Commission Watch
A Market-Access Plan for Vertically Integrated Utilities
Assimilating the best of the regulated-utility and merchant models.
August 2004
By Larry Eisenstat, Pat Alexander, and Don Gelinas
Vertically integrated utilities (VIUs) have served us well and do not need to be dismantled in the name of competition. That said, VIUs need to address, once and for all, the legitimate, although sometimes unfounded, concerns of the Federal Energy Regulatory Commission (FERC) and a number of market participants over vertical market power and the incentive that some VIUs have to wield that power to foreclose competitive suppliers from accessing transmission and competing for the wholesale purchasers that this transmission serves. The largest among these purchasers are the VIUs themselves, given their often huge native load obligations.
In theory, a fully functioning RTO with well-structured markets is intended to eradicate both forms of foreclosure. Yet, in many areas, RTO development is stalled, if not dead, due in large part to concerns of state regulators that FERC needlessly has interfered with state prerogatives and inflexibly ignored regional differences.
Moving forward, VIUs can put the vertical market power issue behind them and immediately capture for themselves and their customers many of the benefits of an RTO by:
- Undertaking both short- and long-term competitive procurement processes, and integrating merchant generating plants into both, thereby creating well-defined and accessible markets from which no seller can be foreclosed; and
- Vesting an independent third party with sufficient oversight and decisional authority to ensure that all potential sellers and buyers have fair and equal access to the market.
We propose a market-access plan (MAP) that does not advocate sweeping changes; it instead builds on existing VIU frameworks with structural improvements that are technically feasible, cost-effective, and politically practicable. The result assimilates the best of the VIU and merchant models; benefits the industry investment climate; increases the level of low-cost, efficient, and environmentally friendly power supplies; and promises to save customers millions of dollars.
Two Market Models Can Co-Exist
In the spring of 2002, a comprehensive plan was coming together to support the merchant generation fleet that many believed eventually would become the centerpiece of competitive wholesale markets and customer savings. FERC was completing an extensive dialogue on its standard market design (SMD) and was about to issue a proposed rule for implementation over the coming year. At the same time, through its proposed rule to standardize generator interconnections and its newly announced Network Resource Interconnection Service, FERC was about to extend network service to merchant generation plants that usually don't know which specific customers they will serve at any given point in time, nor the location of these customers at all times over the life of the units.
The reality facing the industry now is strikingly different. FERC has issued its rules on standardized interconnection, but its other initiatives are paralyzed by controversy, attributable not so much to the major principles underlying those initiatives as to their breadth and complexity. Many state regulators recognize the value of price transparency, liquid day-ahead and real-time regional markets, and the benefits of long-term competitive procurement, but they are concerned that some of the changes necessary to realize such benefits cannot be achieved without undermining their jurisdiction or their jurisdictional utilities.
Indeed, in places like the Southeast, many would contend that the vertical integration model has served customers well, and regulators are understandably reluctant to dismantle this model or redesign it from top to bottom. On the other hand, consumers should not be denied the benefits of thousands of megawatts of efficient, environmentally friendly merchant generation that already has entered, or soon could enter, commercial operation.
Our MAP proposes neither the sweeping changes of SMD, with its one-dimensional focus on establishing a single market platform centered on the disaggregation of electrical supply into its component parts, nor a continuation of the status quo (see "The Market-Access Plan: A Breakdown," this page).
Co-Existence Requires Change
FERC intended RTOs the means to prohibit a VIU from exercising vertical market power through either denial of the transmission needed to reach wholesale markets, or by otherwise foreclosing those markets from competition by refusing to purchase from merchant generators, even when those generators offer less expensive, reliable energy.
Market foreclosure is a particular concern in areas where a lot of distressed but highly efficient, low-cost merchant power sits idle. No doubt many VIUs do not engage in market foreclosure, and if challenged, readily could claim they were incapable of exercising market power. Membership in a fully functioning RTO should serve the same purpose. In theory, a properly structured RTO, which is independent of market participants, ensures fair and equal access to transmission and administers organized markets from which no seller could be foreclosed. These markets are liquid and provide vital price transparency. By contrast, outside of the three RTOs, there are no organized markets, little price transparency, and usually no structural mechanisms to prevent a VIU from foreclosing merchants from the market, or that would allow a VIU to demonstrate that it could not do so even if it wanted to.
Indeed, in areas where the vast majority of the wholesale market consists of the VIU itself, given its obligation to meet its native-load requirements, the VIU is vulnerable to attack when it refuses to purchase economical wholesale power from merchants. The concern is that the VIU is attempting to use its position as the dominant wholesale buyer in a given market, together with its large fleet of generation assets, and its control of the transmission system to prevent competitive entry. Increasingly, this concern has led to claims that certain VIUs possess and have exercised monopsony power, and that their decisions to dispatch their own more expensive generation, while refusing to purchase from their less expensive competitors, amounts to market foreclosure, harms competition, and ultimately raises costs to customers.
It is at least reasonable, therefore, to conclude that VIUs and state commissions should adopt structural changes that eliminate these concerns. The MAP proposes the structural changes needed to accomplish this in regions where these concerns may be legitimate, with minimum effect on the VIU model overall.
A Partnership That FERC and Regulators Can Embrace
One of the lessons learned from the collapse of the SMD initiative is that making markets work is about saving customers money-not debating the merits of various concepts. The MAP is specifically designed around selected structural changes that recognize the crucial importance of state commissions, and that are technically feasible, cost-effective, and have the greatest potential to save customers money.
Indeed, perhaps the most significant lesson from the SMD experience is that the changes needed to eliminate the most obvious impediments to well-functioning markets require a cooperative effort between FERC and the state commissions. Requiring an all-inclusive economic dispatch protocol or an RFP process for long-term competitive procurement clearly implicates state interests because they are part and parcel of ensuring that retail customers receive the lowest-cost power consistent with reliability requirements. On the other hand, it is equally clear that FERC does have the authority to require a given utility to implement a state-approved economic dispatch or RFP program as structural remedies to prevent possible vertical market foreclosure.
Similarly, equal and fair access to transmission, which is vital to realizing the benefits of well-functioning markets and competitive procurement, requires clear and consistent FERC policies. But FERC should neither undertake a policy nor implement a remedy unless there are very good reasons for its belief that doing so will provide clear benefits to wholesale competition without harming native load customers.
The MAP recognizes this important federal-state partnership. It does not amount to a federal push to impose retail competition in jurisdictions that don't want it and don't see its benefits; and it does not infringe on the authority of state commissions to set rates for bundled retail service. Rather, it builds on the vertical model, relies on state commission involvement, is consistent with continued state retail rate regulation, and keeps its focus precisely where there is no federal-state tension-on simple, understandable, and cost-effective ways to make customers and competition better off.
Moving Forward With a MAP
The MAP combines the best elements of the VIU and merchant models in a cost-effective manner. If adopted, the MAP would improve transmission expansion, add transparency to the procurement process, create access to short- and long-term markets, and provide additional revenue sources to load-serving entities. It also would avoid distracting litigation and costly uncertainty, and, hopefully, get federal and state regulators back to working cooperatively in the consumers' best interests.
Larry Eisenstat is a partner with Dickstein Shapiro Morin & Oshinsky LLP and head of the firm's electric power practice. Pat Alexander and Don Gelinas are energy consultants with Dickstein Shapiro. Eisenstat can be reached at eisenstatL@dsmo.com.
The Market-Access Plan: A Breakdown
How to spread the benefits to all players.
By adopting some straightforward and state-friendly changes that build on existing regulatory structures and frameworks and that are technically feasible, utilities and merchants can offer their customers the greatest potential to save money. The following initiatives strike an appropriate balance of interests.
Create Accessible Short-Term Markets
- Establish a formal mechanism to include merchants in economic dispatch. Seek approval from state regulators to retain a portion of the annual savings.
- Offer parking services in order to mirror day-ahead and real-time market structures. This is an important service for merchants that rely on point-to-point service and must identify a specific delivery location to reserve transmission. The transmission provider would assess a parking fee for this service.
The amount of parking service available would be defined in advance and would not exceed the level that could be provided consistent with reliability requirements.
Often, a merchant wishes to reserve transmission even though it has not yet entered into a sale with a particular customer. Parking would allow a merchant to schedule the first leg of the transaction on a day-ahead basis by designating the transmission provider as its sink. The next day, the merchant can designate the ultimate delivery point once it has entered into a third-party sale. The transmission provider will have "parked" the power by providing the merchant with the load it needs day ahead to reserve transmission while it searches for the best buyer to sell to on a same-day or real-time basis. The transmission provider also would be the default sink and buy the power at, say, 90 percent of its decremental cost if the merchant did not line up a buyer.
- Engage an independent market administrator (IMA) to oversee those processes on a day-to-day basis, and assure regulators and market participants that the structural protocols will prevent the VIU from favoring its own generation.
Create Accessible Long-Term Markets
- Individual VIUs, in separate state proceedings, would establish a formal process to competitively procure all long-term native load supply requirements. The process could include a variety of asset-backed products, including both unit and system sales of various terms. The merchant arm of the transmission provider must bid under the same rules as any other bidder.
- The structure of the RFP, the bid evaluation, and the bid selection should be overseen by the IMA.
- The purchasing utility would be allowed an adder as a substitute for return on rate base for selections that involve power purchases from third parties as though the utility had chosen to satisfy its requirements via plant acquisition or construction.
Establish Equal and Fair Access to Transmission
- The IMA would oversee, process, and administer transmission service requests, including OASIS administration (computation of TTC, ATC, etc.). The IMA would not simply be a monitor but would actually grant or deny service requests. The transmission provider still would perform the actual work required to evaluate and accept or deny a transmission request, but all such efforts would be reviewed and approved by the IMA prior to the customer being notified of the results.
- The IMA would oversee, process, and administer interconnection requests, including system impact studies and facility studies. As with transmission requests, while the IMA ultimately would be responsible for granting an interconnection service request, the transmission provider, if it chose to do so, would be responsible for conducting whatever studies or other activities were required in connection with the request, subject to the IMA's oversight and approval prior to the customer's being notified as to whether interconnection service is available.
- The IMA would review, in real time, the transmission provider's operation of its transmission and generation facilities, including the transmission provider's decisions with respect to line ratings, transmission outages, and generation dispatch, in order to provide assurances that operational decisions were not made to foreclose competition.
- The transmission provider would be required to proceed under the non-rate terms and conditions of its OATT when securing transmission or ancillary services to serve its native-load customers. The processing of all such transmission and ancillary service requests would be subject to the IMA's oversight and approval, as would transmission and ancillary service requests from wholesale customers.
Improve Transmission Expansion
- The IMA and the transmission provider would determine the nature and cost of required network upgrades.
- The cost of upgrades not already included in the transmission provider's base plan (upgrades needed to meet existing firm commitments for the planning horizon) would be directly assigned to the party that requested the service for which such upgrades were necessary without transmission credits. Upgrades required to serve native-load requirements would be "assigned" to the transmission provider and recovered under its retail service tariff. In exchange, the entity directly assigned the cost of the network facilities would receive the financial benefits related to those facilities, such as congestion savings or, possibly, the additional transmission revenues that would not have existed but for the transmission construction.-L.E., P.A., D.G.
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