SCC Comments to the Structure And Transition Task Force

August 12, 1998

Introduction

As noted in our June 30, 1998 submittal, the Commission Staff believes that a prudent competitive transition plan should not treat restructuring as a one-time, final decision and that an appropriate plan would provide for a diminishing level of regulation that corresponds with an increasing level of competition. Such an approach recognizes that competition for electricity will not be established overnight and that competition must be allowed to evolve.

We have been asked to provide you with a brief summary of our earlier restructuring outline and to comment on submissions made by other interested parties with a focus on areas of consensus as well as areas of disagreement. Our comments are organized by major areas of importance with a brief summary of the Staff's position followed by a discussion of the positions of other parties. Due to time constraints, this presentation will not address every topic covered by our June 30, 1998 submission.

Market Power and Regulation of Generation Assets

The Commission Staff believes that the enormous potential for generation market power is the most significant obstacle to successful restructuring. As such, we will devote the bulk of our comments to this topic. The market power of incumbent utilities must be mitigated prior to the relaxation of traditional regulation of incumbent utility generation assets. Customer choice can be implemented without such mitigation provided that generation is not completely deregulated or there are some other forms of long-term price protections. In our earlier comments, we noted that the General Assembly has several options for addressing market power issues, including:

• Deregulate generation assets by a date certain and rely on the FERC or the ISO, under FERC oversight, and the U. S. Department of Justice to monitor and mitigate market power abuse;

• Require or encourage incumbent utilities to divest their generation assets and either maintain State regulatory authority over "must-run units" or rely on the FERC to regulate such units; or,

• Specify criteria for relaxing traditional regulation of generation assets as a sufficient level of competition develops and the market power of incumbent utilities is effectively mitigated through the development of new competitive market organizations and infrastructure enhancements including new transmission facilities to alleviate constraints as well as more local generation.

With the exception of Virginia Power, Allegheny Power, and Washington Gas, the parties filing comments on June 30^th noted that market power was a significant concern and suggested several alternatives for addressing this concern. Several parties noted that mandatory divestiture of generating units should be considered while others suggested that incumbent utilities should be given strong incentives for divestiture. While both Virginia Power and Allegheny were opposed to mandatory divestiture, they continued to support deregulation of the prices for generation. Allegheny would provide for continued price controls until five years after customer choice is first initiated. Virginia Power would like to see prices for generation deregulated as soon as retail choice is initiated. In fact, Virginia Power's proposal calls for deregulation before it would provide commercial and residential customers an opportunity to choose alternative suppliers. Other commenters, who did not necessarily support mandatory divestiture, supported continued price protections until such time as the potential for market power is eliminated or there are sufficient competitive alternatives.

Virginia Power apparently believes that the FERC's regulation of ISOs and power exchanges will, in conjunction with the development of additional privately owned generation, provide sufficient protection to consumers against market power abuses. Virginia Power does note, however, that the Commission should be authorized to delay choice for residential consumers if market power has not been sufficiently mitigated. We would note that a delay in choice does not address market power, only a delay in deregulation can help. In support of its position, Virginia Power notes that new merchant plants being proposed or built in New England would increase that regions generating capacity by 40 percent.

We would like to make several observations regarding Virginia Power's comments. First with respect to New England's expected increase in generating capacity, we would note that much of this new capacity has simply been proposed and that much of this capacity may not actually materialize. It should also be noted that New England is a very high cost region where the expected cost of new generation is typically below that of existing generation. Virginia is, on the other hand, a relatively low cost region where the embedded cost of existing generation is, in many instances, significantly below the incremental costs of new generation. Consequently, developers of merchant plants may be unable to compete and therefore are unable to locate new generating resources in Virginia.

Virginia Power's suggestions would place a significant reliance on the FERC to provide for sufficient mitigation of market power. As you have heard from a number of parties, including Shelton Cannon from the FERC, the FERC is still feeling its way with respect to market power issues. Mr. Cannon noted that "We [the FERC] clearly have a lot of work ahead of us as we try to get a better handle on identifying market power problems, resolving areas where state and Federal jurisdiction overlap, and defining an appropriate role for ISOs in the restructured electric industry."

In other comments to the joint subcommittee, the Staff of the Bureau of the Federal Trade Commission offered the following warning regarding the FERC's handling of market power issues through its regulation of ISOs:

As a general proposition, a market power monitoring office within the ISO may not be a good substitute for up-front divestiture of generation capacity. Several states, including California, have confronted the generation market dominance issue directly and required divestitures of key generation capacity in conjunction with forming an ISO. As noted earlier, antitrust may not be an effective policy tool for addressing existing market power created under past regulation. Hence, the Task Force, other state public utility commissions, and FERC may be in the best position to address this aspect of restructuring as part of the ISO formation process.

In a footnote, the Staff of the Federal Trade Commission also noted that antitrust enforcement may not apply to a firm that lawfully acquired market power. This could potentially be the case if restructuring legislation preserved the market dominance of incumbent utilities.

Other developments cast further doubt on the FERC's ability and willingness to effectively deal with market power issues and raises questions regarding whether even divestiture is an effective tool for relieving market power dominance. On June 30, 1998, the FERC lifted price caps and allowed market based rates for certain ancillary services provided by divested generating units in California despite objections by the California ISO. Subsequent to that order, the California ISO witnessed dramatic spikes in prices for replacement reserve capacity. On July 14, the California ISO experienced a market clearing price of $9.99 per kW for reserves. The price could have been even higher but for the fact that the ISO's computer software could not accommodate a higher number.

On July 17, 1998, the FERC issued an order which initiated further fact finding with respect to the market power of the ancillary service providers and authorized the California ISO to reject bids in excess of what the ISO deems to be a reasonable price. The July 17 order has been challenged by an independent power producer which maintains that the FERC has inappropriately delegated its regulatory authority to the California ISO. This activity highlights the problems being faced by the FERC and lends further doubt to whether the FERC can or will effectively address market power issues.

The Commission Staff also questions the effectiveness of delaying choice for residential customers as a remedy for addressing market power in light of Virginia Power's proposal for deregulation of prices for generation. We simply do not understand how a delay in customer choice would protect residential customers from market power abuses if there were no provision for continued price protections. In such an instance, residential choice may be one of the few remaining tools for seeking to relieve market power concerns.

Commencement of Customer Choice

In our earlier submission, the Commission Staff noted that effective competition depends on a number of factors not yet in place, among them: a sufficient number of competitors, one or more independent system operators and power exchanges, educated consumers, new metering and billing systems, and regional mechanisms necessary to assure reliability and accountability. We noted that the General Assembly could simply fix a date for customer choice regardless of whether the prerequisites for successful competition are in place, or the General Assembly could authorize the Commission to accelerate or delay the date for choice based on a factual analysis of whether certain prescribed competitive elements are in place. Should the General Assembly find it desirable to establish a fixed date for choice, it is critical that the General Assembly provide for rate limits in the form of caps or freezes to prevent unreasonable pricing until competition develops.

Most if not all of the parties submitting comments on June 30, suggested that the Commission be given authority to alter the timeline for customer choice. Virginia Power and Washington Gas would limit that authority to instances associated with action or inaction by the FERC or with higher court appeals. As noted earlier, Virginia Power also proposes that the Commission be authorized to delay choice for residential customers if market power has not been sufficiently mitigated. Some parties suggested that the Commission be given full authority with respect to the schedule for customer choice while others suggested that the General Assembly establish specific criteria to be considered by the Commission in adjusting the dates for choice in conjunction with periodic reports to the General Assembly.

With the exception of Virginia Power, the commenters suggested that, at a minimum, residential customers be granted choice at the same time as other customers. Virginia Power would provide choice to residential customers after industrial and commercial customers had been granted access to competitive suppliers due to implementation issues associated with providing choice to smaller customers. Several commenters suggested a phase-in for choice with equal percentages for the various customer classes.

The Commission Staff believes that the dates for customer choice as provided for in H.B. 1172 are reasonable provided that necessary information gathering systems and other consumer protection measures such as codes of conduct and supplier registration requirements are in place. We believe that customers should be allowed to voluntarily participate in retail choice programs as long as they have an opportunity to participate in alternative programs which afford protection from market power abuses. In other words, deregulation does not have to occur in order to provide customers with choice.

Last Resort and Default Service

As we noted in our June 30^th comments, legislative authorization of customer choice does not guarantee that every customer will choose or be able to choose a competitive supplier. Consequently, it may be necessary to designate a default service provider. There are basically three options for selecting such a provider: 1.) require incumbent suppliers to be last resort suppliers either temporarily or permanently; 2.) require the selection of a last resort supplier through competitive bid; or 3.) require all competitive suppliers to serve a portion of the default service customers based on that supplier's share of the competitive market.

The majority of commenters noted that distribution utilities should be the supplier of last resort or default service provider. Washington Gas drew a distinction between the supplier of last resort and the default service provider and suggested that distribution utilities be suppliers of last resort while default service providers be selected through competitive solicitation. ALERT suggested that the Commission have the authority to determine the supplier of last resort. A few parties commented that selection of incumbent utilities as suppliers of last resort could act to discourage competition over the longer term.

Several parties suggested that the rates for such services should be market based. The Southern Environmental Law Center and the Virginia Council Against Poverty suggested that some form of price control should be established for suppliers of last resort. Specifically, the Virginia Council Against Poverty recommended that the costs of supplier of last resort services be no more than the costs for customers who are exercising their right to choose.

Independent System Operator and Power Exchange

The Commission Staff believes that the successful development and implementation of ISOs and power exchanges are critical to restructuring. In fact, the Commission has initiated a proceeding that entails an on-going evaluation of ISOs. While we believe that Virginia, through authority vested with the Commission, has certain authority with respect to ISOs, additional clarification regarding the role of the State may be needed. Given the factual and jurisdictional complexity of ISOs and power exchanges, the General Assembly could pursue several approaches, including:

• Directing Virginia's utilities to form or join an ISO subject to the Commission's review, where the review would apply criteria established by the General Assembly; or,

• Directing owners of generation to form or join a power exchange subject to the Commission's review, where the review would apply criteria established by the General Assembly.

Most, if not all, of the commenters expressed support for the development of one or more ISOs while stressing that ISOs must truly be independent. ALERT suggested that the Commission have authority to approve participation in an ISO and that the Commission have an on-going authority to determine if continued participation in an ISO is appropriate. AOBA supported the development and application of a public interest standard by the Commission. CNG noted that creation of an ISO may create regulatory gaps and recommended that the Commission work with the FERC and other regulatory bodies to address any such gaps. Other parties supported less formal Commission involvement in the development of ISOs.

While most parties expressed general support for the development of one or more regional power exchanges, the commenters generally indicated that power exchanges should be allowed to develop with limited governmental involvement. ALERT and Washington Gas supported Commission approval of participation in a power exchange and Commission application of a public interest standard, respectively. AOBA expressed reservations about the need for a power exchange.

Conclusions and Recommendations

The Commission Staff believes, as do many others, that competition is generally superior to regulation and that competition will generally lower costs and increase innovation. However, we also believe that there are many barriers to effective competition in the electric utility industry. As we have noted on numerous occasions, the significant potential for incumbent market power threatens to undermine and potentially eliminate any benefits that restructuring may offer. We believe that it would be a serious mistake to provide for the deregulation of generation as long as there is a potential for market power abuses. Continued authority over existing generating units may be needed in support of long-term price protections and as a means of retaining the benefits of low cost generating resources for Virginia consumers.

The development of ISOs and power exchanges may be critical steps in the effort to eliminate market power concerns and to encourage new entrants into Virginia's electric industry. However, ISOs and power exchanges represent only a partial solution and may even be harmful if developed inappropriately. Consequentially, we urge you to take steps to assure the following:

• that ISOs and power exchanges are truly independent and free from any undue influence by any party, particularly parties owning generation;

• that ISOs and power exchanges are large enough to eliminate inefficiencies associated with transmission pricing and limited aggregation of power supplies;

• that ISOs and power exchanges are developed and operated in a manner that maintains or enhances bulk power reliability; and

• that ISOs and power exchanges provide reasonable solutions to relieving transmission constraints and resolving problems associated with load pockets.

These steps can include the development and application of public interest standards for participation in ISOs and power exchanges. The deregulation of prices for generation could be conditioned on satisfaction of these standards as well. As a cautionary note, it should be noted that participation in a power exchange could potentially shift certain authority to the FERC and in effect limit Virginia's ability to address market power issues. This is disturbing in that it is not clear whether the FERC has sufficient authority or is willing to exercise its authority to fully address market power issues.

We also urge you to condition the deregulation of generation on the mitigation of market power. One option would be the imposition of long-term price caps until incumbent utilities can demonstrate that their market dominance has been sufficiently mitigated or, incumbent utilities could be given strong incentives for divesting at least a portion of their generating assets. Such incentives could be applied through the conditioning of any stranded cost recovery on divestiture of sufficient generating capacity necessary to relieve horizontal market power. It should be noted, however, that divestiture may be an ineffective tool for lower cost utilities and many even be harmful since customers of low cost utilities would no longer have a right to lower cost generating facilities if the owners of these facilities are allowed to sell these facilities or output from such facilities in the open market. Price caps or freezes may be preferable solutions in such instances.

With regard to the provision of last resort or default services, we believe that there is little distinction between such services and that incumbent distribution utilities should, at least initially, be required to provide such services. We would note, however, that this could represent a deterrent to new market entrants over the long term. Consequently, we suggest that flexibility be maintained to address this issue on an on-going basis.

We have only discussed a few of the issues that must be addressed as part of a successful transition to a competitive electric market. Supplier registration, the treatment of stranded costs and benefits, eminent domain, codes of conduct for affiliated service providers, distribution service unbundling, special implementation issues, and other issues will also have to be addressed in an appropriate restructuring plan.

In closing, we would like to bring two items of interest to your attention. The first item is the attached map prepared by the Energy Information Administration. The second item is to note that the FERC is conducting a meeting in Chicago on Friday to discuss pricing issues associated with the June price spikes in the Midwest.

Status of State Electric Utility Deregulation Activity
as of August 1, 1998

¹California, Connecticut, Illinois, Maine, Massachusetts, Montana, Nevada, New Hampshire, Oklahoma, Pennsylvania, Rhode Island, and Virginia.
²Arizona, Maryland, Michigan, New Jersey, New York, and Vermont.
³Alaska, Kentucky, Missouri, Ohio, South Carolina, and West Virginia.
⁴Alabama, Arkansas, Colorado, Delaware, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Iowa, Kansas, Louisiana, Minnesota, Mississippi, Nebraska, New Mexico, North Carolina, North Dakota, Oregon, Tennessee, Texas, Utah, Washington, Wisconsin, and Wyoming.
⁵Florida and South Dakota.
Source: Energy Information Administration.