# Presentation: 411748

## Will Rate-of-Return “Adders” Increase Transmission Investment?

- Thomas P. Lyon
- Dow Chemical Professor of Sustainable Science, Technology and Commerce
- Co-Director, Erb Institute for Global Sustainable Enterprise
- University of Michigan

## Motivation

- Widespread concerns over inadequate transmission infrastructure
- In some recent decisions, FERC has advocated the use of ROR “adders” to stimulate investment
- Energy Policy Act of 2005 includes Section 1241, Transmission Infrastructure Investment
- FERC NOPR RM06-4-000 “Promoting Transmission Investment through Pricing Reform” proposes a variety of incentives, including ROE adders

## Source: Edison Electric Institute

## Future Transmission Needs

- Even though EEI shows transmission investment growing sharply since 1998, it still estimates that investment needs to increase from $4B/year to $5B/year to assure reliability and accommodate wholesale markets

## Energy Policy Act of 2005

- Tax incentives for transmission
- Shorter depreciation 		$1.24 B
- Other tax provisions		$0.08 B
- _New reliability standards_: new Electric Reliability Organization
- New “national interest T corridors,” _FERC siting back stop_
- Requires FERC to establish _incentives for T investment_.
- Authorizes participant funding and native load protections for transmission assets.
- Allows federal power authorities under FERC RTOs.
- Repeals _PUHCA_.
- Modifies _PURPA_.

## FERC RM06-4-000Promoting Transmission Investment

- By August 8, 2006, FERC must establish incentive-based rate treatments for transmission
- Proposed steps:
- ROE adders
- Allowing CWIP
- Accelerated depreciation
- 100% recovery of plant abandoned due to outside factors
- Incentives for transco formation, e.g. ROE adders

## Outline

- Financial Transmission Rights and Investment
- Regulation and Investment
- Rate of return regulation
- Price cap regulation
- “Passive” regulation
- Conclusions

## Merchant Transmission

## FTRs and Investment

- Substantial economic research on bid-based nodal pricing systems shows they can promote efficient exchange of electricity on an existing grid
- Successful operation of PJM, NY ISO, NE ISO supports these claims
- FTRs and CFDs allow market participants to hedge against price volatility.
- It has also been suggested they can promote market-based investment in transmission, if the builder of a new line receives FTRs consistent with the new capacity.
- Unfortunately, this idea suffers from several problems.

## A Simple 2-Node Model

- There are two regions, North and South.
- North has excess supply.
- South has excess demand.
- A transmission link of capacity K connects them

## A Simple 2-Node Model

- PS

- PN

- η

- K

- Congestion Rent

- Congestion Cost

- Net Supply
- In North

- Net Demand
- in South

- K*

- (Uncongested)

- Source: Joskow and Tirole (2005)

## Is Transmission Expansion Profitable?

- PS

- PN

- η

- K0

- Congestion Rent
- Before Expansion

- Net Supply
- In North

- Net Demand
- in South

- K*

- (Uncongested)

- Congestion Rent
- After Expansion

- Gap between
- Social and Private
- Gains from Expansion

- K1

## Market Power and Transmission Investment

- When transmission supplier has market power, increases in capacity cause price to fall.  As a result, a monopolist supplies too little transmission.
- Possible solution: ISO runs auction in which competing investors bid for right to build the capacity.
- If ISO knows demand and cost, it can evaluate the bids effectively.
- Or can compute optimal expansion, and simply put that out for bid at lowest cost.
- Familiar regulatory problems arise if regulator lacks perfect information about demand or cost.
- Holders of other FTRs see their rents fall, as well, so incentives for collusion may arise.

## Loop Flow

- In more complex networks the phenomenon of loop flow emerges.
- Following Kirchoff’s Law, power flows in all directions, in inverse proportion to the resistance it faces.
- As a result, changes in any part of the network have external effects throughout the network.
- This significantly complicates the problem.

## Loop Flow

- 3

- 2

- Demand
- Node
- Consumes q1

- Supply Node injects q1

- 2q1/3

- q1/3

- q1/3

## Loop Flow

- 3

- 2

- Demand
- Node
- Consumes q1

- Supply Node 1 injects q1

- 2q1/3+q2/3

- q1/3-q2/3

- q1/3+2q2/3

- Supply Node 2 injects q2

## Network Expansion with Loop Flows

- Source: Bushnell and Stoft (1997)

- Demand
- Node

- Supply Node 1

- Supply Node 2

## Feasible DispatchesBefore and After Expansion

- q1-q2<3z12
- 2q1+q2<3z13
- q1+2q2<3z23

- q1<z13
- q2<z23

## Impact of Network Expansion

- Source: Bushnell and Stoft (1997)

## Socially Detrimental Investments

- The example above shows a detrimental network expansion
- Bushnell and Stoft (1997) show these can be prevented if initial dispatch is perfectly hedged with FTRs, and investors are forced to take a set of FTRs that result in a feasible dispatch when combined with the existing ones.
- However, this allocation rule is not enough to induce all efficient transmission investments; problems with externalities remain.
- An active regulatory role is hard to avoid.

## Regulated Transmission

## Rate-of-Return Regulation

- If markets for transmission capacity are likely to fail, traditional ROR regulation is an option
- Expenses are passed through directly into rates
- The “rate base” is computed, and the firm collects the “allowed rate of return” on it, which should be commensurate with risk and allow the firm to attract capital.

## Regulation and Investment

- Averch and Johnson (1962) studied the mix of capital and labor used by a regulated firm.
- They found that the regulated firm’s capital/labor ratio is higher than what would be chosen by an unregulated firm.
- This suggests ROR regulation may be a promising way to increase investment.
- However, empirical studies seeking to verify the AJ effect have been inconclusive.

## Regulation and Investment

- In a recent paper, Lyon (2005) finds that the switch from municipal franchise regulation to state utility regulation in the early years of the 20th century significantly increased investment in generation capacity.
- This was not simply an artifact of private utilities buying out municipals.  The total investment of the two types increased.

## The Early History of Electric Utility Regulation

## Regulatory Scope

- Extending regulatory scope from the municipal to the state level significantly increased capital investment
- Eliminated need to deal with multiple jurisdictions
- State regulators had stronger incentives to invest in a reputation for fairness
- Similar incentives may apply to stand-alone transcos regulated solely by FERC, as opposed to traditional utilities regulated by multiple states.

## Does RORR Really Exist?

- Averch and Johnson (1962) model depicts a firm subject to a binding rate-of-return constraint.
- Joskow (1973) argued that in practice regulators are “passive,” adjusting rates only when petitioned by the regulated firm or by consumer groups.  Regulatory lag becomes an important issue, as does what triggers rate review.

## RORR Does Exist!

- Northeast Utilities provides an example of cost-based regulation of transmission.
- Transmission rates are divided into two parts:
- Regional Network Service (RNS)
- Uses an historical rate base.  All companies in the New England ISO compute their "regional" transmission assets, and these are pooled.  Revenue requirements are determined on a regional basis, and allocated to individual companies based on their percentage of total load.  The RNS rate is updated annually.
- Local Network Service (LNS)
- Uses a forecasted test year, and picks up any shortfall between RNS revenues and actual costs.
- There is an annual true-up.
- Congestion revenue rights (CRRs) are typically held by the load, rather than the transmission company.
- Result: Very close to continuously binding ROR constraint, i.e. classic A-J model.

## Rate of Return “Adders”and Investment

- Baumol and Klevorick (1970) show that an increase in the allowed rate of return actually induces the firm to *decrease *its capital investment!
- This is easiest to see in a diagram...

## Adders in a RORR Model

## Adders and Investment

- Thus, in a traditional regulatory environment, simply increasing the allowed rate of return will **not** increase transmission investment!
- What if the ROR constraint is not continuously binding---e.g., price caps or “passive regulation” with regulatory lag?

## Price Cap Regulation

- Attempts to strengthen incentives for efficiency by making the firm the “residual claimant” for its own actions
- For example, this should improve incentives for cost reduction.
- Suppose
- transmission has been divested from generation.
- transmission rate is a simple fixed price, which is kept in place for a pre-determined period.
- the initial price is based upon the existing capital stock and most recent usage of variable inputs

## Price Caps and Adders

- A rate-of-return adder will increase the total cost recovery for capital inputs.
- As a result, this will increase the price charged, and reduce quantity demanded.
- This reduces the need for capacity, and hence *reduces* incentives for investment.

## Performance-Based Regulation

- Regarding transmission, needs to allow firm to earn more when it reduces congestion.
- Huge literature in economics recognizes that firms have better information than regulators. Vogelsang (2001, 2004) presents promising PBR mechanisms tailored to electric power transmission.
- PBR can improve short-run incentives for efficiency.
- However, he recognizes that providing long-run incentives is difficult, due to lack of regulatory commitment.
- Well-intentioned price caps tend to be renegotiated when profits become excessively high or low.
- RORR with prudence review may be as much as US is able to commit to.

## RORR With Cost Disallowances

- It is sometimes argued that transmission investors need to receive an increased ROR to cover the risk of regulatory disallowance.
- There has never been a case of a disallowance of transmission investment, but this may become more likely as electricity markets are restructured.
- In a recent paper, Lyon and Mayo (2005) study the effects of disallowances on electric utility investment during the period 1970-1991, during which over $19 billion of investments were disallowed.

## Slide 36

## Largest Disallowances

| Unit | Utility | Amount
(Billions) | Year |
| --- | --- | --- | --- |
| 9 Mile Point 2 | Multiple | $2.141 | 1987 |
| DiabloCanyon | PG&E | $2.000 | 1988 |
| Wolf Creek 1 | Multiple | $1.618 | 1985 |
| Shoreham 1 | LILCO | $1.395 | 1985 |
| Comanche Peak 1&2 | Texas Utilities | $1.381 | 1991 |
| Fermi 2 | Detroit Edison | $1.310 | 1988 |
| River Bend 1 | Gulf States | $1.297 | 1987 |

## Slide 38

## Slide 39

## Regulatory Opportunism?

- Broad regime shift/opportunism?
- No: Lack of spillover effects
- “Bad luck”?
- No: Disallowed firms did reduce investment
- “Bad management”?
- Yes: Disallowed firms cut back, but others in same state did not
- Opportunistic treatment of nuke operators?
- Possible: Can reject lack of spillover to nuke operators in same state, but cannot reject lack of all spillovers
- However, states with disallowances tended to have many owners/operator.  Agency problems?

## Evidence on Disallowances

- The nuclear power era posed a much greater threat of generation disallowances than does the current regime for transmission disallowances.
- Little evidence of regulatory opportunism.
- Instead, poor construction management seems to have been a much more important cause of disallowances.
- Transmission is easier to build than nuclear power plants, and the risk of disallowance is modest.
- FERC proposes to allow 100% recovery of prudent transmission cancelled or abandoned due to factors beyond the utility’s control.

## Conclusions

- Financial transmission rights can support market-driven investment, but almost certainly will not provide adequate incentives.
- Regulation seems necessary, yet a simple increase in the allowed rate-of-return is unlikely to effectively stimulate investment.
- Siting difficulties may be more important than ROR on investment.