PowerFacts

A RETURN TO COST-PLUS REGULATION: LIGHT AT THE END OF THE TUNNEL, OR THE HEADLIGHTS OF AN ON-COMING FREIGHT TRAIN? (EPSA PowerFact)

Introduction

The Electric Power Supply Association (EPSA) takes seriously the concerns expressed by ELCON in its paper, Today’s Organized Markets – A Step Toward Competition or an Exercise in Re-Regulation?, and supporting materials, Restructured Markets: A Train Wreck Waiting to Happen?, released December 4, 2006. EPSA’s members are suppliers to ELCON and other industrial consumers. EPSA offers these observations and asks the questions below in the spirit of a vigorous, but constructive public dialogue. With the nation about to embark on the largest investment in its electricity system in history to meet increasing demand, all interested parties owe it to the public and each other to respectfully and responsibly address market design and other policy issues. The focus from all of us should be on fact-based, reasoned, practical solutions, not just on complaints.

EPSA’s Reaction to ELCON’s Paper

EPSA wholeheartedly agrees with ELCON that “cost-of-service regulation produces limited benefits for consumers.” However, ELCON later raises the option of exploring a return to that very same system of “cost-of-service” regulation without any analysis that such a return would reduce electricity prices or otherwise improve the situation for consumers. This is especially true in light of several recent announcements of significant cost overruns.

EPSA appreciates ELCON’s belief “that competition in wholesale and retail markets has the potential to bring significant benefits to consumers and to the overall U.S. economy.” Numerous studies have already shown that competition has improved the efficiency of generating facilities, lowered prices, in real terms, for consumers and brought environmental benefits. While markets can continually be improved, ELCON’s paper is longer on generalities and shorter on specifics. EPSA welcomes the opportunity to learn more about any specific proposals ELCON and others may have to further improve competitive markets, together with the analysis that shows how to achieve them and why they would be an improvement.

ELCON’s paper almost exclusively focuses on three FERC-approved markets – New York ISO, ISO New England and the PJM Interconnection. Based on this emphasis, readers might assume that ELCON’s members are satisfied with vertically-integrated utilities in regions without any independent operation of the transmission system. While it is important to continually strive to improve organized markets, areas without open, transparent wholesale markets limit the options and choices available to consumers. These areas are certainly not “problem-free” or better for consumers. EPSA welcomes a comprehensive dialogue on how best to achieve the substantial benefits of competition that EPSA and ELCON agree can be forthcoming.

EPSA generally agrees with ELCON on the seven necessary conditions of competitive markets. However, EPSA raises the following questions and observations about whether these conditions exist, and if not, how best to achieve them.

• Demand response and other conservation mechanisms are an important part of market design. ELCON’s sweeping statement, “consumers cannot react to high prices by reducing consumption,” incorrectly implies that prices are not influenced by supply and demand. While much work needs to be done to improve wholesale market design to accommodate cost-effective demand response, these programs are already making a difference. While not all customers can see real-time prices or respond quickly to those price signals, even a small reduction in demand can have significant impacts on prices. ELCON must recognize that effective demand response programs are also a function of retail rate design. Customers need to both see and respond to prices in real-time.

• ELCON’s claim that capacity markets have not been demonstrated to encourage new generation is not well founded. At the outset, EPSA notes that there a variety of views among competitive suppliers about capacity markets in general and about specific features. That said, it is premature to reach conclusions about whether capacity markets will encourage new generation where capacity mechanisms are only now or will soon be implemented. Even in these areas, ELCON’s claim is easily refuted by data on generator interconnection requests and other metrics on projects in various stages of development. An ability to recover investment costs, a concept undoubtedly familiar to ELCON members, is the fundamental prerequisite for investment. In markets where investment cannot be recovered, it is either not needed, or the market structure requires adjustment so that needed investment will be made. That is what capacity payments are structured to do. Of course, this revenue stream is needed not only to encourage new generation, but to make it economically feasible to continue to operate existing generation. ELCON’s paper makes no attempt to refute the data and analysis in the relevant FERC proceedings that show investment in new generation cannot be recovered with existing “mitigation” mechanisms. EPSA applauds ELCON for noting serious flaws with such “mitigation” mechanisms and welcomes the opportunity to determine whether and how they can be changed or eliminated. However, ELCON has the order backwards. The market-distorting “mitigation measures” must be removed in order to move toward the “true competition” ELCON seeks.

• EPSA agrees with ELCON that consumers should be able to hedge future prices. Long-term bilateral contracts are one of several ways to do so. There are a variety of other physical and financial products available. While various competitive suppliers have different business models, just as industrial consumers do within the same industry, competitive electricity suppliers are willing to enter into long-term bilateral contracts. The real issue, however, is the price at which parties are willing to enter into those contracts and bear the risk of future price changes. There is no commodity market, including those in which ELCON members and other industrial consumers are sellers, where a seller is expected to sell below the market price, whether in a spot market or in the forward market. Unfortunately, we are in a rising price environment, primarily due to rising global fuel prices (which account for over 80 percent of variable costs). This, in turn, obscures reductions in non-fuel operating costs. It is also important to recognize that the new generating capacity that ELCON and others recognize is needed will require significant investment and likely result in increased prices. The cost of labor and materials continues to rise. ELCON members are well aware of these higher costs both because they pay them for their own operations and because some industrial consumers are sellers of these items to generators. The best way to contain these costs is through competition, which exerts a downward pressure on costs. As to blaming the single price auction used for spot market sales in organized markets, EPSA has commented on this extensively elsewhere. ELCON provides no analytical support for the proposition that a pay-as-bid mechanism would produce lower prices; in fact ELCON does not provide an alternative.

• EPSA agrees that there must be adequate transmission infrastructure. However, ELCON’s paper does not address all of the factors that go into why there has been chronic underinvestment in transmission. By only discussing market design issues, readers of ELCON’s paper will draw improper and incomplete conclusions. Many factors are actually at work, including siting objections to specific projects and those utilities that want to use lack of transmission capacity as a barrier to entry to protect their affiliated generation. Thankfully, many major transmission expansions are either actually under construction or are being actively pursued, some in response to recent initiatives by FERC, the U.S. Department of Energy, and RTOs/ISOs. It is simply “piling on” to lay the multi-decade transmission investment gap at the doorstep of newer and evolving organized markets.

• EPSA agrees that market power must be mitigated, but this should include market power in non-organized regions (a point not made by the ELCON paper despite joint efforts by EPSA and ELCON members in these regions). EPSA regrets the inclusion of unfounded and unsubstantiated allegations of market power contained in articles ELCON cites, including The New York Times. EPSA reiterates what it said in response to similar unfounded statements by the Virginia State Corporation Commission several months ago: evidence of “gaming” and other improper conduct should be brought to the attention of the appropriate authorities. To date no such evidence has been presented. EPSA was puzzled by the statement in the preface to the ELCON source material criticizing profits by utility holding companies in organized markets. EPSA was unaware that for-profit industrial consumers, many if not most of which are publicly traded entities, have an aversion to the essential role of corporate profits in a free enterprise economic system.

-EPSA-

CONTACT: JOHN SHELK
(202) 349-0154or 703-472-8660

EPSA is the national trade association representing competitive power suppliers, including generators and marketers. These suppliers, who account for nearly 40 percent of the installed generating capacity in the United States, provide reliable and competitively priced electricity from environmentally responsible facilities serving global power markets. EPSA seeks to bring the benefits of competition to all power customers.