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 ) ) ) I. 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 United States Department of Energy for September 16, 1994 Full Panel Hearing August 24, 1994 Executive Summary The Department of Energy supports the development of competitive electricity markets at the wholesale level and recognizes the responsibilities of state regulatory commissions and legislatures to address retail competition issues. The Department urges the California Commission to promote efficiency in wholesale and retail markets actively. We also believe that development of full competition at the wholesale level will provide significant benefits to all consumers and is essential to the development of efficient retail markets. The Department recommends that the California Commission act to resolve several important issues before deciding to implement the direct access portion of its April 20, 1994 proposal. First, the Department recommends that the California Commission obtain a resolution of the federal/state jurisdictional issues that we identified in our June 8, 1994 comments to this Commission. Second, direct access should not be initiated until a better collective understanding has been established as to how to best structure competitive retail electricity markets to achieve a number of important public policy objectives that we also identified and discussed in detail in our June 8 comments. As a possible alternative to direct access, we urge the California Commission to consider ways to implement what Professor William Hogan of Harvard University termed "efficient direct access" in his June 15 comments to this Commission. "Efficient direct access" would give all customers the opportunity to buy electricity at a price that would be visibly linked to the real-time marginal cost of generating electricity for sale in California. In concept, providing customers with an efficient spot price for electricity, in combination with appropriate bilateral financial agreements, can provide a functional equivalent of traditional direct access. The Department believes that many of the benefits sought by the California Commission can be achieved through the combination of efficient wholesale competition, the provision of transparent spot prices to retail customers, and performance-based ratemaking, with little of the risk, uncertainty, and potential harms associated with the Commission's April 20 proposal for direct access. DOE believes that the most expeditious way to achieve the California Commission's goals in this proceeding would be through a comprehensive combination of ratemaking reforms that would encourage utilities and other parties, such as other categories of electricity producers, transmission operators, and power marketers, to operate efficiently, and send proper price signals to consumers. These reform mechanisms would also provide an effective means of continuing the California Commission's support for energy efficiency, fuel diversity, environmental protection, and other electricity-related policy objectives. 2 I. Introduction The comments presented below, though filed by the Department of Energy, represent the Administration's energy policy perspectives with respect to the proposed restructuring of the electricity industry in the state of California and, more particularly, issues related to retail electricity markets, which is the subject of the present Full Panel Hearing. In parallel, the Secretary of Defense, acting through the Department of the Navy, is filing comments on behalf of the consumer interests of the Department of Defense and other Federal Executive Agencies (FEA). The Department of Energy supports the efforts by the California Commission to increase competition in electricity markets, and believes that increased competition in the electricity industry, properly structured, will provide benefits for all consumers. We recognize that the California Commission and the state legislature have the responsibility to develop and implement policies regarding the regulation and operation of the electricity industry within California, except for matters subject to Federal jurisdiction such as the rates, terms and conditions of the transmission and sale for resale of electricity in interstate commerce, which are the province of the Federal Energy Regulatory Commission. Virtually all intervenors in this proceeding agree that increased 3 competition in the electric services industry can provide significant benefits to consumers. However, there has been much debate between those who argue that most if not all of the benefits sought by the California Commission can be achieved primarily through wholesale competition and performance-based ratemaking (PBR), and others who argue that realization of the expected benefits requires both wholesale competition and retail competition in the form of direct access. To clarify the respective merits of these views we think it is useful to list and discuss three categories of potential real cost reductions in the electric services industry. The Department's analysis of potential efficiency gains in the electric industry is generic and does not make any claim about the extent to which inefficiencies are present in the current operations of California's utilities. Rather, we think that these kinds of inefficiencies are likely to exist to varying degrees across the U.S. electric industry, given its current structure and regulation. II. Categories of Potential Cost Reduction The sources of potential cost reduction in the electric industry, both short- and long-term, may be divided into three general categories: 4 1) Short-run production efficiency: This refers to the economically efficient use of a fixed stock of resources. Short-run efficiency in the generation of electricity within a control area is achieved through economic dispatch. Under economic dispatch, generating plants and bulk power transmission facilities are used in a way that minimizes the cost of producing electricity at any given time. In other words, there is no alternative way of using generation and transmission capacity that would reduce the cost of meeting the minute-by-minute demand within a control area (while maintaining agreed-upon standards of reliability and operating within the physical constraints of the existing system). Extending and consolidating economic dispatch over larger areas will frequently achieve significant savings because multiple utilities can take advantage of load and resource diversity to equalize short-run marginal generating cost between control areas. The limiting case is reached when there are no unrealized gains from trade between control areas, and we do not think that limit has been reached in California. To maximize the potential gains from trade, utilities in some regions have formed "tight" power pools, whereby the aggregate generating capacity of the pool's members is centrally dispatched as if the members were a single utility. 5 2) Long-run production efficiency: This is achieved through the least-cost expansion and use of resources (i.e., generation, transmission, and distribution capacity, as well as end-use capital investments). Utility resource planning has traditionally had the goal of minimizing the long-term present value revenue requirement of serving its customers. Recently, some state regulators have directed their utilities to practice integrated resource planning, which typically requires the affected utilities to treat customer demand as a variable that can be influenced, rather than one that must be accepted as a given. Further, integrated resource planning typically requires utilities to procure resources on the customer's side of the meter if doing so helps to minimize the total cost of providing electricity service. Utilities across the U.S. have had very mixed success in resource planning and procurement, and this experience has contributed strongly to the rate differentials seen today. Planning is always based on a set of assumptions about the future that turn out to be wrong by greater or lesser degrees. Some utilities have been more fortunate or more successful at hedging against future risks and uncertainty than others. 3) Management Efficiency: This category includes all other 6 potential kinds of savings that could be made in the management and operation of electric utilities. A regulated monopolist is not likely to be as cost-conscious in the overall management and operation of its firm as is a firm in a competitive market. For example, a regulated monopolist may be more likely than a competitive firm to be overstaffed or to have excessive overhead. All potential real savings (i.e., reductions in the total cost of providing electricity services) can be assigned to one of these three categories. The largest potential savings are probably those that can be gained through more efficient long-term resource development. However, these savings are probably the most uncertain. III. Achieving the Potential Cost Reductions Reformulating electric markets in a way that will eliminate existing sources of inefficiency without creating new ones will not be easy. In its proposed order the California Commission correctly recognizes that reducing inefficiency in the electric industry will require both regulatory reform and increased reliance on competition. The Department believes that a set of carefully developed policy instruments will be needed to achieve the potential benefits of greater competition while at the same 7 time avoiding the creation of new incentives for uneconomic behavior or interfering with the achievement of other important public policy objectives. In this context, we wish to call particular attention to the need to ensure that the new structure for the operation and regulation of California's electricity industry provides mechanisms for addressing electricity-related environmental concerns effectively and at the least cost over the long term. We do not believe that adequate analysis of this subject has been undertaken. As a result, it is impossible to assess accurately the range or the significance of possible changes that restructuring might induce in the many complex aspects of environmental quality. Reducing this uncertainty is essential. One of the core elements of environmental protection is the provision of adequate safeguards against environmental degradation. As long as restructuring translates into heightened uncertainty about environmental impacts, it undermines the goal of environmental protection. As the U.S. Environmental Protection Agency (EPA) stated in its June 24, 1994 comments, environmental concerns should be integrated into the Commission's restructuring and Performance Based Ratemaking (PBR) proposals to avoid consequences that could be detrimental to California's environment, public health, and economy. Four points from EPA's June 24 comments warrant reiteration here: 8 1) Energy efficiency and renewable technologies are "clean air measures" which should be accorded an integral role in California's electric generation sector, particularly in the state's non-attainment areas. We urge the California Commission to consider how its regulatory reforms might affect ongoing efforts to attain the health-based standards of the 1990 Clean Air Act Amendments. To the extent that restructuring alters the resource mix serving California's electricity needs, environmental regulators may need to consider alternative means of limiting emissions to reach attainment. This could result in the inadvertent substitution of more expensive pollution control measures for cost-effective emission reductions through energy efficiency and renewable technologies. EPA also encourages consideration of the possible effects of the restructuring proposal on air quality outside California, particularly with respect to the visibility in the Grand Canyon and other national parks in the Southwest. 2) Due to the substantial environmental impacts of electricity generation, the California Commission should consider the possible long-term implications of these impacts, including the possibility of changes in environmental regulations, and it should reflect these uncertainties through appropriate market mechanisms that will signal parties that they are responsible for anticipating the risks of possible 9 regulatory changes. Environmental impacts, including those of residual emissions, should be reflected at each juncture in the regulatory process to avoid giving electricity sellers or users incentives to use electricity technologies which are less efficient or more polluting. 3) EPA urges the California Commission to pursue regulatory policies that will allow the state's utilities to maintain their leadership role in the commitment to reduce U.S. greenhouse gas emissions to their 1990 levels by 2000. 4) In implementing PBR, environmental factors, including the risk of future environmental regulations, should be included as performance criteria. PBR should be designed to minimize customers' overall energy service costs rather than electricity rates alone. Short-run production efficiency The Department of Energy believes that short-run production efficiency is most likely to be achieved through market-based power pooling arrangements structured along the lines of the "POOLCOs" proposed by San Diego Gas & Electric, Southern California Edison, and Dr. Hogan. A POOLCO-type arrangement would provide access on a non-discriminatory basis to all generators seeking to sell power into the region it serves. 10 There has been much debate in this proceeding about the relative merits of a wholesale market featuring a pool versus one characterized by a network of bilateral contracts. This debate strikes us as inappropriate because electric generation supplied to an integrated transmission network is unavoidably pooled, regardless of the extent of wholesale trade or the method by which parties compensate each other for transactions. Thus, it is not a question of having a pool or not having a pool; the question is whether there will be efficient (least-cost) pooling or less efficient pooling. Having all plants within a large geographic area centrally dispatched ensures that the least-cost reliable mix of generation will always be in use from moment to moment to meet the area's fluctuating demand requirements. By comparison, dispatching generating plants primarily on a contractual basis would minimize the area's short-run production cost only by occasional good fortune, not systematically. Market-based pools would achieve savings beyond those achieved by today's centrally dispatched power pools because dispatch would be based on price bids rather than on plant cost information given to the control area operator. Generators would have a stronger incentive than they do today to minimize their operating costs because recovery of their fixed costs would depend, in part, on the margin between the pool spot price and the plant's average variable cost. The fact that the pool would be open to all potential generators within the affected geographic area 11 would also put downward pressure on spot prices. Long-run production efficiency The Department believes that properly formulated wholesale competition would significantly improve long-run production efficiency. In our July 26 comments in this proceeding we discussed several conditions that we consider necessary for effective wholesale competition. These are: 1) Open, non-discriminatory, and comparable access to regional transmission networks for all generators; 2) Transmission prices that are regulated and reflect the underlying cost of a given transaction; 3) Transparent spot market prices for electricity; 4) Rate regulation that encourages good portfolio management; 5) Open and full competition for all incremental generation supply; and 6) A sufficiently large number of competitors in all regional generation markets. Having these conditions in place would improve a utility's resource procurement because it would have more options, generation costs and demand-side management would be disciplined by competition, transmission prices would be regulated to reflect 12 real costs more accurately, and the utility would have a financial incentive to acquire the least-cost portfolio of resources. Advocates of direct access believe that it is inherently inefficient for a utility to procure resources for a large and diverse set of customers (i.e., all customers in a franchise service territory). They argue that different customers desire different levels of service reliability and different types of financial arrangements. An adequate level of product differentiation, it is argued, cannot be provided efficiently by a single utility. Hence, resource development needs to be decentralized and made more customer-driven. Others argue that end-use efficiency will be harmed, not enhanced, if direct access is implemented and resource development becomes decentralized. Those who adhere to this view contend that the utility performs a valuable role as a portfolio manager and that the total costs of electricity-related services will not be minimized on a system-wide basis if resource development is purely customer driven. In addition, opponents of direct access argue that resource development will be overly affected by pressures on sellers to keep short-term prices low, so that investments that are cost-effective on a life-cycle basis but which do not have a quick payback (i.e., which raise rates in the near-term) may not be made. This means that the long-run 13 cost of providing electricity-related services would not be minimized. The Department sees merit in both points of view. Integrated resource planning could, under ideal conditions, minimize the long-run cost of providing electricity. Giving customers direct access to resource suppliers could lead to a better allocation of the risk of new resource development. It is not clear a priori which route would provide the greatest benefits. Fortunately, the California Commission does not need to decide this question. Customer choice and customer-driven resource development are not wholly dependent on direct access or retail wheeling as traditionally conceived. In concept, customers can obtain the functional equivalent of direct access (termed "efficient direct access" by Hogan) if they can buy electricity at a price that is visibly linked to the real-time spot market price of electricity generated for sale in California. Once a pool of the type described earlier is established, the spot price seen by wholesale sellers and wholesale buyers can also be provided to all retail customers. The customer would have a two- part tariff, one part would be the pool-derived spot price for electricity and the other part would reflect the local utility's fixed costs of providing service. Once customers have access to a real-time spot price, they can continue to buy electricity at that price, or enter into a hedging contract or contract for 14 differences with any party they wish. Thus, a customer could use a contract for differences to obtain the equivalent of insurance coverage against unexpected fluctuations in the spot price, if that is a concern. Many other types of contracts are conceivable. For example, a customer might buy an option on a demand-side resource from an energy service company as a hedge against possible increases in total energy costs. These benefits could become available to even the smallest retail customers through the development of standard contracts or service packages offered to broad groups or associations of customers. This point is worth emphasizing. "Efficient direct access" would provide the opportunity for the customer-driven resource development that advocates of traditional direct access seek. It would engender the development of contracts for differences and similar hedging instruments to the same extent as traditional direct access. Customers will have the opportunity to freely enter into contracts with whomever they want and thus will be free to do their own resource planning. Finally, it is important to recognize that direct access as traditionally conceived is essentially fictional. Except in rare circumstances, no end user could literally contract with an "alternative supplier" for its electricity. Unless the customer 15 were connected by a dedicated transmission line to a single generating unit, the electricity delivered to the customer would be drawn from a pool--some form of pooling is unavoidable--and the ultimate source of electricity would be unknowable. Further, unless the customer were to move to another service area, he or she would remain linked to the local distribution company as the means of obtaining electricity in a physical sense. The result is that traditional direct access can only exist in the form of bilateral financial agreements essentially similar to those that would result under "efficient direct access." Allowing these agreements to flourish, with minimal regulation, will be important to achieving the full benefit of restructuring the industry. Management Efficiency The Department believes that well-designed performance-based regulation (PBR) can greatly improve the management efficiency of utilities. Utilities will have more incentive to keep their costs down under PBR because a utility's shareholders benefit when a utility reduces its costs. Under traditional cost-of- service ratemaking cost reductions are ultimately passed through to customers, as are cost increases. However, weeding out management inefficiency is also held to be a benefit of traditional direct access. That is, the unrelenting 16 need to compete with other suppliers will force utilities to pare the cost of their operations. The assumption is that competition would probably do a better job of weeding out waste than formula- based regulatory incentives. The Department thinks it plausible that retail wheeling would weed out more management inefficiency than PBR by itself. At the same time, we think that the incremental savings from "belt tightening" above and beyond those achievable through PBR (and more efficient wholesale markets) are likely to be relatively small, given that the scope and cost of the activities still subject to detailed rate regulation would be considerably smaller than they are today. To summarize this section: The Department believes that most of the potential cost reductions can be achieved through properly formulated wholesale competition, PBR, and "efficient direct access." The latter gives customers the opportunity to do their own resource planning by entering into long-term financial contracts with whomever they want. This combination of measures would yield substantial short- and long-run cost savings associated with wholesale competition, as well as the cost savings and risk allocation benefits of customer choice. 17 IV. "Design Requirements" and Traditional Direct Access In its June 8 comments to the California Commission the Department said it could support traditional direct access or retail wheeling provided the jurisdictional uncertainties were resolved and nine other essential design requirements were met. These requirements pertain to ensuring the continued achievement of important public policy objectives in the following areas: 1) economic efficiency and industrial competitiveness; 2) environmental protection; 3) system reliability; 4) fuel diversity and renewables; 5) research and development and use of new technologies; 6) equity; 7) stranded assets; 8) integrated resource planning; and 9) demand-side management. We think that "efficient direct access"--or some other approach that combines efficient wholesale markets and accurate price signals to customers--largely averts the jurisdictional issues because all customers would still literally buy power from the local utility. Hence the legal issues associated with wheeling electricity to retail customers would not arise. The Department also believes that "efficient direct access" can be designed in a 18 way that will be consistent with other important public policy objectives that the Department thinks should not be abandoned or harmed in a restructured industry. By comparison, we are not yet convinced that traditional direct access can be designed in a way that would be consistent with the policy objectives articulated as design requirements. The Department wishes to work with the California Commission to achieve the goals of its proposal in a manner consistent with national interests and federal responsibilities. We appreciate the opportunity to participate in this proceeding and believe that the debate launched by the California Commission's initiative has been very fruitful. We applaud your boldness and look forward to participating in further dialogue with you and other parties to this proceeding. ____________________ ____________________ Susan F. Tierney Robert R. Nordhaus Assistant Secretary General Counsel Office of Policy 19