For almost a decade now, the Federal Energy Regulatory Commission (FERC) has pursued the goal of promoting competition in bulk-power markets, focusing on access to transmission as its primary tool to achieve that end. This trend first emerged in the 1987 PacifiCorp merger case. It gained momentum with the strong message sent by the Congress in the Energy Policy Act of 1992 (EPAct). It has culminated in the FERC's proposal for across-the-board, nondiscriminatory access to transmission, as described in the March 1995 Notice of Proposed Rulemaking (NOPR) on open-access transmission services.

In the past, the FERC has consistently identified transmission market power as the key stumbling block to competitive generation markets. Thus, if we assume that the final rule will reflect the NOPR, what is left for the commission to do in regulating wholesale generation? The NOPR anticipates this issue and asks a series of threshold questions about how the FERC should regulate generation rates once the rule becomes final.

Similar questions have been asked in other contexts. Both the majority's proposed policy decision and Commissioner Knight's alternative proposal in the California "Blue Book" case recognize the need to confront generation market power. Also, at the June hearing on Senator Nickles's bill to reform PURPA (Public Utility Regulatory Policies Act), much of the discussion focused on how to ensure a competitive generation market in the event of repeal of PURPA's mandatory purchase obligation.

Market-based rates for wholesale generation are not new. The FERC began approving such rates about seven or eight years ago. This policy has led to a three-part test for approving market-based generation rates: First, does the seller possess generation market power? Second, does the seller possess transmission market power? Third, can the seller erect "other barriers to entry?"

Testing Market Power

In the vast majority of cases, the real issue has arisen under the second prong of the test. In theory, transmission owners can thwart competition by denying access and favoring their own generation. But what happens if the commission succeeds with the basic concept of the NOPR, and every jurisdictional utility in the nation files an open-access tariff? Can the commission then approve blanket market-based rates for all such sellers and their affiliates?

It's noteworthy that the FERC has never found an instance in which an

applicant-seller failed the first prong of the test. That is, the FERC has never found that a seller possessed generation market power in connection with a request for market-based rates. Does that mean the test will shrink to a single prong (em whether the seller can erect "other barriers to entry?" Or, does it mean that we need to take a closer look at the standard?

Here, it's instructive to look at the FERC's order of May 13, 1994, in Kansas City Power & Light Co., 67 FERC

 61,183. In that case, the FERC drew the distinction between long-, medium-, and short-term generation markets. As to long-run markets, the commission found that, "[F]or sales from new (unbuilt) generating capacity there is no need for the commission to focus on whether the seller has market power in generation." Based on this finding, the commission stated that it no longer had to examine generation market power in such cases, as long as the seller has demonstrated that it (alone or in combination with its affiliates) does not possess transmission market power and cannot erect other barriers to entry. In effect, the only generation markets left for examination are short- and medium-term markets.

Indeed, the KCP&L decision implicitly assumes that many markets will retain a significant concentration of ownership

in installed generating capacity. The

commission must still examine that issue on a case-by-case basis. Yet, the question arises: Does the potential concentration of ownership in generation preclude the FERC from approving market-based rates for medium- and short-term generation markets? The answer may depend on the framework chosen for analysis.

Defining Market Boundaries

The FERC's current method for analyzing whether concentration of ownership results in market power is adapted from the approach used by the Department of Justice to weigh the possible anticompetitive effects of mergers. This approach, outlined in the so-called DOJ Merger Guidelines, involves three steps: 1) Identify the relevant product market,

2) Determine the relevant geographic market, and

3) Assess the degree of market concentration.

Will this framework prove useful for evaluating the electric power industry at its current stage of competitive evolution? Certainly, the application of Merger Guidelines will raise some interesting issues. The open-access NOPR touches on many of them.

For example, the NOPR asks a question about defining the scope of electricity markets as they become more competitive. Defining the size of the market is a key determinant in analyzing market power (em one that can produce far-reaching effects, since the smaller the market, the greater the chance that any given firm will be found to possess market power.

The Merger Guidelines define the "relevant geographic market" as the area in which a hypothetical monopolist might impose and sustain a price increase. As transmission availability increases, by definition the geographic market for electricity ought to change. What were once balkanized regional markets will most likely expand. Could we reach a point of thinking in terms of two major markets, the Western Intertie and the Eastern Intertie? Should we recognize markets of different dimensions for different products? For example, is the geographic scope of the market for short-term generation sales different from the market for long- and medium-term sales?

In addition, unlike markets for other products, the market for electricity is bounded not only by the laws of economics, but also by the laws of physics. Do the physics of transmission (line losses) place an inherent limit on the size of generation markets? Similarly, how should regulators account for

transmission bottlenecks in their analyses? Should we also account for the possible anticompetitive effects of pancaked transmission rates that may occur when a seller or a purchaser arranges to transmit electricity across multiple service territories?

Other factors may also prove significant. For example, as power marketers enter the picture, will markets effectively get "bigger" as buyers and sellers get access to better information? This question highlights the importance of distinguishing between relatively static, mature markets (oil pipelines, for example) and dynamic, evolving markets such as electric generation. But as a practical matter, is all this analysis worth the cost?

Beyond the practical impediments, some experts question whether the Merger Guidelines may be unduly restrictive. How many alternatives are really needed before we can say that a seller of electricity "lacks market power," and so allow the seller to collect market-based rates? Under the Guidelines, a market is presumed "competitive" if no firm enjoys a market share greater than 18 percent. Thus, a market is deemed competitive if at least five or six equally sized firms occupy the field. Do the Guidelines pose too high a threshold? Should a buyer's self-generation option count as an alternative and thus affect how market share is figured? On a more fundamental level, some ask why the FERC uses an approach more restrictive than that used under the Sherman Act to determine whether an illegal monopoly exists. Critics of the Merger Guidelines approach also point to many sectors of the economy where the existing market concentration levels rise far higher than the 18-percent test, but where the law nevertheless imposes no economic regulation.

Others say we ought to be looking more closely at vertical market power. They claim that the vertically integrated nature of the traditional electric utility creates a distinctly different barrier to entry. Thus, the FERC's NOPR on open-access electric transmission might not adequately mitigate the market power attributable to vertical integration. This view has been advocated in a widely circulated paper sponsored by the National Independent Energy Producers.

Seeking Market Structures

What should the FERC do about all of this? If you assume that a final rule in the open-access NOPR will not introduce enough competition into wholesale generation markets to allow the commission to authorize market-based rates for all existing generation, what then are the commission's options?

Here are three approaches that occur to me.

First, the FERC could continue to employ a case-by-case approach and address individual applications for market-based rates as they are presented. This approach would certainly give the agency a good deal of flexibility, but does little to advance the ball.

Second, the commission could attempt to "structure the market" for competition. This path could include taking what might be considered "invasive" regulatory steps to break down the concentration of ownership in generation. The most important question here is whether such steps would fall within the FERC's legal authority under the Federal Power Act. I believe the law is fairly clear that the FERC cannot directly compel divestiture. But can it encourage utilities with a combination of "carrots and sticks"?

Third, the commission could take a less intrusive approach and rely on monitoring and enforcement to police any abuses of market power. Is this approach realistic? Would it comport with the FERC's statutory responsibilities? What if the commission could design more creative methods to encourage the development of institutions that might mitigate residual market power? In other words, why not select rules of the road that are, in a sense,

"self-enforcing"?

We are not alone in this. This next tier of issues in electric restructuring will find the states playing a significant role. It is even possible that the states may take steps at the retail level that will alter the market-power equations that come before the FERC. In short, if you thought open access was fun, you ain't seen nothin' yet. t

Donald J. Santa, Jr. has been a Commissioner at the Federal Energy Regulatory Commission since 1993. Previously, he served as counsel to the Senate Committee on Energy and Natural Resources. Commissioner Santa is a graduate of Duke University and the Columbia University School of Law.

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