BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA Order Instituting Rulemaking on the ) Commission's Proposed Policies ) Governing Restructuring California's ) R.94-04-031 Electric Services Industry and ) (Filed April 20, 1994) Reforming Regulation ) ) ) Order Instituting Investigation on ) the Commission's Proposed Policies ) I.94-04-032 Governing Restructuring California's ) Electric Services Industry and ) Reforming Regulation ) ) DIVISION OF RATEPAYER ADVOCATES' COMMENTS ON COMPETITIVE WHOLESALE ELECTRIC MARKETS AND MARKET INSTITUTIONS Attached and incorporated herein by reference are the comments of the Division of Ratepayer Advocates (DRA) on competitive wholesale electric markets and markets institutions, in accordance with the July 8, 1994 Assigned Commissioners' Ruling. Respectfully submitted, /s/ HALLIE YACKNIN Hallie Yacknin Staff Counsel Attorney for the Division of Ratepayer Advocates California Public Utilities Commission 505 Van Ness Avenue San Francisco, CA 94102 July 26, 1994 (415) 703-2195 I.SUMMARY The Division of Ratepayer Advocates (DRA) believes that wholesale competition is a critical component within the restructured electric industry which should be encouraged and supported. Since direct access will not be the choice of all, substantial numbers of consumers will be dependent on wholesale competition. However, the importance of wholesale competition should not limit the opening of direct access. Meaningful choice should be the goal of the restructuring process and that choice should come through direct access, unbundling of rates for those who remain with the utility and availability of a variety of services for the consumers. Wholesale competition is maturing rapidly, and likely offers enormous benefits in both the short and long term. However, wholesale competition is not fully mature and many segments of the wholesale market continues to be dominated by monopoly utilities. Consequently, the Commission should consider the following actions: o First, the Commission should set aggressive performance based rates in order to pressure the utilities to realize the benefits of wholesale competition. o Second, the Commission should mitigate excess market power problems. High utility market share creates a major risk that a less regulated wholesale market will result in oligopolistic results. DRA has recommended prohibiting utilities from the incremental generation market, with the long term goal of de-integrating generation from transmission and distribution. o Third, the Commission should take affirmative steps to deter anticompetitive behavior. The current regulatory framework is inherently flawed. Utility profits primarily accrue from the actions of regulators rather than the satisfaction of customers. It should therefore come as no surprise that utility management appears to be more driven by influencing regulator action than by meeting customer needs. Realistic goals which encompass retail competition should be an effective tool in transforming utility corporate culture to become more attuned to customers. Given the long term payoff from retail competition, broader global issues relating to retail competition should not be used as an excuse to delay expanded wholesale competition. While the Commission needs to consider the implications of long term contracts, mid-term resource procurement (and divestiture) should be geared toward wholesale competition. DRA examines the functions of pools and concludes that a pool does not need to be in place before either expanded wholesale or retail competition can be realized. While the current infrastructure for scheduling transactions and system reliability is not infinitely expandable, limited retail competition should not pose a large burden for the existing system or require expansion of the existing infrastructure. Some have advocated a pool because of the valuable economic functions one could provide. However, many of those functions could also be fulfilled by a futures market. The pool question will probably ripen once the New York Merchantile Exchange electricity contract is in place. Furthermore, a pool right now (or soon) may not be beneficial because a pool dominated by utility generation is subject to price manipulation, similar to that in the UK. II. WHOLESALE MARKETS DRA agrees with many parties that the Commission should aggressively foster wholesale competition in the generation of electricity. However, retail competition does not necessarily have to wait until generation markets are fully competitive at the wholesale level. DRA also recommends that the Commission not preclude retail competition if it decides to focus on enhancing wholesale competition first. The Commission will have to address and resolve many of the same issues regardless of whether competition is limited at the wholesale level or is extended to the retail customers. A. History of Competition While recent developments in the generation and transmission sectors have been promising and impressive, wholesale competition is of relatively recent vintage and scope. The number of participants and the range of services subject to competition is still limited. The history of significant competition is short. To place competition in context, the electric industry has only started to realize the benefits of competition. An optimistic view is realistic: most benefits of wholesale competition lie in the future. The Energy Policy Act of 1992 (EPAct), and the determined implementation of this Congressional act by the Federal Energy Regulatory Commission (FERC) are shaping up as a watershed event in the history of electric competition. A brief survey of significant historical developments indicates why that is the case. The genesis of modern wholesale competition lies within long distance, large transmission lines, which made a bulk power market possible. These in turn relied on significant communication ability in order to maintain synchronized operation of an increasingly far-flung interconnected grid. One of the major western transmission paths, the Pacific Intertie, is less than thirty years old. For many of those thirty years, bulk power competition featured a limited number of participants and unequal conditions. Utilities competed on a limited basis among themselves. In an era of voluntary transmission access, transmission owners clearly dealt from a position of strength. Formation of the Western Systems Power Pool (WSPP) in 1987 has aided in the establishment of a more competitive short term market between utilities. The WSPP is utility-dominated, although other market participants are allowed to join. The WSPP allows a range of generation and transmission services to be sold at market based rates, capped at certain pre-established prices, so long as the transaction is less than one year. For that commerce which does not occur in the WSPP, arrangements made within the WSPP provide reference prices. The WSPP builds on a long history of short term buy-sell arrangements. The short term market is probably the most efficient wholesale electric market segment, although further efficiency improvements are probably possible. The WSPP has also led to the development of some service variations, such as short term recallable power. On a day to day basis, utilities are fairly likely to employ marginal cost principles, and sell at close to their own marginal costs. The willingness of some utilities to make longer term arrangements at rates below embedded cost has been more limited. Utilities essentially own the market for various services. Virtually all, if not all, load-following generation is provided from the utility-owned portfolio. Even interutility contracts which provide for energy to be scheduled typically allow changes no more frequently than hourly. In contrast, Norway has an "instant" market for load following. The Public Utilities Regulatory Policy Act (PURPA) was a crucial, but limited step in breaking the utility monopoly. Utilities were required to purchase competing resources at the utilities' avoided cost. This led to the rapid development of the independent power industry. However, for many years, PURPA implementation was not particularly competitive. The independent power production was in its developmental stage. There was no competition among independents in the sense that prices were based on utilities' full avoided cost. Only recently, the Commission has developed procedures through its Biennial Resource Planning Update (BRPU) to procure power through bidding by independent power producers competing with one another. This competition is still limited in the sense that bulk of the total power generation that comes from utilities' existing power plants does not face competition from non-utility power suppliers. The BRPU solicitation indisputably represented a significant advance in generation procurement in California. It accommodated transmission costs, provided a set of rules for transmission access, and provided significant information on transmission planning and costs. It included environmental considerations. It included early termination of long term contracts. Front- loaded capital recovery was largely eliminated. The prices for large cogeneration projects were strikingly low. In addition, competition from independents was limited to must-take, typically baseload generation. Competition for peaking and intermediate power occurred between utilities. For many reasons, the competition from independents has been of a different type than between utilities. One primary reason is that utilities own a portfolio of generating resources served by a transmission system, and independents do not. Utility offers to each other are often for system power backed by all of a utility's generation resources. Independent offers are almost always of a particular generating unit. Since system sales spread outage risk over more units, system sales are generally regarded as more reliable that unit sales. With consolidation in the independent power industry and improved transmission access, independents will likely offer portfolio-based arrangements in the future. The important role of project finance should not be overlooked in reviewing the emergence of the independent power industry. Standard offer contracts, particularly Interim Standard Offer 4 contracts, contained several features that financed the industry. Capacity payments were levelized. Capacity payments were front- loaded, although not as front-loaded as utility ratebase recovery. Take and pay contracts between the monopoly utility and the independent producer provided a strong guarantee of cash flow from the utility, essentially allowing many independent projects to borrow the utility's financial strength. Individual projects could then borrow large amounts based on that cash flow, and provide very little equity. These project finance conditions will not be present in the wholesale generation market since it will be influenced by the retail competitive market of the future. Monopoly utility market share will not be virtually guaranteed under retail competition. Project developers' ability to borrow money will be reduced. The guarantee of utility cash flow is worth less now. Increased competition reduces the profitability of independent projects. The ability to raise money will play a more significant role in the independent industry. Consequently, there are likely to be fewer, but better financed, industry participants. The new borrowers of utility financial strength appear to be utility affiliates and subsidiaries, rather than independent projects. Only recently has more extensive competition started to occur. First, competitive solicitations were held for power in other states. California municipals have also held competitive solicitations. The long-awaited solicitation in California for the investor-owned utilities finally started in 1993, and will likely be completed in 1995. To summarize, while generation competition has recently made significant advances, only some providers and some types of generation have been subject to significant competition. Even though California utilities currently purchase a significant amount of power from independent power producers, the largest competitors in the power generation market -- the utilities -- are not competing on the same terms yet as other competitors in the market. The competition is limited to the independents or QFs. Existing power contracts between California utilities and QFs are based on utilities' avoided costs. Thus these contracts reflect a market in which price for all competitors is based on the costs of one big competitor -- the utility. The new QF contracts in California are based on a market model in which price is determined by competition only among the independent power producers. Both of these market models insulate the utilities from competition as far as their existing power generation assets are concerned. The revenue that the utilities are authorized for power production from existing plants is based on the utilities' cost of production. Under current regulation, the utilities are allowed to collect a higher price for power if their costs are higher than the competitive price paid to independent power producers. The most common argument in defense of this market system is that the past high cost investments by utilities reflect decisions made in an era with different conditions and different rules and regulations and that it is not fair to change market rules related to existing assets. Opponents argue that a large part of the high costs of some of utilities' existing generating plants may be due to over protection from competition. The regulations so far have given utilities a guaranteed share of the market regardless of whether their costs are competitive or not. DRA is concerned that as long as there is this dichotomy between contracts for existing power and new power, the benefits of competition will not be fully realized. The Commission should explore ways (such as direct access) in which the utilities will compete head to head with other competitors. The Commission must make this transition very thoughtfully. Even though a large potential of independent power exists, the fact remains that with their large asset base of generating power, the utilities could dominate the market for years. Utilities' ability to dominate the market will be especially significant as long as they are vertically integrated and have control over transmission systems. Their ability to cross-subsidize competitive activities with the regulated part of the business would give utilities further advantage over competitors. This is an important reason why DRA recommends that wholesale competition not be an end point in the restructuring process. It is likely that true competition will not occur until utilities have divested of their existing generating assets and the market has a large number of suppliers all competing on an even footing. Whether the utilities divest or not, the key issue is market power. The Commission will have to be watchful of how the market shapes itself. Domination of the market through consolidation of utility or non-utility interests could hamper competition and jeopardize provision of reasonably priced and reliable power. The Commission must have a continuing monitoring and surveillance role to ensure power generation markets are indeed competitive over time. B The Commission Should Deter Anticompetitive Acts As DRA mentioned in its June 8, 1994 comments, the Commission must examine and, if necessary, mitigate the anticompetitive impacts of allowing the utilities to continue as both buyers and sellers, and potentially expand their monopoly power, under the new regulatory regimen. In the comments to date, there have been relatively few words that address prevention of anticompetitive acts. DRA has recommended structural solutions, such as prohibiting the utilities from participating in incremental generation with a long term goal of divestiture, in order to mitigate market power. Mitigating market power helps control one of the conditions which facilitate anticompetitive acts. So long as utilities have dominant market positions, the Commission should signal strongly and unequivocally that it will not merely correct abusive acts, but punish them. Utilities should be convinced that the benefits of anticompetitive acts are not worth the costs, and that such acts will be found out and prosecuted. There are many actions the Commission can take to deter anti- competitive acts. First, the Commission's policy statements on consumer protection can and should include policies to avoid anticompetitive behavior. Competitors do not need to be protected from the consequences of their business decisions, but do need to be protected from acts calculated to favor the utility over its competitors. Second, the Commission should adopt a policy statement that anticompetitive behavior will be punished. The Commission can provide a forum to grant swift injunctive relief to aggrieved competitors. The Commission can also remove some of the disincentives to reporting anticompetitive acts to it. Competitors may see the risks of coming to the Commission as considerable, and the benefits as few. Utilities may be able to couch anticompetitive acts as attempting to get more for ratepayers, by charging an above-cost rate for a monopoly service for example. The Commission will likely be perceived as having little interest in pursuing such acts. Power marketers and independent power producers face the risk of harsh treatment in other business dealings should their reports of competitive abuse to the Commission get back to the utility. The Commission can allow competitors to focus on business, by assuming some of the legal burden of enforcing its policy. Thorough enforcement of the law can persuade competitors that reporting anticompetitive acts to the Commission is worthwhile. Utilities have the resources for lengthy litigation. The Commission can equalize the playing field by assuming legal enforcement for reasonably demonstrated anticompetitive acts. This enforcement should focus both on future prevention and on making the competitor whole. The Commission may also need to work with the Attorney General's office and district attorneys' offices. III. MARKET INSTITUTIONS Access to transmission and the transmission of the power are the critical links between the generator and end user. Discussion of market institutions, therefore, focuses on transmission infrastructure and control of the system. The passage of EPAct has clearly lead to significant improvements in transmission access and availability of transmission information. FERC has undertaken a broad range of policies intended to aggressively implement the competitive provisions of EPAct. These policies include guidelines for good faith transmission access requests and responses, a policy statement on regional transmission associations, a rulemaking on transmission pricing, transmission information filing requirements, and some individual decisions requiring that network service be made available. Furthermore, FERC has recently enunciated a general policy concept of "comparability" in transmission service. While much of the implementation lies ahead, comparability means that third parties are entitled to the same level of quality of service as a utility provides to its native load customers. Despite this impressive progress, much work remains. Transmission providers have up to 60 days to respond to transmission requests. This can preclude short term transactions. Few utilities have filed open access transmission tariffs. The availability of network service rates is very limited. No regional transmission group bylaws have yet been approved by FERC. Comparability is still a concept. The WSPP provides many attributes of a spot market. The emergence of a spot market was an important development for competition in the natural gas industry. Unlike the gas industry, there is still no futures market. The New York Mercantile Exchange electricity futures contract is still at the planning stage. This absence of a functioning futures market has important consequences for wholesale electric competition. The wholesale market is not highly liquid. Hence, transaction costs are relatively high. Bid-ask spreads are also likely to be relatively large. Narrower spreads increase efficiency. The futures market can also provide an essential building block for a variety of services and service packages. Without a futures contract, service packaging appears to require the skills of power marketers. Power marketers have emerged only in the wake of EPAct. While dozens of marketers have received FERC authority, this industry sector's market share is miniscule. Nevertheless, some marketers have already succeeded in providing low cost power, and are likely to be a source of market innovation. DRA believes that role will significantly expand. A. The Pool The looming question for the Commission is the pool: Whether one is needed, what its functions would be, what the timing is to establish one, who establishes it, etc. These questions can be seen in the light of who controls the restructured market. Will competition be the dominant force or will the utilities continue to dominate? DRA maintains that lowering rates is what should drive the restructuring. Meaningful choice between direct access or specific rates or services from a utility is a means to lower rates. There is general agreement that some kind of centralized coordination will be required as the number of transactions increases exponentially. However, while a pool is probably inevitable at some future juncture, DRA does not believe it is a necessary prerequisite to initiating direct competition. Those who limit their discussions to the development of a competitive wholesale market perhaps with a comprehensive pool structure are being distracted from the main discussion of consumer choice. DRA agrees that "...the retail wheeling prohibition is a monopolistic device that grants strong market power to utilities and thus inhibits competition." (Charles M. Studness. "Investors and the Financial Risks of Utility Competition" Fortnightly, January 15, 1994.) Pool functions There have been many opinions and few facts regarding formation of a pool. DRA submits that there is no common understanding of what functions a pool would perform. DRA enumerates functions which have been identified for a pool below. As a general note, the term "pool" encompasses a number of functions, ranging from system operation to purely economic functions. Since most pool functions involve the price of conducting some element of system operations, most functions fall in between pure operations and pure economics. Many of those who question the value of a pool question the economic functions. Pool critics are often silent on the subject of how reliable operation and instantaneous load balancing would occur given vastly more parties scheduling transactions. In fact, pool functions range from those which predominately relate to system operation to those which predominately concern economic functions. The following list of pool functions also identifies some of the pools which currently perform such functions. 1. Assure reliable system operation: Pools may operate to coordinate real time operation of generation and transmission resources. Such operations may include switching on capacitors and use of automatic generation control to instantaneously follow load. 2. Transaction scheduling: This involves coordination of receipts and deliveries, and the allocation of service when too many parties want to use transmission resources. The transaction scheduler would determine whose transmission line use would be curtailed and by how much if too much power is scheduled over a line. Currently, most transaction scheduling is performed on an hourly basis. Transaction scheduling may go beyond simple scheduling, to perform uneconomic dispatch of its own system to relieve a transmission constraint, and recover those costs through a transmission rate. 3. Centralized dispatch: The New England Power Pool centralizes dispatch, so that all generation and transmission resources are operated on a unified basis in an attempt to operate at least cost. Arrangements may involve lengthy specification such as an obligation to provide a given amount of capacity to peak load. The UK Pool also attempts to operate on least cost; however, suppliers are free to change their offer price under the UK pool. 4. Purchase ancillary services: Ancillary services refers to services other than generation capacity, energy, and the wheeling of power. The UK pool purchases ancillary services including reactive power, frequency control, transmission constraints, and load following via an "uplift" charge. Generation has at least two basic components: a continuous rate of delivery, and load following, which is the ability to vary that continuous rate of delivery in order to meet real time changes in customers' loads. The uplift also covers certain extra generation charges related to the provision of capacity and energy, such as reserve margin, and unexpected payments to generators for events like a forced outage. 5. Provide a centralized repository for pricing information: The Western Systems Power Pool and the Mid America Power Pool provide bulletin boards, from which parties may reach bilateral arrangements. Utilities and other parties may (but need not) list prices for services they wish to offer. 6. Take title to power: In addition to scheduling power, the UK pool goes beyond any pooling arrangements in California by taking title and physical possession of the power. Hence, the pool both buys and sells power. The act of taking title results in changing (and possibly mitigating) supply risk. Purchasers may regard different suppliers as presenting risks of non- performance. The pool combines many suppliers into one supply, and thus presumably has a lower risk of non-performance. 7. Set load following prices: Norway has an instant market to instantly match load and demand. Note also that the UK Pool deals with this by purchasing load following. 8. Set short term prices: The UK Pool establishes a short term market clearing price by matching the intersection point of the supplier demand curve and the amount of customer load. The result is the merit dispatch order. While the merit dispatch order is established in advance, the pool price associated with that dispatch order is not final. The pool price is trued up to reflect actual demand, forced outages, transmission constraints and unforeseen events. This trued up pool price is based on a second price auction, which means that every supplier will at least receive their bid price. The Norway Pool also sets a market clearing price. However, this price is based on both supply and demand curves. Furthermore, both suppliers and consumers are obligated to supply or consume. 9. Set long term prices: Norway also offers a futures market using standard contracts on a weekly basis for up to five years ahead. 10. Establish reference prices: UK and Norway pools also act to establish reference prices. While relatively little commerce occurs at pool prices, those pool prices have significant influence on bilateral contractual arrangements outside the pool. 11. Financial instruments: The UK pool offers two different financial instruments, contracts for differences and energy forward agreements, both of which are derived from pricing relationships between the financial instrument price and a reference price, such as the spot market price. These financial instruments involve an exchange of price risk, which is sometimes referred to as a "swap" or a "hedge." Contracts for differences cover differences in prices, so that one party pays another for the difference between the contract price and the actual pool price. Forward agreements are very similar in concept, but seem to differ in terms of allowing customized exchanges of price risk. 12. Substitute for all bilateral agreements: Edison's POOLCO proposal suggests replacing the existing bilateral contract regime with an entirely new mechanism, based on a broad pool in which participation is mandatory. This is in sharp contrast to the UK and Norway pools where over 80 percent of transactions are outside the pool. How Are Market Institutions Established? As the Commission examines the question of whether a pool is necessary for wholesale competition and the role that the Commission should play, analysis of the functions and who can efficiently provide them becomes important. The Commission has the advantage of not having to start from scratch to create a pool where none exists. In fact, some of the functions listed above are currently being provided by WSPP, most especially the setting of a price for short-term markets. Rather than creating a new infrastructure, the Commission should look to encourage and empower the evolution of the existing infrastructure to respond to the changing needs of the changing market. Pools provide price guidance in the bilateral market and an instant market to guarantee system balance and system reliability. The WSPP bulletin board provides a potential for the electric power information clearinghouse that DRA advocated in our earlier comments. The WSPP bulletin board could be expanded to provide a range of reference prices similar to what may generated through a pool. The emergence of contingency contracts, derivative markets, and electricity brokers who arbitrage the cost difference between loads could potentially restore many of the benefits of a diverse load in the absence of a pool. The existing markets seem able to handle the non-trivial amount of power volumes moving through the system. PG&E has stated that "currently 400 independent generators are connected to PG&E's grid, dwarfing in number the about 100 PG&E-owned generators." (Comments of Pacific Gas and Electric Company on Restructuring of the Electric Supply Industry Before the United States House Subcommittee on Energy and Power, July 13, 1994.) DRA recommends that the Commission not mandate a power pool, but instead encourage the existing infrastructure to expand to meet the needs of the changing markets. Industry is in the best position to adapt existing processes or organizations to assist more active markets: the California Power Pool and the WSPP were organized and developed through industry efforts; the Western Regional Transmission Group (WRTA) was organized through concentrated industry effort. As those organizations mature and begin to deal with the day-to-day problems of multiple generators serving multiple end-users, the Commission can play a role in ensuring that all have fair access to the market. However, the Commission should step aside to allow the flexibility of the infrastructure to develop without prescribing specific efforts or roles. We had experience prescribing a competitive market action through the BRPU and found that the market developed more quickly than the regulatory process. We should learn from that experience and the Commission should play a policy role and consumer surveillance role rather than a prescriptive, defining role of market interventionist. B. Sequencing of Competitive Markets In order to accomplish the goal of lower rates for all consumers, the benefits of competition must flow to all consumers. DRA recommends that the Commission move along parallel tracks for both wholesale and retail competition since many of the mechanisms are similar. Unbundling rates will benefit both wholesale and retail markets; development of packages of services should help both wholesale and retail; a clearinghouse of information, although primarily for retail customers, could also provide a benchmark for wholesale competition. As DRA recommended in its June 8, 1994 comments, as the Commission moves the industry toward an openly competitive future, it should choose an implementation strategy that maximizes the benefits of wholesale competition for all consumers. To that end, competitive procurement by the utility from a competitive wholesale market, optional real-time pricing or broadly-based time-of-use pricing, and unbundling of services to expand customer choice and an aggressive performance-based ratemaking system to encourage efficiency, are all important steps along the path to lowering rates through competition. The sequencing of potential actions by the Commission should be dictated by those actions which reduce rates the most. DRA recommends: 1. A performance-based ratemaking mechanism which directly and proximately affects rates and forces utilities to realize potential of competition. 2. Unbundling as a necessary step to both wholesale and retail maturation. 3. Invest in and prepare for the future by allowing direct access at the same time that wholesale competition is strengthened. CERTIFICATE OF SERVICE I hereby certify that I have this day served the foregoing document upon all known parties of record in this proceeding by mailing by first-class mail a copy thereof properly addressed to each such party. Dated at San Francisco, California this 26th day of July, 1994. /s/ JOANNE COXUM Joanne Coxum CERTIFICATE OF SERVICE I hereby certify that I have this day served the foregoing document upon all known parties of record in this proceeding by mailing by first-class mail a copy thereof properly addressed to each such party. Dated at San Francisco, California this 26th day of July, 1994. Joanne Coxum