BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA Order Instituting Rulemaking on the ) R.94-04-031 Commission's Proposed Policies ) Governing Restructuring California's ) Electric Services Industry and ) 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 ) ) INITIAL COMMENTS OF JEFFERSON ELECTRIC INC. ON WHOLESALE MARKETS AND MARKET INSTITUTIONS Jerry R. Bloom MORRISON & FOERSTER 345 California Street San Francisco, CA 94104-2675 (415) 677-7533 Attorney for Jefferson Electric Inc. July 26, 1994 159299.4 EXECUTIVE SUMMARY Experience in competitive electricity markets abroad, and in the domestic deregulation of natural gas, shows the primacy of retail competition in providing consumer benefits. This experience also demonstrates that appropriate market mecha- nisms to further competition will rapidly evolve, provided the regulator (1) allows consumer choice, (2) eliminates the market power of the vertically integrated monopoly through functional separation, (3) guards against excessive concentration of produc- tion capacity, and (4) enforces nondiscriminatory access to the marketplace. The Commission should adopt these goals and poli- cies. The Commission cannot and should not try to channel competition or engineer market mechanisms. Much of the benefit of energy industry restructuring may be lost if the Commission tries to constrain competition within a mandated pool, or limit competition to the wholesale level. The other great danger to restructuring is delay. Staging competition is unnecessary and unfairly denies the benefits of competition to many consumers. A lengthy transition period will increase the Commission's regulatory burden and may well cause additional problems such as overbuilding of generating capacity. 159299.4 i TABLE OF CONTENTS Page I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . 1 II. THE MARKET THAT PROVIDES SIGNIFICANT CHOICE BEST SERVES CONSUMERS . . . . . . . . . . . . . . . . . . . 2 III. THE NEW ZEALAND EXPERIENCE SHOWS THAT RETAIL COMPETITION CAN DELIVER BENEFITS TO CONSUMERS WITHOUT A COMPETITIVE WHOLESALE MARKET . . . . . . . . . . . . 3 IV. THE NORWAY EXPERIENCE SHOWS THAT BENEFITS TO CONSUMERS DERIVE PRIMARILY FROM COMPETITION AT THE RETAIL LEVEL . . . . . . . . . . . . . . . . . . . . . 5 V. THE UNITED KINGDOM EXPERIENCE SHOWS THAT A POOL- DEPENDENT MARKET IS RIGID AND UNRESPONSIVE TO MARKET NEEDS . . . . . . . . . . . . . . . . . . . . . . . . . 6 VI. THE UNITED STATES NATURAL GAS EXPERIENCE SHOWS THAT COMPETITION DRAMATICALLY REDUCES PRICES . . . . . . . . 7 VII. EXPERIENCE WITH COMPETITIVE ENERGY MARKETS TEACHES CLEAR LESSONS . . . . . . . . . . . . . . . . . . . . . 9 VIII. THE ROLES OF REGULATORS, PRODUCERS, CONSUMERS, MERCHANTS, AND UTILITIES WILL BE CLEARLY DEFINED IN A FULLY COMPETITIVE ELECTRIC SERVICES INDUSTRY . . . . . 13 IX. THE COMMISSION SHOULD ACT NOW TO CREATE A MARKET STRUCTURE THAT ALLOWS VIGOROUS BROAD-BASED COMPETITION FOR ALL CUSTOMERS . . . . . . . . . . . . . 14 159299.4 ii I. INTRODUCTION The Commission's third and fourth full panel hearings advance its policy inquiry to the vital question of how various types of markets and market institutions work and interact. Jefferson Electric Inc.1 ( Jefferson Electric ) believes this question is exactly the right one at this juncture in the pro- ceeding. In particular, a clear understanding must be reached about what wholesale markets can and cannot do, and about what benefits and limitations pooling arrangements bring to the marketplace. Jefferson Electric supports the Commission's goal of lowering the overall cost of electric services for Californians but believes that the focus should be expanded to creating a market of service options, offered under various terms and conditions and at various prices. Competition is by far the most promising means for furthering these goals. The Commission should evaluate market structures presented to it according to their ability to allow the most vigorous, broadest-based competi- tion for all consumers and all types of services. The Commission need not rely on academic treatises for answers. As Jefferson Electric will show in these comments, the experience with electric markets in New Zealand, Norway, England 1 Jefferson Electric is a wholly owned subsidiary of Jefferson Gas Systems, Inc., a company developing and marketing competitive energy-related services and programs to a broad array of energy users in California and throughout the United States. With the opening of California's electric services industry to competi- tion, Jefferson Electric will engage in the direct sale of electric products and services to consumers of all sizes in this State. 159299.4 1 and Wales, and with the domestic natural gas market, offers clear lessons for the Commission. Using the information provided in comments and at the panel hearings, the Commission will be able to finalize some of the major policies that will shape the rest of this proceeding. Jefferson Electric urges the Commission to issue a decision adopting those aspects of its April 20 proposal that affirm direct access and many other key elements of its original proposal. In addition, the Commission should order the utilities to develop compliance plans and thus move this proceed- ing onto implementation issues. II. THE MARKET THAT PROVIDES SIGNIFICANT CHOICE BEST SERVES CONSUMERS. Markets provide the fundamental channel of communica- tion between producers and consumers. The clearer the communica- tion, the better the match between the producers' product and the consumers' desires. In other words, the product of an effective free market is an informed consumer capable of making choices from a broad array of products and services. Especially vital to this vision is the ability of the market to allow prompt and efficient comparison of the various features of the goods and services offered. An electricity market that simply quotes a price for energy from a pool or bulletin board will not provide real choice for customers. In titling this proceeding as an investigation of the electric services industry, the Commission correctly signaled that this investigation should not be merely about cents per kilowatt-hour. To state the goal of reform as simply lower prices ignores much of the benefit competition offers consumers. 159299.4 2 Lower prices can always be achieved, but the cost may be lost features. The Commission's principal goal should be to enable consumers to choose electricity services within a context of accurate and useful information and unfettered access. Ultimately, this will result in diverse services being offered in the market, under market-determined terms, conditions and prices. The Commission can and should let the consumer choose among levels of reliability, pricing mechanisms and when it desires to buy and curtail purchases. The Commission has a critical role in establishing and protecting the consumer's ability to make these choices. The Commission should not try to create a competitive market but should safeguard the competitive market that is already emerging and release it from regulatory obstacles that prevent it from achieving the Commission's objectives. III. THE NEW ZEALAND EXPERIENCE SHOWS THAT RETAIL COMPETITION CAN DELIVER BENEFITS TO CONSUMERS WITHOUT A COMPETITIVE WHOLESALE MARKET. Many parties have assumed that wholesale competition must precede retail competition. While the modest level of electric competition in the United States began with the whole- sale market, that fact is simply historical. In fact, in New Zealand consumers have benefited from retail competition even in the absence of wholesale competition. Prior to deregulation, New Zealand's generation and transmission services were provided by one government department, and 42 public-owned regional electricity boards provided distri- bution services. As part of New Zealand's privatization and 159299.4 3 economic restructuring of its economy, the electric system was partially deregulated. First, the generation and transmission department was restructured into a government-owned corporation. Subsequently, each of the 42 regional electric boards was sold to private investors. The newly privatized regional supply compa- nies had both a merchant function (the selling of electricity at the retail level in competition with the other regional boards), and a lines function (the distribution of electricity). It was the intent of the deregulation that the merchant function be separate from the distribution function. The results of deregulation were lower electricity prices for retail customers that exercised their competitive choices. Thus, New Zealand has shown that lower prices can be achieved by going directly to retail competition without first establishing a competitive wholesale market. If the Commission adopts a similar approach, it too can look forward to lower consumer prices, with the added benefit of avoiding a battle with the Federal Energy Regulatory Commission ( FERC ), which has stated its interest to focus on further advancing wholesale competition. Like the United States natural gas industry, New Zealand continues to deal with implementation issues. Specifi- cally, because of an inadequate unbundling of services and func- tions, the regional supply companies used their distribution business to frustrate competition. For example, distribution charges are being increased to compensate for lost commodity revenues. As well, the incumbent suppliers have threatened 159299.4 4 service reliability as a means to frustrate the market. As discussed more fully below, this experience confirms the need to enforce the separation of distribution and merchant functions. IV. THE NORWAY EXPERIENCE SHOWS THAT BENEFITS TO CONSUMERS DERIVE PRIMARILY FROM COMPETITION AT THE RETAIL LEVEL. Norway has had a wholesale power pool for over 20 years. Prices were set within the pool through physical trades between more than 200 participants. The retail consumer, captive to the suppliers, continued to face monopoly pricing. As a result of the pool's failure to avoid excess capacity or to lower consumer prices, Norway instituted retail competition in 1991. The benefits have been dramatic as compe- tition at the retail level unexpectedly also resulted in more competition at the wholesale level. Within two years of intro- ducing retail competition, consumers experienced savings of 18% to 23%. An essential factor in Norway's success in reducing retail prices was the entry of independent traders. The most significant savings to consumers occurred after such traders appeared in 1992. Following the decline of wholesale electric prices which followed the introduction of retail competition, generators did two things. First, the generators unsuccessfully lobbied the government to curb retail competition. Second, the largest generators colluded to raise prices. Then, the largest generator enforce a floor price by flooding the market whenever the pool price went below the floor. The Norway experience shows that 159299.4 5 only a 30% market share was sufficient to exert market power. This lesson from Norway is that competition may require a limit on market share as well as separation of functions. V. THE UNITED KINGDOM EXPERIENCE SHOWS THAT A POOL-DEPENDENT MARKET IS RIGID AND UNRESPON- SIVE TO MARKET NEEDS. In the United Kingdom ( UK ), England and Wales privat- ized and separated generation from transmission, and created a wholesale pool from which the local distribution companies purchase power.2 Retail access is being phased in gradually, with large customers being given the first access. Producers bid prices one day in advance; the pool regulator then ranks these bids, predicts demand, and chooses which bids should be accepted, giving rise to a system marginal cost paid to all producers dispatched. If the regulator deems the generation offered at that bid price to be inadequate to meet demand, it adds a value representing lost load to the system marginal cost in order to get additional supply. The UK system, though advertised as a market, is actually only an extension of the old utility central dispatch regimen. The result is a rigid, mandated pool that does not innovate, has no exposure to competition from alternative market- ing arrangements, and drastically constrains primary market transactions. A true market, in contrast, is characterized by flexibility, marketing arrangements that compete with each other, and a spectrum of transactional choices. Flexibility in the UK 2 In Scotland generation is privatized, but not in the same way as in England and Wales. Northern Ireland is not interconnected with the rest of the UK and does not participate in the pool. 159299.4 6 system is not found in the pool; rather, it is only found in the secondary market, where traders provide hedging against the volatility of the pool price. Furthermore, the privatized generation companies were large enough to manipulate the pool price by exercising market power. Ultimately, the regulator had to intervene and introduce a pool price cap to limit the market power of the generation companies. This action constitutes a major acknowledgement of the pool's failure to function as a substitute for a competitive market. This Commission has rueful experience of its own with the manipulation of bidding systems. Recently, it imposed a price cap on Final Standard Offer 4 ( FSO4 ) contracts based on substantial evidence of manipulative bidding in the Biennial Resource Planning Update ( BRPU ) auction. Thoughtfully designed mechanisms to forestall pricing manipulation in both the UK pool and the BRPU auction failed. This is because whenever competi- tion is constrained within a rigid regulatory structure, an incentive exists to game the system. The more rigid the structure, the more vulnerable it is to such manipulation and gaming, which wastes resources and results in higher prices to consumers. VI. THE UNITED STATES NATURAL GAS EXPERIENCE SHOWS THAT COMPETITION DRAMATICALLY REDUCES PRICES. Before the 1980's, the price of natural gas increased regularly for all customer classes. Such long-term price in- creases are representative of monopoly pricing. 159299.4 7 With the partial deregulation of the natural gas industry, those customers allowed access to the competitive market experienced dramatic price declines. For those customers who were not allowed access, prices continued to increase. This point is graphically demonstrated by Figures 1, 2 and 3, attached herein as Appendix A, which show dramatic decreases for industri- al and Utility Electric Generation customers as compared to other customers whose rates remained relatively high. The benefits of wholesale competition failed to reach all consumers because utilities shifted costs to captive customers and used their commodity savings to compete in the wholesale markets. Experience with Order 636 indicates that when competi- tion was permitted in the interstate capacity market, prices for transportation services fell rapidly and savings flowed immedi- ately to consumers. Hundreds of successful bilateral, private market transactions have occurred in the capacity brokering market in the brief period since Order 636 was implemented. Transactions have been initiated, processed, and settled effi- ciently and accurately without any need for a government-mandated and utility-dominated clearing house or pool. Moreover, price discovery and hence efficient resource allocation occurred via the decentralized workings of the market. Significantly, competition in the natural gas industry has depended on marketers. Such firms attacked monopoly prices and quickly brought the benefits of competition to consumers, for example, by bidding down the price of surplus interstate trans- portation assets. This reinforces the lessons learned from 159299.4 8 international electric markets, where independent firms are critical to ensuring competition. The deregulation of the United States natural gas industry thus shows that: Where competition has been allowed to flourish, prices have fallen dramatically; Where competition has been allowed only at the whole- sale level, retail consumers have not benefitted; Where policy makers have allowed the markets to develop the transactional structure, the greatest efficiencies have been realized. Markets have spontaneously created price discovery, resource allocation, transaction processing, and balancing mechanisms, without utility- dominated and government-mandated pools; The true drivers of competition are the independent merchants and enforcement of competitive policies by regulators; and Regulatory delay and partial implementation of a public policy favoring competition has cost consumers billions of dollars since limited open access began in the early 1980's. VII. EXPERIENCE WITH COMPETITIVE ENERGY MARKETS TEACHES CLEAR LESSONS. Competitive energy markets in the United States and abroad teaches ten clear lessons. 1. Act Quickly Because the Cost of Delay is Enormous. A long transition period simply delays the gains from competi- tion, and could even add costs in the form of overcapacity. As 159299.4 9 well, phased deregulation sends conflicting signals and is ineffective. There is no technical or market reason to stage the introduction of a competitive retail electric market for Califor- nia. 2. Let the Market be Free to Implement Commission Policy. Competitive markets have demonstrated repeatedly that they are superior to command-and-control systems. It is suffi- cient for the Commission to establish and enforce policies favoring competition without specifying, in detail, how market participants should deliver the benefits to consumers. 3. Wholesale Competition Alone Will Do Little to Further the Commission's Goal of Lower Prices to all Consumers. A competitive wholesale market will produce only lower wholesale prices. In contrast, the example of Norway shows that the introduction of retail competition will benefit all consumers and will lead to more efficient resource allocation in all market segments. While the FERC focuses on wholesale competition, the Commission can bring competition to the retail market. 4. Wholesale Competition is Not Necessary for Retail Competition. New Zealand has successfully introduced retail competition, with associated benefits to consumers, yet no wholesale competitive market exists. There is no principle requiring wholesale competition to precede retail, and to apply such precedence would only lengthen the transition period, with all the costs and complexities that accompany delay. 5. Separate Generation, Transmission, Distribution, and Merchant Functions to Minimize Manipulation of the Market. 159299.4 10 Experience overwhelmingly demonstrates that separation of these functions must occur. Companies with market power are inappro- priately able to integrate these functions. They can thwart competition by shifting costs and by creating non-price barriers to entry. An example of this in New Zealand is imposition of complex billing practices and operating procedures. 6. Limit Producers' Market Power to Set Prices. Norway's experience shows that as little as a 30% market share may enable suppliers to exercise market power in setting prices. Thus, the Commission should limit market power of suppliers. 7. Allow Small Customers Immediate Access to Competi- tion. New Zealand and Norway have shown there is no need to stage the introduction of competition. In the United States, denying small consumers access to the competitive gas market has prevented them from enjoying the benefits of that market. Prices to smaller consumers have remained high, while prices to larger consumers have fallen. In sum, the Commission should abandon its staged proposal and simultaneously provide the entire market access to competition. 8. Allow Independent Marketers Open Entry Into the Competitive Market. In each of the energy markets examined, independent marketers were vital in promoting consumer choice and reducing prices. Independent marketers accelerate innovation and thus bring the benefits of competition to small consumers who, by themselves, are unable to participate in the market due to their lack of understanding and resources. Aggregators provide small 159299.4 11 consumers an ability to negotiate with suppliers from a bargain ing position similar to large consumers. 9. Pools Have Limited Usefulness as a Market-Clearing Mechanism and Invite Federal Preemption of Commission Regulation. The advertised purpose of a pool is efficiency in resource allocation and transaction processing. While a market-created pool or other trading structure will inherently benefit consum- ers, a regulatory-contrived pool will not. For example, a regulatory-contrived pool may be susceptible to manipulation by those with monopoly power and may be too rigid to respond to market signals. Further, as mechanisms for managing and process- ing wholesale electricity transactions, pools created and regu- lated by states give rise to federal preemption issues since wholesale energy markets are the jurisdiction of the federal government. 10. Regulatory Action Should Be Limited to Accepting Consumer Choice and Protecting the Emerging Market. Just as FERC did not create the secondary market for interstate natural gas transportation capacity, the Commission should not attempt to mandate the intricacies of the emerging market. In gas, FERC wisely recognized that a market was naturally emerging that offered consumers greater benefits than the prior regulated system for allocating capacity. This Commission has a similar opportunity to recognize the emerging structures in the electric services industry and the desire among consumers for choice. Thus, the Commission's role should be limited to accepting 159299.4 12 consumer choice and protecting the market as it emerges to ensure it remains a mechanism for ongoing change. VIII. THE ROLES OF REGULATORS, PRODUCERS, CONSUM- ERS, MERCHANTS, AND UTILITIES WILL BE CLEARLY DEFINED IN A FULLY COMPETITIVE ELECTRIC SER- VICES INDUSTRY. Competition in the market place will bring clarity to the roles of regulators and participants compared to the confus- ing, ambiguous, and contradictory messages they give and receive under the present hybrid industry structure. These roles can be summarized as follows. 1. The Regulator's Role is to Foster Competition, Regulate Monopolies, and Protect Captive Customers. First, the Commission should foster electric competition in three industry sectors: generation, merchant (including metering and billing), and transmission (via the creation of secondary markets). Second, the Commission should continue to regulate distribution as a monopoly function. Third, those consumers precluded from or unable to exercise choice are captive customers, and they must be protected by the Commission. The goal of public policy should be to minimize the number of captive customers, thus bringing the benefits of competition to all consumers and limiting the market power and the role of the monopolist. 2. The Producer Can Focus on Least Cost Production. The producer can and should focus on the most efficient and reliable production of the electric commodity while responding to market signals provided by the purchasers of the electric commod- ity. 159299.4 13 3. The Utility Will Own, Operate and Maintain the Distribution Systems. The utility will provide nondiscriminatory distribution service. It will no longer impede other market participants performing competitive functions or thwart public policy. 4. The Merchant Will Link the Producer, Distribution System and the Consumer. The merchant should bid for supply from all producers and compete for services to all consumers. 5. The Consumer is the Sovereign. The consumer will dictate what products he or she demands, and the market will respond accordingly. IX. THE COMMISSION SHOULD ACT NOW TO CREATE A MARKET STRUCTURE THAT ALLOWS VIGOROUS BROAD-BASED COMPETITION FOR ALL CUSTOMERS. The goal of public policy change and electric industry restructuring is to better serve the needs of the consumer. The Commission's fundamental premise should be that consumer choice is the key to consumer benefits. The implementation details will follow that premise. Specially, the Commission should adopt the following policies: Empower consumers to make meaningful choices by (1) permitting retail competition in electricity services; (2) requiring the separation of generat- ing, transmission, distribution and merchant func- tions; (3) ensuring nondiscriminatory access to the transmission and distribution systems by con- sumers, merchants and producers; and (4) enforcing vigorous competition by limiting market power, 159299.4 14 encouraging new market entrants and policing ob- structive behavior by utilities. Encourage the development of market institutions that are best created by market participants, including consumers. The key to success is to act now. The goal is not perfection but immediate action because the costs of imperfect competition are far less than no competition at all. Ultimately, the market will give consumers the benefits they seek through mechanisms they trust. Respectfully submitted, JERRY R. BLOOM MORRISON & FOERSTER By: Jerry Bloom Attorneys for Jefferson Electric Inc. 159299.4 15