Market Power Barriers to Competition

The electric industry is in the midst of a transformation from reliance on regulation to reliance on competitive forces. The Federal Energy Regulatory Commission, which has jurisdiction over wholesale electricity sales by investor-owned utilities, has taken to heart the procompetitive intent of the Energy Policy Act of 1992 and has sought to move toward "market" (non-cost-based) pricing of electricity in many circumstances.

States too are chanting a competitive mantra. Many are considering, and some have enacted, laws to enable retail customers to purchase electricity from the nonregulated supplier of their choice. Federal legislation facilitating or mandating retail electricity competition is being considered.

Underlying these dramatic changes is the belief that Adam Smith's invisible hand of competition will do a better job than regulation at disciplining electricity prices. While the natural monopoly characteristics of the transmission and distribution functions continue to require regulation, the assumption is that competition among electricity suppliers will ensure reasonable wholesale and retail prices: If customers are given the opportunity to choose their suppliers, prices will be forced down to a competitive level.

But the invisible hand will not have the opportunity to work its magic if market power impedes development of vigorously competitive wholesale electricity markets and chokes retail competition. Market power must be restrained or mitigated if competition is to have a chance of disciplining prices.

Transmission

Transmission is the most obvious source of market power potent enough to distort the operation of electricity markets. Transmission is the highway of commerce in electricity, the vital link between buyers and sellers.

Unlike the interstate highway system, the interstate transmission grid is typically owned and controlled by vertically integrated, investor-owned utilities, each owning the facilities that span its retail service area. Transmission owners have both the incentive and the opportunity to use their control over these essential highways to restrict or encumber the access allowed their competitors and customers.

Inspired by the procompetitive intent of the Energy Policy Act, FERC took a major step forward on April 24, 1996, by issuing Order No. 888. To remedy what the commission found to be widespread discrimination by transmission monopolists (by refusing transmission or providing only inferior transmission to competitors), Order No. 888 required all jurisdictional utilities to file transmission tariffs by July 9, 1996, providing "open access" to all wholesale buyers and sellers on the same FERC-established terms.

FERC also required these utilities to "functionally unbundle" transmission by taking service for their own new wholesale sales under the same tariffs and by separating their transmission personnel from those responsible for marketing generation. In Arizona Public Service Co., 78 FERC ¶61,016 (1997), FERC has sharpened the teeth of these unbundling requirements by, among other things, making them applicable to amendments of transmission owners' existing wholesale contracts and restricting owners' ability to deviate from the tariffs.

While Order No. 888 takes a historic stride toward opening up the transmission grid and subjecting all users to the same roles, its utility-by-utility approach leaves significant room for a transmission owner to exercise market power and to erect substantial barriers to competition. Implementation of the tariffs is largely left in the hands of individual owners, albeit with the directive not to discriminate. As recognized in a "Declaration of Independence" for independent system operators (ISOs) issued in October by a number of state regulators, myriad, impossible-to-police Operational decisions made each day by a transmission owner have a profound effect on the availability and pricing of the transmission service vis-à-vis competitors.

For instance, it is left to the transmission owner to determine the "available transmission capability" that can be used for a competitor's transactions, taking into account the owner's projected needs. The owner also decides whether and what studies need to be done to determine if transmission capacity is available for its competitor's transactions.

A claimed absence of capacity is the best way to eliminate potential competition. Order No. 888 obligates owners to construct transmission to meet the needs of others. However, there is no way to ensure that the owner will be as diligent in pursuit of the often difficult state siting process or as speedy in constructing the new line, when that owner can keep out competitors (or charge more for its generation) so long as the new line is not in service. All the incentives are otherwise.

In short, the transmission owner's incentives and ability to use its control over transmission to favor its own electricity sales, and the distorting effect of that control on the market, cannot be overstated — especially when the stakes are raised through introduction of retail competition. It is essential that the infrastructure necessary for competition be provided on a nondiscriminatory basis by a neutral entity whose electricity sales are not at stake.

In addition, the utility-by-utility structure that Order No. 888 largely leaves in place needlessly fragments electricity markets geographically. With limited exceptions, Order No. 888 requires each utility to file rates for transmission across its own system. A transaction that crosses two systems will require payment of two transmission rates, even though the combined costs of the two systems would produce a combined rate far lower than the two "pancaked" rates.

Pancaking of transmission rates acts as a toll, insulating the transmission owner from competition and unnecessarily limiting the market. As recognized in FERC's Dec. 18, 1996, Policy Statement on Mergers, 61 Fed. Reg. 68,595, FERC Stat. & Regs., Regs. Preambles 1991-1996 ¶31,044, pancaking can restrict the economic alternatives available to customers of the transmission owner.

Significantly, this restriction is artificial: There is no real cost of transmission related to corporate boundaries, and transmission facilities typically have been built and operated on the basis of regional loads and generation, rather than on the basis of loads and generation of a single transmission owner. Pricing schemes based on distance similarly do not reflect cost causation on an integrated grid. Rather, they ensure the large, vertically integrated transmission owner that has located generation on its system a huge, artificial home-court advantage.

The best way to eliminate market power created by the bias and pancaking associated with the current system of individual transmission fiefdoms would be to require divestiture of transmission facilities to regional transmission companies. Such "transcos" would own, operate, and construct the regional grid to maximize throughput and minimize constraints, independent of the interests of any market participant.

The second best way would be "virtual divestiture" on a regional basis. The transmission owner would retain ownership of its transmission facilities, but would be required to turn over operation and control to a truly independent ISO.

Either way, the regional transco or the ISO would provide all users with transmission access at regionwide, nonpancaked rates on the same basis.

Order No. 888 encourages transmission owners, and particularly power pools, to form ISOs, and sets forth 11 principles that FERC will apply to judge their sufficiency. In its first encounter with a pool-proposed ISO — that of the Pennsylvania-New Jersey-Maryland Interconnection (PJM) — FERC found "lack of independence ... a fundamental flaw." Atlantic City Electric Co., 77 FERC §61,148 (1996). In sending PJM back to the drawing board, FERC made clear that it would insist on a governance structure not dominated by transmission owners.

In Pacific Gas & Electric Co., 77 FERC ¶61,204 (1996), FERC showed backbone in questioning aspects of the ISO proposed by California investor-owned utilities in response to California Public Utilities Commission orders and the state's restructuring legislation. Significantly, FERC required the ISO itself, rather than the California utilities, to submit portions of the "Phase II" filing and to have final say on which transmission facilities were to be controlled by the ISO.

On the other hand, to the extent FERC accepts an ISO that merely directs the operation of the grid, while allowing the transmission owners to "maintain local control centers in order to operate their facilities consistent with the direction of the ISO" (as FERC did in the PJM case), the commission condemns the ISO to de facto subordination to the transmission owners, no matter how independent and balanced the governance structure. Also troubling is FERC's apparent acceptance (in both the PJM and Pacific Gas & Electric cases) of some form of "zonal" rate structure — under which rates for regional use would vary based on corporate ownership boundaries — as a "transition" (which might last five years) to the nonpancaked, gridwide tariff called for by its ISO principles.

Establishment of ISOs that truly achieve virtual divestiture will be no mean feat, especially where FERC's authority to require ISOs largely stems from denial of carrots (mergers, market-based rates) rather than threat of a divestiture stick (which FERC now lacks). The concept of a "voluntary" ISO, created by compromise among the stakeholders, is incompatible with the complete negation of the owners' transmission market power that is necessary for competition not to be distorted by advantages that transmission owners refuse willingly to relinquish.

To ensure the equality necessary for robust competition, any federal legislation to facilitate restructuring should give FERC explicit authority to mandate formation of truly independent, regional ISOs to control, operate, maintain, plan, improve, construct, and provide transmission service at nonpancaked regionwide rates, as well as to enforce reliability. If regional ISOs prove insufficient to achieve the functional equivalent of divestiture, FERC should have authority to order divestiture of functions and assets to an independent, regional transco.

Generation

Generation market power is also a fact of life in the electricity industry, where high concentration levels are common. Such concentration can allow the exercise of market power by a utility both as seller (the generation provider) and as buyer (an aggregator serving the needs of the customers to which the utility distributes electricity). These concentration levels may leave the market controlled by the actions of one or relatively few players.

For example, where a utility (or small group of utilities) controls the great bulk of the generation in a market, its decisions regarding availability, pricing, and even dispatch of generation can materially affect the market, as well as the availability of transmission capacity for the transactions of others. Because of the physics of electric system operations, the availability of transmission capacity is highly dependent on which generators are pushing electricity into the grid. The manner in which generation is dispatched, or bid into an energy market, can create transmission constraints that keep alternative resources out of the market and require resort to the dominant utility's higher-priced resources. Market power may also be present where one or a few utilities control the bulk of resources with certain operating characteristics or within the same variable cost range.

Even where the market structure is generally favorable to competition, market power may still be alive and well at particular locations, times, or seasons. Geographic barriers and transmission restrictions can significantly increase market power in particular areas. For example, transmission limitations can give the owner of generation in a constrained area complete market power over electricity pricing during a significant number of hours of the year. Moreover, the process of constructing facilities to relieve a transmission constraint is typically in the hands of the transmission owner whose generation may be benefited by maintaining that constraint.

FERC's Policy Statement on Mergers addresses the threat to competition of increased concentration levels through merger. However, it does not remedy the obstacle to competition posed by the high degree of concentration that exists already, without additional mergers.

For example, even with an ISO and a spot energy market, the California Public Utilities Commission concluded that generation market power could be exercised in California and, therefore, provided incentives for divestiture of 50 percent of the generation resources of the state's two largest utilities. See Dec. 20, 1995, Policy Decision in CPUC Docket Nos. R.94-04-31, I.94-04-32. In the FERC proceedings associated with the California restructuring effort, economists for these two utilities found concentration levels unacceptably high absent very substantial divestiture of generation resources (which neither FERC nor the California Public Utilities Commission has clear authority to order). One recently told FERC that generating units that "must run" for reliability will provide local market power regardless of owner, so divestiture alone may not be sufficient.

To make competition a reality in the electricity industry, it will take more than preventing harmful increases in market power through merger. Congress must give FERC authority to take all steps necessary to ensure vigorously competitive generation markets (while not impairing reliability), including but not limited to requiring divestiture of generation to unaffiliated entities.

Reliability

Reliability is another critical element that must be addressed if there is to be a market with many competitors, rather than just a few very large ones. For reliability to be maintained in the face of growing competition, the current means of setting and enforcing reliability standards needs to be changed. Large, vertically integrated utilities effectively control most reliability councils, and impose and enforce reliability requirements on smaller competitors.

This structure is unworkable and, with increasing competitive pressures, may lead to a degradation of reliability. Reliability is too important to the economy and too competitively sensitive to leave enforcement to peer pressure within the old-boy network of other similarly situated large utilities, which can then use heightened reliability requirements as a club against smaller competitors. A FERC-regulated impartial body (such as an ISO), with no stake in the generation market, is needed to develop nondiscriminatory reliability standards and to enforce them evenhandedly.

In addition, if competition is to thrive, FERC must exercise its existing (or enhanced) authority to require continuation of the mutual backup or coordination arrangements long recognized as necessary to allow utilities of all sizes to provide reliable service at reasonable cost. See Gainesville Utilities Dep't v. Florida Power Corp., 402 U.S. 515 (1971). As competition intensifies, large utilities may see the competitive advantage of withdrawing from such coordination arrangements in order to burden smaller competitors and create insurmountable barriers to the entry of new competitors. The "ancillary services" that FERC has required under Order No. 888 operate adequately only against the backdrop of coordination arrangements. Absent coordination, reliability and competition will suffer.

Inside Information

Information and unfair competitive practices also can skew the market. Entities with superior inside information regarding customer demands can use that information unfairly in bidding their generation into an energy pool or otherwise participating in the generation market. The potential for abuse is heightened where prices are indexed to markets that themselves may be distorted by information limitations.

As the stock market illustrates, competitive markets thrive on, and indeed require, information availability. While disclosure of particular buyers and sellers may not be essential, prompt reporting of the effective price and key terms of all power delivery contracts, as well as financial hedging arrangements, is critical to creating educated consumers and a robust market. Public, transparent pricing will go a long way toward minimizing opportunities for manipulation and abuse, such as predatory pricing and affiliate abuses. In addition, there need to be effective penalties for insider trading, market manipulation, and other abuses.

In light of the market power challenges pervasive in the electricity industry, a state's decision to allow retail customers to choose their electricity supplier will not ensure competitive prices. More likely, the deregulated price will reflect the ability of dominant players to exercise market power freed from many preexisting regulatory restraints. If we are to rely on the competitive market to discipline retail as well as wholesale prices, the electricity industry must be carefully restructured to make such discipline a reality.

Mere deregulation, without putting in place structures and protections up to the daunting task of taming market power and other abuses in a less regulated market, will not work. Consumers will not realize the potential benefits of retail competition unless Congress takes fundamental steps to ensure vigorously competitive regional markets and to prevent the exercise of market power and other abuses, while preserving reliability. Otherwise, our economy will be held hostage to the worst of all worlds: deregulated monopolists.