With few regrets, a regulator steps down from the PUC, still touting his brand of electric competition.
I'm proud to have been an author of the first chapter of a book still being written.
Today's electric industry is more competitive, more reliable, more efficient, and more dynamic than it was six years ago when I joined the California Public Utilities Commission. However, the future of the industry has not been set. The steps taken over the next several years will determine the outcome of electric competition.
Six years ago, as President Bush signed the Energy Policy Act of 1992, the California commission asked its Division of Strategic Planning to study competitive conditions in the electric industry. That request led eventually to the "Yellow Book," a report known in more formal terms as California's Electric Industry: Perspectives on the Past and Strategies for the Future. In its report, the DSP outlined four possible options for the commission. One was identified simply as "Strategy D: A Restructured Utility Industry." That option is not that far off the mark from where we are today.
These two events, EPAct and the Yellow Book, would fundamentally and permanently alter the electric utility industry.
Nevertheless, when I joined the commission five years ago, the idea of "retail wheeling" (as direct access was then known) was not yet acceptable as cocktail party chatter amongst the electricity intelligentsia. Such musing was often denigrated by industry experts (em patronized as an intellectual exercise and ultimately dismissed as the folly of people who did not understand the business.
Yet today, there is retail competition in California.
Dispelling Old Myths
In California we have filleted and salted all of the red herrings of why competition wouldn't work in the electric industry. We have proven that retail wheeling works. We have shown that the physics of electricity is not a barrier to markets (em that consumers do care about who provides them electricity.
• We have shown that competition can be introduced while still addressing sunk investments and above-market contracts.
• We have shown there is no such thing as stranded benefits. We can have social programs to assist low-income power customers. Funding can continue for public purpose research and development.
• We have proved the untested notion that educated consumers are willing to choose to pay a premium for renewable energy.
• We have proven that power plants need not sell at "fire sale prices."
• We have shown that securitization can work (em that asset-backed securities offer a reasonable way to finance either a government-mandated rate reduction or recovery of uneconomic costs.
• We have created the Independent System Operator and the Power Exchange, proving that dedicated people working on seemingly impossible deadlines can perform miracles.
• We have shown that meters can be installed, maintained, and read by new market participants, with no degradation of worker or consumer safety.
• With the ISO, we have transformed the electric market without risk to reliability. System integrity can and will be maintained, even during record-setting summer temperatures.
• We have introduced new players to the market without sacrificing the protections that California consumers have come to expect.
By August, more than 93,000 Californians had signed on to direct access with energy service providers. More than 13 billion kilowatt-hours of electricity was moving each month under bilateral agreements. Yes, those same dreaded bilateral contracts that so many decried have won acceptance as legitimate economic currency.
At last count, direct access consumers represented more than 8.5 percent of the residential load. Over 20 percent of the power consumed by California's industrial consumers was provided through the direct access market, and more than 8 percent of the large commercial load. All of this has happened in the short months that the market has been open. The 30 days ended Aug. 31 saw a 16.5-percent increase in the number of consumers and a 5-percent increase in the share of the load served by direct access providers.
Despite these achievements, it seems in vogue to trash California's move to competition. Could we have done better? Yes, of course. Are there items that still need attention? Sure there are, because that's the inherent nature of change and economic progress. Did we devise the perfect answer to every problem? No. Only a fool or unfit leadership would have entertained such a wasteful strategy.
Above all, we moved forward. We blazed a trail that others dared not walk, but now seek to follow, even while scrutinizing the footprints we left behind.
Those who criticize the California model perhaps should reflect on their role as protagonists for a system that has contributed to what could be characterized as the economic violation of our citizenry. Let them bask in the glory of central planning that led to uneconomic QF contracts and investments that sapped our economic and human resources for years and saddled us with these stranded costs.
People forget that in California, the winter reliability problems in 1994 and the August blackouts in 1996 occurred under the traditional regulated scheme. People forget that in the Midwest, where competitive markets have yet to take hold, consumers faced supply problems this past summer. What we saw in the Midwest this summer was the death throes of the traditional utility monopoly.
Setting New Goals
What about the future? In my judgement, seven goals remain to achieve a true renaissance in California's electric sector.
1. End Municipal Exemptions. In California, vast numbers of consumers are denied choice because competition stops at the boundaries of municipal utilities and irrigation districts. For California's electric market to grow, these protected enclaves must be purposely breached. We must have a marketplace that allows statewide marketing and rollout of services. Thousands of California businesses in the service territories of investor-owned utilities already have opted for advantages of direct access. It doesn't stand to reason to deny such choices to thousands of businesses, and millions of consumers, in Los Angeles, Palo Alto or Sacramento.
2. Avoid PX Preferences. Regulators and policy makers should not offer special treatment to the power exchange. Though innovative, the PX is only one of many schedule coordinators. Policies that favor the PX or subsidize it will harm those who go elsewhere to procure power. We must not shelter the PX from market forces. If it is to be an important part of the industry, it must innovate. If it is protected by regulators and other policy makers, it will lose any incentive to modernize and will fall back on the old mentality (em one that builds a silent bank account of future stranded costs, a stockpile of obsolescent technology, and outmoded business practices.
3. Boost Shopping Credits. Direct access customers receive an energy credit representing the costs they avoid when they buy their electricity from a competitive electric service provider. In California, we should increase this credit by including in generation costs all appropriate procurement and retailing costs.
In other words, the PX credit should include not only the energy price generated by the hourly bidding process of the PX, but also the PX costs paid by the utilities. That includes the costs the PX must pay the ISO, as well as the costs of operating the PX. Furthermore, any upfront development fees paid by the utilities as full requirement customers should be included as well. To prevent double recovery of these utility costs, they should be amortized over a reasonable period and recovered as part of the competition transition charge to keep the utility whole. To not reflect these costs as part of the energy credit understates the procurement costs of the utility. An understated energy credit, without these costs paid by the utility to the PX, will undermine the competitive market.
Moreover, all customer service and inquiry costs must be recovered from generation supply sources, including generation procured through the PX. While some utility executives argue this cost is relatively small, the direct-access business that must stand or fall on slim margins; inclusion of these costs is vital to ensure fair competition. Advertising and marketing costs as well should be considered for inclusion in this energy credit. Here again, the utility can be made whole because the annual cost of customer service and customer inquiry allocated to generation would continue to be recovered from customers for whom the utility still procures generation.
4. Unbundle Distribution Rates. The Commission must develop truly unbundled rates for the utility distribution company, or UDC. By unbundling, we ensure that consumers who no longer require certain utility distribution services will no longer pay for them.
While these unbundled rates shouldn't be effective during the rate freeze, we must still move quickly to unbundle various rate components of the distribution charge. This unbundling, referred to as "add-on unbundling," will rationalize the pricing of these services. True unbundling allows competitors to mix and match services and functions of the UDC. As we have seen in telecommunications, this type of unbundling enables visionaries to launch innovative products and services by combining elements of the basic UDC services with their own.
5. Don't Stop with Gas. California must develop a competitive natural gas market, so that energy service providers can provide a panoply of energy products, not just electricity.
If the California retail electric market is to succeed, adjunct markets must be opened. Opening the natural gas market to greater competition will enable ESPs and gas marketers to take advantage of synergies, raising the bar for economies of scale and scope. These industries interact. California's unfortunate political delay in opening the gas market, mandated by Senate Bill 1602, will only retard competition in electricity. It will lock in protectionism that may serve to thwart gas innovations. My hope is that the California natural gas market will be open to greater competition in 1999, with an expanded core aggregation program and a more comprehensive restructuring in 2000.
6. Get Past the Rate Freeze. California needs to get the rate freeze period behind it as fast as possible. The rate cuts engendered by competition will then flow through to customers. The distortions created by the CTC collection and the rate freeze will be reduced in the post-rate freeze era. If one accepts the argument that these stranded costs are the hangover from the heady days of cost-of-service and rate-of-return regulation, then this excess baggage needs to be eviscerated from the system. The rate freeze and its interactions with how the CTC is calculated creates marketplace distortions.
7. Hasten the Transition. Generally, when people discuss the transition they are thinking of the CTC and the rate freeze. However, there is much more to be accomplished in the transition. In a broader view, the transition should change mindsets.
The transition began in December 1995. The passage of Assembly Bill 1890, the divestiture of generation plants, the development and implementation of the PX and the ISO, the development of a process that lets market participants exchange information, the unbundling of revenue cycle services and other proceedings (em all are part of the transition.
So far, the focus of restructuring has been "utility-centric." The commission proceedings dealing with cost unbundling, divestiture, rate reduction bonds, regulatory streamlining, and stranded costs have all dealt with the incumbent utility.
However, as we move toward competition, our regulation must become less utility-centric and more focused on issues faced by competitors: access to customers, fairness, enforcement of rules for competition, making it easier for consumers and ESP's to effectuate switching. Competition in distribution itself warrants further analysis.
In the past, particularly in California, the vision and the business model have been driven by regulators and legislators. Now that the basic legal and regulatory framework is in place, the industry must shape its own future. New technologies for information and communications will drive innovation in metering, meter reading, and billing. New technologies based on turbine advances in the defense and aeronautics industries will spur lower costs and more efficient generation.
The electricity market is a narrow-margin business with high customer acquisition costs. New entrants will add customers slowly. As time goes on, cash flows and profits from existing customers will finance faster growth. Electric retailing won't require significant investment in plant and equipment, but it will demand expenditures in advertising, marketing, and customer service.
The competitor who figures out how to lower these acquisition costs, retain customers, increase margins slightly more than competitors and offer superb customer service will succeed in this business. I agree with Judith Smith, an analyst with Morgan Stanley Dean Witter, who said, "success in this market will go to those that imagine how things that don't yet exist, together with things only recently created, will interact to produce a whole new world of opportunity."
As I write, California's restructured electric market is just a few days short of 180 days old. That is a nanosecond in the life of a market. Not long ago, I was the lone voice at the commission advocating retail competition. Today, we have a market in the middle of a transition, with most people at the commission agreeing with my thinking more often than not.
As I finish my term, I'm optimistic that California and the nation will reap significant benefits from electric competition. Years from now, when we reflect on decisions made at the close of the 20th century, we will not fault ourselves for moving too fast, but rather for underestimating the promise of restructuring for our state and the nation.
Jessie J. Knight Jr. has served on the California Public Utilities Commission since 1993. His term ends next month.
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