Ohio's proposal for retail marketing areas would give all customers meaningful choice and all suppliers even footing.
When grocery shoppers go looking for a can of tuna fish, they must decide which brand to buy. No particular brand will jump off the shelf into their shopping carts. The same is true with automobiles or any other consumer good. First you choose a make and model. Electricity and other utilities, however, are a special case. In the transition from monopoly to competition, consumers face a different prospect. If they fail to make a choice - and if the rules fail to anticipate such an occurrence - the right to serve the customer will fall by default to the incumbent, the former monopolist.
We know from experience with long-distance telephone deregulation that even after many years an incumbent monopolist can retain a substantial share of the market. This customer inertia appears unique to this type of case: It occurs where competition has been introduced to a product market in a geographical area in which an incumbent utility has long retained close to a 100 percent market share.
For example, the Federal Communications Commission reported last year that by 1996, AT&T's market share of operating revenues for long-distance carriers had dropped only to about 48 percent.fn1 It took 12 years for share to fall from a figure of 90 percent, where it had stood in 1984, the year of AT&T's breakup. This same pattern is beginning to emerge in state retail electric markets, according to early reports/fn2/, and may be especially true for residential and small commercial customers.
There may be many different reasons why customers are unwilling to choose from among competitors in deregulated markets. Customers can be faced with a bewildering amount of information, at least in the beginning, or the potential savings may be too small to be bothered with. Both of these reasons may be related in that the expected transaction costs for customers to search for their best options may exceed the expected savings.
Of course, no one expects incumbent electricity suppliers to maintain a 90 to 100 percent market share over time - any more than AT&T did. But it is likely that retail electricity markets will follow a similar pattern of gradual market share erosion. Considering that electric supplier incumbents start out with nearly 100 percent of market share, it may take years to decline to where there would be general agreement that market dominance is not a problem.fn3
Why this customer inertia? Quite simply, it is inherently difficult to penetrate an incumbent's market.
In telecommunications, service providers were assigned randomly to customers that did not choose a long-distance carrier - an effective but arbitrary remedy. In electricity, however, no state has yet to solve the problem of these "default" customers.
In electricity restructuring, at last count, alternatives to random assignment appeared to be under consideration in Mississippi, Missouri, Nevada and Ohio. While these proposals vary somewhat, the basic idea is to have a competitive bidding process to determine who will serve the retail customers who did not specifically choose a supplier, rather than have them simply default to the incumbent utility.
The Ohio plan, which would create "retail marketing areas," or RMAs, represents a fully developed bidding plan. Potentially, the biggest selling point for RMAs is that they should ensure that all customers - large and small - will benefit from retail competition from the beginning, not just the "big dogs eating first." This more equal footing among customers is coupled with a more equal footing among the incumbent utility and new entrants. This model should help "jump-start" competition in a state by providing a means for fair entry by all qualified suppliers and provide a platform for vigorous competition. Even so, the RMA plan creates its own set of complexities. Auction design is critical in avoiding collusion or bias in allocating market rights.
The Ohio Plan:
Competition Through Auctions
Legislation proposed in Ohio in both the House and Senate in 1998 would divide the state into geographic areas, or RMAs, representing subdivisions of the current utility service territories. Each RMA would consist of an aggregate pool of retail customers. Only those retail customers that did not choose a specific electric supplier would be in the RMA.
Under the proposed legislation, the Public Utilities Commission of Ohio would conduct a bidding process to determine the supplier for customers in each RMA. The proposed RMAs would be temporary. They would run for five years with the first bid at the beginning of retail competition (proposed to begin Jan. 1, 2000) and the second bid 2-1/2 years later.
RMAs are not intended to replace customer choice. The proposed process will not interfere with the right and ability of customers to choose an electric power supplier. Customers first will be given an opportunity to choose a supplier, including choosing to remain with their incumbent utility. Then customers will be given a warning notice that they are about to become a part of a pool of retail customers unless they "opt-out" by choosing a supplier. After that, customers still can choose a different supplier from the one that wins the bid for their RMA. However, they may be required to pay a switching fee based on the administrative cost of the changeover. At no time will customers be stuck with a supplier they do not want or be prevented from choosing to buy power from any available and qualified supplier they want. The only customers in the RMA are those that either chose to be in it or never made a specific choice.
The size and composition of the RMAs would depend on several factors. The RMAs would have to be a large enough aggregation of customers that the benefits of size would be obtainable (the same benefit that large industrial customers enjoy). Also, the RMAs would have to be large enough that the total number of RMAs in the state is manageable by the PUC when administering the bidding program. However, they should be small enough that new suppliers will be given a reasonable opportunity to participate in the bidding process. Also, the RMAs should be composed of a mix of retail customers; that is, there should not be a concentration of either highly "desirable" (say, large industrial or commercial customers) or "undesirable" customers (say, low-income consumers). It is also advisable, when possible, to keep the size and composition of customers in the RMAs comparable throughout the state. Maintaining some uniformity across RMAs would facilitate the submission of bids by suppliers and the evaluation by the PUC.
Utilities first will be given an opportunity to subdivide their service territories for the RMA boundaries. They should draw the boundary lines of these contiguous geographic areas with an eye toward transmission and distribution facilities. The creation of transmission and distribution bottlenecks would have to be avoided, to prevent any supplier being given an advantage. A logical dividing parameter may be to have the RMAs correspond with the distribution customers served by one or more distribution substations. Utilities could combine substations until the desired number of retail customers is reached. The PUC would be given authority to review the proposed boundaries and, provided the criteria for determining RMA boundaries have been met, will have final authority to approve the boundaries.
Before any potential supplier could submit a bid, it would need the PUC's designation as a "qualified bidder." This qualification would be based on a demonstration of sufficient financial resources and capacity commitment. It would serve as a minimal screening process to prevent participation by unqualified suppliers with inadequate financial resources and access to capacity.
Bidding: Sealed or Open?
A critical element in the RMA design is the selection of the winning bidders. There are two distinct possible designs: a sealed-bid auction run by the PUC or an automated auction that would be similar to the FCC's spectrum auctions.
In a sealed-bid auction, now part of the RMA proposal, the PUC would disclose in advance the bid evaluation criteria, which would explain price and non-price factors to be used to select winning bids. This procedure would be similar to the competitive bidding for new power supply that some states used for PURPA-qualifying facilities and new capacity needs. Price would be the most important single factor, but significant consideration should be given to non-price factors. These non-price factors primarily would be intended to ensure and maintain the state's system reliability. They would include an evaluation of the probability of supply, the financial viability of the supplier and specific performance guarantees. The evaluation criteria, procedures and selection of winning bidders should be disclosed to the public.
An advantage of the sealed-bid process is that the confidentiality of bidders' proposals can be maintained. This feature limits the chance of collusion among bidders and leads to the best price for consumers.
The downside is that suppliers may bid a very low price that causes financial hardship - that is, the "winners curse" may be more likely.fn4,fn5 While that is good for customers, it is important to maintain the reliability of the electricity system to ensure that suppliers are not withdrawing from the market because they cannot cover their costs.
Process: Multiple Rounds?
Another disadvantage of the sealed-bid auction process comes from the difficulty the PUC will encounter when evaluating the various bids. The bids likely will contain a complex mix of customer size and time- and type-of-use prices. This is exemplified by the complex tariffs that comprise the current rate structures utilities have. In addition, there will be many non-price factors to consider, such as reliability. Another problem with the sealed-bid auction is that bidders will not be able to react to other bidders as they could in an open competitive market. This makes the bidding static and somewhat of a "black box" for bidders. Finally, if bidding were statewide where all RMAs are bid at the same time, this could place a heavy burden on the PUC. Breaking the bidding into state regions may relieve some administrative burden, but could lead to an uneven price distribution across the state as the existing capacity is bid and suppliers adapt and learn from each successive bid.
An alternative is an automated, simultaneous multiple-round auction. This is a type of auction mechanism that the FCC has used to assign spectrum licenses in 16 auctions since 1994. This model would allow the simultaneous auction of all of Ohio's RMAs. Bidders would submit bids on one or more RMAs of their choice. There could be a number of price categories, which would be determined in advance, for each RMA that bidders could bid on. (These would parallel price tariffs utilities now have, such as by load size, season, etc.) There would be multiple rounds of open bids so that for each round, all participants would know the best bidder's price and identification.
This multi-round process also would create a more open and dynamic process in which bidders would immediately and actively participate in the auction, make adjustments, learn the results of their bids and tailor responses. Suppliers would be able to take advantage of synergies that would arise from multiple-RMA and price category bids. That is, if a bidder wins one or a group of RMAs, then adjacent RMAs are more valuable to them. They could then more aggressively bid on these adjacent RMAs. Customers would benefit from the fostering of a more transparent and active competitive market that allowed broad and aggressive supplier participation.
Since the basis of selecting the winner will be price only, the qualification of bidders becomes more important than it would be with a sealed-bid auction. Bidders would have to be pre-screened on the basis of financial viability, reliability of capacity and energy and performance guarantees.
A disadvantage of an open auction of this type is that collusion among suppliers is easier and more probable. The PUC would, as the FCC does, monitor the bidding activity, be on the lookout for possible collusion and take action when it does occur. Another disadvantage is that the process, while open, becomes more rigid in terms of evaluating bids since it is based on price only for the specified price categories. Once these customer groups have been established, bids that do not fit the criteria cannot be given consideration. This may mean that innovative bids, for example, from a potential supplier that wants to combine some conservation measures along with its supply proposal, cannot be assessed.
Service Rights: Exclusive to Each Zone?
Another important issue is whether there should be only one supplier or if multiple suppliers for each RMA should be allowed. It may be more advantageous for customers to have one supplier serving the RMA since smaller customers, such as residential customers, will benefit from the aggregation with larger customers. In this case, the bids could be evaluated based on a weighted average of several different predetermined tariffs. Alternatively, multiple suppliers could be allowed in a system that awards the bid for each customer group to the best bidder of that tariff. The advantage of this approach is that suppliers with certain generation characteristics could specialize in supplying certain customers. The disadvantage is that these suppliers could target ("cherry pick") the choicest customers and ignore or at least not be as aggressive in marketing to smaller customers.
Many other design features will need to be worked out. These include whether there should be discrete versus continuous rounds, the number of price categories and the timing limits (if any) of the rounds and the auction.
Once winning bidders are selected, the PUC will have to arrange contracting with the suppliers. Standard contract terms and conditions could be worked out in advance and publicly disclosed. These could include operating standards, a requirement that the RMA supplier serve new customers that move into the RMA and do not choose a specific supplier, force majeure clauses and performance security bond or letter of credit requirements. Contracts should also include contingency provisions in the event of non-performance or financial insolvency.
Why We Need RMAs
Ohio utilities, not surprisingly, have concerns about this proposal. They understand that without customer assignment, they would retain 70 or 80 percent of the market in their old service territories, even if their prices are higher than alternatives. However, the proposed RMA concept gives incumbent utilities three opportunities to convince customers to choose them as their supplier.
First, the incumbent utility will be allowed to convince customers to select it as the supplier and not become part of the RMA. Second, the incumbent utility will be allowed to bid to serve its historic service territory customers and new customers outside of its traditional territory. It may expand (or contract) its customer base at its discretion. Finally, the incumbent utility can urge customers to return to it once they are in the RMA not served by the incumbent. Incumbents can retain customers they had when they were monopolists, but they will have to do it in the same way suppliers that are new to the area will attract customers - that is, by convincing customers that they offer the best deal for their needs. In short, utilities will not just inherit the lion's share of customers; they will have to do it the old-fashioned way, by earning their market.
A criticism of the RMA concept is that it forces a choice on consumers. This is simply not the case. Customers will have ample opportunity to select their preferred suppliers and never will be "stuck" with suppliers they do not want. Clearly, it would be better if there was no need for RMAs. We could simply let each customer decide and allow the competitive market to sort out the suppliers and find the best way to satisfy demand with the available supply. However, even with the multi-million dollar consumer education campaigns we have seen for the long-distance telephone market and electric markets, customers may be slow to switch from their incumbent utilities.
This customer inertia is a source of horizontal market power for the incumbent utility and a significant barrier to entry for alternative suppliers. Some states have required divestiture of generation as a means of alleviating vertical market power. However, divestiture does little to lessen horizontal market power unless it is coupled with a limit on the percentage of the total capacity that may be owned by one firm. This may be difficult to implement and result in a loss of some economies of scale. Also, for some jurisdictions, the divestiture option may be difficult for a state to mandate, such as in the case of multi-state holding companies and where some generation is beyond the state's borders.
The temporary use of RMAs is intended to overcome customer inertia in the early stages of retail competition. This will prevent the incumbent utility from getting the vast majority of customers by default. The RMA idea is proposed as a better alternative to the random assignment of customers to suppliers since it is less arbitrary. If RMAs are not used to solve the problem of customer inertia, then some other means should be considered.
Kenneth Rose, Ph.D. is senior economist at the National Regulatory Research Institute at the Ohio State University. Rose assisted lawmakers in the development of proposed legislation, introduced in 1998, which included the RMA concept. He can be reached at firstname.lastname@example.org. His views and opinions do not necessarily reflect those of the NRRI or funding organizations of the NRRI.
The Ohio Legislation RMAs Caught in a Crossfire?
As of December 1998, legislation to set up RMAs appeared less than a sure thing, after Ohio's major investor-owned electric utilities had weighed in with recommended changes to the state's proposed electric restructuring plan.
RMA Proposal. The twin bills on electric restructuring - S.B. 237, sponsored by Sen. Bruce E. Johnson (R), and H.B. 732, sponsored by Rep. Priscilla D. Mead (R) - were introduced to the Ohio legislature March 26. The bills proposed a broad plan covering many issues, including "temporary" RMAs during a five-year transition period, through which retail customers might choose to receive electric generation service as part of an aggregated group.
However, the bills died late last year when the 122nd General Assembly adjourned without approving them, and were to be reintroduced in the new 123rd General Assembly this month.
Utilities Weigh In. In August, American Electric Power, Cinergy, Dayton Power & Light and FirstEnergy had called for amendments on other matters. Their proposals would establish larger, broader tax cuts, freeze rates at current levels for the five-year transition period, allow the utilities to recover stranded costs during the rate freeze and allow securitization. They also recommend a transition to customer choice on Jan. 1, 2001, one year later than proposed by the bills, and a rewrite of state law regulating electric utilities.
The very notion of RMAs is a problem for the utilities, according to Tom Holliday, spokesman for AEP's Ohio operations, who says they "represent unnecessary government intervention in the competitive process."
Some are critical of the utilities' recommendations, however.
Ohio Consumers' Counsel Robert S. Tongren notes that a major difference in the utilities' proposal concerns the period of transition to a competitive market. "As I understand it," he says, "it looks more like it is designed to help the utilities prepare for competition, rather than to get consumers to a competitive market."
Not so, says Holliday. "The transition [proposed by utilities] does provide customers with the opportunity to become familiar with competitive markets and ¼ provides the utilities an opportunity to recover stranded costs."
Tongren insists, however, "rather than suggestions to the lawmakers, what the utilities are proposing is the exact opposite" of the Johnson-Mead plan. He adds, "It's not too great a sign from the industry that [it would] like to find some meaningful consensus."
Outlook. Johnson and Mead continue to work with representatives from industry and consumer groups to reach accord. However, a major sticking point is the matter of reclaiming stranded costs. While the Johnson-Mead five-year plan proposes a process that would allow utilities to recoup some stranded costs through customer surcharges, utilities want be able to recover a greater portion of costs.
"Johnson-Mead would almost preclude stranded cost recovery for AEP and would limit recovery for other Ohio utilities," says Holliday. "We think there needs to be a greater opportunity for utilities to recover those stranded costs."
He notes that the proposals presented to date may take on an entirely different form when reintroduced to the state legislature. "We're looking at a blank slate in 1999," he says.
Rep. Mead says it's difficult to say how much the bills might be revised, but agrees, "I can tell you that 732 and 237 will not be reintroduced as is. There will be substantial changes to reflect the changes in our world [since the bills were drafted a year-and-a-half ago]."
In late December, The Columbus Dispatch reported that state lawmakers had decided to keep the informal discussions among stakeholders private. House Speaker Jo Ann Davidson said the meetings must be kept under wraps if investor-owned utilities were to participate, to avoid any impact from the negotiations on the value of their stock. Davidson is aiming for a Feb. 1 introduction of the legislation, according to the report.
"I'm not concerned [about the meetings being held in private], because residential consumers are represented through our participation," said Tongren.
Noting that incoming Ohio Gov. Bob Taft has named electric deregulation among the state's highest priorities for enactment as soon as possible, he added, "The message to the industry is that we're going to do this, so [stakeholders] better come to the table ready to seriously participate [in crafting the legislation]."
The Johnson-Mead proposal is based on recommendations issued in January 1998 by the Joint Select Committee on Electric Utility Deregulation, which the pair co-chair. Access the report at: www.state.oh.us/cons/pain.htm. Or, check the status of Ohio legislation at http://lsc.state.oh.us/ domino/lscstatus.nsf?open.
1 Zolnierek, James and Rangos, Katie, "Long Distance Market Shares, Third Quarter 1997," Federal Communications Commission, January 1998.
2 For views on the development of retail electric markets, see "California's Electric Market: What's in It for the Customer?" by Ryan Wiser, William Golove and Steve Pickle, Public Utilities Fortnightly, August 1998, p. 38; and "California's Electricity Market: Are Customers Necessary?" by Robert McCullough, Public Utilities Fortnightly, July 15, 1998, p. 36.
3 Another way of looking at market concentration is to consider the Herfindahl-Hirschman Index for the long-distance market. In 1984 the HHI (the sum of the squares of market shares for individual sellers) was 8,155 and dropped to 2,823 in 1996. At this level, even after this 12-year decline, some analysts are still concerned about market domination by AT&T.
4 See, e.g., "Winners' Curse: Why Spectrum Bidders Overpaid," by Stephen Maloney, Public Utilities Fortnightly, Oct. 15, 1997, p. 31.
5 In telecommunications, bid winners in spectrum auctions later proved unable to pay their bids. The auctions arguably changed the relationship between the FCC and the licensees it regulates. See "Spectrum Auctions at the FCC: A Lesson for Utilities?" by Shirley S. Fujimoto and Christine M. Gill, Public Utilities Fortnightly, Oct. 15, 1997, p. 26.
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