Some want a tighter grip on generators, but FERC should steer clear.
Fortnightly Magazine - October 1 2001

Some want a tighter grip on generators, but FERC should steer clear.

The turmoil surrounding the California electricity crisis has prompted calls for the Federal Energy Regulatory Commission (FERC) to reexamine its approach to analyzing market power and granting market-based rate authority to wholesale generators.1

In a series of dissenting opinions,2 Commissioner William Massey has waged a campaign against what he calls the agency's "outdated and unreliable" hub-and-spoke analysis3 for assessing market power.

It is now clear that this issue will become part of the regulatory agenda for the newly reconstituted Commission, because Massey's new colleagues, Chairman Pat Wood, III and Commissioner Nora Mead Brownell, also have expressed interest in this initiative.4 Yet this debate should not occur in isolation from the commission's global initiatives to promote open-access transmission and competitive markets for wholesale power.

The Larger Agenda

Commissioner Massey would have FERC place the issue at the top of its agenda.5 But does it merit that level of priority?

In short, the emergency is over. With its mitigation orders, the commission has already acted politically and substantively to address the crisis-real or perceived-in wholesale electric power markets.

Even if we concede that hub-and-spoke has failed, the commission has now imposed temporary market mitigation measures in the regional markets that are most completely restructured and where, not coincidentally, there exists the greatest concern about power producers exercising market power.6 Also, we can expect to see a significant amount of generating capacity come on line within the next several years in virtually all of these markets.7 That should make it more difficult for power producers to extract scarcity rents for that last megawatt.

Instead of immediately building a better mousetrap for screening market power, I suggest that FERC should put market structure atop the agenda. After all, that's one of the principal lessons of the California debacle.

For reasons now known all too well, the California market structure was fatally flawed. That, plus a lack of investment in new generating capacity, caused power prices to skyrocket. Get the market structure right and there will be less of a need for examining whether individual generators possess market power.

Some Want the Merger Screen

The commission's July 11th Sunshine meeting featured a lively discussion of possible alternatives to the hub-and-spoke analysis. In particular, in his comments and in dissenting opinion from in the commission's Sierra Pacific order, Commissioner Massey offered some ideas for revamping the test for market-based rates (MBR). Here are some of the issues that arise in connection with these ideas.

It was recognized that almost any alternative to the hub-and-spoke test (with the possible exception of blanket MBR authority that FERC has granted for natural gas wholesales) will be more complex and resource intensive. That raises practical considerations, since the commission in the past has authorized MBRs some 900 times using the hub-and-spoke test. Even accepting a considerable overlap in terms of multiple authorizations for affiliated entities within the same geographic market, a case-by-case approach would eat up a lot of time and money.

It also was suggested that the commission consider replacing the hub-and-spoke analysis with the Appendix A screen already used for analyzing market power in merger cases.

The commission and the industry already are familiar with the Appendix A screen, which is set out in FERC's merger policy statement in Order No. 592. The Appendix A screen provides a much more refined look at the factors that shape geographic and product markets than does the hub-and-spoke test. And using the Appendix A screen would allow the commission to shift its focus from individual market participants to wider conditions present in the overall market. Yet the Appendix A screen could also tax administrative resources. And it raises substantive issues as well.

First, many have contended from the start that the focus on the analysis of individual destination markets in Appendix A tends to produce an analysis that is too narrow and that naturally yeilds to high concentration numbers.8 The commission has never really addressed the substance of this criticism.

Second, while Appendix A is based on the horizontal merger guidelines issued by the Federal Trade Commission and Department of Justice, FERC has applied the concentration numbers resulting from the HHI analysis (Hirschman-Herfendah Index) in a way that differs significantly from how the antitrust agencies apply such numbers. For example, DOJ and FTC use the HHI numbers purely as a screen, or a trip wire, for determining whether the merger warrants greater scrutiny. At FERC, however, the HHI screens have become more akin to hard and fast walls through which a merger cannot proceed if the increase in market concentration exceeds the pre-set limits.9

Third, how would Appendix A apply in the context of MBRs? In the merger context, FERC uses Appendix A to analyze that change in market concentration attributable to the merger. In the case of MBR authority, there is no change in concentration. What would be the threshold for determining that the commission either must deny MBR authority or else prescribe market power mitigation measures as a condition for MBR authority?

In the merger context, the FERC has said that an HHI above 1800 gives cause for concern. A score of 1800 implies six equal-sized sellers. But that standard might prove too stringent for the industry as a whole in the context of market-based pricing. In the general economy, many consumer product markets would show much higher HHI levels-yet no one sees a need for regulation.

Massey Offers Other Ideas

In addition to analyzing market concentration, Massey suggested that the commission focus on market structure and, in particular, the criteria that might be indicative of whether a market could support workable competition among generators. In his dissenting opinion, Massey described "some of those elements" that might be looked at as leading indicators. Each of these criteria deserves careful consideration. Some raise fundamental questions about market design. Others may push FERC beyond its jurisdiction.

Generating Capacity Adequate? This question is valid, but one cannot reasonably suggest that the problem will be remedied by denying authority for market-based pricing. Instead, denying MBR authority would chase away investment in new power plants. If any new form of regulation is needed in capacity deficient markets, it should come in the form of a price cap, low enough to prevent sellers from extracting scarcity rents, but still set high enough to induce new investment.

Reserve Requirements In Force? By suggesting this criterion, Massey appears to make reference to California's lack of any kind of a capacity market, such as the ICAP markets in New England, New York and PJM. While capacity markets exist in the regional markets that are considered to be the most successful markets, not everybody favors them.10 Furthermore, it is the state regulators who typically impose such a capacity requirement on load-serving entities. The FERC's statutory authority extends to wholesale sellers of electricity, and not necessarily to wholesale buyers.

Uniform Interconnection Standards? As part of its regulation of interstate transmission, the commission could mandate uniform standards for the interconnnection of new generation to the transmission network. Still, there are parts of the United States where non-jurisdictional utilities, such as TVA and BPA, control large parts of the grid.

Available Plant Sites? Here is another matter of state law that lies outside FERC authority. And the fact that so much new generation will be coming on line in the next few years raises the question about whether a plethora of available plant sites is a prerequisite for workable competition.

Rules for Managing Congestion? Like interconnection standards, the Commission can require this as part of its regulation of interstate transmission.

Use of Hedging? This idea is an obvious reaction to California's market structure and the past reluctance of the California Public Utilities Commission to let the state's investor-owned utilities hedge their market exposure. Still, should not the goal be a market structure that does not create a bias one way or the other? Load-serving entities can get burned just as much by an over-reliance on long-term contracts as one can get burned by an over-reliance on the spot market. (Remember the interstate gas pipeline take-or-pay crisis?) Again, this issue lies largely outside the commission's jurisdiction, because state regulators review the purchasing practices of regulated, load-serving entities.

Rules to Prevent Gaming? The commission could achieve this result by acting within its authority to review wholesale market design. Still, if this idea implies that a workable market must have a centralized institution for managing anything beyond short-term reliability, there are those who will take issue. Some would suggest that such centralized market institutions by their very nature invite gaming.11

Effective Demand Response? This idea might be the single most effective means for mitigating market power, while at the same time minimizing regulatory intervention. Demand-side initiatives have been viewed historically as falling within the province of state retail regulation. And politicians remain reluctant to see consumers exposed directly to market prices. Still, perhaps the commission can make at least some inroads here by requiring demand-side bidding in the exchanges administered by the RTOs (regional transmission organizations). If we are serious about competition, and want to minimize regulation, then greater demand-side response to market prices should become a federal priority. It should become part of the debate in Washington about what the federal government can do to promote a more efficient and competitive energy economy.

Ex Ante Price Mitigation. Commissioner Massey expressed some fascination with the measures that the commission has approved on a temporary basis for the New York ISO. Still, before proceeding down this path, one should look at what has happened out West, where the mitigated price is not set until just before delivery. That practice created general confusion in the wholesale power market. Some would say it has reduced liquidity.12

RTO Participation. On the face of it, this criterion would appear to apply only to generators affiliated with transmission-owning utilities. Still, could it mean something broader? For example, while Commissioner Massey was unclear, was this a reference to a condition that a seller would be entitled to market-based pricing only if it sold its output into markets administered by an RTO? If so, this gets us back to the debate over centralized versus decentralized markets. (Remember the "Poolco versus Bilateral" debate?)

Pat Wood's Reaction

FERC Chairman Wood has expressed support for Commissioner Massey's approach and also has expressed interest in using MBR authority as a "carrot" for getting generators to make other commitments that would strengthen markets. In particular, he has mentioned a need for infrastructure, specifically generation and exchanges.

That said, the commission nevertheless should be selective in using MBR authority as a "carrot" for strengthening markets. The incentives should motivate results that truly will strengthen markets, and the market enhancements that are a condition for receiving MBR authority should be things within the control of the entities seeking such authority.

For example, if there is any crying need for infrastructure in the electric power industry, it is on the transmission side of the ledger, not the generation side. Yet grid expansion is not something that falls within the control of most entities seeking MBR authority.13

Smart meters and other similar technology improvements are essential for building an infrastructure to facilitate demand side price responsiveness. But here too, the critical infrastructure falls outside the business of most firms seeking MBR authority. Linking such improvements to market-based rates would mark a questional exercise of FERC's conditioning authority.14

Chairman Wood also has appeared strongly inclined to focus on markets instead of individual companies. He has suggested that for those markets that fail to pass the applicable screen, the commission might condition MBR authority until such time as the screen could be passed. This proposal sounds a lot like the current situation in wholesale markets in California, PJM, New York and New England, with the only question being whether the commission will ever be satisfied enough to remove the training wheels.

The Longer Term View

Regardless of the final policy choice, FERC should not allow the perfect to become the enemy of the good. And I say that not just to offer a trite excuse for mediocrity. Overly complex and burdensome market power screens could discourage competitors, increase the cost of capital for the power industry, and reduce consumer benefits in the long run.

And if the alternative to MBRs should call for some form of regulation, then remember that regulation itself produces its own set of inefficiencies and unintended consequences. (That is why the electric power industry is being restructured in the first place.) In short, the FERC should carefully consider both the costs and the benefits of any departure from the status quo.

Perhaps the FERC should wait until RTOs have taken shape and boundaries are settled before implementing any new analysis. RTOs could define (or redefine) the scope of the relevant markets for generators. In the meantime, whatever interim mitigation measures remain in place will be a sufficient safeguard against the exercise of market power.

In fact, the commission might very well choose to assign to the RTOs the responsibility for presenting the market power analysis. And in the case of a for-profit RTO, the RTO's independent market monitors could assume that responsibility. (After all, under Order No. 2000, RTOs already will be responsible for market monitoring.) Under this scenario, as under current MBR rules, the RTO would be required to update its analysis after three years, or some other suitable interval.

In the end, getting market structure right is the key to workably competitive generation markets. That, together with all of the new generation that is coming on line within the next couple of years, should greatly diminish the opportunities for generators to exercise unchecked market power. Once the requisite market structure is in place, the commission can shift to addressing localized market power and other discrete issues where fine tuned market power diagnostics and a big stick are truly needed.

  1. , 78 FERC ¶61,309 (1997); see also ., 62 FERC ¶61,016 (1993),, 58 FERC ¶61,234 (1992).
  2. , 96 FERC ¶61,050 (2001) (Massey, dissenting) (order dismissing rehearing).
  3. The hub-and-spoke method, as FERC has applied it over some 10 years now, examines market shares for total and uncommitted generating capacity, both within the applicant's service area and in first-tier interconnected markets-i.e., those markets directly interconnected with the applicant.
    As part of its request that the FERC adopt a more sophisticated market power screen, the One of its staunch opponents, the Illinois Commerce Commission, defined the hub-and-spoke analysis as follows:method in a recent brief filed with the FERC arguing for its demise. As stated there, the method requires an applicant to compares its own controlled generating capacity to the sum of (a) the generating capacity controlled by itself, (b) any alternative generating capacity in the service area and (c) all generating capacity in the first-tier utilities. As stated there, FERC then "examines the relative size of the sellers as a measure of the ability of a utility to dominate electricity supply in a geographic market or to raise prices by withholding capacity." .
  4. , Inside FERC, July 16, 2001, at 1.
  5. , 96 FERC ¶61,050 (2001) (Massey, dissenting) (order dismissing rehearing):
    "The Commission must move immediately to develop a more sophisticated approach to market analysis. The restructuring that has occurred in the industry so far places increasing reliance on competitive wholesale markets to discipline prices, and thus places increasing importance on the wisdom of this Commission's market analysis."
  6. PJM, NY and NE, California, and the remainder of the Western Interconnection that was was affected by the events in California.
  7. For example, 10, 500 MW of capacity are slated to come online in New England this year and 5,300 MW in 2002. 2,600 MW are expected to go into service in PJM this year and another 3,800 MW in 2002. The California Energy Commission reports 11,303 MW of approved projects, another 6,465 MW pending in the review process, another 11,236 MW of announced projects and finally 17,836 MW of planned projects. Another 6,000 MW are slated to come on line next year in the Western Interconnection.
  8. , Foster Electric Report, September 9, 1998, at 1. (Dr. Mark Frankena, a principal at Economists Incorporated, has suggested that FERC should drop the current "Delivered Price Test" analytic method. That method requires separate market concentration studies for each target destination market of the merging companies and focuses all physically and economically available generation supply on those markets to determine each company's market share. Frankena argues that FERC's method is outdated and leads to inaccurate results.)
  9. Walter Surratt, , Electricity J., v. 11, no. 6, July 1998; see also [Any cite for this point of viewThe Honorable Richard D. Cudahy, The FERC's Policy on Electric Mergers: Abit of Perspective, 18 Energy L. J. 113, 118 (1997).
  10. , Electricity Consumers Resource Council, June 2001, at 13-14.
  11. , Electricity Consumers Resource Council, June 2001, at 10-12.
  12. James Sterngold, , New York Times, July 4, 2001, at A8; see also John G. Edwards, Nevada Regulators Ask Federal Officials to Revisit Wholesale-Power Price Caps, Las Vegas Review-Journal, July 19, 2001.
  13. This need also highlights that FERC lacks some essential tools in the area of transmission siting-a key area for promoting competition and maintaining reliability. Transmission siting marks perhaps one of the two most important initiatives that the Congress could take in electricity policy-the other would be to encourage greater demand response to market pricing as a federal priority.
  14. It is unclear what Chairman Wood meant at the July meeting by his reference to exchanges, but if the sentiment is that MBRs should be tied to participation in a centralized power exchange, there are significant policy issues that first must be resolved.

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