LexisNexis(TM) = Academic

PUBLIC UTILITIES FORTNIGHTLY

July 1, 1995=20

SECTION: FEATURES; Pg. 43=20

LENGTH: 2232 words =

HEADLINE:=20 Proposition PoolCo: Inventing the Wrong = Market=20

BYLINE: By Robert J. Michaels; Robert Michaels = is a=20 professor of economics at California State University, Fullerton, and = consultant=20 with JurEcon, Inc. He has testified on these matters before the = California=20 Public Utilities Commission and the California Energy Commission. The = views=20 expressed in this article are not necessarily those of his clients.=20

BODY:
Attacking the state's high electric = rates at=20 the source, a year ago the California Public Utilities Commission (CPUC) = proposed to end retail monopoly and give end users "direct access" to = supplies=20 of their choice. In response, two of the state's three major utilities = (San=20 Diego Gas & Electric Co. and Southern California Edison Co. (SCE)) = proposed=20 variants of "PoolCo." Independent of existing utilities, PoolCo will = take offers=20 from all over the West and dispatch the generation of successful bidders = to=20 yield a time-varying energy price that clears the market. Although only=20 utilities can buy from PoolCo, retail ratepayers can hedge its energy = price with=20 financial instruments like Britain's "contracts for differences." =

The=20 CPUC plausibly argued that regulation itself had been a major cause of = high=20 rates. Save in rare cases, regulators allowed utilities to recover the = costs of=20 poor investments from captive ratepayers. Inaccurate fuel-price = forecasts and=20 poorly designed contracts had produced billions of overpayments to the = state's=20 nonutility generators (NUGs). With two separate agencies monitoring = utilities,=20 California enjoyed the worst combination of regulatory bureaucracy and = political=20 expedience. If these factors were responsible for high rates, PoolCo = addresses=20 none of them.

Instead, PoolCo addresses non-problems. SCE has = testified=20 that the West is already dispatched efficiently without PoolCo. = Inefficient end=20 use of power results more from poor rate design than from absence of a = pool=20 price. Energy prices are already reported at the California-Oregon = border, and=20 southwestern prices will soon be available. Because PoolCo permits = continuation=20 of demand-side management (DSM) and utility-funded social projects, it = will not=20 alleviate their rate impacts. Anyone could have proposed PoolCo a decade = ago.=20 Only now, however, do utilities propose it, and in response to an = initiative on=20 retail competition.

The Market that Matters =

PoolCo trades=20 in today's energy, which is produced by yesterday's capacity = investments.=20 Existing markets allocate energy production quite effectively without = PoolCo.=20 Today's prices in part result from past capacity contracts, and the = market for=20 those contracts has not functioned so well. As they do in the markets = for=20 housing and mortgages, people negotiate contracts for generating = capacity=20 without going to a central exchange. In any market, transactors gather = and=20 evaluate information about alternatives that are offered to them. = Potential=20 parties to capacity contracts can negotiate with numerous others over = both broad=20 choices and complex details. If you and I both have choices, the deal we = strike=20 (if any) will be the best prospective package we can negotiate, given = the=20 alternative projects and partners that are available. Prospectively = inferior=20 contracts and their offerors get weeded out of the market. =

Utilities,=20 contractors, independent power producers (IPPs), and financiers = participate in=20 today's market for capacity contracts. Many contracts are internal to = vertically=20 integrated utilities, with ratepayers responsible for paying off the = utility's=20 investments. Other contracts, such as those for jointly owned plants, = are=20 between utilities. Still others are between IPPs and utilities. End = users are=20 conspicuously absent from virtually all of today's capacity contracts. = Direct=20 access will end their absence, but PoolCo as proposed will not. Today's = retail=20 customers are the ultimate financial guarantors of contracts they had no = say in=20 negotiating. Direct access will let retail customers participate in the = market=20 for capacity contracts, taking on risk and responsibility as they cannot = do=20 today.

Even if utilities do their very best for ratepayers, = today's=20 capacity market needs end-user access to function well. Choices there = are=20 becoming more numerous and more difficult to evaluate by the day. A = single=20 utility might choose correctly from a dozen options. But, through no = fault of=20 its own, that utility will probably choose poorly in a market with more = numerous=20 possible investments, each of which requires a contract with hundreds of = provisions. As the world's complexity grows, so do the gains from = allowing end=20 users to tailor service and capacity choices to their own needs. In an = age of=20 self-sufficient service territories and standardized generation, a = monopoly=20 utility might well know all of the choices and be able to evaluate them=20 rationally. If it ever existed, that age died at the hands of stronger=20 interconnections, NUGs, the Energy Policy Act of 1992, unbundling of=20 coordination services, demand-side innovations, and (soon) standardized=20 financial instruments. Today's utility is just one more competitor in a = market=20 for capacity contracts that no one participant can ever understand = fully.=20 Competition is not a supply-and-demand diagram for PoolCo's energy. It = is a=20 process of discovery and innovation, where parties sink costly = investments in=20 their electrical futures and bear the risks of those choices.
=
Capacity Crediting

PoolCo offers end users and generation = owners=20 little more than opportunities to hedge energy prices. Only in rare = cases will=20 it allow them to make capacity contracts. PoolCo's supporters call = energy hedges=20 "efficient direct access" ("virtual direct access" in the latest = proposal), but=20 if hedges were the same as direct access, utilities could cheaply = resource=20 themselves with energy contracts alone. Under PoolCo, as proposed, the = market=20 for capacity contracts will remain closed to end users. To see why, = assume that=20 an end user and a generator make a contract in which the end user buys = the=20 plant's energy and commits to paying off its capacity. If the plant is = an=20 efficient energy producer, it can bid into PoolCo and recover its = operating cost=20 at the PoolCo price. After paying its local utility PoolCo's energy = price, the=20 end user can settle up with the generator on the energy price hedges = they have=20 chosen.

In addition to an energy price, the end user must pay = its=20 utility a demand charge. In addition to social programs, DSM, and = strandings,=20 the demand charge pays off capacity the utility either owns or has under = contract. Under PoolCo, the end user who invests in capacity pays a = double=20 demand charge -- once to the utility, and once for its own investment. = Crediting=20 this customer's demand charge seems efficient and fair. End users with = credit=20 will only bypass when their total capacity and energy costs are lower. = Failure=20 to credit will keep end users from making economically warranted = investments=20 that lower society's total power costs.

In a 1973 antitrust = settlement,=20 municipal utilities in SCE's territory obtained operating agreements = forcing the=20 utility to include capacity crediting in wholesale rates. The result: = Two=20 decades later, even the smallest of these municipals is largely = self-resourced.=20 Without crediting, a double demand charge would surely have kept = municipals in=20 captivity, allowing them at most short-term energy transactions. =

The=20 capacity crediting issue is critical for determining the mix of future = resources=20 and who will be responsible for them. However, SCE has told the = California=20 Energy Commission that PoolCo will not offer end users capacity credit = because=20 it might engender litigation. This is an odd worry for a utility which, = unlike=20 end users, can recover its legal expenses in regulated rates. The more = probable=20 cause is that SCE has every reason to expect its market and political = roles to=20 shrink drastically if retail bypassers get capacity crediting, PoolCo or = no.=20

Interpreted charitably, SCE misunderstands both markets and = litigation.=20 When valuable commerce begins in a new good (think of oil pools or = broadcast=20 frequencies), the law must establish property rights, allow = experimentation with=20 new transactions, reconcile differing interpretations of contract terms, = and=20 fill in missing terms. In a new market, court decisions give useful = guidance for=20 future transactions. As time passes, contracts become more standardized, = and=20 litigation arises only in extraordinary cases. Such a sequence well = describes=20 the growth of the interutility bulk-power market over the past three = decades.=20

The Capital Markets

Utilities have often = rationalized=20 monopoly as being necessary for economical finance of power production. = Because=20 generators are expensive, durable, fixed in location, and useless in = other=20 industries, low-cost finance requires retail monopoly that commits = customers to=20 pay off these investments. In an industry with more easily marketable = assets,=20 lenders can cope with default by, for example, selling a foreclosed = building in=20 the real estate market and shipping its general-purpose equipment to a = buyer in=20 another region. Since a failed power plant carries little more than = salvage=20 value, lenders will likely insist that someone commit to purchasing its = output=20 or otherwise paying off the plant's cost.

Future power plants = will=20 probably be as idiosyncratic as today's, but PoolCo's advocates expect = that=20 risk-takers will build them without capacity commitments. Finance is = unlikely to=20 come cheaply if capital recovery for investors depends on the margin = between=20 operating cost and PoolCo's price over the plant's lifespan. Investors = cannot=20 hedge capacity risk with energy-price instruments. According to = California=20 testimony, British energy hedge contracts usually run for fewer than = three years=20 and never more than five. They cannot feasibly guarantee payoff of a = plant with=20 a 20-year lifespan. SCE's municipals have direct access and capacity = crediting,=20 and still nobody builds for them on speculation. Builders of nonutility=20 generation, including SCEcorp's independent power subsidiary, Mission = Energy,=20 invariably write contracts that specify the terms of power purchases or = capacity=20 payoffs, even when payment for the plant's energy output is = market-based.=20

If end users cannot commit to pay for capacity, the only = reasonable=20 alternative is utility business as usual. Uncommitted generation will = prove=20 costlier than committed generation, regardless of who owns the latter. = Without=20 end-user crediting, assertions by utilities that they are leaving the = capacity=20 business lack credibility. State regulators, particularly those with = integrated=20 resource planning (IRP), will probably not tolerate capacity shortages = large=20 enough to induce investment in uncommitted generation. Venturers who are = restricted to uncommitted plants will cut risk by building less durable = ones=20 with lower investment per kilowatt. Such practices will validate=20 environmentalist fears that competition distorts least-cost planning in = favor of=20 quick payoffs. The sorry outcome, however, results from retail monopoly = and=20 exclusion of end users from the market for capacity contracts. Some = advocates of=20 competition mistakenly feel that people will only have strong incentives = to=20 build low-cost plants if capacity contracts are unavailable. Do they = really=20 believe that in a capital-intensive industry the best way to cut total = cost is=20 to raise the cost of capital?

Building Open Institutions=20

PoolCo's supporters have demonstrated consummate tactical skill, = turning=20 a debate about the long-term future of electricity into a quarrel about = the=20 details of short-term energy markets. Professor William Hogan is quite = accurate=20 in saying that the differences in energy markets between the = PoolCo and=20 bilateral camps are largely technical and terminological. But it is = nothing=20 short of tragic that these differences obsess so many otherwise = thoughtful=20 people. California's problems and the nation's electrical future are not = about=20 these short-term issues. The difficulties do not lie in the energy = market, and=20 the solutions will not be found there either. California's electrical = disaster=20 came from poor capacity choices, and will only be set right when the = market for=20 capacity is opened up to end users.

PoolCo has been sold = intellectually=20 as a new "institution" that must be "put in place" for competition. Its = backers=20 compare PoolCo to stock and commodity exchanges, but those analogies are = not=20 valid. Unlike PoolCo, the use of exchanges is voluntary. Not "put in = place" for=20 traders without alternatives, the exchanges thrived by becoming more = attractive=20 than other places people might trade. They evolved not by compulsion, = but by=20 persuasion as new opportunities and new ideas came along. No grand = concept was=20 placed before a "collaborative" of "stakeholders" who would decide on = all the=20 details of a scheme no one could escape in the future. =

Productive=20 economic institutions accrete from individual dealings, not from the = collective=20 compromises endorsed by PoolCo's advocates. Institutions are = competitive. People=20 who can agree on better ways of doing business forcibly displace those = whose=20 interests are with the old ways. "Let the market decide" is the = disingenuous=20 refrain of many California parties. The only market most seem to want is = the one=20 that they dream of.

Everybody claims to want competition, but = the=20 utility wants to keep retail monopoly, the independent generator wants = to keep=20 the Public Utility Regulatory Policies Act, the bypasser wants to keep = utility=20 service obligations, and the environmentalist wants to keep IRP. Nobody = will be=20 totally happy about, it, but the most likely way to get anything right = is to let=20 the market decide what the market is to look like. =

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