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

Ross Hemphill

Niagara Mohawk Power Corporation

I will address several topics regarding the restructuring of the electric industry to introduce competition in the state of New York. These will include the so-called "price problem" in New York; the multiyear rate case process; Niagara Mohawk's Power Choice Proposal; and other proposals under consideration.

Electric power prices in New York are among the highest in the nation for both industrial and residential customers. Figure 1 is a map showing the average price paid by industrial customers in each state, using data from Edison Electric Institute reports. Industrial customers in New York are paying significantly higher prices, on average, than those in most other parts of the country. This has not always been the case; these prices have increased significantly over the past decade.

The problem manifests itself in the price of electricity, but price is not really the problem; it is a symptom of the problem. The problem can be traced to an outdated system of regulation and an industry in need of restructuring. The two largest contributors to the growth in prices since 1990 at Niagara Mohawk are (a) requirements to purchase power from independent power producers (IPP) at above market prices and (b) increases in state and local taxes. Between them, these two items will account for more than half of Niagara Mohawk's costs in 1996, which is to say that more than half of the company's costs are outside our control. Figure 2

shows that the IPP costs are increasing much more rapidly than any other costs. Niagara Mohawk also built two nuclear power plants, of course, but their costs are decreasing and will be less of a problem as the years go by, while IPP payments continue to rise.

While there is, strictly speaking, no retail competition in the electricity business, the price problem presents real challenges to the company already. Self-generation, for example, is financially attractive to many industrial customers when compared to our full retail tariff, and a growing number of customers are considering it. Relocation of companies is another challenge. A number of customers say they are moving to other regions for lower priced power. We also face competition for residential and commercial customers; efforts to form municipal utilities are underway all over New York.

To confront some of these challenges, Niagara Mohawk, about a year and a half ago, filed what is probably the most flexible tariff in the nation. It is a tariff that allows Niagara Mohawk the flexibility to sign contracts with pricing terms much different from the standard rates under which customers normally purchase electricity. The state regulatory commission requires justification of any such discounts on the basis of the customers' competitive alternatives. It is not a trivial task to make that determination. These case-by-case reviews are not practical in the long run. A more systematic solution is needed.

Niagara Mohawk took the first step in that direction in February 1994, when it filed a multiyear rate case in which it asked for a price cap and indexing mechanism (something almost unheard of in the industry at the time). This multiyear proposal is still being negotiated more than two years later.

The proposal included indexing of prices to the consumer price index over five years. The initial year was to be established using traditional cost-of-service ratemaking, which would have resulted in a fairly large rate increase in the first year.

The proposal went nowhere, owing to opposition from the Public Service Commission staff, customer groups, and other interested parties. All parties had problems with the initial year's increase and most of the parties disliked the indexing plan. Industrial customers wanted assured

reductions and were not satisfied with the proposal, under which Niagara Mohawk could reduce prices but was not required to reduce them. Advocates for residential customers saw too much flexibility in the plan, seeing it as a plan to impose greater than average price increases on their constituencies. Environmental advocates liked the idea of a multiyear price plan, but wanted something more conducive to conservation; they see price caps as providing too much incentive for sales growth.

As a result, the commission bifurcated the case, dividing the proposal between the initial year (1995) and the subsequent years (1996-99). It directed the parties to negotiate a solution. From this directive came Niagara Mohawk's Power Choice proposal.

In October 1995, as a result of these negotiations, Niagara Mohawk released its Power Choice proposal, which has 10 elements:

1. Financial separation of generation from the rest of the Niagara Mohawk Power Corporation. The generation company would include all generating assets and remaining contracts with independent power producers. The remainder (transmission, distribution, and gas operations) would operate as a regulated utility, in a holding company.

2. A competitive wholesale generation market. An independent system operator also known as a ''Poolco" would administer the competitive wholesale market using real-time location-based marginal cost pricing. This pricing allows the creation of an efficient spot market taking into account constraints in the transmission system.

3. Customer choice of generation suppliers. Retail competition would be phased in within three years after the independent system operator and power exchange are operational, (and would ultimately include residential customers by the year 2000). Customers would pay the full costs of the necessary metering and communications technology for hourly pricing, and for stranded costs remaining after contributions by Niagara Mohawk and independent power producers (see items 5 and 6 below).

Purchases would be made either through an independent system operator or through bilateral contracts.

4. Freezing prices through the year 2000. In the current structure, continued cost-based regulations would require price increases of more than 4 percent for 1996 and 1997. The Power Choice proposal would impose a price freeze for all customers from 1996 through 2000, except industrial customers, who would see price decreases of 10 to 12 percent. On February 12, 1996, Niagara Mohawk filed for temporary rate relief. We also filed a full revenue requirement rate case for rates effective January 1, 1997. These actions were taken to protect the interests of our shareholders.

5. Funding the price freeze. The $2 billion cost of the price freeze would be shared by Niagara Mohawk ($400 million) and independent power producers ($1.6 billion), in proportion to the parties' shares of the stranded costs of generating units.

6. Recovery of stranded costs from independent power producer contracts with advance-payment accounts. One of the most onerous types of independent power producer contracts, advance-payment contracts, required Niagara Mohawk to pay in advance, to help independent power producers obtain financing. The contracts require independent power producers to repay the amount they have been overpaid relative to avoided costs; since avoided costs have fallen, the amount owed is substantial. Under current state and federal law, the New York Public Service Commission has the authority to order such independent power producers to obtain commercial acceptable firm security for these obligations, which would save Niagara Mohawk customers about $1 billion (net present value).

7. Recovery of the remaining strandable costs resulting from restructuring independent power producer contracts. Opening generation to competition in 1997 would produce about $5 billion in stranded costs (net present value) if no provisions for recovery were made. An absolute condition on the proposal is that any strandable

costs remaining after cost reduction would be fully recoverable by Niagara Mohawk and the independent power producers through access charges for the remaining monopoly services.

8. Restructuring contracts with independent power producers. To ensure adequate numbers of generation competitors and to improve the efficiency of the market, some or all of the independent power producers must sell into that market or directly to customers as retail access is phased in. Niagara Mohawk prefers to negotiate, but it is prepared to restructure contracts through its power of eminent domain.

9. Additional state action. The relevant state agencies are requested to take a variety of actions. The Public Service Commission would approve the proposal, including the use of condemnation by Niagara Mohawk in restructuring independent power producer contracts; issue an order requiring firm security from independent power producers with advance payment accounts; eliminate regulatory micromanagement; eliminate or reduce public purpose programs that cannot be supported by the market (such as subsidized demand-side management); and ensure a level playing field for Niagara Mohawk and its successors. The New York Power Authority would refrain from shifting strandable costs to residential customers through subsidized industrial rates; would take steps to make condemnation possible; and would assume financial responsibility for nuclear units.

10. Formation of a holding company. Unregulated affiliates formed to offer generation and other services would be housed in a new holding company.

During the past two years Niagara Mohawk has identified ways to decrease its costs in many ways. As mentioned earlier, the cost of its own generation has declined significantly. The company has also reduced its work force by 28 percent since 1994. However, because of the reasons

stated earlier, it still has costs that will not be recoverable in a competitive market. The show-stopper in this plan is the question of strandable costs resulting from the restructuring.

The utilities will ultimately recover their strandable costs. The question is whether the country will face years of litigation before that fact is established. If customer advocates and commissioners take stands against appropriate recovery of these costs, they will slow the process of restructuring immensely.

The independent power producers are no different in that respect from the regulated utilities. They received long-term contracts for their power. On the basis of those assured revenue streams, their shareholders and bondholders invested. Faced with losing that revenue stream, they will litigate.

An important part of the process of unbundling services offered, and the prices paid for them, is what we call the competitive transition fee. (In California they call it the Competition Transition Charge.) Customers will see it as a line item on their bills. Over time, depending on the terms of the arrangement, it will be phased out, and generation will be a fully competitive market. Customer service, distribution, and transmission will continue generally to be offered by a franchised utility on a monopoly basis, although some customer services might become competitive in the future.

The process of unbundling services requires assigning the transition fee to the various customer classes and the various services. How this is done will certainly vary depending on what state your business is in. The Niagara Mohawk Power Choice proposal is designed to allocate the transition fee to customers in a manner that has relatively little effect on the total bill that was being paid under full-service regulation. In other words, the transition fee is designed to keep the customer bill from rising or falling.

Two other serious proposals for utility restructuring are being considered. One is embodied in a bill from the New York General Assembly. The other is a recommended decision by the staff of the Public

Service Commission. The two proposals have much in common with the Power Choice proposal, but each has some stark differences, which Niagara Mohawk sees as problematic. The point is that restructuring is inescapable, in New York as well as in California.

Electricity generation is no longer a natural monopoly. Functional unbundling, if not complete financial separation, is imminent. I believe retail competition in generation will become a reality much more quickly than many observers expect. Recovery of strandable costs is a requirement for retail competition. Complete recovery of strandable costs in the short-term—that is, over the phase-in period—will not significantly decrease prices but will not increase them. In the long-term, however, everyone will benefit from the restructuring.

The electric utility industry is shifting from a monopoly mentality to a focus on markets. One speaker at a conference last year observed that the electric utility industry seems to experience eras. It started with a technical era, looking for technical efficiencies. Then it went through a financial era, in which power plants were built in great numbers and utilities strived to recover those investments. Now it is moving into a market era. The market era will provide many, many benefits for the customers. It is a very exciting time to be involved.