FERC's Standard Market Design: Too Detailed To Evolve
The Federal Energy Regulatory Commission's standard market design (SMD) proposal states objectives that are important and supportable, both theoretically and empirically. Uniform rules and business practices reduce transaction costs and limit opportunities for institutional arbitrage, increase the extent of the market, and increase market liquidity and investment. In fact, the goal of unleashing market incentives for transmission investment is prominent in the SMD, and that goal is correct and crucial for continued dynamism and value creation in the electricity industry.
The current SMD proposal, though, is too mired in details to be a good blueprint for institutional change in electricity regulation. The SMD proceeds on the assumption that mandating a single, uniform set of detailed rules is preferable to mandating simple, general rules across the country and letting the parties figure out the details that suit them best. Such detail will make the SMD static and costly to change as the industry evolves. FERC faces the problem of walking the fine line between uniform general rules to reduce transaction costs and top-down imposed, detailed rules that will create advantages for some market participants. To be robust and create the most possible value, the SMD should comprise simple rules that will adapt to the unknown, not dictate the specifics to the extent contained in the current proposal.
One simple rule that would accomplish much of what the SMD proposes regarding transmission investment and congestion pricing would be to reduce entry barriers in transmission. The proposed SMD recognizes that improved transmission coordination and investment can make wholesale generation markets more competitive, but does not recognize that the reverse is also true. Changes in generation regulation and technology can make transmission more competitive, and therefore indicate that transmission is no longer a natural monopoly. The proposed SMD does not reduce the artificial barriers to entry that restrict our ability to put transmission to a market test. In the absence of these barriers, transmission is contestable, or faces potential competition. An approach likely to create real benefits and dynamic efficiency would be to reduce artificial barriers to entry in transmission and see the extent to which transmission really can be contestable, and the timeframe over which that contestability evolves. Furthermore, reduced entry barriers would enable investors to create beneficial redundancy and increased grid security. Such beneficial redundancy does not exist with transmission regulated as a natural monopoly.
Market-based retail pricing is another simple rule, which would obviate the need for FERC and ISOs to perform market monitoring. Market-based retail pricing connects demand and supply, maximizing information transmission in markets and disciplining supplier exercise of market power better than any other known institution. However, the bifurcated legal jurisdiction between federal/wholesale and state/retail prevents FERC from determining retail-pricing policy. States are only slowly moving toward market-based retail pricing and retail choice. Thus, we are going to have market monitoring for the foreseeable future, but it should have sunset provisions as the percentage of retail load on competitive contracts increase. Market-based retail pricing is more likely than market monitoring to create value for consumers, and one reason for that advantage is that market monitoring is almost certain to suppress dynamic investment incentives.
The SMD abounds with excessively detailed rules, including mandatory use of locational marginal pricing (LMP) to value congestion. Why specify that all market participants use LMP, rather than stipulating that transmission providers must offer clear and transparent transmission congestion pricing methods to purchasers? Then, with legal recourse serving as a deterrent to keep transmission providers from being opaque, the differences among different congestion pricing systems would not be an impediment to exchange, as long as the participants face clear and transparent congestion prices. Such a straightforward approach is also consistent with rules by which open access problems have been addressed relatively well in other industries. This approach would also be more effective if transmission entry barriers were reduced, because dissatisfied purchasers would have choices.
Redispatch tariffs and congestion revenue rights (i.e., firm transmission rights) are also stipulated in great detail in the SMD. Why do they have to be so extensively specified? Are there more parsimonious ways to bring about reliability-based redispatch? Again, FERC could implement simpler, more flexible redispatch rules if transmission entry barriers were lower, because transmission owners would have increased incentives to offer attractive redispatch terms to their customers. Similarly for congestion revenue rights: simply require that the transmission provider adhere to and enforce congestion revenue rights, based on the stipulation that there must be defined congestion property rights. "Offering several different types of Congestion Revenue Rights would make the system more flexible and better able to adapt to the needs of specific customers," (SMD, p. 139) but why not let the participants figure out the details for themselves? Financial markets typically work that way, which is how new and innovative approaches are discovered.
Detailed rules run the risk of regulatory path dependence and lock-in. What if FERC mandates LMP for everyone, and some technological or contracting innovation makes LMP superfluous or obsolete? The new institutional structure in the SMD should be flexible and reversible, with clear, credible phase-out provisions as market-based retail pricing expands and technological change happens. Regulatory lock-in and ratchet effects are large potential problems in institutional change, and in the case of moving away from LMP in the future, regulatory lag could result in substantial lost profits due to delays in the process of shifting from old regulations to new ones. The amount of time and effort going into this institutional change should encourage us to consider the costs of changing the institutions in the future.
Robust institutions that will stand the test of time and create value for consumers must be able to adapt to the unknown. And there is a lot that is unknown in electricity, particularly in the regulatory, financial, and technological future. Market design that focuses too much on precise details and not enough on simple rules that will adapt flexibly to changes in the environment will be ineffectual at best, and counterproductive at worst.
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