The profound changes now occurring in the electric industry will most directly affect those who are engaged in the enterprises of generation, transmission, and distribution of power. But challenges and opportunities confront gas companies as well. Certainly, the electric industry will continue to influence markets for gas: both in bulk fuel supply and in retail energy. Beyond that broad observation, though, much else depends on the speed and form of the transition to a competitive electricity market.
Will the transition be swift and complete? If so, one could expect gas to compete on a level playing field for retail customers, with gas-fired plants emerging as the investment of choice for new capacity.
Or will it prove slow and compromised? In that case, one can envision electric utilities shifting costs to save threatened retail load, with "special deals" proliferating to keep nuclear plants running even though not economical.
Where is the power business going? How is it responding to change? What does it all mean for natural gas?
Forces of Change
in the Power Business
The electric power industry stands as one of the last remaining regulated, monopoly industries in the United States. With regulated rates far above current market prices, pressure is mounting for increased reliance on market forces. Opening this market to competition gives policymakers a broad opportunity to make U.S. business more competitive (em to foster economic development, bolster local industry, and cut consumer prices generally. It is little wonder, then, that the forces of change have been irrevocably unleashed in the power business. These forces stem from several factors:
s Global Competition. Industrial managers worldwide leave no stone unturned in their efforts to cut costs and boost productivity.
s Market Fancy. U.S. business chooses to rely more and more on market forces in lieu of government regulation (as evidenced by the successful deregulation of other industries).
s New Players. A competitive independent power industry that relies on increasingly efficient, gas-fired generation.
Fundamental changes are also emerging in the formation and deployment of capital, the legal and regulatory arena, the participants in the electricity marketplace, and the pricing and terms of transactions.
Capital Reconfiguration. The utility merger trend is well known. But it is only part of a broader emerging trend of "capital reconfiguration." Straightforward, utility-to-utility mergers will prove only one of many transaction forms. The industry will probably also undergo disaggregations and spinoffs of assets and functions and reaggregations of assets and functions in new combinations. Indeed, some companies are already refunctionalizing within the existing corporate umbrella in possible preparation for more dramatic action.
This capital reconfiguration will take place in the context of an increasingly open transmission grid and power market. In this environment, geographical proximity of a company's activities will be less important than the development of skill sets and core
competencies. One can imagine the reconfiguration of organizations along the functional lines of generation, transmission, distribution, and merchant services;
the merger of these functions
into consolidated "GenCos," "TransCos," and "DisCos"; as well as the formation of companies specializing in the operation of coal or gas facilities (as distinct from facilities consuming other fossil fuels).
Legal Frameworks. The Energy Policy Act enabled a new class of exempt generators (EWGs) to compete for wholesale power markets. It also laid the foundation for wider competitive access to the transmission grid. More recently, the Notice of Proposed Rulemaking issued by the Federal Energy Regulatory Commission (FERC) would unbundle transmission and ancillary services, expand transmission access, provide equal access, reduce preferences for the utility's sales function, and provide equal access to essential transmission information. States likewise are beginning to question the historical assumptions underlying the regulation of the electric industry (see Figure 1). Competition for retail load, the historical service obligation, and the prudence of the traditional, vertically integrated, franchised monopoly are all on the table in this debate.
Most important, perhaps, is how the nature of the debate has changed in just the last 12 months. The policy debate ended almost before it started. Few now question the wisdom of introducing competitive forces into the industry. The question is no longer whether, but when and how.
New Participants. The independent power-producing segment of the industry is now augmented by nearly 100 power marketers that either have, or have applied for, authority to buy and sell power in the bulk-power market. Power marketers include utility affiliates, successful players in the gas industry restructuring, and financial and trading houses. As the grid opens, these firms can expect to see their transaction volumes climb and their collective market share rise. Competitive pressure will mount on traditional power merchants, just as it did in the gas industry a few years ago.
New Transactions. The unbundling of access to transmission assets and information already allows competitors to offer a wide variety of products and services in the physical power market. As liquidity increases, financial transactions will become more prominent as well. The New York Mercantile Exchange plans to open an electricity futures exchange early in 1996. As the grid opens, electricity will move readily from region to region, crossing traditional boundary lines and integrating regional markets. This integration will reveal capacity surpluses and rationalize the market. Consequently, new investment in generating capacity is already being deferred. Prices for existing output are falling.
Other forces are at work as well. The monolith is cracking. Utilities that once found it easy to cooperate with other similar entities now encounter deepening rifts as the market becomes competitive. Some utilities welcome change. Others live in various stages of denial. The progressive utilities are rapidly giving the lie to traditional arguments about reliability, cost-shifting, and even stranded costs. The push for change from within the utility fraternity, and the overall resignation to competition, is perhaps the most profound catalyst of all. Without the excuse that the "lights will go off," utilities are left with very thin arguments to resist free-market forces as a substitute for government regulation and the monopoly franchise.
Technology is also changing. In the days of large capital accumulations, central planning, and guaranteed recovery, a monolithic approach to technology development and deployment was the order of the day. "Bigger is better" coal and nuclear plants were the norm; they are now a big part of the problem. In an open market, technology development and deployment will be refocused to new investments: technology to de-bottleneck the grid where existing resources are underutilized or simply unavailable to outside markets; more flexible and efficient plant and equipment; smaller, more easily financed, and less risky generation. Development and deployment of new technology will no longer lie hostage to the budgets or regulatory agenda of the utilities.
All of this change is leading to better choices for consumers. Enron's electricity trading group has observed, and participated in, an enormous price decline in those pockets of the market where competition is allowed to operate. In the last 12 months, prices in Western markets have fallen 25 to 35 percent for comparable transaction terms. Even after adjusting for the effects of surplus hydro power, we estimate the decline at about 15 percent. In Eastern markets, $40 per megawatt-hour (Mwh) purchased power is replacing $60/ Mwh generation in seasons of rising temperatures. Perhaps most dramatic, however, are price declines in the nascent forward market, where purchased-power transactions are winning requests for proposals over new generation costing perhaps 40 percent more. Increasing diversity in nonprice terms is also observable. Currently, these products of competition are confined to a narrow segment of the wholesale market (em an even smaller slice of the overall power market. Whether these benefits expand beyond these narrow confines depends on how wisely and expeditiously the
transition to competition is undertaken.
The Importance of the Transition
Whether electric industry restructuring proves positive or negative for the gas industry will depend on how the transition breaks. The job of deregulation is far from over. Utilities are not sitting on their hands while beloved protections fall away.
The gas industry would benefit from a swift and complete transition to competition. In such an environment, new generation would likely be gas-fired, nuclear assets would be retired, opportunities would flourish for capital reconfiguration, and retail markets would find a level playing field. But a slow and compromised transition would have the opposite effect. Here's how.
While competition is beginning to take hold in wholesale markets, retail markets are immune so far. Competition in such markets is coming but not here yet. While waiting for this eventuality, utilities have filed for a proliferation of "special deals" to insulate their retail markets. "Cogen deferral" rates shift costs away from large customers who might otherwise choose a gas-fired cogeneration facility. (As shown in Figure 2, industrial rates in many areas of the country are much higher than the cost of new gas-fired generation.) These customers either disproportionately benefit from utility cost-cutting and shareholder absorption, or the utilities shift costs to other ratepayers.
Many utilities are working on "special deals" for their generation assets as well. Deals have been made for the recovery of costs associated with nuclear assets. Proposed pricing and rate systems would allow competition on a marginal-cost basis rather than on fully allocated cost. (The difference is recovered on utility assets, but through fixed charges that circumvent market price-setting mechanisms.) A glaring example of such arrangements is the PoolCo proposal favorably endorsed by a majority of the California Public Utilities Commission. This proposed decision would insulate nuclear assets from bidding into the pool (while still running these assets and permitting cost recovery). Other assets would face the competitive bidding process for what is left of the market not absorbed by these subsidized assets.
Many electric utilities, while they fight the introduction of competition and push for full recovery of stranded costs, are nevertheless
attempting to alter their contractual commitments to independent power producers. Many of these facilities are gas-fired. Efforts are underway in Congress, at the FERC, and at various state commissions to escape contract commitments or unilaterally to change price and other key contract terms. Utilities should be aware that the arguments they make to escape these contracts could also be made by utility customers seeking to escape stranded costs. There is a more prudent course for policymakers: 1) honor existing contracts, 2) allow recovery of stranded costs, and 3) undertake prospective reform of the Public Utility Regulatory Policies Act only in the broader context of opening all power markets to competition.
While procompetitive reforms are proceeding, utilities are working hard to compromise the transition, particularly at the state level, where their political power is most concentrated. The challenge for gas companies, consumers, and others whose interests depend on an open and competitive electric market is to ensure a swift and complete transition. Only then will the benefits of a competitive market accrue to the economy. t
Richard D. Kinder is president and chief operating officer of Enron Corp. He also serves as chairman of the Interstate Natural Gas Association of America.
What Electric Deregulation Means for Gas CompaniesA host of new challenges and opportunities will arise for natural gas companies:
. Gas-fired IPPs. Pressure on existing contracts with independent power producers means pressure on gas suppliers, transporters, and in some cases, distributors (LDCs).
. Exposed Costs. Open retail markets mean reduced ability for utilities to cost-shift to shield retail markets from end-use gas competition.
. Generation in Flux. Revealed capacity surpluses dampen near-term prospects for new base-load generation. However, retirement of nuclear plants in response to competition and decentralization of generation planning means increased medium- to long-term opportunities for efficient, low-cost gas facilities.
. One Market. Gas companies will pay closer attention to the relationship between the market prices for gas and power, viewing power plants as facilities for "processing" gas into power. Gas merchants will also see opportunities to serve customers with both gas and power products. Pipelines will be forced to pay more attention to electric transmission lines as competitors.
. Pipelines/Producers. Capital reconfiguration will present opportunities for savvy gas companies. Gas producers may vertically integrated into power production. LDCs may see opportunities in spun-off distribution facilities. Pipelines have much to offer when it comes to successfully transitioning power-transmission assets.
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