The road to the current reliability crisis is paved with four decades of bad policy decisions.
The technical causes of the great Northeast blackout of August 2003 are coming into focus. For reasons yet unknown as of press time, transmission lines in northern Ohio were lost to the grid, and within seconds 50 million people in the United States and Canada were without power. Soon we will no doubt know the specific reasons for the blackout, and technical corrections and improvements will be made.
Not so well understood are the management and social causes of the blackout, or that anything needs to be done about them. The August blackout, the California energy crisis, the 1996 West Coast power interruption, 1999 system disturbances in the Mid-Atlantic and Midwest, generally deteriorating reliability throughout the country, and the near bankruptcy of major segments of the electric power sector all have the same source. The electric power sector has lost its way, and we are now living with the consequences.
The Electric Power Sector Has Lost Its Purpose
Let's define what the central purpose of the electric power industry was, and should still be: to deliver electric power economically, safely, and reliably to all demographic and economic segments of the United States (or any other country).
Electricity is a commodity and an absolute requirement of an industrial or post-industrial economy. As the blackouts in California, the Northeast, and elsewhere demonstrate, without electricity civilization as we know it comes to a halt. Transportation stops, food spoils, living conditions deteriorate, and factories close.
As economies modernize they become increasingly electrified. The purpose of the power industry is to ensure electricity is available at all times at as inexpensive a price as possible, consistent with safety in production, delivery and use.
But isn't this purpose understood? Don't we already know this? We once did, but no longer-until the events of August 14th. While it existed as a responsibility of the electric industry, it had been superceded by other missions that evolved from regulators, politicians, environmentalists, social interest groups, and finally by power industry managers who seek to satisfy the numerous and often conflicting demands of these aforementioned segments.
The 1960s and '70s saw the Vietnam War, the sexual revolution, the growth of environmentalism, and other social trends that challenged the post-World War II economic and political order. The electric power industry was no exception. Challenges to the power industry's purpose would grow despite the Northeast blackout of 1965, the energy crises of the 1970s, and the economic resurgence beginning in the early 1980s.
Changes in how the electric power industry has been regulated and managed over for the last third of the 20th century leads to the observation that the purpose of the electric power industry became diluted, and the ability of the industry to accomplish this purpose compromised. The industry lost its way.
The Onset of Adversarial Regulation
The tension between utility management and regulators grew with the onset of inflation and high interest rates in the 1960s and '70s. These caused the cost of doing business to rise faster than economies of scale could reduce them. During the economically stable 1940s, '50s, and early '60s, economies of scale drove down the cost of electric power in both real and absolute terms. With the onset of stagflation, real costs may still have been falling, but in absolute dollars they were not. The energy crisis of the 1970s also caused fuel costs to rise, quadrupling petroleum prices, with consequent impacts on other fuel forms.
In response, utilities went to regulators for rate increases to cover rising costs and retain their credit ratings. Regulators being as much influenced by politics as by utility financial needs, granted some, but not all, the rate increases requested. And as economic conditions worsened, and the public's tolerance for absorbing sharply higher energy costs decreased, the increases tended to grow smaller and smaller, while utility bond ratings steadily declined. The relationship between utilities and rate regulators became adversarial.
Utilities were in the midst of major construction programs to upgrade their systems, exacerbating the situation. These upgrades were a response to the 1965 Northeast blackout and the rapid increases in electricity demand. Few reading this article will remember the 1973 National Power Survey prepared by the Federal Power Commission (FERC's predecessor). The survey, completed in response to the 1965 blackout, called on utilities to make significant investments in new generation and transmission plant to ensure adequate electricity supplies and reliable service.
Utilities were in effect complying with the wishes of the FPC, while at the same time meeting resistance from state commissions that had the final say on the rates utilities could charge customers, what they could earn, and thus what they could invest and pay shareholders and creditors. Much of the construction driving utility capital requirements took the form of large nuclear and coal-fired power plants, two very capital-intensive technologies. Rising inflation and high interest rates increased the cost of building these plants. In addition, the cost of these plants would increase as schedules lengthened in response to capital rationing and the technical complexity of introducing new technologies (nuclear in particular) on a massive scale.
As these large projects were completed, regulators grew less willing to incorporate their full costs into the rate base. In response, the 1970s and 1980s saw a plethora of prudency reviews to determine whether new plants were in fact needed, and if so whether utilities mismanaged construction, resulting in higher costs than justified. In either case, electric utilities were the losers. Rate requests were less than requested, phased in, or disallowed.
Consequently, the creditworthiness of electric utilities declined precipitously:
- Bond ratings declined;
- Common stock dropped to below book value;
- Earnings dilution occurred as utilities sold stock to complete construction projects that were beyond the point of no return;
- Utilities began unloading assets to remain liquid. Con Edison's sale of generating plant to the New York Power Authority in 1974 was the first of these sales; and
- Con Edison cut its dividend, introducing turmoil to valuation of utility common stocks where previously stability had been the watchword.
As political and regulatory resistance grew to building new generation and transmission plants, utilities quite naturally grew increasingly reluctant to make these investments. Completed plants were sold in part or entirely to public entities that could more easily raise rates and capital. Projects were canceled, many of which were already under construction. Occasionally completed projects were written off, such as the Shoreham nuclear plant on Long Island. No new significant projects were undertaken.
To summarize, the presumption that providing economic and reliable electric service was the sine qua non of the electric utility industry was now on the table as a negotiable item. No one made a public admission, but the decisions made by regulators, politicians, and utility managers spoke louder than words. Many news stories discussing the 2003 blackout noted that few major transmission investments have been made since the 1960s, supporting the notion that providing economic and reliable service had become negotiable or secondary to financial survival.
Utilities as Social Policy Delivery Instruments
While the power industry's financial condition was deteriorating, external social and political forces were changing its basic business model. This too contributed to an undermining of the economic and reliable service mandate. Utilities became instruments for accomplishing social policy, versus corporations delivering an essential commodity needed for the functioning of modern civilization.
This change in the essential mission of electric utilities was aided and abetted by growing disillusionment with electricity production and delivery systems. The Three Mile Island and Chernobyl accidents did much to feed the disillusionment with commercial nuclear power. Also contributing was a spotty operating record of long construction lead times and resulting high cost, and questions over the need for new capacity. Unresolved spent nuclear fuel disposal and a general unease with an energy form that has military applications made nuclear power vulnerable to concerns about its suitability as an energy source.
Coal-fired power plants avoided public policy disenchantment for a while, but no longer. Pulverized coal-fired power plants are seen as significant sources of pollution and possible contributors to man-made climate change, since they are a major source of CO2. Coal-fired power plants have become the center of significant regulatory and legal proceedings. In the late 1990s, EPA sought to force the closure of coal-fired power plants. States and utilities in the Northeast are suing utilities in the Midwest over the operation of pulverized coal plants. These suits take place even though coal-generated electricity is essential to preventing future blackouts in the same states hit on August 14th.
Nuclear and coal-fired power plants produce more than 70 percent of all the electricity consumed in the United States. Large hydroelectric plants produce another 8 percent. There is no public support for their construction either, or constructing transmission that would bring hydro electricity down from Quebec. In summary, public officials and regulators are unsupportive of using technologies that produce more than 80 percent of power generated in the United States.
There is also little public support for enhancements to the electricity delivery system. Over the last 40 years, increasing transmission capacity has become time consuming. Enhancements to transmission capacity are contested at the local, state, and federal level. This is the "not in my backyard" syndrome. The consequence is that utilities and public officials have lost the power of eminent domain.
The new business model for the electric utility sector as envisioned by regulators, politicians, and environmental and allied conservation groups included:
- Small is beautiful. The smaller the production and delivery technology the better. Co-generation and distributive generation became popular concepts. The idea was to have neighborhood generation eliminating the need for central station power plants and large transmission facilities. PURPA (passed in 1978) was the quintessential policy statement on this concept. But the small is beautiful model flies in the face of electric power economics and how to ensure the reliability (i.e., the need for interconnected systems).
- The greening of the electric power sector. To the degree that generation was needed, it should be renewable or at least be perceived as environmentally benign. The result is the current emphasis on windmills, other solar, biomass, and low-head hydro. It matters little that even with large tax and other financial subsidies they are uneconomic, born out by the fact that all these technologies combined produce less than two percent of electricity consumed in the country. To the extent that conventional generation is acceptable it must be fueled by "clean burning" natural gas.
- Conservation. Conservation was deemed a public policy good that the power industry should accomplish. Regulators acting at the behest of environmentalists, soft energy advocates, and federal and state government policy-makers, mandated utilities institute conservation programs under the rubric of least-cost planning. Least- cost planning meant any demand-side program (except raising prices) was preferable to building new plants. Conservation was too important to be left up to the marketplace and individual decisions, but it had to be implemented by utilities directed by regulators and their "soft path" allies.
These policies became politically correct, and advocates believed they could stabilize electricity consumption at zero or extremely low growth rates. This meant no investment was required in conventional electric systems, renewable forms of generation would eventually displace coal and nuclear, the impact on the environment would be minimal, and rate increases to support new investment would be unnecessary. Utility executives, being politicians as well as business executives, saw where the political winds were blowing and embraced this new power industry business model. The federal government is funding renewable energy and conservation initiatives, and Congress has passed tax credits encouraging investment in renewable and conservation technology.
The essential point is that ensuring economic and reliable service had become secondary to delivering politically correct technologies and services. It also became secondary to enacting an environmentally idealized version of the power industry. The bottom line was that investments that once went to ensuring economic and reliable electric service were going elsewhere.
Restructuring, Deregulation, and the End of the Commitment to Reliability
As the economic expansion that began in the early 1980s surged into the 1990s, and with it continued growth in electricity demand, it became clear that some mechanisms had to be put in place to satisfy growing electricity needs. The answer was partial industry restructuring, including passage of the 1992 Energy Policy Act.
The Act gave utilities and independent power producers the ability to invest in generation wherever and whenever they wanted. But it did not resolve the issue of who would pay for it (remember retail rates are set by state regulators), and did not address the need to upgrade the power-carrying capacity of the electrical grid. The result was that utilities and independent power producers went in search of profits outside historical lines of business, and left the electrical grid to a condition that was, in effect, benign neglect. Electric infrastructure investments as a percent of revenue dollars fell to record lows.
Unfortunately, not only did essential electric infrastructure investments not get made, but significant elements of the electricity sector are in a state of near bankruptcy as one unregulated investment after another failed.
- Natural Gas Merchant Power Plant Investments. Upward of $100 billion dollars was invested in merchant power plants since passage of the 1992 Energy Policy Act. Nearly all of these plants are fueled with natural gas (because they are cheap to build). But as a result of the steady increase in natural gas prices over the last four years, nearly all are uneconomic. Power plants fueled with natural gas will simply not be dispatched when natural gas costs $4.50 per MMBtu and up. Accompanied by a reduction in wholesale electricity prices as the national economy slowed, merchant power plant profit margins collapsed. Those companies that made merchant power plants a key component of their business strategy have seen their share price collapse.
- Energy Trading. Energy trading, and in particular electricity trading, combined with misleading if not falsified financial statements, were at the heart of the collapse of this business. Again, literally billions of dollars have been lost by energy trading organizations and their financial backers on Wall Street. Investors failed to realize there was much less business here than could sustain the hype surrounding it. Electricity wholesale contractual agreements almost always exist between companies or organizations in close proximity to one another. This is because the greater the number of electric systems bulk power has to move across, the greater the friction in moving it, and consequent transmission losses. Unless systems are strongly interconnected, bulk power transfers become uneconomic, if not physically impossible.
- International Acquisitions. Beginning in the early and mid-1990s, acquisition of power plants and other utility assets in the international market place became a preferred investment strategy. While international investments were worldwide, they were concentrated in Latin America, the United Kingdom, and Southeast Asia. Acquisitions included buying existing generating assets, building new plants, and buying entire distribution systems. It is the rare utility that has made any money in international utility investments. Most, like TXU in the United Kingdom or AES in Latin America, lost hundreds of millions, if not billions of dollars.
As a result of these and other investment misadventures (e.g., diversification into telecommunications and real estate) the electric power sector has been, to put it mildly, financially traumatized.
The Dow Jones Electric Utilities Index reached a high of just over 170 in December 2001 and stands at 103 as of this writing.
This and the broader Dow Jones Utilities Index declined after the end of the tech-stock bubble in March 2000, and the terrorist attacks on 9/11. In fact, electricity stocks were thought to be a safe financial haven. Diversification failures changed this assumption. Not only has the electric industry walked away from delivering economic and reliable electric service as its mission, but much of the industry no longer has the financial capacity to make investments directed at this mission.
The silver lining is that the segment of the electric power sector that escaped financial collapse are utilities that focused on producing electric power for the grid and managing the grid to ensure reliable delivery. Southern Co., Entergy, and Exelon appear to be the prime examples. Each of these companies has outperformed both the Dow Jones Electric Utility and the S&P 500 indexes by wide margins, seeing significant price gains.
Truth and Consequences
As investments in the electricity infrastructure declined, so did its reliability. Up until the recent recession, generating capacity reserve margins declined to dangerously low levels of 15 percent and less.
It has since recovered to just over 20 percent, but only through the addition of natural gas-fired power plants that are now uneconomic and operated by organizations that are bankrupt or struggling for financial survival. How reliable can this capacity be? Pepco and Northeast Utilities are among utilities dependent on near-bankrupt organizations for significant portions of electric supply, and are at risk of seeing these supplies cutoff.
As of now there are few new plants under construction, and those planned are being pulled off the books; thus, capacity margins may soon begin to trend down again. The only capacity that will almost assuredly be added are the up-ratings planned for many nuclear power plants. Nuclear is the most economic source of electrical energy available to the grid, thus the strong likelihood of the up-rates.
The dearth of new transmission capacity is well documented. Electricity consumption increased by 35 percent in the 1990s alone (and is twice the level of the early 1970s), with transmission carrying capacity increasing by only 10 percent. Bulk power sales are also on the upswing as load grows and capacity margins tighten.
Examples of the consequences of an aging generation and transmission system with little investment for modernization are of course obvious. They include the August 14th blackout; the New York City blackout of 1977; the West Coast power interruption of 1996; voltage reduction and loss of load in the Midwest, Northeast, and Mid-Atlantic states in 1999; and the California energy crisis of 2000-2001.
As technology advances and increasingly sophisticated equipment is developed, the need for a stable electricity grid will increase. Voltage and frequency fluctuation will be less tolerable without damaging equipment. Increasingly sophisticated manufacturing will also be less tolerant of even minor fluctuations in the electrical grid.
Warnings from North American Electric Reliability Council (NERC), the present administration, and even this author have been issued. The essential message was that there is underinvestment in the electric generation and transmission system and that there will be significant consequences. So what to do?
A Return to Basics
The historical business model of focusing on delivering electricity reliably at an economic price can be successful for both investors and consumers of electricity. This can serve as a starting point for developing policy reforms to modernize the grid.
The most obvious vehicle for reform is the energy legislation now in Senate-House conference. Other reform vehicles include changes in FERC, the Department of Energy, and state rate regulatory policies.
What should the overall objectives be?
- The underlying mission of delivering reliable electric service at as economic a price as possible should be the principle that underlies any and all actions.
- Economics and practical technology should drive investment decisions, not some preconceived notion of an ideal world.
- Utilities and power generators are corporate entities that deliver an essential commodity, not organizations to be used for implementing public social policies, e.g., conservation.
- Expanding and upgrading the electric transmission system is critical to accomplishing this mission.
- Optimal transmission investment is encouraged when investors are able to realize significant financial returns.
- Enforcing transmission rules of the road is required, along with re-establishing the principle of eminent domain.
- Generation diversity should be an option, and tax and regulatory policies should be technology neutral.
- Economic and financial stability in the electric sector cannot be accomplished by relying on a single fuel form, i.e., natural gas.
- Economic and financial stability and reliability cannot be accomplished by over-reliance on energy forms that are at best ephemeral, i.e., renewables.
- Free play should be given to reducing electricity sector barriers to entry.
- Much of the electricity sector is non-monopolistic, especially generation
- If utilities can squander investment dollars in non-traditional businesses, fairness requires that new entrants be allowed in to replace them.
- Regulators' scope of operation should be limited to enforcing rules for participation
- Companies should be free to earn as much as possible, as long as electricity is delivered reliably.
- Operating rules should be spelled out, and whenever possible, be uniform.
- The balkanized regulatory structure needs reform.
- The Federal Power Act established the regulatory structure for the power industry, and like the Public Utility Holding Company Act, dates back to the 1930s.
- Nearly all power companies have operations that are regional in scale, and bear little resemblance in scope and operations to the 1930s.
- There are frequent conflicts between the goals of federal policy-makers and state officials. At the state level in particular, politics, not national interest, govern power industry regulatory and policy decisions.
Finally, the power industry would be well served by executives who make decisions in the best interests of electricity customers, shareholders, and the nation at large. All too frequently power industry managers have pursued business strategies with the sole purpose to pass muster by their regulatory and political masters.
This head-in-the-sand position will have to change. Enacting legislation and regulatory policies that work will require re-education of public officials on the economic and technical fundamentals of the electric power industry. This will require a willingness to admit that what passed for progress in the electricity industry in the past helped bring about the August blackout, the California energy crisis, and other events that have eroded the essential character and mission of the industry.
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