Revisiting the Keystone State

Deck: 

Rate caps have squelched competition in Pennsylvania.

Fortnightly Magazine - July 2008

When I was a member of the Pennsylvania Public Utility Commission in 2001, I wrote an article in Public Utilities Fortnightly (October 2001) evaluating retail electricity competition in the Commonwealth. The bottom recently had dropped out of Pennsylvania’s retail market, with the amount of electric load purchased from competitive suppliers plummeting from a high of 35 percent in April 2000 to 9 percent in July 2001. An increase in wholesale electricity prices and inflexible caps on the supply charges of utilities had combined to force competitive suppliers out of the market.

To revive competition, I recommended: 1) relaxing the rate caps so that utility supply charges would reflect higher wholesale market prices, thereby providing competitive suppliers with an opportunity to re-enter the market; 2) applying the extra revenue from these higher prices to eliminate customers’ stranded-cost obligations more quickly, thus shortening transition periods; and 3) changing the structure of retail prices gradually so they would more closely reflect the value of electricity, which varies over time.

These ideas did not attract political support, however, and the rate caps have remained unchanged.

Competition in 2008

The prolonged period of capped rates in Pennsylvania—years longer than in any other state—has produced some benefits and some drawbacks. On the plus side, due largely to the rate caps, electricity costs in the Commonwealth have fallen from 15 percent above the national average in 1996 to below the national average in 2007.1 This has been a significant benefit, but a temporary one that many have taken for granted.

On the down side, active retail competition has not developed, except in the service territories of utilities whose rate caps have expired. In addition, the caps have encouraged over-consumption of electricity and have prevented customers from seeing and learning to adjust to higher prices, which will require corrective measures such as allowing customers to phase-in significant price increases when the caps expire in most of Pennsylvania in 2010 and 2011.

It is now clear that the wholesale price increases that stymied retail competition in 2000 and 2001 were the beginning of a new era of more expensive electricity. The rapid industrialization of countries such as China and India have increased the global demand for fuels and for many types of raw materials, including those used in energy infrastructure, thus driving up prices. Increasingly stringent environmental requirements also have contributed to the trend.

The electric industry in Pennsylvania—including electric distribution utilities, competitive retail suppliers, and wholesale generators—faces an uncertain future as policymakers consider how to respond to the expiration of rate caps and the beginning of higher prices. The generation industry faces an additional source of uncertainty—whether the federal government soon will place limits on carbon emissions to combat climate change. All of this uncertainty discourages investment in electricity infrastructure.

My goal in 2001 was to improve electricity competition, and in 2008 I still believe this goal is in the public interest. The global forces described above, not competition, are causing increases in electricity prices. In fact, competition dramatically has improved the operating efficiency of generating plants, and reversing these gains by re-regulating generation would add yet another factor pushing electricity prices higher. Moreover, significant investment in generating plants will be needed in coming years to meet economic and environmental goals, and electricity consumers will be better off if that investment takes place in a competitive market, where investors bear the risks.

Lawmakers in Pennsylvania, however, hold differing views on policies that should be pursued as the rate caps expire. Some lawmakers continue to support electricity competition and simply want to help customers through the transition to market prices. But others contend that electricity competition has failed and that “broken” wholesale markets are responsible for higher prices. These opponents of markets favor measures such as legislation to extend the rate caps. Yet another group is less concerned about whether competition has succeeded or failed—they believe that combating climate change is the most important goal in setting energy policy. This group tends to support additional mandates for renewable energy.

Given these disparate views, it’s not surprising that the General Assembly has found it difficult to pass major legislation in the special session on energy that began in the fall of 2007.

Answering Market Critics

The distrust of electricity markets by some lawmakers in Pennsylvania mirrors the reaction of many officials in other states where rate caps expired a few years ago. In Illinois, Maryland and Delaware, the expiration of rate caps in 2005 and 2006 coincided with a spike in wholesale electricity prices due to the damage that Hurricanes Katrina and Rita inflicted upon natural gas infrastructure in the Gulf of Mexico. Customers in these states had grown accustomed to paying capped prices, and they were surprised and angered upon learning that they would soon be paying much higher electricity bills. Many elected officials reacted by blaming wholesale markets and generators for the increases.

This blame was misplaced. Aside from the temporary spike caused by Hurricanes Katrina and Rita,2 increased fuel and infrastructure costs—which are outside the control of generators or entities such as PJM that oversee wholesale markets—have caused electricity prices to increase. From 1999 to 2007, the price of coal increased by 56 percent, and the price of natural gas increased by 200 percent in the PJM market area.3 In addition, a recent study shows that the cost of building a new generating plant in North America increased by 130 percent from 2000 to today.4 This means that a plant that cost $1 billion to build in 2000 would cost $2.3 billion now.

State policymakers who distrust competition downplay the global forces that are driving higher electricity prices. Instead, they draw attention to the profitability of baseload generating plants that were built under regulation. They suggest these profits prove wholesale electricity markets are not truly competitive. In addition, the focus on generator profits seems calculated to incite populist indignation as customers begin to pay higher prices.

Market critics ignore the fact that the financial incentives provided by competition have spurred generators to operate plants very efficiently. As a lawyer at the Pennsylvania PUC in the 1980s, when most generation was owned by utilities and was not subject to competition, I recall investigations into lengthy outages at nuclear power plants. Now, nuclear plants in Pennsylvania operate 93 percent of the time because they do not earn revenue during outages. These efficiency gains have benefited consumers by reducing both the need to build expensive new plants and the number of hours that plants with higher fuel costs must be operated.5

Most important, market critics overlook the hard truth that the cost of building and operating new infrastructure, not infrastructure built in the past, must drive prices for an industry to be self-sustaining. If prices are not high enough in the long run for investors to recover the costs of new plants, they will not invest and a shortage will result. Our society is willing to accept occasional shortages of most commodities, but not electricity.

Shortages of electricity were developing in parts of the PJM area before PJM filed its “Reliability Pricing Model” (RPM) with the Federal Energy Regulatory Commission in 2005. That filing was made because the “net revenue analysis” conducted by the PJM Market Monitoring Unit in its annual State of the Market Reports showed that revenues available to generators had not been sufficient to cover the fixed costs of new plants since PJM’s markets started in 1999. In fact, only in 2005, when wholesale prices spiked due to the Hurricanes, were generator revenues sufficient on average to allow recovery of the fixed costs of a new baseload plant.6 However, RPM is beginning to work: Net revenues were sufficient to cover new plant costs (even baseload plant costs in some areas) in several constrained areas in 2007, and investors are adding capacity in response to these improved incentives.7

In summary, the argument by wholesale market critics that prices are too high directly conflicts with the reality that prices have not been high enough to allow investors to recover the costs of building and operating new plants in the PJM area, although this situation is improving due to RPM.

In the short run, states have little ability to influence these conditions. The best they can do is to educate customers, allow them to phase-in higher prices, and give them the tools to conserve. In the long run, states can minimize price increases by maintaining their commitment to competition, by preserving a stable environment for investments in generating plants, and by encouraging development of needed electricity infrastructure. On the other hand, policies based on the mistaken notion that competition is to blame for higher prices will discourage investment and create even greater problems in the future.

Combating Climate Change

Many citizens are dissatisfied with the response of the federal government to the climate-change issue, and some state and local policymakers have stepped into this void and adopted policies intended to lower emissions of carbon dioxide and other greenhouse gases. Pennsylvania is among a group of roughly half the states that have passed laws mandating that specific percentages of the electricity consumed in the state must come from renewable energy sources, such as wind and solar. Pennsylvania law requires that by 2020, 18 percent of electricity consumed in the Commonwealth must come from “alternative energy” sources, a term that includes renewable sources and waste coal plants.8

Some lawmakers in Pennsylvania want to go further. Among the ideas that have been proposed are increasing the required percentages of renewable energy in the portfolio standards law, requiring that all increases in the demand for electricity be met with renewable energy or conservation, and encouraging utilities to rely heavily upon long term contracts with alternative energy suppliers to provide default supply service to non-shopping customers.

It’s questionable whether these proposals constitute wise energy policy or effective environmental policy. First, climate change is a global problem that requires a global solution. Actions by individual states intended to reduce carbon emissions will not have a material impact on the earth’s climate without effective national and international policies. In particular, emerging economies such as China and India, which have been adding significant amounts of coal-fired generation in recent years, must be brought into a global strategy to reduce carbon emissions.

Only the federal government can adopt an effective national strategy and negotiate with other countries to assure that they do the same. A change in federal policy seems likely within the next few years since the remaining candidates for U.S. president all support federal legislation to limit carbon emissions.

Second, even if one views combating climate change as a moral imperative, the most cost-effective means to achieve this goal is likely to be one that relies on markets rather than government mandates to pick technologies to lower carbon emissions. The chief role of government should be to support research and development for a broad range of technologies, including renewable energy and carbon sequestration at coal-fired plants. The latter is particularly important in light of our country’s abundant coal reserves.

Renewable energy has positive attributes—it is emission free and has no fuel costs. It is likely to be one component of an optimum mix of technologies necessary to address climate change.9 But state policymakers are overstating the case for renewable energy when they portray it as the primary solution to climate change. Wind and solar are intermittent sources—they generate electricity when the wind blows and the sun shines. Thus, they require significant amounts of backup generation to ensure reliable service. These intermittent sources may supplement, but not supplant, generation technologies that operate around-the-clock and can be dispatched more reliably. Mandating ever-greater reliance on renewable energy is unwise until the reliability and cost impacts of these technologies are better understood.10

Finally, some policies under consideration before the Pennsylvania legislature could serve both environmental and economic goals if they work as intended. Many legislators support establishing a schedule to provide advanced meters to all customers. These meters make time-of-use pricing plans possible, which is consistent with the goal of encouraging time-varying pricing stated in my 2001 article. In addition, there is support for establishing statewide targets for conservation and reduction of peak usage. Discussion of this topic is warranted, because greater conservation will be necessary in the future for both environmental and economic reasons. At the same time, there are costs associated with both of these proposals that must be weighed.

In summary, Pennsylvania and many other states have assured some development of renewable energy by mandating that these sources be included in electricity supply portfolios. The states would be wise to exercise restraint in adding to these mandates, especially given the likelihood of a change in federal policy toward climate change within the next few years.

Committing to Competition

Much has changed since my 2001 article on electricity competition. One thing has not changed, though—political sensitivity to increases in electricity prices. While Pennsylvania and other states cannot change the global conditions that are driving higher prices, they can minimize price increases by maintaining their commitment to competition and resisting the urge to impose additional mandates for renewable energy pending federal action to address climate change.

 

Endnotes:

1. U.S. Department of Energy, Energy Information Administration, “Average Retail Price of Electricity to Ultimate Customers by End-Use Sector, by State,” available at www.eia.doe.gov.

2. One lesson that regulators, including me in my former position, learned from the wholesale price spikes in 2005 was that utilities should stagger their purchases of energy for default service to minimize the risk of buying when the market is high due to transient events.

3. PJM Market Monitoring Unit, 2007 State of the Market Report, Vol. II, Sec. 3, page 124.

4. IHS Inc. and Cambridge Energy Research Associated, Power Capital Costs Index, press release dated Feb. 14, 2008.

5. Collin Cain and Jonathan Lesser, The Pennsylvania Electricity Restructuring Act: Economic Benefits and Regional Comparisons, Bates White, LLC (February 2007).

6. 2007 State of the Market Report, Vol. 1, page 13.

7. News Release, “PJM Reliability Pricing Model Draws Largest Amount of New Capacity So Far,” February 1, 2008; 2007 State of the Market Report, Vol. 1, pages 12-13, 17, 27. In the capacity auctions held to date, RPM has resulted in: additional demand-side resources and new generation, generating capacity brought out of retirement, and uprates at existing plants. In addition, more generators have offered capacity in each succeeding auction.

8. Act 213 of 2004, 63 Purdon’s Statutes Sec. 1648.1 et seq, entitled “The Alternative Energy Portfolio Standards Act.”

9. See, Electric Power Research Institute, The Power to Reduce CO2 Emissions, 2007, available at www.epri.com.

10. For example, the Electric Reliability Council of Texas was forced to implement emergency procedures on Feb. 26, 2008 due to a series of events that began when wind-energy production dropped from 1,700 megawatts to 300 megawatts as evening electricity load was increasing. See, Press Release, ERCOT Demand Response Program Helps Restore Frequency Following Tuesday Evening Grid Event, Feb. 27, 2008, available at www.ercot.com. In addition, a recent academic study concluded that the costs of solar photovoltaic panels outweighed the economic and environmental benefits of this technology. Severin Borenstein, The Market Value and Cost of Solar Photovoltaic Electricity Production, University of California Energy Institute, January 2008, available at www.ucei.org.