Changing the Game

Deck: 

Why did Michigan cap competition?

Fortnightly Magazine - February 2010

The sweeping regulatory reform implemented in Michigan over the past year is often couched as a response to the economic crisis. Decoupling rates from utility profits, the reasoning goes, will remove disincentives to efficiency. Reducing the subsidies that commercial customers have long shouldered will ease their financial burdens. New renewable portfolio standards and wind generation initiatives will create green jobs and much-needed infrastructure.

To be sure, the recession has hit Michigan and its manufacturing-based economy particularly hard. A disastrous 2009 saw bankruptcies at two of the big three automakers, leading to the demise of several familiar brands and sending shock waves through the auto parts supply industry. Further, the latest blows are nothing new—Michigan’s economic decline over the course of decades is a sad and familiar story.

It would be a mistake, however, to view the new regulatory regime solely as a response to the current economy. The legislative effort behind the state’s regulatory reform laws, Public Acts 286 and 295 (see “Re-Restructuring in Michigan”), dates back years before the 2007 financial meltdown. And while Michigan’s long-term economic plight creates the backdrop for every aspect of the state’s energy business, critics say the real guiding force behind the new laws is the influence of Michigan’s two dominant investor-owned utilities, Detroit Edison (DTE) and Consumers Energy.

“They basically wrote the legislation,” says Bob Strong, a lawyer for ABATE, an association of large industrial power customers in Michigan. “These laws have not been helpful to the public; they’ve been helpful to the utilities. Frankly, the utilities are using the acts to create their own economies, and not live in the same economies as everybody else here in Michigan.”

The criticism is most pointed when it comes to a controversial aspect of PA 286 that caps retail competition at 10 percent of each utility’s market base. The cap, which already has been reached, shackles Michigan’s alternative energy suppliers (AES), which the IOUs say are cherry-picking the most lucrative customers.

As associations of utility customers and AES companies push back hard, lawmakers are considering new legislation that would lift the cap and once again shift the leverage in Michigan’s deregulation scheme. This ongoing regulatory teeter-totter calls into question Michigan’s commitment to retail market competition, and whether in fact competition is advisable or even viable in such a troubled state.

Hybrid Market

Just a decade ago, Michigan was moving vigorously toward a new market structure. Cognizant of the deregulation mistakes that led to the California energy crisis, the state embarked on its own effort to create retail market competition.

“Michigan had the benefit of that history prior to passing our legislation. The end result, at that time, was that it worked very well,” says Barry Cargill, executive director of the Customer Choice Coalition (CCC), a group lobbying to lift the cap. Members of the CCC include a range of utility customers, from businesses to school organizations, plus several AES companies. (Editor’s Note: Several AES companies were contacted for this article. They either didn’t respond to interview requests or confined their comments to generalities on the value of market competition.)

In addition to keeping prices in check, Cargill says the deregulated market sparked investment in generation assets that helped fix chronic reliability problems.

“About 4,000 MW of gas-fired peaker plants were built shortly after 2000, and it resolved our brownout problem,” he says. “The price of electricity never dropped, but it was more competitive here in Michigan than any of the other Midwest states. Previously, our trend was going the other way.”

But right from the start, IOUs opposed the AES model. Because of the way the market was structured, IOUs saw nothing but downside in retail competition.

Unlike other deregulated markets where generation assets are transferred to non-regulated entities held by the parent company, or sold altogether, in Michigan, only transmission was fully spun off. This partially deregulated approach left IOUs to compete in the retail market, while still fully responsible for fixed costs.

The IOUs’ biggest complaint was that AES plucked their best customers—i.e., high-load, low-risk industrial users—leaving utilities with the low-income residential market and the full responsibilities of being provider of last resort.

“We would prefer to see electric choice completely eliminated in the state, but it didn’t happen,” says Trevor Lauer, vice president of marketing at Detroit Edison.

Lauer says the competition cap issue has overshadowed the fact that PA 286 also “de-skewed” rates in Michigan, reducing the premium—which was as high as 30 percent—that commercial customers long have paid to subsidize residential service.

“The average commercial industrial customer in Michigan will see anywhere from a 5-percent to 15-percent reduction in their utility bill based on de-skewing,” he says.

From the IOUs’ perspective, retail competition in Michigan was a false market from the get-go, because the hybrid market design didn’t evenly distribute risk and cost. De-skewing helps in part by reducing rate disparities that made some large customers easy pickings for alternative suppliers. And eliminating, or at the very least capping competition, they say, is a fair trade-off for ensuring reliability and a measure of rate stability in an ailing market.

Hard Sell

By the middle of the decade, the IOUs were fully mobilized in an effort to re-regulate the retail market. With a little help from term limits, they largely got their way.

In the early 1990s, Michigan passed term limits for state legislators—three terms (six years) in the House, and two terms (eight years) for senators and constitutional officers, such as the governor and attorney general. The law matured in 1998, ushering out the last of the old guard.

The practical effect was a dramatically reduced institutional memory in the legislature. Even unbiased observers comment that the fresh legislators lacked the sophistication and experience necessary to deal with the most complex issues, such as health care and energy.

Without a nuanced understanding of the complicated and often murky interplay of utilities and the markets, as well as the ways perceived interests don’t always align, and how customers are ultimately affected, critics say the legislature essentially was cowed by the powerful IOU lobby.

“The legislation was heavily influenced by them,” Cargill says. “They spent a lot of money on campaigns, as did organizations that they’re affiliated with, in an effort to reduce choice.”

The IOUs, for their part, readily acknowledge their opposition to retail choice. Their pitch to legislators was straightforward: Without a regulated monopoly, they couldn’t afford to invest in generation, customer-service technology or the smart grid.

“We said we needed the 10-percent cap in order to give us the certainty to invest in things like this proposed clean coal plant up in Bay County,” says David Mengebier, senior vice president for governmental and public affairs at Consumers Energy. “If we build that plant, we’re talking 1,800 construction jobs, 100 permanent operating jobs, and about $2.5 billion in economic benefits to the state and region as a result.”

Promises of jobs and an influx of money have self-evident appeal in a state with high unemployment and a beleaguered industrial base, and the IOUs argue these points convincingly.“The whole economy issue as it relates to the Michigan energy law really was a major factor in the legislature moving this forward,” says Mengebier. “That’s true if you look at the other aspects of the law as well. The company will invest about $1.2 billion in renewable energy between now and 2017, and we’re going to invest about $500 million in energy optimization programs. All of these create jobs, and the economic and environmental benefits are a direct result of the fact that the legislature decided to put this 10-percent cap on choice. We think it’s been very good.”

Backlash

Michigan’s IOUs are pleased with the result of the state’s comprehensive regulatory overhaul. “I would say 295 and 286 have created a very constructive regulatory environment here in Michigan,” says Detroit Edison’s Lauer. “It’s a very bi-partisan law that was signed off by all the people at the table. It’s working very well and we’re moving forward on a lot of fronts.”

But for critics, the proof is in the price. After just over a year under the cap, competition advocates say there’s ample evidence of its adverse effect on customers. Consumers Energy hit the 10-percent threshold in the fall, and DTE reached the cap just before the new year. With no further competition in play, advocates say any meaningful impact on price has been negated.

“We’re looking to overturn this,” says Cargill. “The cap has allowed the utilities—free of the threat of competition—to raise rates, particularly in the residential area. Rates have gone up substantially while the national wholesale price of electricity is going down.”

Michigan Senator Cameron Brown currently is working on legislation that will lift the cap. At last report, the legislation was still in draft form, but nearly ready for introduction. Cargill says it’s unlikely the cap will be dropped entirely, but he hopes it will be raised to a level that will foster meaningful price competition.

“It’s a question of how much competition there is, and clearly 10 percent isn’t enough,” he says. “We feel 30 percent would be a reasonable amount, where there would be a continuous element of competition. That’s the appropriate cap for Michigan.”

Whether Michigan’s utilities can accept this greater exposure to competition depends in part on other aspects of the state’s regulatory evolution.

Risk Reward

From the outside, Michigan’s partially regulated market can seem like a tangled mess of qualifications and counter-measures. But this much is certain: the competition cap issue can’t be segregated from other elements of PAs 286 and 295, including rate decoupling, cross-subsidization and RPS.

The decoupling issue alone presents a perplexing array of interests and motivations. Generally speaking, vertically integrated IOUs tend to oppose decoupling, because it can make it more difficult to grow the generation rate base. The opposite is true in fully unbundled markets, where decoupling can protect T&D utilities’ profits while giving them incentives to invest in wires. But in Michigan’s hybrid market, where transmission has been unbundled and the big IOUs’ wholesale and retail businesses remain connected, the issue is far murkier.

An unspoken subtext in the decoupling debate involves how Michigan’s manufacturing decline is affecting IOUs’ profitability. In this context, decoupling might serve less to provide incentives for efficiency than it does to ameliorate the fixed costs of base-load generation and distribution.

In the run-up to regulatory reform, IOUs argued they needed a competition cap for cost certainty as they embarked on building new generation assets for projected load growth. With load shrinking—and, in fact, with a requirement under PA 295 to reduce load by 2 percent by 2012—this rationale no longer seems valid. However, under the new RPS, and with federal carbon emissions standards looming, Michigan likely will need investments in new, cleaner generation—investments utilities are planning to put into the rate base.

Mengebier says Consumers Energy projects its fuel mix in 2018 will be less than one-third coal and just over one-third gas, with the remainder coming from renewables, demand response, efficiency programs and purchased power. That transition, he says, requires a substantial investment—and a regulated market to support affordable financing.

But how those investments ultimately will affect Michigan seems unclear at best. On one hand, power companies argue that new investments will create new jobs. But on the other hand, rate increases to pay for new generation assets won’t help the state’s economy. Moreover, the state’s constrained and uncertain power market seems unlikely to cultivate vigorous wholesale price competition, leaving customers with few options other than rate-based generation investments.

The complexities and contradictions of Michigan’s regulatory scheme reflect the difficulty of balancing constituencies in a state under great economic duress.

“From the 30,000 ft. level, PAs 286 and 295 are a push to improve, modernize and clean up the dirty business of utilities,” says Joe Baumann, an energy lawyer at the Dykema law firm in Lansing. “On the ground, however, it involves a tremendous amount of legislative compromise.”

All the complexities, however, can be distilled into a single factor: risk. In a burgeoning economy, risk taking can offer the prospect of innovation, lower costs and greater efficiency—and lawmakers favor a market structure that lets ratepayers reap the rewards. But in a troubled economy, the opposite is true. “In a scary environment, the upside of risk becomes less valuable than the comfort of reliability in service and stability in the industry,” Baumann says.

Michigan’s lawmakers seem unlikely to overcome the basic conflict between the costs and rewards of risk any time soon, particularly with the state’s difficult economic outlook. As a result, Michigan’s power market continues to be defined more by compromises and contradictions than it does by competition.