Joint presentation on behalf of
Virginia Power and Virginia Independent Power Producers

Stranded Costs and Related Issues Task Force

The Joint Subcommittee Studying Electric Industry Restructuring

June 30, 1998

Mr. Chairman and members, I'm pleased to be with you this morning.

As I understand it, there were some questions during your last meeting about past governmental mandates to utilities, which required expenditures that may, in the future, contribute to stranded costs.

This morning, I'd like to review briefly the economic conditions that existed when the US Congress passed the Public Utility Regulatory Policies Act of 1978 (PURPA). I will then describe PURPA's past and continuing requirements on public utilities such as Virginia Power. Then, I'll tell you how the federal law was administered and supported by the Virginia State Corporation Commission. Finally, I will share the reasoning behind my view that any future stranded costs that might result from the PURPA obligations should be recovered in full, and that the existence of generation-related stranded costs is logical, explainable and perfectly prudent.

Initial Passage of PURPA - The National Energy Situation

President Jimmy Carter signed the Public Utility Regulatory Policies Act (PURPA) into law in November, 1978. The US Congress had passed PURPA as part of a package of energy legislation proposed by President Carter to combat the 'energy crisis' of the late 1970s.

Although some twenty years have gone by, most of us likely remember the energy shortages that existed in the '70s. Energy prices had increased very rapidly - oil prices, for instance, had increased from $3.18 a barrel in 1970 to $21.50 in 1980. Natural gas increased from 17 cents per thousand cubic feet in 1970 to $1.59 in 1980. These very rapid and substantial price increases, coupled with perceived shortages of natural gas and imported oil, stimulated the federal legislature to enact PURPA, which had as its principal goal to "promote energy independence and diversification of supply, improve the overall efficiency of supply, and conserve electric energy…"

PURPA was an unprecedented federal intervention into the generation sector of the private utility industry. PURPA authorized financial and regulatory incentives to encourage private development of alternative domestic energy sources, as ways to promote its goal of decreasing reliance on foreign fuel sources.

In particular, PURPA created a new class of electricity generators. "Qualifying facilities" - known as "QFs" - were structured to achieve the national goal of improving the overall efficiency of electric power generation. QFs - some of which are also commonly known as cogenerators - are required to meet stringent fuel conversion efficiencies. Unlike traditional electricity generating facilities, which burn fossil fuels to create electricity, cogenerators are required by the federal law to use the steam produced by burning fossil fuels for two distinct purposes: production of electricity and for some other separate commercial or industrial purpose. Cogenerators, then, achieve greater fuel efficiencies by producing two useful energy products, and thus serve the primary goal of the PURPA legislation. Earlier in this century, cogeneration provided approximately 25% of the nation's total electric production. For a variety of business and regulatory reasons, including a reluctance on the part of the electric utility industry to deal with such facilities, this share of production dropped to less than 5% in the 1970s. A specific goal of PURPA was to overcome this reluctance with a federal mandate.

As a result, if certain efficiency and ownership requirements were met, PURPA also required electric utilities such as Virginia Power to purchase power from "qualifying facilities," at the utility's "avoided costs." Avoided costs are the costs the utility would have incurred itself if it had constructed traditional utility-owned generating facilities and had operated these facilities themselves. Thus, the PURPA law attempted to ensure both that a mandatory market would exist and that consumers would not be required to pay higher prices than they otherwise would experience.

PURPA in Virginia

The Early PURPA Contracts

Virginia Power entered into its first PURPA-mandated contracts in 1982, as a way to meet its need for new capacity at that time. Starting in 1982 and continuing until 1986, Virginia Power negotiated contracts with ten non-utility generators, aggregating 377 megawatts of capacity. The first negotiated contracts were mostly with large industries in Virginia, which had substantial power and steam requirements. These included Stone Container, Westvaco, Merck, Chesapeake Corporation, Norfolk Naval Shipyard, Park 500, the Alexandria municipal solid waste facility, Union Camp, Cogentrix-Portsmouth and Cogentrix-Hopewell. The rates negotiated in these early contracts were largely determined using the avoided cost methodology approved by the Virginia State Corporation Commission in two cases conducted to establish avoided costs for very small projects.

The 1986 Competitive Solicitation

In anticipation of the great demand for new generation in Virginia, Virginia Power was inundated by numerous offers to sell power from qualifying facilities. To cope with this great demand in an organized fashion, in 1986 Virginia Power became one of the first utilities in the nation to move from contract negotiation to a system of competitive bidding to select among many cogenerators vying to enter the marketplace. Competitive bidding was a logical extension of the PURPA mandate to purchase from qualifying facilities, and it contained additional benefits for the utility and its customers. I view Virginia Power's decision to go beyond negotiated PURPA contracts to a competitive bidding system as an effort to refine its application of the federal mandate in order to produce greater benefits for consumers in Virginia. My own view at the time was that Virginia Power had actually limited the application of the federal law to achieve a benefit for its ratepayers.

In 1986, Virginia Power advertised for bids to provide 700 megawatts of needed capacity, and new competitive forces operating in the marketplace responded with offers totaling more than 5,000 megawatts, more than seven times the capacity needed. This intense competition certainly resulted in better contract terms, including dispatchability, for Virginia Power and its customers, although prices were set based on Virginia Power's costs for its next generating unit.

The 1988 Competitive Solicitation

By 1988, Virginia Power had refined its competitive bidding process. Again, in compliance with the mandatory purchase requirements of PURPA, it solicited bids for all of its capacity needs not only from QFs but also from other types of potential suppliers. This competitive solicitation was reportedly the first in the United States to require price competition, as a way to let competitive market forces establish "avoided costs." Virginia Power also again solicited dispatchable capacity, which is more valuable to the utility and more beneficial to its customers. Again, this represented a benefit to its customers that went beyond the scope of the PURPA legislation. Virginia Power sought bids to purchase 1,750 megawatts of capacity. Again, a very vigorous marketplace responded with bids for 95 different projects, totaling 14,600 megawatts - more than eight times as much capacity as was needed. Again, a competitive generation market produced tangible benefits for ratepayers.

Review by SCC Staff

The scope and nature of this 1988 competitive solicitation was unprecedented.

Virginia Power's use of competitive bidding to satisfy the requirements of PURPA was reviewed by the Staff of the State Corporation Commission. While the Staff made some suggestions for improving future solicitations, it gave this one very high marks:

Overall, the Staff's impression of Virginia Power's 1988 competitive capacity solicitation was favorable. The Request for Proposal (RFP) was well developed. It provided the basic information needed by a potential project developer. The solicitation participants that we interviewed generally commented that the RFP was clear and comprehensive. Virginia Power held a pre-bid meeting on April 7, 1988 to explain its RFP and to answer any questions that potential bidders had. This meeting and the three addenda to the RFP were useful in further explaining and clarifying the Company's intentions. The RFP was well publicized; over 300 were distributed.

The evaluation process was thorough. The bids went through multiple screening and optimization stages using state of the art computer software. This process was reviewed and considered to be consistent with State Corporation Commission guidelines as elaborated in the final order in Case No. PUE870080. Favorable weights, although sometimes small, were assigned to the "non-price factors" mentioned in the Commission's order. The Staff found no evidence of unfair treatment or favoritism shown toward any particular project by Virginia Power evaluators.

Virginia Power was assisted in its evaluation by consultants from McKinsey and Company, Inc. McKinsey and Company was hired by Virginia Power to observe and advise in the evaluation of bids and to conduct analyses and checks on the process. McKinsey and Company concluded that the evaluation of the bids received in the 1988 solicitation for power,

was formulated to be consistent with sound management practices,

was applied fairly and impartially to all bids, and

resulted in a set of winning bids that appropriately balance the trade off between total system cost and the non-price factors prescribed by the RFP.

Virginia Power has spent considerable time and resources in developing a sophisticated bid solicitation and evaluation process. The process was carefully constructed in an effort to achieve several goals. The Company wanted to develop a "winning plan" of projects that would provide capacity at a cost below that which would be incurred by building its own units. The Company, however, also wanted a plan that was attractive when important non-price factors were taken into consideration. The reliability of the power, the stability of its energy price component and certain associated societal benefits were among the important non-price factors the Company chose to consider. Virginia Power also wanted to develop an evaluation methodology that would treat each bid that was submitted fairly and without prejudice. Virginia Power has largely achieved these goals with its 1988 solicitation. [Emphasis supplied.]

The 1989 Competitive Bidding Solicitation

In August, 1989, Virginia Power again used competitive bidding to comply with its PURPA obligations and to select among competing suppliers. The utility sought 1,100 megawatts of capacity and received offers for more than 11,000 megawatts. Again, this huge competitive response - more than 10 to 1 - worked to the benefit of ratepayers by driving down prices for capacity and energy.

Competitive Bidding Summary

Virginia Power used its competitive bidding process three times to satisfy the mandatory purchase requirements of PURPA, when bids were below the utility's own costs. Intensely competitive bidding supplied 82 percent of all the non-utility generating capacity furnished to Virginia Power, at prices judged to be equal to or less than what Virginia Power's own costs would have been to construct needed generating facilities itself. During this time, Virginia Power also constructed generating facilities itself, and purchased from other utilities when it determined that the costs of doing so would be lower than purchasing from cogenerators or other bidders. Since 1986, Virginia Power built Chesterfield 7, Chesterfield 8, peakers at Darbytown and Gravel Neck, the Clover generating station and purchased capacity from the APS utility system.

The remaining 18 percent of Virginia Power's NUG capacity resulted from small power producers (Schedule 19 providers) and contracts arbitrated by the SCC.

The PURPA Mandate

In each of the above situations which led to contracts with non-utility generators, Virginia Power was complying with the requirements of the federal PURPA legislation. While it is true that Virginia Power favored contracting with NUGs and using competitive bidding - when it produced results more favorable than its own self-building strategy - it is also true that the federal PURPA legislation required that the generation industry be opened to new suppliers.

PURPA imposed an absolute mandate on utilities, as it was implemented by the Federal Energy Regulatory Commission ("FERC") regulations. These obligated utilities such as Virginia Power to purchase "any energy and capacity which is made available from" qualifying facilities at the utility's avoided cost. FERC underscored this utility mandate in the context of bidding in its Notice of Proposed Rulemaking ("Bidding NOPR"), which was issued in 1988 but not implemented in final rules. In discussing states' implementation of FERC's bidding proposal, FERC further noted that, regardless of whether capacity was obtained through bidding or other means, no capacity could be exempted from qualifying facility offers and set aside for either the utility's own construction program or purchases of power from non-qualifying facility sources.

The mandatory purchase obligation imposed by PURPA clearly was supported in all pertinent respects by the statements and policies of the Virginia State Corporation Commission. In its 1985 order concerning small power producers (Schedule 19s), the Virginia State Corporation Commission wrote:

The development of cogeneration and small power production in Virginia must be encouraged, and this Commission intends to do so. Such development has this Commission's full support for a number of persuasive reasons.

. . . .

We believe the results we have reached here will make it clear that cogeneration and small power production facilities are welcome in Virginia and that this Commission fully supports the underlying concepts and intends to see that the development of those facilities is strongly encouraged in this state.

Later, as the SCC apparently came to believe that Virginia Power might be relying too heavily on power purchases and not heavily enough on its own construction program, the SCC Hearing Examiner acknowledged that the Commission had given strong encouragement to PURPA-type generators:

There is no question that many of the problems identified by the Staff and the Committee are a direct result of the passage of PURPA and Virginia Power's efforts, with the strong encouragement of the Commission, to actively pursue an extensive cogeneration program.

PURPA and Stranded Costs

This task force is considering the question of stranded costs. First, I would point out that it is unknown today whether stranded costs will exist in the future. Perhaps they will, but it is not possible to know that today, because the commonly accepted definition of stranded costs requires a comparison between the future contemporaneous costs of generation (which we know reasonably well) with free market prices in the future (which we do not know with acceptable certainty).

If free market prices in the future are below future contemporaneous generation costs, stranded costs will result. If market prices turn out to be above contemporaneous generation costs, stranded costs will not exist.

Assume for this discussion, though, that stranded costs will exist in the future. One of your key considerations, I believe, is to determine whether and how stranded costs should be collected from customers, as a way to move into a competitive retail market for electricity. I strongly believe that stranded cost recovery should be allowed if the electric utility acted prudently and in good faith and honored its obligation to serve all customers, known as "the regulatory compact." Since Virginia Power's actions resulting from its PURPA mandate were prudent, its resulting stranded costs are also prudent, and should be recovered from consumers.

In its Order 888, pertaining to wholesale competition and stranded costs, the Federal Energy Regulatory Commission (FERC) established a three-part stranded costs test. FERC concluded:

We reaffirm our preliminary determination that the recovery of legitimate, prudent, and verifiable stranded costs should be allowed. Having considered the arguments raised by the commenters that oppose stranded cost recovery, we continue to believe that utilities that entered into contracts to make wholesale requirements sales under an entirely different regulatory regime should have an opportunity to recover stranded costs….[W]e do not believe that utilities that made large capital expenditures or long-term contractual commitments to buy power years ago should now be held responsible for failing to foresee the actions this Commission would take….We will not ignore the effects of recent significant statutory and regulatory changes on the past investment decisions of utilities. [Emphasis supplied.]

As noted above, the principal determining standards used by FERC (and many states) are whether potential stranded costs are (1) legitimate, (2) prudent and (3) verifiable.

Certainly potential stranded costs are legitimate if they result from actions mandated by a governmental agency.

Potential stranded costs are prudent if utilities were satisfying legitimate needs for new capacity (as Virginia Power was) and if the costs were the lowest obtainable at the time the obligations were entered into. Virginia Power's use of bidding produced immense competitive pressure to lower prices.

And potential stranded costs resulting from NUG contracts are absolutely verifiable. The payments to NUGs are specified with great precision in the existing contracts, and any variance from future market prices will be known as these prices unfold.

Summary and Conclusions

Regulated electric utilities have been subject to a number of governmental requirements and mandates over the years. A significant mandate imposed by the federal government is PURPA, which mandated that electric utilities must purchase capacity and energy from cogenerators who met certain efficiency and ownership standards, when the costs are at the utility's 'avoided costs.'

Purchases from cogenerators and other independent generators may result in stranded costs in the future, as the nation moves from the present system of utility regulation to a free market system of retail competition.

If electric utilities were required by PURPA to purchase capacity and energy, if the utilities were encouraged to pursue cogeneration projects by state regulatory commissions, and if the decisions of the regulated utilities to purchase were prudent, it would be extraordinarily unfair to deny the utilities full recovery of any stranded costs associated with the NUG contracts that might result in the future.

Stranded Costs Resulting from New Generating Unit Additions

Stranded costs are a logical, predictable and natural outgrowth of the actions of prudent utilities in a time of declining generation costs. The actions of a prudently managed regulated utility in meeting additional customer demand with new generating capacity - self-built or purchased - can, in and of themselves, lead to stranded costs when after the fact these actions are compared to a current or forecasted market standard. This is a basic property of the transition from regulation to competition, and should be seen as such. My point is simply that there is nothing inherently wrong with the existence of stranded costs, and their existence should be recognized as being totally consistent with prudent utility planning.

This result occurs because capacity additions are most economically made in large discrete blocks, and there is a need to maintain adequate reserves to maintain reliability. Given historic regulatory concerns about power shortages and outages, it is not hard to understand why prudent planning leads to continuing slight surpluses in capacity which, in a competitive market, have no immediate monetary value, and most importantly drive the market value of all generation capacity to zero. Added to this factor is the uncertainty in the forecasting of growth and demand.

Thus, prudent planning by a utility inherently yields stranded capacity costs when the pricing or valuation of capacity shifts from a regulated system with embedded cost-based compensation to a competitive market, where regulatory standards almost certainly will result in a surplus capacity market with little or no value for capacity. It would be surprising not to see this result generally within the industry in a transition from a planned cost-based system to a market-based one.

I provided lengthy testimony on this and related issues to the Virginia State Corporation Commission, which details the fashion in which totally prudent actions, even "below market" contracts, can lead to stranded costs. This testimony can be made available to anyone who wishes it.

Collection of 'Stranded Costs' in Other Previously-Regulated Network Industries

Other previously-regulated network industries have recovered their versions of stranded costs as they were deregulated. Like the electric industry, these industries also had mandated obligations to serve customers and profit restrictions imposed by law or regulation. Policymakers, regulators and legislators have recognized the equities of stranded cost recovery in these other 'network' industries, which include airlines, railroads, interstate trucking and telephones.

In all these cases, the transition from regulation to competition was accompanied by recognizing the significant financial interests of lenders and investors, who supplied capital to construct facilities during periods of regulation, and the interests of customers, who were moving into a new period of competition.

I'll be pleased to respond to your questions.

Case No. PUE800102 and Case No. PUE830067.

Utilities purchasing "dispatchable" capacity generally start, stop and modify operation of the generator, in response to customer demand for electricity, within contract specifications.

Review of Virginia Power's 1988 Competitive Bid Capacity Solicitation.

PURPA also required the establishment of standard rates for purchases by utilities from smaller qualifying facilities, and PURPA required the states to have proceedings to establish the rates. The Virginia State Corporation Commission held a number of such Schedule 19 proceedings, to set rates and establish certain other conditions for these mandated purchases.

One cogeneration developer refused to participate in the competitive bidding process and instead filed petitions for arbitration of contracts. The State Corporation Commission agreed with the developer that such a right was reserved under PURPA and appointed a member of the SCC to arbitrate the dispute. Eventually, the arbitrator found that PURPA required Virginia Power to sign contracts, and four cogeneration contracts resulted. Three generating facilities were actually built.

16 U.S.C. Sec 824-a-3(a), as implemented by 18 C.F.R. Sec. 292.303(a).

Application of Virginia Electric and Power Company, Case No. PUE830067, Final Order, 1985 SCC Ann. Rep. 384, 386 (November 15, 1985).

Application of Virginia Electric and Power Company, Case No. PUE890007, Final Report of Glenn P. Richardson, Hearing Examiner, p. 16 (January 22, 1990).

Federal Energy Regulatory Commission (FERC) Order No. 888, Promoting Wholesale Competition Through Open Access Non-Discriminatory Transmission Services by Public Utilities, Recovery of Stranded Costs by Public Utilities and Transmitting Utilities. [Docket No. RM94-7-001] Issued April 24, 1996.

Testimony of Roy J. Shanker, Ph.D. on behalf of Virginia Independent Power Producers, before the State Corporation Commission, Case No. PUE960296, Case No. PUE960036, filed December 23, 1997.