We stand on the threshold of a new era in the electric services industry. I deliberately avoid the term "electric utility industry," because the future is not limited to the vertically integrated monopoly utility. Many utilities may already perceive the first cracks in their armor: nonutility generators (NUGs), self-generators, and energy service companies.
Competition is not in the industry's future; it is here now. Further, competition and market forces are not going to magically disappear. Any prudent corporate manager eyeing construction of a new manufacturing plant can list a full array of electricity supply choices. Investor-owned utilities, municipal utilities, NUGs, demand-side management providers, self-generation, fuel cells, photovoltaics (em these options are all available now.
If we have our way in California, consumers will be empowered to a rare level. They will gain the ability, if they choose, to buy generation services from any number of NUGs and pay for transmission and distribution to their site of consumption. Brokers and marketers will develop and offer procurement services to interested consumers, perhaps even offering a bundled price tied to an exogenous index. A concrete manufacturer in California, for example, may be able to buy electricity at prices linked to the market price for concrete. Consumers interested in high-quality service will be able, independently or through brokers, to contract with several different backup and standby sources (em either generators or consumers willing to shut down.
California's "Transition Charge"
Nevertheless, certain impediments obscure this new vision. For many, the big question is "stranded costs" (em largely the embedded costs of existing utility generating assets that will be overvalued in a market-oriented system. But to my mind, the term "stranded cost" is not really accurate; a better term is "uneconomic cost." Nothing is really "stranded"; generating assets can continue to produce a commodity with value. What is happening is that the movement or transition from a regulated environment to a market environment compromises the "regulatory compact." We will no longer be able to guarantee that the amount a utility spends on an asset can be recovered through rates.
So, what do we do with these costs? One option is to continue to charge them to consumers that remain on the utility system, the so-called "captive" customers. Unfortunately, this option only exacerbates a utility's uncompetitive position. Another path is to ignore such costs by requiring utilities to write down their assets and, in more than a few cases, leaving them open to bankruptcy. Again, not an attractive option.
In California, we proposed a "competition transition charge" (CTC). Utility generating assets are divided into economic and uneconomic portions. The uneconomic portion is collected from direct- access customers leaving the system. The utility remains at risk for the economic portion, but can compete to serve potential direct-access customers. If it cannot compete, the shareholders must foot the bill. Calculating the uneconomic costs of utility generation is, of course, very complex. First, what mechanism separates economic from uneconomic costs? Ideally, an exogenously derived market price: Costs above market price are uneconomic; costs below are economic. Of course, we have yet to define market price. (In fact, our goal in industry restructuring was to create a system that develops such a price.) The proposal by the California Public Utilities Commission (CPUC) envisions system marginal cost as a proxy for a market price, but determining and using that price would prove difficult. Further, the market price, and thus the size of the uneconomic assets, is changing every day. California utilities, in filings to the CPUC in November, recommended balancing accounts to ensure that uneconomic costs are adjusted to changing market prices. I'm not sure that's the answer.
Another problem is that nonutility generating assets also contribute to the uneconomic status of utility generation. The success of qualifying facilities (QFs) in California led the move toward competition, but also produced an inventory of contracts with prices greater than prevailing market prices. (Southern California Edison's recent CPUC filing estimates the uneconomic costs of their contracts with QFs at $5 billion.) The CPUC's restructuring proposal suggests that excessive contract costs should be factored into the CTC, but calculating those costs is not as easy as it might appear.
Of course, California utilities have their own ideas. The lessons in natural gas regulation learned by Pacific Gas & Electric (PG&E) are manifest in their mid-February filing with the CPUC. In that filing, PG&Erequested regulatory approval of a three-year experiment that would enable industrial and other large energy users to choose among electricity suppliers. The experiment would apply beginning in 1996 to customers with annual average demand above 7,500 kilowatts. Eligible customers could choose from any supplier of electricity inside or outside California (including their local utility) and would receive a credit on their bill equal to the cost the utility avoids by not having to supply the electricity needed by that customer. Prices would remain fully "bundled," and lower revenues to the utility resulting from the experiment would not be offset through rate increases to other customers. The proposal is similar to an interim experiment used successfully while natural gas competition took hold in California (em an experiment the FERC found acceptable.
On the other side, San Diego Gas & Electric (SDG&E) and Southern California Edison have
advanced a "PoolCo" concept. This idea (em a variant
of the United Kingdom's electric industry restructuring (em would limit participation to wholesale producers and consumers, although the utilities express an increasing willingness to allow some retail consumers to participate. Recovery of uneconomic costs would form an element of the price charged for power flowing out of the pool to either wholesale or retail consumers. PoolCo does not and cannot avoid uneconomic costs. PoolCo, and the UK experience in general, troubles me. The creation of a pool and the requirement that all transactions go through the pool strikes me as a form of "managed health care" where market forces are not allowed full play.
Reforms in transmission planning and pricing are essential to achieve the vision implied in the Energy Policy Act of 1992. As in telecommunications and natural gas, the electric industry must provide nondiscriminatory open access to monopoly facilities, or nothing will happen. The policy statement on transmission pricing issued last October by the Federal Energy Regulatory Commission (FERC) marks a hopeful step forward. The contemplation of transmission tariffs not necessarily based on embedded costs and the "nonconforming" proposals of the recent transmission pricing policy statement mark a significant change for an agency so long focused on ensuring cost-based rates. Nevertheless, the FERC's concern over the monopoly power of transmission owners is well placed.
My own experience includes examples of competitive business concerns using any edge to gain an advantage over the marketplace. Yet this search for a competitive advantage is the result of the competitive forces we covet. Regulators must ensure that advantages come only from innovative services and consumer sovereignty (em that regulation does not itself create advantages. In this new world, regulators will be interested less in the cost of service and more in preserving and maintaining a "level playing field." In other words, commissioners will assume the role of "referee." They must disdain the "command and control" ethic of the micromanager.
The FERC inquiry into power-pooling institutions, including the "PoolCo" concepts that have been proposed in the CPUC's own restructuring proceeding, holds the promise of also exploring a radically different industry structure for electric service. The "divested utility," no longer vertically integrated, may provide the answer to many of the seemingly intractable problems regulators, at both the state and federal levels, now face. Concerns over market power are reduced when the transmission and distribution systems are no longer owned by generation interests. We eventually learned that lesson in natural gas.
Nevertheless, the transition will not be quick or easy. These steps, as important as they are, will in time be seen as our first "baby steps" toward the new competitive world. As such, they are tentative, uncertain, wobbly steps open to much debate. Is this the right direction?
Are we doing it in the correct manner? Is there an easier path? Questions like this will occupy the industry for some time. It is important, though, that we all quickly reach agreement on one issue: that the goal of open nondiscriminatory transmission access and a competitive generation "market," is both reasonable and achievable.
Performance-based regulation (PBR), also referred to as "incentive" or "price cap" or "CPI-X" regulation, is not unique to the electric industry. In California we have used this idea with some success in telecommunications since the late 1980s and, to a lesser degree, in natural gas. The United Kingdom now relies on this approach for its restructured electric industry. While there have been some fits and starts there, PBR has not been seriously questioned. I should admit to being a Commissioner during these explorations of alternatives to cost-of-service in California's telecommunications and natural gas industries; it has been, to say the least, an exciting period.
In general, the idea is to replace cost-of-service ratemaking with an approach oriented more toward rewarding performance. Traditional utility rate regulation ensures compensation to utilities only for the costs they incur. This simple cost-of-service formula obscures the tremendous uncertainty and subjectivity that built the foundation upon which regulatory bodies exist. In California entire proceedings are dedicated to just one particular aspect of this rate/cost calculation (em the cost of capital determination is a good example. This complexity has only increased as competition begins to knock at the door. Parties have come to realize that the CPUC, through its powers over the regulated utilities, can endow them with benefits they may be unable to garner in the competitive market. This is not something that cost-of-service regulation, nor the regulatory bodies themselves, were ever designed to deal with. Although we have not yet begun to see the full effects of competition in the electric industry, again my experience in telecommunications and natural gas convince me of what is likely around the corner for the electric industry. The natural tendency of regulators (em to view themselves incorrectly as a higher level of utility management (em can no longer persist. If it ever was justified (em and I have my doubts (em it is inconsistent with the competitive market and the need for quick and accurate decisionmaking now emerging in the electric industry.
PBR regulation is one step in the right direction. Rather than setting rates equal to costs, we replace much of our current general rate case and reasonableness review procedures with economic benchmarks that directly measure utility performance. Such a system will put utilities at risk for management and investment decisions, while at the same time allowing them to be rewarded for taking the right risks.
An example of a PBR mechanism, currently under consideration by the CPUC for several utilities, is to link changes in the utility's base rate revenues to increases in the consumer price index, less an annual productivity adjustment of 2 or 3 percent per year. Such an index should produce utility rates that decline in real terms, a prospect that traditional regulation has been unable to achieve. Properly structured, such a PBR approach allows utilities the freedom to minimize costs. Shareholders benefit as long as service is maintained at acceptable levels, as defined by the CPUC.
Back in April 1994, when the CPUC outlined its proposed vision for the electric industry, we promised an August release date for a final policy statement. But then came the debates. Looking back, it may seem hopelessly naive of the CPUC to have established such an ambitious schedule. We unleashed a national debate. We were unprepared for the breadth of the discussion that would ensue. However, I don't think we were naive. The timing of this document just could not have been better. We were surprised because the industry (em regulators, utilities, producers, and consumers (em were all reaching the same conclusion that we were at about the same time: that regulation and the industry needed to change to prepare for the next century.
Please fault us, if you wish, for unimagined good timing. t
Patricia Eckert is a former member of the California Public Utilities Commission. She was appointed by Gov. George Deukmejian in 1989 and served through the end of 1994. Ms. Eckert would like to thank James Greig, Scott Sanders, and William Meyer for their valuable contributions to this article.
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