IN A RECENT SPEECH TO A SOPHISTICATED WASHINGTON AUDIence of electric industry players, FERC Commissioner William Massey raised a difficult question: "Can ISOs become self-policing institutions, thereby allowing FERC to embrace light-handed regulation of transmission?"
In answering his own question, Massey confirmed a quasi-judicial role for independent system operators (em but only if they are "equipped with proper operational rules, including market monitoring plans that report market power abuses and contemplate enforcement mechanisms to assure compliance." %n1%n
Despite such optimism, it appears unlikely the FERC will easily shed significant regulatory functions by making ISOs its proconsuls in a restructured electric power industry.
The FERC has provoked a growing controversy by its provisional approval of market monitoring plans filed by the Western Power Exchange and ISO-New England (formerly NEPOOL). Industry critics have raised constitutional, due-process and pro-competitive objections. Some state regulators believe the indicated mitigation measures to be inadequate; others question the efficacy of having ISOs use "behavioral" as opposed to "structural" remedies for market power abuses.
This gathering debate implicates radically opposed views on the proper role for ISOs.
The FERC and most state regulators envision several regional ISOs, with broad powers to operate the grid, manage power exchanges and curb market abuses. To accomplish these tasks, ISOs would enjoy authority similar to that exercised by the FERC. With FERC-approved regional transmission tariffs as a platform, ISOs would adopt monitoring and mitigation plans to acquire detailed market information. If necessary, ISOs would intervene to prevent market power abuse through price caps and price floors. They also would employ sanctions to prevent strategic withholding of capacity and use of transmission constraints to exclude competitors.
Not all agree, however. To many regional transmission owners that have ceded operational control of the grid, this proposed intervention stretches the envelope of ISO power. Such owners typically view an ISO as little more than a neutral service provider and transmission tariff administrator.
A Structural or Behavioral Remedy?
As conceived by antitrust theorists at the Department of Justice, ISOs are "structural institutional arrangements, short of divestiture, that¼ separate operation of the transmission grid and access to it from economic interests in generation." %n2%n
Once in place, according to this view, an ISO adequately addresses vertical market power by decoupling transmission and generation. The question then arises: What about horizontal market power?
In response to requests for market-based rates filed by ISO-NE, WEPEX and the Pennsylvania-New Jersey-Maryland Power Pool, the FERC has had to consider residual horizontal market power exercised by generators within a pool. Horizontal market power manifests itself in the behavior of market participants, particularly generators. To contain such power, ISOs must do more than operate the grid. They must also identify anomalous market behavior, devise acceptable mitigation procedures and be prepared to punish offenders.
In pursuit of these functions, industry critics assert, the WEPEX and ISO-NE market-power monitoring and mitigation proposals "represent a new and unstudied form of regulation, which entails extensive data collection and investigation, after-the-fact policing of seller behavior, and the imposition of sanctions." %n3%n
On the other hand, FERC claims comprehensive monitoring and mitigation by ISOs is "critical to¼ the Commission's efforts to address market power." %n4%n Indeed, FERC granted market-based rate authority in the WEPEX proceedings based on "effective monitoring programs being in place." %n5%n
THE WEPEX PLAN. Through its reliance on monitoring and mitigation, the FERC appears to acknowledge the practical limits of structural reform. Thus, with FERC's blessing, the WEPEX ISO will focus instead on day-to-day behavior of market participants, including strategic withholding of capacity, mischaracterization of generation as must-run and creation or manipulation of transmission constraints. The ISO will collect and analyze data, including market-clearing prices, bids, unit availability over time, market share data and generating costs. In this way, the ISO will seek to monitor bidding strategies and predatory pricing. If market abuses are identified, the ISO may impose sanctions subject to approval by the FERC, including fines and suspension of trading rights. The ISO is encouraged to "consider the appropriateness of price caps." %n6%n The ISO also will file annual reports with the FERC that will analyze power problems, general market operation and effectiveness of mitigation measures.
THE ISO-NE PLAN. In its proceeding to restructure itself from a power pool to an ISO, the ISO-New England also had filed a plan designed to detect and mitigate the exercise of market power in transmission-constrained settings. ISO-NE had proposed to identify anomalous bid patterns (indicative of economic withholding) and instances of unjustifiable physical withholding before applying corrective measures.
As initially filed, the proposal drew sharp criticism from state regulators for doing too little to thwart horizontal market power. The New England Conference of Public Utilities Commissioners found the market power analysis "clearly inadequate" since, according to a separately commissioned study, market power was found to pose a serious threat to competition in affected markets even in the absence of transmission constraints. %n7%n
Under a revised proposal filed December 1997, ISO-NE can reduce the bidding flexibility enjoyed by a particular supply resource, or increase a participant's reserve requirements and substitute a "default bid" for a participant's bid. During transmission constraints, the ISO will apply a market structure screen to detect if competition exists and a price screen to evaluate whether a resource has raised its bid substantially. If the former reveals a lack of competition in the constrained area or the latter detects that necessary resources are bid higher than average, the ISO will restate the resource's bid to a default level equal to the applicable screen price. These procedures for constrained periods are intended to be applied with mitigation for general withholding in unconstrained periods.
Even as revised, however, this new proposal from ISO-NE has not escaped criticism. The Maine attorney general has asserted that "effective mitigation of market power in affected markets requires a structural remedy." %n8%n
Similarly, the staff of the Bureau of Economics of the Federal Trade Commission sees potential difficulties in detecting and preventing market power. According to the staff, "Monitoring and mitigation through behavioral regulations could require virtually transaction-by-transaction oversight and likely would be particularly difficult when transactions are highly time-sensitive, as they are in electric power." %n9%n To supplement behavioral constraints, the staff urged the FERC to make "appropriate structural relief a predicate for granting the authority sought in these proceedings." %n10%n Although the staff's comments do not so state, "structural relief" would almost certainly entail divestiture.
The Battle: PJM's Mitigation Plan
On Nov. 25, 1997, the FERC conditionally approved the proposal of the PJM Supporting Companies %n11%n to restructure the Pennsylvania-New Jersey-Maryland Interconnection. Shortly thereafter, PECO Energy spoke out harshly against the proposal, attacking the idea of price caps in certain circumstances for must-run generating plants.
In its November order, the FERC required the PJM Office of the Interconnection as ISO to submit a monitoring plan addressing "the potential to exercise market power within [the PJM power pool]," including an evaluation of both pool and bilateral markets and "any proposed enforcement mechanisms that are necessary to assure compliance with pool rules." %n12%n How will PJM address this requirement?
PJM's restructuring plan contemplates, but does not yet implement, market-based pricing for sales through the power exchange. As proponents of market-based pricing, the Supporting Companies have offered proposals to deal with market power associated with generating plants that "must run" to maintain system reliability.
Consultants for the Supporting Companies warned: "Those who own¼ specific generators¼ that must be run for reliability purposes under certain demand and supply conditions could, if unconstrained by contract or regulation, extract monopoly profits. The owners of such must-run generation could bid very high prices for their output, and the ISO would be forced to call on them to operate for reliability reasons even if the energy which they provide could be replaced by much cheaper sources absent the must-run constraints." %n13%n
If generation is deregulated and retail customers have choice of suppliers, owners of local must-run generation could exercise market power "because there no longer will be traditional native load and therefore no longer a requirement to supply the output of must-run generators, at cost-based regulated rates, to serve native load." %n14%n
As a solution, the Supporting Companies have proposed that when constraint relief is required (except in the case of constraints on PJM's western, central and eastern interfaces), any bids offered by generators called upon to operate for reliability purposes should be capped at one of three levels: (1) prior period locational marginal prices, (2) cost or (3) a level negotiated by the ISO and the generation owner.
PECO Energy attacked the proposal to cap rates of must-run units and claimed the PJM ISO would have "power to set the bid price for up to 35 percent of the net dispatchable generation in PJM." %n15%n It said: "Supporting companies have no legal right to offer or impose rate caps on the generation assets owned by PECO or other market participants. [R]ate cap rules¼ will provide a strong disincentive to participation by generators in the PJM Interchange Energy Market." %n16%n PECO concluded that the ISO's "highly discretionary powers... would be tantamount to delegation of ratemaking responsibility to the [ISO]," though the FERC "has no statutory authority to make such a delegation." %n17%n
Seizing on PECO's objection, other critics have come forward. Those who question the growing role of ISOs in monitoring and mitigating possible market abuses now speak of an "ISO-centered regulatory regime" %n18%n:
1. Unlike traditional cost-based utility regulation, which takes the form of administrative agency review of prices proposed in advance, ISO monitoring and mitigation plans evaluate data on completed transactions and impose sanctions against sellers whose conduct is deemed improper. ISOs must therefore make post hoc judgments about the behavior of sellers in a competitive market.
2. By allowing ISOs to perform regulatory functions, the FERC may have engaged in unconstitutional delegation of governmental authority to private entities, whose discretion to investigate and apply broadly defined standards of conduct threatens the due process rights of market participants.
3. Sellers subject to investigation, price limitations and potential sanctions for prior misconduct will be inhibited; competitive market behavior will be chilled. The distinction between permissibly aggressive competitive pricing behavior and unlawful conduct is subjective and has not been adequately defined by decisional law or regulations.
4. Traditional antitrust analysis should be used to judge market power concerns. An ISO's mitigation procedures should be limited to must-run situations and to avoid exercising discretion.
More Government Or Self-Regulation?
Self-regulating ISOs are hardly a novelty, nor should they represent any insidious bureaucratic encroachment on free markets. ISOs are in use in Canada and Australia. In each instance, as in the U.S., a practical consideration has motivated the decision to allow self-regulation: The government plainly lacks the resources and expertise to sustain an ongoing program of monitoring and mitigation. %n19%n Effective self-governance through an ISO reduces the need for external regulation. The philosophical choice is not between unfettered competition and self-regulation; it is between self-regulation and government regulation or forced divestiture. As long as residual market power exists, self-regulation can facilitate oversight at lower cost and with less intrusion on competition than government regulation.
Self-regulation works in other markets. Federal law requires self-regulation by securities exchanges, which retain the obligation to formulate rules governing the conduct of exchange members and to police themselves for fraud, deception and price manipulation. In the event abuses are found, an exchange can suspend or expel members.
For example, NASD Regulation Inc., a subsidiary of the National Association of Securities Dealers, is charged with monitoring the NASDAQ market to spot insider trading, price fixing and other market abuses. NASD uses automated market surveillance systems to look for unusual price and volume movements. Monitoring leads to formal investigations and referrals to the Securities and Exchange Commission, called "'the shotgun behind the door,' ready to be used but with the hope that it would never have to be used." %n20%n
Self-regulation need not imply unlawful delegation of legislative authority to private entities, such as ISOs. The devil, as always, is in the details. To withstand constitutional scrutiny, ISOs must employ "pre-established objective criteria" %n21%n to run monitoring and mitigation programs. Objectivity will be served if the ISO follows an "intelligible principle" %n22%n in exercising authority coupled, of course, with adherence to due process and scrupulous avoidance of conflicts of interest. Finally, as a matter of simple prudence, ISOs should not impose sanctions such as fines or market preclusion unless these are first approved by the FERC. If ISOs are careful in monitoring and mitigation, those functions should survive legal scrutiny.
The broader question concerns the wisdom, on policy grounds, of using ISOs to address horizontal and vertical market power. Experience in other industries and in other countries has not yielded any persuasive argument why ISOs should not monitor and mitigate market power abuses. In exercising such functions, ISOs would simply use their regulatory authority to ensure efficiency. F
Jeremiah D. Lambert is a partner in the Washington, D.C., office of Shook, Hardy & Bacon LLP. He has served as counsel concerning restructuring of the PJM Power Pool.
The FERC told the PJM ISO to police market power.
PECO Energy complained that the ISO would control bid prices for up to 35 percent of generation in PJM.
1 Speech on Feb. 23, 1998 at EXNET Conference in Washington, D.C., reported in Foster Electric Report, March 4, 1998.
2 FERC Order No. 888, Docket Nos RM95-8-000, RM94-7-001, Apr. 24, 1996, 75 FERC ¶ 61,080, FERC Stats. & Regs. ¶ 31,036, 71 Fed. Reg. 21540 (May 10,1996) mimeo p. 56.
3 Raskin, ISO Market Monitoring and Mitigation, p.2 (paper presented to Harvard Electricity Policy Group, Jan. 29-30, 1998) (hereafter "Raskin").
4 Pacific Gas & Electric Co. et. al., Docket Nos. EC96-19-001, et al., Oct. 30, 1997, 81 FERC ¶ 61, 122, mimeo p. 242.
5 Id. at 247.
6 Id. at 249.
7 Request for Technical Conference and Comments of NECPUC on ISO-NE Market Power and Mitigation Issues, July 16, 1997.
8 Comments of the Maine Attorney General on the ISO-NE Market Monitoring, Reporting and Market Power and Mitigation Proposal dated Dec. 19, 1997, filed Jan. 23, 1998.
9 Comments of the Staff of the Bureau of Economics of the Federal Trade Commission in FERC Docket Nos. ER97-237-00 and ER97-1079-000, Feb. 6, 1998.
11 Defined as Atlantic City Electric Co., Baltimore Gas & Electric Co., Delmarva Power & Light Co., Pennsylvania Power & Light Co., Potomac Electric Power Co., Public Service Electric & Gas Co., and three subsidiaries of GPU Inc., those being Jersey Central Power & Light Co., Metropolitan Edison Co., and Pennsylvania Electric Co.
12 Pennsylvania-New Jersey-Maryland Interconnection, Docket Nos. OA97-261-000 et al., Nov. 25, 1997, 81 FERC ¶ 61,257.
13 Supporting Companies' Report on Horizontal Market Power Analysis dated July 14, 1997, FERC Docket Nos. OA97-261-000 and ER97-1082-000.
15 Motion to Intervene, Protest and Request for Summary Rejection or, in the Alternative, for Hearings in FERC Docket No. ER97-3729-000, Aug. 13, 1997.
16 Id. at p. 8.
17 Id. at p. 10.
18 Raskin, p. 10.
19 Barker, Tennebaum and Woolf, "Regulation of Power Pools and System Operators: an International Comparison," Energy Law Journal 261, 316 (1997).
20 Walter Werner, The SEC as a Market Regulator, 70 VA. L. REV. 764 (1984).
21 Perot v. Federal Election Commission, 97 F. 3d 553, 559 (1996).
22 Mistretta v. United States, 488 U.S. 361, 372 (1989).
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