```
                                                                 
Energy Markets: Concerted Actions Needed By FERC To Confront	 
Challenges That Impede Effective Oversight (14-JUN-02,		 
GAO-02-656).							 
                                                                 
The Federal Energy Regulatory Commission (FERC) has not yet	 
adequately revised its regulatory and oversight approach to	 
respond to the transition to competitive energy markets. FERC	 
recognizes that the change from highly regulated monopolies to	 
competitive markets requires it to fundamentally change how it	 
does business. However, it has struggled through various	 
strategic planning and other efforts to define the specific	 
strategies, processes, and activities to regulate and oversee	 
these markets. GAO found that FERC (1) has had difficulty	 
recruiting staff because it has trouble competing with private	 
sector salaries; (2) faces the retirement of over one-quarter of 
its employees by 2005; (3) has used recruitment bonuses,	 
retention allowances, tuition reimbursement, and flexible work	 
schedules to attract new staff and to retain current employees,  
but it has not taken advantage of the full range of personnel	 
flexibilities and tools available to federal agencies, such as	 
special salary rates; and (4) has not developed a strategic human
capital management plan to assess its workforce needs and to	 
develop strategies to address them.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-656 					        
    ACCNO:   A03417						        
  TITLE:     Energy Markets: Concerted Actions Needed By FERC To      
Confront Challenges That Impede Effective Oversight		 
     DATE:   06/14/2002 
  SUBJECT:   Electric energy					 
	     Monopolies 					 
	     Natural gas					 
	     Competition					 
	     Prices and pricing 				 
	     Regulatory agencies				 
	     General management reviews 			 
	     Strategic planning 				 
	     FERC First 					 
	     FERC Open Access Same-Time Information		 
	     System						 
                                                                 

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GAO-02-656
     
Report to Congressional Requesters

United States General Accounting Office

GAO

June 2002 ENERGY MARKETS Concerted Actions Needed by FERC to Confront
Challenges That Impede Effective Oversight

GAO- 02- 656

Page i GAO- 02- 656 Energy Markets Letter 1

Executive Summary 2 Purpose 2 Background 2 Results in Brief 4 Principal
Findings 6 Agency Comments 10

Chapter 1 Introduction 12 FERC Is the Principal Federal Agency Regulating
and Overseeing

the Natural Gas and Electricity Industries 12 The Nation?s Natural Gas and
Electricity Industries Are Evolving 19 Objectives, Scope, and Methodology 28

Chapter 2 FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets 31

FERC Recognizes That It Needs a New Approach for Competitive Energy Markets
31 FERC Has Struggled to Define and Implement a New Approach 33 FERC?s
Market Oversight Initiatives Have Been Incomplete or

Ineffective 38 FERC?s Outdated Legislative Framework and Frequent Leadership

Changes Have Contributed to Its Difficulty in Developing a New Regulatory
Approach 46 Conclusions 50 Recommendations for Executive Action 52 Matters
for Congressional Consideration 52 Agency Comments 52

Chapter 3 FERC Faces Significant Management Challenges to Effectively
Monitor Competitive Energy Markets 55

FERC Has Taken Some Steps to Address Its Human Capital Needs, but
Significant Challenges Remain 55 FERC?s Organizational Structure Limits Its
Effectiveness 64 Conclusions 65 Recommendations for Executive Action 67
Agency Comments 67 Contents

Page ii GAO- 02- 656 Energy Markets Appendix I FERC?s Principal Strategic
Goals and Objectives for

Energy Markets 69

Appendix II GAO Survey of Current FERC Employees in Selected Offices 71

Appendix III Comments from the Federal Energy Regulatory Commission 84

Appendix IV GAO Contacts and Staff Acknowledgments 96

Tables

Table 1: Major Events and Milestones in Restructuring the Natural Gas and
Electricity Industries 27 Table 2: FERC?s Statement of Its Mission in the
1997, 2000, and

2001 Versions of Its Strategic Plan 34 Table 3: Percentage of FERC Staff
Indicating That Additional

Training Would Help Them Better Monitor and Regulate Energy Markets, by Type
of Training 57 Table 4: FERC?s Principal Strategic Goals and Objectives for

Energy Markets 69

Figures

Figure 1: FERC Staff Years, 1993- 2003 13 Figure 2: FERC?s Organization 15
Figure 3: Transmission Ownership in the United States 19 Figure 4: Major
Wholesale Electricity Trading Hubs and

Centralized Power Markets 26 Figure 5: Percentage of Employees in Mainstream
Occupations

Eligible to Retire in Fiscal Years 2002- 2005 60

Page iii GAO- 02- 656 Energy Markets Abbreviations

AFMC Air Force Materiel Command EPACT Energy Policy Act ERCOT Electric
Reliability Council of Texas EWG exempt wholesale generator FERC Federal
Energy Regulatory Commission ICE Intercontinental Exchange IRS Internal
Revenue Service ISO independent system operator MMU market monitoring unit
MOR Market Observation Resource NYMEX New York Mercantile Exchange OASIS
Open Access Same- Time Information System OMB Office of Management and
Budget OMTR Office of Markets, Tariffs, and Rates OPM Office of Personnel
Management PJM Pennsylvania, New Jersey, Maryland PUHCA Public Utility
Holding Company Act PURPA Public Utilities Regulatory Policies Act QF
qualifying facility RTO regional transmission organization

Page 1 GAO- 02- 656 Energy Markets

June 14, 2002 The Honorable Joseph I. Lieberman Chairman, Committee on
Governmental Affairs United States Senate

The Honorable Jean Carnahan United States Senate

As requested, we are reporting on the Federal Energy Regulatory Commission?s
(FERC) efforts to revise its approach to regulating and overseeing the
nation?s natural gas and electric power industries in light of these
industries? evolution from highly regulated monopolies to competitive energy
markets. This report contains recommendations to the Chairman of FERC on
developing and implementing an effective regulatory and oversight approach
for these markets. The report also contains a matter for congressional
consideration on the need to review FERC?s legal authorities to determine
whether revisions are warranted in view of the change to competitive energy
markets.

As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days from
the date of this letter. We will then send copies to other appropriate
congressional committees; the Chairman, FERC; and the Director, Office of
Management and Budget. We will also make copies available to others upon
request. In addition, the report will be available at no charge on the GAO
web site at http:// www. gao. gov.

If you or your staff have any questions concerning this report, please call
me at (202) 512- 3841. Key contributors to this report are listed in
appendix IV.

Jim Wells Director, Natural Resources

and Environment

United States General Accounting Office Washington, DC 20548

Executive Summary Page 2 GAO- 02- 656 Energy Markets

Consumers in various parts of the United States have experienced substantial
fluctuations in the prices they pay for natural gas and electricity as these
industries make the transition from regulated monopolies to competitive
markets. These fluctuations- the most notable in California during the
summer of 2000- have caused some consumers and state officials to question
the wisdom of moving to competitive energy markets. They have also raised
concerns about the ability of the federal government to adequately regulate
and oversee these new markets. The responsibility for ensuring that
wholesale prices for natural gas and electricity, sold and transported in
interstate commerce, are ?just and reasonable,? generally rests with the
Federal Energy Regulatory Commission (FERC).

The Chairman of the Senate Committee on Governmental Affairs and Senator
Carnahan asked GAO to determine (1) how FERC has revised its regulatory and
oversight approach in response to the new energy markets and (2) what
management challenges FERC faces in effectively regulating and overseeing
these markets. To respond to the request, GAO reviewed relevant legislation,
regulations, studies, and documents pertaining to FERC?s regulation and
oversight of these industries. GAO also interviewed a wide range of current
and former FERC Chairmen, Commissioners, and officials. In addition, GAO
surveyed FERC staff in the Office of Markets, Tariffs and Rates and related
sections of the Office of the General Counsel who have primary
responsibility for regulating the natural gas and electricity industries.
About 71 percent, or 271, of these 384 staff responded to GAO?s survey.
Furthermore, GAO obtained information from a wide range of FERC?s
stakeholders- including state and industry representatives- and other
industry experts. For example, GAO surveyed the chairmen of the state public
utility commissions or boards. Thirty of the 49 commissions or boards
responded to GAO?s survey. (See ch. 1 for GAO?s detailed scope and
methodology and app. II for a copy of the FERC employee survey with the
quantitative results.)

FERC was established in 1977 as a successor to the Federal Power Commission.
FERC is an independent federal agency of about 1,200 employees. Five
Commissioners, each appointed by the President to a 5- year term, and
confirmed by the Senate, lead the agency. The President designates one of
the Commissioners as the Chairman, who is responsible for the agency?s
administrative operations. In addition to regulating and overseeing
interstate transportation and wholesale sales of natural gas and
electricity, FERC regulates transmission of oil by pipelines, licenses
hydroelectric projects, and approves site choices for interstate pipelines
Executive Summary

Purpose Background

Executive Summary Page 3 GAO- 02- 656 Energy Markets

and related facilities. Jurisdiction over other aspects of the natural gas
and electric industries, such as retail sales, construction of electric
power plants and transmission lines, and intrastate transportation, belongs
to state and local governments.

For nearly a century, the natural gas and electricity industries were
regulated as natural monopolies and dominated by a relatively few, large
public utilities that produced, transported, and sold natural gas and
electricity to the ultimate users. 1 This monopoly structure controlled the
entry, prices, and profits of industry participants. With technological,
economic, and policy developments over the past 25 years, these industries
have undergone a transition from this highly regulated environment to one
that places greater reliance on competition to determine entry, prices, and
profits. Natural gas was first to make the shift, facilitated by passage of
the Natural Gas Policy Act of 1978 and subsequent FERC orders in 1985 and
1992 that opened pipeline transportation to all on equal terms and required
pipeline companies to completely separate or ?unbundle? their
transportation, storage, and sales services. As a result, natural gas became
a commodity bought and sold separately from its transportation.

The electricity industry has experienced similar developments, starting
about the same time but evolving more slowly than the natural gas industry.
The Public Utility Regulatory Policies Act in 1978 introduced competition by
requiring electric utilities to buy electricity produced by nonutility,
electric power generators. Then in 1992, the Congress passed the Energy
Policy Act, authorizing FERC to require utilities, on a case- bycase basis,
to allow competitors to use their transmission lines for wholesale sales of
electricity. In 1996, FERC ordered that electric transmission systems be
opened to all qualified wholesale buyers and sellers of electric energy.
FERC also required utilities to ?functionally unbundle? their generation and
transmission businesses to prevent discriminatory practices, such as not
allowing competitors equal access to transmission lines. One option FERC
provided the utilities to help them achieve unbundling was to transfer
management of their transmission lines to an independent system operator
that would manage the system without any special interests and for all
users? benefit. In 1999, FERC

1 A natural monopoly is a company that becomes the only supplier of a
product or service because the nature of that product or service makes a
single supplier more efficient than competing ones.

Executive Summary Page 4 GAO- 02- 656 Energy Markets

issued an order asking all utilities to transfer control of their
transmission lines to regional transmission organizations. FERC is in the
process of establishing these organizations to cover the continental United
States.

Under the traditional regulatory framework, FERC established individual
utilities? terms, conditions, and rates for transportation and wholesale
sale of natural gas and electricity in interstate commerce. To ensure that
the rates these utilities charged were just and reasonable, FERC based the
rates on the utilities? cost to provide the service plus a fair return on
investment, which is generally referred to as cost- of- service regulation.
With the opening of pipelines and transmission lines, other energy producers
and marketers began to compete with the traditional utilities to the point
that a complex structure of formal and informal primary and secondary energy
markets has evolved. As competition has increased, FERC has allowed more and
more producers and marketers to sell their energy at prices determined in
the marketplace.

FERC has not yet adequately revised its regulatory and oversight approach to
respond to the transition to competitive energy markets. The agency
recognizes that the change from highly regulated monopolies to competitive
markets requires it to fundamentally change how it does business. However,
it has struggled through various strategic planning and other efforts to
define the specific strategies, processes, and activities that it will use
to regulate and oversee these markets. Specifically, GAO found the
following:

 An ambitious, 2- year reengineering effort begun in 1997 was intended to
position the agency to operate within the new market realities, but the
effort achieved little more than superficial changes to FERC?s
organizational structure.

 To date, FERC?s initiatives to monitor competitive markets have served
more to help educate FERC?s staff about the new markets than produce
effective oversight efforts. For example, the agency?s Market Observation
Resource room makes a substantial amount of market data available to staff
in a readily usable format; however, this information has not yet been used
to initiate an enforcement action or to confirm or refute a problem
identified elsewhere in the agency.

 FERC?s difficulties with developing an effective approach for monitoring
competitive markets are compounded by the need to continue to carry out
Results in Brief

Executive Summary Page 5 GAO- 02- 656 Energy Markets

its traditional cost- of- service regulation as the industry makes the
transition to competitive markets.

 FERC is attempting to develop an approach for competitive markets using
legal authorities that were enacted primarily when the energy industries
were regulated monopolies. For example, FERC generally does not have the
authority to levy meaningful civil penalties. While this authority may not
have been necessary for cost- of- service regulation, it is important if
FERC is to pose a credible threat and deter anticompetitive behavior or
violations of market rules by market participants.

Absent an effective regulatory and oversight approach, FERC lacks assurance
that today?s energy markets are producing interstate wholesale natural gas
and electricity prices that are just and reasonable. Although many details
remain to be decided, FERC?s current thinking is that the regional
transmission organizations will be required to establish independent units
to serve as the agency?s frontline monitors for the new markets. However, it
is likely to be several years before these units will be fully operational.
Therefore, GAO is making recommendations to the Chairman, FERC, aimed at
improving the interim regulation and oversight of these markets until a
long- term, comprehensive approach can be established. In addition, GAO is
suggesting that the Congress may want to review and revise FERC?s
authorities in the context of competitive market structures, such as the
need to levy meaningful civil monetary penalties.

Under any future scenario, FERC must overcome significant human capital and
organizational structure challenges to effectively regulate and oversee the
evolving energy marketplace. Although its staff will continue to do some
cost- of- service regulation, FERC needs more staff knowledgeable about
competitive energy markets and skilled in regulating and overseeing them.
FERC is taking steps to transform its workforce so that it will be able to
successfully regulate in a competitive market environment. However, GAO
found that FERC

 has had difficulty recruiting such staff, in large part, because it has
trouble competing with private sector salaries;

 faces the impending retirement of a large portion of its staff- over
onequarter of its employees will be eligible to retire by 2005;

 has used recruitment bonuses, retention allowances, tuition reimbursement,
and flexible work schedules to attract new staff and to retain current
employees, but it has not taken advantage of the full range

Executive Summary Page 6 GAO- 02- 656 Energy Markets

of personnel flexibilities and tools available to federal agencies, such as
special salary rates; and

 has not developed a strategic human capital management plan to assess its
specific workforce needs and to develop strategies to address them.

Furthermore, FERC?s current organizational structure diffuses its market
oversight function, making it more difficult to provide the communication,
focus, and management attention needed to successfully implement a new
regulatory and oversight approach. FERC plans to establish an Office of
Market Oversight and Investigation reporting to the Chairman to provide this
communication, focus, and management attention, although many details are
yet to be resolved. GAO is making recommendations to the Chairman, FERC, to
help address the agency?s serious human capital concerns.

In commenting on a draft of this report, FERC agreed with GAO?s conclusions
that the agency has not done all that it could to oversee energy markets and
with the report?s recommendations to improve market oversight and to address
the human capital challenges faced by FERC. The agency also provided
technical comments that GAO incorporated as appropriate.

As competitive energy markets started to develop in the early 1990s, FERC
recognized that it would need a new approach to ensure just and reasonable
energy prices. Its first strategic plan, which was completed in September
1997, confirmed the need for this new approach but did not delineate the
strategies needed to put such an approach into place. Instead FERC, in 1997,
launched a 2- year, $20- million project to reengineer itself to operate in
this competitive- market environment. One of the more significant results of
this project, which is referred to as FERC First, was to combine the
agency?s staff responsible for natural gas and electricity regulation into a
new Office of Markets, Tariffs and Rates. This new office was to be
responsible for regulating and overseeing competitive energy markets. FERC
First, however, did not bring about the fundamental changes that were
anticipated and needed to implement a new regulatory approach. For example,
74 percent of the employees responding to GAO?s survey believed that FERC
First had improved the agency?s ability to effectively monitor or regulate
energy markets to little or no extent. The Principal Findings

FERC Has Not Yet Defined and Implemented an Effective Regulatory and
Oversight Approach for Competitive Energy Markets

Executive Summary Page 7 GAO- 02- 656 Energy Markets

agency has subsequently continued to struggle to define the specific
strategies, processes, and activities that it will use to regulate and
oversee the emerging energy markets. For example, although FERC made
improvements to its strategic plan in 2000 and 2001, the plan still lacks
outcome- oriented goals and objectives and important details on how FERC
will monitor these markets. The agency has yet to decide what market
monitoring means in the context of FERC?s responsibility to ensure that
energy prices are just and reasonable.

FERC has also tried various efforts to oversee energy markets, including a
staff investigation in 2000 of the nation?s wholesale electricity markets
and the development of a Market Observation Resource room that serves as a
central source of market data that FERC staff can view electronically using
various software packages. These efforts to date, however, have served more
as educational opportunities for FERC staff than as effective oversight
tools. For example, in commenting on the staff investigation of wholesale
electricity markets, FERC management concluded that the investigation made
it clear that the agency did not have enough people who could analyze market
information. Similarly, the major products of the Market Observation
Resource room have been daily and monthly informational newsletters prepared
for FERC?s Commissioners and managers on energy market events and
conditions, such as business news, natural gas supply levels, electricity
price trends, and power plant outages.

Moreover, because FERC?s legal authorities for natural gas and electricity
are mostly derived from laws enacted when the industries comprised highly
regulated monopolies, FERC has been attempting to develop and implement a
regulatory and oversight approach for competitive markets, with an outdated
legislative framework and using authorities that may not be adequate for
today?s competitive markets. For example, the potential for a company to
engage in anticompetitive behavior and charge excessive prices for
electricity is a significant concern when rates are determined by the
marketplace instead of cost- of- service regulation, especially when the
markets are still evolving. However, FERC?s authority to levy civil
penalties if it identifies this type of behavior is limited, because its
authority is derived from laws that were enacted in a cost- of- service
environment. Without a meaningful range of penalties, FERC lacks adequate
enforcement ?bite? to deter anticompetitive behavior or other violations of
market rules. Such deterrence is an important part of an effective oversight
approach, especially because FERC will likely not be able to review all the
transactions in detail to identify such behavior or violations.

Executive Summary Page 8 GAO- 02- 656 Energy Markets

Finally, frequent changes in FERC?s leadership have been another
contributing factor to FERC?s slow progress in developing and implementing a
new approach. FERC has had four different Chairs over the past 5 years. As
the agency?s chief administrator, the Chair sets the agenda and priorities.
Making fundamental changes in an agency?s operations, such as implementing a
new regulatory and oversight approach, can take a sustained effort over
several years. This can be difficult to achieve with significant shifts in
an agency?s agenda and priorities caused by continuous change in its top
leadership.

To address these issues, GAO recommends that the Chairman, FERC, take the
following actions:

 Update the agency?s strategic plan to include outcome measures that can be
used to assess how well FERC is doing in achieving its strategic goals and
objectives for overseeing competitive energy markets. This plan should also
include specific strategies for achieving the goals and objectives that set
out explicitly how FERC will work with market participants to provide
comprehensive oversight of the markets.

 FERC should examine how the bulk power studies and the data sources
currently available through the Market Observation Resource room can be used
as effective market monitoring tools in the interim, until a more
comprehensive approach for overseeing energy markets is developed.

In addition, GAO is suggesting that the Congress may wish to convene public
hearings to review FERC?s authorizing legislation and determine, in
consultation with FERC Commissioners, whether FERC?s authorities need to be
revised in light of the changing energy markets. The Congress may also want
to consider providing FERC with the appropriate range of authorities to levy
civil penalties against market participants that engage in anticompetitive
behavior and violate market rules.

FERC does not currently have enough staff with the skills and knowledge of
competitive energy markets to effectively regulate and oversee these
industries. FERC?s employees were mostly recruited and trained for costof-
service regulation, and the agency has not yet conducted the training and
hiring necessary to adapt its workforce to a competitive market environment.
FERC has been providing its current staff with increased training
opportunities to enhance their knowledge of energy markets. For example, the
Office of Markets, Tariffs and Rates doubled its training budget from 2000
to 2001. Despite these efforts, the general feeling among FERC Faces
Significant

Human Capital and Organizational Structure Challenges to Effectively
Regulate and Oversee Competitive Energy Markets

Executive Summary Page 9 GAO- 02- 656 Energy Markets

FERC staff responsible for regulating and overseeing energy markets is that
they still need additional, focused training on how energy markets work.
Over 80 percent of the staff in the Office of Markets, Tariffs and Rates and
the related sections of the Office of the General Counsel who responded to
GAO?s survey said that they needed more training in market functions and
market structures.

Moreover, successfully recruiting staff at the mid- and upper- levels who
already have knowledge and experience with competitive markets is critical
to FERC?s efforts to quickly adapt its workforce. However, FERC has had
limited success with hiring these types of employees. According to FERC, the
salary differentials between government positions and those in the private
sector have made it difficult for the agency to attract highly skilled and
knowledgeable professionals away from the private sector. For example, FERC
has advertised an ?Energy Industry Analyst-( Energy Trader)? position at the
GS- 15, step 10, level- which currently pays about $120, 000- three
different times with little success in finding a qualified candidate.

In addition, over one- quarter of FERC?s employees will be eligible to
retire by 2005, creating an opportunity for FERC to refocus its workforce
competencies to those more geared toward regulating and overseeing
competitive markets. However, this large- scale retirement will also create
a dearth of institutional knowledge, because FERC will continue to perform
some traditional cost- of- service regulatory work as the industries
transition to competitive markets, and for some time it will continue to
need highly qualified and experienced staff to perform these functions.

Nonetheless, FERC has not taken full advantage of the personnel
flexibilities and tools available to federal agencies to help it address
recruitment and employee retention challenges. Although FERC has used
recruitment bonuses, retention allowances, tuition reimbursement, and
alternative work schedules, it has not yet used other available tools, such
as special pay rates, to help it address its human capital challenges.

FERC?s efforts to address its human capital issues have also been hampered
by its lack of a strategic human capital management plan. FERC has not yet
undertaken a systematic strategic human capital planning process to identify
the specific staff competencies it needs and develop the strategies that it
will use to meet these needs. For example, FERC has not completed a detailed
assessment and plan that will help the agency address its potential loss of
leadership continuity, institutional knowledge, and expertise from the
impending retirement of many of its employees.

Executive Summary Page 10 GAO- 02- 656 Energy Markets

Furthermore, FERC?s market oversight function currently is dispersed across
various parts of the agency. This organizational structure makes it more
difficult for this function to receive the priority and attention that is
needed to bring about fundamental change. FERC?s recently announced plans to
create a new Office of Market Oversight and Investigation, which will focus
on analyzing and monitoring energy markets, may address this issue. For
example, this new office is expected to report directly to the Chairman,
thereby elevating the attention of the market oversight function within the
agency. However, many details about the office and how it will carry out its
responsibilities have not yet been determined.

To address its serious human capital challenges, GAO is recommending that
the Chairman, FERC, in the short term, identify and formally assess the
personnel tools, flexibilities, and strategies available to federal agencies
to recruit and retain employees. The Chairman should also develop an action
plan to identify and target additional training and development
opportunities for current staff involved or potentially involved in carrying
out FERC?s market oversight functions.

In the longer term, GAO recommends that the Chairman, FERC, develop a
comprehensive strategic human capital management plan to guide FERC?s
efforts to recruit, develop, train, and retain staff knowledgeable in
regulating competitive markets. The plan should be linked to FERC?s
strategic and business plans.

We provided FERC with a draft of this report for review and comment. FERC
agreed with GAO?s conclusions, noting that its internal restructuring to
support its new market oversight role has not kept pace with the speed of
the energy industry?s restructuring. The agency also commented that GAO?s
recommendations are consistent with its current direction. FERC said that
its recent aggressive measures to address its key challenges are paying off.
According to FERC, it has developed preliminary plans on how its new Office
of Market Oversight and Investigation will work and the office will be
operational in August 2002. FERC also said that it has recently made
significant progress in hiring new employees and will explore all of the
hiring flexibility available to it as it focuses on the skill sets needed
for market oversight and investigation. FERC further said that it is
reviewing existing budget allocations across the agency for additional
resources and working to craft more focused training programs to build its
staff?s technical and leadership capabilities. FERC also agreed that its
ability to develop, regulate, and oversee competitive energy markets could
be enhanced with additional statutory authority, particularly for assessing
Agency Comments

Executive Summary Page 11 GAO- 02- 656 Energy Markets

civil penalties, and with guidance from the Congress on the agency?s
appropriate role in these markets.

FERC?s written comments are presented in appendix III. The comments contain
an attachment summarizing the agency?s current efforts to address issues of
energy market oversight and human capital, and the need for additional
legislative authority. FERC also provided a draft of the mission and
function statement and organizational design for its new Office of Market
Oversight and Investigation, and a list of the services and products the
office is to provide. In addition, FERC provided us with some technical
changes, which we incorporated into the report as appropriate.

Chapter 1: Introduction Page 12 GAO- 02- 656 Energy Markets

Consumers in various parts of the United States have recently experienced
large fluctuations in energy prices as the natural gas and electric power
industries undergo a major restructuring from regulated monopolies to
competitive markets. The price spikes and supply disruptions that occurred
in California and other parts of the West during 2000 and into 2001 are
examples of the complications that have arisen for these industries and
government regulatory agencies during this shift from regulated prices based
on utilities? cost of providing service to marketbased prices. The Federal
Energy Regulatory Commission (FERC) has both prompted and reacted to the
fundamental changes that the energy industries are undergoing. Established
to regulate energy monopolies, FERC first encouraged the restructuring of
the natural gas industry and today is doing the same for electricity. The
price spikes in California and elsewhere have fueled debate about the wisdom
of restructuring these industries and have drawn wider attention than ever
before to FERC and its ability to carry out its legislative responsibilities
for ensuring that natural gas and electricity prices are just and
reasonable. In response to these concerns, the Congress is currently
debating comprehensive energy legislation.

The natural gas and electricity industries perform three primary functions
in delivering energy to consumers: (1) producing the basic energy commodity,
(2) transporting the commodity through pipelines or over power lines, and
(3) distributing the commodity to the final consumer. A range of federal,
state, and local entities regulate different aspects of these functions.
While generation siting, intrastate transportation, and retail sales are
generally regulated by state or local entities, wholesale sales and
interstate transportation generally fall under federal regulation, primarily
by FERC. Under federal law, FERC is responsible for regulating the terms,
conditions, and rates for the interstate transportation and sale for resale
of natural gas and electricity. FERC is charged with ensuring that the
terms, conditions, and rates are just and reasonable.

FERC was established in 1977 as a successor to the Federal Power Commission
and is an independent regulatory agency. In addition to regulating and
overseeing the interstate transmission and interstate wholesale sales of
natural gas and electricity, FERC regulates the interstate transmission of
oil by pipeline; licenses and inspects private, municipal, and state
hydroelectric projects; and approves site choices as well as decisions to
abandon interstate pipelines and related facilities no longer in use.
Chapter 1: Introduction

FERC Is the Principal Federal Agency Regulating and Overseeing the Natural
Gas and Electricity Industries

Chapter 1: Introduction Page 13 GAO- 02- 656 Energy Markets

FERC?s estimated budget for fiscal year 2002 is about $192 million and
provides funding for 1,200 staff years. 1 For fiscal year 2003, FERC has
requested a budget of about $200 million and 1,250 staff years. While FERC
has requested an increase for fiscal year 2003, its staffing levels have
generally decreased over the last decade. For example, the 1,250 staff years
requested for next fiscal year are 238 fewer than FERC had in fiscal year
1993 (see fig. 1). According to FERC managers, these staff reductions have
occurred while the agency?s workload has increased in both volume and
complexity. Although the Congress sets FERC?s budget, FERC recovers the full
cost of operations through annual charges and filing fees assessed on the
industries it regulates.

Figure 1: FERC Staff Years, 1993- 2003

Note: 1993- 2001 staff years are actual figures. The 2002 and 2003 figures
are estimates based on the budget requests for those years.

Source: GAO?s analysis of FERC budget data.

Five Commissioners, each appointed to a 5- year term by the President, and
confirmed by the Senate, lead FERC. The President designates one of the five
Commissioners as the Chair, who also serves as the administrative head of
the agency and directs its staff. FERC?s staff are currently

1 Staff resources are measured in this report in terms of full- time-
equivalent staff years. FERC?s Resources and

Organizational Structure

Chapter 1: Introduction Page 14 GAO- 02- 656 Energy Markets

organized around the agency?s two major program or responsibility areas-
energy markets and energy projects- with their supporting administrative and
management functions. About 35 percent of FERC?s staff focus on energy
markets. These staff are predominantly located in the Office of Markets,
Tariffs and Rates (OMTR) and the Office of the General Counsel. OMTR was
created in 1998 to integrate the agency?s regulation of the electric,
natural gas, and oil pipeline industries. It plays a lead role in
monitoring, promoting, and maintaining competitive natural gas and
electricity markets, while regulating and overseeing the terms and
conditions for energy transactions that continue to be regulated on the
traditional cost- of- service basis. The Office of the General Counsel
provides legal services and is responsible for the legal phases of the
Commission?s activities.

Forty percent of FERC?s staff focus on energy projects, an area that
includes the physical infrastructure of pipelines, dams, and related
facilities. These staff are primarily located in the Office of the General
Counsel and the Office of Energy Projects. The Office of Energy Projects
authorizes nonfederal hydroelectric projects and ensures that dams under its
jurisdiction are properly constructed, operated, and maintained. This office
also certifies the construction and operation of natural gas pipelines and
approves the abandonment of pipelines no longer being used. In addition, the
office reviews hydropower and natural gas projects to ensure their
compliance with environmental laws.

The remaining 25 percent of FERC?s staff are located mostly in
administrative and management support offices. These offices are responsible
for the agency?s planning, budgeting, human capital, information technology,
financial management, and related processes. (See fig. 2.)

Chapter 1: Introduction Page 15 GAO- 02- 656 Energy Markets

Figure 2: FERC?s Organization

Source: FERC.

Natural gas companies were initially locally franchised monopolies, many of
which manufactured natural gas locally from coal. With the discovery of
large natural gas reserves in the Southwest in the early 1900s, large
interstate pipeline companies soon became a major sector of the natural gas
industry, which nonetheless retained strong features of a natural monopoly.
2 In 1938, the Congress passed the Natural Gas Act, which gave the Federal
Power Commission (and now FERC) jurisdiction over interstate transportation
and sales for resale of natural gas. The act also gave the agency
jurisdiction over new construction and abandonment of natural gas pipelines
and related facilities.

Under this regulatory scheme, producers located natural gas reserves,
drilled wells, gathered the gas, and put it in marketable condition for sale
to interstate pipeline companies. After purchasing the natural gas, pipeline
companies generally transported and sold the gas to local distribution
companies for final sale and distribution to the ultimate consumers, such as
homeowners. The interstate pipeline companies also sold some natural gas
directly to consumers. FERC regulated the pipeline companies? terms,
conditions, and rates for interstate transportation and sale for resale of
the natural gas to ensure that they were just and reasonable. State and
local

2 A natural monopoly is a company that becomes the only supplier of a
product or service because the nature of that product or service makes a
single supplier more efficient than competing ones. FERC?s Legislative

Authorities for Natural Gas Regulation

Chapter 1: Introduction Page 16 GAO- 02- 656 Energy Markets

authorities generally set the transportation rates that the local
distribution companies charged consumers. FERC and the state and local
governments generally set rates on the basis of the companies? cost of
providing these services, plus a reasonable rate of return on their
investment.

A 1954 Supreme Court decision interpreted the Natural Gas Act as also
requiring the Federal Power Commission to regulate the prices that producers
charged to pipeline companies in the production area (wellhead) for the
natural gas sold in interstate commerce. 3 However, comprehensive regulation
of natural gas wellhead prices proved a failure. By the mid- 1970s, severe
gas shortages occurred as a result of artificially low prices. During cold
winters, such as 1976- 77, these shortages translated into delivery
curtailments for many customers in the northern United States. Responding to
these supply problems, the Congress passed the Natural Gas Policy Act of
1978 to begin the phased deregulation of wellhead prices. For the phase- out
period, the act established a pricing scheme that encouraged increased
natural gas production. Producer price deregulation was completed with the
Natural Gas Wellhead Decontrol Act of 1989, which mandated that federal
controls over natural gas producer prices end by 1993, when prices would be
freely set in the marketplace.

In response to the Natural Gas Policy Act of 1978, FERC reduced regulation
of natural gas supplies transported between intrastate and interstate
pipeline systems. According to FERC, this breaking down of barriers between
the intrastate and interstate markets accelerated a fundamental change in
the natural gas industry, leading to marketing natural gas as a commodity
distinct from its transportation. Additional changes have occurred in the
restructured natural gas marketplace as a result of FERC regulatory action
and other developments that are discussed later in this chapter.

The Public Utility Holding Company Act of 1935 (PUHCA) and the Federal Power
Act of 1935 established the basic framework for electric utility regulation
for over 40 years. 4 PUHCA was enacted to eliminate unfair practices by
large interstate electricity and natural gas holding companies, which
evolved and dominated the industry in the 1910s and 1920s, by requiring
federal control and regulation of these companies. In 1935, the

3 Phillips Petroleum v. Wisconsin, 347 U. S. 672 (1954). 4 PUHCA and the
Federal Power Act were enacted as part of the Public Utility Act of 1935.
FERC?s Legislative

Authorities for Electricity Regulation

Chapter 1: Introduction Page 17 GAO- 02- 656 Energy Markets

Federal Power Act created the Federal Power Commission, FERC?s predecessor,
and charged it with overseeing the rates, terms, and conditions of wholesale
sales and transmission of electric energy in interstate commerce by public
utilities.

This basic legislative framework for electricity went largely unchanged
until 1978 when, primarily in response to the oil embargoes and higher
energy prices of that time, the Congress passed laws to encourage the
development of alternative sources of power and energy efficiency. The
Public Utility Regulatory Policies Act of 1978 (PURPA) was enacted, in part,
to augment electric utility generation with more efficiently produced
electricity and conserve natural gas. The act required all utilities to buy
electricity produced by nonutility power production facilities, known as
?qualifying facilities.? To facilitate entry of these entities into the
electric generating market, the Congress exempted them from most regulation
under the Federal Power Act and PUHCA, but they had to meet specific
ownership and operating requirements. 5 More significantly, by opening
wholesale power markets to nonutility producers of electricity, PURPA laid
the groundwork for increased competition and a shift in the way that
wholesale electricity rates were set. Before implementation of PURPA,
wholesale interstate electricity prices were set by FERC on the basis of the
seller?s costs to generate and transmit the power- known as cost- ofservice
pricing. Subsequently, under PURPA, states set rates, pursuant to general
regulations enacted by FERC, for nonutility qualifying facilities (QF) based
on the buyer?s ?avoided? cost. 6 PURPA allowed these facilities to sell at
avoided cost rates because, unlike the utilities, these QFs did not have a
large enough market presence to be able to unduly influence prices.

Electricity regulation was significantly changed again with the passage of
the Energy Policy Act of 1992 (EPACT). EPACT created a new category of power
sellers called exempt wholesale generators (EWG) that are exempt

5 Qualifying facilities fit into one of two categories: (1) cogenerator
qualifying facilities, in which electric energy and another form of energy,
such as heat or steam, are produced sequentially using the same fuel source
and (2) small power producer qualifying facilities, in which at least 75
percent of energy source inputs are from renewable resources. Both
cogenerating and small power producing qualifying facilities cannot have
more than 50 percent of their equity interest held by an electric utility.

6 Avoided costs are the energy and facilities costs that would have been
incurred by the purchasing utility if that utility had to provide its own
generating capacity. According to FERC, while it certifies and provides
general avoided cost QF regulations, states set the QF rates that are often
above market rates.

Chapter 1: Introduction Page 18 GAO- 02- 656 Energy Markets

from FERC regulation under PUHCA. In addition, EPACT authorized FERC to
require utilities, on a case- by- case basis, to allow competitors to use
their transmission lines to sell wholesale electricity, setting the stage
for the open- access transmission that exists today. Unlike QFs, these EWGs
did not have to meet the same operating requirements, such as having to meet
cogeneration and renewable fuel limitations. In addition, utilities are not
required to purchase power from EWGs, as they are with QFs. By making it
easier for nonutility generators to enter the wholesale market for
electricity, EPACT not only expanded competition but also facilitated the
shift in how electricity prices were set, since utilities could purchase
electricity from EWGs at market- based rates, traditional cost- ofservice
prices, or a combination of both.

For the electric power industry, FERC does not have legislative authority
over electricity generation, construction of transmission lines, intrastate
transmission, or retail sales, all of which fall under state or local
jurisdiction. FERC also has no direct authority over system reliability-
that is, ensuring that consumers can obtain electricity from the system
when, and in the amount, they want. This reliability has largely been the
responsibility of electric utilities, and, since its creation in 1965, of
the North American Electric Reliability Council and member organizations.
Currently, an estimated 30 voluntary utility groups are working to improve
reliability. Adherence to the standards established by these groups is
largely voluntary and therefore subject to the willingness of the utilities
to comply.

Furthermore, FERC?s jurisdiction extends primarily to investor- owned
utilities. FERC does not have jurisdiction over federally owned utilities, 7
publicly owned utilities, or most cooperatively owned utilities. 8 These

7 Although the commission has jurisdiction under sections 211 and 212 of the
Federal Power Act to order federally owned utilities to provide transmission
in certain circumstances, this jurisdiction is limited. The commission also
has limited authority to approve the Bonneville Power Administration?s power
and transmission rates and, by delegation from the Secretary of Energy, to
review the rates charged by other power marketing administrations.

8 There are nine federal electric utilities: Tennessee Valley Authority,
Bonneville Power Administration, Western Area Power Administration,
Southwestern Power Administration, Southeastern Power Administration, U. S.
Army Corps of Engineers, U. S. Bureau of Reclamation, U. S. Bureau of Indian
Affairs, and the International Water and Boundary Commission. Publicly owned
utilities include municipal authorities, state authorities, public power
districts, and irrigation districts. Cooperatively owned utilities are
formed and owned by groups of residents, often in rural areas, and provide
service mostly to members.

Chapter 1: Introduction Page 19 GAO- 02- 656 Energy Markets

nonjurisdictional utilities own 27 percent of the U. S. electric
transmission system (see fig. 3).

Figure 3: Transmission Ownership in the United States

Source: Energy Information Administration, The Changing Structure of the
Electric Power Industry 2000: An Update, DOE/ EIA- 0562( 00) (Washington, D.
C.: October 2000).

For almost a century, the energy industries were regulated as natural
monopolies and the entry, prices, and profits of industry participants were
controlled. However, during the last 25 years, because of technological and
economic developments, these industries, along with other regulated
industries such as telecommunications, airlines, and banking, have come
under pressure to restructure and move toward greater reliance on
competition rather than regulation. A key expectation for restructuring
these industries from a regulated environment to competition- based markets
was that it would result in improved efficiencies that, in turn, would lead
to lower costs and ultimately lower prices for consumers. About two decades
ago, the natural gas industry began restructuring. Currently, the focus is
on the electricity industry. The Nation?s Natural

Gas and Electricity Industries Are Evolving

Chapter 1: Introduction Page 20 GAO- 02- 656 Energy Markets

The U. S. natural gas industry has evolved from a collection of regulated
monopolies to a national system of producers; pipeline, storage, and local
distribution companies; marketers; and consumers. In the past two decades
since the Congress passed the Natural Gas Policy Act of 1978 to deregulate
federal controls over wellhead prices, FERC has issued orders to encourage
further competition in the industry. The result of these orders is that the
natural gas industry?s restructuring is several years ahead of that of the
electricity industry.

FERC issued a series of orders during the 1980s and early 1990s to address
what it believed was the biggest obstacle to competitive natural gas
markets: the inability of natural gas users to gain access through the
pipeline systems to competitive natural gas suppliers. These orders- the
most notable of which were Orders 436 and 636- opened pipeline
transportation to natural gas producers, suppliers, and users on equal terms
and eventually resulted in interstate pipeline companies relinquishing their
traditional merchant function. FERC issued Order 436 in 1985 to institute
open- access, nondiscriminatory pipeline transportation. As a result,
natural gas users could buy directly from natural gas merchants in the
production area and ship that gas via the interstate pipelines. The pipeline
companies could still make bundled sales of the natural gas and its
transportation and storage to local distribution companies. Order 636, which
was issued in 1992, required the pipeline companies to completely separate
or ?unbundle? their transportation, storage, and sales services. As a
result, natural gas as a commodity was decoupled from gas transportation.
Pipeline companies were required to treat other parties wishing to use the
pipeline to transport natural gas the same as they would their own
affiliated sales services, if they continued to have any. Order 636 also
allowed shippers to release to other shippers unneeded pipeline
transportation capacity, on either a temporary or a permanent basis, leading
to the creation of a secondary capacity market designed to compete with the
primary pipeline market.

As a result of this restructuring, producers sell natural gas to a variety
of consumers, as well as to brokers/ traders and resellers of natural gas.
With the removal of federal price controls, producers? prices are determined
in the marketplace. In addition, natural gas that is ultimately sold to
consumers moves via the pipelines under a variety of contractual
arrangements. Natural gas may be sold under contract or on the spot market,
where an owner auctions a package of natural gas at a specific location for
the price prevailing at that time and place. Buyers and sellers arrange for
pipeline capacity to transport their natural gas to market. The purchaser
pays the pipeline company for transportation and may also The Natural Gas
Industry

Has Substantially Restructured

Chapter 1: Introduction Page 21 GAO- 02- 656 Energy Markets

contract for ancillary services, such as storage, en route. In some
transactions, pipeline companies deliver natural gas to customers located
directly along the pipeline right- of- way or near enough to a customerowned
pipeline. In other cases, natural gas is delivered to a local distribution
company from the pipeline drop- off point, often referred to as the ?city
gate.? The local distribution company operates an intrastate utility
regulated by the state public utility commission that delivers natural gas
from the city gate to residential, commercial, and industrial users along
its route. For residential users, the local distribution company usually
purchases the natural gas for resale to them. For commercial and industrial
users, the local distribution company is usually delivering natural gas that
the users have purchased directly from producers. However, generally
speaking, commercial and industrial customers may also choose to buy natural
gas from the local distribution company.

For competitive markets, the wholesale price of natural gas sold in
interstate commerce is generally determined by the marketplace, subject to
FERC?s review to ensure that the rates are just and reasonable. For
pipelines without competition, FERC sets the rates using the traditional
cost- of- service regulatory format.

Natural gas pricing is becoming increasingly complex. One outgrowth of
FERC?s orders was the creation of new market centers to provide central
pipeline interconnections where individuals and companies could come
together to buy and sell natural gas. Today, natural gas prices are set at
dozens of distribution ?hubs? and at 16 city gates. For example, spotmarket
prices are set for the Henry Hub, a distribution center for natural gas, in
Louisiana. In 1990, futures contracts for natural gas delivered at the Henry
Hub were first traded on the New York Mercantile Exchange (NYMEX). 9 Since
then, NYMEX has created contracts for swapping natural gas at other hubs
with gas priced at the Henry Hub. Options contracts are

9 A futures contract is a risk management tool used in agricultural, metal,
and energy commodities markets designed to manage the risk of price changes.

Chapter 1: Introduction Page 22 GAO- 02- 656 Energy Markets

traded on the price spread of Henry Hub gas between different delivery
dates. 10

Another development is the natural gas industry?s increasing convergence
with the electricity industry. As restructuring of the electricity industry
takes place and natural gas has become a major fuel for generating
electricity, electric power producers are buying interests in natural gas
reserves and/ or pipelines as a way to ensure gas supplies for electricity
generation. In addition, natural gas producers, pipeline companies, and
marketers are also buying interests in the electricity industry, such as in
electric power generating plants. The growing complexity and intertwining of
these industries further complicates the regulation and oversight of these
markets.

When the Federal Power Act was enacted in 1935, the fundamental structure of
the electricity industry was based on ?vertically integrated? electric
utilities, which were single entities that owned generation, transmission,
and distribution facilities and sold electricity as part of a ?bundled?
service to wholesale and retail customers within their geographic area. Most
electric utilities built their own power plants and transmission systems,
entering into interconnection arrangements with neighboring utilities.
Because the utilities operated as monopolies, wholesale and retail
electricity pricing was regulated. Rates were derived from a utility?s costs
plus a fair rate of return on the utility?s investment.

As previously described, this industry arrangement of tightly regulated,
vertically integrated monopolies and cost- of- service pricing continued
relatively unaffected until the late 1970s when the enactment of PURPA began
the transition to a more competitive format in which generators of
electricity compete for customers and prices are established by the market.
In the 1970s, rapid price increases in some parts of the country and
significant technological changes in power generation led the Congress to
pass PURPA, which requires utilities to purchase power from

10 Options contracts are unilateral contracts that give buyers and sellers
the right to buy or sell a specified quantity of a commodity at a specific
price within a specified period of time, regardless of the market price of
that commodity. On publicly regulated exchanges such as NYMEX, buyers and
sellers are revealed once the transaction is complete. This is different
from sales made in nonregulated forums, such as ?over- the- counter? or in
Internet markets, where the parties are known only to one another or to
Internet- service subscribers and the market?s operators. These over- the-
counter prices (but not the buyers and sellers) are aggregated and reported
the next day in the energy trade press. The Electricity Industry Is

Changing Significantly

Chapter 1: Introduction Page 23 GAO- 02- 656 Energy Markets

qualifying facilities and to sell them backup power. As nontraditional power
producers, such as qualifying facilities, began to compete in electricity
markets, FERC encouraged these new entities by authorizing market- based
rates for their electric power sales on a case- by- case basis.

The Energy Policy Act of 1992 authorized FERC to require utilities, on a
case- by- case basis, to provide other wholesale buyers and sellers access
to their transmission lines and created exempt wholesale generators to
further compete with the utilities. FERC began to require utilities to open
access to their transmission lines as a condition of approving utility
mergers or market- based rates for their power sales. Since the late 1980s,
FERC has approved more than 850 applications to sell power competitively in
wholesale markets.

In April 1996, FERC issued Orders 888 and 889, opening the transmission
systems of public utilities to all qualified wholesale buyers and sellers of
electricity. Commonly known as the ?open access rule,? Order 888 required
that transmission line owners offer other transmission users point- to-
point and network transmission services under comparable terms and
conditions that they provide for themselves. The vertically integrated
nature of utilities in the past had not allowed independent power suppliers
equal access to transmission systems. By limiting the extent to which
independent power suppliers could provide service to electricity customers,
growth of competitive power generation markets had been hindered. Order 888
also required that utilities ?functionally unbundle? their generation and
transmission businesses to prevent favoritism and discriminatory practices
in providing transmission services, such as not allowing competitors equal
access to transmission lines. This was accomplished by requiring utilities
to separate their transmission service functions from other business
activities. Order 888 also encouraged utilities to form independent system
operators (ISO), 11 to which they could transfer operating control (but not
ownership) of their transmission facilities. This could be one solution to
the unbundling requirement

11 An ISO is an entity encouraged by FERC to manage the transmission system
as the electric industry in the United States is restructured. An ISO is to
control the power system or grid without special interest, and is to own no
generation, transmission or load. Therefore, the ISO is intended to run the
system fairly, for the benefit of all market participants.

Chapter 1: Introduction Page 24 GAO- 02- 656 Energy Markets

contained in the order. Since Order 888 was issued, six ISOs have been
formed and are now operating. 12

To effectively ensure nondiscriminatory access to the transmission system,
up- to- date information about transmission must be unrestricted and public
to all transmission users. To meet this need, FERC issued Order 889
requiring all investor- owned utilities to participate in the Open Access
Same- Time Information System (OASIS). OASIS is an interactive Internetbased
database containing information on available transmission capacity, capacity
reservations, and transmission prices. By providing timely access to all
qualified users regarding transmission market information, the goal of OASIS
was to facilitate the functioning of competitive electricity markets.

In December 1999, FERC issued Order 2000, which asked all transmissionowning
utilities, including nonpublic utilities, to voluntarily place their
transmission facilities under the control of an appropriate regional
transmission organization (RTO). ISOs created under Order 888 would be
supplanted by larger RTOs covering the entire nation. FERC?s thinking
underlying RTOs is that the nation?s transmission systems should be brought
under regional control in order to eliminate the remaining discriminatory
practices in use, better meet the increasing demands placed on the
transmission system, improve management of system congestion and
reliability, and achieve fully competitive wholesale power markets. Order
2000 does not specifically require RTO participation; however, if a utility
opts not to join an RTO, it is required to prove why doing so would harm it.

Since issuing Order 2000, FERC has taken a more aggressive stance on
developing RTOs. For example, on July 12, 2001, FERC issued several orders
requiring utilities to enter into discussions to form four large RTOs
covering the continental United States. FERC subsequently issued an order on
November 7, 2001, that reiterated FERC?s goals and process for

12 These ISOs are California ISO; ISO New England; Midwest ISO; New York
ISO; Pennsylvania, New Jersey, Maryland (PJM) ISO; and Electric Reliability
Council of Texas (ERCOT) ISO. FERC approved the Midwest ISO as the first
regional transmission organization in December 2001. ERCOT established an
ISO in 1996 to satisfy the requirements of the Public Utility Commission of
Texas for deregulating the wholesale electricity market in the state. The
wholesale market in the ERCOT region is basically isolated from other U. S.
markets because its power grid or transmission system has only minor
connections to other U. S. transmission systems. FERC has limited
jurisdiction over the region because the ERCOT market is essentially
intrastate.

Chapter 1: Introduction Page 25 GAO- 02- 656 Energy Markets

creating RTOs. FERC approved the formation of the first RTO- to include the
Midwest ISO- on December 20, 2001. This RTO will operate in some 20 states,
stretching from New Mexico to the Canadian province of Manitoba. FERC also
encouraged another group, the Alliance Companies, to explore joining the
Midwest RTO, potentially expanding its scope even further. To address state
and industry concerns regarding the merits of forming RTOs, FERC
commissioned a study to examine their potential economic costs and benefits.
This study, released on February 26, 2002, found that substantial economic
benefits, from $1 billion to $10 billion per year, could result from
instituting RTOs. However, the study found only minor differences in savings
between larger and smaller RTOs.

FERC is also developing a notice of proposed rulemaking to provide a
standardized market design for all electric transmission providers. In
October 2001, FERC held workshops to discuss core issues related to RTO
development, including market monitoring, reliability standards, and market
design and structure. FERC subsequently held technical conferences relating
to market design for wholesale electric power markets, as well as how
responsibility for performing wholesale market functions would be allocated
within an RTO region.

With the restructuring that has taken place and FERC?s approval of market-
based rates for electricity sales, the industry has experienced a
significant change in the way power is sold across state lines. Four ISOs-
California; Pennsylvania, New Jersey, Maryland; New York; and New England-
are currently operating centralized power markets where electricity
suppliers submit bids to sell power in regional markets. In these markets,
the ISO evaluates the bids and selects the most economical bid to meet
energy demand in the region. Another recent development outside of these
markets is electricity trading hubs. A hub is a location on the power grid
representing a delivery point where power is sold and ownership changes
hands. Although each control area on the power grid could become a trading
hub, only a few hubs account for the bulk of power trading. Development of
electricity futures contracts at NYMEX and the Chicago Board of Trade has
contributed to the emergence of these hubs. (See fig. 4 for these major hubs
and centralized power markets.)

Chapter 1: Introduction Page 26 GAO- 02- 656 Energy Markets

Figure 4: Major Wholesale Electricity Trading Hubs and Centralized Power
Markets

Note: Power trading also occurs at locations not indicated on the map. NYMEX
has established electricity futures contracts for the Cinergy, COB, Entergy,
Palo Verde, and PJM trading hubs. The Chicago Board of Trade has established
electricity futures contracts for the ComEd and TVA trading hubs.

Source: Energy Information Administration, The Changing Structure of the
Electric Power Industry 2000: An Update, DOE/ EIA- 0562( 00) (Washington, D.
C.: October 2000).

Finally, development of Internet- based trading systems, such as
EnronOnline, Dynegydirect, and Intercontinental Exchange, has further
changed the way in which electric power is sold. These systems provide a
platform for both physical energy (electricity and natural gas products) and
energy derivatives to be bought and sold. 13

Table 1 describes the major events and milestones that have occurred during
the restructuring of the natural gas and electricity industries.

13 Derivatives are financial instruments based on the value of one or more
underlying stocks, bonds, commodities, or other items, such as contracts for
future natural gas sale or distribution. Derivatives involve the trading of
rights or obligations based on the underlying product but do not directly
transfer property.

Chapter 1: Introduction Page 27 GAO- 02- 656 Energy Markets

Table 1: Major Events and Milestones in Restructuring the Natural Gas and
Electricity Industries Event Natural gas industry Electric industry

Early steps toward competition Some large consumers in the interstate market
started purchasing gas and pipeline transportation separately- mid 1970s.

Utilities file FERC rates with ?up to? cost based formulas- early 1980s.
Public Utility Regulatory Policies Act mandates purchases from qualifying
facilities- 1978. Exceptions to cost- of- services rates Natural Gas Policy
Act gradually removes

some natural gas price ceilings- 1978. PURPA exempted qualifying facilities
from cost- of- service regulation. FERC recognizes competitive bidding for
new capacity- 1988. Transmission access proposed to dampen anticompetitive
behavior and encourage competition

FERC encourages pipelines to provide open- access transportation- 1985. FERC
initiates transmission access

conditions for market- priced power sales- 1990. Energy Policy Act
authorizes FERC to order transmission access to encourage competition- 1992.
Standards to mitigate monopoly control in transmission announced Order 636
issued in 1992:

 Comparable transmission and storage open- access required.

 Functional unbundling of product and transportation sales required.

 Pipeline companies allowed to make market- priced gas sales through
affiliates.

 Firm transportation customers get flexible receipt and delivery points.

Orders 888 and 889 issued in 1996:

 Nondiscriminatory, comparable open access required.

 Functional unbundling generation and transmission businesses.

 Investor- owned utilities required to participate in OASIS. Order 2000
issued in 1999:

 Transmission owning utilities encouraged to place transmission facilities
under the control of RTO. Access to information to support market functions
Trade press publishes spot gas prices-

1989. FERC mandates individual pipeline electronic bulletin boards- 1992.
FERC mandates standardized Internet communication protocol- 1997.

Market- based pricing includes requirements for electronic bulletin boards-
1992. Energy Policy Act requires public capacity reporting- 1992. FERC
orders OASIS- 1996. Market characteristics evolve Company consolidation
starts- mid 1980s.

Product markets active; prices transparent- 1987. Gas marketing evolves as
an unregulated industry- 1987. NYMEX futures contract for Henry Hub gas-
1990. Robust market centers/ hubs for physical trade- 1993. Futures markets
mature with large consumer access to transportation available in most
states- 1994. Internet trading of gas and transmission rights- 1999.

Company consolidation starts- late 1980s. Spot and forward markets still
largely restricted to utilities- 1995. Neither transportation nor product
prices are transparent yet- 1995. Development of a futures market hindered
by a lack of a standardized spot market for benchmarking. New entrants are
trying to find/ produce niches. Innovators hope to combine gas and electric
market instruments for added value- 1995.

Source: Adapted by GAO from Energy Information Administration, Restructuring
Energy Industries: Lessons from Natural Gas, Natural Gas Monthly
(Washington, D. C.: May 1997).

Chapter 1: Introduction Page 28 GAO- 02- 656 Energy Markets

The Chairman of the Senate Committee on Governmental Affairs and Senator
Carnahan asked us to determine how FERC has revised its approach to
regulating and overseeing the natural gas and electricity industries in
response to the transition to more competitive markets and identify the
major management challenges that FERC faces to effectively regulate and
oversee these competitive markets.

To address both these objectives, we reviewed pertinent documents and
obtained information and views from a wide range of FERC officials and
stakeholder representatives. We obtained information and views from FERC and
stakeholder representatives through a variety of means, including interviews
and surveys. We interviewed the Chairman of FERC and the other current
Commissioners, as well as three former Commissioners/ Chairs who served at
FERC within the past 5 years. In OMTR, we interviewed all the managers at
the division head level and above, including the director and deputy
director of the office. We also interviewed the group managers of the
office?s Divisions of Market Development and Market Information. For the
Office of the General Counsel, we interviewed the general counsel, deputy
general counsel, and the lead counsels for the Market Oversight and
Enforcement section and the Markets, Tariffs, and Rates section. The two
sections directed by these lead councils advise OMTR and the Commissioners
on regulation of the natural gas and electric industries. In addition, we
interviewed the team leaders and various members of the joint OMTR and
Office of the General Counsel teams that FERC formed in 2000 to review the
nation?s wholesale electricity (bulk power) markets. Furthermore, we
interviewed the deputy director for FERC?s Office of Strategy and
Organizational Management and the agency?s director for human resources
management.

In addition to our interviews, we conducted a survey of the staff in OMTR,
and staff in the Office of the General Counsel?s sections for Markets,
Tariffs, and Rates and Market Oversight and Enforcement, up to and including
those at the division or section director level. The survey was conducted
using a self- administered electronic questionnaire posted on the World Wide
Web. We sent e- mail notifications to 384 FERC staff beginning on December
14, 2001. We then sent each employee who was surveyed a unique password by
e- mail to ensure that only members of the target population could
participate in our survey. We closed the survey on February 8, 2002, having
received a total of 271 responses, for an overall response rate of 71
percent. A copy of this survey with the quantitative results can be found in
appendix II. Objectives, Scope,

and Methodology

Chapter 1: Introduction Page 29 GAO- 02- 656 Energy Markets

The practical difficulties of conducting surveys may introduce errors into
the results. Although we administered our survey to all known members of the
population of employees, and thus our results are not subject to sampling
error, nonresponse to the entire survey or individual questions can
introduce a similar type of variability or bias into our results- to the
extent that those not responding differ from those who do respond in how
they would have answered our survey questions. We took steps in the design,
data collection, and analysis phases of our survey to minimize population
coverage, measurement, and data- processing errors, such as checking our
population lists against known totals of employees, pretesting and expert
review of questionnaire questions, and follow- up with those not reachable
at original addresses or otherwise not immediately responding.

We also spoke with representatives of a wide range of FERC stakeholders,
including the National Energy Marketers Association, the National
Association of Regulatory Utility Commissioners, the Electric Power Supply
Association, and the American Public Gas Association. In addition, we
interviewed representatives, primarily from the market monitoring units, of
the New York ISO, ISO New England, the California ISO, and PJM ISO. We did
not interview representatives of the Midwest ISO because it had just begun
operations toward the end of our review. Furthermore, we visited three major
energy trading companies to discuss the information they use in making
energy trades.

We also surveyed the chairs of the state regulatory commissions or boards
from 48 states and the District of Columbia via e- mail to ask them for
comments, from their states? perspective, on FERC?s regulation and oversight
of the natural gas and electricity industries. 14 The initial e- mail was
sent on November 15, 2001, with a follow- up reminder sent on December 10,
2001. The final deadline for submissions was December 21, 2001. We received
responses from 30 of the 49 state commissions or boards surveyed.

In addition, we reviewed laws and regulations pertaining to FERC?s
responsibilities for regulating and overseeing the natural gas and
electricity industries. We reviewed pertinent FERC documents, including
annual reports; budget requests; strategic and annual performance plans;

14 We did not survey Hawaii, where FERC does not have regulatory
jurisdiction, nor did we survey Nebraska, where no state regulatory body
exists.

Chapter 1: Introduction Page 30 GAO- 02- 656 Energy Markets

orders; case filings; studies; reports; human capital analyses; speeches and
congressional testimony by FERC Chairmen, Commissioners, and other
officials; and staff research papers. We also reviewed appropriate documents
from outside sources, including the Department of Energy?s Energy
Information Administration, the North American Electric Reliability Council,
the Congressional Research Service, ISOs, academia, and other natural gas
and electricity industry experts. Furthermore, we drew on our prior work in
the areas of electricity, natural gas, and human capital management.

We conducted our work from June 2001 through April 2002 in accordance with
generally accepted government auditing standards.

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 31 GAO- 02- 656 Energy Markets

FERC has recognized, since the early 1990s, that it needs to change its
approach for regulating and overseeing the natural gas and electricity
industries in response to their evolution from regulated monopolies to
competitive markets. However, FERC has struggled to define and implement a
comprehensive regulatory and oversight approach, and its efforts to monitor
these markets, to date, have been incomplete or of limited effectiveness.
Moreover, the agency?s outdated legislative framework and frequent
leadership changes over the last few years have contributed to further
limiting its progress in developing and implementing an effective approach.

For nearly a decade, FERC has recognized that it needs a new approach for
regulating and overseeing the emerging competitive energy markets. With the
evolution to market- based rates for natural gas and electricity, FERC has
concluded that its approach to ensuring just and reasonable prices needs to
change: from one of reviewing individual companies? rate requests and
supporting cost data to one of proactively monitoring energy markets to
ensure that they are working well to produce competitive prices. From 1994
to the present, the need for this change has been a reoccurring theme in a
variety of key FERC documents, such as its annual budget requests, strategic
plans, and performance reports.

For example, we found that as early as February 1994, in its fiscal year
1995 budget request to the Congress, FERC stated that the centerpiece of its
strategy for the natural gas and electricity industries was to encourage
competitive market processes wherever appropriate. In this document FERC
noted that while competitive forces could benefit energy customers all over
the country, harnessing the benefits of competition without allowing abuses
of market power required many regulatory innovations, including many new
approaches to oversight. FERC concluded that the electricity industry would
see significant changes under the Energy Policy Act of 1992, largely through
increasing competition among electric power producers and more open
transmission access, and that these changes would inevitably require new
long- term policy development as well.

The need for a new regulatory and oversight approach has been reiterated by
FERC throughout the last several years in a variety of other key documents,
such as the following: Chapter 2: FERC Has Not Yet Defined and

Implemented an Effective Approach to Monitor Competitive Energy Markets

FERC Recognizes That It Needs a New Approach for Competitive Energy Markets

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 32 GAO- 02- 656 Energy Markets

 In its fiscal year 1996 budget request, dated February 1995, FERC stated
that its goal was to find ways to regulate natural gas and electric
utilities effectively in order to protect consumers while working with
competitive commodity markets. FERC stated that it expected to continue the
shift in emphasis away from its traditional routine casework of reviewing
companies? rate filings and more toward monitoring and compliance. It stated
that increasingly, its approach to regulation would be to monitor the
industries it regulates and act only when there is a clear need to do so.

 In its first strategic plan for fiscal years 1997 through 2002, issued in
September 1997, FERC again stated that, at the most basic level, the agency
was moving away from a traditional command and control approach of setting
individual companies? rates to economic regulation. 1 The plan anticipated
the need to respond to the evolving natural gas and electric power
industries with increased flexibility and speed. FERC placed particular
importance on the convergence of the natural gas and electric industries and
on the need to coordinate with other federal agencies and states. The plan
also noted that as the need for regulation in the industries changed, the
agency must change to respond in ?real time? to these needs.

 In its State of the Agency report for fiscal year 2000, 2 FERC noted that
like all regulatory agencies, it faced uncertainty about its resources and
its future mission. The report concluded that to ensure consumer confidence
in competitive energy markets, FERC must adapt the way it does business to
address the real- time needs of market participants and changing market
dynamics, while still maintaining the integrity of its regulatory functions.

 In its most recent budget request for fiscal year 2003, dated February
2002, FERC again stated that it needs a much stronger ability to recognize
and respond to problems in the markets. FERC further stated that it needs to
recognize problems when or before they happen and craft solutions

1 The Government Performance and Results Act of 1993 required almost all
federal agencies to, among other things, develop strategic plans covering a
period of at least 5 years. These strategic plans were to include the
agency?s mission statement, long- term general goals, and the strategies
that the agencies will use to achieve these goals. Agencies were to submit
their first strategic plans to the Office of Management and Budget and the
Congress by September 30, 1997.

2 Federal Energy Regulatory Commission, First Annual State of the Agency
Report, Fiscal Year 2000 (Washington, D. C.: October 2000). FERC has not
issued similar reports for subsequent fiscal years.

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 33 GAO- 02- 656 Energy Markets

quickly and also be able to police individual behavior in markets much more
effectively than in the past.

Despite its long- standing awareness of the need for a new regulatory
approach, FERC has struggled to define the specific strategies, information,
processes, and activities that it will use to regulate and oversee
competitive energy markets. Various planning and reengineering initiatives
that FERC has recently undertaken have not been successful in defining and
implementing a comprehensive approach for these markets. Moreover, while
California?s energy problems in 2000 provided a ?wake up call? for the
agency and the impetus for a greater focus on market oversight functions,
they also delayed the agency?s efforts to establish an effective market
oversight program by diverting substantial management attention and
resources.

FERC?s strategic planning process helped lay the groundwork for the agency
to begin revising its regulatory and oversight approach. However, the
process has not produced the specific goals, strategies, and milestones to
effectively make the change. FERC first issued its strategic plan in
September 1997, and has since revised it twice, once in September 2000 and
again in September 2001. The overall direction of the strategic or general
goals and objectives set out for natural gas and electricity in these
versions has essentially remained the same. Although the 2001 version of the
plan provides greater and more explicit focus on FERC?s oversight and
monitoring of the markets than earlier versions, it still lacks key details
on how the strategic goals and objectives will be accomplished and how
progress in achieving them will be assessed.

An agency?s statement of its mission is a critical element of its strategic
plan. It is intended to bring the agency into focus, explain why the agency
exists, and tell what it does. FERC?s mission statement has only very
recently explicitly recognized oversight of the energy industries as an
important part of its mission. The mission statement in FERC?s 1997 version
of its strategic plan essentially stated that the agency regulates the
energy industries to ensure that the rates, terms, and conditions of service
for the industries are just and reasonable. The 2000 version of the mission
statement provided a more direct focus on markets by stating that the
agency, in regulating key interstate aspects of the energy industries,
chooses regulatory approaches that foster competitive markets whenever
possible and ensures access to reliable service at a reasonable price.
However, it did not explicitly mention oversight of the industries or
markets. The 2001 version does not refer to competitive markets but FERC Has
Struggled

to Define and Implement a New Approach

FERC?s Strategic Planning Process Has Not Provided the Goals, Strategies,
and Milestones to Implement a New Approach

FERC Has Been Slow to Explicitly Incorporate Energy Market Oversight into
Its Mission Statement

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 34 GAO- 02- 656 Energy Markets

instead states that FERC?s mission is to regulate and oversee the energy
industries in the economic and environmental interest of the American
public. (See table 2.) According to FERC, ?[ t] he California crisis showed
that the need for good oversight and investigation is not only important but
also far more urgent than we (or most others) had fully understood.?

Table 2: FERC?s Statement of Its Mission in the 1997, 2000, and 2001
Versions of Its Strategic Plan

Version Mission statement

1997 The Commission regulates, in the public interest, essential aspects of
four of the nation?s critical energy industries: electric power transmission
and sales for resale, natural gas transportation and sales for resale, oil
pipeline transportation, and nonfederal hydroelectric power. The Commission
ensures that the rates, terms, and conditions of service for the electric
power, natural gas, and oil industries are just and reasonable and not
unduly discriminatory or preferential, and that licensing, administration,
and safety actions for the hydropower industry and other approvals for all
four industries are consistent with the public interest. 2000 The Commission
regulates key interstate aspects of the electric power,

natural gas, oil pipeline and hydroelectric industries. The Commission
chooses regulatory approaches that foster competitive markets whenever
possible, assures access to reliable service at a reasonable price, and
gives full and fair consideration to environmental and community impacts in
assessing the public interest of energy projects. 2001 The Federal Energy
Regulatory Commission regulates and oversees energy

industries in the economic and environmental interest of the American
public.

The goals and objectives that FERC has set out in the initial versions of
its strategic plan have focused more on efforts to foster the development of
competitive markets than on their oversight. For example, the 1997 version
of the plan contained no strategic goals and one strategic objective
specifically addressing oversight of market rules and behavior. (See app. I
for FERC?s principal strategic goals and objectives relating to energy
markets.) That objective- for constraining market power- states that market
participants will have confidence that natural gas markets, electric
markets, and all transportation services are working efficiently and fairly
and that market participants are not subject to abuses of market power. The
plan stated that FERC would monitor the electric utilities and assess
whether they can exercise market power that could adversely affect wholesale
electric prices. In addition, FERC would respond appropriately to market
power issues in the context of market- based pricing and in reviewing the
effects of mergers on competition. However, the plan offered no details
about how FERC would monitor energy markets beyond FERC?s Strategic Goals
and

Objectives Have Focused More on Market Development Than Market Oversight

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 35 GAO- 02- 656 Energy Markets

its approval of individual companies to sell electricity at market- based
rates and review of proposed mergers of energy companies.

Similarly, FERC?s 2000 version of its strategic plan contained one goal for
energy markets. That goal- to benefit consumers by providing a fair, open,
and efficient regulatory foundation for competition- had four objectives. As
with the 1997 version of the plan, one objective was to constrain market
power. In addition, monitoring energy markets was included as a subobjective
under the general objective to nurture competitive market institutions. FERC
stated that it must be able to monitor markets so that it can follow events,
such as significant price spikes, and react appropriately. To fulfill its
market monitoring strategy, the plan stated that FERC would (1) develop up-
to- date, flexible information systems, (2) use investigations and audits as
valuable market monitoring tools, and (3) begin to publish an annual report
on the state of the markets. According to the plan, to constrain market
power, FERC would detect and respond to all forms of market power and use
enforcement and litigation as necessary to remedy anticompetitive behavior.
The plan also stated that market monitoring could help FERC detect potential
or actual market power abuse and that FERC would try to limit operations of
existing and emerging entities that may possess market power. Although the
2000 version provides more results- oriented goals and objectives and a
greater elaboration of strategies than the 1997 version, it does not provide
the details and measures to allow the agency and the Congress to assess
whether the goals and objectives were achieved and the strategies were
effective.

Only recently, in its 2001 revision, has FERC increased the strategic plan?s
emphasis on market oversight and improved its description of the strategies
that will be used to achieve the goals and objectives. 3 The Chairman of
FERC told us that making competitive energy markets work well depends on (1)
an adequate delivery or transmission infrastructure to ensure that
sufficient supplies of energy are available to create an environment where
competition can succeed, (2) a market structure and market rules that ensure
competition, and (3) effective oversight to identify market structures and
rules that do not work well and market participants that engage in
anticompetitive actions. The Chairman said that when he arrived at FERC in
the summer of 2001, he found that FERC

3 FERC?s 2001 revision was not a complete update of the strategic plan
document. Instead, new strategic goals and objectives were developed and
made available on FERC?s Internet Web site, and the agency?s fiscal year
2003 budget request provides information on the new strategic goals and
objectives and the strategies to achieve them.

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 36 GAO- 02- 656 Energy Markets

had been working on the first two items- the infrastructure and the market
structure and rules- but was doing little in the way of effective market
oversight. As a result, he revised the strategic plan to provide a balanced
approach that covers all three factors.

While the 2001 version provides more information than earlier versions on
the strategies to be used to achieve the agency?s goals and objectives, the
plan still provides few details on how FERC will work with market
participants to accomplish the goals and objectives. The plan also does not
have quantifiable outcome measures that can be used to assess FERC?s
progress in achieving the goals and objectives over the period of the plan.
For example, to protect consumers, the plan states that FERC will detect
abuses of market power quickly. To do this, FERC will pay close attention to
complaints as it receives them and will also develop its analytical
capabilities. However, there is no information on what new actions FERC will
take to pay close attention to the complaints or what actions it will take
to develop its analytical capabilities. There are also no quantifiable
outcome measures to evaluate FERC?s success in achieving this goal and its
related objectives.

In December 1997, FERC launched a major management review and reengineering
project, referred to as ?FERC First.? According to FERC documents, the
project was undertaken as a result of the 1997 strategic planning process,
during which the agency concluded that it would have to move away from
traditional command and control approaches and move toward economic
regulation of the evolving energy markets. The project was to assess the
external influences affecting the agency?s operations, as well as the
adequacy of the agency?s processes, employee development practices,
information technology infrastructure, communication, and other business
practices. According to FERC, the project?s costs from February 2, 1998, to
March 31, 2000, totaled $20.1 million, including about $7.5 million in
agency personnel costs and about $7.7 million for the two principal
consulting firms that it used.

FERC First resulted in a number of changes, including the following:  a new
organizational structure for the agency, including the creation of the

Office of Markets, Tariffs and Rates (OMTR) to focus on energy markets;  a
formal process for strategic planning and management with a focus on

energy markets, energy projects, and the management services needed to
support them; FERC?s Major

Reengineering Project Did Not Address Fundamental Oversight Issues

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 37 GAO- 02- 656 Energy Markets

 the combination of responsibilities and personnel for natural gas and
electricity to reflect the convergence under way in these industries;

 the modification of work processes to minimize hand- offs from one person
to another and one office to another, reduce the number of reviews, and
integrate them with information technology;

 the increased use of teaming of staff, within and across groups, to
perform the agency?s work; and

 new criteria for selecting and training managers that emphasized
leadership qualities over technical expertise.

Although well intentioned, FERC First is generally considered by most FERC
employees that we contacted to have failed in achieving its objectives. For
example, 74 percent of the employees responding to our survey believed that
FERC First had improved the agency?s ability to effectively monitor or
regulate energy markets to little or no extent. In contrast, 4 percent of
those responding said that it improved FERC?s ability to a great or very
great extent. Furthermore, 80 percent of them believed that FERC First had
improved their ability to perform their job duties to little or no extent.
In contrast, 6 percent of those responding said it improved their ability to
a great or very great extent. While many employees that we contacted told us
that overall FERC First was a failure, several stated that it was a
?disaster.? Common concerns cited by employees included (1) the project took
too long and diverted too many agency resources for the limited number of
changes that resulted and (2) it made the agency less effective rather than
more effective.

Moreover, FERC First did not bring about the fundamental changes needed to
implement a new regulatory and oversight approach for competitive energy
markets. For example, although FERC First established OMTR to give more
priority to developing and monitoring competitive energy markets, OMTR has
had difficulty defining the specific strategies, information, processes, and
activities that it will use to oversee these markets. In October 1999, the
director of OMTR said ?[ w] e have to decide what we want to do with
markets, how much resources we want to devote to the different views, what
information will we need from outside the building to do our job, what type
of IT [information technology] hardware and software will we need to do
that, what type of skill sets of people will we need.? In August 2000, when
FERC hired a director for OMTR?s Division of Energy Markets, these details
had still not been determined. At that time, the California energy problem
had occurred and,

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 38 GAO- 02- 656 Energy Markets

according to FERC officials, the Markets Division devoted most of its
attention and resources to responding to the California problem over the
next year.

California?s energy problems in 2000 forcefully demonstrated what could
result when markets do not work as intended. Ironically, while the
California problem was, in the words of several FERC officials, a ?wake up
call? for the agency, it also delayed the agency?s efforts to establish an
effective market oversight program by diverting substantial management
attention and resources away from this task. The California problem was
shortly followed by the bankruptcy of the Enron Corporation, again causing
OMTR and its Markets Division staff to become involved in addressing
concerns related to this new crisis.

Consequently, although it has been almost 4 years since the creation of OMTR
was announced, FERC has not been able to devote the time and attention
needed to resolve the fundamental issues relating to its market oversight
function. FERC currently has two task forces working to determine its
information needs for market oversight and is still in the process of
developing a working definition for market power. According to industry
experts that we spoke to, FERC?s lack of progress in clearly defining its
market oversight function has eroded their confidence in the ability of the
agency to provide the level of regulation and oversight needed for the
emerging energy markets.

FERC has initiated several actions to enhance its oversight of competitive
energy markets; however, most of these actions have been incomplete or
limited in their effectiveness. Recent FERC oversight initiatives have
included (1) creating a Market Observation Resource (MOR) room to collate
information on energy markets in a user- friendly format, (2) conducting a
series of studies to assess the state of the wholesale electricity (bulk
power) markets, and (3) requiring independent system operators (ISO) to
establish market monitoring units. However, to date, the MOR room and the
bulk power studies have had limited results beyond increasing FERC staff?s
knowledge about competitive markets, and the ISOs? market monitoring units
provide only limited coverage of the nation?s energy markets. FERC?s Market

Oversight Initiatives Have Been Incomplete or Ineffective

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 39 GAO- 02- 656 Energy Markets

To more effectively monitor increasingly competitive energy markets, in mid-
2001 FERC established the MOR room at its Washington, D. C., headquarters.
This room, which was patterned after market operation centers or rooms of
ISOs and major energy trading companies, uses computers and various software
packages to make large amounts of data on natural gas and electricity
markets available in a useable format. FERC created the MOR room to serve as
a central data source, an education center for the agency?s staff, and a
regulatory and oversight tool. Since establishing the room, FERC has been
acquiring and testing market reporting services and software programs while
building an easily retrievable database. However, FERC has not yet been able
to use the MOR room to its full regulatory and oversight potential because
(1) the data available through the facility are mainly limited to those that
are available free of charge, (2) additional data needs for the agency have
not yet been determined, and (3) an overall regulatory approach has not been
developed. Instead, the MOR room serves principally as a technical learning
resource for data analysts in OMTR and as a convenient market information
resource for the agency?s staff.

While the MOR room is becoming a central data source for FERC, the
information that it contains is limited for effective monitoring and
oversight of energy markets. Currently, the MOR room provides FERC staff
with both commercial and proprietary information services, ranging from
Bloomberg Professional Energy service to the PJM E- Data for the
Pennsylvania, New Jersey, Maryland (PJM) ISO?s mid- Atlantic electricity
markets. Electricity market data provided by these services include prices
on the spot market and for futures contracts, plant outage information,
business news, and historical data for trend analysis. For example, FERC
subscribes to FriedWire, which tracks supply, demand, price, and
transmission data. Natural gas market data include spot and futures prices
and market commentary, storage levels, imports and exports, and supply/
demand statistics. The MOR room receives detailed and timely reports about
energy prices on regulated exchanges, such as natural gas futures contracts
for the Henry Hub traded on the New York Mercantile Exchange (NYMEX). In
addition, several weather services are available to monitor changing
conditions nationwide, as weather and climate affect energy supply and
demand in both spot and futures markets.

However, the MOR data do not yet include detailed information about energy
prices on ?exempt? commercial markets, such as the UBS- Warburg, The Market
Observation

Resource Room Has Yet to Fulfill Its Potential

The MOR Room Is Becoming a Central Data Source but Currently Lacks Data on
Critical Aspects of Energy Markets

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 40 GAO- 02- 656 Energy Markets

Dynegydirect, and Intercontinental Exchange (ICE). 4 Although FERC staff can
view natural gas and electricity prices free of charge from the UBSWarburg,
Dynegydirect, and ICE Web sites to track general market behavior, FERC would
need to become a paying subscriber for these services to routinely obtain
the names and other details of the parties trading in these exempt markets.
This information would be necessary, for example, if FERC needed to identify
instances of power companies or traders exercising excessive market power.
Similarly, the MOR room does not receive timely information about over- the-
counter markets- where informal dealings that are not federally regulated
occur. Some over- thecounter sales in which two parties buy and sell natural
gas contracts privately, and offsetting trades known as ?swaps,? are
aggregated and reported the next day in the energy trade press; others are
aggregated from a NYMEX report. In commenting on a draft of our report, FERC
said it may not have jurisdictions over these trades and, therefore, may not
have access to this information. However, we believe that unless FERC staff
can regularly track these reports and then compare them to simultaneous
behaviors by participants in other markets, it would be difficult to
identify instances of market manipulation.

Since the summer of 2001, FERC has established two teams- the Review of
Information Collection Team and the Comprehensive Information Assessment
Team- to take stock of the agency?s current and future market information
needs. These teams were tasked to identify information that FERC currently
collects and additional information that it might need. To date, neither
team has completed its work, although their initial findings highlight some
of the difficulties FERC faces in obtaining additional data.

For example, the Review of Information Collection Team is seeking to learn
precisely what data the agency now collects. As of January 31, 2002, the
team has determined that FERC has more than 50 active information collection
and reporting requirements for the energy companies it regulates and
oversees, and that FERC receives about 33,600 industry

4 UBS Warburg and Dynegydirect are ?bilateral? electronic traders that, like
the once dominant market- maker Enron, always take one side of a buy or sell
transaction. ICE is a ?multilateral? electronic trader, which invites and
matches buy and sell orders for other customers. FERC Is Identifying
Additional

Market Information Needs, but Its Progress Has Been Slow

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 41 GAO- 02- 656 Energy Markets

responses annually. 5 According to the team?s supervisor, the team?s effort
has not been considered a high priority within FERC. He predicts that it may
be several more months until the team completes its detailed assessments of
the data, and more than a year until proposed regulations to collect these
data can be developed.

Similarly, the Comprehensive Information Assessment Team is identifying the
information that the agency will need in order to more effectively regulate
and oversee emerging energy markets. The team has already identified about
80 information ?needs? for FERC. A critical challenge, according to FERC
officials, is to transform this list of needs into a practical set of data
requirements. To do this, FERC must first decide how aggressively it will be
monitoring energy markets; however, this decision has yet to be made by the
agency.

A key feature of FERC?s data collection plans is to have other organizations
such as federal and state agencies, commercial sources, trade associations,
and regional transmission organizations provide FERC access to much of the
information needed to monitor energy markets. However, at this point, it is
unclear how FERC will ensure that these data are accurate and reliable. Nor
is it clear how FERC and its data sources will standardize the data and pay
for their collection. Another issue to be addressed is how FERC will
integrate these new data requirements with the data already available in the
MOR room.

FERC plans to review the results of the two information teams later this
spring, and then hold meetings and workshops with market participants. More
than likely, any new data identified as important to FERC?s market
monitoring efforts will not be formally required from market participants
until 2003. Moreover, as required by the Office of Management and Budget,
FERC will have to offset any new information requests from the industry by
eliminating existing ones. One FERC official told us the agency can fulfill
this requirement by eliminating certain filings required under the cost- of-
service regulation that may no longer be relevant.

5 In 2000, FERC set a goal to reduce paper filings by 90 percent within 2
years, although currently only four of its forms must be filed
electronically and another four may be at the filer?s discretion.

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 42 GAO- 02- 656 Energy Markets

When first created, the MOR room was expected to showcase ?the important
function of monitoring and assessing the energy market.? However, because
FERC has not determined how it will regulate and oversee competitive energy
markets, the MOR room?s use, as a regulatory and oversight tool, remains
largely undecided and untapped. For example, FERC officials that we spoke
with were not aware of any enforcement actions that had been initiated
through use of the MOR room or any market problems detected elsewhere in the
agency that had been confirmed or refuted with MOR room data. Currently, the
MOR room serves principally as a technical learning resource for data
analysts in OMTR and as a convenient resource for the agency staff who
prepare the daily Energy Market Report and monthly Energy Markets Review.
These publications keep FERC Commissioners and senior staff aware of news
and market events, such as energy trading companies? financial problems,
power- plant outages, and energy supply and price trends.

Nonetheless, one energy data analyst who helped design and now operates the
MOR room told us that it is likely to become an integral part of FERC?s
proposed new Office of Market Oversight and Investigation, which is intended
to concentrate FERC?s market- monitoring resources in one work group (see
ch. 3 for more detailed information on this new office). But just how the
MOR room will assist the new office has yet to be decided. The extent to
which the MOR room can contribute to FERC?s regulation and oversight of
energy markets also depends on how FERC decides to divide market monitoring
responsibilities with other entities, such as the regional transmission
organizations. These decisions also have yet to be made.

As another oversight initiative, on July 26, 2000, FERC issued an order
directing its staff to undertake an investigation of the nation?s wholesale
electricity (bulk power) markets and report the results by November 1, 2000.
The investigation was ordered because the nation?s bulk power markets were
in different stages of transition, and some areas of the country had
experienced extreme price fluctuations. By reviewing technical or
operational factors, federal or state regulatory prohibitions or rules,
market or behavioral rules, and other factors affecting the reliability or
competitive pricing of electricity in these markets, the investigation was
to determine whether the nation?s bulk power markets were working
efficiently. The MOR Room?s Use as a

Regulatory and Oversight Tool Is Largely Undecided

FERC?s Bulk Power Studies Were Not an Effective Oversight Tool

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
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Page 43 GAO- 02- 656 Energy Markets

FERC assigned a study team for each of the five regions covering the
continental United States: the northeast, southeast, midwest, west, and
Electric Reliability Council of Texas (ERCOT) regions. 6 The teams took
about 2 to 3 months to conduct the investigations and write their reports.
They reviewed publicly available data and reports and, with the exception of
the ERCOT study, obtained input from market participants and others, such as
ISOs and state public utility commissions, and also requested specific
market information, such as market participants? data on bids during the
period.

The final reports from each team generally included data on electricity
supply and demand, transmission systems, the regulatory and institutional
environment, market design, prices during the summer of 2000, factors
affecting these prices, and issues relating to inefficiencies or
improvements needed in the markets? design or operations. 7 In addition, the
reports generally provided policy options for the Commission, such as
potential ways to correct the conditions that led to price spikes, improve
market rules, or improve access to the transmission systems to increase
competition.

Instead of serving as an effective oversight tool, however, these studies
mostly provided FERC staff an opportunity to learn about electricity
markets. The study teams were not allocated much time and lacked the
expertise and data to provide the depth of investigation needed. According
to many of the study team leaders that we talked to, when the studies
started the teams knew little about the markets they were examining and they
had only about 3 months to complete the work and prepare the reports. Most
of the team leaders and members said that more time, more data, and/ or
staff with different skills or expertise would have been needed to perform
in- depth studies. The types of staff skills or expertise cited as being
needed included more knowledge of economics and market

6 ERCOT established an independent system operator in 1996 to satisfy the
requirements of the Public Utility Commission of Texas for deregulating the
wholesale electricity market in the state. The wholesale market in the ERCOT
region is basically isolated from other U. S. markets because its power grid
or transmission system has only minor connections to other U. S.
transmission systems. FERC has limited jurisdiction over the region because
the ERCOT market is essentially intrastate.

7 On February 1, 2001, FERC staff issued a report on the bulk power markets
in the Northwest during November and December 2000. This report, which was
an extension of the November 1, 2000, report on the west region, focused on
the rapid increase in electric power prices during these 2 months.

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
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Page 44 GAO- 02- 656 Energy Markets

operations and skills in compiling and analyzing large amounts of data.
According to FERC management, it became clear during these investigations,
that the agency did not have enough staff who could analyze the relevant
market information. This shortage related both to skills in finding,
manipulating, and analyzing large data sets and to economic and other
expertise in focusing information analyses on critical market questions and
interpreting the results.

Most of the study team leaders and members we spoke to indicated that
periodic bulk power studies could be a useful oversight tool for FERC if
they were done in more depth. While the studies provide some important
baseline data on these markets, FERC has no plans to update the bulk power
studies. As an alternative, it proposes to conduct periodic assessments of
market performance, supplemented by other reports. In its fiscal year 2003
budget request to the Congress, FERC stated that it plans to publish
semiannual seasonal market assessments of major regional markets for both
natural gas and electric power. These assessments are to report on a series
of objective measurements for each market, such as basic supply- demand
balances and the degree of market concentration. They are to also report on
the markets? experience with current market rules and on major
vulnerabilities, if any, that might threaten to disrupt the markets in the
future. FERC plans to supplement these assessments with other periodic
reports, including bulletins that analyze fast- breaking market
developments. According to FERC, information will come from its MOR room,
industry contacts, and close coordination with the market monitoring units
(MMU) of the yet- to- be formed regional transmission organizations. These
supplemental reports will also include analyses of apparent market
anomalies- for example, instances of high prices seen in unexpected places
or apparently abnormal volumes of trading transactions.

However, it is likely to be some time before FERC can fully implement these
plans. FERC anticipates that the market performance measurements to be used
for the seasonal assessments will be finalized during 2003. In addition, the
MMUs of the regional transmission organizations (RTO) may not be operational
for up to 3 years. FERC is depending on these units to provide much of the
data and analysis that it will use for the seasonal assessments and the
other reports. As a result, until these new analyses are available, it
appears that FERC will not be conducting detailed evaluations of the
markets.

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Page 45 GAO- 02- 656 Energy Markets

The formation of ISOs provided FERC additional market monitoring support for
certain energy markets. Under Order 888, FERC gave public utilities the
option to create ISOs to independently operate their electric transmission
systems and thereby meet the requirement for separating, or unbundling,
interstate wholesale power service from transmission. In approving their
formation and use, FERC required ISOs to, among other things, establish a
market monitoring unit. MMUs are required to develop market monitoring
plans, which must be approved by FERC, and periodically report on their
monitoring activities.

Although MMUs play an important market oversight function, their coverage of
the nation?s electricity markets is limited. Because FERC made the formation
of ISOs voluntary, most of the nation is not covered by an ISO, and
therefore is not subject to monitoring by an MMU. Currently, FERC has
approved five ISOs that cover only parts of the United States. These include
the New York ISO; ISO New England; and PJM ISO in the Northeast and the
California ISO in the West. The Midwest ISO, covering at least parts of
several states in the Midwest from Canada to Kentucky, began selling
transmission service in February 2002 but had not yet established an MMU.
There are no ISOs operating in the Southeast, the West outside of
California, and much of the Midwest. Therefore, market monitoring
responsibilities for these areas fall to FERC.

Moreover, the MMUs we contacted- California, New York, New England, and PJM-
primarily focused their monitoring activities on reviewing market
transactions for abuses of market power by market participants and for
market design problems within their particular markets. According to these
MMU officials, the strength and value of an MMU?s market monitoring activity
is in its ability to review minute- by- minute transactions looking for
anomalies in market behavior. They believe that FERC?s market monitoring
role is better suited to evaluating overall market performance at the
national or regional level. According to an official from PJM?s MMU, FERC
has the luxury to look at the overall market picture from a policy
perspective, whereas MMUs are down in the trenches dealing with detailed
information. The MMUs told us that FERC should leave the responsibility for
monitoring daily market transactions to MMUs and concentrate on the larger
policy issues.

Finally, MMUs employ different strategies and techniques in reviewing market
transactions, which may limit the usefulness of the information they provide
to FERC. FERC requires that the MMUs independently and objectively monitor
and report on the markets operated by ISOs and that the MMUs? market
monitoring plans be designed to ensure competition, ISOs? Market Monitoring

Units Provide Oversight Support but Do Not Cover All the Markets

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 46 GAO- 02- 656 Energy Markets

prevent any undue influence by market participants, and correct any design
flaws. FERC allows MMUs flexibility with respect to the scope of their
monitoring and how it is carried out. As a result, the four MMUs we
contacted varied in their size, operations, and focus. For example, the MMUs
of the New York and PJM ISOs take different avenues to identifying and
mitigating or correcting market power abuse. 8

Because of these differences in operation, the information provided to FERC
by MMUs may not be comparable and may make it significantly more difficult
for the agency to develop a comprehensive nationwide analysis of energy
markets. This issue will become more important as FERC approves the creation
of the larger RTOs under Order 2000 to replace ISOs. FERC is currently
developing a standardized design for the RTOs? market monitoring function
and the types of market monitoring information that they will be required to
provide the agency.

FERC?s legislative framework of regulatory and oversight authorities has
remained essentially the same, even as the energy industries have undergone
substantial restructuring. As a result, FERC is struggling to develop and
implement a new regulatory and oversight approach for these emerging markets
because it is using authorities that were designed when the industries
operated as regulated monopolies and their rates were based on the cost of
service. In recent years, FERC has also been subjected to frequent changes
in its leadership. These changes have caused the agency to experience
substantial shifts in policy direction and priorities, which may have
directly affected its progress in developing a new regulatory approach.

8 The PJM ISO uses the presence of congestion on the transmission lines to
determine that, during the period of congestion, competition is reduced and
market- based bids or offerings of electricity for sale should be replaced
by cost- based bids. In contrast, the New York ISO looks directly at bidding
behavior and resulting price effects to determine if market power exists
that warrants mitigation. FERC?s Outdated

Legislative Framework and Frequent Leadership Changes Have Contributed to
Its Difficulty in Developing a New Regulatory Approach

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
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Page 47 GAO- 02- 656 Energy Markets

To some extent, FERC?s lack of specific legislative authority for
competitive energy markets, and especially for electricity markets, may have
delayed development of its new regulatory approach. This is because FERC
derives much of its legislative authority, for electricity, from mandates
that were enacted almost 75 years ago, when the industry was structured as a
regulated monopoly and rates were based on the cost of service. As a result,
FERC has had to force fit changes that it would like to accomplish within
the framework of these outdated statutes. This has led market participants
to contest FERC?s legal authority to direct change in these industries.

For example, in Order 888, FERC invoked its authority under section 206 of
the Federal Power Act when it ordered ?functional unbundling? of wholesale
generation and transmission services, imposed a similar open access
requirement on unbundled retail transmissions in interstate commerce, and
declined to extend the open access requirement to the transmission component
of bundled retail sales. Market participants, however, challenged FERC?s
authority to order these changes. In response to a number of review
petitions, in 2001, the District of Columbia Circuit Court upheld most of
FERC?s jurisdiction to issue Order 888. 9 That decision was appealed in the
Supreme Court. Last year the Court agreed to hear argument on two issues:
FERC?s jurisdiction over unbundled retail transmissions and its refusal to
assert jurisdiction over bundled retail transmissions. 10 The Supreme Court
agreed with FERC on both issues. Specifically, the Court stated that because
the Federal Power Act unambiguously gives FERC jurisdiction over the
?transmission of electric energy in interstate commerce,? without regard to
whether the transmissions are sold to a reseller or directly to a consumer,
FERC?s exercise of this power is valid. Similarly, FERC?s decision not to
regulate bundled retail transmissions was accepted as a statutorily
permissible policy choice by the Supreme Court.

FERC?s efforts to guide or direct restructuring of the electricity industry
without legislation explicitly mandating the change have also resulted in
debate, within and outside the agency, about its specific authorities over
these new competitive markets. In some instances, this uncertainty may have
contributed to FERC?s hesitation in clearly defining how it would apply its
authorities to the emerging electricity markets. An example of

9 TAPS v. FERC, 225 F. 3d 667 (D. C. Cir. 2000). 10 New York v. FERC, 535 U.
S. 1 (2002). Transition to Competitive

Markets Has Been Occurring Without Substantial Changes to FERC?s Regulatory
and Oversight Authorities

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 48 GAO- 02- 656 Energy Markets

this is FERC?s recent attempts to create RTOs. Questions about FERC?s
authority to require the formation of RTOs led the agency to initially make
participation in RTOs voluntary, as it had done in the past for ISOs.
Despite outreach efforts to convince the industry about the advantages of
participating in RTOs, FERC made little progress in getting RTOs formed.
Although its legislative authorities did not change, FERC recently
determined that it did have adequate authority to require RTO formation, and
there was a significant policy shift within the agency to require
participation in RTOs by the industry. Industry participants not joining an
RTO now have to prove to FERC why doing so would harm them. Although the
Chairman of FERC believes that the agency has the general authority to take
this new course of action, he has stated that it would be helpful if the
Congress gave FERC the explicit authority to create RTOs.

Moreover, some of FERC?s legislative authorities with regard to refunds of
excessive rates and penalties for violations of market rules may not be
adequate for regulating in a competitive environment, where there is greater
potential for market power abuse. Under its current legislative framework,
FERC is limited by the extent to which it can order refunds, and it does not
have adequate authority to levy meaningful penalties for market violations.
As a result, it is difficult for FERC to curb and respond effectively and
firmly to anticompetitive behavior, particularly for electricity markets.
For example, under sections 205 and 206 of the Federal Power Act, FERC has
the authority to review whether new or existing electricity rates filed with
the agency are just and reasonable. If an existing rate is found to be
unjust or unreasonable, FERC may set a new rate and may order a refund for
the amount charged in excess of the just and reasonable rate. However,
refunds may only be ordered for the period following the refund ?effective?
date. The earliest the refund effective date can be is 60 days after a
complaint is filed with FERC or after a notice of Commission- initiated
investigation is issued. As a result, this limitation provides no remedy for
instances where market participants have charged unjust or unreasonable
rates during the period before the refund effective date. In addition, under
the Natural Gas Act, FERC is even more limited in ordering refunds than it
is under the Federal Power Act. For example, under section 5 of the Natural
Gas Act, FERC cannot set a refund effective date but can only change rates
prospectively from the date that the Commission finds an existing rate to be
unjust and unreasonable.

In addition, FERC does not have a meaningful range of penalties to levy
against violators of energy market rules. The Federal Power Act provides
FERC with the authority to assess civil penalties for violations of certain
regulated activities but not for violation of the just and reasonable rate

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
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Page 49 GAO- 02- 656 Energy Markets

requirement. For example, section 31( c) of the Federal Power Act authorizes
penalties for violations relating to hydropower generation, and section 316A
provides FERC with the authority to levy penalties for violations relating
to the transmission of electricity and sales by exempt wholesale generators.
11 No section of the act allows FERC to levy monetary penalties against
market participants who charge unjust or unreasonable rates for electricity.
Although the Natural Gas Policy Act of 1978 gave FERC some authority to levy
civil penalties, this authority applies only to a limited number of natural
gas transactions in interstate commerce.

In today?s competitive energy markets, the lack of adequate refund and
penalty authorities may be a significant handicap to FERC?s ability to
fulfill its regulatory mandate because market participants have the
opportunity to profit by millions of dollars within a very short time
through exercising market power and engaging in other anticompetitive
behavior. For example, in response to filings made after the recent
electricity price spikes in California, FERC determined that it had no
authority to order refunds for unjust and unreasonable rates charged prior
to the refund effective date. If FERC does not have the authority to curb
anticompetitive behavior by ordering refunds or levying meaningful penalties
against market violators, the risk of engaging in this type of behavior for
market participants is severely diminished. Many FERC officials that we
spoke to believe that FERC?s credibility as an effective regulator of
competitive electricity markets is limited without the authority to levy
meaningful penalties. They believe that industry participants do not
perceive FERC as a forceful regulator because it does not have adequate
?bite? to go after market abusers and therefore cannot deter future
violations.

Over the past 5 years, FERC has had four different Chairs. Such a high level
of leadership turnover may have had a significant impact on the ability of
the agency to develop a new regulatory approach for emerging energy markets
because the Chair of the Commission also serves as the agency?s leader and
as the chief administrator of FERC?s staff. The Chair, in effect, sets the
agency?s agenda and controls its strategic plan and outcomes.

11 16 U. S. C. 824j, 16 U. S. C. 824k, 16 U. S. C. 824l, 16 U. S. C. 824m.
FERC Has Experienced

Frequent Leadership Changes as It Has Attempted to Develop a New Approach

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 50 GAO- 02- 656 Energy Markets

Our reviews of high- performing public and private sector organizations have
shown that fundamental changes in operations and culture can take years to
achieve and usually require long- term commitment on the part of agency
leaders. When agencies such as FERC experience a high level of turnover in
their top leadership, their efforts to effect change are often hampered. For
example, the Health Care Financing Administration, which administered the
multibillion- dollar Medicare program, had 19 administrators or acting
administrators in its 24 years of existence. We found that this high rate of
leadership turnover was an inhibiting factor in the implementation of long-
term Medicare initiatives and the pursuit of a consistent management
strategy for this agency. 12

Similarly, the lack of continuity in FERC?s top leadership may have directly
contributed to the agency?s lack of progress in developing and implementing
a new regulatory approach for competitive energy markets, especially over
the last 5 years. Some senior FERC staff told us that the seemingly constant
transition caused by recent changes in FERC leadership, coupled with the
intense pressure created by the California energy crisis and the bankruptcy
of the Enron Corporation, has resulted in a lack of consistent management
and direction for the agency. Several agency officials told us that every
new Chair brings a different direction to the agency and that when there is
a change in the chairmanship, the progress made under a past Chair often
becomes irrelevant as everyone?s attention shifts to the new Chair?s
priorities and agenda. Consequently, steps taken to develop a new
organizational structure or regulatory approach under a past Chair are often
jettisoned, and the staff start the process all over again under the
direction of the new leader.

The longer FERC struggles to define and implement an effective approach for
the emerging energy markets, the longer these markets will continue to
develop and operate without adequate oversight and, potentially, without
adequate regulation. At the current time, FERC is not adequately performing
the oversight that is needed to ensure that the prices produced by these
markets are just and reasonable and therefore, it is not fulfilling its
regulatory mandate. While FERC has taken some tentative steps in the right
direction, more decisive action must be taken to define and

12 U. S. General Accounting Office, Major Management Challenges and Program
Risks: Department of Health and Human Services, GAO- 01- 247 (Washington, D.
C.: January 1, 2001). Conclusions

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
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Page 51 GAO- 02- 656 Energy Markets

implement an effective regulatory and oversight approach. To accomplish the
mammoth undertaking posed by the rapidly evolving and increasingly complex
energy markets, FERC will have to place the highest priority on developing
its oversight function and devote significant management attention and
adequate resources to this task.

FERC has not yet developed a detailed oversight approach for competitive
energy markets. Market participants need this specificity if they are to
view FERC as an effective market monitor and regulator. Although FERC has
recently revised its strategic plan to place more emphasis on its oversight
of competitive energy markets, the plan still lacks specifics about how the
agency will monitor these markets. The revised plan does not include outcome
measures for its goals and objectives so that the agency?s progress in
achieving them can be assessed. The plan also does not clearly and
explicitly state how FERC will work with market participants to
comprehensively oversee the markets. For example, it appears that FERC plans
to rely on the RTOs? MMUs to serve as its frontline for monitoring wholesale
electricity markets. The agency, however, has not yet set out expectations
for how these units will monitor the markets and how FERC will evaluate
their effectiveness.

Moreover, FERC needs to recognize that a new regulatory and oversight
approach will require both interim and long- term measures. The agency
cannot continue its current policy of waiting for the market structures to
be fully in place before developing monitoring actions. For example, FERC
does not have the luxury to wait for the RTO structures to be in place,
which may take several more years, before detailed monitoring of the markets
begins. As the California energy crisis has made adequately clear, FERC
simply cannot let the markets continue to go unmonitored for this length of
time. Nonetheless, FERC does not have an action plan for oversight of the
markets for the interim period before the RTOs? market monitoring units are
functioning and the agency can put a comprehensive market oversight approach
into place.

Finally, FERC?s difficulties in developing and implementing a comprehensive
regulatory and oversight approach for competitive energy markets can be
attributed, at least in part, to its attempts to help create and to regulate
and oversee these markets without explicit direction and guidance from the
Congress as to the agency?s appropriate role in these markets. FERC has been
attempting to design a regulatory and oversight approach for these markets
around legal authorities, such as those for ordering refunds and assessing
penalties, which were generally enacted when the natural gas and electric
industries were subject to cost- of- service

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
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Page 52 GAO- 02- 656 Energy Markets

regulation. As part of its current debate in formulating the Energy Policy
Act of 2002, the Congress has started to review FERC?s legislative
framework.

To help ensure that FERC can effectively carry out its responsibilities for
overseeing interstate wholesale natural gas and electricity markets, we
recommend that the Chairman, FERC, take the following actions:

 Update the agency?s strategic plan to include outcome measures that can be
used to assess how well FERC is doing in achieving its strategic goals and
objectives for overseeing competitive energy markets. This plan should also
include specific strategies for achieving the goals and objectives that set
out explicitly how FERC will work with market participants to provide
comprehensive oversight of the markets. Because of their significant role in
FERC?s oversight approach, the plan should set out clear expectations for
how transmission organizations will monitor energy markets and how FERC will
evaluate the effectiveness of their MMUs. These expectations should be made
part of FERC?s approval of these transmission organizations.

 Develop an action plan for overseeing energy markets, in particular for
electricity, until the transmission organizations? market monitoring units
become fully operational and FERC can implement a comprehensive oversight
approach for these markets. In developing the action plan, FERC should
examine how it can use the bulk power studies and the data sources currently
available through the MOR room as more effective market monitoring tools.

To help ensure that FERC can effectively carry out its oversight role with
respect to energy markets, the Congress may wish to convene public hearings
to review FERC?s authorizing legislation and determine, in consultation with
FERC Commissioners, whether FERC?s authorities need to be revised in light
of the changing energy markets. In addition, to help FERC deter improper
market behavior, the Congress may want to consider providing FERC with the
appropriate range of authorities to levy civil penalties against market
participants that engage in anticompetitive behavior and violate market
rules.

In its written comments on a draft of this report, FERC agreed that it had
not yet done all that it could to oversee energy markets. The agency stated
that, despite a long- standing recognition that it needed to develop the
Recommendations for

Executive Action Matters for Congressional Consideration

Agency Comments

Chapter 2: FERC Has Not Yet Defined and Implemented an Effective Approach to
Monitor Competitive Energy Markets

Page 53 GAO- 02- 656 Energy Markets

information, procedures, and staffing to oversee energy markets, it had not
previously focused its efforts clearly enough to succeed. According to FERC,
this situation is now changing with the launching, in January 2002, of the
new Office of Market Oversight and Investigation to oversee and assess the
fair and efficient operations of electric and natural gas markets. The new
office, according to FERC, will be up and running in August 2002. FERC
stated that the office?s job will be to understand energy markets and risk
management, measure market performance and analyze market data with an eye
to recommending market improvements, investigating compliance violations,
and, where necessary, pursuing enforcement actions. FERC also stated that
the office will report to the Chairman and other Commissioners, bring
together all of the staff devoted to oversight and enforcement in one place,
and receive the resources it needs to restore and maintain the integrity of
the nation?s energy markets. FERC further stated that the agency has
developed preliminary plans on how the office will work, including a draft
mission and function statement, an organizational design, and a
comprehensive list of the services and products the office will provide.

We are encouraged and hopeful that FERC?s creation of this new office will
provide the focus needed to succeed where prior efforts, as described in our
report, have not. However, we do not believe that a reorganization alone
will be enough to bring about the fundamental changes needed in FERC?s
regulation and oversight of energy markets. Sustained leadership and top
management attention will be necessary to guide and direct the agency
through these changes. Many details of the new office?s operations are yet
to be worked out, and FERC still needs to overcome significant challenges to
provide the office with the information, tools, and staff with the skills
and knowledge to effectively oversee competitive energy markets.

FERC also agreed with our conclusion that its ability to develop, regulate,
and oversee competitive energy markets could be enhanced with new statutory
authority and guidance from the Congress on the agency?s appropriate role in
these markets. FERC agreed that it has often struggled to find market
solutions while operating under legislative authority designed for regulated
monopolies with cost- of- service rates. The agency noted that additional
statutory authority is needed, particularly in providing FERC with the
ability to assess civil penalties for violations of the law or FERC rules.
FERC further said that the Congress could strengthen the agency?s ability to
create competitive wholesale energy markets by clarifying the Commission?s
authority to order the formation of

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Page 54 GAO- 02- 656 Energy Markets

RTOs. As pointed out in our report, FERC has currently approved the
formation of only one RTO.

Separately from its written comments, FERC provided us with some technical
changes, which we incorporated into the report where appropriate. FERC?s
written comments are presented in appendix III.

Chapter 3: FERC Faces Significant Management Challenges to Effectively
Monitor Competitive Energy Markets

Page 55 GAO- 02- 656 Energy Markets

As FERC develops a new regulatory approach to respond to the restructured
energy industry, it will have to overcome significant human capital and
organizational challenges. FERC?s workforce, which was largely recruited and
trained for cost- of- service regulation, currently lacks the knowledge and
mix of skills needed to effectively regulate and oversee competitive
markets. Although FERC has taken steps to train its current staff and
recruit new staff, it has made limited progress in adapting its workforce to
the new regulatory environment. In addition, FERC has not fully explored all
the personnel tools and flexibilities- such as establishing special pay
rates- that are available to federal agencies for responding to workforce
recruitment and retention challenges. FERC also has not conducted systematic
strategic human capital planning to recruit, develop, train, and retain the
type of workforce that can effectively regulate and oversee competitive
energy markets. Moreover, FERC?s current organizational structure diffuses
its market monitoring responsibilities and does not provide the focus and
attention that this function needs in the changing regulatory environment.

FERC has been unable to adapt its workforce to meet the challenges of the
new competitive markets. Its current staff skill mix is inadequate and
training of current staff and recruitment of new staff have not yet occurred
at a level that would alleviate gaps in the staff?s skill mix. In addition,
many experienced and highly trained FERC staff will soon be eligible for
retirement and could depart from the agency over the next 3 years. While
these retirements provide FERC the opportunity to bring in new staff to fill
gaps in its skill mix, the departures will also result in the loss of
traditional skills and knowledge that the agency continues to need. Although
FERC management has been aware of these issues and has taken some steps to
address them, its progress has been limited. Moreover, FERC has not fully
explored the use of all the personnel tools and flexibilities available to
federal agencies to help them attract, motivate, and retain employees, and
FERC has not performed the systematic and comprehensive planning that is
needed to resolve its human capital challenges.

FERC?s current workforce will need to undergo a substantial and rapid
transformation if it is to effectively meet the challenges of regulating and
overseeing competitive energy markets. Historically, FERC staff operated in
a highly regulated environment, setting rates for wholesale electricity
sales based on a utility?s cost to provide the service. The competencies
required to perform this task are markedly different from the Chapter 3:
FERC Faces Significant

Management Challenges to Effectively Monitor Competitive Energy Markets

FERC Has Taken Some Steps to Address Its Human Capital Needs, but
Significant Challenges Remain

FERC Faces Daunting Human Capital Challenges

Chapter 3: FERC Faces Significant Management Challenges to Effectively
Monitor Competitive Energy Markets

Page 56 GAO- 02- 656 Energy Markets

competencies needed to effectively monitor dynamic energy markets. For
example, to perform cost- of- service rate setting, FERC traditionally
employed staff with knowledge and skills in finance, economics, engineering,
and the operations of regulated industries. However, to support its
responsibilities for regulating and monitoring competitive markets,
correcting anticompetitive situations, and promoting fair and open
competition, the Commission needs employees with knowledge and skills in the
collection and analysis of market data; information technology; and market
operations, including expertise in market rules and structures, competitive
pricing, commodity trading, and risk management. According to senior FERC
officials, the agency lacks adequate numbers of staff with these
competencies and has had trouble attracting and retaining such staff. Energy
market participants and state regulators told us that they are also
concerned that FERC staff do not have the depth of knowledge and
understanding of competitive markets that are needed to effectively regulate
and oversee the evolving energy industry. For example, one former FERC
Commissioner now working in the energy industry said the skills of FERC
staff have fallen behind those of the companies that they regulate.
Additionally, many of the state regulatory bodies that we surveyed expressed
a lack of confidence in FERC staff?s ability to fully understand the
complexities of the markets it regulates.

In an effort to increase its staff?s knowledge of energy market issues, FERC
has been providing additional training opportunities. For example, FERC more
than doubled the training budget for the Office of Markets, Tariffs and
Rates (OMTR) from fiscal year 2000 to fiscal year 2001 and has used
contractors to provide staff training on market- related subjects, such as
derivatives. Despite this increased emphasis on training, the general
feeling among the staff that we surveyed in OMTR and the Office of the
General Counsel is that additional, focused training is needed. Our survey
found that over 80 percent of FERC employees responsible for regulating and
overseeing energy markets expressed a need for more training in market
functions and market structures- in particular, they need a better
understanding of how financial markets interact with energy markets and of
such issues as trading, hedging, derivatives, and financial instruments. In
addition, over half of these staff stated that additional training in basic
economic principles and definitions, economic theory and models, and
regulatory theory would help them perform their duties (see table 3).

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Table 3: Percentage of FERC Staff Indicating That Additional Training Would
Help Them Better Monitor and Regulate Energy Markets, by Type of Training

Type of training Additional

training would assist me

Already proficient in

this area Does not

apply or no basis to judge

How financial markets interact with energy markets (including trading,
hedging, derivatives, and financial instruments)

86% 3% 11% Market structures 84 9 7 Market functions 81 12 7 Economic
theory/ models 60 25 16 Regulatory theory 55 40 6 Basic economic principles/
definitions 52 39 9 Statistical software packages 41 7 52

Note: Some rows do not total 100 percent because of rounding. Source: GAO?s
survey of FERC employees.

FERC has also tried to fill the gaps in its workforce skills by recruiting
new employees. However, it has been largely unsuccessful in recruiting and
retaining the highly skilled staff it needs. For example, over the last 2
years, FERC has tried to fill a total of 49 nonadministrative positions in
OMTR. However, FERC was only able to fill 25, or 51 percent, of these 49
positions, and of the positions filled, the majority represented
reassignments of employees within FERC. There were only 10 new hires from
outside the agency. Most of these were at the GS- 11 level or lower. Several
higher level positions remained unfilled.

According to FERC officials and energy industry experts, the Commission is
unable to recruit the qualified employees it needs mainly because of the
significant difference between government pay scales and compensation in the
private sector. Consequently, FERC has historically had trouble getting
qualified individuals to apply for jobs and subsequently hiring them into
key market regulation and oversight positions at the mid- and upper levels.
For example, in fiscal year 2001, FERC advertised an ?Energy Industry
Analyst-( Energy Trader)? position at the GS- 15, step 10, level, which is
the highest pay grade and step level available under civil service rules and
currently pays about $120,000. The position was first listed from October 31
to November 30, 2000, but garnered only three applicants meeting initial
qualifications, and FERC hiring officials did not find any of these
applicants suitable to meet the agency?s needs. When the position was re-
listed from December 11, 2000, to January 11, 2001, only one

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qualified person applied, who was also considered unsuitable for the
agency?s needs. After listing the position a third time from January 22 to
February 20, 2001, advertising heavily in key markets such as Houston, New
York, and Washington, D. C., and accepting electronic applications, FERC
received information from 16 qualified applicants. However, as of February
12, 2002, the position remained unfilled because, according to FERC?s human
resource staff, after the interview process the hiring officials determined
that none of the interviewed applicants met the needs of the position. This
example clearly illustrates the difficulty that FERC has had in hiring
people with ?real world? experience in competitive energy markets,
particularly former energy traders.

To help address its recruitment challenges, FERC has started various
initiatives to enhance entry- level recruitment. One such initiative is
FERC?s summer intern program, which began in fiscal year 2001. Of a total of
27 interns who participated in the program, 5 were offered permanent
positions and 4 had accepted as of February 2002. FERC plans to expand
participation in the program to 40 interns and increase to 12 the number of
interns hired into permanent positions for fiscal year 2003. While these
positions will help build a future FERC workforce, they do not address the
immediate and compelling need that the agency has for experienced and
trained market regulation and oversight staff at mid- and upper levels.

FERC is taking extra steps to retain its newly hired staff by helping them
to more quickly become familiar with their duties and responsibilities and
the agency?s operations. Recently, FERC implemented a mentoring program
designed to guide new employees in their career development and enable them
to more quickly gain institutional knowledge from more experienced staff.
Additionally, new employees in several offices participate in a series of
orientation sessions, offered first by human resources staff and later by
their program office. These sessions help new employees understand how FERC
functions, what its regulatory priorities are, and what is expected of them.

FERC is also challenged in retaining its highly skilled and experienced
employees. Although FERC has an overall low rate of attrition (an average of
7 percent per year since 1995), some managers said that key employees are
leaving to join private sector energy firms. They said that FERC employees
are attractive to the industry because of their knowledge of the regulatory
process. In fiscal years 2000 and 2001, OMTR had 15 separations, 13 of which
were in upper level positions; of these, 7 staff listed ?taking a job in the
private sector? as the reason for their resignation. Of the remaining six
employees, three said that they were

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relocating or transferring to other federal agencies, and three did not give
a reason for leaving.

Another human capital challenge for FERC is the impending retirement of a
large portion of its staff (see fig. 5). Over one- quarter of FERC?s
employees will be eligible for retirement by 2005. Many of the employees who
will be eligible to retire by 2005 have 20 years or more of government
service; are highly educated and trained; and are knowledgeable about the
Commission?s policies, procedures, and workload. While the departure of so
many staff creates opportunities for FERC to realign its workforce skills to
better match its needs for the future, it also poses a significant loss of
institutional knowledge. FERC has to fulfill a dual responsibility: It must
monitor the emerging competitive energy markets while it continues to
provide traditional cost- of- service regulation for those areas of the
country that are not undergoing energy industry restructuring. According to
FERC, this en masse departure of highly qualified and experienced staff may
adversely affect the agency?s ability to continue to perform highquality
traditional regulatory work.

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Figure 5: Percentage of Employees in Mainstream Occupations Eligible to
Retire in Fiscal Years 2002- 2005

Source: FERC. Note: Chart reflects retirement eligibility of mainstream
occupations as categorized by FERC and includes biologists, accountants/
auditors, attorneys, energy industry analysts, and engineers. The
percentages for any given year reflect staff that became eligible to retire
in prior years, as well as those newly eligible in the year listed.

All federal agencies, including FERC, have flexibilities and tools available
to them to help overcome workforce recruitment and retention issues,
including flexibilities and tools that (1) can be initiated by federal
agencies on their own, such as the use of signing and retention bonuses and
alternative work schedules; (2) require approval from the Office of
Personnel Management (OPM) or the Office of Management and Budget (OMB),
such as special salary rates; and (3) require legislative approval, such as
excepted service positions. 1 Of these special tools, FERC has used
recruitment bonuses, retention allowances, tuition reimbursement, and
alternative work schedules to help resolve some of its human capital
challenges. For example, according to a senior official in FERC?s Office of

1 A handbook entitled Human Resource Flexibilities and Authorities in the
Federal Government is available from OPM and provides information on the
various human resource flexibilities and authorities available to federal
agencies. FERC Has Not Explored

the Use of All Available Civil Service Flexibilities

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the General Counsel, FERC has had recent success in offering recruitment
bonuses and tuition reimbursement to attract new attorneys. FERC may be able
to further expand the use of these flexibilities by reviewing the
experiences of other agencies. For example, the State Department is using
retention allowances to create incentives for learning. It pays retention
allowances ranging from 5 to 15 percent to certain information technology
workers who obtain job- related degrees and certifications. OPM reported
that after 1 year of operation, these retention allowances have helped to
significantly reduce turnover and increase the skills base of the State
Department?s information technology workforce.

According to FERC?s human resource manager, the agency has not yet requested
any of the other flexibilities and tools available from OPM, OMB, or the
Congress. For example, FERC has not requested OPM approval to establish
special pay rates for critical occupations. Special pay rates allow an
agency to offer rates that may be higher than basic pay rates for an
occupation or group of occupations. These rates can be established
nationwide or in specific local areas if it is determined that the
government?s recruitment or retention efforts would be significantly
handicapped without these higher rates. Similarly, FERC has not asked OMB to
establish critical pay authority for its staff. This authority can increase
the rate of basic pay for a specific position and may be authorized for
positions that require extremely high- level expertise in a scientific,
technical, professional, or administrative field or one that is critical to
the agency?s successful accomplishment of an important mission. 2 However,
critical pay may be granted only to the extent necessary to recruit or
retain an individual exceptionally well qualified for the position.

As a final option, federal agencies may also request legislative approval to
create excepted service positions, which are exempt from the provisions of
general civil service requirements. However, FERC has not yet fully examined
the need for excepted service positions and is still in the early stages of
developing the supporting documentation for this authority. Excepted service
authority allows agencies to hire staff through a noncompetitive selection
process and provides greater flexibility in setting compensation rates.
Exceptions may be granted for entire agencies, such as the Federal Bureau of
Investigation, or for specific positions, such as members of the State
Department?s Foreign Service. Some agencies, such

2 This is subject to the limit on aggregate compensation established by 5 U.
S. C. 5307 and 5 CFR part 530, subpart B.

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as the Internal Revenue Service, have used flexibilities available within
the existing personnel system in concert with excepted service authority to
better tailor their human capital policies and practices to their needs. 3

To better determine how to apply these tools and flexibilities to resolve
their workforce issues, some agencies have undertaken formal internal
assessments. For example, the U. S. Mint?s Office of the Chief Financial
Officer formed a Human Resources Flexibilities Team and conducted a two-
phase study of the various flexibilities and tools available to, and used
by, the agency. Phase one of the study included an extensive review of all
human capital flexibilities available to the U. S. Mint under existing laws
and regulations. Phase two included an analysis of the U. S. Mint?s use of
these flexibilities and the development of recommendations to agency
leadership for increasing the effective use of these flexibilities as
recruitment and retention tools. FERC management has yet to conduct such an
assessment for the Commission.

While FERC?s human capital problems appear to be overwhelming, they are not
unique and are, in fact, quite similar to issues affecting other federal
agencies. As we recently reported in our Performance and Accountability
Series, serious human capital shortfalls are eroding the ability of many
federal agencies, and threatening the ability of others, to economically,
efficiently, and effectively perform their missions. 4 Our past work has
shown that agencies such as the Department of Defense, the National
Aeronautics and Space Administration, and the Nuclear Regulatory Commission
are struggling as FERC is to maintain the workforce skills that they need to
fulfill their regulatory responsibilities and missions. These struggles are
due to problems such as recruiting qualified employees, downsizing, and
pending retirements by many current employees. Given the seriousness of the
human capital problem facing agencies throughout the federal government, we
added this issue to our list of federal programs and operations that are at
high risk in 2001.

3 The Congress, in the Internal Revenue Service (IRS) Restructuring and
Reform Act, authorized IRS to establish up to 40 critical pay positions to
attract senior managers with special knowledge and skill that IRS would
otherwise have been unable to attract. IRS also created a broadbanded
personnel classification and pay system to increase its flexibility in
rewarding and utilizing managers.

4 U. S. General Accounting Office, Performance and Accountability Series:
Major Management Challenges and Program Risks: A Governmentwide Perspective,
GAO- 01- 241 (Washington, D. C.: January 2001). FERC Lacks a Plan for

Addressing Its Substantial, but Not Unique, Human Capital Challenges

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Some agencies with human capital challenges comparable to FERC?s are
beginning to take steps to resolve these issues, and an important first step
is the development of a comprehensive strategic human capital management
plan that is linked to the organization?s strategic and business plans. For
example, the Air Force Materiel Command (AFMC) has taken steps toward
improving its human capital situation by developing comprehensive plans to
reshape its workforce and meet its future business needs. In light of this
detailed effort, AFMC gained a better understanding of current and potential
workforce gaps and was better able to successfully transform its workforce.
However, FERC has yet to undertake a systematic strategic human capital
management planning process that can help guide its efforts to recruit,
develop, train, and retain the type of workforce that can effectively
regulate competitive energy markets.

We have also found that high- performing organizations in the public and
private sectors identify their current and future human capital needs-
including the appropriate number of employees, the key competencies for
mission accomplishment, and the appropriate deployment of staff across the
organization- and then create strategies for filling any gaps that are
identified from this process. Moreover, high- performing agencies
aggressively pursue comprehensive succession planning and executive
development actions to address the potential loss of leadership continuity,
institutional knowledge, and expertise. This kind of systematic planning
process is essential to address the breadth and complexity of human capital
challenges and succession planning issues that are looming at FERC. Although
FERC senior managers have begun to discuss the issue, to date, FERC has not
embarked on such systematic planning efforts. The only related analysis that
FERC has conducted is its June 2001 Workforce Analysis, prepared in response
to a request from OMB (OMB Bulletin 01- 07). While this analysis provides
both a ?snapshot? of FERC?s current workforce and some observations on
future issues of concern to FERC management, it falls short of the detailed
planning and assessment that effective strategic human capital planning
entails.

As we have recently reported, 5 many needed improvements in human capital
management can be achieved if federal agencies take a more strategic and
performance- based approach to managing their workforce.

5 U. S. General Accounting Office, Managing For Results: Building on the
Momentum for Strategic Human Capital Reform, GAO- 02- 528T (Washington, D.
C: March 2002).

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Such an approach would include performing effective workforce planning,
developing performance goals and measures to address workforce challenges,
and linking employee performance to results. We recently developed a model
of strategic human capital management to help federal agency leaders better
manage their organizations? most important asset- their people. The model is
designed to help agency leaders effectively use their people and determine
how well they integrate human capital considerations into daily decision-
making and planning for the program results they seek to achieve.

Because the transition to modern performance management will require changes
in management systems and organizational cultures that often take years to
implement, it will also require long- term commitment on the part of agency
leaders and managers. To accomplish this, agency leaders need to commit
their organizations to valuing and investing in their employees, empowering
and providing the employees with the tools to do their best, and
implementing modern performance management and incentive systems to focus
their efforts on achieving agency missions and goals. However, we have found
that the lack of continuity in leadership often hampers these efforts at
many agencies. As discussed earlier in this report, FERC has had four
different Chairs in the past 5 years. This constant change in leadership,
coupled with the demands for management attention to resolve other issues
such as the California energy crisis, has diverted FERC?s attention from
aggressively addressing its human capital challenges.

FERC?s current organizational structure cannot ensure that the emerging
energy markets are adequately monitored, because the structure does not give
adequate priority and attention to FERC?s market monitoring function. At
FERC, the market monitoring function is currently assigned to two of the
nine divisions within OMTR. These two divisions- Market Development and
Market Information- compete for resources and management attention with the
other seven, which are mostly responsible for analyzing case filings and
applications from the electricity and natural gas industries. This casework
has historically been, and continues to be, FERC?s principal mechanism for
regulating the activities of energy industry participants. FERC is required
to complete its work on most of these cases within legislatively set time
frames, such as 30 or 60 days. Consequently, casework demands may receive a
higher priority than general market monitoring activities. FERC?s

Organizational Structure Limits Its Effectiveness

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In addition, having the market monitoring and casework functions within the
same office hampers effective communication between FERC?s market monitoring
staff and industry participants. Under FERC?s rules to ensure independence
of its process for resolving cases before the agency (known as ex parte
rules), staff are prohibited from private discussions with parties involved
in a case pending before FERC. However, many companies or organizations
(such as ISOs) from which the market monitoring staff need to obtain
information are likely to have cases before FERC at any given time.
Consequently, the market monitoring staff may be limited in their ability to
hold discussions with these companies or organizations, as well as with
other FERC staff who may be involved in case resolution. For example, the
Director of Market Analysis for the California ISO told us that because of
ex parte rules and FERC?s organizational structure it was very difficult for
her office to communicate directly with FERC?s market monitoring staff
during the California energy crisis. Instead, she was forced to communicate
with FERC staff in other offices and hope that they would accurately relay
her concerns to the appropriate parties within the agency. A former
Commissioner also noted this barrier, commenting that ex parte concerns
hindered information flow at FERC and inhibited the agency?s ability to
gather market monitoring data.

FERC has recently created a new Office of Market Oversight and Investigation
that will report directly to the Chairman and will be staffed by a
multidisciplinary team. The functions of the new office will include
understanding energy markets and risk management issues, measuring market
performance, investigating compliance violations, and analyzing market data.
According to FERC, the new office will have a total of about 100 staff.
About 50 staff members will be transferred to this new office from OMTR and
the Office of the General Counsel. FERC is requesting funding in its fiscal
year 2003 budget proposal to hire the other 50 staff members. FERC stated
that many functions of the new Office of Market Oversight and Investigation
require expertise that is currently limited at the agency. FERC further
stated that in order to fulfill its responsibilities, the new office will
need to augment the agency?s capabilities in several areas, including
conducting intensive market investigations and performing sophisticated
market information analysis. However, according to a FERC manager, many
details about the office and how it will carry out its responsibilities have
not yet been determined.

As the energy industry has evolved, the resources and structures that FERC
has in place are no longer adequate to fulfill the agency?s new Conclusions

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responsibilities for regulating and overseeing competitive markets. The
challenge for FERC is further complicated by the fact that while the agency
needs to transform its workforce rapidly and revamp its organizational
structure decisively to meet the needs of the new energy markets, it must
also maintain the ability to fulfill some traditional regulatory
responsibilities. Having staff in place with the requisite competencies to
regulate and oversee traditional and emerging competitive markets is
essential for FERC to be able to detect and head off service disruptions,
price spikes, and market abuses similar to those that occurred in California
and other parts of the West in 2000 and 2001. While FERC has taken steps to
address its organizational challenges by creating a new Office of Market
Oversight and Investigation, much remains to be done to address the agency?s
persistent human capital challenges.

FERC has struggled to recruit and retain highly qualified and experienced
employees in order to be able to regulate and oversee evolving competitive
energy markets. However, without having explored the full range of personnel
tools and flexibilities that could help address these issues, FERC cannot
determine which of the available tools may be best suited to help it achieve
its staffing goals. Furthermore, without enhanced training, FERC cannot
ensure that its staff will have the knowledge and skills required to
understand and adequately regulate and oversee the increasingly complex
energy markets. Because of the impending loss of institutional knowledge
possessed by the large number of staff soon eligible to retire, it is also
questionable whether FERC will be able to effectively provide the
traditional regulatory work for which the agency is still responsible.

On a broader scale, without a comprehensive and systematic strategic human
capital planning process to guide the agency?s efforts to recruit, develop,
train, and retain staff, FERC will be unable to effectively regulate and
oversee competitive markets. Although this type of planning takes a
substantial amount of time and commitment from any agency?s top leadership
and management, without this high level of attention and commitment, FERC
will be unable to effectively resolve its human capital problems. Our model
of strategic human capital management should prove helpful to FERC as it
moves forward in its planning efforts.

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To help ensure that FERC has the mix of staff skills and expertise that it
needs to effectively carry out its regulatory and oversight responsibilities
for emerging competitive energy markets, we recommend that the Chairman,
FERC, identify the personnel tools, flexibilities, and strategies, other
than those already in use by FERC, available to federal agencies to recruit
and retain employees. A formal internal assessment of the effectiveness and
applicability of these to FERC, especially for the new Office of Market
Oversight and Investigation, should be conducted. On the basis of this
analysis, the Chairman should develop an action plan to use the appropriate
tools, flexibilities, and strategies to begin to recruit and hire needed
expertise. The Chairman should also develop an action plan to identify and
target additional training and development opportunities for current staff
involved or potentially involved in carrying out FERC?s market oversight
functions.

In the longer term, we recommend that the Chairman, FERC, develop a
comprehensive strategic human capital management plan to guide FERC?s
efforts to recruit, develop, train, and retain staff knowledgeable in
regulating competitive markets. The plan should be linked to FERC?s
strategic and business plans and should include the following:

 a skills assessment program that would identify gaps in skills currently
held by the workforce that are necessary to carry out the agency?s evolving
regulatory and oversight responsibilities;

 a recruitment and retention initiative, based on priorities for meeting
future regulatory and oversight staffing needs, which addresses filling
skill gaps in the current workforce;

 a training effort targeted at increasing staff knowledge in the areas of
market functions and market structures, so that FERC staff will be better
prepared to regulate and oversee competitive energy markets; and

 a comprehensive succession plan for solving challenges posed by the large
number of impending retirements within the agency, including reliable
projections of the number of eligible staff who may actually retire.

In its written comments on a draft of this report, FERC stated that the
report accurately addresses the human capital challenges that the agency
faces. It noted that its staff today is better suited to regulate cost- of-
service rates rather than market- based rates. The agency stated that how it
replaces the large number of its employees retiring in the near future will
Recommendations for

Executive Action Agency Comments

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have a profound effect on its future capabilities. FERC also stated that it
has made significant progress recently in hiring new employees through an
aggressive recruitment program and is focusing on the skill sets needed for
market oversight and investigation. The agency further stated that it will
explore all the hiring flexibility available to the agency to build a world-
class oversight staff, drawing ideas from agencies with similar regulatory
responsibilities over complex and rapidly evolving markets. According to
FERC, it has already received congressional authorization to hire five new
senior positions for market oversight and investigation and has requested
congressional authorization for 50 new positions and $5 million in
additional funding. FERC said that it is presently reviewing existing budget
allocations across the agency for further resources. Finally, FERC stated
that the agency has implemented training programs for existing staff and is
working to craft more focused training programs to build technical and
leadership capabilities. While all of these steps will help FERC address
some of its human capital challenges, we believe that it is important for
the Commission to have a comprehensive human capital management plan to
guide these efforts over the longer term.

Appendix I: FERC?s Principal Strategic Goals and Objectives for Energy
Markets

Page 69 GAO- 02- 656 Energy Markets

Table 4 shows the Federal Energy Regulatory Commission?s (FERC) principal
goals and objectives relating to its regulation and oversight of energy
markets, as contained in the 1997, 2000, and 2001 versions of its strategic
plan.

Table 4: FERC?s Principal Strategic Goals and Objectives for Energy Markets
Version Strategic goals Strategic objectives

1997 Regulate electric transmission and bulk power markets to

 foster the growth of efficient, competitive commodity markets and

 protect customers from excessive transmission rates and service
discrimination.

Regulate natural gas pipelines to

 ensure that pipeline transportation service supports efficient,
competitive commodity markets and

 protect consumers from excessive transportation rates and service
discrimination.

Efficient, competitive markets: Customers will have more new products and a
reasonable range of suppliers from which to choose in both the electric and
natural gas industries.

Efficient, competitive markets: Natural gas and electric power prices will
become more responsive to market conditions- that is, prices will reflect
changing supply and demand conditions more clearly and more quickly.

Efficient, competitive markets: Natural gas prices within each trading
region will tend to converge, except to the extent that there are
demonstrable transportation constraints or costs. Wholesale electricity
price differences will also tend to narrow.

Efficient, competitive markets: It will be less costly, administratively, to
transact business on the interstate natural gas transportation grid.

Constraining market power: Market participants will have confidence that
natural gas markets, electric markets, and all transportation services are
working efficiently and fairly and that market participants are not subject
to abuses of market power. 2000 Benefit consumers by providing a fair, open,
and efficient

regulatory foundation for competition. Increase pricing efficiency.

 Promote innovative, efficiently priced services.

 Promote reliability by using market pricing to encourage capacity
expansion.

Nurture competitive market institutions.

 Increase transportation system integration through regulatory reform.

 Increase transparency of Commission policies and availability of market-
related information

 Monitor energy markets. Constrain market power.

 Detect and respond to all forms of market power.

 Use enforcement and litigation as necessary to remedy anti- competitive
behavior.

Appendix I: FERC?s Principal Strategic Goals and Objectives for Energy
Markets

Appendix I: FERC?s Principal Strategic Goals and Objectives for Energy
Markets

Page 70 GAO- 02- 656 Energy Markets

Version Strategic goals Strategic objectives

Resolve disputes quickly and fairly.

 Promote informal procedures to resolve issues, especially the use of
alternative dispute resolution.

 Target litigation for those cases where it makes sense. 2001 Promote a
secure, high- quality, environmentally- responsive

energy infrastructure through consistent policies. Remove roadblocks
impeding market investment. Provide clarity of cost recovery to
infrastructure investors.

Proactively address landowner, safety and environmental concerns.

Stimulate use of new technology. Promote measures which improve the security
and reliability of the energy infrastructure. Foster nationwide competitive
energy markets as a substitute for traditional regulation. Advance
competitive market institutions across the entire

country. Establish balanced, self- enforcing market rules. Protect customers
and market participants through vigilant and fair oversight of the
transitioning energy markets. Improve our understanding of energy market
operations.

Assure pro- competitive market structures. Remedy individual market
participant behavior as needed to ensure just and reasonable market
outcomes. Efficiently administer the agency?s resources to accomplish the
agency?s goals. Attract, train, and retain staff to fulfill the strategic
plan.

Manage information technology to better serve the public and streamline work
processes.

Communicate our activities more clearly with customers, elected officials,
and industry.

Integrate agency business planning and budgeting processes.

Build strong partnerships with all stakeholders, particularly with governors
and states.

Appendix II: GAO Survey of Current FERC Employees in Selected Offices

Page 71 GAO- 02- 656 Energy Markets

This appendix contains the questions and responses from our survey of FERC
employees in the Office of Markets, Tariffs and Rates and staff in the
Office of the General Counsel?s sections for Markets, Tariffs, and Rates and
Market Oversight and Enforcement. Responses are expressed as a percentage of
those responding to the survey. Appendix II: GAO Survey of Current FERC

Employees in Selected Offices

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix III: Comments from the Federal Energy Regulatory Commission

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Appendix IV: GAO Contacts and Staff Acknowledgments

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Jim Wells (202) 512- 3841 Anu Mittal (202) 512- 9846

In addition to the individuals named above, R. Stockton Butler, Elizabeth
Erdmann, William Lanouette, and Raymond Smith made key contributions to this
report. Important contributions were also made by Stuart Kaufman and Barbara
Timmerman. Appendix IV: GAO Contacts and Staff

Acknowledgments GAO Contact Acknowledgments

(360104)

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