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  R. 94-04-032   Order Instituting Investigation on the  Commission's Proposed Policies Governing  Restructuring California's Electric Services  Industry and Reforming Regulation   COMMENTS OF THE NEW YORK MERCANTILE EXCHANGE ON MARKET INSTITUTIONS IN THE RESTRUCTURED ELECTRIC INDUSTRY Robert A. Levin Senior Vice President New York Mercantile Exchange Four World Trade Center New York, NY 10048 (212) 938-2222 July 26, 1994 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  R. 94-04-032   Order Instituting Investigation on the  Commission's Proposed Policies Governing  Restructuring California's Electric Services  Industry and Reforming Regulation   COMMENTS OF THE NEW YORK MERCANTILE EXCHANGE ON MARKET INSTITUTIONS IN THE RESTRUCTURED ELECTRIC INDUSTRY I. INTRODUCTION The New York Mercantile Exchange ("NYMEX") provides its comments below on the development of wholesale market practices, conventions, standards, and institutions to the California Public Utility Commission ("CPUC") in response to the Commission's invitation in the Assigned Commissioner's Ruling of July 8, 1994. We discuss the underlying dynamics of this development as well as the relationship between the wholesale market and retail markets, especially retail access to the wholesale market. \\\ \\\ \\\ 1 II. DEVELOPMENT OF WHOLESALE MARKETS AND THEIR INSTITUTIONS A. Wholesale Market Taxonomy Wholesale market activity comprises the sum of physical trade, movement, and storage of product upstream of retail distribution or delivery. The wholesale market is often referred to any of the following: cash-market, physical market, commercial market, wholesale market, and, in industries where market practices are more advanced, sometimes as the over-the counter ("OTC") market. The heart of any wholesale market is virtually always the forward market, where each of producers, marketers, processors (refiners), distributors, and major end-users negotiate future obligations to deliver or take delivery of product. As wholesale markets develop and become more advanced, most activity takes place in the forward market, where market participants are able to work through the details of future plans and participation. In the absence of a forward market, planning and preparation by members of an industry are greatly limited. A forward market enables participants to plan effectively, and effective planning greatly enhances market efficiency throughout the distribution chain from production to consumption. The nearest term delivery cycle of the forward market for an underlying product is customarily referred to as the spot-market. In some wholesale markets, such as the North American pipeline system delivery market for crude oil, the spot-market refers to delivery during the next calendar month. In others, such as heating oil or unleaded gasoline delivered by barge, it refers to deliveries occurring over the next week or so, beginning with the very next day. In electricity in North America, it even includes the next hour beginning on the hour. Sometimes, due to changes taking place within the industry, the spot-market becomes somewhat a misnomer. 2 Historically, in the North American natural gas market, the spot market was the next calendar month forward. Recently, however, the ability to transact business for the remainder of the current calendar month has become possible. Even though this delivery period is nearer term than one calendar month forward, it is not called the spot-market. The tradition of calling the one calendar month forward market the spot-market has been retained. The current remaining month forward is referred to as the swing market. Whereas the forward market embodies participants' planning and preparation for the future, and values for the underlying product determined within it reflect the integration of those different plans and preparations, the spot-market typically reflects unplanned and unanticipated activity. Spot-market values reflect scarcity value for unanticipated consumption or immediate demand. Some wholesale market participants try to anticipate spot market supply and demand through market activity. They take on the risk of incurring loss by pursuing profits, arbitrating between the forward price for product to be delivered during a given period and the spot price for delivery during that same period, when it is time to deliver. Such arbitrage is common, not only between forward markets and future spot markets, but between all varieties of activity within the forward market. In a competitive market, this arbitrage is the process by which efficiency in allocation is achieved, ensuring that product is delivered to those who value it highest by those who can deliver it at the lowest achievable cost. Efficiency means allocation with no waste in resources. The engines of efficiency are driven by the combination of profit maximization and value maximization. A fully developed forward market is characterized by a wide variety of product alternatives, several commonly used reference prices, and a depth of market activity from large and small participants alike. It provides 3 a substantive measure of price transparency, price discovery, and liquidity. Larger end-users have the choice to participate directly in the market as equals, and smaller retail users can indirectly participate through derivative products offered by intermediaries, but based directly on forward market determined prices (or futures prices). It contains natural incentives to innovate, test new ideas, and continually increase the capabilities the market and its physical constraints over production, processing, consumption, and, especially movement, storage, and delivery. Through competition, these incentives manifest themselves via efficient allocation and prices. Further below, we provide more on these incentives, but first we describe the process of standardization and development of market institutions. B. Standardization in Wholesale Markets Standardization emerges in the practices within a wholesale market because participants jointly benefit, invariably through reduced costs. One source of reduced costs is the physical constraints on the system. To the extent that these physical constraints represent individual activity, there is not much room for savings in shared costs. Consumption typically falls into this category, as does processing. Sometimes there are shared cost savings from production, like in oil fields where competitors extract from the same reservoir, but often there are little savings to be shared in production costs. In energy industries, physical constraints on the market that have consistently yielded shared savings through standardization are movement, storage, and distribution. For instance, standardization in quality specifications often arises to take advantage of cost savings in moving, storing, or distributing the product. If quality is standardized then product belonging to different shippers can be commingled, rather than segregated, which clearly increases the efficiency of the systems that move and store the product. Timing of delivery periods is often standardized dictated by cost 4 saving yielded by the movement, storage, and distribution systems. A second source of reduced costs through standardization is transaction costs. The cheaper it is to conduct commercial activity, the greater that activity and the higher the level of economic efficiency that is achieved through arbitrage performed among alternatives in the wholesale market. Consequently, reduced transaction costs are an important source of economic efficiency in the market. There are a number of examples of reduced transaction costs worth noting. Though standardization in product quality specifications and delivery timing results in reduced physical costs in the movement and storing of product, it also results in reduced transaction costs in areas such as processing and consumption. Purchases of feedstock by processors or fuel by consumers become cheaper with standardization. This is because processors and consumers do not have to waste time estimating and comparing differences in value between products that offer no meaningful benefits in variety.1 (Processors and consumers have no qualms about comparing the values between products that offer genuine tradeoffs in variety.) Another example of reduced transaction costs through standardization is delivery location. Standardization in delivery points means that market participants need only evaluate the relationship of values between their customized commercial delivery locations and those locations that serve the wholesale market as forward pricing points. If, for purposes of this comparison, quality of product is kept the same, then the relationship depends only on the cost of moving product between the customized delivery location and the forward pricing point location. Compare this to a situation without standardized delivery locations. A market participant would have no 1 There are some physical cost savings achieved by processors and consumers as well, through reductions in adjustment and calibration associated with use of the product. 5 reference points by which to measure his/her customized activities. To assess the relative value of his/her customized delivery location activities, he/she would have to assess the value of all other potential delivery locations (or at least many other locations). This would be very expensive and time consuming to do, yet this is precisely what must be done in industries where the wholesale market has not yet established a set of standard delivery locations. In those industries that have established a set of standard delivery locations, such locations are often referred to as terminal markets. Standardization in product quality specifications, delivery timing, delivery location, and delivery procedures comprises most of the characteristics of a typical forward market reference price. C. Reference Prices and "Commoditization" At the point of evolution when an industry accepts a set of standards in practices, conventions, and location that govern delivery as well as standards in a product's characteristics for use as common references for pricing most wholesale transactions, the underlying product can be said to have become a commodity (or set of commodities). The price (or prices) for the product as a commodity becomes the industry's wholesale market reference price (or prices). As explained above about reduced transaction costs, a small set of reference prices enables wholesale market participants to save time and expense in assessing the relative value of their transactions in pursuit of maximizing their revenues or minimizing their costs. Forward markets revolve around commodities and their corresponding reference prices. To accommodate commercial demand to transact in terms of the commodity and its corresponding reference price, the industry develops a means to document the transfer of title for the commodity at a very low price. This makes it inexpensive to trade the commodity, and, in industries where competition is the rule, the trading volume of these commodities reaches 6 multiples of actual production or consumption of the product. (NYMEX previously described this process in its "Reply Comments of the New York Mercantile Exchange In Response to the Order Instituting Rulemaking and Order Instituting Investigation" to the CPUC, dated June 21, 1994. ["Reply Comments"]) The reference prices become a unit of account within the wholesale market by which all transactions are measured. They commonly become part of formulas that are used to price all products and transactions within the industry, including those whose terms and conditions differ from the standards of the commodity. For instance, a cargo of the Nigerian crude oil stream "Bonny Light" in transit to an oil terminal located at the US Gulf of Mexico Coast would typically be priced in terms of the industry commodities "West Texas Intermediate" (which is delivered at Cushing, Oklahoma) or "Louisiana Light Sweet" (which is delivered at St. James, Louisiana). If the cargo was in transit to Northern Europe, it might be priced in terms of the commodity "Brent" (which is delivered at Sullum Voe, Scotland). (A fuller description of commodities in the crude oil industry is contained in NYMEX's Reply Comments) A set of well-developed commodities and reference prices enables participants to manage unfavorable movement in prices more effectively. These participants benefit from the arbitrage between different commodities that constantly takes place in the wholesale market. The arbitrage ensures that prices always reflect relative values to the industry. Anyone worried about price risk enters a forward transaction for one of the industry's standard commodities that offsets their wholesale market exposure. Because transactions costs governing the transfer of title for the commodity are low and because trading volume in the commodity is high, the market participant is confident that he/she will be able to liquidate their forward position easily at the time they choose. 7 Futures markets for an underlying commodity even further reduce transactions costs and, consequently, offer higher trading volume and greater liquidity. Whereas forward markets offer some degree of price transparency and price discovery, active futures markets offer full price transparency and price discovery. Futures contracts and related options contracts constitute completion of the evolution of a wholesale market. D. Derivatives As forward and futures markets are developed, derivatives of these products are designed. Commodity swaps typify these. (Commodity swaps were further described in NYMEX's Reply Comments) The obligations with swaps are purely financial as opposed to forward markets and futures markets2 where there are physical delivery obligations as well. Swaps enable interested parties who lack the means or interest to participate directly in the wholesale market opportunity to benefit indirectly from wholesale market activities. This could include an end-user of a product that wants to effectively hedge against unfavorable price movements. The end-user would typically contract with an intermediary to enter into a swap that offsets his/her financial risk. E. Retail Access to Wholesale Where regulation permits, large commercial or industrial end-users typically participate directly in wholesale markets on even footing with other members of the industry. To do this, they must have equal access to the tools governing delivery of product, including moving or storing the product, and the underlying market must be competitive. In return for equal access, they are expected to act in accordance with the market's 2 Sometimes futures contracts do not entail actual delivery obligations. However, all of NYMEX's futures contracts for energy do entail physical delivery. NYMEX expects that its prospective electricity futures contract will also entail physical delivery. 8 standard conventions and practices. Nothing else is really needed. Other retail customers can have access indirectly to the wholesale market through intermediaries that offer commodity swaps. Usually, these swaps would not embroil a customer in the details of spot-market price fluctuations. Rather, they would be customized to meet customers' preferred delivery horizons. For heating oil distributors in the Northeast US, this is approximately seven consecutive months each year. By locking in price certainty, these distributors are able to offer price certainty in advance of the heating season to their residential customers. Virtually every residential heating oil consumer in the Northeast currently has access to price certainty in advance of the heating season. As long as the underlying forward market is competitive and the swaps market is competitive (financial markets tend to be competitive), end-users are ensured of indirect access at efficient prices. Nothing else is really needed. Regardless of whether or not a retail customer accesses the wholesale market, in industries where there are no regulatory defined boundaries between retail and wholesale, the markets are able to develop compatibly on their own. The extent by which a retail customer participates in the wholesale market is self-determined. Distributors will always be available to bridge any gap, and if the market for distribution is competitive, end-users choosing not to have any access to the wholesale market will benefit from efficient prices. Nothing else is really needed. F. Wholesale Markets: Perspective Above, we have described the structure and processes of change that occur in unfettered wholesale markets where competition reigns and market participants are free to pursue their best interests. On their own, these markets are able to develop institutions that reduce both costs associated 9 with physical constraints and transactions. Indeed, in every industry, due to pushes that originate with innovations in the wholesale market, physical constraints are often able to expand in response. Certainly in the last twenty years, improvements in the operations or policies governing transmission in electricity have emerged more often in response to commercial pressure than simply from the laboratory alone. This has been the case with other energy industries as well. As long as competition reigns, the process by which wholesale markets and their institutions evolve is self-correcting, always adapting in search of lowering the collective costs of market participants. Furthermore, market participants, constantly in search of profit and in response to competition, probe new ideas, develop new products or services, and, through the discipline of the market, develop innovations which offer consumers and other end-users greater value at lower cost. These innovations challenge operators of physical constraints within the industry to respond with changes in operations or policies that effectively expand the capacity of the industry. As long as competition reigns, the process does not end. Nothing else is really needed. Each of the crude oil, heating oil, unleaded gasoline, and natural gas industries have well-developed wholesale markets where competition reigns, and which have self-developed and self-correcting institutions governing delivery and pricing. They each followed a pattern of evolution similar to that described above and which has brought them to their current position. They each continue to develop and evolve. Below, we assess the level of evolution in the western US electricity market, and its likely course of continued evolution. III. WESTERN US ELECTRICITY WHOLESALE MARKET 10 NYMEX has previously commented regarding the Western US electricity market (Refer to "Initial Comments of the New York Mercantile Exchange In Response to the Order Instituting Rulemaking and Order Instituting Investigation" to the CPUC dated June 8, 1994; Testimony at June 14, 1994 hearing and Reply Comments) and will try to limit repetition here. The Western US electricity wholesale market covers all of the Western US interconnect, British Columbia and Alberta in Canada, and Baja California in Mexico. Dozens of entities actively participate in this market. Many are members of the Western Systems Power Pool ("WSPP") which provides definitions for electricity as a set of commodities and regulations governing commerce. There are over sixty members of the WSPP. Transmission of electricity throughout the western US wholesale market is overseen by a series of control area operators with oversight for specific geographic areas. These control area operators abide by procedures established by the Western Systems Coordinating Council ("WSCC"). Within this framework, on its own, the western US wholesale electricity market has developed a series of delivery points for electricity which are commonly used as reference price points. These include Four Corners (NM), West Wing (AZ), Palo Verde (AZ), Mead (NV), McCullough (NV), El Dorado (NV), COB (CA, OR), NOB (NV, OR), and Big Eddy (OR). In addition, there are plans to construct transmission between the Northwest and Southwest which would enable arbitrage to operate without restraint between the two areas year-round. (Currently, such arbitrage runs into transmission capacity constraints more than half of the year. This is another example of commercial pressure pushing the physical constraints on market activity to expand.) The development of well-accepted standards governing commodities and delivery and pricing is remarkable given the degree of regulation that this industry is still subject to. By comparison, the natural gas industry 11 developed its first terminal market only in response to the need for a well- defined delivery point for its futures contract. It took three years for another to develop, and only now, in response to further deregulation by the FERC are other market centers, as they ar called, being developed. In crude oil, which is an international wholesale market, pricing points only developed in response to avoiding government regulation. With "Brent," it was to minimize taxation of production; with "West Texas Intermediate," according to lore, it was to sidestep price regulation. In the western US electricity market, it has been simply to improve wholesale market efficiency. It is our understanding that approximately half of the electricity produced and consumed in the western US is sold forward. This number will only grow, because buying and selling forward enables participants to plan and prepare more effectively. New types of services are becoming available. We fully expect that what now serves as delivery points within this market will soon grow to become delivery networks, where a series of points and their connecting transmission serves as the basis for delivery and pricing. In a relative sense, the electricity market is accomplishing this more rapidly than has the US natural gas market. Standardization in delivery periods in the forward market will increase. The market will compatibly work out differences in preference between operators of transmission who schedule forward on a weekly basis and end-users of electricity who prefer to schedule decisions on a monthly basis. In other industries, such differences have evaporated as commercial practice has led to standards that are independent of the everyday physical movement of product. In other words, schedulers will continue to operate according to their preferences, and forward market participants will be able to transact according to their preferences. 12 The forward market will grow. Utilities subject to performance based rates will actively seek to minimize costs according to the discipline of the market. Non-utility generators, marketers, self-generating utilities, and municipal will continue to minimize costs and/or maximize revenues. In the event of retail access to the wholesale market, competition can only increase. IV. ELECTRICITY WHOLESALE MARKET INSTITUTIONS AND GOVERNMENT'S ROLE NYMEX has previously provided criticism of mandated market and pricing mechanisms. We continue to point out that, compared to a wholesale market where participants can freely negotiate their own best interests, mandated mechanisms lead to higher costs, less variety, and lower value; in sum, substantially reduced efficiency. Mandated mechanisms contain no means for self-correction. If the mechanism is faulty, then the only means to change it is a regulatory one, and that process is rarely quick, and, with all due respect to the Commission, not necessarily efficient. Consider the "tight" power pools in the Northeast US: NEPOOL serving New England, NYPOOL serving New York, and PJM serving the Mid-Atlantic states. NYMEX has previously commented and testified that members of these pools are systematically abandoning the formal pool mechanism to complete wholesale market transactions. Fortunately for them, they can simply bypass the pool. However, what about participants in the United Kingdom ("UK") pool? They have no alternative or means to bypass. If the UK pool is faulty, users are just stuck. The UK pool has been faulty. By comparison to the WSPP or the western US wholesale market, it has been horrendous. In February of this year, the UK's regulator imposed price ceilings because it had lost confidence 13 the pool reflected competitive pricing. Many industrials and other end-users are dissatisfied that the pool is biased toward producers. For them, there is no alternative, except the hope that the growing commercial pressure to allow wholesale transactions, including delivery, outside the pool will succeed. In the meanwhile, the faulty mechanism, which cannot self-correct, persists. We urge the Commission to learn from the lessons of successful wholesale markets which have developed in the US and elsewhere on their own as well as from the lessons of unsuccessful mandated mechanisms. As long as competition reigns and all competitors have fair access to transmission and distribution, nothing else is really needed to ensure efficiency. As such, NYMEX recommends the market alternative over mandated or subsidized pool mechanism alternatives. The proper role of government to ensure efficiency is to nurture competition, enforce fair access to transmission and distribution, and to educate existing and future market participants as to how free and competitive markets function, operate, change, and self-correct. Dated: July 26, 1994. Respectfully submitted, By: Robert A. Levin Senior Vice President New York Mercantile Exchange Four World Trade Center New York, NY 10048 (212) 938-2222 14