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

Commissioner John Hanger

Pennsylvania Public Utility Commission

My perspective is that of the Pennsylvania Public Utility Commission. I think Pennsylvania offers a useful microcosm of the nation. Ideally, there should not be a debate about whether competition is good or bad, and we should immerse ourselves in all the detailed economic issues that must be considered in determining how to create a system that brings the total costs down for everyone. But let me assure you, as a state regulator, that we are at a much more basic level, asking whether competition is a good idea or not. The answer to that question is not always derived from a purely technical analysis.

I am one of those commissioners who believe that we should engage in price regulation in this society only to the extent that a product or service is a natural monopoly. If a product or service is not a natural monopoly, I believe in letting the competitive market regulate price. To me, price regulation is a very different issue from environmental regulation or health or public safety regulation. Certainly, those forms of regulation are necessary, in my judgment often, even when products or services are competitive.

I had thought there was rather wide consensus about that principle. Then I read the headlines in the Washington Post a few days ago, saying, ''Government To Look at Gas Prices," because gasoline prices have gone up 10 percent in a few months. Yesterday there was a headline reading, "Government To Look at Beef Prices." They are too low, so we are going to try to raise beef prices. Most Americans profess to love a competitive

market, but sometimes when the market moves in a particular direction some of us get very nervous.

Nonetheless I believe that, so long as a product or service is not a natural monopoly, we should let the market rule. Intervention would be appropriate only if monopoly power prevents the market from functioning effectively, and only to the limited extent necessary. Many regulators may agree rhetorically with those statements, but in practice they are what I would call protectionists, who are looking to protect the monopoly.

Electric competition started in 1978 with the Public Utility Regulatory Policies Act (PURPA). Congress passed this act in reaction to the energy crisis of the 1970s. Its intention was not particularly to create competition, but rather to diversify the mix of fuels that plants used to generate electricity. Much of the electricity in this country in the 1970s was generated from oil; today, other fuels have largely replaced oil.

The 1978 act has had the unintended consequence of turning generation into a clearly competitive function. Nearly all existing plants at that time were built by public utilities, companies with monopolies granted by state governments. By 1996, more than half of all new generation plants built in this country will be built by companies that do not have monopoly franchises (often called independent power producers or nonutility generators).

That 20-year experience with the independent power business shows regulators that this business really has three main segments: generation, transmission, and distribution. Generation is generally agreed to be a competitive function. Society does not need to give a company an exclusive franchise to build a generation plant in order to get the least-cost generation supply.

Transmission and distribution, on the other hand, are generally agreed to be natural monopolies still. The term "deregulation," as applied to the electric industry, is inaccurate. I am not aware of anyone who is proposing any policy option that would in fact deregulate the industry. What is being discussed instead is the deregulation of the price of generation by allowing customers to choose their generation suppliers through the existing transmission and distribution system. Transmission and distribution would remain among the most fully regulated industries in the economy. All customer service and safety regulation could remain just as it is now.

In 1992 Congress passed the Energy Policy Act. This act gave the Federal Energy Regulatory Commission (FERC) authority to require transmission owners to open access to their systems to third party suppliers of energy. It also authorized FERC to require that those owners charge rates that are comparable to the rates the transmission owners charge their own customers. In April 1996 FERC published its rule implementing these provisions of the act.

A number of factors have driven policy toward creating competition and customer choice in the electric industry. Advances in technology have lowered generating costs. Legislation such as PURPA and the 1992 Energy Policy Act have opened up markets. The changing economics of utilities permits any number of nonmonopoly companies to build smaller, more efficient generation plants in a much shorter time than previously was possible. The more competitive global economy has brought opportunities to buy and sell power and generation assets worldwide. Finally, the failure of regulation to produce uniform and reasonable rates has led to calls for relief from consumers.

The debate is important, because electricity is central to the economy. We spend more than $200 billion each year on electricity in this country—more than we do on oil, unleaded gasoline, and heating fuel combined. Electricity will be the dominant fuel of the 21st century. In view of all the recent attention to gasoline prices, it is surprising that we rarely see blaring headlines or calls for congressional or Justice Department investigations into the cost of electricity.

The reason is that most people don't know what they are paying for electricity. It is not a traded commodity, by and large although that is changing rapidly. To find out what electricity costs one must look through thousands of pages of tariffs from 50 state commissions, in addition to many special contracts that have been approved and sometimes permitted to remain confidential.

Pennsylvania spends $10 billion per year on electricity. It is vital to our energy-intensive manufacturers, many of whom spend 20 percent of

their total production costs on electricity. Some spend as much as 70 percent. In steel and some other industries, such as glass making, the cost of electricity is more than the cost of labor. For those reasons, electricity prices are an important site selection criterion for plants and industries.

The cost of electricity is not only a concern of big business. Families also spend a lot of money on utilities. In Pennsylvania, the average family works from the first of January to the middle of February to pay the bills for light, heat, water, telephone, and sewer service. Families living in poverty may spend as much as half of their income on utility bills, with 15 percent of their income required for the electric bill.

Table 1 shows the remarkable divergence of electricity prices among Pennsylvania utilities over a period of 20 years; I suspect many states would show a similar pattern. In 1970 the spread between the high-cost producer and the low-cost producer was relatively narrow, less than one-half cent per kilowatt-hour, or about 25 percent. By 1990 the spread was enormous: more than 7 cents per kilowatt-hour (actual price without

any adjustments). The spread between the low-cost and high-cost producers had become well over 100 percent.

What happened? Bad, or unlucky, management and regulatory decisions were made. Table 1 indicates a failure of regulation. West Penn Power would be the prominent exception. In other cases we had enormous failures, such as PECO's climb from 2.54 to 12.58 cents. (One underlying fact is that West Penn did not invest in nuclear power, and PECO invested very heavily in nuclear power.) PECO (in the Philadelphia region) has the 9th highest residential rate in the nation. Duquesne (in the Pittsburgh area) has the 14th highest rate. As a result of the failure of regulation, PECO and Duquesne residential customers pay more than 100 percent more than West Penn's customers. When I travel around the state, people often ask me why their companies or families are paying twice what their competitors or relatives are paying a few miles away, in another utility service territory. That is a very good question, which has no good answer.

Pennsylvania's average rates are 15 percent higher than the national average. We spend $10 billion per year. If rates were 15 percent lower, at the national average, Pennsylvania's annual electricity bill would be $1.5 billion lower. That savings would have an important economic impact.

In commercial and industrial rates we see similar ranges in price in Pennsylvania. (The industrial rates are subject to various special contracts at this point, so it is difficult to track them.) If we compare Pennsylvania's average industrial rates with those in other Atlantic seaboard and Midwest states (Table 2), you see large differences again, with Pennsylvania near the middle. Of the states in the region with higher prices than Pennsylvania, New Hampshire, Massachusetts and New York are, not surprisingly, among the most aggressive states in moving toward retail competition. They have decided to allow all customers to have retail choice starting in 1998. New Jersey is another state with high electricity prices. Governor Whitman has just announced her intention that New Jersey permit customer choice soon.

In Pennsylvania there are three bills in the legislature; hearings have already begun. The Commission issued its report on July 3, 1996 recommending a transition to customer choice. Pennsylvania is already at a competitive disadvantage in electricity rates with neighboring states, including Ohio and Maryland. Table 2 would look much worse if it included states such as Wisconsin and Kentucky and a number of others. We are mindful that the neighboring states with which we do have a

competitive advantage in electricity rates are the very states that are moving aggressively to open their markets to competition.

Table 3 shows how selected Pennsylvania and U.S. rates compare with those of some European countries. In global terms, the average U.S. rate, and even the average Pennsylvania rate, is actually very good. Some have interpreted that fact to mean that the system is working well enough. But the average U.S. rate, like the average Pennsylvania rate, conceals great variations. Furthermore, electricity ought to be one of the industries in which the United States has an enormous comparative advantage in

international competition. If we want to have high wages and a high standard of living, we must have comparative advantages, whether they are found in education or the cost of capital or electricity infrastructure services. We need to get every ounce of comparative advantage achievable from the electric industry and the energy industry generally.

Pennsylvania has lost more than 300,000 manufacturing jobs since 1980, and more than 14,000 jobs in the last 12 months. From 1983 to 1993, manufacturing establishments in Philadelphia dropped from 2,154 plants to 1,537, and 85,900 manufacturing or construction jobs were lost—a loss of 50 percent. Pittsburgh experienced a 30 percent decline in jobs, from 103,300 to 73,000, over the same period. Electricity costs are not solely responsible for these losses, but they have contributed to them. The debate over competition is being driven by these concerns. Every state is trying to make itself business-friendly and competitive, particularly for high-wage manufacturing employment.

A variety of issues will face the nation as states move toward retail customer choice. These include stranded investment, reliability, universal service, conservation and environment quality, and the obligation to serve.

Stranded investments. Stranded investments are mainly costs of generation plants that are above the likely market price for electricity if retail customers are allowed to shop. Stranded investment is at the top of nearly every utility's list of concerns about competition, because they want to be sure they can recover the costs of past investments. Some low-cost utilities have argued that there should be no recovery of stranded investments. West Penn Power Company, for example, the company in Pennsylvania with the lowest costs, has taken that line. They view stranded cost recovery as a bailout of their future high-cost competitors. PECO and some other companies facing large stranded investments, on the other hand, favor 100 percent recovery.

Nationally, estimates of stranded investment range from $75 to $200 billion. In Pennsylvania the figure is roughly $6 to $10 billion. These sums are a tremendous indictment of traditional regulation. If regulators had

been doing an effective and efficient job, we wouldn't be talking about stranded investments of that magnitude. But we are.

The question is who pays for it. Today, all existing customers are paying for stranded investment as reflected in rates. Shareholders pay none of it, under tariffs approved by regulators like myself in the past. The question is whether, when retail choice arrives, consumers will continue to pay 100 percent of that stranded investment or whether shareholders will bear all or some of these costs?

One of the dangers in stranded investment is cost shifting, which is occurring today. By cost shifting I mean transferring costs from one class of consumers to another. Stranded investment solutions, first of all, should involve no cost shifting. Those investments are all reflected in rates now, pursuant to formulas that allocate stranded investments among the various customer classes. So long as that allocation is respected, cost shifting will not take place, even if regulators provide for 100 percent recovery of stranded investments.

The second part of the solution is mitigation. Utilities should be required to reduce the amounts of stranded investments they hold. There are things that they can do, and many are doing those things aggressively. Even so, stranded investments will remain, and we will need to decide how much to allow to be recovered in the future. And we will need a mechanism for collecting it. A "wires charge" on the regulated transmission and distribution service that must be used by all retail consumers could be collected during a transition period of perhaps three to ten years. Such a mechanism would ensure that all utilities and consumers pay a fair portion of stranded investment.

Reliability. Maintaining reliability requires careful planning; it is good now, and we must make sure nothing happens to change that. Use of an independent system operator to coordinate all transactions on the existing interconnected power grid provides an opportunity to maintain, or even improve, system reliability.

Universal service. Universal service must be maintained. Electricity is a necessity of life. Pennsylvania had 43 deaths in six years as the result of utility services being terminated. Those deaths were caused by fires due to candles, kerosene heaters, and other dangerous heating and lighting

substitutes. Three senior citizens have frozen to death in their homes in Pennsylvania in that same period.

In my state, utilities incur a bad debt expense equal to about 2 percent of revenues. That bad debt is not due only to customers with limited and fixed incomes. The middle-income family that moves to Florida, doesn't pay its last bill, and cannot be found also contributes. If that amount of money, roughly two percent, were collected in the form of a wires charge and distributed to and targeted appropriately to low income families, we could probably improve our rate of universal service in Pennsylvania.

Conservation and environmental quality. Environmental standards, such as those concerning clean air, are not established by public utility commissions. They may stay the same or be modified, whether or not generation becomes competitive. Conservation programs are built into many utility rate structures. They may continue to be provided by the local distribution utility, just as they are now. The economic basis for such programs would probably become end-use efficiency instead of avoided generating costs. Renewable energy sources and other "green" technologies will get a real boost from customer choice. Consumers now must use whatever fuel their monopoly generator chooses. They will be able to choose green fuels if they prefer. Wind power already can be produced at less than 5¢ per kwh, while nuclear power can cost more than 10¢ per kwh. Yet we have lots of nuclear power and no wind power in Pennsylvania. Solar power is not yet cost-competitive primarily because of limited production. If green consumers choose solar power, the industry will develop economies of scale and more competitive prices sooner than it otherwise would have.

Obligation to serve. Utilities have a traditional obligation to serve, that is, to connect all customers in a service territory and provide them with power of certain specifications. That obligation will be reexamined in a competitive retail market. Does giving retail customers a choice imply that the utility is no longer obligated to serve? If you go to a restaurant, they do not have to serve you, they can close whenever they want, and they can decide what menu items to offer. The obligation to serve does not exist normally in the market. What form would it take in a competitive retail market for electricity?

Remember, generation is likely to be subject to competition, but natural monopolies will remain in transmission and distribution. On that basis, most people agree that, in the future, utilities will have the obligation to connect all customers to the system, and to allow electricity to flow over that system.

Utilities will have a contractual obligation to supply electricity to customers who wish to remain with their local utilities. But that obligation, most people agree, would not apply to customers who decide to go shopping for outside generation; for them, the utilities' obligation is simply to connect and deliver. It would be up to the customer to enter into contracts to secure the new source of electricity.

There are four fundamental models of industry restructuring:

1. Simply maintaining the monopoly and improving it, for example by performance-based ratemaking and allowing wholesale competition. This model would not allow for customer choice, for the most part. This is the model being proposed by what I call the protectionists in the debate. They are the people who do not want too much change.

2. The ''pure poolco" model, in which all generation would be competitively priced, sold into the pool, and bought from the pool. The retail price of generation would be charged to equal the pool's competitive price. This model is being advanced by Professor William Hogan and some of the California utilities.

3. A voluntary power pool, unlike the mandatory pool in model 2. Generation would be bought and sold on the basis of competitive bidding. One could buy generation from the pool, or one could make direct contracts with suppliers.

4. Exclusive use of direct contracts. Customers would have authority to purchase electricity directly from any generator. No competitive pool would be created, although one might develop naturally.

California is moving toward a market structure similar to model 3. I suspect that, over time, that kind of market structure will develop around the country. Norway has a similar system, in which about 30 percent of the transactions are done through the pool, and 70 percent on a retail bilateral basis.

When the new industry structure is fully in place all retail customers will be able to choose among several alternative sources of electric supply. The market will develop a range of choices that accommodate the needs of different customers with different requirements. Choices will be available not only for customers with considerable time and knowledge to follow power markets, but also for those who prefer "one-stop shopping." All customers will continue to receive local distribution services from their existing utilities. Customers could instruct their local distribution utilities to deliver electric generation services on their behalf by selecting such options as:

• Paying rates set by the Public Utility Commission, just as they do now. This option could remain available through a transition period for any customer not choosing another option.

• Buying from a particular generator through a direct contract. With this option, consumers preferring a particular type of generation or related services could more precisely purchase the services they wanted or obtain volume discounts by purchasing for multiple facilities.

• Through a spot market at an average price. This option would make the same market rate available to all consumers so as not to require significant effort or knowledge by consumers. This option would make the benefits of restructuring available to all consumers equally.

• Through a spot market at an hourly time-of-use price. With this option, consumers who were able to adjust their usage to off-peak hours would achieve even greater savings.

• Through aggregators, such as marketers, brokers, local governments, or purchasing cooperatives. This option is a secondary form of direct contracting. A third party would assemble a group of consumers, to obtain the broadest range of services without requiring knowledgeable, active involvement by consumers.

• Through the local distribution utility providing electricity as an aggregator. This option would provide another competitor for consumers and give existing utilities an equal opportunity to provide generation to their present customers.

The debate is an exceedingly important one. I urge federal facilities in Pennsylvania and around the country to approach their commissions and become part of that debate. Some have already done so. Now is the time to speak up.