In the United States, the Federal Energy Regulatory Commission (FERC) has undertaken the task of guiding the electric power industry from regulation to competition. But unless the FERC develops a plan to consider all facets of electric deregulation at the same time, we may end up driving on the wrong side of the road.
Last October the FERC issued its policy statement on electric transmission pricing. See, Inquiry Concern. Pricing Policy for Trans. Servs. Provided by Pub. Utils. Under the Federal Power Act; Policy Statement, Dkt. No. RM93-19-000, Oct. 26, 1994, FERC Stats. & Regs. (CCH) 31,005, 59 Fed.Reg. 55031 (Nov. 2, 1994). This document raises troublesome issues stemming from continued piecemeal deregulation. The time has come for the FERC to choose: Set transmission rates on embedded cost, or let utilities charge market rates. The FERC cannot legally continue forcing utilities to design transmission rates based upon either embedded cost or market, whichever is less.
Regulation vs. Market Pricing
Before considering the impact of the policy statement, let's look at the record of partial deregulation to date. The figure on the next page depicts the range of possible transactions for utilities buying or selling bulk power or transmission service at prices dictated by regulation (em prices that fall either above or below an unregulated market price.
QF Price Above Market. Let's first examine the effects of utilities buying bulk power above the market price (upper left quadrant), epitomized by New York's famous 6-cent rule. In that case, the New York Public Service Commission (NY PSC) required state utilities to purchase all energy offered them from qualifying facilities (QFs) at a minimum of 6 cents per kilowatt-hour (›/Kwh), a price far above market. Nonutility power suppliers flocked to New York. And with QFs collecting a regulated price above market, very little was heard from free-market proponents. The result? New York utilities were saddled with hundreds of millions of dollars of unneeded generation that forced prices higher and made them less competitive. (Note: The staff of the NY PSC now complains that this power is too expensive and should be disallowed for ratemaking purposes.)
QF Price Below Market. Now consider the case in which utilities buy QF power at prices below the all-in cost of new generation (lower left quadrant), as in Arizona where the Corporation Commission has set a low QF purchase price because of excess capacity. In states like Arizona, utility managers assigned to buy bulk power from independent power producers (IPPs) generally have less to do than the local Maytag repair person.
Generation Above Market. Now let's look at the sell side of the grid. Assume that the embedded cost (the regulated price) of utility generation exceeds the market price for the new generation, as governed by the all-in cost of new gas turbines (upper right quadrant). What happens? IPPs give stirring speeches on the power of the free market and the monopolistic attitude of utilities. Competitors demand that the market be allowed to operate.
Transmission Below Market. An interesting transformation occurs, however, when the subject changes to transmission pricing (lower right quadrant), and the regulated price falls below the market price. Those IPP fans of the free market suddenly turn schizophrenic. They begin expounding the obvious principle that a utility should never earn more than its cost of service. Their speeches sound so good, they bring tears to regulators' eyes. These regulators view with dismay and consternation even the possibility that a utility could ever charge rates above embedded cost. (And yet they remain silent when utilities must sell capacity or economy energy below embedded cost rates because "that's where the market is.")
FERC's Double Standard
In the electric power industry, deregulation is a story of double standards. The FERC created this double standard by forcing utilities to charge market rates only when embedded cost is higher (em for instance, in economy energy sales. In a vacuum, each FERC order may well fall within the bounds set out in the Supreme Court's famous 1941 Hope case. But the overall effect forces utilities to operate only in the upper left and lower right quadrants of the Figure. Unless the rules are changed, this internally inconsistent deregulation will deny utilities the opportunity to earn a fair return on assets, forcing rate confiscation that violates the U.S. Constitution (see sidebar).
The first pages of the policy statement on transmission pricing imply that the FERC is adopting an economically sound position:
"To the extent practicable, transmission rates should be designed to reflect marginal costs, rather than embedded costs, in a manner consistent with the remaining principles. We favor marginal cost prices in order to promote efficient decisionmaking by both transmission owners and users.... In our view, this means that transmission pricing should promote good decisionmaking."
The FERC adds that its policy should foster efficiency in:
s expanding transmission capacity
s locating new generators and load
s using current transmission facilities (and allocating constrained capacity through appropriate market-clearing mechanisms)
s dispatching generating resources.
The actual test of the FERC's intentions will come in the pricing orders, but the language of the policy statement suggests that economic efficiency will take a back seat to traditional regulatory principles.
The FERC is attempting to combine the free-market system with the traditional regulatory system. In the latter system, regulators must balance admittedly incorrect price signals by allocating resources using mechanisms such as certificates of convenience and necessity or integrated resource planning. But the FERC's new system sets a regulated price and then relegates allocation to the free market. It won't work! It cannot work. When a regulated price is "let loose" in the free market without the correct allocation signal, it creates a shortage or surplus with economic inefficiency, as surely as night follows day. New York's 6-cent rule offers a prime example.
Because the regulated price for transmission falls below the marginal price in most cases, power producers and wheeling customers will tend to demand too much transmission capacity. Some power plants might be built too far from loads simply because the transmission rate is too low. Transmission is a scarce asset, one that lies at the heart of the electric system and is almost impossible to reproduce. Yet, by default, the FERC has fashioned an allocation policy (or, I might say, nonpolicy) that assigns access to transmission on a first-come, first-served basis.
Consider a transmission line with an embedded-cost price of $7 and a replacement cost of $100. Assume that the first party to request use of the line will sell power to generate $20 in benefits. This type of transaction will occur under existing FERC policy. But should it? What if next week another party requests wheeling to arrange a power sale with a $100 benefit, but the line is no longer available. That transaction will not occur. Under the FERC's first-come, first-served policy, transmission lines are used to capture a gain of $13 for a private party, forgoing a higher public benefit.
Before the reader concludes that I only want to raise transmission rates, let me state that I would accept either a market price with invisible-hand allocation, or a regulated price with regulated allocation. But in denying purely market rates and then letting the "market" decide, the FERC effectively abdicates its responsibility to oversee the nation's largely irreplaceable transmission system. Now, the FERC's policy statement does acknowledge that nonconforming proposals must "produce greater overall consumer benefits than a conforming proposal." But optimum overall societal benefits arise when transmission is sold at its marginal cost for the period of the sale. Any sale above or below the correct marginal cost will produce fewer benefits. The FERC's own language, therefore, would seem to mandate market pricing.
And no regulatory system (em however complex, well conceived, or well accepted (em can possibly deal with the thousands of combinations and permutations that the free market handles with ease. In the United Kingdom, the National Grid receives more than one million pieces of information daily on competitive transactions and yet, last fiscal year, endured only
1,427 disputes. That number will surely drop significantly as the pool gains experience and sets precedents.
Lessons From Gas
One argument states that electricity is not like gas: What worked for gas will not work for electricity, ergo we cannot deregulate electricity.
Electricity is not like gas, but neither is it like tomatoes, cars, or single malt scotch, which all sport well-functioning commodity markets. An electricity market can work, but we must recognize the factors that make it unique. One major difference in the electric system is the lack of storage. Gas molecules can take two days to travel from producer to consumer. But gas from a storage field or line pack can be delivered instantly. (With single malt scotch, delivery takes about 10 to 25 years.) In the electric system, however, input must match output at all times.
This real-time constraint means we must hire operators and deploy equipment around the clock to perform switching, provide VARS, control frequency, institute load shedding, and execute the host of services known as "control area operations." The amounts associated with these services are not trivial. The National Grid was allowed to charge œ592 million (about US$954 million) for these services last fiscal year. Yet, the FERC has been racing ahead without considering the correct charges for these items or who will pay what portion (and they will cost much more in the United States than in the United Kingdom because our domestic market is larger).
When the natural gas market was deregulated, meters and other equipment had to be added to make the system function and to collect all of the necessary data to control it properly. Suppliers were allowed to collect for these items. These items are already in place in the electric system, but utilities should be allowed to collect for them. Microwave systems, computers, reserves, frequency control, black start capability, and area control services are essential to operate the transmission system, and require billions of dollars of hardware and software. Shouldn't sellers be required to pay for this service and meet operational guidelines? Shouldn't all sellers of electricity be licensed (em or, at least, required to comply with guidelines imposed by the North American Electric Reliability Council (em and pay market for all services they use?
Some Thoughts on Generation
Let's consider another critical area of deregulation: Who should construct new generation, and for whose benefit? Moreover, whose interests were served by prior plant construction? Do utilities deserve compensation for departing customers?
Over the years, many state commissions have raised the price of electricity for large customers to ease the burden on residential customers or promote social programs. Under these circumstances, large customers have every reason to leave the system. Again, regulated pricing, when applied to a free-market system, produces strange results. These customers don't necessarily want to generate their own power. Nor do they necessarily want utilities to build for them. They want cheap power at market rates (em and nothing more. Unless we honor that simple need, those customers will leave.
When large electric customers wonder whether to build their own generation, the only price signal they see is the embedded cost of utility generation, plus mandated programs. Seeing this incorrect price signal, they logically decide to build their own "low-cost" plant to obtain the market price. The correct price (em the marginal cost that the utility would incur to generate more energy for the customer (em remains hidden. It makes no sense for a customer to install new generation at 4›/Kwh to escape a utility price of 6›/Kwh if utilities can produce the energy, on the margin, for 2›/Kwh. Yet from a customer's point of view, the correct decision has been made. Thus, we have projects being built for the gain of a few; projects that would not be constructed in a free market; projects that are economically inefficient, but look good (em all because of regulated price signals escaping to the free market.
The assets left behind we then describe as "stranded." "Stranded assets" are an artificial creation. They only occur when the FERC or some other regulatory agency switches back and forth between cost and market, whichever is lower, "stranding" those assets priced above the market while "trapping" those below the market.
But for the sake of argument, let's assume that we do need more generating capacity. The question then arises: For whose benefit should we build these facilities? Let's assume the current FERC version of a "market economy" is in place and that large customers, seeing the incorrect pricing signal, build the needed facilities to obtain lower cost.
Most observers would say that the host utilities will suffer a loss. While that may be true, analysis shows that the remaining customers will also bear an opportunity cost. If the host utility had been allowed to expand its generation or purchase additional power, the new low-cost power would have been blended into the power supply; each customer would have received a share of the new cheap power. However, if large customers build the capacity, they acquire 100 percent of the new low-cost power. Residential customers are shut out.
Many of those who espouse competition in generation are, in effect, arguing price relief for large customers. The average homeowner, for instance, cannot install an LM-6000 in the backyard. In fact, if homeowners could collectively install gas turbines, the price of gas might rise significantly, making new construction more costly. Thus, large customers currently enjoy a monopoly on the limited amount of cheap power. Would it be better to mandate that utilities acquire all energy through competitive bids, thus spreading the benefits of new low-cost generation to all customers?
Nobody's Perfect
The FERC should not worry about creating perfect competition. Competition is not perfect. Just listen to Dostoyevsky: "Although, when we're guided by our desires, life may often turn into a messy affair, it's still life and not a series of extractions of square roots."
We cannot go forward with a piecemeal approach to deregulation that exacts an economic penalty from industry and society. The FERC must not deregulate for the sake of deregulation. If it acts, the FERC must replace regulation with a more efficient system, such as efficient competition. And efficient competition requires efficient pricing. The FERC must step back, look at all of the issues and effects, and develop a comprehensive plan (em one that puts us on the right side of the road. t
Charles E. Bayless is chairman, president, and CEO of Tucson Electric Power Co. in Arizona.
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