For the past seven years, the New England electric power industry has been transitioning to a competitive market structure. Electric restructuring—identified in some quarters with Enron, California, and the August 2003 blackout—has brought significant, measurable benefits to us in New England.
The introduction of competition into the wholesale electricity markets has resulted in a more reliable, economical, and environmentally friendly power system. New England's wholesale electricity prices, after adjustment for fuel costs, have declined by 5.7 percent since the first full year of operation (2000) and 11 percent since 2001. New power plants are producing cheaper, cleaner electricity, and five major transmission projects are underway to enable power to flow more efficiently throughout the region. Moreover, the lights stayed on throughout most of New England during the massive 2003 Northeast Blackout.
This progress has not come without controversy. There are some who continue to question whether the promise of deregulation is being realized and whether we should reinstate some form of regulation. Others fight each new initiative without considering the immediate impact of inaction or weighing the potential long-term benefits to consumers.
Seven years after restructuring began, it's a good time to assess the challenges that remain and gauge whether to stay the course toward continued restructuring. The best way to explore this question is by considering the current state of the industry in New England. We need to look at where we started, what we've done, and where we are going.
The goals for restructuring are clear: increased supplies, reliable delivery, efficient and clean production, and lower prices, all based on competitive markets that provide reasonable returns for investors. How do we get there? The steps already taken help define our future direction.
In New England, where electric rates are among the country's highest, five of the six states passed restructuring laws that required utilities to divest their power plants (Vermont did not). With 88 percent of its electricity generation unregulated, New England has the most disaggregated electricity marketplace in the nation and a strong foundation for achieving successful competitive markets.
Actively managing the transition has been the key to its progress. The Federal Energy Regulatory Commission (FERC) recognized that independent oversight was needed to ensure open access to the transmission grid and a competitive marketplace. An independent system operator (ISO) was formed in 1997 to oversee New England's six-state region-a highly integrated, tight power pool with a tradition of regional cooperation. ISO New England (ISO-NE) is a not-for-profit corporation that oversees a system of 350 generating units, 8,000 miles of high-voltage transmission lines, and 12 interconnections to neighboring systems serving 6.5 million New England businesses and households.
When ISO-NE was created, formal wholesale electricity markets did not exist. Electricity was dispatched from generators based on longstanding power pool practices. Working with regulators, the industry, and other stakeholders, ISO-NE developed and launched "interim markets" in 1999, and thus began the evolution from regulation to functioning markets.
The introduction of competitive markets led to the development of a merchant-power sector that invested in highly efficient and clean plants. These plants significantly improved both reliability and competition. The markets provided new and more transparent information about the performance of the power system, helping to identify needed infrastructure improvements, including new transmission lines that could carry more power more efficiently.
Competitive markets also created incentives to improve the operation, utilization, efficiency, and overall performance of existing generation and transmission facilities. This increase in "power system availability" lowered wholesale-market costs.
Despite these developments, the interim markets needed risk-management tools, such as a day-ahead market, and mechanisms to enhance efficiency, such as pricing that accurately reflects power system needs. Day-ahead markets protect against price volatility. Accurate pricing is based on the true cost of producing and supplying power at numerous locations on the system.
In 2001, ISO-NE and its market participants adopted the market system used by PJM, the RTO for the Mid-Atlantic States, to provide these features. This standardized market design (SMD) created markets with an appropriate level of flexibility to preserve best practices and adapt to the unique needs and characteristics of New England. SMD was implemented March 1, 2003. SMD's features, such as eight pricing zones for electricity and a day-ahead market, have benefited New England markets. For example, creating a separate pricing zone for Connecticut, where demand is high and growing rapidly and transmission capability is weaker than anywhere else, means that prices can be higher-thus encouraging more investment in that area.
In 1999, ISO-NE launched wholesale markets with approximately 160 participants. Today, more than 260 companies and entities participate in these markets and complete more than $7.25 billion of wholesale electricity transactions annually. These new markets have demonstrated real returns, indicating that a successful market infrastructure can be built where none existed-and in a relatively short period of time.
Major benefits of the transition so far include:
Competitive markets, in our experience, work best with strong oversight and well-structured governance. The continued transition will not work without a comprehensive, collaborative planning process and strong independent leadership.
ISO-NE is spearheading necessary market improvements through the Wholesale Markets Plan. The plan provides a guide for making improvements to the market, so that participants have the ability to make informed decisions about future purchases and investments.
We also instituted an annual system planning process involving industry representatives, state regulators, and public officials that identifies critical power system needs and encourages market responses. The planning process is resource-neutral, and all solutions, whether generation, merchant transmission, or demand response, are considered equally.
In early 2005, ISO-NE evolved into a regional transmission organization (RTO) structure with clear operational control over the management of the region's transmission facilities, authority for the terms and conditions by which transmission customers receive non-discriminatory transmission service, and the ability to require transmission owners to pursue needed upgrades. ISO-NE will continue to be the single point of control to maintain reliability, not only on a daily basis, but also in emergencies. Through these authorities, it has an increased ability to protect the region from system failures.
Although New England is building a strong foundation for achieving successful competitive markets, more work remains. Reliability remains a serious concern in Greater Boston and Connecticut, where there is not enough electricity produced locally to meet growing demand, and transmission infrastructure is inadequate to bring surplus power in from other parts of New England, New York, and Canada. This mismatch between where the supply is produced and where it is used, combined with an aging and inadequate regional bulk power grid, results in reliability problems in the heaviest demand centers and adds significantly to the cost of power.
Five major factors contribute to the risks to reliability:
New England has come to the end of its building boom for new power sources. At the same time, we project that average peak demand for electricity will grow by approximately 1.5 percent annually during the next 10 years. The growth rate is higher, approximately 1.9 percent, in high-demand areas such as Connecticut. Moreover, there is a potential for a large number of generator deactivations or retirements, some of which are located in critical load pockets. The region also has become heavily reliant on natural gas-fired generators, many of which do not have a firm fuel supply. That poses potential reliability issues for the winter peak-load periods.
Five major transmission projects have been identified and planned, but the process of siting these facilities has been contentious and slow, particularly in Connecticut. Even with planned transmission upgrades, additional resources or repowering of existing resources will be needed within the load pockets to offset potential retirements and meet growing demand. As early as 2008, New England could face electricity shortages that would require emergency actions to meet peak demand in the summer.
There are three schools of thought as to where we go from here.
Some propose a approach and promote it as the "least-cost" option. This approach would require a series of administrative actions and market interventions, causing inefficiencies, higher costs, and increased reliability risks. This approach would lead to a continuation of expensive reliability contracts to secure supply from older, less efficient generators, and to the continued operation of the flawed installed capacity (ICAP) market. Other measures would cost consumers money but not attract needed investments in the system.
Some say free market solutions are not working, and they advocate a retreat to some form of regulated market. One recent proposal would allow utilities to own generators again as a way to ensure investment in new power plants. This first step back to regulation would create a situation in which generation projects financed through retail rates would have a substantial competitive advantage over projects that rely on wholesale market revenues for cost recovery. Merchant companies would be unlikely to enter the market, and competition and choice would disappear. Consumers would pay more for less reliable service, and over time, the full risk of investment would be shifted back to them.
While we recognize that our region still faces significant challenges, turning back now is akin to someone who sets out to swim the English Channel, only to turn back when halfway across. It's far better to meet the challenges head-on and continue making progress than to turn back and end up where you started.
ISO-NE has proposed changes to the wholesale market to send appropriate price signals for existing and new capacity. These changes will encourage more generation development by competitive companies and less reliance on rate-based mechanisms to maintain and develop needed resources-another step toward a fully restructured industry.
These initiatives include a locational installed capacity (LICAP) market to promote the development of new resources inside load pockets; enhancements to our ancillary services markets that reflect the need for operating reserves by location; and improvements to our demand-response programs.
Changes in the capacity market are needed to ensure future investment. The absence of a functioning capacity market has necessitated costly contracts with generators to keep needed power plants available for reliability. The cost of these reliability agreements currently is $800 million on an annual basis, and is expected to continue to increase. The bigger long-term issue, which LICAP is designed to solve, is creation of a market incentive to attract investment in new power plants or demand-side resources to meet the growth in New England's electricity use.
The LICAP proposal is before FERC, and implementation has been delayed until Oct. 1, 2006, at the earliest. The New England state regulators are exploring alternative designs, which would take longer to implement. The ISO has continued to advocate for LICAP as the best solution for now, but has committed to assist the regulators with their efforts.
ISO-NE also proposes changes to our reserve markets, allowing more efficient use of the resources in the right locations, at the right time, that provide these services and creating incentives for investment in needed resources in heavy demand areas.
The most significant change would add a "locational forward reserve market" to the existing forward reserve market (FRM). A new FRM went into operation Jan. 1, 2004, to improve incentives for installing and maintaining reserve power plants that could be called upon to produce power quickly and help maintain reliability. This change will better value reserves to reflect where demand is greatest, providing a price signal for investment in local quick-start plants in those heavy demand areas.
ISO-NE also is planning improvements to current demand-response programs intended to integrate demand response into the wholesale electricity markets on an equal footing with generation, and to build stronger links between the wholesale and retail markets.
One such improvement would allow retail customers to "bid" their load reduction into the day-ahead energy markets the same as any generator. A further step would allow load reduction to be dispatched in real time, in the same manner as generation. Another objective is to encourage the six New England states to adopt policies that link retail electricity prices to hourly wholesale electricity prices. Such retail rate designs would encourage customers to reduce their electricity consumption when wholesale prices are high. This could create a concrete link between the wholesale and retail markets, because lowering consumption on the retail side would have a positive impact on wholesale prices.
New England is building a strong foundation for achieving successful competitive markets. As the markets mature, we will continue to respond to developing challenges. The additional enhancements that are planned will ensure the long-term reliability of the region's electricity system, so it can continue to meet the needs of New England consumers and support economic growth.
During the coming years, ISO-NE and our peers around the country will continue to refine the model of competitive markets transforming the industry. It is important for the power industry as a whole to continue to move forward with market-based initiatives, and to not fall back into the perceived "safety" of a regulated environment. On the basis of our experience in New England, we have come to believe that competition in the power industry is critically important for the reliability of the nation's power system and the health of its economy.