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 ) Reforming Regulation ) ) ) Order Instituting Investigation on ) the Commission's Proposed Policies ) Governing Restructuring California's) I.94-04-032 Electric Services Industry and ) Reforming Regulation ) ) COMMENTS OF THE FEDERAL EXECUTIVE AGENCIES (Third Round) NORMAN J. FURUTA, Associate Counsel Western Division Naval Facilities Engineering Command 900 Commodore Drive San Bruno, California 94066-2402 (415) 244-2103 July 26, 1994 COMMENTS OF THE FEDERAL EXECUTIVE AGENCIES (Third Round) I. BACKGROUND AND INTRODUCTION On April 20, 1994 the Commission issued its landmark Order Instituting Rulemaking and Order Instituting Investigation in R.94-04-031/I.94-04-032 (Blue Book Proposal). Pursuant to the assigned Commissioners' Ruling dated July 8, 1994 (Ruling) the Secretary of Defense hereby files these third round comments on behalf of the consumer interests of the Department of Defense and other Federal Executive Agencies (FEA). The comments were prepared only from FEA's perspective as a consumer of large quantities of electric energy. Contemporaneous with this submission, the Department of Energy is filing its own comments which FEA supports. As the Ruling notes,1 some parties who participated in the initial comment rounds argued that competitive wholesale markets must be developed before the industry can move to direct access; while other parties argued that the Commission should limit its restructuring to the development of a competitive wholesale market, forgetting about the concept of direct retail access. the resolution of this key issue will have far reaching implications for not only the direction of the Commission's 1Ruling at Page 2. - 1 - effort, but the ultimate success of its goal of bringing customer choice and lower rates to all California electric consumers. These comments respond to the Commission's interest in the role of the wholesale market in a restructured electric industry. In some cases, the distinction between wholesale and retail is solely a matter of regulatory jurisdiction rather than market reality. As long as electric utilities serve an intermediary function and have the sole responsibility for developing and purchasing power supplies for sale to ultimate customers, market signals can be obscured and distorted. Markets will be most efficient when the consumer of power, such as the FEA, can deal in a competitive market and fashion a transaction that best meets its specific requirements. II. SPECIFIC COMMENTS A. Necessity of a Wholesale Electric Market for Retail Access The term "wholesale" as conventionally used in the electric utility industry, means a purchase of power by one entity for resale to others. For example, if Southern California Edison Company (Edison) purchases electricity from a qualifying facility (QF) and/or other sources, and that power is combined with power generated by Edison and then resold to customers under Edison's Commission-regulated tariff, that purchase would be - 2 - characterized as wholesale.2 This distinction between wholesale and retail has historical significance, and is useful in describing some of the jurisdictional issues in the current debates about open access, but the possibility of competitive sourcing by means of direct access requires a broader view. The terms "wholesale" and "retail" traditionally have applied to two easily distinguishable kinds of transaction. For example, under the Blue Book Proposal, customers of the California utilities who elect not to secure their own electric supplies in the market, but instead continue to rely upon their franchised utilities for such service (utility service customers) clearly will be making what have been traditionally called retail purchases. Similarly, to the extent that the electric utilities acquire a portion of the electricity required to serve this load by purchasing the power from other suppliers, a traditional wholesale transaction clearly will have taken place. In contrast, customers who elect to secure their electricity supply in the competitive generation market (direct access customers) will be making a purchase for use at retail, even though the power may be supplied by the same source from which Edison purchased power in a wholesale transaction. The point of this discussion is to draw the distinction between the market in which a transaction takes place, and the 2In addition, some power is sold by Edison to municipalities at wholesale, who in turn resell to their customers. - 3 - nature of the transaction. Both "wholesale" and "retail" purchases can be made from the same sources. The same power sources can potentially be used in a wholesale transaction, a retail transaction, or a combination. It is more useful and more important to focus on the nature of the market, and the degree of competition which exists in that market, than it is to dwell upon such artificial descriptions as wholesale market or retail market. What is critical is the development of a competitive market, wherein many purchasers can choose to purchase from among many sellers. To be sure, this market has primarily developed to date on the basis of wholesale transactions, and likely will continue to do so for some time, primarily because there has heretofore been no opportunity for end-use customers to competitively source their power needs. The markets can most easily be expanded, and their competitiveness increased, by focusing first on wholesale transactions, simply because the existing institutional structure facilitates that approach. A competitive market in which wholesale transactions can occur is highly desirable for all electricity consumers. More competition at the wholesale level will contribute to the reduction of the prices paid by the utility company. This reduction in its cost of purchased power would result in reduced charges to its service customers. For this reason, if some - 4 - consumers, eligible for direct access, elect to remain as utility service customers and rely upon the utility to procure the power supplies necessary to serve their loads, these consumers will benefit from wholesale competition. A competitive market, of course, is desirable for direct access consumers who will benefit immediately through their own purchases. If sufficient competition develops, this Commission may be able to lighten its regulation of the utilities' development of power supply resources. Until it does, however, regulation must continue, although its parameters may need to be changed. FEA fully expects that markets will evolve naturally, without undue regulatory interference. For example, trading in the Western Systems Power Pool (WSPP) will likely increase as players become increasingly aware of the need to develop skills and techniques in buying and selling resources competitively and as more buyers and sellers understand that open access and competition are a reality. In addition, it is fully expected that Regional Transmission Groups (RTG) will form and develop protocols and procedures that further expand the use of the transmission system and thereby increase the competitiveness of the market. The recent filing with the Federal Energy Regulatory Commission (FERC) of the proposed Western Regional Transmission Association (WRTA) governing agreement is indicative of the interests of investor-owned electric utilities, municipal - 5 - utilities and independent power producers (IPP) in developing a more robust market. Although the market may initially develop and mature on the basis of expanded transactions that are now conducted on a wholesale for resale basis, the pricing techniques and procedures are transferable to transactions between large end-use customers and power suppliers; and indeed may use the same infrastructure. The greater the degree of competition at this supply level, the greater the ultimate success of the direct access market. B. Sufficiency of A Developed Wholesale Market in Meeting the Commission's Objectives The primary objective set forth by the Commission in the Blue Book is a reduction in the price of electric service to all California electric customers. Development of a market in which only wholesale transactions take place competitively, will not maximize the benefits of the Commission's proposed reforms. A competitive wholesale market alone means that choice exists only when a monopoly utility purchases power from another utility, QF, IPP, etc. for resale; not when an end-use customer purchases power. While, as noted above, it is important for the wholesale market to become more competitive, limiting the competition strictly to sales to electric utilities may not fully achieve the Commission's goals. Competition among suppliers at the wholesale level is, - 6 - of course, desirable as it introduces additional choices and options, and puts downward pressure on the prices of electricity. However, if direct retail transactions are precluded, then the only degree of competition which exists is at this wholesale for resale level, where utilities with monopoly service territories are choosing among different suppliers. Preventing the utilities from passing through the cost of uneconomic or imprudent purchases to their captive customers who have little or no say in what the utility purchases, necessitates reasonableness reviews which result in having to maintain an expensive and burdensome regulatory structure. The entire concept behind increased competition is to bring to bear market forces by allowing a multitude of potential suppliers to compete for the right to sell their services to the end-use customers. Competitive markets produce efficient results because of the interaction of multiple buyers and sellers under circumstances where no individual buyer or seller possesses enough power to dominate the market. Choice by virtue of direct access will produce these efficiencies provided a truly competitive market is allowed to exist. In such a truly competitive market, multiple suppliers will apply their ingenuity in developing and packaging services and pricing designed to meet the needs of the various customers in the market. If a supplier is inefficient or otherwise non- responsive, the customer may choose another supplier, and the - 7 - inefficient and/or apathetic supplier will either modify its behavior and services or will go out of business. Another reason why direct access is beneficial and will bring efficiencies is that it permits individual customer requirements to be recognized. When a utility is responsible for the acquisition of all resources needed to meet the requirements of all customers within its service territory, it must necessarily develop its strategy based on a consideration of customers in the aggregate, and plan in accordance with a level of risk and with a view toward a level of reliability that is consistent with the aggregate needs of its customers. Not all utility customers have the same degree of risk- aversion. Utilities must plan for all customers on an aggregate basis which is, intrinsically, inefficient. When individual customers that have risk/reliability preferences different from the aggregate are permitted to contract separately and directly for their requirements, choosing from a variety of interested suppliers, the potential exists for a more efficient employment of resources and lower overall costs, since the unique requirements of the individual customers are matched with willing suppliers who are able to meet such individualized needs. As an example, a large industrial customer may want to contract for power supplies only over a five-year horizon, and be willing to assume the market-related risks associated with future - 8 - supply replacement or contract renewal. In contrast, a utility intending to supply its service territory would typically assume that the load of the industrial customer will be present over the entirety of the planning horizon (often 20 years or more) and plan to secure a long-term source of supply (perhaps by construction of its own facility or by execution of a long-term power purchase agreement) to serve its entire load, of which the industrial load in question is an undistinguished component. As a result, the utility may both pay too much for its supplies, and contract for too long a period of time. Were the individual customer allowed the opportunity to separately arrange for power supply at prices and under terms and conditions suited to its unique situation, the end result would be more efficient. C. Steps in Developing a Competitive Wholesale Electric Market A competitive market must have multiple buyers and sellers, and the parties must be able to transact with one another on a nondiscriminatory basis. One of the most important elements of a competitive wholesale market is the availability of transmission access to all potential suppliers, on a nondiscriminatory basis, under reasonable terms and conditions, and at cost-based rates. In order to maximize the number of potential transactions, all potential suppliers must have reasonable access to all potential - 9 - purchasers. At a minimum, this means that all utilities should have FERC-approved open access tariffs in order for a competitive wholesale market to develop. Open access tariffs would allow a variety of potential power suppliers (other utilities, Qfs, IPPs, etc.) to move power through the systems of third party utilities to the system of another utility with whom it had contracted. Without open access tariffs the intermediary utility could refuse to allow its system to be used, and the transaction would be blocked. Or the intermediary utility could allow the transaction but charge a high "monopoly rent" from the party contracting to use its system. In either case, important efficiencies are lost. A second important requirement in making the electric market more competitive is to place the responsibility for resource acquisition squarely on the shoulders of the electric utility by abolishing the current practices of state approved forecasts, pre-approval of plans and contracts and guaranteed cost recovery. They make it impossible to demand accountability from the utility--since so many other parties are involved in the decision-making process. If the utility is given the freedom and responsibility to manage its affairs, then it can be held accountable for the consequences of its decisions. This will clearly place the burden of the decision making on the utility where it belongs and cause the utility to behave more - 10 - competitively. In a wider context, and without reference or adherence to existing structure, the greatest degree of competition would exist in the electricity market if there were a separation of ownership for generation assets, transmission and distribution assets, and the assets used to dispatch and control the electric system. When the owner of the transmission/distribution system (to which the customers are attached) also owns a substantial amount of generation, there may be a natural tendency to want to maximize the use of that owned or controlled generation by employing it to supply service to its customers. This may manifest itself in a number of actions such as resistance to shopping the market for more economical power supplies, high prices and restrictive terms and conditions for transmission service, and restricted access to and/or overpricing of system control, dispatch and other ancillary services. Currently, the largest market for each utility's generation is its own transmission and distribution system; and each transmission and distribution system's largest supplier is its own generation division. It is no wonder that there has been a lack of competitive cost-cutting behavior by the utility companies who also operate in an expensive regulatory environment. For this very reason, the Commission has expressed serious reservations about allowing utilities to retain ownership of generation and - 11 - transmission assets.3 If the industry were being developed from scratch, there is little question that generation and transmission ownership would be separate in order to maximize the operation of competitive forces. This is not the case, however, and the existing structure must be taken into account. Nevertheless, it is useful to keep in mind this preferable structure in deciding which actions to take. In the evidentiary hearings, which we expect will be forthcoming, the Commission should require the respondent utilities to address the question of separation of generation-- either directly to independent companies; or as an intermediate step, to separate subsidiary companies. The Commission should give serious consideration to the unbundling of electric services, to the development of separate charges for the distribution, transmission, generation and system control/dispatch functions. Not only will this separate identification of costs serve as a fundamental step toward more accurate pricing, but the result will allow a more accurate appraisal of the extent to which each utility's generation assets are above or below market value. This step will also minimize the opportunity for utilities to unilaterally shift part of the cost of uneconomic generation assets to the transmission, 3Blue Book at Page 51. - 12 - distribution and other charges. Unbundling is important regardless of whether there is to be a formal separation of assets. D. Role of the Commission The following suggestions respond to the Commission's request for comments about its role in a new wholesale market. Consistent with the new regulatory direction, the Commission should confine its activities to directing the utilities to take action to achieve specified objectives, monitoring the results of those activities, and imposing sanctions if necessary. The Commission should not interject itself into the detailed development of any new market structures, or make management decisions for the utilities or other entities. The Commission should direct each utility under its jurisdiction to develop and file with the FERC an open access tariff. The Commission should not attempt to establish the parameters or dimension of the filing, but should make it clear to the utilities that its objective is to maximize the number of potential transactions while protecting the interests of the native load customers. The Commission, of course, has the option to request FERC to grant it intervenor status in any proceeding involving these filings. - 13 - Second, the Commission should direct each utility to unbundle costs and develop separate prices for each component of the services it provides. This will entail developing cost of service, unit costs and unit prices for such components as generation, transmission, distribution, system dispatch and control, and other ancillary services. These functional costs should be further separated into fixed and variable components. The Commission should direct each utility to file these studies in the evidentiary hearings. Third, the Commission should direct the utilities to demonstrate how each of them intends to provide services consistent with the competitive market while simultaneously retaining ownership of generation, transmission, distribution and system control/dispatch assets. Each utility should also be given the option of proposing an alternative under which it divests assets, creates subsidiary companies, refrains from constructing new generation in its own service territory, etc. Utilities should be afforded wide latitude to propose innovative concepts designed to minimize self-dealing and to maximize competition. Fourth, the Commission should move forward expeditiously with this docket and not become ensnared in the details of any specific proposal at this stage. Based on the discussion above, the Commission will be presented with a - 14 - multitude of options to consider and weigh and from which to choose those solutions that provide the most benefits to all stakeholders. For example, parties may present ideas that do not limit themselves to a pool mechanism like the much-discussed one in the United Kingdom. This type of pool arrangement may be useful, but is certainly not the only option. As Pacific Gas & Electric Company (PG&E) noted in its Round One reply comments4 it is perfectly sufficient to begin a direct access structure by reliance upon bilateral and multilateral contracts. Both the pool arrangement and PG&E's proposal should not distract the Commission at this point in time but should be given consideration along with all other ideas when filed. Fifth, the Commission should retain its full regulatory jurisdiction over any noncompetitive services, which it has the power to regulate. The transmission and distribution functions will retain their natural monopoly character, since it will be impractical for multiple suppliers to provide these services. To the extent the Commission has regulatory authority over these assets, it should continue to exercise it. In addition, the Commission must retain regulatory authority over the sale of the generation and all other components of the service provided to utility service customers. Finally, the Commission should move forward with its 4PG&E Round One Reply Comments, Page 8. - 15 - consideration of Performance Based Ratemaking (PBR) and a development of the appropriate "starting" revenue requirements and rate levels to be used in conjunction with a PBR mechanism. E. Lessons Learned From Existing Wholesale Electric Market Institutions and From the U. S. Natural Gas Industry Several important lessons can be learned from experience to date in both the U. S. natural gas industry and wholesale electric markets. Turning to the gas industry first, the most important lesson is that when competition was expanded, prices to ultimate consumers decreased. There is no reason to expect a different result in the electric markets. Second, not all of the necessary changes can occur at once. Reform in the natural gas industry began in earnest with the FERC's issuance of Order 436 in 1985. The most recent order on natural gas industry restructuring issued by the FERC was Order 636.5 The FERC and state commissions continue to advance the agenda of competition and still more changes will occur as the regulators and market participants develop new and better approaches. The regulators, the utility industry and the customers did not have all the answers at the beginning, as is obvious from the evolutionary nature of the changes. The same is 5Order 636 was issued in April, 1992, and Order 636-B was issued in November, 1992. - 16 - true of changes in the electric industry which will ultimately lead to a structure embodying direct access. No one can pretend to have all the answers, or know the best ultimate solution. What is necessary is to move forward on a studied and incremental basis, and incorporate into the process any knowledge gained through this experience as it becomes available. The biggest mistake that could be made would be to wait until the "perfect" approach has been designed. A third lesson learned from the introduction of competition into the natural gas industry is that change creates some disruption, and there will be both winners and losers. As an example, in the deregulation of the natural gas industry, producers holding above-market contracts were required to reform those contracts in order to make them more marketable. One should expect a similar occurrence in the electric industry. A fourth lesson learned from the natural gas markets is that regulators have to determine who will pay for the cost of transition. While it may not be appropriate for all stakeholders (i.e., producers or generators, transmitters/distributors and customers) to share equally, it will be a practical necessity for the burden of the transition to be shared, at least to some degree, by all stakeholders. Another lesson to be learned from the gas industry experience is that when services are unbundled and priced - 17 - separately, customers can make the most efficient choices about operating procedures and can select the most logical and reasonable combination of techniques and services that meet their individual circumstances and requirements. An important lesson learned so far in wholesale electric markets is that competition brings forth lower prices. The relatively low prices offered by independent producers in the last round of capacity bidding in California clearly demonstrate the effect of competition on prices. Again, this should give the Commission a high degree of confidence that it is moving in the right direction by introducing competition in the electric utility industry. Yet another lesson learned from experiences in the wholesale electric market, particularly in California, is that the market should be allowed to determine both prices and quantities of supplies. Following the passage of the Public Utility Regulatory Policies Act (PURPA) of 1978 the Commission devised elaborate contracts and pricing structures and effectively permitted utilities to sign up for QF capacity without regard to need.6 While the Commission should move forward with all reasonable dispatch, it should not rush headlong 6This is not to say that the utilities which entered into these contracts are not responsible for the result. Merely, it is indicative of the fact that when an administrative agency gets caught up in popular trends, and ignores the market, uneconomic decisions will be made and customers will pay dearly. - 18 - into a new structure without providing adequate time for input by all interested parties or without opportunity for careful consideration of the implications of the decisions made. This again argues for an approach where change occurs incrementally, where impacts can be monitored, and the experience gained incorporated into future steps. \\\\\\\\\\\\\\ \\\\\\\\\\\\\\ \\\\\\\\\\\\\\ \\\\\\\\\\\\\\ \\\\\\\\\\\\\ \\\\\\\\\\\\\ \\\\\\\\\\\\\ III. CONCLUSION As the Commission considers its options and future actions, it should keep clearly in mind the objective of this proceeding--namely a reduction in the price of electric power to all California electric consumers. Increased competition at the wholesale level will assist in achieving this objective. Activities to increase competition at the wholesale level should proceed in parallel with other efforts, but the Commission should not allow its attention to be diverted from changes that are required to make it possible for end-use customers to contract - 19 - directly with their choice of electric supplier. Respectfully submitted, Dated: July 26, 1994 NORMAN J. FURUTA For the SECRETARY OF DEFENSE - 20 -