Perspective
In His Own Words
A face-to-face interview with FERC Chairman Pat Wood III.
MONTH 2004
By Richard Stavros
Bold. Fearless. Relentless. These are the words now being used by both critics and supporters to describe Federal Energy Regulatory Commission Chairman Pat Wood III.
FERC's recent policy initiatives and directives mark a strong shift from what was last year regarded as a more reluctant commission.
In recent months, FERC has taken on highly contentious issues such as interconnection standards, regional transmission organization membership, and market power and reliability, in a way that is unprecedented, analysts say.
Perhaps because of the lack of movement by Congress on the energy bill, or the addition of two new commissioners, FERC has shown itself willing to sacrifice political capital, endure legal challenge, and even pre-empt Congress to meet its objectives.
What has prompted this sudden change in tenor at FERC, and what does it mean for the industry? Public Utilities Fortnightly Executive Editor Richard Stavros, in an exclusive interview, talks to the man at the center of the storm and asks what the commission has in store for the electric utilities industry in 2004 and beyond.
Fortnightly: After the blackout, transmission investment has been sub-optimal. At what point should regulators step in and require upgrades?
Pat Wood: Well, I don't think since the blackout it has been sub-optimal. It's a pretty short-term thing from the way company's planning cycles [and] regulatory response cycles are. I think a lot of problems that existed today and existed before the blackout is, what's the incentive for a company to build a more robust grid when all it does is advantage their competitors generation, which is the more vertical market now? The other [problem] is, why would I invest in transmission when I can get a better return in "fill-in-the-blank"? That was probably a bit more attractive argument before the blackout, and not since...
The real core issues ...[are] how do you know you're going to get your money back? Generation actually, even unregulated generation, depending on the nature of the deal, has had a more predictable payback than transmission, what with rate caps at the retail level, the questions about jurisdiction between us and certain states, siting issues that take decades, the fact that the people who are trying to build transmission [in] about half the markets in the country are also out there with the retail brand, and they don't want to sell it. Transmission lines have gone through people's yards and barns and ranches and cemeteries and what have you. They aren't really popular projects, so to have the same name on their company that also is out there competing for your business [is] probably not what a marketing agency would advise you to do. There are a lot of things going on there that I think really don't get dealt with unless the transmission and generation issues are dealt with.
Fortnightly: I wrote an editorial about my surprise that there was no investment going on in transmission. You made the point that it was because these transmission assets aren't independent, and that's why the investment isn't happening.
Pat Wood: Let me clarify, and it's a point I want to make clear. The transmission investment is basically what I call super-distribution, to keep up with local voltage and delivery power beams within the local region, which is what utilities have done pretty well for 50 years. It's the interconnects between utilities that [are] really where investment has never happened, and hasn't picked up yet, because again, it's ... uncertain how the costs are going to be recovered. ...
How can regulators make some of that work better? You come before me for rate reviews, we're going to look into whether you're complying with NERC or not. Now ... I don't know whether there are many rate reviews going on anywhere-not like there were during the '80s-and I'm not sure they generally have professional staff looking into the utility's compliance with NERC, planning criteria, and operating protocol. That may change as NERC gets a more pro-active approach toward compliance audits and readiness audits. That may be a weeks and months kind of thing, rather than a months and years kind of thing.
Fortnightly: What's your next step on electric reliability if Congress fails to pass a comprehensive energy bill that gives NERC enforcement power? How long do you wait for legislation? You've obviously moved on reliability when you directed staff to develop an order last year requiring transmission system operators to report violations of the industry's power grid reliability standards.
Pat Wood: There are things we can do in tandem with waiting. I think [national energy legislation] has a shot here in the [Congressional] session, and I want to see it get in there. There's a lot of stuff other than reliability there that I think benefits the country and the energy industry. So I think that the package [or energy bill] would be better than the single shot.
Fortnightly: Do you still have hope that it will pass? What's the inside word on passage?
Pat Wood: Honestly, no, but I don't hear horribly bad things either. I'm not the best reader in that sense. I think they'll [Congress] do what they do when they're ready to do it. They'll whittle away at the price tag, get it down to where it's more acceptable. But there are things we are doing now, I think the most important of which is the readiness audits that NERC is leading, and we're participating as a team member. ... It's one of those steps that is a big step up from what NERC or anybody on the more public interest side of this has done to look at the ability of these large transmission control areas to meet the basic engineering and operational needs of the country. That is critical. That could go on with or without a bill. But what the bill does is give [NERC reliability standards] teeth.
Fortnightly: Let's say utilities fail the reliability readiness test. What do you do?
Pat Wood: Did you read that Nathanial Hawthorne book in high school, The Scarlet Letter? No CEO wants to be wearing the big capital letter "L" for loser on the front of the readiness audit from NERC. It has a tremendous incentive to comply. It may not be enough, but I'm willing to think it will be sufficient for what we're doing now.
The rules themselves are not clear. There aren't black and white standards right now for auditing for reliability. There are some basics but not a lot. And that's what we hit when I came out in December. The commission said they wanted to start having failures to comply reported publicly, and they still do. But once they started getting really deep into that, after our December workshop, it became pretty clear that, yes, we should have a reliable grid that maintains the outcomes. You want to keep it 60 Hertz, 99 point whatever percent of the time. OK, how do you translate that into an auditable practice? It's difficult. It's being done, but it ain't done yet. So that's the trickiest part.
Fortnightly: And NERC verifies that they've made the changes? Are utilities being locked into a certain date by which they must report or comply?
Pat Wood: They're finding some stuff that's being discussed by the professionals on the team, and quite frankly, I'm not driving the NERC leadership. The professionals on those teams are doing that.
Fortnightly: I should probably ask you about one other concern raised in one of my editorials by an anonymous utility executive. As you're staffing your new transmission division, you might be taking away some of the intellectual capital from NERC before Congress sets it up as the enforcement agency.
Pat Wood: If CEOs have time to be worrying about that, then they need to be working on keeping their stock prices up. Good Lord, have mercy.
You've got to have good people at every level, you need them in the utilities, you need them at NERC, and you need them at the commission.
Fortnightly: How do you declare victory? I mean, obviously you're still setting standards, but is there any thought about the mission of the transmission department and how FERC would say that it's effectively promoting reliability standards?
Pat Wood: The external standards to look at would be percentage of time found out of compliance ... whether it's frequency or voltage, or violation of first contingencies, scenarios. It's very uneven because it has been so decentralized. You can have a very sophisticated operation like PJM and then a relatively unsophisticated operation at some other entity on the Eastern Interconnect, yet they're all connected to the same engine. So you're only as good as the weak [links]. So some aspect of how to beef up the tails of people who are on the wagon-end of the bell curve-how to move their compliance standards up-I would say [that] would be a big focus.
Fortnightly: We've been watching the RTO process for a very long time. And there was talk that they were going to enforce reliability in the future.
Pat Wood: I wonder, I've heard that debate, and as we've gotten closer to the reality of the legislation passing, we look at how all the people work together.
I think it's going to be difficult. Again, this is just my view of the independence world-that an RTO is really a transmissions operator. If they don't own the transmission, they're at least operating it. And it's the operator who has to comply with the NERC standards. So you can't have a transmission operator be its own judge, it doesn't work. It really needs to be NERC above that, or some delegated party from NERC, but preferably NERC itself overseeing the operation, the compliance with the standards.
Fortnightly: So, the market monitors at each RTO will not enforce reliability?
Pat Wood: Compliance of market issues is a little different skill set, with the compliance with the engineering and reliability issues. And I don't know, quite frankly, that you would ever have one person or one team being able to do both. They interplay, they relate very directly to both, but I think my dream scenario would be, say, 10 RTOs in the country or eight, and a mixture of market economists and analysts and engineers at each satellite office in the country.
Fortnightly: Moving on, who builds the next generation: merchants or utilities? Is the dream of merchant or independent power finished?
Pat Wood: Oh, not at all. ... Nuclear power plants and big expensive coal plants were built in the 1970s ... and then when we hit the recession in the early 1980s, all the cost of that excess supply got thrown in the electricity rates, and in that recession, everybody's power rates went up. In this recession, they stayed down because 45 or whatever percent of the power plants are not out of rate base and the cost of over-supply was not linked to being put on the back of a captive customer through the regulatory compact. It was out there in the marketplace, where that risk was managed. Some people didn't manage it well and went bankrupt. But that's how America works.
The plants are still there. They'll hand those plants to somebody else, but the shareholder and the investors in the original power plant, as opposed to the regulated customers of that power plant, were the ones who shouldered that risk. I think what will happen in the second is somehow allocation of risk between the two will happen. Depending on the nature of regulation of the given state, whether it's retail bundled or retail unbundled, that may dictate different ways to share the risk. But I think it won't be the all or nothing that we saw with it being all the risk on the customer in the pre-competitive era, or in chapter one of the more competitive era, where all the risk is on the back of the merchant. I think you'll probably see some reallocation back toward the customer, but not completely. That's not a bad allocation.
Fortnightly: But the real bearers of the risks were actually the banks.
Pat Wood: They were leveraging some of those assets, had a lot of debt, not a whole lot of equity.
Fortnightly: How will plants be financed in the future?
Pat Wood: I don't want to call it equitable, but a different allocation of risk than they saw the first time, far more equity in the company, probably initially, and I think they're going to require more independence with these plants concerning long-term contracts. Just don't go out and build plants, but build with a customer or two in mind for 50 percent of the base load capacity, or 70 percent, depending on what kind of plant you've got.
Fortnightly: How do you respond where a utility makes a competitive solicitation for supply, and there are no takers?
Pat Wood: What if you don't have enough interest or enough participation to even make for a real competition in the first place, assuming an open and fair solicitation has taken place according to commission policy? Even if they do that, what if you throw a party and nobody comes? Well, good question. It's a lot of sweet icing to eat by yourself. State regulators care a lot about this, too, because they're the ones ultimately who have to look at that solicitation and say is it good for the retail regulated customer.
Fortnightly: Given the tight credit situation for merchants, do you worry that there will not be enough independents and power plant developers coming into the market when more supply is needed?
Pat Wood: That always happens when you open up the market to competition. Inevitably, the bubble's going to burst, and then you'll see the climb back up to a more workable market. If you have a solicitation for supplying power three years out, you'll have a lot of people bid on that, as long as they've got access to a balance sheet. There's a good deal of money to be made, as long as the hometown guys aren't creating a disadvantage. It's too important a commodity for people to just sit on the sidelines. The credit will come back up, I think it's going up as we speak.
Fortnightly: It seems now the only way a plant will get built is if it is tied to a long-term contract. Does this concern you?
Pat Wood: I think that's better for stability. You have the spot markets to fill in the space, but at the bottom you do have the contracts that are needed, just like we needed in the gas industry, to support long-term investment and supply. You've got to have more long-term dependable cash flow. We learned that from the gas industry over the past 12 years. The spot market is a tough place to be. It will pay for a little bit, a good chunk of it, but not for all of it. If you have markets that are all spot driven on the supply side, those break.
Fortnightly: Why do you think the West is still in trouble?
Pat Wood: Well, the fundamental structural regional approach to the power markets there has not changed since we've been addressing the issues that the Western energy markets have been battling. There's still not region-wide transmission. The first step in any region-and this is happening in New England, the Midwest, in S&P, in Texas planning-is plan this grid, like planning a highway grid. Then commerce starts to use that grid, and that's fine, but you've got to have some way of planning and paying for the grid. Once there's sufficient infrastructure, then people do shift over and start worrying about what the rules are going to be.
The West is different, you've got a different generation mix, [with] the load centers being very distant from the sources of supply, which is more pronounced than we see in the East.
Fortnightly: Do you think we need more downstream gas storage capacity in market areas? What can you do to encourage that?
Pat Wood: It's what it is, what it's always been. We have more summer usage of gas. We're using a lot of gas to run generation plants, all incremental loads for powers coming from the gas industry. The nature and usage of the system is a little bit different, but I think if you want to use storage more equitably, we're probably going to have not only more storage but probably more pressure on the existing pipes to get it into storage, so it's a package deal.
The West is different, you've got a different generation mix, [with] the load centers being very distant from the sources of supply, which is more pronounced than we see in the East.
I think there are just certain areas like New England where there's just no surface strata that works for gas, so there's nothing we can ever do to get gas there. So it's going to have to be the backwoods in Pennsylvania where you've got natural caverns for this stuff, Michigan, some parts of the Midwest, the Gulf Coast, for example.
Fortnightly: You're thinking of an emphasis on LNG?
Pat Wood: Our result is getting reasonable, reliable supplies to the customer. And that [could] happen [with] LNG or through some combination of storage and pipeline capacity.
Fortnightly: What about gas gathering activities? Do we need more FERC oversight on that? Are you happy with the way things are?
Pat Wood: No and no.
Fortnightly: How would you address those issues?
Pat Wood: You have customers that depend-ed on a regulator being there to protect them for 30 years. The pipeline company says, "I'm going to make this unregulated and charge what the market will bear." That's where I'm concerned-the detrimental alliance that historic customers have had for a certain framework being in place. If that gets uprooted without their needs being provided for during the transition, that's a problem. If we can just address that, we'll have a lot less concern about gas gathering. If you have a new gathering system, the customer knows from day one that that's going to be unregulated, FERC's not going to be there to protect them unless it's something horribly onerous, but apart from that, those guys know from day one that they have to negotiate their own deals, that FERC's not going to protect them.
Fortnightly: Commissioner Kelliher said that FERC should either fish or cut bait on its current test for market mitigation. Do you think we need an entirely new test?
Pat Wood: We needed the full commission to deal with that, and I think we will.
Fortnightly: You recently responded to the Southern governors in terms of their claims that FERC's proposed market power screen was not a back-door to forcing vertically integrated utilities into RTOs. If a company fails the SMA [Supply Margin Assessment] screen, they either they have to accept cost-fixed rates or join the independent market, isn't that right?
Pat Wood: Well, that's what the test said two years ago. I think we're probably in a little different place today. Basically, if you have market power, then that market power will be held in check. Some RTOs have the ability to do that, [but] at least one doesn't. The RTO itself isn't magical. It's got to be an RTO with market oversight and market mitigation. But the customers up there have protections. Why should customers be disadvantaged if the companies aren't in an RTO? Why should customers have to be facing viable market power in a generation sector? Why should the customers there be any less protected than customers in an organized power market?
Fortnightly: I remember reading in one of the filings that many companies would fail if that test would apply.
Pat Wood: Seventy companies.
Fortnightly: Seventy companies would fail. In that situation, what will companies essentially do?
Pat Wood: There are several options. That's what's taking a while. How would you mitigate them in their market power, if they aren't in an RTO? How do you give them protection for their customers? There are a number of ways to do that. Cost-fixed rates seem to be everybody's only assumption. We discovered a number of other tools that would work, and we'll probably focus on those in the next couple of months.
Fortnightly: Do you think the SMA issue will be closed by the end of the year?
Pat Wood: Yeah, we're getting there. We've got a lot of good input on what the pros and cons of different approaches are, how to replace the hub and spoke test. We'll see what the other commissioners want to do.
Fortnightly: If you did find bad behavior, what next?
Pat Wood: This is just potential to charge non-market prices, It doesn't imply bad behavior.
Fortnightly: Would you charge them bigger fines?
Pat Wood: That's a separate issue again.
Violation of the market behavior rules, which were adopted in November, you didn't really hear about them.
Fortnightly: So fighting market power isn't necessarily an indictment of prices?
Pat Wood: No, I want to say it's a different issue than the one we put out in November. Those are economic withholdings, fiscal withholdings, maintenance records, but our fining ability is still pretty restrictive. That's a separate issue than the SMA testing. I think the assumption was that a positive market would develop. One did not develop in many parts of the country. In '95 or so, when a market-based rate program was enforced, there was an assumption for open access for Order No. 888, that it would be pretty much a given that we'd get to market much like we did with gas. It's probably happened in half the country but not the other half. And so, you've got to look at other issues. You don't leave customers exposed to raw market power while you sit there and twiddle your thumbs waiting for the market to show up. You've got to come and say okay, we're going to take care of customers.
Fortnightly: We recently did interviews with your two new commissioners (See SPARK, February 2004). One of your new colleagues, Commissioner Kelliher, doesn't believe every region is going to adopt an RTO. Is that your belief?
Pat Wood: I think you will have issues if you don't have a radically new and formal approach to the market. Market institutions like an RTO could perhaps be different, if they're all administrating the same type of rules and being held to … the same standards across the region.
Fortnightly: You've got to respect regional differences. What would you say is essential to a market design?
Pat Wood: Look at Texas as a good example. That's one I helped set up. It is very important to provide the liquidity and opportunities for customers to save money by having a mature market structure in place. Texas will move there on its own in the next couple of years to put those things in place. It's got to be something that the customer benefits from. Don't move to those detailed markets, to those day-two market structures, until you've done a cost benefit that says that the benefits will outweigh the costs.
Fortnightly: Some say that grid reforms would boost exports of cheaper coal-fired power from the Midwest to the Mid-Atlantic states, lowering rates there. How do you balance the interest of states and regions that might end up competing with each other?
Pat Wood: Being from Texas, we had lowest-cost energy there for most of our lifetime, and we exported it to other states and they paid for it. In the Midwest, you see the economy changing and manufacturing jobs being lost. How do you make up for that? You've got a very valuable service in clean coal power to the rest of the country, and that's a pretty positive thing. What I hear from governors in those states [is that they would] like to find a way to get coal-fired power to every switch in the West. Build to the East, too.
The big issue there is they've got to decide what coal plants are going to be able to grow up. They've got to make either a regulatory or congressional decision about the Clear Skies issues. It's got to be done so that investors in coal plants and utilities, and customers of that product, know what the emissions criteria is going to be for the next 30 or 40 years. Nuclear power? I'd like to see it come back. I think we can certainly make it more amenable to at least existing means of nuclear power, existing licensing. We need a mix of all these. Coal is the net winner today, and it's going to export more power across the country, [so] let's make sure we have a sufficient grid. They're talking about who pays for it. We might deal with it as early as the spring. For the record, the chairman would like to say he supports Clear Skies.
Fortnightly: I talked to the general counsel of Southern last week and he was telling me about billions of dollars that it was going to cost him to upgrade transmission. Why is there so much concern by the Southerns of the world over this interconnection issue?
Pat Wood: I think the interconnection rule will actually have the effect of opening up the grid. I hope that's not their concern, but it's certainly our objective to have one large barrier to entry being removed by not allowing the hook-up process to be used to thwart the investment of new generation. I think they've been concerned that the price that's being set by our pricing policy does not encourage generators to build in the smartest places on the grid, and that's a fair concern. I think we'll be able to address some of those things.
Fortnightly: Can we expand the hydropower we have now?
Pat Wood: It's tough, very tough. I wish we could. It's a clean, renewable source of energy that's based on weather and rain, and where it exists, it's a wonderful resource because it's instantaneous. It's as good, if not better than gas-fired power. You just turn on a switch and it's going. But it's difficult to build. We've got a lot of competing considerations in hydro that, quite frankly, eclipse the concerns we have with most gas projects. There are cultural issues, tribes and other customers, there are resource issues on fish, recreational issues on boating, and landowners alongside a lake.
I personally do not think our commission has generally administered those statutes very equitably. I think for the long-term interest of what's good for the country, we've got to have a good balance of hydro in the mix. Canadian hydro is good, too. We'll take theirs.
Richard Stavros is the executive editor of Public Utilities Fortnightly. Contact him at stavros@pur.com.
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