MEMORANDUM
TO: Honorable Richard J. Holland
Honorable John Watkins
Co-Chairmen
Stranded Costs and Related Issues Task Force
Legislative Services
State Capitol
Richmond, Virginia 23219
FROM: Reginald N. Jones
DATE: July 30,1998
RE: Revised Stranded Costs/Stranded Benefits Draft Language
Dear Senators Holland and Watkins:
On behalf of the Alliance for Lower Electric Rates Today ("ALERT") we hereby submit our revised proposed Stranded Costs/Stranded Benefits draft language for your consideration. We inadvertently submitted a prior draft that did not include all changes intended to be incorporated. We apologize for any inconvenience this may have caused.
We appreciate the opportunity to address the members of the Stranded Costs and Related Issues Task Force ("Task Force") on the critical issues of Stranded Costs and Stranded Benefits and their recovery. These comments are designed to give the members of the Task Force a better understanding of these issues from the perspective of the residential, small business, commercial, and industrial consumers that make up ALERT.
A. Stranded Costs, Stranded Benefits, Market Value and Effective Competition: Details (and Definitions) Do Matter.
ALERT has provided several comprehensive definitions for your consideration in the determination and recovery of Stranded Costs and Stranded Benefits. These definitions recognize the relationship between the determination and recovery of Stranded Costs and Stranded Benefits, on the one hand, and the development of an effectively competitive retail electricity market on the other. They also envision the incorporation of this Stranded Costs/Stranded Benefits policy into a comprehensive restructuring proposal.
B. The Stranded Cost/Stranded Benefit Policy Issues Cannot be Considered Apart From Other Restructuring Determinations.
The General Assembly's approach to Stranded Costs and Stranded Benefits will not only directly impact the prices consumers pay and the economic incentives for choosing an alternative supplier, but will also have a profound effect on the development of an effectively competitive electricity market for all Virginians. Stranded Costs and Stranded Benefits policy should therefore not be considered as isolated parts, but as one element of an integrated, mutually-supportive approach to the restructuring of the electric utility industry here in Virginia. Through ALERT's Definitions and Calculation methodology, the determination and recovery of Stranded Costs and Stranded Benefits is directly tied to the development of an effectively competitive retail electricity market.
ALERT's proposed legislation requires that the State Corporation Commission determine whether "Effective Competition" exists for a particular service for which Stranded Cost recovery or a determination of Stranded Benefits is requested, prior to approving a request for Stranded Costs recovery or a determination of Stranded Benefits. In making this finding, the Commission is to consider evidence relating to the existence and degree to which "Market Power" is present for the particular product or service.
1. Stranded Costs are a by-product of an effectively competitive retail electricity market. Their recovery should be conditioned upon a Commission finding that there is Effective Competition for the product or service at issue.At the heart of ALERT's proposal is the principle that Stranded Costs are the by-product of an effectively competitive retail electricity market, and that their recovery should be conditioned upon a Commission finding that there is Effective Competition for the product or service at issue. We make the distinction between "Embedded Costs" and their recovery as "Stranded Costs." We make a similar distinction between the concept of "Embedded Margins" and their recovery as "Stranded Benefits."
The decision to allow full recovery of Embedded Costs as Stranded Costs can negatively impact the efficiency of the developing market for retail electric goods and services in at least three ways: (1) full recovery reduces or eliminates a utility's incentives to lower its Embedded Costs and to Mitigate those Embedded Costs as Stranded Costs; (2) recovery of a utility's Embedded Costs as Stranded Costs acts as a barrier to entry and exit; and (3) it allows a utility to retain more profit than under regulation, while simultaneously guaranteeing that any potential downside loss from competition will be recovered from consumers.1 Because of these negative impacts, any recovery of Embedded Costs as Stranded Costs should be conditioned upon, and a product of, Effective Competition.
As the Task Force is aware, Market Power represents the ability of a particular seller, or group of sellers, to influence significantly the price or availability of a particular good or service to their advantage over a sustained period of time. ALERT has framed the issue in its draft language by requiring a Commission finding of Effective Competition as part of any recovery of Stranded Costs. This finding requires the Commission to consider evidence of "Market Power" as part of its determination that Embedded Costs are recoverable as Stranded Costs. The Commission will consider such utility-specific factors as "Transmission Constraints," "Load Pockets," strategic bidding, capacity withholding, "must-run" generation units, barriers to entry and other impediments to Effective Competition in making its determination.a. A finding of Effective Competition requires a consideration of the degree to which Market Power is present for the particular product or service.
To the extent that any of these Market Power factors is present, alone or in combination, sellers will have the ability and incentive to influence the price or availability of the product or service to their advantage. The existence and degree of Market Power, and its impact on the development of Effective Competition in Virginia's retail electricity markets, cannot be determined in advance by the General Assembly This proposed legislation recognizes the dynamic nature of such considerations, and therefore relies upon the unique skills and expertise of the State Corporation Commission to assure that Virginia's retail electricity market is subject to Effective Competition before allowing Stranded Costs recovery.
This provision is present because the FERC's present method for approving an application for market-based rates does not necessarily take Transmission Constraints and other Market Power factors into consideration.b. Virginia, through the State Corporation Commission, should make its own finding as to whether Market Power presents a barrier to Effective Competition for retail customers. FERC's analysis regarding market power, made in the context of an application for market-based rate authority, does not necessarily take Transmission Constraints or several other Market Power factors into consideration.
The FERC generally allows wholesale power sales at market-based rates, such as would take place through a Regional Power Exchange (RPX), if the seller and its affiliates do not have, or have adequately mitigated, market power in generation and transmission and cannot erect other barriers to entry. In order to demonstrate the absence or mitigation of market power, FERC requires a transmission-owning utility to have on file an open access transmission tariff so that customers can use the transmission system in ways that the transmission owner does, and at comparable rates. FERC also considers whether there is evidence of affiliate abuse or reciprocal dealing.
With regard to generation market power, utilities perform a "hub-and-spoke" analysis in support of their applications. FERC has consistently held that the "hub-and-spoke" test is the appropriate test for analyzing market power in the context of requests for market-based rates, notwithstanding many requests from State Public Utility Commissions, State Attorneys General, transmission customers and others that the FERC discard this method in favor of more comprehensive methods, such as the Competitive Analysis Screen used for evaluating market power issues in merger proceedings.
The primary shortcoming of the FERC's approach is that the "hub-and-spoke" analysis fails to account for the very factors that restrict the competitive options of consumers, including relative generation prices, transmission prices, losses, and transmission constraints. The General Assembly (and the Commission) should therefore take steps to assure that a seamless regulatory framework exists to appropriately account for these factors. A Virginia-specific finding by the SCC with regard to Market Power will do more to protect Virginia's retail consumers than will a finding by FERC based upon a "hub-and-spoke" analysis.
2. Stranded Benefits are the symmetric reciprocal of Stranded Costs. Both represent the difference between the Market Value of an asset, product or service, and the value a utility has previously recovered from ratepayers through the utility's regulated rates. They are recoverable from the time of Effective Competition, but are measured, monitored and adjusted from the date on which Alternative Sellers of similar services begin to provide such service to retail customers.To illustrate the relationship between Stranded Costs and Stranded Benefits, on the one hand, and the sensitivity of recovery to both timing and market prices on the other, consider the following scenario. The "useful" life of Utility A's asset, as measured on its books, is represented by line A-B, and the same "useful" life of Utility B's asset is represented by line C-D. Triangle A-B-X represents the amount of depreciation to be recovered from ratepayers over the life of the Utility A asset, while triangle C-D-Y represents the amount of depreciation to be recovered from ratepayers over the life of Utility B's asset. Both assets cost the same, and are depreciated in the same manner-the only difference is that Utility A purchased its asset in year 0, while Utility B purchased its asset in year 4. Line E represents the hypothetical market price, and Line M-N represents the date stranded costs are determined. The triangle f-g-h represents the present amount of Utility A's "stranded" benefits, because point g represents the present depreciated value of Utility A's asset. The triangle h-i-j represents the present amount of Utility B's "stranded" assets, because point represents the present depreciated value of Utility B's asset. Note that both calculations ignore the continuing decline of the asset's net plant book value over time. They also fail to take future market price fluctuations or plant life extensions into account. If rates are set at Line R, these calculations also ignore the relationship between future depreciation and present-day rates.
Assume the same scenario, except that Stranded Costs and Stranded Benefits are determined in year 12, as represented by Line P-Q. What we now see is that both Utility A and Utility B appear to have Stranded Benefits. The triangle j-k-l represents Utility B's "stranded" benefits at that point in time, because point I represents the present depreciated book value of Utility B's asset under this scenario. However, if under this same scenario the value of Utility B's assets are measured, monitored and adjusted from year 8 to year 12 and in year 12 the Commission finds that there is Effective Competition, the apparent "stranded" assets (represented by triangle h-i-j) and apparent "stranded" benefits (represented by triangle j-k-l) would be measured, monitored and adjusted to determine the just and reasonable amount of the portion of Embedded Costs or Embedded Margins to be owed by or to the ratepayers. ALERT's approach to recovery would take this and other changes into account on a going-forward basis.
Both Stranded Costs and Stranded Benefits represent the difference between the Market Value of an asset, product or service, and the value a utility has previously recovered from ratepayers through the utility's regulated rates. if they are recoverable from the time of Effective Competition but measured, monitored and adjusted from the date on which Alternative Sellers of similar services begin to provide such service to retail customers, the legislative response should be symmetric.
3. A Price Cap mechanism is proposed to address Stranded Benefits, as well as to protect consumers from ineffective competition and Market Power abuses, while also providing one mechanism to test the extent to which Effective Competition has developed in a given market. A class-specific Price Cap will also help protect captive or core customer groups from cross-subsidizing more competitive customer classes, and Noncompetitive Services from subsidizing Potentially Competitive Services.ALERT has proposed a Price Cap mechanism for individual customer classes as a means to address Stranded Benefits and protect consumers from ineffective competition and Market Power abuses, while providing one measurement of the extent to which Effective Competition has developed in a given market. In addition, a properly designed and implemented Price Cap may help protect captive or core customer groups from cross-subsidizing more competitive customer classes, and prevent the revenues from Noncompetitive Services from subsidizing Generation Service, Aggregation Service, or other Potentially Competitive Services. Thus, a Price Cap will function as a transition mechanism, as well as a Stranded Cost/Stranded Benefit recovery mechanism.
C. Explanation of Changes From Prior Submission.
One inadvertent omission from the prior version of ALERT's Stranded Costs/Stranded Benefits Draft Language may be found in paragraph 4 on page 5. In addition to requiring the Commission to adopt a just and reasonable method and procedure for affording the opportunity to recover Stranded Costs or Stranded Benefits, the Commission is to determine the period over which such recovery may occur. The Commission may also assess just and reasonable charges or credits as necessary. This paragraph also recognizes that retail customers may presently choose to serve their own needs through self-generation without paying an exit fee or similar charge, and that this option should remain available in the future and unaffected by restructuring legislation.
D. Conclusion.
The General Assembly's approach to Stranded Costs and Stranded Benefits warrants close attention to details. Determinations by the General Assembly will not only directly impact the prices consumers pay and the economic incentives for choosing an alternative supplier, but will also have a profound effect on the development of an effectively competitive electricity market for all Virginians. ALERT urges this Task Force and the Joint Subcommittee not to consider Stranded Costs and Stranded Benefits policy as isolated parts, but as one element of an integrated, mutually-supportive approach to the restructuring of the e~ectr~c uti~ity industry here in Virginia. ALERT's Definitions and Calculation methodology directly tie the determination and recovery of Stranded Costs and Stranded Benefits to the development of an effectively competitive retail electricity market in Virginia.
On behalf of ALERT, we appreciate the opportunity to provide this additional explanation of our proposal, and look forward to working with the Task Force members and the other members of the Joint Subcommittee on these and other important issues. We would be pleased to answer any questions you may have.
§ 1 Definitions.
"Aggregation Service" means the act of organizing electricity consumers into a group for the purpose of purchasing electricity on a group basis. Aggregation Service includes the act of purchasing, or attempting to purchase, electricity on a group basis.
"Aggregator" means an entity established for the purpose of gathering individual customers into a group or entity for the purpose of purchasing electricity. A unit of federal, state, or local government shall not require Commission authority to act as an Aggregator.
"Alternative Seller" means a Marketer, Broker, Aggregator or any other authorized entity selling any component of Electric Service to the public at retail, other than a Noncompetitive Service unless the Alternative Seller has been designated to provide the Noncompetitive Service. The term shall include the affiliate of a Vertically Integrated Electric Utility, but does not include the Vertically Integrated Electric Utility.
"Broker" means an entity that acts as an agent or intermediary in the purchase or sale of electricity, but does not take title to such electricity.
"Commission" means the Virginia State Corporation Commission.
"Effective Competition" means, with respect to a particular service, a market structure and a process under which an individual seller is not able to influence significantly the price of the service as a result of
1. the number of sellers of the service;"Electric Billing and Metering Services" include billing and collection; provision of a meter; meter testing and maintenance; and meter reading.2. the size of each seller's share of the market;
3. the ability of the sellers to enter or exit the market; and
4. the price and the availability of comparable substitutes for the service.
"Electric Service" includes Generation Service, Aggregation Service and any other component of electric service provided as of (date) by a Vertically Integrated Electric Utility or public utility, as that term is defined in § 56-232.
"Embedded Costs," as used in this Act, means the unavoidable, unmitigable, legitimate, verifiable, prudently incurred and administered costs of existing assets and obligations incurred by an electric company prior to (date), pursuant to the provision of retail Electric Service, and made unrecoverable as the result of the restructuring of the electric industry to permit Retail Access as required by Virginia law and determined by the State Corporation Commission. Any entity seeking recovery of Embedded Costs shall have the burden of proof with regard to the right to recover such Embedded Costs as Stranded Costs. The recovery of Embedded Costs as Stranded Costs shall not include a return on such investment.
"Embedded Margins," as used in this Act, means the difference between the Market Value for Generation Service, Aggregation Service and any other Potentially Competitive Service and the unavoidable, unmitigable, legitimate, verifiable, prudently incurred and administered costs of existing assets and obligations incurred by an electric company prior to (date), pursuant to the provision of retail Electric Service, and given up by the consumers of a Vertically Integrated Electric Utility as a result of the restructuring of the electric industry to permit Retail Access as required by Virginia law and determined by the State Corporation Commission unless recovered as Stranded Benefits.
"FERC" means the Federal Energy Regulatory Commission.
"Generation-related Ancillary Services" include those functions that support Generation Service, transmission service and distribution service, and include the following services: reactive supply and voltage control from generation sources service; loss compensation service; scheduling, system control and dispatch service; regulation and frequency response service; system protection service; energy imbalance service; operating reserve- spinning reserve service; and operating reserve-supplemental reserve service.
"Generation Service" means the sale of electric energy or capacity from equipment that converts other forms of energy into electricity by the owner of that equipment.
"Load Pocket" means a geographic area of load that, because of transmission limitations, must have resources internal to the area available to operate so as to ensure reliable service to the area's load.
"Marketer" means an entity that acts as an intermediary in the purchase and sale of electricity, and that takes title to electricity for sale to retail customers.
"Market Power" refers to the ability of a particular seller, or group of sellers, to influence significantly the price or availability of a product or service to their advantage over a sustained period of time. Market Power includes, but is not limited to, the ability to raise prices by restricting output. For purposes of this Act, evidence of Market Power includes, but is not limited to, the existence, magnitude and effect of Transmission Constraints and Load Pockets; strategic bidding; capacity withholding; "must-run" generation units; barriers to entry; and the ability to leverage the sale of Generation Service, Aggregation Service or other Potentially Competitive Services through the use, ownership or control of Generation-related Ancillary Services or Noncompetitive Services.
"Market Value," for the purposes of determining the recovery of Stranded Costs or Stranded Benefits, means the value of a particular good or service for which the Commission determines there is Effective Competition.
"Mitigation" includes all actions or occurrences that reduce the amount of money that an electric company would need to collect in order to recover its Embedded Costs over time, including those resulting from both matters within the company's control (such as, but not limited to, sales of assets) and from matters not wholly within the company's control. Mitigation includes, but is not limited to (1) sales of capacity, energy, or Ancillary Services from generating facilities that are wholly or partly owned by the company or any affiliate of the company; (2) sales of capacity, energy, or Ancillary Services from generating facilities with which the company has a power purchase agreement; (3) adjustments to the company's obligations under power purchase agreements that decrease such obligations, such as those that may be obtained through contract buy-out or renegotiation; (4) residual value; (5) refinancing debt to reduce interest obligations; and (6) sales and voluntary writedowns of company assets.
"Noncompetitive Service" means any electric service determined by statute or by the Commission pursuant to statute to be unsuitable for purchase by customers from Alternative Sellers.
"Potentially Competitive Service" means a component of Electric Service determined by the Commission to be suitable for purchase by customers from Alternative Sellers. The term includes any Potentially Competitive Service that is deemed to be competitive pursuant to the Act. A Vertically Integrated Electric Utility may not provide a Potentially Competitive Service except through an affiliate
1. on or after (date); or2. the date on which the Commission finds that the service is a Potentially Competitive Service.
"Retail Access" means the ability of a retail consumer of electricity to purchase Electric Service from an Alternative Seller.
"Stranded Costs" for purposes of this Act means the recoverable decremental net difference between those Embedded Costs that remain after accounting for maximum possible Mitigation of such costs and the Market Value of Generation Service, Aggregation Service, or another Potentially Competitive Service.
"Stranded Benefits," for purposes of this Act, include but are not limited to the recoverable incremental net difference between the Embedded Costs and the Market Value of Generation Service, Aggregation Service, or another Potentially Competitive Service.
"Transmission Constraint" means any action or occurrence, whether caused by physical limitations or discretionary control over generation or transmission assets, that limits the simultaneous capability to transfer firm capacity or energy into, out of, within or through an area.
"Vertically Integrated Electric Utility" means any public utility or public service corporation in the business of supplying electricity or its successor in interest that as of (date) held a certificate of public convenience and necessity issued by the State Corporation Commission to furnish electricity, either directly or indirectly, to or for the public.
1. For purposes of this Act, the term shall not include a cooperative association or nonprofit corporation or association or other provider of Electric Service, that is declared to be a public utility pursuant to § 56-232 and provides service only to its members.
§ 2 Calculation of Stranded Costs and Stranded Benefits.
For each Vertically Integrated Electric Utility, the Commission shall determine the net sum of the following to the extent that they qualify as Stranded Costs or Stranded Benefits:
1. the Market Value of its Generation Service, Aggregation Service or any other Potentially Competitive Service, once the Commission finds that there is Effective Competition for such service; and2. the recoverable Embedded Costs and Embedded Margins associated with assets and obligations that are documented in the accounting records of a Vertically Integrated Electric Utility and that are properly allocable to Generation Service, Aggregation Service or other Potentially Competitive Service as of the date on which Alternative Sellers of similar Services begin providing such service to retail customers of the Vertically Integrated Electric Utility.
3. In determining the amount of recoverable Stranded Costs or Stranded Benefits, the Commission shall consider
a. the extent to which the utility was legally required to incur the costs of the assets and obligations;4. For purposes of this Section, the Commission shall adopt a just and reasonable method and procedure for affording the opportunity to recover from ratepayers or the Vertically Integrated Electric Utility that portion of Embedded Costs or Embedded Margins that are determined by the Commission to be owed by or to the ratepayers. The Commission shall determine the period over which such recovery may occur, and the Commission may assess just and reasonable charges or credits. Such determinations or procedures shall not unduly discriminate against a participant in the market. The Commission shall not impose an exit fee or other similar charge, directly or indirectly, on a retail consumer who elects to self-generate.b. the extent to which the Market Value of the assets and obligations of the utility, relating to the provision of Generation Service, Aggregation Service or other Potentially Competitive Service, exceeds or is less than the Embedded Costs of such services;
c. the effectiveness of the efforts of the utility to (i) increase and realize the Market Value of any assets, and (ii) decrease the costs of any obligations, associated with the provision of Generation Service, Aggregation Service or Potentially Competitive Services;
d. the extent to which the rates previously established by the Commission have compensated shareholders for the risk of not recovering the costs of the assets and obligations;
e. the effects of the difference between the Market Value and the cost, including, without limitation, tax considerations, for the assets and obligations;
f. if the utility had discretion to determine whether it would incur or Mitigate the costs, the conduct of the utility with respect to the costs of the assets and obligations when compared to other utilities with similar obligations to serve the public;
g. if the utility has made reasonable efforts to reduce Market Power and avoid the need for administrative projections of Stranded Costs or Stranded Benefits by divesting assets; and
h. any other factor the Commission concludes is just, reasonable and necessary to protect the public interest.
5. In determining the Market Value for Generation Service, Aggregation Service or other Potentially Competitive Service, the Commission shall implement a Price Cap for individual customer classes to protect captive or core customer groups from cross-subsidizing more competitive customer classes, to prevent the revenues from Noncompetitive Services from subsidizing Generation Service, Aggregation Service, or other Potentially Competitive Services. Such Price Cap shall provide a mechanism to address Stranded Benefits and protect consumers from ineffective competition and Market Power abuses, as well as one means of testing the extent to which Effective Competition has developed in a given market. The Commission shall develop an appropriate Price Cap Formula that provides the percentage of annual change in the price for a group of customers based upon three main components:
a. a price index;expressed in the following Price Cap Formula:b. a productivity index; and
c. an adjustment factor for idiosyncratic costs or benefits,
/\ Pit = (PI(t-l) - X(t-1)) ± Z(t-1)where/\ Pit = percentage change in the price of electricity for customer class i for period t,6. Commission Finding of Effective Competition. On motion of any party or on the Commission's own motion, the Commission shall, prior to approving a request for Stranded Costs recovery or a determination of Stranded Benefits, determine whether Effective Competition exists for the service for which Stranded Cost recovery or a determination of Stranded Benefits is requested. In making such a finding, the Commission shall consider the degree to which Market Power is present for the particular product or service. In making this determination, the Commission shall not be bound by a determination by the FERC in approving an application for an entity to sell at market-based rates, but may consider the evidence produced in connection with such application as part of the Commission's determination. The Commission shall consider all relevant evidence relating to the existence and degree of Market Power in making its determination.PI(t-1) = price index for latest reporting period,
X(t-i) = productivity offset calculated from latest reporting period data, and
Z(t-1) = adjustment factor for company-specific Stranded Costs or Stranded Benefits for the latest period