WHY IS ELECTRICITY COMPETITION NOT WORKING? The principal reason is the failure of Order 888 to accommodate the economic and technological constraints of wholesale power markets.
Soon after Congress passed the Energy Policy Act of 1992, to give authority to the Federal Energy Regulatory Commission to compel electric utilities under its jurisdiction to wheel power for others, the FERC correctly recognized that piecemeal wheeling orders wouldn't work well without a tariff. A tariff would make the service quickly available to the user without the need for time-consuming negotiation.
But the devil is in the details. Instead, there is an important difference between electricity and natural gas. In electricity, had the only barrier to competition been the transmission lines connecting a wholesale load to a power producer, Order 888 might have proven as successful as Order 636 in gas. With electricity, however, the FERC failed to take into account a second barrier to entry. That barrier instead results from conflicts between economy and reliability. Despite Order 888, this barrier will prevent entry by small bulk power supply systems that might otherwise compete with established systems in selling the product distribution systems can use.
To sell successfully in a competitive wholesale market, bulk power suppliers must draw on large-scale, base-load units of about 500-600 megawatts, and yet still be able to produce reliable power with reserve capacity of only 12 to 20 percent. These two conditions conflict when a bulk power supply system is small, yet each is required because the wholesale customer -- the electric distributor -- must have access to more economical bulk power. It must obtain reliable power delivered to its load center. That supply can be described as RQ power, or "requirements power." RQ power denotes a commercial product different from exchange power, yet the FERC has failed to recognize this fact.
Ironically, the Commission had gotten it right in the early 1970s. At that time, the FERC had independently reached the same market definitions as the Justice Department's Antitrust Division, namely two distinct markets, upstream and downstream.
The FERC had defined the upstream market as the "coordination services market" (called the "power exchange market" by the DOJ). This market was seen as a "cluster market," featuring a variety of submarkets of nonsubstitutable products sold in conjunction with each other, such as economy energy, unit power, emergency energy and the like, incident to a variety of bilateral coordination arrangements between bulk power suppliers, or multilateral agreements within a power pool. Both the DOJ and the contrasted this upstream market to the downstream "requirements" market, in which a buyer would combine coordination services with generating resources (base-load, intermediate-load and peaking) to build a level of reliability necessary to serve distributors.
Nevertheless, after 1979, and after FERC Opinion 57, %n1%n that distinction was lost. Without explanation, the FERC redefined the two bulk power markets as "short-term firm" and "long-term firm," a structure it retained in Order 888. Today, by blurring the difference between coordination and requirements services, the FERC still fails to recognize the two distinct product markets for electric power.
Who wins and who loses?
Privately owned and fully integrated distribution utilities are not much affected by Order 888. They always have enjoyed the freedom to trade in power exchange services with other private utilities, using transmission of others, voluntarily supplied. %n2%n However, with some exceptions no transmission was available to the non-profit municipal agencies that integrate bulk power supply systems for member distribution systems, nor to the non-profit cooperative "G&Ts" formed for a similar purpose. Private utilities have to compete with municipal agencies and G&Ts in wholesale RQ markets and with their members in retail markets. In contrast, there's rarely any competition in the wholesale or retail RQ markets between private utilities.
Power marketers, the new private entrants into the power exchange market, would be helped if they could obtain transmission outlets for their product. The FERC's OASIS system was to let all buyers and sellers have an equal opportunity to obtain the use of excess transmission capacity, but there are indications that OASIS is not working well.
One barrier to entry that Order 888 might remedy is to provide transmission access to assist in the coordinated development of large-scale, base-load units. Open access gives small bulk power suppliers an opportunity to obtain small amounts of capacity from larger-scale units. But this advantage is only as good as the availability of transmission and the success of OASIS.
Municipal agencies and G&Ts benefit only to the extent that they lie adjacent to utilities that were not previously subject to wheeling conditions in their nuclear licenses (and obtain a tariff that gives effect to such conditions). Their member distributors stand a chance to gain to the extent that Order 888 helps them obtain a low-cost power supply from their G&T or wholesale agency. However, municipalities currently served at retail under a franchise granted to the bulk power supplier still cannot look to a competitive bulk power supply because wheeling only gives it access to three or four privately owned first-tier suppliers of RQ power. A market that has only three or four dominant sellers will not be competitive where the product is a simple one and it is easy to keep track of the prices of others. This is because of fear of retaliation.
For the retail distributor, however, the relevant market is RQ power; there is no effective substitute. Small retail systems don't want to enter the bulk power supply business. Building a system with 500-MW base-load units on speculation requires a stronger stomach for risk than most investors have. They would be being asked for hundreds of millions of dollars, or even billions. If municipal agencies and G&Ts (which have access to low-cost investment capital) have difficulty in developing an integrated bulk power supply system, one is faced with the question of: How can private entrants, which suffer the same or worse disadvantages, be expected to do even as well?
Order 888 will prove of no use to those who wish to enter the uncomplicated retail electric distribution business without getting into the risks and complexities of bulk power supply. There is nothing a municipality would like better than to pay a good part of the costs of running its city with profits from a municipal electric power system if it can price its power to its retail customers at prices competitive with other, likely private, competing systems. They can wait for existing franchises terminate, or even condemn current franchise rights.
The fact that "municipalization" isn't now taking place proves that Order 888 wheeling doesn't change the market to a competitive structure. These potential competitors have long been captive to a monopoly bulk power supplier. Order 888 will make no difference.
In essence, the FERC in Order 888 has created a market structure that accommodates limited competition only for about 15-25 percent of all the kilowatt-hours generated -- the market for coordination service. This market already was competitive and available to all, except for munis and co-ops. It has achieved nothing for the 75-85 percent of bulk power supplies sold to retail distribution systems, or transferred to thousands of captive distribution systems that remain far too small to enter the bulk power supply business. %n3%n With this lack of encouragement to retail distributors, the FERC's initiative cannot foster competition nor offer true benefits to ultimate consumers. Instead of fostering competition, Order 888 provides a dream market structure for dominant utilities -- they can buy in a competitive market and sell in a market they can control.
The RQ Market:
Its Power is Essentially Local
Since high-voltage, polyphase electric power can travel for many hundreds, even thousands of miles over copper or aluminum conductors, one may well ask: Is the market national is scope? The answer is a resounding "no."
A high-voltage transmission system can transfer power for hundreds of miles with very low losses. However, losses from a transcontinental transfer for 3,000 miles, say from Southern California Edison to Commonwealth Edison of New York, would make such a transfer prohibitive, even if there were a suitable high-voltage transmission path. %n4%n
Moreover, line losses aren't the only factor. Even a shorter transfer -- a sale from New York to Nebraska, for example -- would be impractical. While there are no statistics available, from my experience over the last 35 years I would estimate that over 98 percent of all sales of RQ power are made to retail distribution systems to serve load centers located within the control area of the system making the sale. I know of only a few examples where the RQ power is sold from generation located in even a first-tier control area adjacent to the area in which the power is consumed. I know of none where the RQ power is sold from a control area twice removed from source of the load.
Why is supply of requirements power such a short-range matter?
Communications from adjacent and twice-removed control areas are inherently unreliable. It is not unusual for the telecommunications channels between control areas to go awry. Guidelines from the North American Electric Reliability Council require communications through all intervening control areas on the contract path when a seller is not located in the same control area as the buyer. This rule is reasonable to guard against a cascading outage. But a communications channel involving three or more persons is prone to serious mistakes.
By contrast, a larger geographic market is available for power exchange or coordination services. In that case reliability is not as great a concern, since the power is likely to make up only a small part of the generation resources available to the system operator in the receiving control center. Under NERC rules the operator may rely on the interconnected system for up to about 10 minutes in the event of failure in one of his generating resources or interconnecting transmission. He or his colleagues, the trained system dispatchers, are on duty 24 hours of the day, ready to act. Accordingly, while power exchange transactions usually occur between adjacent control areas, they may involve second-, third- or even fourth-tier areas. Supplies of RQ power from this larger area are not a practical alternative for a retail distribution system which has no control center and no 24-hour dispatchers.
Because the relevant geographic market consists only of the hub and the first-tier distribution systems, many areas will feature at most only four or five competitors (plus the hub, which previously had a de facto monopoly) for sales of RQ power. %n5%n If a market is dominated by as few as four or five sellers and the product they sell is relatively simple to keep track of (such as kilowatts and kilowatt-hours), it is well recognized by those skilled in industrial organizations that the dominant sellers will likely not compete with each other for fear of retaliation. They will compete with new entrants or smaller enterprises within the market. %n6%n The formation of an Independent System Operator, buying from all generators and reselling the product back to all sellers in the same area, only nullifies price competition among suppliers in the sale of RQ power. With those arrangements, all sellers of RQ power have the same bulk power supply costs, as well as transmission and distribution costs; it makes price competition almost impossible.
They Can't Replicate RQ Power
Nearly 20 years ago, Louisiana Power & Light Co. attempted to triple its wholesale power price by terminating its requirements contract with the City of Winnfield and in its place offering to sell power exchange services to the city. It claimed that Winnfield had no need for requirements power because LP&L's license conditions gave Winnfield access over its transmission lines to several other bulk power suppliers.
The FERC in that case recognized the significance of RQ power and ruled that a coordination contract wasn't a realistic substitute. Also, it allowed Winnfield to show when it approached alternative suppliers of RQ power at the periphery of LP&L's system and asked them to serve, there was no contract forthcoming. %n7%n Presently, however, the FERC describes testimony of that sort as anecdotal, refuses to credit it and assumes that under Order 888 a distribution system will receive a competitive offer, rejecting evidence to the contrary.
The FERC has attempted to remedy the situation by providing in Order 888 for a variety of ancillary services under its pro forma tariff to supplement the short- and long-term firm power that is conceptually available. This is ineffective in transforming these two products into RQ power. Ancillary services only deal with a very short term and don't provide the economical means based on insurance principles of dealing with the risk of forced outage.
So far as is known, to this date no municipal, rural cooperative or independent electric distribution system has canceled its RQ power from a bulk power supply system selling RQ power in favor of a supply from a seller of "short-term firm" or long-term firm" power, even though Order 888 requires the bulk power supplier to transmit and to furnish ancillary services. The FERC's pro forma tariff is silent as to who would have public utility responsibility for the supply of power to the independent distribution system.
In the 1970s, in cases brought under Section 104(c) of the Atomic Energy Act (involving conditions imposed on nuclear licenses to compel wheeling), the Antitrust Division suggested and the Nuclear Regulatory Commission found that three elements were necessary to break the barriers to competition: (1) reserve sharing, (2) opportunities to engage in the coordinated development of base-load units, and (3) opportunities to wheel power over the transmission of dominant utilities. %n8%n
Reserve sharing applies insurance principles so as to deal with risk economically. If a contract for reserve sharing is unavailable, a smaller system must purchase sufficient backup generation (at the time of system peak) to meet the forced outage of capacity at least as great as the system's single greatest generating resource. If a small bulk power supplier seeks to enter the market with no reserve-sharing contract and buys 10 MW of power out of a single, large-scale base-load generating unit (i.e., the FERC's short- or long-term power) it would need to buy 10 MW of reserve. That occurs because the ancillary services provided by the pro forma tariff exclude any responsibility on the part of the transmission provider to offer backup. %n9%n This rule in effect repeals reserve-sharing obligations set out by the FPC in 1968. %n10%n
If an independent power producer, for example, wanted to provide reserve for all his customers, for the sale of power from an optimally sized 500- to 600-MW unit, he would have to buy 500-600 MW of reserve. The power to be sold, therefore, must carry 100-percent reserves as a percentage of the peak load of the customer but it must compete with the power of power systems that have the ability to meet that "single-largest-unit-down" or "single-largest-resource-down" reserve standard, or one even higher. These competing bulk power supply systems, because of their large size, will need only 12 percent to 15 percent reserves as a percentage of peak load even when they are using generating unit sizes of 500 MW or larger. The smaller system can do that only with reserve sharing and opportunities for the coordinated development of base load units. If it were to obtain the needed 10 MW by purchasing the FERC's short- or long-term firm power, it would end up supplying its entire load with base-load capacity, not a very economical way to supply a customer whose valley loads may only be 35-40 percent of peak. (See Sidebar, "Unworkable Competition.")
Meanwhile, the competition would have a low-cost mix of generating capacity, and would carry much lower reserves, while still maintaining reliability of power supply as good or probably better than the smaller system entering the market. Finally, the new entrant also would have to carry the burden of "stranded costs," which significantly increases his transmission costs.
What Promise for Retail Competition?
Retail competition won't likely develop when all parties at wholesale will use the same distribution and transmission facilities and incur the same costs for the wires portion of their businesses. The future remains in doubt while so much state legislation is pending, but retail competition could develop in states that mandate divestiture of bulk power supply from retail distribution systems, as long as they avoid creating an ISO to nullify price competition in RQ power and break down the barriers to entry for systems able to sell RQ power.
New federal laws might also help. But to work well, legislation must give the authority to the FERC in many areas, allowing it to:
1. Compel divestiture of bulk power supply from retail distribution and from transmission for systems over the size able to use 500-MW units.
2. Continue to require publication of wheeling tariffs.
3. Coordinate development of base-load generation even where it requires the addition of generation so long as someone else offers to provide the investment capital for such addition.
4. Disallow "alternative pooling concepts" which make price competition impossible.
5. Make reserve sharing available to all sellers of generation.
Such legislation also should continue to direct the Commission to divide the country into districts in which a single joint transmission rate is effective (as suggested in section 202 of the 1935 legislation).
With the optimal size of base load generators down to 500 MW rather that 1000 to 1500 where it was initially thought to be, and with compulsory developmental coordination to obtain even that size, no reason exists for more mergers except to enable systems to expand generation with 500-MW base-load units. In fact, the FERC might do well to break up existing systems: no operating or holding company should be larger than needed to support a generation expansion program with base-load units of 500 MW.
On balance, Order 888 does not enhance competition very much. Why then, all the praise? The economist Schumpeter once noted: "One of the touches that distinguish intellectuals from other people is the absence of direct responsibility for practical affairs . . . the absence of firsthand knowledge which only actual experience can give." F
Attorney Wallace Edward Brand is winding down his solo practice in Washington, D.C., where he has represented small electric systems. In the 1970s, at the Antitrust Division in the Department Of Justice, Brand tried cases involving the obligations of nuclear license applicants to wheel power, share reserves and engage in power coordination. His views have been presented to the FERC and the D.C. Circuit Court of Appeals (Louisiana Energy & Power Authority v. FERC, D.C. Cir. No. 97-1098, decided April 24, 1998), but neither body responded to the arguments. This article is adapted from a chapter from a work in progress, "The Electric Power Business," a book the author expects to publish soon.
The economics of electric distribution without reserve sharing or coordinated development.
TOO UNRELIABLE. Agree to build a 500-MW generating unit and try to sell the power. You are selling unit power, not RQ power. You can call it "long-term firm" and agree not to interrupt its output, but that won't make the power commercially acceptable to a retail distribution system. You can only sell the output to a marketer or other bulk power supplier. (Once the plant is built the output is "short-term firm," but the result is the same.)
FIRMING UP. Do you want to firm it up? Then you have to build an additional 500-MW unit for reserves. If each kilowatt costs $1,000 dollars, your investment will be $2,000 per kW for RQ power but your established competitor can supply RQ power with only $1,100 or $1,200 of investment per kilowatt.
AN ALTERNATIVE. You could try using 250-MW units. Build three and you can sell 500 MW of firm power. The heat rate won't be as good and you are still maintaining 50 percent reserves compared to your competitor's 10-20 percent. You have to carry the fixed charges for that extra 30 percent. You burn more coal for each kWh.
GOING ALL OUT. If you enter the market in a big way, you can match these economics until your load starts growing. How much investment will that take? If you had a power system of 2500 MW you could build a 500 MW unit for reserves and maintain only a 20 percent reserve. (If you wanted only a 10-percent reserve you would have to build a 5000 MW system.) Assuming you can build a new 500-MW unit in today's market for $1,000 per kW with the necessary antipollution equipment, 2500 MW will cost $2.5 billion. Know any investors who will bite simply to compete with someone else already in the market and well-prepared for competition?
WHAT IT WILL COST. If you do, and your load grows, you have to keep on adding those 500-MW units. You can add some peaking in small increments which will help. Eventually you will have to add base load. If your load is only 2500 MW and your load growth is 3 percent, each year you will need an additional 75 MW. That means that the first year you have added a new 500-MW unit you will have 425 excess MW (and 350 in year two) on which you will have to pay carrying charges.
COSTS OF GROWTH. It is likely that the fixed annual charges for capital cost, insurance, maintainance and operation will run to about 15 percent of your investment. Over the next five or six years, without coordinated development, you will be carrying on average an excess 212.5 MW of reserves, and the annual cost will exceed $30 million per year. That will either cut back on your abiliity to offer competitive prices or cut back on the return to your investors. If you are using some debt capital, remember that you have to keep paying your bondholders no matter what. Of course to get the debt capital you will have to offer the bondholders some assurance that the project will be a great success.
Know Your Power Products
How Coordination Services Differ from Requirements Power
REQUIREMENTS POWER. The purchaser of RQ power is typically a small municipal, a cooperative, or in some cases a private distribution system, whose loads are too small to allow them to develop an integrated bulk power supply system with large scale base load generating units and low reserve percentages. Municipalities served under a franchise are potential purchasers.
COORDINATION SERVICES. Describes the wide variety of non-requirements, wholesale power sales agreements, including interconnection, pooling, and other agreements, and is generally sold on an interruptible basis, with the seller undertaking no "public utility responsibility," and includes:
(1) emergency energy supplied under a reserve-sharing agreement;
(2) economy energy, supplied when one utility has a lower system lambda (marginal cost) than another (allowing the two systems to effect a transfer and split savings);
(3) maintenance energy for a planned unit outage;
(4) unit power, or sales the capacity and energy of a single base load unit (generally noninterruptible unless the unit goes down, but the seller may undertake to supply reserves).
PLAYERS. IPPs, EWGs and marketers and brokers can sell power, but because they do not operate an electric power system, they cannot offer RQ power.
"Firm" Power: A Useful Product?
How FERC drew a faulty analogy with natural gas.
"FIRM POWER" from thermal generating units makes an interesting contrast with "firm" gas supply, which exposes the fallacy of ignoring the RQ concept in FERC Order 888.
PIPELINES VS. WIRES. Made of thick steel buried underground, as pipeline has very good reliability. Even if a compressor fails, the pipe will have sufficient "line pack" (gas under pressure in the line) to maintain deliveries. Any analogy with electricity is mistaken, since "firm power" implies a system of generators and transmission lines engineered to account for all reasonably forseen contingencies such that power is available more than 99.5 percent of the time.
SHORT-TERM VS. LONG-TERM. Though it agreed initially in Opinion 57 to define two bulk power markets for (1) coordination and (2) requirements power, the FERC later redefined the two bulk power products as (1) short-term firm and (2) long-term firm. These definitions invoke the concept of "unit power." Neither represents RQ power. The FERC mistakenly used the term "firm" in same sense firm natural gas deliveries are not interruptible by the seller, but are sold without reserves of additional pipeline capacity.
1 Florida Pwr. & Light Co., Opinion No. 57, 8 FERC ¶61,121 (1979).
2 That has been encouraged since 1935 under sec. 202 of the Federal Power Act, because it promotes economy and reliability in bulk power supply.
3 The author's examination of bulk power supply markets in Louisiana, Kansas and Missouri shows that RQ energy represents about 75-85 percent of all kilowatt-hours generated. These proportions likely hold true for the entire U.S.
4 In fact, no such route exists, since the path would span the Rocky Mountains, the approximate border between the Western and Eastern Interconnections, which offers limited interface capability.
5 In the few cases where there are more than four or five, the hub system will be found to be much larger than other entities in the geographic market and its retaliation to competition from the first tier will be a formidable threat.
6 Moreover, the advances in competition in the electric power market gained by the antitrust division's enforcement program under Section 104(c) of the Atomic Energy Act in the early 1970s may likely disappear under current FERC practice. See, for example, the case of Louisiana Energy & Pwr. Auth. v. Cent. La. Elec. Co., Opinion No. 420, 83 FERC ¶61,125 (1998), in which the dominant seller sold at its average cost to two small municipalities, about 26 mills per kWh, plus fuel costs, but at the same time sold power at 7 mills in competition with a new entrant to the market. Prior to the sale, CLECO's corporate model showed that its average cost was rising, so its incremental cost must have been above 26 mills. With an incremental cost of over twenty six mills, and selling at 7, it was losing at least 19 mills on each kilowatt hour. Municipal agencies and G&Ts have little hope remaining in business against that kind of competition. (The author represented LEPA in the case.)
7 See, LP&L Co., 16 FERC ¶61,019 (1981), 17 FERC ¶63,020 (1981), aff'd 17 FERC ¶61,230 (1981).
8 The author represented clients in many of these cases.
9 See Order 888 at p. 31,710.
10 Gainesville. Utils. Dept. v. Florida Power Corp., 402 U.S. 515 (1971) aff'g 40 FPC 1229 (1968).
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