Will the Crown accept the olive branch offered by its colony, or will conflict ensue? That was the question posed on July 13 by Thomas Page, CEO of San Diego Gas and Electric Co., at the "Western States Workshop on California Restructuring," the first industrywide meeting to discuss the policy proposals issued six weeks before by the California Public Utilities Commission (CPUC).The Crown sent its emissaries. Arriving from the Federal Energy Regulatory Commission (FERC), both Chair Elizabeth Moler and Commissioner William Massey attended the meeting and pledged their cooperation. But their royal prerogative they would not cede. The colony may experiment, but the Crown will decide.

Common Faith, Diverging Paths

The CPUC and the FERC share a common faith that, on a macroeconomic scale, the generation market is or can be made workably competitive, allowing policymakers to lower the price of electricity by effectuating competition among sources of electric generation. Nevertheless, each agency has mapped out a different path to its desired result.

The CPUC's "Majority Pro-posal"1 does not effectuate retail wheeling. It offers a model fashioned on a wholesale pool of generation that would forge a real-time, spot market in electric power. An independent system operator (ISO) would run the transmission system and dispatch generating plants to ensure supply and delivery of wholesale power. The ISO would do this independently of any generator or owner of transmission facilities. Thus, the majority proposal represents a form of wholesale market restructuring; retail assets are converted to wholesale supply. Retail competition is furthered through Contracts for Differences (CfDs) (a financial hedge against the wholesale pool price), thereby permitting "virtual direct retail access." These contracts would act as a financial hedge, with settlements based upon the spread between the pool price and the contract price for bulk power. But by electing a reform of wholesale markets, the CPUC acknowledges FERC authority over many of the essential features of the state's plan.

The FERC has selected a different model. It proposes to restructure the interstate transmission and bulk-sales market. The FERC's Open-Access Model2 requires all utilities subject to its jurisdiction to file transmission tariffs that provide point-to-point and network transmission services that are open, unbundled, and nondiscriminatory. It effectuates competition through the idea of transmission provided as an independent commodity, with power traded via bilateral contracts.

Perforce, the FERC ostensibly addresses competition only at the wholesale level (em the nominal extent of its jurisdictional reach under the Federal Power Act (FPA). That market historically has featured long-term transactions in which bilateral power contracts were the norm. Over time, the number of market participants has grown with more interconnections. And, with the passage of the Energy Policy Act of 1992 (EPAct), participation levels are growing with the tide of exempt wholesale generators and power marketers.

The market structure at the state level is far different. The retail market is characterized by a wide variety of consumers, ranging in power-purchase expertise from large, savvy industrial concerns to residential neophytes. Whereas direct retail access through bilateral contracts would permit large firms to reap immediate benefits, it remains unclear how residential users might participate effectively. With a wholesale pool as the prime market for electricity, the ISO would act as a wholesale aggregator for all retail customers and direct the economic dispatch of generation resources. The CPUC majority believes that this regime will reveal price signals, spurring competitive forces and spreading the benefits of competitively priced power.

Both the CPUC and the FERC recognize that the vertically integrated nature of the electric utility industry is anathema to competition. Each would disaggregate the vertical functions of utilities by separating generation, transmission, and distribution. But they would do it differently.

The FERC would require electric utilities to unbundle transmission from the sale of electricity and operate transmission as common carriage. The utility maintains operational control, and contractual assignments provide transmission access, with native load presumptively accorded priority rights. By contrast, the CPUC would have pool participants transfer operational control of transmission to an ISO. The retail function of each participating utility would acquire its power from the wholesale pool. The generation function (participants and other generators) would submit bids to supply power. The ISO would accept power-supply bids on economic dispatch principles, and use the integrated capacity of the transmission grid to meet retail requirements. The difference in models is profound: The FERC invites buyers to shop for generation; the CPUC majority would have generators competing among themselves for the right to serve a single aggregate market. Generators and nongenerators would be permitted to compete for individual retail customers only pursuant to CfDs, but such contracts would not entitle generators to actually dispatch power. Generators would be required to bid into the pool to supply power under their CfDs, with a zero bid price perhaps necessary to ensure dispatch. Again, however, all power would flow through the pool, and prices would be set in the first instance by the pool clearing price.

The CPUC and the FERC also part company on "stranded costs," both on definitions and cost recovery.

The CPUC would measure stranded costs on an asset basis (em comparing book values to market values in a competitive environment. It would minimize stranded investment by bundling high-cost nuclear facilities with low-cost hydro. It would recognize retail stranded cost for rate purposes only to the extent that the net present value of the stream of market-priced revenue from nuclear/hydro fell below the book value of the combined assets. The FERC prefers a "revenues lost" approach that compares the revenue a utility reasonably expected to receive from a given customer against the price the utility could command for that power on the open market. The differential would represent stranded costs.

For cost recovery the CPUC would bill all current retail consumers through a "competitive transition cost" (CTC) surcharge. But the FERC would assign stranded costs individually to certain departing customers (those without notice provisions in their contracts).

Will the FERC Cooperate?

At the July 13th meeting both Chair Moler and Commissioner Massey pledged the FERC's cooperation in the California restructuring. They offered encouraging statements, seeing "much to like" in the CPUC's preferred industry structure.

Nevertheless, they proclaimed three qualifications that may loom large as the CPUC fleshes out policy:

s The FERC will have complete and exclusive jurisdiction over PoolCo operations.

s The state proposal must embrace all salient features in the FERC's Open-Access NOPR.

s The FERC may act only upon formal proposals (em not informal dialogue.

The question arises: Do states enjoy latitude to adopt restructuring proposals that are meaningfully dissimilar from the federal model?

While the ISO as a grid operator finds precedent in FERC lore, the ISO as a marketmaker is both unique and, arguably, inconsistent with the unbundled transmission principles that underlie the FERC's NOPR. Professor William Hogan, widely considered the intellectual father of PoolCo, flatly states that the FERC open-access regime and the CPUC model are mutually inconsistent. Nevertheless, the pool's principal proponents have assured the CPUC that there is no inconsistency.

Proponents of "virtual direct access" claim their policy reflects reality, whereas "bilateral direct access" defies the physics of electric transmission. Others argue that PoolCo denies generators and consumers the cornerstone right to "unbundled transmission" guaranteed in the FERC NOPR. They claim the ISO will retain a first call-transmission capacity to dispatch power from facilities deemed "must run." Generators could be denied comparable transmission access to the grid to serve customers who retain the right to acquire power from third parties.

The CPUC majority views the ultimate right to enter into CfDs as providing access for generators and consumers that is equal, if not superior, to a naked right to transmission access. Indeed, CPUC chairman Daniel Fessler has challenged parties to describe a situation in which virtual direct access cannot replicate the economic function of a bilateral contract (em and very few examples have been provided. Nevertheless, the FERC eventually must decide whether to allow (or require) FERC-filed tariffs to be modified to conform to the CPUC's majority proposal, or whether both systems may coexist, or whether a centralized market role for the ISO is fundamentally inconsistent with the basic requirements of the federal system.

Apart from philosophical differences, proponents of the wholesale pool must convince the FERC that the existing market power of the state's three large investor-owned utilities (IOUs) can be adequately mitigated, and that operation of the power will yield "just and reasonable" prices under the FPA standard. Without question, the state's three IOUs have Hirschman-Herfindahl indices that indicate possession of market power in generation. PoolCo (em open to generators throughout the region (em is predicted to deprive the IOUs of market power. Moreover, the CPUC would set a floor and ceiling rate of return for the utilities' generating assets (other than the nuclear and hydroelectric). But those wary of the IOUs say there simply is not enough transfer capacity into California to rely on external generation sources. They argue that the IOUs alone will have generator facilities downstream from transmission congestion points, and thus may exert market power during peak periods and for ancillary services.

To date, while various representatives of the FERC have extolled the virtues of the pool concept for grid operation, they have provided small assurance to the CPUC that market-power issues have been adequately addressed. The CPUC, for its part, is grappling with the undeniable fact that existing monopolies will have some measure of market power until a competitive market matures. The CPUC is considering divesture, but that might affect taxes and stranded costs.

The CPUC must also convince the FERC that pool prices will be "just and reasonable" under the FPA. Unlike the natural gas industry, where restructuring was propelled by explicit congressional deregulation of producer prices, there has been no alteration of the FPA mandate of "just and reasonable" rates (em which means cost-based rates, according to much judicial precedent. Under economic dispatch principles, baseloaded resources usually have a lower operating cost than marginal resources, which stand farther back in the dispatch queue. If the uniform clearing price of the pool is predicated upon the cost of operating the most marginal resource needed for a given period, operators of baseload resources may receive "uplifted" payments that do not reflect the cost of operation.

In the natural gas industry, the FERC permitted so-called "old gas" to be sold at market prices, while still subject to regulation under the just and reasonable standard. However, the FERC went to great pains to justify its action by setting an alternative, higher, reasonable price based on a replacement cost method. Historically, the courts have held it impermissible to rely solely on market forces to ensure that prices will be just and reasonable. The question will be whether the uniform pricing concept of the wholesale market, where all dispatched generators are paid the market-clearing price irrespective of their cost or bid, will pass muster at the FERC.

These issues take on greater significance in light of the FERC's procedural quandary. At the July 13th workshop, Commissioner Massey, while enthusiastic about the California proposal, stressed that he is but one of five FERC Commissioners, and noted that no California proposal was "before" the Commission. Chair Moler added that the CPUC policy preference needs "more meat" before it is amenable to FERC review: California must be prepared to show that state IOUs will not exert market power in generation in a pool structure.

Will it Matter?

Time may be running short for engaging the FERC in a meaningful exercise to consider a state restructuring scheme that is not the retail equivalent of the federal wholesale direct-access model. In a recent order, the FERC offered inducements for utilities to accept conforming open-access tariffs in advance of the final rule. If these inducements prove sufficiently attractive, the FERC may achieve de facto restructuring before the states can adopt variants on the FERC theme. A rapid transformation nationwide may temper the FERC's willingness to work with the states on any form of restructuring not in lockstep with the federal scheme.

And who can tell whether the California pool will end up reflecting truly competitive market prices? Will the generation "market" prove too shallow to yield a truly competitive price? The CPUC's pool model requires the ISO to dispatch nuclear, hydro, and qualifying facilities (QFs) outside the bid sequence. And that's a big chunk: In the Pacific region generally, 56 percent of electric energy comes from hydro, 15 percent from nuclear, and 19 percent from gas-fired plant, mainly in QFs. Thus, on a regional basis, over

90 percent of generating capacity will fall in categories that will constitute the base load of the pool outside the context of the bidding scheme. Moreover, the Pacific region currently suffers from substantial surplus capacity. Given these factors, the quantity of demand open for bid may prove too small to forge a market price.

In the short run, the wholesale price might come in too low, not too high. The perception persists that out-of-state generators will attempt to dump excess capacity into the California market at low incremental prices. Utility generators, flush with CTC payments, may tolerate very low wholesale pool prices to drive existing independent generators out of the market and forestall new entrants.

Finally, while California's transition-cost recovery plan is more innovative than the FERC's, it may still generate sufficiently high costs that restructuring creates a "zero-sum" game: high CTC charges raise rates and postpone any consumer benefits from competition. Moreover, the CTC could encourage an accelerated "fire sale" of marginal generating plants (em attenuating utility market power and raising stranded costs.

Nevertheless, the bottom line favors the broad consensus that something must be done to cut the cost of electricity in California. Nations throughout the world have implemented industry structures similar to that proposed by the CPUC's majority proposal, and those structures, in the main, have worked. They have trimmed prices while accommodating private contractual relationships. PoolCo's most vocal critics may fear that it will work too well. To the extent that the wholesale pool makes prices transparent, the role of marketers and marketmakers will shrink.

As the details are addressed, no one should forget that the CPUC initiated the electric restructuring movement. Its proposal offers savings for all consumers, but candidly acknowledges the various hurdles that lie in the way. t

Sheila S. Hollis is the senior partner at Metzger, Hollis, Gordon & Mortimer, representing numerous players in domestic and international energy matters. She is a professional lecturer in energy law at George Washington University Law School, chair of the ABA's coordinating group on energy law and a member of the ABA's house of delegates. She is past president of the federal energy bar and served as first director of enforcement at the FERC. Widely published, Mrs. Hollis is a recognized expert in energy law and policy.

Stephen L. Teichler is a partner at Metzger, Hollis, specializing in domestic and international energy law. He has represented a broad spectrum of power-related entities in regulatory, contractual, and litigation matters. He is also a veteran of the FERC's natural gas restructuring initiative. Prior to joining the firm, Mr. Teichler was a partner in the Washington office of Baker & Botts.PoolCo Pressure PointsComments highlight some key policy questions emerging in the California debate:

. Participation. Should muni utilities surrender all G&T to the ISO to buy from pool?

. ISO Role. A grid operator, yes, but a marketmaker, too?*

. Pricing. Highest winning bid or lowest loser? (The so-called "second-price" auction.)

. Bid Rules. Allow a zero-price tender, or mandate a marginal-cost bid?

. Grid Constraints: Will bottleneck areas command economic rents? If so, what does the ISO do with the extra money?*Some equate the PoolCo/ISO model with "command-and-control" economies. But the natural gas experience doesn't prove that bilateral contracts are better. A 10-year study by the MD PSC (1983-93) shows a 40% cut in gas prices for industrial customers, but only 4% for residential. Meanwhile, the CPUC anticipates allowing retail, physical bilateral contracts two years after the pool begins operating--after solving issues involving the CTC, jurisdictional conflicts, nonpool transfers, and horizontal market power.

1 Re Proposed Policies Governing Restructuring California's Electric Services Industry and Reforming Regulation, Decision 95-05-045, R.94-04-032, I.94-04-032, May 24, 1995, 161 PUR4th 217.

2 Promoting Wholesale Competition Through Open Access Non-discriminatory Trans. Servs. by Pub. Utils., Dkt. RM95-8-000, Dkt. RM94-7-001, Mar. 29, 1995, 70 FERC (pp 61,357 (F.E.R.C.). Recovery of Stranded Costs by Pub. Utils. and Transmitting Utils., Dkt. RM94-7-001, Mar. 29, 1995, 70 FERC (pp 61,357 (F.E.R.C.).

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