The September-October 1998 issue of Public Power included an article by M. Douglas Dunn and Mark Williams entitled "Trancos: The Key To Open Access?" In this article, we respond to that rhetorical question. Our answer: The key to open access may be either independent system operators (ISOs) or transcos, but it surely is not the specific transco outlined by Dunn and Williams. We say this for two reasons. First, the contention that their transco model is superior to inadequate, passive ISOs hardly demonstrates that a transco is better than an effective ISO with authority to plan and expand the grid. Second, their transco model does not achieve the independence that they acknowledge is necessary, nor does it even purport to be regional in scope. Whatever "transmission entities" do emerge from the current debate, they must be regional, truly independent and armed with sufficient powers to carry out their short- and long-run transmission mission. Otherwise, the electric industry will never make the long awaited transition to competitive generation markets.
The authors paint ISOs as inefficient and ineffective not-for-profit entities with cumbersome governance, no incentives to provide service, and no ability to require construction of new transmission facilities. But an ISO's powers and incentives to provide service depend on its structure. To the extent ISOs currently in place are flawed, it is largely due to the failure of participating investor-owned utility transmission owners to cede sufficient powers to them.
Dunn and Williams asserted that ISOs cannot alleviate transmission constraints, but can act only as "an allocator of existing capacity, with all its defects and inadequacies." But there is no reason why ISOs cannot and should not take the lead in regional transmission planning, and require member transmission owners to undertake construction of new transmission facilities found to be required through the planning process. Nor is there any reason why ISOs should not seek bids on construction of new transmission facilities (assuming state law does or can be made to accommodate such a process), especially if the incumbent transmission owners are not eager to undertake the needed construction. Thus, the vision of ISOs that merely "allocate the constrained, suffocating plant already in place" is much like the vision of the future that the Ghost of Christmas Yet to Come showed Scrooge: It will only come to pass if the industry — or the Federal Energy Regulatory Commission — settles for emasculated ISOs with insufficient powers to direct construction of new transmission.
Dunn and Williams blame the current inadequacies of the national transmission grid on rate disincentives and claim these would only be exacerbated with ISOs. If they are right, one has to wonder how the electric industry managed to build the substantial transmission infrastructure now in place. In fact, needed new transmission facilities are not being built primarily because of environmental and land-use problems — and for strategic competitive reasons. Transmission owners will seek ways to avoid timely construction of needed transmission facilities if keeping transmission constrained enhances the value of their generation, shields their loads from competition, or otherwise maintains their market power.
Absent strategic reasons not to construct transmission, electric utilities regulated under cost-of-service rates have a real financial incentive to add new transmission facilities. FERC allows investor-owned utilities to recover the cost of their new transmission facilities in their cost-based rates. New facilities increase the rate base on which they are entitled to earn a return intended to compensate public utilities for their cost of capital. These additions offset rate base reductions due to depreciation of older facilities and thus increase the revenue requirement transmission rates are designed to recover.
This will not change if IOUs participate in an ISO. A steady regulated rate of return on transmission facilities is nothing for a utility (or a utility investor) to sneeze at, especially given recent experiences with other, more risky lines of business — like unregulated wholesale power sales! Indeed, at a recent FERC conference regarding ISOs, one IOU representative candidly admitted that facilitating siting and minimizing regulatory lag on recovery of the regulated return on new investments are the only inducements necessary to encourage construction.
Dunn and Williams also argue that ISOs, as not-for-profit entities, have no incentive to open markets or relieve transmission constraints. Again, this would be so only if ISO structures are set up to tolerate such results. Every well-run consumer-owned electric system should be offended by the assumption that "not-for-profit" ownership and operation automatically means inefficiency and lack of incentives to provide quality service. It certainly offends us. The California ISO, in its May 1, 1998 comments in the pending FERC docket regarding ISOs, noted that it has made meeting the 11 ISO principles that FERC outlined in Order No. 888 "the core of the Cal-ISO's incentive compensation program for all employees." The Midwest ISO also plans to give its employees incentives to meet that ISO's goals. For-profit transcos would undoubtedly have their own set of incentives, but they may not be good for transmission customers.
The authors also fault ISOs for their "complex governance structures," which supposedly make them "difficult for regulators to police." There is no question that dictatorships have a simpler governance structure than democracies, but this does not make dictatorships preferable. Not-for-profit ISOs must balance the competing interests of the various ISO members, both owners and customers. They do this through either representative "stakeholder" boards or "disinterested" boards with representative advisory committees. While ISO decision-making may be more complex, its decisions are more likely to reflect consensus, based on a process that airs all aspects of a problem.
Rather than making ISOs more difficult to police, consensus decision-making may make it more appropriate for the FERC to give some degree of deference to ISO actions. In contrast, it would not be appropriate to apply light-handed regulation to a for-profit, monopoly transco, whose decision-making would be driven primarily by the need to maximize profits to its shareholders.
Dunn and Williams also claimed that ISOs have no profits or assets from which they can pay refunds. Again, this is misleading, particularly as to the bulk of ISO charges that are based on the costs of service of participating transmission owners or generation owners (in the case of ancillary services or must-run units). The ISO generally acts as a conduit, passing the revenues it collects from customers back to these owners. If ISO rates are subject to refund, then both the ISO and the individual owners should take the appropriate financial actions to account for the possibility that refunds might later have to be paid. If refunds are ordered, then the owners that received the revenues the ISO passed through should refund amounts to the ISO for return to affected customers.
Dunn and Williams argue that ISOs are very expensive. They cite the high start-up costs of the California ISO, and claim that the Pacific Northwest's IndeGO initiative was scrapped due to its high projected expenses. But IndeGO's demise had as much to do with the potential cost shifts among transmission providers and customers in the Northwest as it did with the expense of setting up IndeGO itself. Every new regional transmission entity, be it an ISO or a transco, will have to face the knotty problem of transmission cost shifts, and no new transmission entity will get off the ground unless the cost-shifting issue can be resolved successfully. As for the California ISO, the California restructuring legislation required two entirely new, first-of-their-kind entities to be set up in a very short time, to assume a broad array of functions. The California ISO is responsible for certain costs the investor-owned utilities otherwise would have had to bear individually for new computer systems needed to support full retail competition. And ISO startup costs must be weighed against the competitive and reliability costs of leaving the current system in place. One lesson from this summer's price spikes is that new regional institutions must be developed to use the grid more efficiently or many consumers will pay through the nose.
In short, ISOs need not stand for "Ineffective System Operators." Messrs. Dunn and Williams posit passive, regressive ISOs and then find them wanting. We agree that such ISOs would be bad for the industry and public power. But ISOs do not have to and should not conform to that dark vision.
Dunn and Williams' preferred model features a for-profit corporation (transco) in which a divesting transmission owner retains a substantial (or even the majority) equity interest, but decision-making veto authority is held by a "publico," an investor-owned corporation that would have no interest in the generation market. This transco is touted as having an "affirmative economic incentive to maximize system utilization, which can lower marginal rates to ultimate customers." Existing transmission owners would be given an economic incentive to divest. Transco rates would provide an incentive for growth and improvement, subject to short-term "hold harmless" protections typical of FERC merger proceedings. What's wrong with this picture? Just about everything.
The Dunn and Williams transco would cover only a single IOU's transmission facilities. They define "transco" as a company owning the transmission facilities contributed by a utility that would be a transco investor. Although they define "gridco" as a "potentially regional transco composed of transmission resources contributed by more than one utility," they never discuss gridcos, or their role, in describing their proposal.
Transmission entities must be regional in scope to provide the competitive and reliability benefits the industry so badly needs. As FERC recognized in its recent order conditionally approving the Midwest ISO:
"There is widespread agreement ... that a large ISO would have five principal benefits. It would encourage the development of more competitive and efficient bulk power markets; reduce pancaking of [individual system] transmission rates; increase power system reliability due to improved information and control over transmission facilities; allow more accurate ATC calculations; and facilitate more efficient congestion management."
Individual utility transcos provide none of these benefits. Although a regional gridco, if sufficiently large, could provide benefits comparable to a large regional ISO, simultaneous multisystem divestiture is unlikely to be achievable. Structuring an organization to permit participating IOUs to divest their transmission facilities over time presents significant challenges, as those who have been involved in the Alliance transmission entity discussions can attest. Issues associated with tax-exempt financing make it particularly difficult for public power transmission owners to participate in a for-profit transco. Thus, forsaking ISOs for a for-profit transco structure could seriously impede efforts to regionalize the grid.
The transco Dunn and Williams envision does not even come close to ensuring the independence from the influence of market participants that FERC has found to be the bedrock of ISOs. Giving the publico a decision-making veto hardly makes the transco independent of the influence of the divesting transmission owner, who would have a continuing, substantial equity interest. Predictably there would be choices that would benefit the divesting transmission owners, while harming other market participants, where the publico is financially indifferent to the outcome. Further, it has been long recognized that a majority voting interest is not a prerequisite to control and that seemingly modest ownership interests can confer an influence over a publicly held corporation. For example, the Public Utility Holding Company Act's use of 5 percent equity ownership (or even less if SEC so determines) as the trigger for affiliate status is no accident.
Divesting transmission owners that retain more than a de minimis ownership interest in a transco would be able to influence transco decisions in a manner different from all other market participants, thereby destroying the independence FERC has insisted upon when judging ISOs. As staff of the Federal Trade Commission's Bureau of Economics told the Mississippi Public Service Commission in comments on Entergy's proposed transco; discrimination by the transco management in favor of divesting transmission owner's generation would be "difficult to detect and document because such transactions are very sensitive to timing and nuance."
Dunn and Williams suggested that transcos "can make money only if they efficiently provide more and better nondiscriminatory, open-access service." But as natural monopolies controlling an essential facility, transcos will make money no matter what — they are the only game in town. A transco's profit incentive will not ensure maximization of transmission throughput and construction of all upgrades needed to support vigorous competition and reliable electric service, or increased responsiveness to customer needs. Economics 101 teaches us that monopolists (unlike entities that face real competition) can maximize profits by reducing output and by increasing price above marginal cost. That is why regulation is needed — to prevent unreasonable transmission prices and ensure adequate service. Merely separating generation interests from the monopoly transmission function does not eliminate this need, much less justify "light-handed regulation."
Nor would a transco's profit motive ensure that the right transmission upgrades are made. Dunn and Williams do not propose broad participation in the transmission planning process. Transcos may find it profitable to maintain congestion. Conversely, they may be motivated to solve every constraint problem with expensive transmission additions (where feasible), rather than seeking out potentially cheaper transmission fixes (e.g., capacitors), or more efficient generation-based solutions (that do not contribute to transco profits), as staff of the FTC Bureau of Economics warned the Mississippi commission.
Dunn and Williams' model would provide transmission owners an incentive to divest to the transco, and then pay the transco incentive rates to encourage new investment. Compensating transmission owners for the strategic value of their transmission assets and dangling monetary incentives to motivate transcos (in which these owners still retain equity interests) to construct new facilities will plainly line the pockets of transmission owners. But these concepts should not apply to monopoly transmission facilities, built with the power of eminent domain to serve the public. As described above, there is no basis to conclude that a regulated return will be insufficient to attract new transmission investment. Inducements of this nature will needlessly burden future consumers with excessive transmission rates (and discourage efficient trades), even assuming hold harmless provisions. Rate freezes might protect consumers for the next few years, but would not address the need for new investment or customers' right to rate decreases as existing facilities depreciate in the absence of new construction. When the freeze expires, the transco would seek to recover whatever unjustified premium it paid above book value, as well as the rate incentives.
It is not clear that ISOs are the only answer to the industry's transmission quandary. But it is clear that transcos owned or influenced by one group of market participants — divesting transmission owners — are not. What the industry needs are large regional entities — whether they be ISOs or transcos — that are truly independent of market participants and have both the responsibility and authority to operate, maintain, plan and expand the transmission system, eliminating any competitive advantage from transmission ownership. Public power entities and others who care about robust competitive electric markets should settle for nothing less, or they will likely undermine their own long-run competitive viability.