Innovations in Retail Choice for Large Commercial and Industrial Customers

• Author: John C. Hilke and Michael Wroblewski
• Position: Electricity Project Coordinator in the Federal Trade Commission s (FTC) Bureau of Economics
• Pages: 04

John C. Hilke is an independent economic consultant. He previously served as an economist and the Electricity Project Coordinator in the Federal Trade Commission¥s (FTC) Bureau of Economics. Michael S. Wroblewski is an Assistant General Counsel for Policy Studies and Attorney Advisor to Commissioner Thomas B. Leary at the Federal Trade Commission. The views expressed in this paper are our own and do not purport to be the views of the Federal Trade Commission or of any individual Commissioner. We thank Denis A. Breen and John H. Seesel for comments on drafts of the paper.

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I Introduction

THE ELECTRIC POWER INDUSTRY is the largest remaining major arena of utility regulatory reform in the U.S. With sales of over $250 billion annually, the electric power industry dwarfs most other industries, and its importance to modern life and economic wellbeing is difficult to overstate. Recent blackouts provide a vivid demonstration of the importance of electric power to every aspect of American society. The journey to reform the electric power industry regulatory structure, where market-based profit incentives rather than administrative decisions guide investment and service offerings, has not been particularly smooth.¹ One of the roughest spots in the road has been retail competition in which customers pick their own retail electric power supplier rather than relying on their franchised electric utility.² Much of the damage in the California energy crisis of 2000 and 2001 stemmed from problems with California¥s insistence that retail prices remain frozen despite wholesale prices that rose dramatically.³ One aspect of retail competition, namely continued state mandates for provider-of-last-resort (POLR) service at regulated prices, has been particularly problematic. POLR service applies primarily to customers who have not selected a retail electricity supplier, although customers whose retail supplier has exited the industry also receive electric power through POLR service until they select another supplier. Most states that permit retail electricity customers to choose their own supplier require that each local distribution utility provide POLR service at fixed, administratively determined prices.

The Federal Trade Commission (FTC) Retail Competition Staff Report found that prices for POLR service in many states prevented new suppliers from offering retail electricity services to customers and caused financial distress for POLR service providers.⁴ If POLR prices are fixed, as many states have done, increases in wholesale prices eliminate most incentives for entry of efficient and innovative retail suppliers. Moreover, fixed POLR prices can create financial distress for the distribution utilities providing POLR service because, as wholesale prices rise, the utilities are unable to pass on their higher costs to POLR customers. On the customer side, extended periods of below-market POLR prices remove incentives for customers to be active market participants and may make entrants¥ subsequent marketing efforts more costly.

In this article, we discuss recent POLR service developments that seek to eliminate many of the market distortions caused by many initial POLR policies. The new POLR service pricing approach for large commercial and industrial (C&I) customers in Maryland and New Jersey, for example, avoids some of the pitfalls of divergent retail and wholesale prices. POLR service prices that closely track wholesale prices can restore incentives for entry by efficient and innovative retail suppliers and can assure that supplying POLR service does not cause losses for distribution utilities. At the same time, the presence of diverse offers from entrants (and incumbents) creates incentives for customers to search for the best match between their preferences and available offers. The availability of diverse service offerings (including variations in prices, environmental characteristics of the supply purchased, reliability of the supply, Page 14 etc.) can benefit consumers as compared to the limited range of services offered by incumbent utilities. These pricing innovations also help eliminate any cross-subsidization between large C&I customers and other classes of customers, such as residential and small commercial customers. Because several states with existing retail customer choice programs are reaching the end of their respective phase-in "Atransition@" periods for customer choice, it may be a propitious time to reexamine POLR service pricing practices to avoid their detrimental effects on the development of competitive retail electricity markets.

II POLR Pricing Analysis in the FTC Retail Competition Staff Report

A PRINCIPAL CONCLUSION OF THE FTC Retail Competition Staff Report was that POLR pricing policies prevented new retail suppliers from offering services to eligible customers, thus dooming the initial prospects for a vibrant retail supplier market. States have adopted POLR service because the lack of electricity, even for a short period, may be life-threatening or impose severe hardship on customers. As implemented by several states, a customer may take POLR service when it has decided not to select a retail supplier or simply failed to make a decision (and there is no mechanism to assign an alternative supplier to the customer), when no alternative supplier has accepted the customer (usually because of the customer¥s credit or payment difficulties), or when the alternative supplier selected by the customer has exited. State regulators have generally assigned POLR service obligations to the incumbent distribution utility whose franchise territory includes the customer¥s location. POLR service assures that every customer always has an associated retail supplier and thus avoids any lapse in electrical service for retail consumers.⁵

The most harmful POLR service policy choice occurred when states established fixed retail prices that did not vary with changes in fuel prices used to generate electric power.⁶ When natural gas and some other fuel prices increased substantially and retail prices were fixed, utilities with POLR obligations in several states had costs that exceeded revenues for POLR service. This situation was most severe in California during 2000 and 2001, where natural gas is the predominant fuel for generation and where utilities purchased power to meet their POLR obligations primarily in the spot market.⁷ This condition also eliminated incentives for most types of retail entry. The only notable exception was retailers supplying green power. Green power entrants were sometimes able to attract sufficient customers at prices above the price for POLR service. Experience since 2001 confirms the conclusion in the FTC Retail Competition Staff Report. In several states that initiated retail customer choice policies, few alternative suppliers entered or remained in the market and relatively few customers actively considered alternative suppliers. This fact, and the substantial market design flaws present at the retail and wholesale levels in California,⁸ eroded interest in electric retail customer choice programs in other states (and countries) during the early part of this decade, with the notable exception of Texas.⁹

Based on this experience, retail electric power markets with effective competition are more likely to develop if prices for POLR service closely follow wholesale prices.¹⁰ POLR service prices that do not closely track wholesale prices undermine incentives of new competitors to enter the market for two reasons: (1) they decrease the expected level of profitability if POLR prices are on average less than competitive market prices; and (2) they increase the expected risk of entry, (i.e., the variability in profitability) to the extent that POLR prices are determined administratively and may not be linked to underlying market conditions. In other words, new entrants must compete against POLR services, offers that may not represent competitive conditions.¹¹ Fixed POLR prices also discourage customers from initially becoming, and thereafter acquiring the habits of, active market participants that keep informed about the range of offers available from different suppliers and act quickly and effectively to protect their own interests. These actions can undermine anticompetitive price increases when the transition to customer choice is completed. In addition, fixed POLR service prices may increase costs for existing and potential retail suppliers. Both types of retail suppliers may have to pay more to attract capital because their expected earnings are subject to greater variance than would be the case if POLR service prices closely tracked wholesale electricity prices.

"One of the roughest spots in the road has been retail competition in which customers pick their own retail electric power supplier rather than relying on their franchised electric utility."

POLR prices that track wholesale prices are also likely to Page 15 increase the efficiency of the electric system overall.¹² When retail prices track wholesale prices, peak loads are likely to be reduced (peak load shaving) and loads during off-peak periods are likely to increase as customers shift electricity use to less expensive off-peak periods. When customers have accurate and timely price information, they also have efficient pricing signals to invest...