Date: June 25, 1998

To: SJR-91 Joint Subcommittee and Interested Parties
Re: Comments of Allegheny Power Concerning Allegheny Power's Proposed Plan For Deregulation And Implementing Customer Choice In Virginia

Allegheny Power supports competition and the goal of allowing customers to have their choice of electricity suppliers. As a multi-state holding company, Allegheny Power supports federal legislation to achieve this goal for customers in all states by a date certain. Action by the federal government is also needed to ensure that electric utilities are not disadvantaged in a competitive environment under existing federal statutes. Despite the need for federal legislation, Allegheny Power supports the right of states to implement retail choice and is presently conducting a retail pilot program in Pennsylvania in preparation for full customer choice in accordance with that state's restructuring laws and regulations.

Allegheny Power was an active participant in the Virginia State Corporation Commission's (SCC) investigation into retail competition last year and actively supports the work of this Joint Subcommittee on this issue. We submit that the following plan to implement retail choice in Virginia will ensure that consumers, utilities and their shareholders are fairly treated in the transition to more competitive electricity markets.

The Transition to Customer Choice

In order to implement customer choice in Virginia and ensure a smooth transition from a regulated environment to a competitive one, the legislature and the SCC must ensure that several critical steps are taken. These include:

  1. Permitting utilities to unbundle retail electric rates into separate transmission, distribution and generation charges;
  2. Deregulating generation used to supply power at retail;
  3. Approving implementation of a utility's unbundled retail distribution tariff;
  4. Determining the time frame in which customer choice will be implemented;
  5. Determining the level of retail stranded costs and establishing a non-bypassable mechanism for recovering such costs;
  6. Making changes to existing state tax codes to ensure that no competitor is unfairly burdened or advantaged;
  7. Developing and implementing consumer protections, including, customer information and safeguards, licensing requirements for retail electricity suppliers and other competitive safeguards;
  8. Determining the need for and establishing funding mechanisms for universal service and other social programs, including non-discriminatory and non-bypassable charges on end-users; and
  9. Ensuring that all competitors play by the same rules.

The evolution from the current regulated structure for generation to a competitive market structure characterized by full customer choice will require a period of transition during which an alternative form of regulation will guide the restructuring of utilities and the development of a competitive market. When seeking to structure an alternative form of regulation, the future competitive market must be considered. A fully mature competitive market for generation will, at a minimum, reflect the following characteristics:

Allegheny Power advocates a transition period during which customers will be permitted to shop for alternative suppliers of electricity, non-shopping customers will be protected, and incumbent utilities will be allowed to recover their transition costs. Prior to implementing customer choice, utilities will unbundle their retail rates into separate rates for generation, transmission and distribution functions and file them with the SCC. Customer choice would be phased-in to allow for an orderly registration process, avoid disruptions and minimize transition costs. During the transition period, the SCC would freeze retail rates at current levels for customers who do not seek alternative electric suppliers, thus preserving for retail customers the existing benefits of the state's already low electricity rates. Utilities would be allowed to charge a competitive transition charge to recover stranded costs from customers exercising choice.

Under Allegheny Power's plan, all classes of customers will have the opportunity to choose alternative electric suppliers during the phase-in period. Customers could be selected on either a subscription or lottery basis. All consumers who exercise choice would pay a non-bypassable competitive transition charge (CTC) to the local distribution company. The CTC during the transition period would be structured to recover stranded generation costs, non-utility generator costs, regulatory assets, and any other transition costs as they are quantified during the transition period. The CTC for stranded generation costs would be equal to the excess of the unbundled, frozen retail rate over the then-current market price. Customers who exercise choice would pay the distribution rate of the local distribution company, the CTC of the local distribution company, any applicable transmission rate(s), and the price offered for generation by the supplier(s) they have selected. Customers who do not exercise choice would pay a rate equal to the sum of the local utility's unbundled rates. After the transition period, generation will be fully deregulated and any remaining stranded costs for regulatory assets, nuclear and fossil decommissioning costs, and other (non-generation) transition costs arising from prior regulatory decisions could be recovered via a wires charge.

The following discussion examines in greater detail many of the issues addressed above, as well as many additional issues that will arise and must be dealt with when Virginia restructures its electric industry. The ultimate implementation of customer choice will be dependent upon the successful completion of a series of complex and interrelated tasks that include the passage of necessary tax and restructuring legislation and the completion of associated SCC rulemakings. Failure to complete or address one aspect of this proposal will have implications for other activities and may delay the successful implementation of customer choice.

Retail Rate Unbundling

An essential first step in preparing customers to make energy choices in the future is to unbundle the retail rates they presently pay into their component parts. Cost-of-service studies have long been the established and accepted methodology for assignment of costs, particularly common costs to functions and subsequently to customer groups. These studies should be used as the basis for unbundling rates. That process may require some modifications to obtain the needed information, but the basic allocation process should remain intact.

The following principles should be incorporated into the unbundling process:

1. Costs should be functionalized into distribution, transmission and generation functions.

2. Overall revenue neutrality should be maintained - total revenues should neither increase nor decrease due solely to the unbundling process.

  1. Fuel rates should be rolled-in to the base rates without making a correction factor permanent - this may require a temporary surcharge or rebate to dispose of any existing deferred balance. The focus should be on the level of the fuel rate that is rolled in to base rates, not on the fuel rate's components.
  2. Clear subsidies among rate schedules should be eliminated.
  3. The distribution rate component should be set based upon cost-of-service studies and frozen at that level, provided that the distribution component is set at no less than the last authorized rate of return.
  4. There should be no rate freeze on the transmission component of the unbundled rates. FERC has claimed jurisdiction over transmission service for retail customers with choice of generation suppliers, therefore the FERC open access transmission tariff must be the basis for the transmission component of the unbundled rates.
  5. Under an overall price freeze, the generation rate component should be the residual of the frozen rate after the transmission and distribution portions are removed.
  6. Generation-related rate features such as weekly averaging of maximum demands should be discontinued, and others affecting both generation and T&D (such as interruptible discounts) should be reexamined.
  7. Any participation credit in the rate structure that is intended to encourage customers to switch generation suppliers must be cost justified.
  8. While it may be feasible to unbundle certain aspects of distribution service such as metering and billing as a competitive option in the future, it is premature to address the further unbundling of distribution service prior to having a full retail access framework developed, initial suppliers in place, and customers educated about the basics of customer choice.

Deregulation of Generation

The purpose of introducing competition and customer choice in generation is to allow the forces of competition to discipline electricity prices for all customers. Once choice is implemented, all utility generation in the competitive marketplace must be fully deregulated. If competition is to be established, existing utility-owned generation cannot continue to be regulated under the traditional, cost-of-service framework. This will not promote competitive markets, nor is it necessary to protect customers.

Transition Period

A transition period should be established during which customers will be allowed to choose alternative electricity suppliers, non-shopping customers will be permitted to remain with their incumbent utility at regulated rates, and certain utility stranded costs will be recovered from all shopping customers via a non-bypassable wires charge. Allegheny Power supports a transition period that would last for five years from the start of customer choice.

During the transition period, incumbent utilities will freeze rates at existing levels, subject to exception for extraordinary events, e.g., an increase in state or federal taxes, state or federal environmental mandates, or maintenance of financial integrity. This rate will be available to retail customers who are unable or unwilling to choose an alternate generation supplier. The transition period should be used to sequentially replace embedded generation facility service with contractual service that the distribution utility will place on the customer's behalf with the market. After the transition period, the price of generation supplies for all customers, including customers who choose to remain customers of their local distribution utility, would be market-based. Transmission and distribution would continue to be regulated.

Any customer that chooses to shop during the transition period before full competition is implemented should be permitted to return to the incumbent utility at market-based rates. Virginia should avoid setting up a system where customers can choose between regulated (or frozen) cost-of-service generation supply options and market supply options. This would place regulated distribution utilities in the untenable position of being obligated to obtain and/or maintain regulated resources, with their associated expenses, that their customers (who can still shop) would have no obligation to buy, possibly leading to future stranded costs. To the extent a customer leaves the local utility and is permitted to return to the regulated rate during the transition period, a minimum stay of one year should be required to avoid cost avoidance and gaming of the system.

Enrollment Periods and Customer Phase-In

Based on its experience in the pilot programs in Pennsylvania, Allegheny Power has gained valuable experience in administering the new concepts involved in customer choice. These concepts include new and improved customer services, customer education, billing, supplier interface, ancillary service support and other administrative responsibilities that need to be worked out with a manageable volume of customers before proceeding to full-scale operations. There should be an enrollment period of several months' duration prior to the time that customers will begin to take service from alternative energy suppliers. Time will be needed to carry out customer education efforts and allow interested marketers to qualify and effectively participate in the state. Providing sufficient time to accommodate the needs of both customers and suppliers will serve to minimize potential confusion at the outset of the process.

Allegheny Power also supports a phase-in of customers to retail choice in Virginia. This is advisable due to the logistics of switching large numbers of customers to alternate suppliers and answering customer questions on a timely basis. A phase-in that allows an increasing number of customers the right to exercise choice over a finite period of time will allow for a manageable and nondisruptive transition period.

Default Service and the Role of the Distribution Utility

At present, there is no need to make major changes to the traditional regulation of distribution services. All retail customers should have access to their utility's distribution services in much the same manner as they do today. Distribution utilities will retain the obligation to connect all customers to the electric system and will have the obligation to deliver power from their generation supplier of choice. Distribution utilities will also continue to provide metering and billing services to all customers as part of that distribution service, at least in the first years of customer choice. While it may be feasible to unbundle certain aspects of distribution service such as metering and billing as a competitive option in the future, it is premature to address the further unbundling of distribution service prior to implementing full retail access.

At the onset of customer choice, all customers should have the option of remaining with their incumbent utility at regulated rates for the duration of the transition period. After the transition period is over, any price caps will be eliminated and the distribution utility will have the obligation to procure electricity at market rates for customers who do not choose an alternative supplier. At the end of the transition period, customers should have the option of choosing, either directly or by default, their incumbent distribution utility to supply them with power at market-based rates in the future. The availability of market alternatives will be sufficient to protect the customer from concerns about the prices charged by the local utility for default generation services. In a competitive market where choice is available to all customers, customers will only choose to stay with the local utility if it continues to provide them with service (including price, terms and conditions) that is equal or superior to the service that they will be able to get from other competitive suppliers.

Contracts with Existing Customers

Regardless of how choice is implemented, special contracts between large commercial and/or industrial customers and incumbent utilities should be honored until their contract terms allow for termination. Confidential contracts between utilities and their customers should be kept confidential.

Stranded Cost Recovery

The definition of stranded costs and the criteria for recoverability should be mandated by statute. For existing utility-owned generation, projected revenue requirements less market resale values should define the method of calculating generating asset stranded costs. This revenue requirement projection should be conducted over a reasonable period of time, i.e., a three-to-five year transition period that corresponds to the length of time that any portion of retail rates are frozen for non-shopping customers. If a longer time period is used, station decommissioning costs, necessary capital additions and the costs of complying with new environmental regulations become legitimate additional components of stranded costs.

Market revenues should be determined by a market mechanism, such as a periodic auction of a representative block of power. If an administratively determined market price projection is used, it should be done over a reasonable time period where both the revenues and costs can be reasonably known, and should allow for periodic true-ups to guard against over or underrecovery. The time period used for any projection of market prices should match the time period over which the revenue requirement is projected. Further, any delay or amortization of stranded cost recovery should recognize the time value of money to the Company. Additional components of stranded costs that result from past regulatory decisions include PURPA contract costs (net of market revenues realizable from energy resale) and regulatory assets, which should be recovered via a non-bypassable wires charge. Utilities should be required to undertake reasonable measures to mitigate stranded costs.

A final component of potentially strandable costs that should be recoverable in a deregulated environment are those costs incurred by the incumbent utility as a result of the transition to competition. These are costs incurred due to state requirements for customer education, unbundled billing requirements, implementing new universal service and/or other public interest programs, etc. If the Commonwealth decides to establish new programs after generation markets are deregulated, they should be funded by a non-discriminatory, non-bypassable funding mechanism that applies equally to all suppliers and does not distort the market for energy services. Any new funding mechanism would need to be added to existing, unbundled rates and should not be part of any rate freeze.

Taxes

Because electric utilities are large taxpayers in Virginia, the state and local tax structure must be carefully reviewed and revised as appropriate in conjunction with restructuring. Every effort should be made to avoid a tax advantage or disadvantage to any supplier or class of suppliers, including municipal and cooperative systems. The competitive position of Virginia generation in relation to generation in other states also demands serious consideration. At the same time, state and local tax revenues must be preserved. The primary tax that should be targeted for study is the state gross receipts tax. While this tax has been workable in a regulated environment, competition will emphasize its regressive nature-as it is imposed on gross receipts rather than on income, a company would be liable for it even if it made no money. Problems in collecting the tax from out-of-state suppliers of electricity could also arise. A consumption tax, application of the corporate net income tax, or some combination thereof would significantly mitigate the undesirable features of the gross receipts tax. The local gross receipts tax should be reviewed in a similar manner. Any plan for implementing restructuring should include consideration of its tax consequences.

Electric Reliability and System Reserves

To ensure system reliability, the operational requirements for all market participants must conform to all NERC and the appropriate Regional Reliability Council reliability criteria. The location of the load to be served, the control area to be traversed by power destined for that load, and/or the generation sources should act as the determinant of the appropriate Regional Reliability Council rules to be followed at any point in time. Further, electric system reliability should be measured differently in a competitive generation services procurement era than it is now. In a competitive market, the required services are contained in the ancillary services standards and provisions of the FERC open access tariff. FERC requires that generation service customers procure power delivery services over the transmission system in a way that comports with NERC and Regional Reliability Council standards, including the maintenance of operating reserves. Those reserves, and those reserves alone, should be recognized as the sole aspect of generation supply reserves that can be mandated as an index of system reliability. That is because they serve a real-time function in allowing the integrated bulk power network to respond instantaneously to inevitable short-term perturbations in the power supply/demand balance as generators fail, loads spike or there are combinations of both.

According to the FERC pro forma tariff, the transmission service provider is the monitor of the customer's compliance with ancillary service standards regarding the provision of operating reserves. If an ISO is the transmission service provider, then such allocation of authority is appropriate. In the future, transmission service providers (including ISOs) will not have affiliated generation services at their disposal to allocate automatically to transmission service customers that cannot or will not provide those operating reserves themselves. As the market evolves, transmission service providers should be required to maintain generation reserve purchase contracts that are competitively and non-discriminately placed with the generation supply market. Providers can call upon these contracts from time to time as necessary to supplement for a fee any shortfalls resulting from insufficient power purchases by customers or the failure of an alternative supplier to deliver contracted-for power supplies.

Treatment of Cooperative and Municipal Utilities

If all customers are to benefit from a competitive market structure, distribution utilities and non-investor owned utilities must be subject to the same rules and regulations as investor owned utilities in the same time frame, including the ability to recover stranded costs. It is appropriate to treat these utilities like any other market player at the outset of the restructuring process to ensure state-wide uniformity. To do otherwise will fragment the retail access market to the disadvantage of non-IOU customers. To the extent cooperative and municipal utilities are exempted from state restructuring plans, they should not be permitted to compete against investor-owned utilities from such a protected position. If a cooperative or a municipal utility seeks to compete in the retail market, full reciprocity and compliance with all state regulatory requirements must be required.

Universal Service

Allegheny Power supports the concept of a universal service fund to ensure that low-income customers are able to pay for essential electric services. In order to protect the customer who is not able (rather than not willing) to pay, the state should require that all energy users support an assistance program, with minimum eligibility requirements, funded by a universal service charge on all electricity service provided in the state. This fund should be set up in such a way that utility shareholders are not at risk for the provision of such publicly desired services.

The distribution utility should not be required to supply customers who default on their bills to third-party competitive suppliers without assurance of compensation. Nor should the distribution utility be responsible for non-payments to third-party energy suppliers. If partial payment is received, it should first be applied toward the distribution portion of the bill because of the distribution utility's continuing obligations to the customer in a deregulated environment and to ensure continued system reliability. The state will need to come up with another means of addressing the problem of customers who refuse to pay for their electric services, including establishing rules for the disconnection of service. (Note: Requirements for universal service programs or customers who default on their payments should not be confused with the default service discussed above, where a customer fails to choose an alternative electricity supplier, thus by "default" chooses to remain with its local distribution utility for generation services.)

Role of Energy Efficiency

As electricity markets are restructured, energy efficiency services will be but one part of a larger portfolio of services that will be packaged and made available to consumers from a wide variety of suppliers. In the move toward a less regulated environment, the Commonwealth should not impose the obligation to deliver energy service programs on incumbent utilities. If Virginia decides to subsidize such programs in a competitive environment, it should do so through a competitively neutral mechanism, e.g., tax credits, and should not become part of the regulated cost of service of the distribution utility.

Environmental Requirements and the Development of Green Power

All suppliers should comply with existing environmental regulations, with the understanding that under current law, environmental regulations are not and need not be identical for all sources. In addition, some sources may be granted variances to regulations due to site-specific circumstances. Compliance with existing laws and regulations will not be impacted by competition. Furthermore, in a competitive market, utilities should not be required to disclose the emissions of individual suppliers. Complications include the relative impact of different pollutants, the location of the emission source, offsetting actions at other sources, emissions by affiliated companies, purchased power from other sources, and day to day changes in the source selection by the energy supplier.

Disclosure of emissions data will not lead to the development of so-called green power or renewable resources. Energy providers will develop renewable power based on an evaluation of its cost effectiveness compared to other power supply options and the demand evinced by consumers. If suppliers wish to advertise the "green" nature of their energy, they should be allowed to do so subject to verification under standard "truth in advertising" requirements. Customer should be free to choose such suppliers if they wish. Ideally, the free market should decide the economics of a supplier's generation mix. To the extent that Virginia chooses to encourage renewable resources, a separate state-funded mechanism should be established that does not burden any competitor in the marketplace.

Customer Education and Safeguards

Customer choice is relatively complex and customer understanding is the key to successful implementation. There is a fairly bright line between customer education and marketing. Because the electric distribution company services will be unbundled from a utility's generation sales services, the distribution utility is the logical entity to conduct a customer education program under the direction of the SCC. However, this activity is expensive and customers should bear the burden of these added costs, which are determined to be a necessary part of restructuring the electric industry.

A customer education program should make customers aware of the opportunity to choose, help them understand how to implement choice of an electric generation supplier and to make an informed choice to maximize their value. Surveys should be conducted to benchmark the success of the customer education program and to assist in targeting specific demographic groups. Because of the complexity of electric customer choice and the likely need for customers to refer to educational material over time, brochures and pamphlets should be the primary media for communicating the information. Broadcast media can be used to create awareness and other means such as speakers' bureau, public exhibits, newspaper releases and advertising, cable television and community action groups can be used to augment the pamphlets and brochures.

False and deceptive advertising should be prohibited and existing state laws governing commercial practices should be sufficient to control and punish such activities. The SCC and the Attorney General's Office have the responsibility and authority to monitor commercial practices and take appropriate steps to sanction illegal behavior. The Commonwealth must resist the temptation to regulate business relationships between suppliers and customers. The best safeguard against consumer fraud and abuse is an informed consumer.

Supplier Authorization

Supplier authorization may be needed to provide public oversight over the entry of new energy suppliers into Virginia, and registration requirements for suppliers should be developed. These requirements should not be overly burdensome on suppliers, but should serve to ensure that appropriate consumer safeguards are maintained, including reasonable risk protections, bonding and credit issues. The SCC should require suppliers to post bonds to protect the cash flow of the local distribution companies (or responsible control entity) in the event of energy imbalances that can occur when a supplier's obligations exceed delivered power.

Independent System Operators and Regional Power Exchanges

As a condition to regulatory approval of the pending merger of Allegheny Energy, Inc. and DQE Inc., the Allegheny companies committed to join an independent system operator (ISO). In part to carry out that commitment, Allegheny Power joined the Midwest ISO. It is believed that regional ISOs will help to promote robust regional electricity markets while ensuring that system reliability and stability is maintained.

Allegheny Power does not believe that a regional power exchange (RPX) is essential to accommodate broad-based retail access. With open transmission access, a viable wholesale generation market has developed that is available to alternative suppliers to serve retail customers, thus, there is no immediate need for an RPX. To the extent they are formed, ISOs should be permitted to function for a while before determining if there is a sufficient market for the services that an RPX would provide. States should encourage the development of ISOs that are compatible with or can easily accommodate the free market development of RPXs.

Competitive Safeguards and Codes of Conduct

The focus of the legislature and the SCC should be on the prevention of anti-competitive abuses by companies providing distribution service in a restructured industry. This can be accomplished through the development of a code of conduct that governs the relationship between the distribution entity and affiliated and non-affiliated electricity suppliers. Allegheny Power recognizes the unique regulated monopoly status of the electric distribution entity in the delivery of electricity, and that a properly designed Code of Conduct is appropriate to prohibit abuse of that status. The code should require the electric distribution entity to provide impartial service without regard to the customer's electric generation supplier and to provide impartial information to the customer.1

Without consent of the customer, the electric distribution entity should not disclose to its affiliated generation supplier or to any other supplier, information obtained in connection with providing delivery service or related utility services. The delivery and generation functions should be functionally separated to avoid sharing of information that may create an advantage or conflict of interest between marketing, generation or delivery of electricity. This can be achieved through accounting controls, organizational structure and operating protocols.

States should not attempt to dictate corporate structures of businesses or the developing marketplace. Mandatory divestiture of corporate assets is neither necessary nor acceptable. Further, the use of corporate name and logo by affiliates should not be prohibited and utilities and their affiliates should not be prohibited from jointly marketing their services. In other words, the Code of Conduct should not be used to interfere with normal competitive processes by, for example, handicapping some participants in the marketplace so they cannot compete as effectively as others. It is in the interest of the Commonwealth to prevent predatory conduct that disrupts the competitive process, not to micromanage competition. Therefore, Codes of Conduct should not be designed to deny more efficient operators and their customers the benefit of those efficiencies. In any competitive arena, the participants bring their own strengths and weaknesses. What can be assured through a Code of Conduct is that the monopoly distribution entity cannot engage in conduct that disrupts the competitive process. That is the goal to be attained.

1 Allegheny Power is already subject to several codes of conduct. Like other utilities subject to FERC Orders 888 and 889, Allegheny Power's transmission business unit is subject to a FERC-approved Code of Conduct governing its dealings with generation providers, including its affiliated generation business unit. Allegheny Power's marketing affiliates, AYP Energy and Allegheny Energy Solutions, are also subject to a FERC-approved Code of Conduct. West Penn Power Company, Allegheny Power's Pennsylvania operating utility, is subject to a Code of Conduct governing the dealings between electric distribution entities and electric generation suppliers in the customer choice program and, on an interim basis pending adoption of a permanent code, in the phase in of customer choice.