BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA Order Instituting Rulemaking ) on the Commission's Proposed ) Policies Governing Restructuring ) R.94-04-031 California's Electric Services ) Industry and Reforming Regulation ) ) Order Instituting Investigation on ) the Commission's Proposed Policies ) Governing Restructuring ) I.94-04-032 California's Electric Services ) Industry and Reforming Regulation ) REPLY COMMENTS OF THE CENTER FOR ENERGY EFFICIENCY AND RENEWABLE TECHNOLOGIES ON COMPETITIVE WHOLESALE ELECTRIC MARKETS AND MARKET INSTITUTIONS IN THE RESTRUCTURED ELECTRIC INDUSTRY JAMES H. CALDWELL JR. Technical Director CEERT 1100 Eleventh St Suite 321 Sacramento, CA 95814 (916) 447 7983 August 18, 1994 No party to this proceeding has taken a position against wholesale competition in the generation sector of the electric utility industry. No one is against "customer choice" per se. The vertically integrated franchise monopoly is dead, at least in this court of ideas. As other parties have noted, this is truly remarkable progress since April 20. However, it is not yet time to proclaim victory. If allowed to set certain preconditions, the majority are at least willing to accept direct access of some kind at some time. First, the old order remains intact in other venues and on the ground. There is no meaningful wholesale competition for generation today. To protect high cost existing generation, the integrated monopoly has shown a willingness and ability to prevent competitors with low cost, environmentally superior generation projects from reaching the California market. Electric rates remain significantly higher than they should or could be. Progress toward a sustainable environmental footprint for the industry, and an equitable sharing of costs among customers, or of rewards among investors and managers, remain stalled. More importantly, no one has yet articulated a new industry structure that can honestly promise such progress might resume soon. Certainly, PG&E's proposal to hold residential ratepayers captive for fifteen years while it picks their pocket for every last dollar of the Diablo Canyon Settlement does not qualify. Certainly, Edison and San Diego's "POOLCO" proposals conferring market power on existing industry players, restricting entry by artificially depressing the pool spot price while collecting past and future fixed costs through other means do not qualify. All of these restructuring proposals have been shaped, not by a vision of how efficient markets should operate in the future, but by the hope that market share can be protected and the fear that stranded costs might not be collected. Finally, there has been little or no discussion of the role of this Commission or any other public oversight body in the restructured industry. Vague references to performance based ratemaking are insufficient. The Commission's approval -- with one eye on Wall Street -- of a San Diego PBR "experiment" that does not apply to the future industry structure does not constitute a good beginning for this vital topic. In these reply comments, CEERT expands on each of these issues in turn. Existing State of Wholesale Markets Several parties in their July 26 comments and at the August 4 en banc hearing spoke of existing vigorous wholesale competition for generation services. In fact, no meaningful competition exists today. Simply because bids to supply a few crumbs of future generation are significantly oversubscribed and utilities exchange surplus power over an electronic bulletin board is not evidence of wholesale competition, only that the potential for competition may exist. The BRPU bids represent about 3% of installed capacity in California. Even if the Commission is successful in forcing utilities to cede this minor market share to winning bidders, meaningful wholesale competition will still be absent. Only when BRPU losers are able to compete for the other 97% of generation will wholesale competition arrive. All competitive commodity markets function by allowing new entrants to force retirement of old capacity when technology allows costs to fall. The BRPU auction is proof that new generation projects of diverse types using diverse energy sources are cheaper to build and operate and environmentally superior to several thousand megawatts of existing utility plant ignoring sunk costs. Market institutions are similarly stunted. The Western States Power Pool sounds like an impressive beginning until one realizes that transmission access is voluntary and that one must be a control area operator or have a contract for control area services from a control area operator to join this exclusive club. Even when the FERC succeeds in its Energy Policy Act of 1992 mission to force transmission access at fair pricing, the stranglehold on control area services enjoyed by the current franchise monopolies will keep wholesale competition (or bilateral retail wheeling for that matter) as a game for the privileged few. Several presenters at the August 4 en banc spoke of the impact of wholesale competition on retail prices. Many spoke of the experience of gas industry restructuring, but no data was given. The attached Figure 1 shows the past ten year history of wellhead (wholesale) natural gas prices. Major price reductions occurred in the mid-1980s due to interfuel competition with falling oil prices and gas-on-gas competition for limited demand. The latter very important predicate for falling prices was a function of the price deregulation schedule of the Natural Gas Policy Act of 1978 and the issuance of FERC Order 380 in 1984 eliminating commodity minimum bills and facilitating working out of off-market take or pay contracts (stranded cost recovery.) Note that as wholesale gas on gas competition began to take hold in late 1987 with the advent of "open access" by FERC Order 436/500, gas price volatility increased dramatically and this volatility correlated closely with consumption. Retail wheeling in gas did not really get off the ground until 1992, some eight years after the major wholesale price decreases, when FERC Order 636 mandated unbundling of prices (control area services.) Note that wholesale prices were consistently rising during this period. The appearance of "deep, liquid forward markets" is a very recent phenomena and is a natural response to a need by both producers and consumers to hedge against a volatile spot market, not a cause of the significant price reductions that occurred some years earlier. 6 7 Figure 2 shows the distribution of retail gains from this falling wholesale price: Figure 2 Average Retail Natural Gas Prices $/Mcf Wellhead Residential Commercial Industrial Utility 1984 2.66 6.12 5.55 4.22 3.70 1993 1.99 6.15 5.16 2.84 2.61 % Change -25 +0.5 -7 -33 -30 Source: American Gas Association from DOE, Monthly Energy Review The lessons for electric utility restructuring are clear. Based on the evidence of the BRPU bids and other recent capacity auctions in the Northwest, free and open wholesale competition will dramatically lower costs and bring on efficient new supply by forcing the retirement of San Onofre and potentially Diablo Canyon. If this competition is allowed to spread to control area services so that the obsolete urban steam boiler plants cannot hide behind "must run" requirements, perhaps one-third of these Korean War era plants will also be forced to retire and become new beaches and parks for California citizens. The cost savings and environmental benefits of these retirements will be significant. The industrial development stimulated by the investment opportunities to replace this obsolete infrastructure will be enormous. Most but not all of the new generation will be fueled by natural gas. If all costs are considered and the restructuring is designed to eliminate market barriers, renewables and DSM will compete and gain market share. At the same time, the cost of capital for generation projects will rise as risk increases. Reserve margins will fall as the expense of maintaining spare capacity becomes apparent. Spot wholesale prices will become very volatile changing dramatically from night to day and summer to winter. Storage projects, short term trades between North and South, interruptible rates that truly interrupt, and load management DSM will all increase in popularity. "Deep forward liquid markets" will form that allow hedging of the volatility and will mitigate somewhat the cost of capital increase. These effects will be amplified to the extent that the marginal price signals are allowed to flow through to the retail level. Most of this has been articulated and accepted, otherwise, the Blue Book would never have been issued. Professor Hogan would never have left the ivy walls of Harvard University. However, we also know that the transition will be painful to many, exciting for a few, and bewildering to all. Wealth transfers of tens of billions of dollars are simply not accomplished without spilling a few hundreds of millions and trampling the slow and the weak in the process. Little has been said about the will and stamina to see this process through. Nothing has been done to prepare the political ground for the inevitable confusion and recrimination. Worse yet, the specific implementation proposals put forward to date frustrate the overall achievement of positive results, ignore significant environmental issues, and channel the benefits of partial success to a privileged few. Bilateral versus pool The "debate" at the August 4 en banc hearing about which model of competition to pursue, bilateral contracts or a tight pool with contracts for differences, was handicapped by two problems. First, the champions for each side were stuck with flawed proposals. Second, discussion was restricted to the narrow issue of wholesale markets. True differences in the two models only become apparent when retail markets and public oversight requirements are added to the list of issues. PG&E's bilateral model makes much of PG&E's pledge to "freeze rates for two years," withdraw from new generation projects, and allow limited retail wheeling to industrial customers immediately. In the fine print is a grandfathering of existing generation including the exorbitantly overpriced Diablo Canyon, conversion of the golden handshake of a rate freeze for residential customers into the golden handcuffs of being a captive landfill for whatever garbage PG&E has no other place to dump, and a "trust me" regulatory oversight proposal. Even the offer of retail wheeling for the privileged few is hollow without a commitment to unbundle 8 prices and throw open control area services to competition. What PG&E gives with the right hand, it will take away with the left hand. Its industrial customers will be given, if necessary, rate reductions all the way down to short run variable costs, while being effectively prevented from leaving the system with threats of high ancillary service charges. "Industrial development" rates can be offered to potential new customers with the security of knowing that the residential customer will automatically pick up the difference. Potential suppliers will face the other side of the gauntlet of high ancillary service charges. President Fessler's comment suggesting that PG&E just wants to be POOLCO was insightful. If PG&E is adroit enough to manage its costs, it can then raise residential rates within the" CPI - X" formula in PBR and sail onward until the Diablo gravy train runs out and the inefficient fossil generation rusts away in 2008. The incentive to "manage costs" by jettisoning anything that looks like R&D or social responsibility or anticipation of future environmental costs will be enormous. The residential ratepayer will underwrite the risk of this short term cost minimization strategy. The rate result will look a lot like Table 1 except the drop in wholesale prices will be considerably less with existing electricity generation grandfathered. With less drop in overall costs than occurred in gas restructuring, we can be fairly confident in predicting that "X" will be less than 2% and that residential rates will rise at least 20-25% in the next ten years if current inflationary trends continue. To the extent that PG&E is not able to manage its costs or the Commission is able to force some sort of fair unbundling and competition for ancillary services, some wholesale competition could result and some "real" retail wheeling could occur. The Commission's role in this case would be dramatically different and far more complicated than simply setting a number for "X" every six years or so. It would have to be the Arbitrator for contract disputes. Except here, it could not be a neutral Arbitrator with the luxury of judicial time and process. Imbalances or breaches of bilateral contracts will have important and pervasive spillover effects on the "system." The aggrieved party will not necessarily be a signatory to the contract or even be aware of the damage caused. The Commission will be constantly arbitrating every line of the "phone book" transmission tariff and be in the uncomfortable position of having to understand the unknowable of loop flows and third level operating contingencies. To be effective, micromanagement will have to extend to electrical engineering as well as accounting. It is too bad that this discussion is not taking place in the State of Washington, at least there, the regulators would be appropriately housed in Olympia. The proposals of Edison and San Diego are equally flawed and equally as protective of the existing players. This is not to say that pool proposals are generically flawed. In fact, the price transparency of a pool overcomes many of the deficiencies in the bilateral model. CEERT intends to actively participate in the San Diego POOLCO design process to make its concerns known. In the current Edison and San Diego proposals, there is no mention of the controlling interest in current generation held by the utility now serving each control area. Almost by definition, each control area will operate as a sub-pool with "congestion transmission pricing" to other parts of the pool. Any reasonable interpretation of this country's anti trust laws would find a per se violation of Section 7 of the Clayton Act if it were not for the regulatory exemption enjoyed by utilities. There is no mention of removing existing generation from ratebase or changing the formula for fixed cost recovery. It is apparent that neither utility's proposal contemplates fixed cost recovery for rate based assets through the pool spot price. Friendly DISCOs owned by the same investors are ready to write a "contract for differences" to cover this piece (plus presumably, the "transition service charge" from the Blue Book.) Competitors, of course, have no recourse for cost recovery except the spot price since its potential customers must pay the full DISCO charge regardless of any contract for differences on generation services. An educated guess at the pool spot price would by 28 mils on peak and 18 mils off peak, much like the current WSPP bid and asked prices. Meanwhile, ratepayers will be paying an average of at least 50 mils for generation. Some marginal cost signal! 9 There is no mention of the transmission owners' influence over the mere renter's decisions to initiate expansion or modification of the transmission system when such expansion will reduce the value of the owners' investment in both existing transmission and generation. Moreover, there is no mention of the current monopoly position over control area services or how a bidding scheme run by a cost plus POOLCO, perceiving real risk but no reward by shifting to some alternate provider, would operate to bring competition to this vital service. With much of their generation bidding into the pool at zero price as "must run" units receiving fixed costs as "control area services" and much of the rest of their generation receiving ratebase like recovery through affiliated DISCOs, the position of the existing control area operators will be pretty secure. This is Christians and lions competition. As many presenters stated at the August 4 en banc, the difference in outcomes between the two models, at least as currently proposed, is likely to be small. We could probably again confidently predict the Table 1 gas industry result with the Edison or San Diego POOLCO. The only difference from the PG&E proposal would be the temptation to measure wholesale prices as the artificially depressed pool spot price. Both Edison and San Diego proposals make much of the fact that POOLCO does not have to be aware of contracts for differences. Therefore, FERC reported wholesale prices would be pool spot price. Regulators and utilities could crow about the marvelous drop in wholesale prices. Ratepayers would catch the scam. Competitors would be frozen out. As long as utilities did not get too greedy and a trust buster was not elected Governor, the club could remain intact. The CPUC role in this world would be very interesting. To protect ratepayer interests, it would have to scrutinize all contracts for difference and like instruments signed by DISCOs, and control area services agreements signed by POOLCO for evidence of self dealing with generation and/or transmission affiliates. It would have to closely monitor pool bidding for evidence of collusion between bidders or between buyers and affiliated sellers. It would have to police "insider trading," illegal price signaling, etc. Organizations like CFEE, EPRI, CURC, etc. would have to reform practices to keep utility executives out of jail. In short, the Commission would have to become both the Attorney General and Security and Exchange Commission for electricity. Meanwhile, the FERC is certain to claim exclusive jurisdiction over pool operations, but will have no jurisdiction or desire to regulate DISCOs. CEERT believes this is an impossible situation for the CPUC. POOLCO is not feasible without structural changes in ownership and basic regulatory processes that ensure compliance with anti-trust laws. Either model can be made to work. Let PG&E explain how it will handle dispute resolution, unbundling and fair pricing of control area services. Let it propose a more workable direct access schedule that treats residential ratepayers fairly and has a more reasonable end to the Diablo Canyon settlement. Let Edison and San Diego propose to remove all generation from rate base and forbid contracts between DISCOs and affiliated generation plants. Let Edison propose sale of its transmission assets to POOLCO. Let all three utilities explain how they will uphold the principle of the polluter pays for dirty generation and how DISCO profits will be uncoupled from final sales so that inefficient consumption is not encouraged. Then the record will be clear. Then an honest comparison between models can be made. Regulatory Oversight Philip O'Connor proposed a "Tehatchapi Compromise" at the August 4 en banc hearing where each utility would be given the opportunity to pursue its own vision of utility restructuring and the Commission could view both for comparison. Mr. O'Connor's only caveat was that both North and South would have the same schedule for direct access. CEERT would like to add its own caveat. The oversight burden will be difficult enough with only one restructuring unfolding. If the Tehatchapi compromise were attempted, each half of the State would be regulated differently. In the North, the Commission would be Arbitrator/traffic cop/engineer. In the South it would be Attorney General/ economist/diplomat (for relations with FERC and neighboring states.) Either role is difficult enough. At the same time, the Commission will be overseeing three different Performance Based Ratemaking schemes, even though it has never seriously considered how PBR system design relates to regulatory 10 goals. This hardly seems to achieve the Commission's goal of lightening the regulatory hand. It is CEERT's opinion that the choice of models rests on which will be easier to have effective public oversight and regulation and how stranded cost recovery is managed to minimize market distortion. Certain parts of the delivery system will remain natural monopolies. The potential for market failure in the "competitive" portions are high. The consequences of this market failure can be disastrous. "Partial deregulations" are very difficult to manage as participants attempt to shift risks to the regulated portion and profits to the unregulated portion of the business. CEERT believes this issue deserves a much fuller airing of views and respectfully proposes a fifth en banc hearing to address regulatory oversight, mechanisms for stranded cost recovery, and Performance Based Ratemaking goals, objectives, and system design. Respectfully submitted, August 18, 1994 __________________ James H. Caldwell, Jr. TGAL, Inc. for the CENTER FOR ENERGY EFFICIENCY AND RENEWABLE TECHNOLOGIES P.O. Box 26 Tracy's Landing, Marland 20779 (410) 257-3195 11 CERTIFICATE OF SERVICE I, Ronda K. Paschal, am over the age of 18 years and emplyed in the City and County of Sacramento. My business address is 1100 11th Street, Suite 311, Sacramento, CA 95814. On August 18, 1994, I served the within document REPLY COMMENTS OF THE CENTER FOR ENERGY EFFICIENCY AND RENEWABLE TECHNOLOGIES ON COMPETITIVE WHOLESALE ELECTRIC MARKETS AND MARKET INSTITUTIONS IN THE RESTRUCTURED ELECTRIC INDUSTRY in R.94-04-031/I..04-04-032 by placing a true copy of each enclosed in a sealed envelope, with postage thereon fully prepaid upon and propserly addressed to all parties of record and the State Service list in this proceeding requesting such service (as indicated by an asterisk (*)0, with two copies (one on paper and one on 3.5 inch disk) also served on the Division of Strategic Planning as required by Ordering Paragraph 3 of R.94-04-031/I.94-04-032, and with two copies by hand delivery or overnight wevice to the Commissioners' offices and to the Commissions's staff in accordance with the Assigned Commissioners' Rulings of May 1 and July 8, 1994, and the Administrative Law Judge's Rulings of June 9, June 21, and July 26, 1994 at San Francisco, California. Executed on August 18, 1994 at Sacramento, California. ______________________ Ronda K. Paschal 12