BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA __________________________________________ ) Order Instituting Rulemaking on the ) Commission's Proposed Policies ) Governing Restructuring California's ) Electric Services Industry and ) R.94-04-031 Reforming Regulation ) __________________________________________) ) Order Instituting Investigation on ) the Commission's Proposed Policies ) Governing Restructuring California's ) Electric Services Industry and ) I.94-04-032 Reforming Regulation ) __________________________________________) COMMENTS OF THE ENVIRONMENTAL DEFENSE FUND ON MARKET INSTITUTIONS IN THE RESTRUCTURED ELECTRIC INDUSTRY DANIEL KIRSHNER, SENIOR ECONOMIC ANALYST JOHN W. KRAUTKRAEMER, SENIOR ATTORNEY THOMAS J. GRAFF, SENIOR ATTORNEY 5655 College Avenue, Suite 304 Oakland, CA 94618 510/658-8008 July 26, 1994 The Environmental Defense Fund supports restructuring to increase competition in the electric services industry. EDF also supports the creation of an independent "pool" entity, but does not consider this either necessary or sufficient for a properly competitive industry. Is an independent pool necessary? No, but it may be very helpful. As discussed further below, a bilateral-contract approach to direct access will still leave thorny pricing issues, such as backup rates, and what direct access customers need to pay for system services such as local reliability, voltage support, and so forth. Presumably these issues can be resolved, but an independent pool may make it easier to do so. Is an independent pool sufficient? No. The efficiencies engendered by competition will benefit customers fully only when generators face the right price signals -- that is, they live or die on the basis of the value of their product -- and customers likewise see these same prices for the product they buy. As explained below, wholesale competition and performance-based regulation alone won't accomplish this. Two things are required: (1) direct access -- or its functional equivalent in transparent pool-based rates and "contracts for differences;" and (2) the provision of competitively-determined energy/capacity rates to all customers. While the achievement of these requirements can be aided by institutional restructuring -- creation of an independent "pool" entity, and separation of competitive generation from still-regulated transmission and distribution -- reforms should proceed expeditiously through available steps. We do not need to await the creation of a region-wide pool -- separate "service-area" pools formed as descendants of the current utility dispatch functions would be a worthwhile step in any case. Similarly, separate regulation of generation is a worthwhile step whether or not utility divestiture of generation takes place. Finally, it should be clear that regulation of transmission and distribution is a separate issue from the existence of competitive generation. Thus, issues of whether demand-side management is preserved with the distribution function, and whether the profits related to the distribution function are re-coupled to kilowatt-hour sales or remain independent of sales levels are also quite separate from competitive generation markets. Thus, EDF reiterates its earlier comments urging the Commission to not re-couple profits and kilowatt-hour sales for monopoly entities, and that the Commission reaffirm its intent to maintain cost-effective energy efficiency programs. I. The "Pool" is Not Necessary -- But it May Be Very Helpful The myth of retail wheeling has been that a customer could simply throw out its old utility relationship and start afresh, as if it were switching to a newly-created utility. Clearly this is not what is going to happen. The direct access customer will still need to pay for distribution services, and for transmission. And the customer will be responsible for some share of current "sunk" costs. Would-be direct access customers will also be faced with other cost issues. Principal among these will be a charge for "backup service:" what the direct access customer will pay for electricity in the event that their generation source is unable to provide power. Remaining "utility service" customers will also be concerned that direct access customers pay their appropriate share of "system services" such as local reliability requirements, voltage support, and so forth. How will would-be direct access customers negotiate these cost issues? Obviously they will be in an adversarial relation with their (would-be former) utility. It seems highly likely, if not inevitable, that these issues would have to be litigated before the Commission. This all could be a formidable hurdle to the introduction of competition to the electric services industry. The "pool," as created in the United Kingdom system, is an independent entity charged with setting generation- and transmission-related rates in a fair and transparent manner. While the direct access model outlined above tends in the same direction -- towards defining fair and transparent rates -- such rate setting probably will be easier to achieve if a new entity that is independent of current generation and customer interests -- such as the "pool" -- is in charge of the negotiations. There are also considerable issues associated with transmission access as well as rates. Again, an independent entity would be some insurance against anti-competitive behavior by the owners of these monopoly assets. II. Competitive Wholesale Markets are Not Sufficient for a Properly Competitive Electric Services Industry As mentioned above, existing wholesale markets can function best if there is insurance against anti-competitive behavior by transmission line owners. But several additional steps are necessary to realize the goal of a competitively-based electric generation sector. In such a competitive industry, resource decisions and investments will be driven by private sector bets on the value and risks of producing electricity by various means. Further, all customers will be free to purchase electricity at market- determined prices, or make their own bets with regard to alternative suppliers. Wholesale markets by themselves -- even when combined with performance-based regulation (PBR) -- do not accomplish this. Why don't wholesale markets and PBR properly provide the benefits of competition to all customers? First, PBR may not provide proper incentives to utilities. So far, PBR proposals have retained the pass-through of fuel costs and the exclusion of various factors "outside the utilities control" (termed "z-factors"). Significantly, factors "outside the utilities control" are deemed to include potential environmental costs. Thus, utilities would not bear all of the risks and benefits of their resource decisions under these proposals. Second, PBR in its very design does not provide all of the potential benefits of competition to customers. In short, PBR sets rate or cost targets for utilities. These targets are currently proposed to be a cost increase somewhat less than general inflation. If costs are less than the target, then the utility profits. If costs are greater than the target, then the utility loses. Thus, while there is the possibility that the utility will face the correct incentives under correctly-designed PBR, there are clearly cases where such regulation is much less favorable to customers than a competitive market result. For example, what if new generation technologies lead to unexpected decreases in electricity costs? Competitively determined prices would drop accordingly. Prices under the PBR targets would remain unchanged: profits would accrue to the utilities. Further, under the Commission's current proposal (as contained in the April 20 Order), it is simply the smaller customers who are excluded from the potential benefits of competition the longest. Large customers -- and, as just explained, the utilities themselves -- would reap the gains. Third, there is the question whether wholesale competition that retains the current utility resource decision-making role really offers a significant degree of competition among buyers of electricity. If there are customers who want to bet on one resource or another, why shouldn't they be able to? Retail competition -- or its functional equivalent in transparent pool- based rates and "contracts for differences" -- does allow this additional degree of competition, provided that decision-makers give proper consideration to the costs of their resource choices. EDF reiterates its previous comments that the production of electricity involves still-uninternalized costs ("externalities"). An integral component of increasing efficiency through competition must be finding ways of properly including all costs (internal and external) in resource decisions. There is an additional step that will help insure that all customers benefit from competition: competitively-determined prices for generation should be provided to all customers. The "pool" model, in which system-wide energy and capacity rates are shown separately ("unbundled") on customer bills may be the most convenient way to accomplish this, although such unbundling can be accomplished by other means, of course. In fact, these requirements -- transparent pool-based rates, and the provision of these competitively determined generation rates to all customers -- imply something other than PBR for generation. The separate regulation of generation (as opposed to transmission and distribution functions) makes the regulatory treatment of generation quite simple: generators should be paid for the value of their product, period. III. Moving Forward With Available Reforms As discussed above, there are institutional reforms-- creation of an independent "pool" entity, and separation of competitive generation from still-regulated transmission and distribution -- that would assist the regulatory reform of the electric services industry. But electric service restructuring does not have to be held hostage to "perfect" institutional settings. Instead, reforms can proceed expeditiously through available, incremental improvements in institutional arrangements. For example, in the area of the "pool," the ideal institution would be an independent entity that covered the entire western grid (including portions of Canada and Mexico). This ideal seems unlikely to be realized in any of our lifetimes. On the other hand, more modest steps towards this end seem achievable. Both San Diego Gas and Electric and Southern California Edison have expressed willingness to explore the "pool" concept. Rather than entering into jurisdictional battles with the Federal Energy Regulatory Commission, or requiring negotiations with other stakeholders such as municipal utilities, a reasonable first step might be to create new pool entities as descendants of the current utility dispatch functions. Such "service-area" pool entities would be a worthwhile first step in any case. Similarly, separate regulation of generation is a worthwhile step whether or not utility divestiture of generation takes place. In the same vein -- of keeping our eyes on simple reforms -- EDF thinks that there is a growing mis-impression that direct access or its functional equivalent requires that time-of-day meters be available to all potential direct access customers. Certainly Professor Hogan did not say such a thing. In fact, a group of customers can have direct access to an alternative provider without requiring time-of-day metering for every customer in the group, provided that there was agreement with regard to the load characteristics of the group (just as load research currently is used to determine the characteristics of rate classes). In reviewing the comments to date of various parties, it appears there may be broad support for some of these available reforms -- especially with regard to the creation of independent pool entities. It is possible for a workable consensus to emerge on such an issue. EDF supports a consensus-based approach to find a way to implement such available reforms. The Commission should support and endorse the efforts of the parties to reach agreement on these issues. IV. Consider Separate Issues Separately Finally, unnecessary hurdles placed in the way of restructuring can also be avoided if one is careful not to intermingle what should be separate issues. For example, it should be clear that regulation of transmission and distribution -- each of which will remain a natural monopoly -- is a separate issue from the existence of competitive generation. Thus, EDF agrees that regulation of generation must be significantly reformed to be consistent with a competitive market in generation. Old regulatory constructs such as ECAC and ERAM must be completely reexamined with respect to generation. On the other hand, given that regulation of transmission and distribution functions has a different rationale, there is no a priori reason that such regulation should seek to re-link profits in these sectors to kilowatt-hour sales. This is an issue that should be considered separately from the de-regulation of generation. EDF again urges the Commission to retain the de-coupling of profits and sales in the transmission and distribution sectors. To do otherwise would again give these monopoly service providers an incentive to exploit their monopoly position by promoting uneconomic increases in sales. Similarly, the rationale for demand-side management -- overcoming the lack of information among many consumers and overcoming other barriers to cost-effective energy efficiency investments -- is largely independent of the creation of a competitive generation market. In fact, current demand-side management functions fit neatly into the regulated distribution function that could be a descendant of current utility structures. Demand-side management might be a better fit with a distribution-only company, since there would then not be a potential internal conflict between selling and saving electricity. EDF's point is simple -- there is no necessary conflict between continued investment in demand-side energy efficiency and full and vigorous competition in supply-side energy and capacity. Again, this is not to say that DSM programs cannot themselves be made more efficient and competitive. But EDF believes that proper review of the evidence will prove that energy- efficiency investments have been highly worthwhile. The Commission should reaffirm its support for effective energy efficiency. Respectfully submitted, Environmental Defense Fund By: _________________________ Daniel Kirshner John W. Krautkraemer Thomas J. Graff