes--though even these are hidden from consumers through averaged prices.
Regulators historically have responded to price spikes with regulation and price caps. Unfortunately, the result is to make the problem worse. Notable examples in the United States were the wage and price controls enacted during the Nixon administration, and, even more relevant, natural gas price regulation. In the early 1980s, before price deregulation at the wellhead, extreme shortages occurred and prices spiked in much the way electricity markets have responded to price caps and the absence of price signals. Forecasters said natural gas no longer would be available by the year 2000. But following deregulation, the competitive market eliminated both problems: Higher initial prices led to widespread exploration, resulting in huge increases in the availability of natural gas, and, in the end, plummeting prices.
The Standard Offer: State-by-State Evolution
A look at the various approaches regulators have taken to pricing energy in competitive markets, and how some are rethinking those plans.
By Paul Gromer
The states that have implemented electric competition have taken very different approaches to the pricing of utility generation service, and most continue to grapple with the issue.
In Massachusetts, for example, regulators adopted a long-term "standard offer," with a seven-year schedule of gradually increasing prices. Wholesale market prices have risen far more rapidly than the standard offer, however, leaving standard offer prices well below the market price. As a result, Massachusetts has achieved just a 0.3 percent customer-switching rate after two years of competition.
California prices its utility generation service at the Power Exchange price, adjusted for class load profiles, line losses, uplift charges, and uncollectibles. The California approach has the advantage of keeping utility generation service prices in step with fluctuating market prices. However, the price does not include the non-commodity costs of providing generation service, such as customer service, accounting, legal, and an allocation of corporate overheads. As a result, competitive suppliers must compete against a utility generation service that is priced at less than the full costs of providing the service.
At some Pennsylvania utilities, "shopping credits" were set above the forecasted cost of power in order to spur the development of the retail market. This approach has worked well, and Pennsylvania quickly developed the most active retail electric market in the country. Indeed, more customers have switched to a competitive electric supplier in Pennsylvania than in all of the other U.S. states combined. However, the Pennsylvania approach does not include a mechanism for adjusting the shopping credits as wholesale market prices change. Recently, several commissions have opened proceedings or issued orders addressing this important issue.
Massachusetts: Moving to Market Prices
On June 30, the Massachusetts Department of Telecommunications and Energy issued an order regarding the procurement and pricing of default service . In Massachusetts, "default service" is the utility generation service provided to customers that are not eligible for the "standard offer." Approximately 20 percent of Massachusetts customers are on default service.
The DTE's order provides that the utilities must procure the power for default service through competitive bids to wholesale suppliers. The wholesale providers must provide an all-requirements service, and are responsible for all costs associated with being the load-serving entity at the independent system operator. The wholesale suppliers must bid a per-kilowatt-hour price for each month of the default service term.
The retail default service prices to customers will be the prices bid by the winning wholesale supplier. As a result, retail default service prices will be linked to market prices. Customers will have two pricing options: a price that is flat for six months, or a price that varies monthly. By setting the retail default service price at the price bid by the wholesale providers, the DTE has included all of the costs of the commodity in the default service price. However, the regulators rejected a request by retail suppliers to also include the non-commodity costs of providing default service.
Rhode Island: Prices Still at Rock Bottom
On June 2, the Rhode Island Public Utilities Commission issued an order regarding the pricing of last resort service . Like Massachusetts, Rhode Island has two forms of utility generation service: "standard offer" and "last resort service" for customers that are not eligible for standard offer.
Prior to the June order, both standard offer and last resort service were priced at 3.8 cents per kilowatt-hour. However, market prices are far higher. In April, the state's largest electric distribution company entered into a six-month contract for last resort service supply at monthly prices ranging from 3.8 cents in May, to 6.5 cents in June, and 8 to 10 cents in July and August.
However, the PUC chose to hold last resort service prices well below market prices. For non-residential customers, it set last resort service prices at 2 to 3 cents below the utility's cost of power. For residential customers, it set last resort prices at 3 to 6 cents below the utility's power cost.
New York: Force Utilities to Exit Sales?
The New York Public Service Commission has opened a proceeding to consider a range of issues relating to the further development of the competitive retail electric and gas markets (Case 00-M-0504). Electric competition is well underway in New York. In this proceeding, the PSC will "refine [its] concept of the mature competitive retail energy markets (especially the future role of the regulated utilities) and É identify and remove obstacles to its achievement."1
Among the issues regulators are considering is a different approach to pricing utility generation service: removing the problem altogether by requiring the regulated utilities to exit the business of selling electricity. The PSC has adopted a similar policy for the gas market. It described the advantages as follows: "Avoid the market-limiting effects of the LDC's dominant-provider position; provide a level playing field for gas supply marketers; place downward pressure on prices; and eliminate the regulation of what would become a competitive function."2
If the utility stops selling electricity altogether, it is no longer necessary to struggle with the pricing of utility generation service. However, it becomes necessary to designate another entity to serve as the provider of last resort, and to determine how that service will be priced. These and other issues will be considered in the New York proceeding.
Texas: Competitive Bidding for Last Resort Service?
The Public Utility Commission of Texas has two proceedings underway relating to the pricing of utility generation service.
The first concerns the establishment of the Provider of Last Resort, or POLR The Texas electric restructuring act provides that competitive retail electric suppliers--and not the regulated distribution companies--will serve as the providers of last resort. The statute requires the PUC to designate those providers, and requires POLR providers to offer a standard retail service package to any customer that requests it.3
The PUC staff has issued a draft rule regarding POLR. The draft rule provides that the POLR providers will be selected through a competitive bidding process that will also determine the rate for POLR service. The staff is requesting comments on this and other aspects of the draft rule.
The second Texas proceeding concerns the "price to beat" . The Texas restructuring act requires competitive affiliates of the regulated utilities to offer a rate known as the "price to beat" to residential and small commercial customers.4 These customers will be placed automatically on "price to beat" service if they don't choose another competitive supplier. Accordingly, "price to beat" functions the way utility generation service does in other states. The price to beat must reflect a 6 percent discount off bundled rates in effect as of Jan. 1, 1999.
Commission staff is conducting workshops regarding the price to beat, and plans to issue a preliminary proposal for comment. Staff is addressing issues such as the rate design for the service and the process for adjusting the "price to beat" rate for fuel price changes and other factors.
1 New York Public Service Commission, Order Instituting Proceeding, Case 00-M-0504, p. 2 (March 21, 2000).
2 Id. pp. 2-3
3 Public Utility Regulatory Act, Texas Utilities Code Annotated § 39.106.
4 Public Utility Regulatory Act, Texas Utilities Code Annotated § 39.202.
The Folly of Market Forecasting
As regulators design deregulating energy markets, many rely on price forecasts of one, two, three, or more years to establish regulated utility prices. The goal is to protect consumers. Unfortunately, this approach is guaranteed to cause major problems not only for those consumers, but also for regulated utilities.
The assumed benefit of the forecasting approach is price stability for consumers, an undeniable political benefit in the short run. However, just as none of us can forecast any market correctly (or we wouldn't be here reading or writing this), none of us can forecast energy markets correctly. That means that when the effects of our incorrect forecast become visible, we'll see negative consequences as early as this summer for the political benefit of stable prices this year or next.
Let's view these consequences hypothetically in two scenarios: too low a forecast, or too high a forecast.
Too low a forecast has the apparent benefit of providing a low price to the regulated utility's energy customers. Because real costs are higher than the regulated utility's price (remember, the forecast is too low), those costs need to be recovered somewhere: either utility shareholders will have to absorb some of those costs or ratepayers (of monopoly distribution prices) will have to pay higher rates. The likely result is a combination of these undesirable possibilities. Another result of too low prices is too little capacity being built--with the possibility of shortages during critical summer peaks leading to the unthinkable: rolling outages. A further result is lack of customer choice, because competitors are inhibited from entering the market. No competitors means no competition, which means no benefits from competition in terms of lower prices and greater innovations.
Those worst affected may be the utility shareholders themselves. Wall Street sees utilities in too-low-forecast situations buying power for more than they are selling the power. Buy high, sell low, and bear the risk of wholesale price fluctuation? Hmmm. ... The result: Investors are selling utility stocks.
Too high a forecast, interestingly enough, is hardly a problem, because competitive markets quickly work to solve the consequences (remember the natural gas market).
Too high a forecast means setting energy prices too high for the regulated utility's energy customers. That is bad, since 100 percent of customers are served by the regulated utility at the outset of competition. However, with actual costs below these prices (the forecast was too high), competitors will enter the market aggressively, and consumers will have many lower-priced choices and switch quickly to companies selling at prices that reflect lower actual costs. Moreover, consumers will complain little about higher regulated utility prices if they have meaningful, lower-cost choices offered by competitors. At the same time, generators will build power plants rapidly, thus avoiding capacity shortages.
Chris King is the co-founder and chief executive officer of Utility.Com. He began in the energy industry at Pacific Gas & Electric in 1980 and has testified before Congress on deregulation issues. Contact King at Chris.King@Utility.Com.
1 The federal agencies have been largely inactive on pricing issues in deregulating energy markets, deferring to state regulators under the "State Action Doctrine," which basically states that prices set by state regulators are assumed not to violate federal anti-trust law because such prices are approved by state regulators.
2 For example, utilities in Massachusetts have been charging default service prices that are below their cost of power, and are recovering that shortfall through distribution rates.
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