FOR ALL THE ATTENTION FOCUSED ON NEW LAWS AND regulations designed to create competition in electric power markets, too few people seem to grasp how a market can work. That will change, however, now that Pennsylvania is the first large state to embrace market pricing.

Pennsylvania's lawmakers and three of its five utility commissioners have developed a market to deliver the benefits of competition to consumers.

Rather than "guarantee" politically attractive rate reductions, the Pennsylvania Public Utility Commission, led by Commissioner John Hanger, has challenged market force to deliver more savings than contemplated in any supposed guarantee. The PUC's decision in the PECO Energy restructuring case

provides a guidepost for utility commissions around the nation for dealing with electric restructuring (see sidebar, "A History Lesson").

Also, as we will discuss, PECO Energy's proposed competitive transition charge, as spelled out in a partial settlement, did not reconcile efficiently with the company's estimate of its stranded costs. By discounting PECO's proposed CTC to derive expected present value, we found a difference of nearly $2 billion with the company's $5.46-billion claim for stranded costs. That difference reflects the concern with the utility's assumed zero-percent demand growth rate and the possibility that securitization might not proceed exactly as planned. These necessary assumptions and inherent uncertainties only serve to illustrate the difficulty in founding a restructuring plan upon government-backed guarantees of consumer pocketbook savings.

The key element of the PUC decision was the replacement of anticompetitive caps on retail electricity prices with a credit. The credit allows (em if not motivates (em consumers to shop for the lowest price.

The PUC's decision was elegant in its simplicity. First, it set a transmission and distribution rate that did not subsidize the incumbent utility's competitive activities. Next, the commission set a levelized "competitive transition charge" to allow the utility to recover stranded costs over an 8.5-year period. The energy and capacity portion of existing rates was then left to consumers to determine by shopping for their electricity.

As the first real test of Pennsylvania's Electric Competition Act, the PECO Energy restructuring case drew national attention due to media fireworks triggered by a blizzard of competing advertising claims by PECO and Enron. This battle was initiated when Enron offered to replace the incumbent as the default supplier of electricity throughout southeastern Pennsylvania and to write a check for about $5.46 billion to effect recovery of the utility's stranded costs.

This test followed only after PECO had crafted a compromise among a number of traditional rate-case parties. That compromise, known as the "Partial Settlement," would have avoided extensive wrangling over terms of the restructuring. But it also would have significantly delayed genuine competition and provided the utility with a disproportionate CTC-based subsidy.

In the end, the PUC rejected both the Partial Settlement and the Enron plan. Commissioners John Hanger, David Rolka and Norma Mean Brownell found a way to unleash market forces that fairly balanced the goals of the incumbent utility and consumers.

Looking Behind the Promises

The Partial Settlement would have insulated the incumbent utility from competition for up to eight years by setting the retail market price below cost. It would have done this by capping the average rate that could be charged by the incumbent. A competitor would have to buy wholesale energy, or generate it, and sell retail power at or below this cap (em and that's after accounting for line losses, reserve margins, load factors and the state's gross receipts tax. Even using the lowest projected prices submitted to the commission, the cap probably would have been too low to enable a competitor to break even until around 2007. %n1%n

The utility volunteered to transfer all of its generation assets to an unregulated affiliate for $2.3 billion. It then shaved the claim for stranded costs from about $7.46 billion to $5.46 billion, the sum to be collected through a CTC. The company also agreed to a number of concessions to the signers of the Partial Settlement, including moving up a temporary 10-percent rate cut by four months and providing additional subsidies to low-income customers.

An examination of the compromise shows just how attractive this plan would have been for the incumbent. The present value of projected CTC revenues should equal the company's $5.46 billion claim for recovery of stranded costs. However, discounting projected CTC revenues to present value as of the initial January 1999 restructuring date (using PECO's after-tax cost of capital of 8.71 percent) implies $6.3 billion for stranded costs. The utility had wanted to discount the CTC stream back to September 1998, the date of the proposed rate cut. There was also a return on stranded costs at a pre-tax rate (which was not noted in the Partial Settlement), and more dollars for the early rate cut and to finance concessions in the Partial Settlement. %n2%n

The utility also assumed zero-percent growth rate in electric demand over the 10 years of the Partial Settlement. By contrast, a 0.8-percent growth rate, submitted by PECO to the Federal Energy Regulatory Commission on Form 714 and used in internal corporate projections, would provide the company with an additional $340 million. The Partial Settlement failed to include a true-up mechanism, which would prevent such over-compensation. %n3%n

That's not all. The temporary 10-percent rate cut was contingent on the absence of legal impediments to securitization. Commissioner Hanger noted that PECO was aware such legal impediments might exist. %n4%n In this scenario, the utility would receive an additional $720 million, and the rate cut for consumers would be reduced to 7 percent.

Adding these items together implies a present value of the CTC of $7.36 billion, which constitutes a potential excess of almost $2 billion as compared to the incumbent's $5.46 billion claim.

Before the Commission

The PUC rejected the compromise by a 3-2 vote on the grounds that it violated the mandate of the Electric Competition Act for a reliable, competitive retail electric generation market. %n5%n

The Partial Settlement would have required that PECO sell energy and capacity to retail customers at an average price of 2.8 cents per kilowatt-hour in 1999, setting a price ceiling for its competitors. The PUC instead set an average energy and capacity credit to consumers of 4.46 cents per kilowatt-hour (5.2 cents for residential customers). Customers could keep the difference between the credit and the price they actually paid for electricity. By relying on the market, Philadelphia-area consumers could receive savings of up to 15 percent.

The PUC found that the utility overreached in its bid first for $7.46 billion and then $5.46 billion in stranded cost recovery. Commissioner Hanger applied the "just and reasonable" standard set forth in the act. Section 2804(13) of the act grants the PUC the "power and the duty to approve a CTC for the recovery of transition or stranded costs it determines to be just and reasonable to recover from ratepayers." Commissioner Hanger referred to a 1980 Pennsylvania Supreme Court decision, which stated that the phrase "just and reasonable" confers upon the regulatory body the power to decide the appropriate balance between prices charged to ratepayers and returns to utility shareholders. %n6%n

Using this standard, the PUC rejected several items on grounds that they either were not included in the rate base or were unknown and unmeasurable.

Despite all these considerations, however, the most important modification of the stranded cost claim was the rejection of the company's calculation of the expected costs associated with its generation assets. That calculation was based on the lowest of the price projections offered by PECO's consultants.

A consultant had produced a price forecast that had led to a value of generation assets of $2.86 billion. In rebuttal testimony, he reduced the estimate to $2.3 billion. Ultimately in surrebuttal testimony, that figure fell to $1.86 billion. %n7%n

Expressing skepticism about downward changes in favor of the company, the commission rejected all of the estimates. Instead, it adopted the testimony of an intervenor witness and determined a market value for the stranded generation assets of $3.96 billion. %n8%n

The PUC decided to provide a total of slightly more than $5 billion in stranded cost recovery (including miscellaneous items). This figure was reduced at a Jan. 15, 1998 public meeting of the commission to $4.94 billion. %n9%n The PUC also applied a cost of capital of 7.47 percent, based on the cost of PECO's long-term debt, in the calculation of the CTC.

Aftermath

The utility reacted by stating that the PUC's decision would cause considerable financial distress. The company filed suit in U.S. District Court on Jan. 21 and Commonwealth Court the next day. PECO claimed in federal court that the Commission's decision violated the Fifth Amendment's just compensation clause, and in state court that the decision violated the "just and reasonable clause" of the Electric Competition Act. %n10%n While the decision should stand up in both courts, legal wrangling may delay benefits to Pennsylvania consumers.

The company followed that action by taking a write-off of $3.1 billion dollars for the fourth quarter of 1997. It blamed the write-off and dividend cut on the PUC's rejection of part of the claim for stranded costs. PECO's chief financial officer said rules maintained by the Securities and Exchange Commission required the company to take the write-off "unless we could tell the accountants we had a high probability we would prevail" on appeals of the PUC order. %n11%n The write-off anticipates losses that might not occur, given the uncertainty of future electricity prices.

The stock market suggests the effect of the PUC's decision on the company was not severe.

The overall impact of the PUC's decisions was to leave the utility's stock slightly higher than after the announcement of the Partial Settlement (see Table 2, "Average Price of PECO Common Stock"). Once investors had time to consider the decision, they saw that the company had suffered little injury.

The bond markets generally did not consider the PUC's decision a disaster. The day after the PUC's decision, and again on Jan. 28, Standard & Poor's affirmed its ratings and positive outlook on PECO. The second rating was in response to the company's announcement of a $1.8 billion after-tax charge to fourth quarter 1997 earnings and a 44-percent reduction in the annual common dividend. Duff and Phelps Credit Rating believed that PECO should be able to offset the pressure on credit quality from the potentially higher rate reductions and reduced stranded cost recovery. Fitch Investors Service did declare a negative ratings watch on PECO's credit because of the potential loss of customers to competition. %n12%n

To Consumers and Utilities:

No Guarantees

The central lesson of this case is mandated rate reductions are unnecessary in the transition to a competitive market.

Such mandates tend to reward higher cost utilities. The higher-cost company has leeway to cut costs and meet a mandated target, while a lower-cost company may have to work much harder to achieve a set level of savings.

States that have mandated rate reductions may find these savings illusionary. Massachusetts has effectively committed to subsidize utilities that cannot cover a 15-percent rate cut. In California, the bulk of stranded costs are due to contracts signed under the Public Utility Regulatory Policies Act; these costs will persist indefinitely. Consider this irony: The "wires" company remaining after divestiture will have a strong argument to evade mandatory rate reductions. It may prove difficult to force such companies to sell power below the cost of purchasing energy on the market. The PUC solution circumvents this problem and the corresponding threat of legal entanglements.

We understand that utility commissions are subject to intense political pressure to demonstrate up-front savings from restructuring efforts. As the PECO case showed, some participants in the regulatory process may prefer continued regulation over the uncertainties of competition.

Several consumer groups were willing to trade the possible benefits of competition for a ceiling on electricity rates. The State Consumer Advocate said: "The tradeoff is between the certainty of rate reductions for 100 percent of customers on Sept. 1, 1998 for the early years for the opportunity perhaps to get larger rate reductions, if in fact competition does produce lower prices." %n13%n Other groups agreed to the Partial Settlement because they had little faith the PUC would protect their interests (as it ultimately did).

This commission's decision stands out for the political courage and economic sophistication it required. The three commissioners are laying the foundation for a market that will be relatively independent of the struggles of competing lawyers, lobbyists and regulatory consultants.

They are setting in motion forces of creative destruction, which result in new technologies, new service orientations and new organizations. Competition should not only lower prices; it should improve service and encourage innovation.

That much wisdom they can and should impart with their decisions. But no commission has the wisdom to know what level of guaranteed savings would be sufficient to compensate society for the inhibition of competitive forces. F

Steve Isser, Ph.D., is a senior consultant and Steven A. Mitnick is a senior vice president of Hagler Bailly in Arlington, Va. Mitnick testified as an expert witness in this case on behalf of the Pennsylvania Electric Competition Coalition (composed of Enron, Connectiv (em a subsidiary of Delmarva Power & Light, and New Energy Ventures). The views expressed here are not necessarily those of the authors' affiliations or clients.

1 See Supplemental Testimony of Steven A. Mitnick in this case, pp. 26-28, Exh. SAM-3. See, Motion of Commissioner John Hanger, Public Meeting, Dec. 11, 1997, dec-alj-116, Docket Nos. p-00973953, p-00971265, p. 7, cited as Re PECO Energy Co., r-00973953, 181 PUR4th 517 [hereinafter "PUC decision"].

2 PUC decision, p. 8.

3 PUC decision, p. 10.

4 The PUC noted that while it had authorized PECO Energy was to issue transition bonds (securitization) to recover a portion (see, Re PECO Energy Co., Docket No. r-0093877, May 22, 1997, at 177 PUR4th), appeals were pending, making it unclear whether such bonds would be issued.

5 PUC decision, p. 2.

6 PUC decision, p. 32, referring to Pa. PUC v. Pa. Gas & Water Co., 492 Pa. 326, 337; 424 A.2d 1213, 1219 (1980) certiorari denied, 454 U.S. 824, 102 S.Ct. 112, 70 L.Ed.2d 97.

7 PUC decision, pp. 43.

8 PUC decision, pp. 43-46.

9 Opinion and Order, Pennsylvania Public Utility Commission, Public Meeting, Jan. 15, 1998. Requiring the SFAS-109 Deferred Taxes Regulatory Asset to be calculated as the present value as of the date of restructuring was the most important change ordered by the commission.

10 PECO Energy 8-K Report, Jan. 22, 1998. State court docket is PECO Energy Co. v. Pa. PUC, Commonwealth Court of Pennsylvania, Docket 245 cd 1998. (PECO also filed an appeal of the PPUC Jan. 15, 1998, revisions to the order, Docket 246 cd 1998.)

11 Rich Heidorn Jr., "PECO Reports Loss of $1.5 Billion, Slashes Dividend," Philadelphia Inquirer, Jan. 27, 1998.

12 "S&P Affirms PECO Energy's Ratings and Outlook," Business Wire, Dec. 12, 1997; "DCR Comments on the PPUC Order on the Pennsylvania Plan Application of CTC Revenues and Proceeds from Securitization Remain Key to PECO's Credit Quality," PR Newswire, Dec. 17, 1997; "PECO Ratings Placed on Negative Rating Watch by Fitch IBCA," PR Newswire, Dec. 19, 1997.

13 Rich Heidorn Jr., "PUC Rejects Settlement on PECO Rates," Philadelphia Inquirer, Dec. 12, 1997, Local, p. A1.

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