The past and future of electricity regulation.

• Author: Tomain, Joseph P.

By 2006-2011, electricity will be purchased and sold in both wholesale and eligible retail markets by any willing creditworthy participant. Markets will clear with competitive prices. Competitive prices will function so as to ration existing supplies efficiently in the short run and to elicit adequate technology and infrastructure in the long run, so that there will be no involuntary curtailment of service at market prices. Electricity markets will be both transparent and liquid, and market participants will have opportunities to hedge risks. Although regulation of monopoly service providers will continue, even these monopolies will feel some pressure of competitive market forces. (1) I. INTRODUCTION

The goal of the Federal Energy Regulatory Commission (FERC) staff to achieve competitive electricity markets by 2011 is overly ambitious, but nonetheless worthy. There is much to note in the quotation. First, both wholesale and eligible retail markets will be competitive, transparent, and liquid. Second, the markets will be so efficient that consumers will not experience involuntary curtailments. Third, market actors will be able to hedge risks, which is necessary for supply reliability. Finally, regulation of monopoly service will continue. This Article concentrates on the continuing regulation of the electricity industry by looking at the past and speculating about the future. Like Heisenberg's Uncertainty Principle, which held that an observer cannot know both the speed and position of an electron, the present state of electricity regulation is too dynamic to pin down.

The last eighteen months have been remarkable for the electricity industry. The California crisis of the summer of 2000, the war against Afghanistan, and most recently, the Enron debacle, called attention to industry restructuring and the future of national energy policy. While each of these events have been catastrophic for California, Enron, and the world (in the case of Afghanistan), none of them should change the direction of electric energy policy. At bottom, the California crisis was about poor economic predictions and poor regulatory design. The Enron debacle was about poor financial hedge management along the lines of the Long Term Capital Management collapse in 1998. (2) And the Bush administration's energy policy was set in place before September 11, 2001 and the following Afghan war. In short, none of these events should affect restructuring because none of them addresses what is most significant, the ability to construct and maintain an efficient reliable transmission system.

Continued regulation is warranted because the transmission segment of the electric industry maintains natural monopoly characteristics. Further, until there are significant technological advances, for example in distributed generation or fuel cells, regulation is justified. The discussion of electricity transmission will be placed in context by briefly discussing the California crisis and Enron in Part II. Part III examines the remaining aspects of natural monopoly in the electricity industry. Part IV discusses the role of electricity in national energy policy. The Article concludes by identifying five challenges facing the industry and its regulators.

2. THE CURRENT SITUATION OF ELECTRIC INDUSTRY RESTRUCTURING

   The language we use in policy analysis is almost as important as the language we use in legal analysis. The popular perception is that the Reagan Revolution was the beginning of deregulation during the last quarter of the twentieth century. That perception is inaccurate. The Carter administration engaged in the deregulation of airlines, trucking, energy, and other industries. (3) Still, the Reagan years stressed the importance of deregulation across a broad range of industries including electricity. Deregulation was and is driven by politics and economics. Economically, the country's infrastructure of roads, pipes, and wires has been built, thus the traditional regulatory scheme has accomplished its goals. Politically, markets and competition were and continue to be attractive on both sides of the congressional aisle. Consequently, deregulation continues.

   The electric industry was not immune from the deregulatory bug. However, the electric industry--and here is where language is important--never caught the worst strain of the bug. While policymakers sought to "deregulate" the industry, the laws and regulations they used were intended and designed to "restructure," not deregulate, electricity.

   To understand why the industry is restructuring rather than deregulating, it is necessary to recognize fundamental principles about the electricity market, such as:

   * Electricity cannot be stored effectively--think batteries.

   * Electricity must be ready for use on demand--think cold beer and the Web.

   * Traditional regulation passed through costs to consumersmthink inelasticity.

   * Traditional regulation encouraged capital expansion--think nuclear power plants.

   * Traditional utilities were immune from competition in their monopoly protected service areas--think local public utility.

   * Traditional utilities controlled the wires that delivered the electrons--think telephone pole.

   * New entrants were waiting in the wings--think Enron.

   All of these elements combined during the twentieth century to construct an expensive electricity infrastructure. (4) Because electricity cannot be stored effectively and because it must be available on demand, the electricity system or grid must operate very reliably. Blackouts are not good. So the traditional rate formula, sometimes known as the regulatory compact, helped assure the construction of that infrastructure by rewarding capital investment. This reward system was both good and bad. The infrastructure was built--that was good. However, because these costs were passed through to customers, utilities were rewarded for building, had a virtually guaranteed rate of return, and were immune from competition. As a result, utilities overbuilt. (5)

   Once utility-generated electricity became too expensive, new entrants were ready to produce electricity at lower cost than the incumbent utilities. However, two significant problems arose. First, traditional public utilities controlled access and, naturally, were not favorably disposed to charge competitors friendly prices to transport electricity. Second, while consumers were anxious to purchase lower priced electricity, they also were concerned about the reliability of supply. With the stimulus of Congress, most notably through the Public Utility Regulatory Policies Act of 1978 (PURPA), (6) the electricity industry began easing transmission access to nonutility electricity producers and, thus, the window to competition opened.

   It is at this point in the developing history of the electricity industry and its regulation that two new words enter our vocabulary--California and Enron. For the last year and a half, the California electricity crisis and the Enron debacle appear to demonstrate the failure of electricity restructuring. That appearance is false even though the restructuring movement has been slowed. As of January 2002, seven states have delayed restructuring activities, California has suspended action, and twenty five states are listed as not active. (7) Both the California restructuring effort and Enron's energy trading modus operandi were the products of design failure, not faulty theoretical assumptions. Indeed, although both were failed attempts, California's electricity restructuring and Enron's energy trading point to the future of a restructured electric industry.

   1. California

      There is no shortage of analyses of the California electricity crisis. (8) Fundamentally, the crisis was a matter of supply and demand, resulting in prices beyond any previously recognized level and a bankruptcy filing by Pacific Gas & Electric, one of California's Big Three utilities. The market distortions were created by poor predictions about demand, a hot summer, a dry Northwest, high natural gas prices, miscalculations about supply, no new generation, and most significantly, a poor regulatory design.

      Although the crisis has passed, and prices have lowered and blackouts, rolling or otherwise, are not on the horizon, there are lessons to be learned from the California experience. (9) Chief among these lessons involves regulatory design, the crux of which was an inflexible market for buying, selling, and pricing electricity. There are three notable aspects to this design, one of which was fatal. First, the major public utilities in California divested their generating units while maintaining an obligation to serve their customers. As long as costs are passed through to consumers, the obligation to serve does not present a severe problem because the utilities earn money to pay their bills. Second, two new regulatory entities were established, the California Power Exchange (PX), which set prices, and the California Independent System Operator (ISO), which directed the movement of electricity through the system. The PX was the market mechanism intended to make the industry competitive. (10) The PX and the ISO are perfectly appropriate entities, again if properly designed.

      The fatal flaw was the price restrictions. They were the medicine intended to help the consumers, but that killed the restructuring. Utilities had to buy wholesale energy at market price from the PX in no more than day-ahead or hour-ahead markets, which meant they could not enter long-term contracts. These spot-market purchases were subject to a great deal of volatility and the highest bid set the price. At the same time, retail prices to consumers were capped until the utility recovered its stranded costs. (11) The problem was that the utilities bought in the spot-market at extraordinarily high prices and sold in a capped retail market, thus putting themselves in a credit crunch with high profits for other producers, high...