A Perfect Storm: Rethinking Electricity Restructuring

A Perfect Storm: Rethinking Electricity Restructuring

Prepared by Hannah S. Flint

Student

Georgetown University School of Law

Published by the Electric Markets Research Foundation

November 10, 2014

I.Introduction

Addressing the U.S. House Energy and Power Subcommittee, Commissioner John Norris of the Federal Energy Regulatory Commission (FERC) acknowledged that although “the energy sector and the electric sector experienced only modest, incremental change for much of the last century . . . that time of incremental change is clearly over.”[1] Stagnant demand growth, the shale revolution and a multitude of federal and state policies have resulted in a rapidly changing energy landscape. Although the entire industry is facing these new challenges,restructured electricity markets that rely solely on market forces have made these changing dynamics even more prominent, and many parts of the country are now facing concerns of near- and long-term capacity shortfalls.[2]

Due in part to an abundant supply of low-cost natural gas, various environmental regulations, and government subsidies for renewable projects, coal-fired and nuclear baseload generationhave haddifficulty remaining economic to operate in today’s restructured markets. Some nuclear and coal plants have already retired, and manymore are scheduled to shut down.[3]The Clean Power Plan proposal issued by EPA in June 2014 to regulate carbon emissions from existing power plants will only further exacerbate the retirement situation. Despite FERC’s efforts to “refine market rules to ensure that all resources are participating in markets on a level playing field,”[4] market structures, subsidies and environmental regulationsquickly made natural gas and renewables the clear market “winners.”[5] This heavy reliance on a less diverse fuel mix in the restructured markets has in turn led to additional challenges, including a need for new infrastructure in order to integrate greater amounts of renewable generation onto the grid[6]and new natural gas pipeline infrastructure to ensure adequate supplies of gas in regions with tight pipeline capacity.[7]

At the same time that new generation is needed to replace retiring baseload generation, generators facing unstable market designs[8] and “rock-bottom power prices”have found “little incentive to invest in [base load] generation”inrestructured markets.[9]Not only is new base load generation not being built, but many market participants are exitingmarkets for less risky investments. Aggressive market oversight and enforcement, along with unclearrules, have increased trading costs and noncompliance risk, which has led market participants, particularly banks, to exit power markets, leading to concerns regarding the liquidity of these markets.[10]In addition, several utilities are seeking growth in more stable investments, namely their regulated businesses and transmission and pipeline infrastructure.[11]FirstEnergy, for example, announced its intention to remake itself “from a champion of competition to a more old-fashioned looking power company”[12] to reduce their “exposure and risk to power markets.”[13] The electric utility committed to “downsizing its unregulated companies” to focus on “becom[ing] more of a regulated company . . . grow[ing] predictable cash flow” from its regulated subsidiaries, which are expected to provide about 80 percent of the company’s revenues.[14] The company also has plans to invest billions of dollars in transmission infrastructure projects, investments that are guaranteed a reasonable rate of return set by FERC.[15]

These challenges have sparkedsubstantial debate as to whether competitive market rules provide the adequate incentives to“achieve efficient market-based outcomes, or whether rule changes are necessary.”[16] Market participants have opined that “the industry is falling apart” as a result of “market protocols ill-suited to address fundamental market changes brought about by lower natural gas prices, stricter environmental regulations and financial compliance regulation.”[17]A study was recently published by the American Public Power Association (APPA) that looked specifically at generating capacity additions in 2013. The APPA study found that almost all new capacity in 2013 was constructed under a long-term contract or ownership. Just 2.4 percent of the new capacity was built for sale into a market, a number that includes new facilities for which no information could be found about the contracts. Moreover, when broken down geographically, only 6 percent of all capacity constructed in 2013 was built within the footprint of restructured markets with mandatory capacity markets.[18]But both restructured markets andFERC appear once againeager to layer on additional market rules in an effort to resolve these issues rather than to evaluate the whole model.[19]During a time of tight supply and already low margins,the critical question is how the restructured markets and FERC planto incentivize additional supply in the market to solve anticipated capacity shortfalls without further depressing market prices and thus devaluingcurrent generators?

Electricity is undoubtedly critical to the U.S. economy and national security, and in light of these challenging circumstances that have significant implications for current electricity rates and reliability, it is time for electricity market restructuring to be reconsidered. This paper takes the position that electricity regulationoffers the financial stability and comprehensive planning necessary to provide reliable and affordable electricity to American consumers,and istherefore, a superior modelto restructured markets as they exist today in the United States.

II.Electricity Regulation and the Push Towards Industry Reform

Electricity regulation began its evolution in the late nineteenth century and was “developed around the concept of a central source of power supplied by efficient, low-cost utility generation, transmission, and distribution.”[20]The move from municipal to state regulation in the early twentieth century was based in part on the view that regulation was in the public interest because the electric industry exhibited characteristics of a natural monopoly, where “one firm can serve the market more cheaply than two or more firms and can keep out rival firms by expanding output and lowering price when threatened.”[21]This was particularly true for transmission and distribution systems, where it would be “too costly to permit multiple lines” to the same destination.[22]Accordingly, states granted monopoly franchises with the exclusive right to serve a particular territory to vertically integrated utilities in exchange for an obligation to serve all customers within that territory.[23]To avoid monopoly pricing, utilities and regulators entered into the “regulatory compact,” where regulators “set the price and quantity of service at hypothesized competitive levels”[24] and ensured that utilities operatedefficiently without excess costs.[25]The regulatory compact is mutually beneficial to the regulated utility and its ratepayers: “utility investors are provided a level of stability in earnings . . . [and] in turn, ratepayers are afforded universal, non-discriminatory service and protection from monopolistic profits.”[26]

A.Push Towards Industry Restructuring

The industry flourished for many years under the vertically-integrated model with state supervision. Regulation allowed the rapid expansion of the electric industry, and increased demand growth allowed utilities to capture economies of scale by building large generating units, driving down costs and electricity rates.[27]Regulation also provided utilities a fairreturn on their investment that attracted capital andallowed them to expand into new regions that previously did not have access to electricity.[28]In the 1960’s, utilities invested heavily in new generation, particularly nuclear power, projecting continued demand growth in the decades to follow.

Beginning in the 1970’s, however, a number of events causeddemand to decline and electricity prices to rise significantly, ultimately leading to a push for industry reform.[29]The Arab oil embargo of 1970 caused fuel prices to skyrocket and contributed to inflation, in turn causing interest rates to more than triple.[30]The rate of electricity demand growth decreased as consumers began conserving energy in response to these rising costs, revealing that electricity demand was more elastic than previously anticipated.[31]At the same time as declining demand, electricity prices spiked as higher-than-expected generation costs went into customer rate-base.

Utilities experienced these higher costs for a number of reasons. In particular, power plants under construction experienced significant material and labor cost overruns due to high inflation and interest rates, causing construction delays and forcing some plants to entirely cancel construction plans prior to completion.[32]Additional safety requirements and a concerned public following the nuclear accident at Three Mile Island also raised costs fornuclear plants.[33]Burdened by high electricity rates, consumers objected to paying for costly excessgeneration, arguing that customers should not be responsible for poor investment decisions made by utility monopolies.[34]And perhaps most importantly, the incremental costs for new generation, partly due to declining gas costs, became less than retail rates paid by large industrial consumers in many regions of the country, and they saw competition as a means of lowering their costs. Other consumers also raised concerns about regulators’ abilities to choose the best investments for utilities and to determine when company operations were efficient.[35] As a result, consumers in many states began advocating for industry reform.

Subsequently, Congress took a number of actions that facilitated the move towards deregulation and industry restructuring. In response to the Arab oil embargo, the nation’s fuel shortages and rising fuel prices, Congress enacted the Public Utility Regulatory Policies Act (PURPA) in 1978.[36] Congress sought to promote energy efficiency to conserve energy resources and promote alternative fuel sources in order to “reduce the need to consume traditional fossil fuels” for power generation.[37] PURPA encouraged the development of non-traditional entities, namely cogeneration and small power production facilities, and required utilities to purchase energy from these “qualifying facilities” (QFs) at the utilities’ “avoided cost.”[38]PURPA was the first introduction of competition into the electric industry, and while the QF industry quickly developed, concerns arose about their ability to access the utility’s transmission systems, and a concern that utilities could charge QFsdiscriminatory rates to wheel power.[39]Some also argued that not only QFs, but other non-utilities, should be able to compete in generation markets. The Energy Policy Act of 1992 (EPAct 1992) and FERC Order 888 addressed these issues and further enabled competition.EPAct 1992 provided market development incentives, created a new class of “independent” generators that were exempt from certain federal laws, and gave FERC broad authority to order utilities to wheel power for wholesale transactions. Consequently, FERC implemented EPAct 1992 in its landmark Order 888, which required utilities to “unbundle” (i.e., financially separate)their generation and transmission functions for wholesale transactions and to provide open access to transmission on a non-discriminatory basis.[40] In 1999, FERC further enabled industry restructuring by adopting Order 2000, which formally created (on a voluntary basis) independent transmission system operators, known as Regional Transmission Organizations (RTOs), and sometimes referred to as Independent System Operators (ISOs), to facilitate greater coordination and access to transmission.[41]These statutory and regulatory actions further facilitated the push for competition within the electric industry.

At a time when other industries, such as the airline, natural gas and telecommunications industries, were experiencing what appeared to be great success after deregulation, electricity restructuring appeared to be the common-sense solution to the problems facing the industry and consumers. Perhaps even more influential, Great Britain, among other countries, privatized its electric industry in the early 1990’s, introducing competition into generation and later into the retail side.[42]After a visit to Great Britain, Elizabeth Moler, FERC Chair at the time, stated that “the Brits’ enthusiasm about the early successes of their restructuring definitely emboldened us to embark upon restructuring.”[43] By the 1990’s, electricity restructuring “took on an appearance of inevitability, an over-whelming force that could not be resisted – a juggernaut.”[44]

B.Halt in Restructuring

In general, states with the highest retail rates advocated most aggressively for deregulation;although, between 1996 and 2000, almost all states were at least investigating deregulating retail competition, and 25 states had adopted legislation or enacted regulations at the state level approving retail competition.[45]The introduction of retail competition in these states called for a restructuring of how the market and transmission access in particular operated, and as a result, most states adopting retail competition also formed or joined RTOs. Thus, 23 states began restructuring their electricity markets by the late 1990’s.[46]This all changed in 2000, however, with the collapse of California’s electricity restructuring.[47]

In the late 1990’s, California’s electricity demand began growing faster than supply, due in part to economic growth, weather conditions, a slower pace of generation construction completion, and a reduction in reserve margins.[48]Rising natural gas prices, market manipulation, reduced electricity imports, and increased environmental costs further exacerbated the situation.[49]A drought in the Pacific Northwest reduced significantly the regular imports that California relied on, and some observers believe that the market rules in California allowed significant market manipulation that also increased prices. By the summer of 2000, all of these factors converged, and the market was left with severe supply shortages, causing market prices to skyrocket, and because retail rates were fixed, utilities were left paying much more for wholesale electricity than they were able to sell it at retail.[50]By the middle of 2001, “in the wake of one bankrupt utility [and the near bankruptcy of others], even higher wholesale prices, and rolling black-outs – skeptics blamed deregulation for putting California in a perilous position.”[51]

Following the California electricity crisis, several states began to rethink restructuring and retail competition, and several states that had already passed restructuring legislation began to delay implementation, modify programs, and even reverse retail competition and restructuring.[52]

C.Electricity Restructuring Today

The experiment of restructuring in the late 1990’s resulted ina fragmented electric industry, with parts of the country restructuring and other parts remaining regulated. FERC expressed its goal to establish a standardized national electricity market and introduced the Standard Market Design Notice of Proposed Rulemaking (NOPR) in 2002.[53] Due to political pushback, particularly from regions that had not restructured,FERC withdrew its Standard Market Design NOPR in “connection with efforts to secure the passage of the 2005 Energy Policy Act.”[54]

Today, the country continues to be greatly divided on the electric industry restructuring question, and states retain the decision-making authority regarding the structure in their states.[55]Several states, mostly in the Southeast, Southwest and Northwest, chose to remain traditionally regulated, with vertically integrated utilities providingend-usercustomers “bundled” services (i.e., generation, transmission and distribution services).[56]Other parts of the country, including the Northeast, mid-Atlantic, much of the Midwest, Texas and California, however, chose to offer some form of competition into their electricity markets, although market structures differ by state.[57]For example, some states allow full retail competition, allowing customers to choose between the incumbent utility or competitive suppliers.[58] Other states have only introduced competition into generation, and the incumbent utility still provides supply services to end-user customers.[59]

III.The Reality ofRestructuring in the Electricity Industry

“The concept [of deregulation] seemed straightforward: Opening the monopoly electric generation market to competition would usher in a new era of lower prices and innovation the same way it did with airlines and long-distance telephone service.”[60] In theory, electricity deregulation should make sense. At the macro-level, the invisible hand of the market, rather than regulators, “assure[s] that supply always exceeds demand” through market price signals, which indicate how much generation is needed and ensure that the least costly generators are selected to operate.[61]Removing the “conscious setting of just and reasonable wholesale rates by fallible mortals”encourages competition, driving down prices and fostering innovation.[62]Deregulationoffers an idyllic promise: “large and small consumers alike will see lower rates, more choices, improved services, all with no impact on reliability.”[63]

A.Electricity’s Unique Characteristics

But in reality, “circumstances do not always fit the vision.”[64]While the restructuring of the airline, telecommunications and natural gas industries have been cited as evidence of the benefits that competition can provide, such as lower costs and innovation, electricity has unique characteristics that prevent the industry from reaping the same benefits. Natural gas, for example, is controllable, meaning the gas is pumped through pipelines at roughly 25 miles per hour to a specific recipient, and gas is capable of being stored.[65] Electricity, in contrast, travels at the speed of light, flows to the path of least resistance, and has limited storage capability, which means that adequate supply must be available at the exact time that it is needed to meet demand. As a resultof electricity’s short-run characteristics, the power grid requires constant balancing in order to maintain reliability, and even small changes in supply or demand can have a significant impact.[66]Adding to this challenge, electricity, unlike many other commodities, requires capital-intensive infrastructure to move it to market, and this infrastructure takes time to build.[67] Generation is also capital-intensive and takes years to build. These factors highlight the extensive coordination required in planning and operating generation and transmission systems in order to maintain reliability that is critical to the U.S. economy and national security.

Unlike other commodities, when demand exceeds supply and prices rise significantly, electricity consumers have no alternative product. For example, when the supply of corn is limited and prices rise, customers may choose to purchase beets instead of paying the higher price for corn, causing supply and demand to balance out. The corn market can also react quickly to rising prices and reallocate farmland around the world to growing more corn. When the supply of electricity is tight and prices rise, however, customers are forced to pay astronomical prices or curtail electricity service, and new generating capacity takes years to build. Electricity regulation provides customers with thesubstantial assurance that electricity supply will always be available without exposing them to price volatility, as utilities are required to plan years in advance to meet forecasted demand.