An analysis of participant funding in natural gas and electricity markets.

Of all the issues in the energy industry, no matter how technically or scientifically complex, none is more important than fairness. Price spikes, contract reformation, market manipulation-all hot-button issues during the last four years-revolve around a core value held by practitioners and regulators alike: Are the prices that exist in the marketplace just and reasonable?

Even as administrative and federal courts take on fairness issues, consumers are finding themselves on the front lines of a different pricing fairness issue-one that threatens to saddle them with huge cost burdens for which they receive no accompanying service benefits: Should the cost of transmission infrastructure improvements be rolled-in with the costs shouldered by utility companies and their native customers, even if those customers receive no benefit from the expenditure?

Shot to the Heart

Fairness, it would seem, requires those who request and receive economic benefits from transmission upgrades also to pay for such upgrades. This concept is commonly known as participant funding, and it strikes right at the heart of Entergy's service territory, which happens to include a large number of low-income customers. These customers can ill-afford to shoulder the burden of between $2 billion and $4 billion that Entergy conservatively estimates would be added to their rates to pay for these upgrades-especially when they will see no change in their service quality.

Fairness still would be the issue even if our customers here were largely from an upper-income economic base. But the fact that it affects those with the least makes the potential outcome all the more egregious to me.

I understand the goal of rolling-in these costs-that at some point all customers will theoretically benefit from an upgraded system-and in light of the blackout in the Northeast last summer, I appreciate the importance of an enhanced grid. However, I can't seem to get past the fact that we're asking those who can least afford it to fund these upgrades, when the merchants understood the risk with their investments and were rewarded with market-based rates in exchange for their risk, and all without the traditional regulatory handcuffs.

There are obvious distinctions that argue against applying a traditional rolled-in pricing methodology to upgrades of the electric transmission network. One distinction is that a rolled-in price doesn't work when overlaid on a system that combines vertically integrated utilities and merchant generators selling in a national marketplace. In the electric model, upgrades affect a national marketplace by asking captive customers to pay for upgrades for a new competing company, with market-based rates and without regulatory impediments, to enter the service area and sell to another segment of customers. Costs should follow benefits and there should be a direct relationship between the two. To do otherwise would not build a competitive environment but instead a market without risks.

Who Pays?

If any issue could further undermine the general public's confidence in our handling of the American electric infrastructure, that issue could be profit without costs. I think the average customer can accept the idea of a higher electric bill, assuming that further blackouts could be prevented with an upgraded grid, but only if it is married to fairness. And fairness requires that all sectors of the industry-not just customers-shoulder their share of the cost.

It also is difficult to find a compelling argument to support rolled-in pricing when we consider how the Federal Energy Regulatory Commission (FERC) has addressed this issue in other industries it regulates. As we struggle with electric deregulation issues, we have been encouraged to look at how natural gas was deregulated in the 1990s. Generally, gas deregulation has been considered a success, and it is often held out as a model for electric practitioners. The gas model is particularly instructive on pricing issues because, after much deliberation and litigation, the commission has embraced a market-oriented pricing regime, including a threshold requirement that participants be able to fund pipeline expansions without subsidies from their existing customers.

FERC has not always held this point of view. At one time, the commission's preference, where equitable, was to roll-in expansion costs.¹ FERC's preference at the time aligned with the industry's attitude, which was to get pipe in the ground, build out the grid, and roll-in costs to do so. But there also was an awareness that this tactic had a cost, a high one, and one that often was paid for by native customers.

In one of the most important cases on the issue of rolled-in versus incremental pricing, the Circuit Court of Appeals for the District of Columbia in 1960 clearly laid out the two lines of thought. In a case involving the Battle Creek Gas Company, the court held:²

There are two basic and potentially divergent methods of allocating new asset costs to be reflected in a utility's rate structure. The first recognizes that a gas pipeline of this sort is not just a collection of discrete pieces and parts, but an integrated system serving all of its customers. Applying this approach the cost of the various assets of the system are collected or "rolled in" to arrive at the cost of the entire system which is then pro-rated among all of the customers. ...³

... At some point the facility becomes so identified with its function as part of the local distributor's gas plant that it may be unfair to charge its costs to all of the customers of the utility. This is particularly so where the extent and cost of such segregated facilities vary greatly among the customers. In such a situation the costs of these facilities are commonly charged as an "incremental" cost added in to the particular customer's rate base.⁴

The court recognized that the rolled-in methodology had some serious drawbacks to it. Both the court and FERC have noted that:

The rolled-in rate method is generally disadvantageous, however, to old customers of an expanding pipeline. The cost of new facilities and new gas historically has risen steadily, and a rolled-in rate requires old customers to pay a higher price and bear part of the cost of an expansion from which they receive little visible increase in service.⁵

There are two basic and potentially divergent methods of allocating new asset costs to be reflected in a utility's rate structure. The first recognizes that a gas pipeline of this sort is not just a collection of discrete pieces and parts, but an integrated system serving all of its customers. Applying this approach the cost of the various assets of the system are collected or "rolled in" to arrive at the cost of the entire system which is then pro-rated among all of the customers. ...³

... At some point the facility becomes so identified with its function as part of the local distributor's gas plant that it may be unfair to charge its costs to all of the customers of the utility. This is particularly so where the extent and cost of such segregated facilities vary greatly among the customers. In such a situation the costs of these facilities are commonly charged as an "incremental" cost added in to the particular customer's rate base.⁴

The basic test has always involved a weighing of costs and benefits. However, in the past, the Commission took a broader view regarding the value of system expansion to existing customers than we have in recent cases. This is, in part, because the increased costs to existing customers resulting from rolled-in pricing were generally relatively small compared to the obvious systemwide benefits in the form of increased capacity, reliability, and flexibility. However, more recently, the Commission's focus on the value of the benefits of expansion to systemwide customers has intensified as costs have risen considerably in relation to the benefits.¹⁶

A number of commenters submit that the existing presumption in favor of rolled-in rates for pipeline expansions sends the wrong price signals with regard to pricing new construction. They urge the Commission to adopt policies such as incremental pricing for pipeline projects or placing pipelines at risk for recovery of the costs of construction. They submit that such a policy would reveal the true value of existing capacity and properly allocate costs and risks.²⁹

An effective certificate policy should further the goals and objectives of the Commission's natural gas regulatory policies. In particular, it should be designed to foster competitive markets, protect captive consumers, and avoid unnecessary environmental and community impacts while serving increasing demands for natural gas. It should also provide appropriate incentives for the optimal level of construction and efficient customer choices."³⁰

As the industry becomes more competitive the Commission needs to adapt its policies to ensure that they provide the correct regulatory incentives to achieve the Commission's goals and objectives. All of the Commission's natural gas policy goals and objectives are affected by its pricing policy, but directly affected are the goals of fostering competitive markets, protecting captive customers, and providing incentives for the optimal level of construction and efficient customer choice. The current pricing policy focuses primarily on the interests of the expanding pipelines and its existing and new shippers, giving little weight to the interests of competing pipelines or their captive customers. As a result, it no longer fits well with an industry that is increasingly characterized by competition between pipelines.

The current pricing policy (rolled-in) sends the wrong price signals, as some commenters have argued, by masking the real cost of the expansions. This can result in overbuilding of capacity and subsidization of an incumbent pipeline in its competition with potential new entrants for expanding markets. The pricing policy's bias for rolled-in pricing also is inconsistent with a policy that encourages competition while seeking to provide incentives for the optimal level of construction and customer choice. This is because rolled-in pricing often results in projects that are subsidized by existing ratepayers. Under this policy the true costs of the project are not seen by the market or the new customers, leading to inefficient investment and contracting decisions. This in turn can exacerbate adverse environmental impacts, distort competition between pipelines for new customers, and financially penalize existing customers of expanding pipelines and of pipelines affected by the expansion.

Under existing policy, shipper's rates may change for a number of reasons. These include rolling-in of an expansion's costs, changes in the discounts given other customers, or changes in the contract quantities flowing on the system. As a customer's rates change in a rate case, it is generally unable to change its volumes, even though it may be paying more for capacity. This results in shippers bearing substantial risks of rate changes which they may be ill equipped to bear.³¹

Our new model is completely consistent with our traditional model except that it now permits pricing grid service on the higher of the grid's average or incremental costs. The result is that the transmission customer pays for all grid facilities at a price equal to or higher than the native load. In the context of our traditional cost-of-service model, this is the equivalent of allocating to the new transmission customer the transmission revenue requirement sufficient to compensate the utility for the expansion of the system. Simply put, it is part of the "cost allocation" process. Thus, by requiring that the new transmission customer pay a rate which is the higher of embedded cost (i.e., a rolled-in rate including the expansion cost) or incremental cost (i.e., expansion cost revenue requirement divided by the new customer's units of service), the new transmission customer is paying an amount that is at least equivalent to a pro rata share of the sum of the cost of the existing grid and the cost of expansion facilities. There are no existing facilities which are being used free of charge and there can, therefore, be no subsidy.

The Commission believes that, to ensure fully comparable treatment of all Generating Facilities, transmission rates should not include the costs of Interconnection Facilities. As stated in the NOPR, this policy is consistent with the Commission's current treatment of generation step-up transformers, appropriately assigns the costs of Interconnection Facilities to the generation customers using them, and ensures that the Transmission Provider's own Generating Facilities and those of its competitors are treated comparably.

In Order No. 2003, the Commission did not intend to abandon any of the fundamental principles that have long guided our transmission pricing policy. [f.n. omitted] In particular, the Commission had no intention to adopt a policy that is inconsistent with its "higher-of" pricing standard for non-independent transmission providers. Thus, we clarify that under our interconnection pricing policy, the Transmission Provider continues to have the option to charge a transmission rate that is the higher of the incremental cost rate for network upgrades required to interconnect its generating facility or an embedded cost rate for the entire transmission system (including the cost of the Network Upgrade).

Where rolling-in the costs of network upgrades incurred for an interconnection would have the effect of raising the average embedded cost rate paid by existing customers, the Transmission Provider may elect to charge an incremental cost rate to the interconnection customer and thereby fully insulate existing customers from the costs of any necessary system upgrades.