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THE PROGRESSIVE PRO-CONSUMER SOLUTION TO TODAY'S ELECTRICITY CRISIS:
Just and Reasonable Rates

**Preliminary Proposal Prepared by the Tellus Institute, Boston,
MA**[^1]

**Dr. Richard A. Rosen, Dr. John Stutz, Freyr Sverrisson**

**Introduction**

Every state that chose to restructure its electric industry and
deregulate generation did so in the hope that tangible benefits would
result. The general assumption was that retail electricity prices would
decline relative to what rates would have been under regulation. Yet,
almost every one of these states now faces rising electricity prices.
And states that did not restructure, such as Washington and Oregon, are
experiencing higher prices due to spillover effects from deregulation in
California. In California itself, deregulation has helped to create
rolling blackouts and has caused exorbitant electricity prices,
threatening the financial health of the state. In New York, Con Edison
now refuses to build new generating plants even though blackouts are
threatening and their legal "obligation to serve" has not been removed.
In general the goals of restructuring go unfulfilled: the price of
electricity is much higher than before, and the quality of service has
declined dramatically. In response to these developments, FERC
Commissioner Massey observed that, "We need a time-out in the
dysfunctional electricity market."[^2] We agree. There is no good reason
to stay on the current course. The country needs to seriously reassess
how it wants to restructure the electric industry.

This preliminary proposal is an attempt to stimulate a national dialogue
and provides a workable approach to providing consumers with a
cost-of-service based source of wholesale electricity, as an alternative
to market-based contracts for power. This is necessary because the
limited price cap approach that FERC has proposed for the wholesale
power markets will never result in fair prices. Our proposal would
re-establish "just and reasonable" wholesale rates as required under the
Federal Power Act.

11 Arlington Street, Boston, MA 02116-3411  Tel: 617-266-5400  Fax:
617-266-8303  www.tellus.org

Printed on recycled paper

Before we discuss what has gone so seriously wrong with deregulation, we
will look back to not too distant days of rate regulation. We will ask
if conditions at that time warranted the enormous risks associated with
attempting to deregulate prices for the generation of electricity. As we
will explain, the answer is "no."

**Section One: A Benchmark - The Regulation of Electric Generation**

In light of the power failures and shameless price gouging associated
with deregulated electricity markets, a renewed respect for the
accomplishments of old-fashioned rate regulation is in order. Typically,
under traditional regulation, the utility was granted monopoly status
and was provided a reasonable return on its investments. In exchange,
the utility was obligated to provide safe and reliable electric service
at reasonable rates. To do this the utility was required to plan ahead
and build enough power plants and transmission and distribution lines to
ensure adequate supplies of power no matter how fast demand grew. And
the utility was required to do this in a cost-effective manner through
least-cost or integrated resource planning. In more recent years, the
social costs of environmental harm and other economic "externalities"
associated with electric generation and distribution was often
integrated into the decision-making process.

*How successful was this traditional arrangement?*

Under traditional rate regulation, the operating reliability of electric
service was generally beyond reproach. There were few blackouts. And
those that occurred were isolated events, not the almost daily
occurrences that now plague California. Reliability under traditional
regulation was excellent because the system was designed to meet
explicit reliability criteria. The general rule followed was that the
probability of a generation-caused outage should not be greater than one
day in ten years. Using this framework, regulators established specific
reserve capacity requirements for the utilities, specifying the need for
new power plants to meet anticipated peak demand, plus some extra
capacity to cover planned and unanticipated outages and other system
emergencies. The utilities would then build power plants and sufficient
transmission lines to meet the reliability requirements the regulators
set. This constituted the utilities' "obligation to serve."

Real electricity prices declined for the last two decades because the
actual average cost of generation was declining. Average cost (not
market prices) is what determined electric rates under traditional
regulation. Since generation plants depreciated over time, and the cost
of marginal new generation was not particularly high (largely because of
declining fuel prices), the average costs tended to decline, and so did
electric rates in most parts of the country. (See Figure 1.)

At the dawn of the push towards electric industry restructuring in the
mid-1990s, conditions in the electric industry were quite good, and
improving rapidly. Real prices were declining and reliability was
excellent. Moreover, the economic efficiency of the industry was also
improving due to the growing implementation of cost-effective energy
conservation programs. All of this was taking place because regulators
were beginning to insist that utilities consider all resource options
and cost factors in their planning processes. There was still much room
for improvement, but the regulatory and planning framework was certainly
not a failure by any means. Unfortunately, the onset of electric utility
restructuring destroyed much of this progressive planning framework, and
much of ![](media/image2.wmf)this stability and progress.

Source: Energy Information Administration, 2001.

*Why the push to deregulate electric generation?*

The short answer is that the proponents of deregulation believed that
cheaper power would be available, if only they could establish
deregulated electricity markets. In particular, large industrial
consumers of electricity wanted to bypass the high price of nuclear
power, as natural gas prices declined. If they could contract directly
and individually for power from new gas-fired combined cycle units, and
leave the higher-priced power for other consumers to buy (primarily
residential customers and small businesses), they naively thought they
would be better off. The possibility for industrials to get cheaper
rates by contracting directly for gas-fired power would, of course,
depend on fuel prices staying low. The industrial consumers also needed
a fair power market, but that requires the absence of market power in
both the wholesale and retail power markets. However, by the year 2000,
the combination of rising fuel prices and market power had removed any
potential cost savings due to deregulation, even for large industrial
customers.

In summary, then, traditional cost-of-service regulation of vertically
integrated utilities was generally characterized by declining and stable
retail prices, excellent system reliability, increased attention to
environmental impacts, and improved long term planning.

**Section Two: The Consequences of Deregulation**

As described above, the consequences of the deregulation of electric
generation have been shocking to most independent observers.
Unbelievably high wholesale electric prices throughout the West,
deteriorating system reliability, little construction of new
transmission lines, too little construction of generating units in some
parts of the country, threatened roll-backs to air quality standards,
and higher retail prices for many customers with additional increases
looming quite soon, have all resulted from deregulation. Even on the
most superficial level, the establishment of retail competition by many
states has failed.

Little retail competition exists in any state. Even Pennsylvania, which
initially was able to jump-start a retail market for the high-priced
utilities by levelizing stranded cost recovery and setting high
"shopping credits," is now losing any real degree of retail competition.
Thus far, it is difficult to point to any positive accomplishment of the
deregulation of electricity. As yet, there are no electricity markets,
retail or wholesale, that are competitive.

The idea behind electric industry deregulation was to create separate
prices and, where possible, separate markets for each component of
electricity service (e.g. generation, transmission, distribution),
instead of having one single price for all services provided. The
assumption was that this was a reasonable and desirable goal because
markets exist for most goods and services in society, and it was
generally believed that markets promote economic efficiency better than
regulation. Why would this not be true for electricity, as well? As a
consequence, then, of setting up markets for electric generation and for
some transmission services existing utilities were often either formally
or informally relieved of their obligation to serve, in other words
their obligation to ensure that the supply of power would keep up with
the demand for power. Effectively, the electricity markets were now
entrusted with this responsibility.

## Electricity is a unique product

As demonstrated by our disastrous experience with electric industry
deregulation, the reason that markets for electricity do not promote
economic efficiency is that electricity is a unique product. Electricity
service is really a set of unique and complex services, and is not a
simple commodity. The special characteristics of electricity make it
extremely difficult to create a viable, competitive market in any one or
all of the many services required to deliver electricity in adequate
quantities, with a high degree of reliability, at reasonable prices as
required by law, and with sufficient environmental protection. These
special characteristics of electricity include, a lack of a comparable
substitute for most end-uses, an instantaneous need to match supply and
demand with little or no supply storage and large changes in demand
during the course of every day, and significant bottlenecks for
delivering electricity, especially in the transmission grid. Another
important characteristic of electric systems is that they require a lot
of lead-time for planning, in part because they are very capital
intensive. Thus, market entry for new generation usually takes several
years, and the construction of new transmission lines usually takes
almost a decade. Markets are often not good at handling capital
intensive technologies that require long planning lead-times so that
supply and demand can remain well-balanced at all times.

*Market power*

One of the worst consequences of electric industry deregulation has been
the extra and new cost due to the development of market power that has
been imposed on customers in many parts of the U.S. One type of market
power is caused by capacity withholding, which results from reducing the
amount of available generating capacity in order to raise market prices
so much that the higher priced energy sold from all the other generating
units owned by the same generator would have more than made up for the
lost output from the units withheld. It has been documented that the
availability of power plants has suddenly decreased significantly both
in California and New England since deregulation took effect.

Another way to exercise market power is for generators to strategically
raise their market bids consistently so that all the power they sell in
all hours of the year fetches prices above what the competitive price
would have been, without triggering a bidding war. It does not require
actual collusion for generators to find a bidding pattern that allows
this to occur. The existence of strategic bidding has also been clearly
demonstrated to be true in California, and elsewhere. The most notable
study of market power in electric generation markets was done by the
California ISO, which revealed \$6.8 billion in over-charges. The
existence of market power in the electricity market of California is,
then, no longer a matter for debate. Even FERC has concluded that the
wholesale prices in California are not "just and reasonable," and that
the market is "dysfunctional."

**Section Three: Why the Administration's Response to Deregulation is
Inadequate**

The Administration is wrong about the reasons for the price increases in
the ailing Western and Northeastern electricity markets. The problem is
not due primarily to an inadequate supply of generation capacity and
fuel. The Administration's response is, therefore, completely inadequate
to the seriousness of the problem. They have just assumed that
increasing the supply of generating capacity and fuel is the best
response. In addition, the Administration's strong opposition to the
imposition of price caps, or any other mechanism for enforcing the "just
and reasonable" pricing standard of the Federal Power Act, is
wrongheaded. Of course, increasing generation capacity and solving fuel
supply problems is important, and will, probably, help to mitigate the
present level of market power somewhat over the long term. However, the
current exorbitant prices in the electricity markets must be dealt with
directly, and quickly. The Administration is unwilling to acknowledge
that it is the deregulated electric industry structure in California
(with some help from the deregulated natural gas industry) which has
created much of the supply problem in the first place, and deregulation
has created the opportunity to manipulate prices. Simply adding
generating capacity at this time would be like taking aspirin which
subdues the fever, but which only hides the raging infection.

*Market power, not the scarcity of resources, is the primary driver of
high prices*

The scarcity of generating capacity and natural gas are catalysts for
rising prices, but most of the economic damage is simply the product of
market power. The California ISO has shown that most of the price
increases seen in the state between April of 2000 and February of 2001
occurred when there was *no shortage* of capacity at all. The ISO showed
that market power had been exercised in 98 percent of the time periods
studied. The result is that ratepayers will have to pay \$6.8 billion in
overcharges, even after adjusting for any "scarcity rents" when supplies
were short, which also is a form of market power. In other words, the
scarcity of generation capacity may have been a catalyst for market
participants to exercise market power, but scarcity alone did not
justify nearly this level of overcharges.

The same is true for the shortages in natural gas supply. When
hydropower supplies literally began to dry up, and additional gas-fired
generation was required to compensate for the loss, the sudden increase
in demand for natural gas created a supply bottleneck in California.
Much like the tight supply of generation capacity, this created an
opportunity for market power in the electricity market, just as a tight
supply of natural gas creates the same opportunity to exercise market
power among natural gas producers and pipeline owners.

*Nuclear energy can not yield an effective response to the crisis*

It is bewildering that the Administration would imply that new nuclear
power plants may be a viable option for solving the current electricity
crisis, or that more nuclear power is even a viable option to consider
for the long run. More nuclear power is not a solution because no
long-term solution exists for the storage of radioactive spent fuel. In
addition, is the persistent occurrence of "minor" accidents and
procedural violations at nuclear power plants that constantly remind us
of the potential danger of nuclear power. Even more importantly, nuclear
power can not help with the problems created by deregulating the
electric industry because it has always been very expensive itself, and
it would tend to drive market prices for electricity up further. Indeed,
the high price of nuclear power in the past helped to motivate the
movement for deregulation in the first place.

## 

## Cheap, sustainable alternatives are ignored by the Administration

Fortunately, generating technologies that are neither dangerous nor
polluting, as are nuclear- and fossil fuel-based generation, do exist.
For example, wind energy is a viable alternative that was economically
competitive with any other type of new generation, even before the
recent increase in natural gas prices occurred. The capital cost of wind
power is less than one-half of the capital cost of building a nuclear
power plant. Furthermore, there is no fuel cost, and operation and
maintenance costs are much lower for wind power. Finally, there is no
cost for processing or disposing of spent fuel. Developers of wind
energy are currently signing contracts at about 2.5 to 6 cents per
kilowatt-hour, depending on the location. Despite all these advantages
of wind energy, the Administration has ignored promoting wind power
altogether. To make its spiteful attitude toward all clean energy
sources absolutely clear, the Administration has proposed a budget that
reduces funding for renewable energy technologies like wind power.
Ironically, the Administration has touted nuclear energy's value in
curbing global climate change, but have downplayed the even greater
potential benefits of wind power in this regard.

*FERC has misused price caps in wholesale electricity markets*

As an immediate, emergency measure to control the price impacts of
current market conditions throughout the West, hard price caps on
wholesale energy market prices might have limited usefulness. However,
the Federal Energy Regulatory Commission has recently implemented
wholesale price caps in California only under very limited conditions
when reserve margins are perilously low. As a result these price caps
are too narrowly applicable in time, and they are not yet applicable on
a consistent geographical basis throughout the West. FERC has also
proposed to investigate price caps for the remainder of the Western
power markets on an even more limited basis than those applied in
California.

The Administration's action to implement price caps is only likely to
make matters in the West worse. In general, market power mitigation
measures need to be comprehensive in order to ensure that all market
participants in an interconnected region are playing by the same set of
market rules. Caps must also apply at every moment, so that market power
can never escape scrutiny and mitigation. FERC's version of price caps
violate these basic principles. In summary, we agree with those critics
who say that FERC is just refusing to do its job to ensure "just and
reasonable" prices in the wholesale power markets. If generators
exercise market power 98 percent of the time, as the California ISO
report shows, and if they collect most of their overcharges when no
scarcity of capacity exists at all, the new FERC price cap policy will
only make a grave situation worse. The same is true in New York and New
England, as well.

There are many things that FERC could and should do now to deal with
market power in the West, and elsewhere, this summer, if our overall
proposal is not adopted by then. Instead of imposing price caps, FERC
should take the following two actions:

-   Address Withholding of Capacity. Generators who take units out of
    service must be subject to inspection by state or federal
    authorities. And where inspection shows withholding, they must be
    subject to serious penalties. For at least the next 18 months,
    refusal to cooperate with such requests for inspection, or a finding
    by FERC that withholding occurred, should result in loss of
    market-based rates for a generator in bilateral contract markets,
    and additional fines.

-   Force Markets to Behave as if They Were Competitive. The operation
    of competitive generation markets should result in sellers pricing
    electric power at or near their variable cost of production. For at
    least the next 18 months FERC should require generators selling
    under market-based rates in spot markets to behave like "price
    takers" not "price makers" by limiting their bids to variable cost
    plus 10%. A finding by FERC that a generator's bids were above this
    level should result in a substantial fine.

Finally, of course, we must recognize that market power is being and has
been exercised in many other wholesale electricity markets throughout
the U.S., including New England, and in the southern New York State
region. Even in the Mid-west, wholesale power prices exhibit a high
degree of volatility which is unlikely to be cost-based. Clearly,
something must be done soon to allow citizens throughout this country to
be assured that FERC will carry out Section 206 of the Federal Power Act
by ensuring that wholesale electric rates will be "just and reasonable"
everywhere. Achieving that goal would be the progressive pro-consumer
solution to the current problems in our electricity markets. But how can
we achieve that goal permanently?

# Section Four -- The Progressive Pro-Consumer Solution to the Current Crisis

The deregulation of the wholesale electricity markets nationally, and
the retail electricity markets in certain states, has proceeded with
little comprehensive and consistent effort to ensure that the rates
charged by generation owners (and transmission owners) will be just and
reasonable. All the market power monitoring and mitigation methodologies
that FERC has approved are extremely weak. As noted earlier, in
California, FERC found that wholesale electric rates were not just and
reasonable some time ago. However, to date, FERC has not taken effective
action to ensure that market prices in California, or elsewhere, will be
just and reasonable. Congress must act now to rectify this situation,
since Congress is the only institution that can do so.

Charges for electricity are just and reasonable if they have as their
point of reference the underlying costs of generating the power.
Providing that linkage will ensure that generators do not earn
unreasonable or excess profits. The linkage between "cost-based" prices
and "just and reasonable" prices is the bedrock upon which regulated
rate-setting has always been based. Market-oriented schemes need to
produce outcomes that are consistent with the underlying cost basis of
the industry, including a fair profit. In light of the continuing
problems in California, the high electricity prices elsewhere in the
West, the difficulty in maintaining adequate service levels in
transmission constrained areas such as New York City and Delaware, and a
myriad of related problems, it is now time to abandon unfettered
electricity markets, and to re-establish just and reasonable rates for
generation and transmission everywhere, as the Federal Power Act
requires. If just and reasonable rates are re-established at the
wholesale level, then it is quite likely that state public utility
commissions will be able to ensure that just and reasonable rates will
exist at the retail level, as well.

However, there is an even more fundamental issue that the U.S. needs to
address. The issue that needs to be thoroughly addressed,
state-by-state, and region-by-region, is whether or not establishing
deregulated electricity markets will ever lead to greater levels of
economic efficiency. The country needs to consider whether restructuring
the electric industry will likely lead to higher or to lower electric
rates, before any decision is made to continue with deregulation. In our
rush to restructure the industry over the last few years, it is quite
surprising these key questions have not been fully addressed, but they
have not. Now is the time to do so, before further damage is done to the
American economy. We believe that careful analysis has shown and will
show that deregulation almost certainly will cause electric rates to be
higher than they would be under cost-based regulation.

The progressive solution to the present crisis that was created by
rushing to restructure and deregulate the electric industry is for the
U.S. Congress to require a return to just and reasonable rates for all
consumers. The electric utility and electric generation industry is too
big and too important to the American economy for us to continue to
careen from crisis to crisis, trying to patch up a poorly thought out
piecemeal set of market structures in various parts of the U.S. before
the next problem occurs. Congress needs to act while more than half the
country has chosen not to restructure at all, and while many other
states are waiting to see the outcome of the present crisis before
continuing with their plans to restructure. We believe that establishing
a cost-based generation alternative as described below, without
eliminating market-based alternatives, will also represent a better
balancing of regulatory and market-based approaches to enhancing
economic efficiency.

Without disrupting the economy any further, we can continue to have an
electric supply market operating in which buyers and sellers of
electricity are free to strike mutually acceptable deals and, at the
same time, ensure that electricity is available at just and reasonable
rates. The key to accomplishing this goal is to create "markets" at the
regional level into which generators not selling some or all of their
output under contracts priced at market rates must sell this residual
output at cost-based rates. This would allow entities that wish to
purchase electricity for their own use, or for resale, to be able
purchase at cost-based prices, as a last resort. With such markets in
place, buyers will not be dependent upon either bilateral contract
markets, or de-regulated "spot markets", in which generators can
exercise market power. Instead, all wholesale buyers will have a
**cost-based alternative**. This will also be true for retail buyers in
states where such direct retail purchases are permitted. The
recommendations presented here are designed to create such an
alternative. We also believe that the current pricing rules and market
structures that FERC has established for transmission services need to
be reconsidered to determine a market structure that protects consumers,
by resulting in just and reasonable rates for those services, as well.

Most, if not all, existing state PUC regulations and laws governing
electric utilities will be unaffected by these recommendations. This
includes existing retail rate caps and "standard offer" rates that have
been established in states that have chosen to restructure, as well as
current rate structures in states that have not restructured. All
existing retail and wholesale power contracts will also remain in force.
Where state law or regulations allow retail customers to contract
directly with suppliers for power, they may continue to do so.

Specific recommendations are presented below on a preliminary basis:

1.  Generating units must report all fixed and variable costs to FERC,
    > planned and unplanned outages, and total generation produced, on a
    > monthly basis.

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2.  Generators with output not required for contract sales, and not
    prevented by planned or forced outages, must offer that output into
    a FERC-assigned **RTO Market.** (An RTO is a regional transmission
    organization.) The RTO Market will pay each unit's actual costs, as
    reported by the generator, and as reviewed by the FERC. In addition,
    depreciation rates, the return on common equity (profit), and any
    other costs which require administrative determination will be paid
    based on FERC-approved pricing formulas. These formulas will be
    structured using the same ratemaking principles as FERC has applied
    to utility-owned power plants in the past. The RTO will recover
    these costs through sales to local electric distribution companies,
    load serving entities, or directly to retail electricity consumers,
    where allowed. These sales will be based on the average
    cost-of-service of all the generating units providing electricity to
    each RTO Market in any given month.

3.  Each RTO shall establish a generation reserve margin for its region
    based on generally accepted reliability criteria as established by
    The National Electric Reliability Council. If the amount of
    generation available is projected to fall below the required reserve
    margin, then the RTO shall be required to contract for or build new
    generation supplies. To ensure an adequate supply of least-cost
    electric generation, each RTO shall be required to set up an **RTO
    Supply Agency** which will, as a last resort, invest in, construct,
    and supply any required incremental generation into the RTO Markets
    on a least-cost basis. RTOs will also perform transmission planning,
    and other functions consistent with this proposal, as specified in
    FERC Order 2000.

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4.  The Congress should also implement a national Resource Portfolio
    Standard that mandates increased use of renewable electric
    generation technologies throughout the U.S. These renewable
    resources, as with any generation unit, could sell into the RTO
    Market on a cost basis, or may contract to sell at market rates on a
    bilateral basis.

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5.  The RTO Market should incorporate demand-side management options for
    all customers. This could include demand-side bidding at or below
    the cost of generation that will permit customers to deliver timely,
    cost-effective, and price-responsive load reductions to the
    wholesale power markets. The RTO must permit demand-side resources
    to participate on a fair and competitive basis with supply-side
    resources.

This proposal is a first attempt to address the extremely complex issues
raised by the current crisis is a timely way. Clearly, many important
related issues and details need to be worked out to bring electricity
prices under a reasonable degree of control, prior to determining to
what extent, if any, any greater degree of the deregulation of
electricity markets than that outlined above is in the best interest of
U.S. consumers. The Tellus Institute welcomes the necessary dialogue
that will be required before draft legislation to achieve these goals
can be written.

[^1]: The Tellus Institute is a not-for-profit research organization
    dedicated to the public interest through the promotion of
    sustainable resource futures and consumer protection.

[^2]: *Electric Utility Week*, May 7, 2001.