US. energy stakeholders have for too long been fooled into believing that patchwork reforms are a substitute for coherent policies. The Energy Policy Act of 2005 (EPACT)1 is the latest, and hopefully the last, example of this tradition.
The key issues confronting U.S. power markets are, for the most part, well-known and generally not in dispute. Three of the most pressing—the first two are addressed in the Act—are:
EPACT fails to advance or resolve these key issues, thereby presenting yet another opportunity for stakeholders to mistake marginal changes for substantive reform.
The price volatility of hydrocarbon fuels, together with the march toward competitive electric markets over the past 25 years, has caused electric utility stakeholders to focus on the need to mitigate price and supply risks associated with imported fuels. (In fact, electric market reforms in the United States originally were promoted to reduce price risks associated with imported oil.) Without a mitigation strategy, stakeholders are left to haggle in a zero-sum environment, where one stakeholder group can win only at the expense of another.
Regrettably, although EPACT was said to offer relief for high energy prices, it does little to address the systemic causes of these risks. Rather than enhance the efficiency, reach, or scope of U.S. energy markets, EPACT resembles a policymaker’s “catch-up” strategy, focusing on long-neglected issues of transmission investment, reliability, and efficiency while ignoring the potential for expanding the scope and efficiency of electric markets.
EPACT does almost nothing to improve the coherence or efficiency of markets, or of the legal and regulatory framework that governs them. In perhaps the best indicator of this shortcoming, the Federal Energy Regulatory Commission (FERC) continues to struggle with the application of regulatory tools that have not been amended substantially since passage of the Federal Power Act (FPA)2 in 1920.
In a wide variety of contexts ranging from the imposition of “equity re-openers” in the 1980s to the attempted expansion of its transmission jurisdiction to nonjurisdictional municipalities, to the recent revocation of market-based rates of more than 100 companies, there is little doubt that FERC has struggled to adapt an old statute to a much changed commercial environment. Despite these and other challenges, the act makes few changes to the basic FPA framework, thereby missing a key opportunity to advance FERC’s ability to influence the operation or efficiency of U.S. electric markets.
That said, EPACT does contain a variety of research and other incentives to encourage the development and deployment of nuclear energy and alternate resources such as renewable energy technologies. Also included are a wide variety of energy-efficiency provisions that increase the energy efficiency of federal buildings, offer incentives for energy-efficient appliances, study the potential benefits of using “intermittent escalators,” and extend the duration of Daylight Saving Time by approximately three weeks.3
In the absence of reforms that improve markets, utility executives and other stakeholders are left to consider commercial initiatives that may lessen risks of future oil price spikes. Among other things, purchase aggregation, fuel-price hedging,3 and long-term contracting are potential industrywide strategies (all of which would either require or benefit from legislative support) that merit consideration in this regard.
On a policy front, market successes to date may be expanded to create a springboard for additional reform. For example, a recent decision4 by the Wisconsin Public Service Commission recognizes investments in energy efficiency as equivalent energy generation. In effect, according favorable regulatory treatment for demand-side reduction and energy efficiency investments should create additional space in utility reserve margins and may facilitate resource planning. However, as discussed below, it remains to be seen whether utility resource planning decisions will be guided by market pricing signals or by command-and-control regulation.
Investment is the lifeblood of a capital-intensive industry, yet restructured (i.e., disaggregated) generation and transmission companies have yet to demonstrate that they can raise private capital on a sustainable long-term basis. Though EPACT was touted as improving the climate for attracting investments in transmission reliability, most of its reforms actually are quite modest and provide little in the way of substantive incentives for new investment.
The “regulatory compact” that once guaranteed utilities a return on their investments is in tatters today. Deregulation has unbundled transmission and generation systems into separate business units, yet markets for generation and transmission services remain inefficient and balkanized.
In its transmission provisions, EPACT reflects an effort to catch up with changed circumstances. While there are incentives for technology innovation (i.e., research and development), the act adds little in the way of reforms to promote efficient markets. Of the approximately 70 pages in the act devoted to transmission matters, fewer than 10 deal with investment incentives, and even those establish strategic objectives and do not promote structural improvements.
Subtitle D of EPACT sets out “Transmission Rate Reform” provisions.5 These are intended to “promote capital investment” in transmission facilities, “provide a return on equity that attracts new investment” in such facilities, and encourage “deployment of transmission technologies” to increase the capacity and efficiency of existing facilities.6 Unfortunately, the act omits any substantive guidance regarding how these objectives are to be be attained.
Equally important, the act’s provisions generally ignore the competitive environment in which electric sector participants operate and fail to confront key problems in financing generation and transmission. The generation sector continues to require large, economically “lumpy” investments to purchase expensive equipment that can achieve economies of scale. Financing such investments requires either a healthy balance sheet or the ability to demonstrate firm long-term revenues, and most of today’s independent generation companies have neither.
Transmission companies suffer from similar shortcomings in their business model and have an added handicap: under current open-access rules, there is substantial doubt that owners of transmission facilities can exercise control over how their facilities are used. Incumbent utilities understandably insist that they should exercise greater control over the transmission lines funded by their ratepayers, while independent power producers argue that transmission facilities are a “public commons” that must be widely available to facilitate free trade in power. EPACT provides no path for resolving this tension.
Electricity is a specialized, value-added commodity (in essence, processed BTUs). The current environment limits the geographic range of electricity markets and heightens pricing, disposition and regulatory risks. If policymakers want transmission investment to be driven by the private sector, reforms to expand the scope and efficiency of markets will be necessary to reduce the minimum risk-adjusted return demanded by private investors. If not, a resurgence of “command and control” alternatives may be unavoidable.
Meaningful reform can be achieved in the area of market integration and value capture for transmission investors, but such reform faces substantial hurdles. FERC’s withdrawal of its standard market design illustrated opposition by incumbents to changes that threatened their economic interests. Moreover, the current administration increasingly is hide-bound by ideological inconsistencies—most notably, its commitment to reduce federal government regulation at the same time it supports legislation (EPACT) that largely pre-empts state authority in liquefied natural-gas siting matters.
Nevertheless, there are reasons to believe that a consensus on market reforms may develop. Competitive markets have broad support in the industrial sector, where large consumers see it as the only way to discipline the market power of incumbent utilities. In fact, some regions (most notably the Northeast) appear committed to regional transmission organizations (RTOs) for the long term.
Stakeholders favoring open access, the RTOs, and the Electric Reliability Organizations mandated by Title XII of EPACT likely will create additional momentum toward open access. If this occurs (and barring any California-like market aberrations), the success of such reforms in facilitating competition and expanding markets will create an end-game in which the benefits of open access become self-validating, thereby consolidating public opinion and political support behind the model. However, the industry may face yet another round of “stranded-cost” proceedings as transmission owners cede control of their assets to independent system operators.
The evolving investment climate no doubt will reflect the repeal of the Public Utility Holding Company Act (PUHCA). Under EPACT, the ponderous and arcane rules governing the definition of utility holding companies and the exemptions to those provisions (e.g., the “integrated service territories” exemption) will be replaced by application of more up-to-date FERC competition “screens” that focus on market power to achieve objectives similar (albeit not literally identical) to PUHCA. In simplifying investors’ economic analysis, PUHCA repeal is a good thing.
However, even this reform is not without nuanced consequences. A substantial consolidation of the industry is likely to follow in the wake of PUHCA repeal, preceded by substantial litigation related to FERC implementation of the market screens. While consolidation will produce larger and more efficient utilities in many respects, the true test of market reforms will lie in the ability of policymakers to accommodate (and, occasionally, withstand) the demands of larger and more powerful utility incumbents seeking to bend market reforms to their own advantage.
Incumbent utilities and institutional investors will have an enormous advantage in the coming wave of consolidation, and some may perceive this as an easy road to higher margins. However, without credibly competitive markets to discipline the unfettered exercise of market power, incumbents must be careful to avoid aggravating socio-political pressures for “re-regulation.”
Finally, a regulatory end-game seems to be forming around the emerging consensus that vertically integrated utilities may not be such a bad thing after all. According to this view, oligopolies can be managed through the proper use of real-time pricing and incentive-based regulation.
Competition has in some cases led to fragmented spot markets, an absence of forward markets, and a lack of incentives for long-term investment, while vertically integrated companies (facing less competition) often have operated quite efficiently. While a smaller population of electric companies might hold prices above marginal cost, they also would carry surplus capacity to meet demand growth and provide a basis for long-term investments. As in other matters, the success of this approach will turn on the creation and maintenance of efficient markets.
In short, EPACT contains only a few momentous provisions to hasten creation of efficient markets, but it does contain the seeds of additional reforms.
Environmentalists have long argued that if pollution costs from thermal power generation were factored into the price of power from thermal generation facilities, non-emitting technologies like solar and wind power quickly would become price competitive with power produced from hydrocarbon combustion. The run-up in oil prices has only strengthened this argument.
Equally important, the Bush administration’s decision to reject the Kyoto accords is being superseded by events. Nine Northeastern states recently announced their voluntary decision to implement a “cap-and-trade” program covering carbon dioxide emissions from more than 600 electric generation facilities.7 More broadly, at least one recent survey indicated that a majority of industry executives believe that Congress will implement regulation of carbon-dioxide emissions within the next five to 10 years.8
Oil price spikes stimulate innovation that creates economic alternatives to hydrocarbon fuels. This effect, combined with the trend toward internalizing the cost of power plant smoke-stack emissions, promises to have profound consequences for the way we produce, transmit, and use electricity.
The growing consensus regarding the link between greenhouse-gas emissions and climate change confirms that this approach represents a long-term trend and not a passing fad. It also confirms the central role of efficient markets in reforming the electric sector.
The energy industry is experiencing an extended and chaotic transition to competitive markets. Some competitive pressures have been eased by market inefficiencies and regulatory interventions, while others have resulted in significant economic challenges for a variety of stakeholders. The regulatory framework has been modified to incorporate market forces without much attention to understanding either the market forces themselves or the markets in which they operate. Producers and consumers of all kinds have been insulated from environmental costs engendered by their fuel use, technology and distribution decisions. All of this will evolve as consolidation intensifies and refocuses competitive pressures.
The entire energy industry has known for 25 years that change would come, but the biggest changes in the power sector are yet to be felt. Market reforms will work if our policymakers take the time to understand how and where to make them effective and efficient. Let’s hope that policymakers and industry stakeholders have the perseverance, creativity and wisdom to usher in timely and constructive change before events again overtake us.
1. Pub L. 109-58, Aug. 8, 2005.
2. 16 USC 791a.
3. Energy Policy Act, H.R.6, Subtitle C sec. 137.
4. 2005 Wisc. PUC Lexis 439.
5. Energy Policy Act, H.R.6, Subtitle D, sec. 1241.
6. Energy Policy Act, H.R.6, Subtitle D sec. 1241.
7. Anthony DePalma, “9 States in Plan to Cut Emissions by Power Plants,” New York Times, Aug. 24, 2005 p. A1.
8. GF Energy 2005 Electricity Outlook, Striving for Certainty in a World of Change, January 2005.