RECENT CONFERENCE on independent system operators held by the Federal Energy Regulatory Commission was, in many respects, a tremendous achievement. It is a testimony to this Commission that its members can muster the stamina to listen to one-and-a-half days of mind-numbing technical discussion of power technology and regulation.

Nevertheless, there is inevitably a misstep or two in these massive "hearing-thons." In this case, the discussion nearly went awry when it turned to comparisons between transcos and ISOs. Although several speakers and the chairman sought to set things right, some unfortunate misimpressions may remain.

The subject was opened when conference participants suggested that an investor-owned, transmission-only company would be preferable to an ISO in many respects. A transco would have no incentive to favor any generators, the argument went, and would therefore solve the problems of nondiscriminatory access, comparability, vertical market power and independent governance in one fell swoop.

Such companies also would want to "maximize throughput," said one speaker, as their revenues would presumably be recovered through a volumetric tariff. As profit-making entities focused solely on transmission business, transcos would prove innovative and efficient, allowing market incentives to replace regulation. Best of all, transcos sound simple (em far more straightforward than the complex FERC regulation that goes with today's ISOs.

All this begs the question: Should the commission put aside ISOs in favor of transcos as the new market model?

If it sounds too good to be true, it is. Transmission systems are natural monopolies governed by the Federal Power Act. Even if we begin immediately to allow merchant transmission lines, it is going to be a while before competing power delivery systems emerge. During the interim, any investor-owned company lucky enough to own an unregulated transmission company would not have an incentive to "maximize throughput," nor would it seek not to discriminate. (By contrast, a transco regulated by cost-of-service principles with a traditional regulatory lag could have incentive to maximize throughput. Perhaps that is what the speaker implied.) Natural or not, monopolists have the incentive to maximize profits by raising prices, reducing output and price-discriminating. That's why we regulate or forbid them in the first place.

So, unless the laws of economics have changed, transcos are going to need regulation (em at least for a while. This brings us to a more realistic set of vertical structure possibilities: (1) partial vertical integration, ISOs, and a gradually increasing set of transcos; (2) forced divestiture into independent for-profit transcos, no ISOs, and direct transco regulation; and (3) forced divestiture into independent not-for-profit transcos (i.e., a public grid) and no ISOs.

To these structures, numerous near-term options can be added (em merchant transmission lines, requirements to bid out new lines, reliability organizations, tradable firm transmission rights, congestion pricing, and so on. These are all critical, but three basic structures remain, upon which these industry features must be grafted.

We can evaluate these three structural alternatives against four questions: (1) What is the minimum amount of regulation required in this structure to prevent economic market power?; (2) What institutions, rules and incentives will be needed to guarantee both short- and long-term system reliability under each alternative?; (3) What institutions, rules and incentives will be needed to guarantee the short-term economic efficiency of the electric power system, including maximally efficient unit commitment and economic dispatch, plus the lowest-cost combination of market-determined generators and publicly controlled transmission assets?; and (4) How long will it take to evolve these structures? Are changes in state or federal laws needed? Is there a feasible route from today's structure to the new one?

I can't reject the proposition that the creation of sound ISOs is as good an approach as we are likely to get anytime soon. Transcos are certain to occur with increasing frequency. They will allow us to experiment further with incentive regulation and new cooperative approaches to transmission system expansion. Transcos will be independent of all generators and will have a potentially important profit motive. Yet experiences in the U.K. prove that transco governance is no piece of cake. And it will take time to assemble gridcos as large as many of today's ISOs.

It is not obvious that the creation of transcos will allow substantial changes in regulation soon, nor that independent transcos large enough to supplant regional ISOs can be established. Meanwhile, the FERC and a score of state commissions have unleashed the creative forces of generation competition, and power markers are crying out for fair access at fair prices now. The FERC may have the luxury of experimenting with alternative ISO models (em a luxury it must enjoy (em but it cannot freeze progress while it lobbies Congress for the authority to make large public or private gridcos.

California ISO President Jeff Tranen responded to a Commission question to compare transcos and ISOs with perhaps the most cogent summary of all. Under either model, Tranen said, "the problems we have to solve are the same."

Not the same, he should have clarified, but similar enough to allow the FERC to continue down the ISO path with the confidence that is neither overlooking nor impeding an obviously better alternative. F

Peter Fox-Penner is principal and director at The Brattle Group. He represents, among other clients, the Midwest ISO.

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