Competition in the Electric Industry: Emerging Issues, Opportunities, and Risks for Facility Operators (1996)

Douglas Long

California Public Utilities Commission

I will discuss the process the State of California has used in developing a proposed market structure; the goals and objectives of electricity restructuring in California; the proposed market structure; transition costs; customer choice; the role of the utility in restructured industry; some of the major current issues; and the state's schedule for implementation.

The California Public Utilities Commission began the process of moving toward competition in 1993, when it published a book, "Perspectives on the Electric Industry," known as "the Yellow Book." That proposal attracted public comment and discussion, on the basis of which the Commission prepared and published another book in April 1994, called "the Blue Book." The Blue Book was an order instituting an investigation of restructuring. It prompted more public comment and commission hearings. In May 1995 the Commission published two alternative potential versions of a restructured electric industry. In response, some of the major utilities and customer groups developed a memorandum of understanding that merged the two alternatives. In December 1995 the Commission published Decision 95-12-063, which outlines the broad goals of restructuring. These goals are expected to be reached by 1998. Decision 96-03-022, published in March 1996, fills in some of the details.

The goals for electricity restructuring in California are to:

• Offer consumers greater choice in purchasing energy services

• Allow competition to flourish where conditions are ripe

• Implement performance-based ratemaking for remaining monopoly services

• Reduce the price of electricity

• Continue to deliver safe, reliable, and environmentally sensitive energy services

• Maintain universal, nondiscriminatory availability of electric services

• Provide the utilities with a reasonable opportunity to earn a fair return on their investments

• Continue to encourage the diversity of energy sources and maintain important public purpose programs.

In outline, the new market structure being proposed for California (to be put into effect January 1, 1998) has the following elements:

• An Independent System Operator (ISO) for the transmission system

• A competitive wholesale power pool (known as the Power Exchange)

• Customer choice of options: full service utility customer, direct access to the competitive electric generation market, real-time rate options, or contracts for differences.

Figure 1 puts this proposed market structure in graphic form.

We expect all consumers, large and small, to benefit from a competitive market for electricity. Statewide power dispatch and competition among generators on an hourly or half-hourly basis will improve efficiency. Consumers will be able to optimize their energy use, taking advantage of off-peak power, through the use of real-time metering.

A reduced rate of return on some uneconomic ("stranded") assets will reduce rates. We shall find out over time whether these expectations are met. In addition, rates for full-service customers will be capped for three years at the levels of January 1, 1996.

At the top of Figure 1 are generators 1 through 6 in this example. Traditionally their power goes through the vertically integrated transmission and distribution systems to customers (numbered 1 through 5 in the example). Figure 2 is a more detailed view.

The California Public Utilities Commission wants to change this pattern. The debate was whether to do it through a Power Exchange, for wholesale power alone, or let customers buy directly. Originally the Commission staff favored the latter approach. One advantage of that approach was that functions of the Power Exchange and the Independent System Operator could be combined in one organization. Under the proposed system, there will be two separate entities (with the Power Exchange as a wholesale market and retail customers permitted to go directly to generators).

In the proposed market structure, the Independent System Operator controls and operates the transmission system. This arrangement will ensure that wholesale transmission for utilities is not favored over retail transmission for customers.

The ISO also:

• Coordinates scheduling the dispatch of power from all sources

• Balances load on a real-time basis

• Efficiently manages transmission congestion

• Maintains reliability

• Recovers the costs of ancillary services

• Provides information on transmission constraints, load distribution, line losses, and other system conditions.

The ISO will be structured to be independent of the utilities and the Power Exchange. The ISO will not own the transmission system, but will

make operating decisions. (The transmission system will continue to be owned by the utilities). Approval by the Federal Energy Regulatory Commission will be required beforehand.

In the proposed market structure, the Power Exchange will provide a market for power with published hourly and half-hourly prices. It will be a competitive, wholesale power pool that will allow power producers to compete using transparent rules for bidding into the exchange. The power exchange will match supply bids with bids from utilities, power marketers, and others, rank the bids on a least-cost basis and then submit the proposed schedule for delivery of power to the Independent System Operator. The Power Exchange will also show a visible price for customers help them to make efficient purchasing decisions and adjust their consumption.

The structure of the Power Exchange will ensure that it is separate and independent from the Independent System Operator. Furthermore, it will have no financial interest in any source of generation. Like the ISO, the Power Exchange must be approved by the Federal Energy Regulatory Commission.

Municipalities, independent power producers, out-of-state producers, and public utilities will be able to participate in the Power Exchange, but their participation will be voluntary. During the five-year transition period, Pacific Gas and Electric, San Diego Gas and Electric, and Southern California Edison are required to purchase all of their energy requirements for full service customers through the Power Exchange. They are also required to bid into the Power Exchange until their generating plants are valued in the market.

To reduce the "horizontal" market power of utilities (due to their ownership of the vast majority of generating plants), the largest investor-owned utilities, Southern California Edison, San Diego Gas and Electric, and Pacific Gas and Electric will be required to divest themselves of some generating assets.

Transition costs are the costs associated with utility assets and obligations that become uneconomic in a competitive environment. Such costs and obligations include the above-market-value portion of the undepreciated fixed costs of generation assets; costs of generation contracts if prices prove to be uneconomic in the future; and other generation-related costs that are completely unavoidable. By 2003, all non-nuclear generating assets will be held out for sale or appraisal. Rates for nuclear generating assets will be determined separately under an alternative ratemaking proposal. Every generating asset must be assigned a value, to identify those that are overvalued or undervalued on the books, compared with their market value. The difference between the market price and what is on the books is what we call a "Competition Transition Charge" (CTC).

A share of the transition cost will be paid by every electricity customer of an investor-owned utility. Utilities will recover all transition costs, but they will earn a lower return on equity for uneconomic assets. Rates for bundled electric service will not rise above January 1, 1996 rates. The CTC will be collected only until 2005. The Commission's preferred policy also states that the CTC cannot be "bypassed" by customers. Nor will there be any cost shifting among customer classes.

Figure 1 shows the two fundamental options for customers. Whether a customer is making a direct access transaction or making Power Exchange purchases from a utility, he or she must deal with the Independent System Operator, and with some form of local distribution utility.

If a customer decides not to stay with the bundled full-service flat rate from the local utility, many options present themselves. With a direct access option, retail customers can choose to arrange the purchase of electric generation service directly from nonutility generation providers. Customers will also have the choice of a real-time rate option which will allow customers to shift their use to lower cost periods, reducing their electricity bills. Under this option, distribution utilities will offer tariffed electric service referencing the real-time price published by the Power

Exchange. Customers may also enter into contractual arrangements that allow for the allocation of risks associated with market uncertainties and price volatility. Customers will also be dealing with aggregators of all kinds who will be telephoning, seeking to sell their products and services, and probably interrupting the customer's evening meals, much as the long-distance telephone companies do today.

Among the other issues we face in California, and probably nationally, are municipal utilities' having competitive advantages over utilities that now exist. Municipal utilities are able to issue tax-exempt bonds at a lower cost than the debt issued by investor-owned utilities. Municipal utilities may arguably be able to control or prevent competition within their territories. In the period of transition to competition, customers may abandon the utilities for municipal and other power companies, leaving the remaining customers to bear the full transition charges.

Utilities under the California Public Utility Commission's jurisdiction will have the following functions:

• Provide safe, reliable, nondiscriminatory distribution service to all electricity customers

• Provide energy from the Power Exchange to all customers who do not choose or are not eligible for direct access (so-called full-service customers)

• Provide service under incentive ratemaking rather than cost-of-service ratemaking for distribution and utility-owned generation assets.

Among the major issues that California is still looking at are public purpose programs and rate-setting. Public purpose programs are functions utilities have come to serve that are considered to be in the public interest, but are not in the immediate interest of the utilities. Utilities support research and development, energy efficiency assistance to customers, rate assistance to low income customers, and the like. Some of these functions

will need to be provided in other ways in the future. Surcharges for research and development, energy efficiency programs, and low income rate assistance and efficiency services are included in the plan. It also includes a renewable energy purchasing requirement.

Rate-setting also is a complicated issue. Rates will need to be established for both transition costs and unbundling pricing. We need to break out those costs and separate them in order to seek approval before FERC for transmission rates charged by the Independent System Operator.

Our goal is to have the new market structure in place by January 1, 1998. Essential actions that are needed prior to January 1, 1998, include the following:

• ISO principals and rates approved by FERC and asset transfer approval by the California Public Utilities Commission

• Power Exchange approved by FERC and asset transfer approval by the California Public Utilities Commission

• Resolution of horizontal market power issues

• Rates unbundled and applicable tariffs established

• Adoption of direct access eligibility and phase-in protocols

• Adoption of direct access standards including billing and access charges

• Adoption of metering standards

• Installation of metering equipment

• Adoption of competition transfer charge mechanism; forecast of costs articulated

• Establishment of rules for new estimates

• California Environmental Quality Act completed and Environmental Impact review official

• Consumer protection in place: service and safety issues and education trust

• Public goods charge in place.