FERC's California fix: Opportunities lost and found
Robert J Michaels

01/01/2001
Public Utilities Fortnightly
34-36
Copyright (c) 2001 Bell & Howell Information and Learning Company. All rights reserved. Copyright Public Utilities Reports, Incorporated Jan 1, 2001

Forget market share. Forget costs. But listen to the data.

WHEN THE STAFF OF THE FEDERAL Energy Regulatory Commission issued its report on Nov. 1, describing the performance of western power markets last summer,1 its arrival was refreshing. Gone were the usual ways of defining markets and market power. In their place came a recognition of a new reality-that markets dear on their own terms. They pay scant attention to embedded costs and other ratemaking niceties.

In theory, the FERC itself relied on that report in framing its celebrated "California" order, issued that same day.2 Yet the two seem to run at odds. Key parts of the order appear as attempts to blend the staff's analysis with the commission's usual regulatory tools. It proposes a reconciliation of the old and new, but might instead engender policies that inhibit competition. By contrast, if the FERC would continue in the vein outlined in the staff report, it would strengthen the integrity of its investigations into electricity competition. It would leave such interested parties as California's elected officials with a more difficult standard to meet, if they should wish to show that prices are unjust and unreasonable. It would do more to foster competition.

Two Steps Forward, One Step Back

The staff report does away with two staples of earlier FERC studies: (1) the painstaking Herfindahl-Hirschman Index (HHI), and the related calculations for territorial aggregates that so often have formed the basis for determinations of competition and market-based rates, and (2) a comparison of market prices and booked costs.

First, instead of the traditional HHI calculations, the staff chose to let the data define the market. It produced correlations between energy prices at different locations that were high enough to show that, save for exceptional times, a single market rules the Western Interconnection. Note that the title of the staff's report refers to "Western Markets," instead of the expected "California Markets" in which the petitioning utilities operate. The report shows California importing and exporting power in response to opportunities all over the West. Choices for its generators extend far beyond the day-ahead energy markets operated by the state's Power Exchange (PX) and the ancillary services and real-time markets operated by its Independent System Operator (ISO).

Second, the staff recognized that when alternatives are as numerous as they are in the West, sellers will trade in accordance with opportunity costs, and recorded expenses will have little or no meaning. According to the staff's report to FERC, "[i]t is important to note that a generator's true marginal cost is the generator's opportunity cost of selling into a particular market?3

How then, does the commission respond?

The FERC relies on the staff's report for facts underlying its market order, but that order appears difficult to square with staff's new focus on opportunity costs. The orders "soft price cap" attempts to forge a compromise between costbased rates that will apply when market power threatens and market-based rates that will apply when it does not.4

The cap is triggered at $150 per megawatt-hour in any PX or ISO market. If a market clears below $150, all sellers receive the highest accepted bid, as they do currently. If supply falls short of demand at $150, all bids under that figure receive the amount of the highest bid, say $148. Accepted bidders over $150 are paid their individual bid amounts. FERC set the $150 threshold by looking at operating costs, but oddly, the agency stated that the figure will not change with fuel costs or emission permit prices.' (The latter have risen by about 1,000 percent since spring.) In 45 percent of hours in August (all on-peak) the PX day-ahead price exceeded $150 per megawatt-hour, which under the new rules would trigger a reporting requirement for those bidding over $150 as a condition of maintaining marketbased rate authority. Reports must include, among other data, their "incremental generation cost,"and they "may also identify legitimate opportunity costs that are known and verifiable that the seller considered in developing its bid, i.e., prior to the transaction."6

The Old at Odds With the New

Even if we step back from the implementation problems, the old regulation and the new appear at odds in the FERC's California order. Like most of us, the commission staff has reached an understanding that opportunity costs link the ISO and PX markets so strongly that both before and after price caps, their various prices have converged quite tightly. Committing to one of these markets means foregoing an opportunity in another, so a generator's bid in the one must reflect the expected clearing price it can receive in the other. But now the staff has ratcheted the reasoning up yet another level, showing that relevant opportunities might exist all over the West and that power will flow into and out of California accordingly.

In reality, the soft price cap marks one final attempt to salvage some part of traditional ratemaking, but the staff's report is almost proof in advance that the attempt will fail The soft cap itself is an "imperfection"-waiting for markets to arbitrage it away. At times when most sellers expect a price above $150 per megawatt-hour in some market, what rational seller would bid into any other market for less?

Regulating a market by comparing prices with expenses makes sense if there are no alternative trading venues. Prior to recent reforms, the U.K. energy market roughly fitted this description, since as a practical matter it was the only outlet for generators, and ancillary services were handled by other means. If a generator's only alternative is not to operate, its foregone opportunities equal the dollars spent on operation, and successful bids above that level may indicate the exercise of market power. The old U.K power market does not remotely resemble the new American West.

FERC gives no indication as to how it will use the data it collects from those bidding over $150 per megawatt-hour. Operating costs are no more than shortterm avoidable expenses, and the commission will not be able to determine cost-based rates without estimates of capital costs, adjusted for risk. Fortnightly editor-inchief Bruce Radford has suggested to me an analogy that the commission probably does not want to revisit: The Federal Power Commission's wellhead price controls on gas during the '50s and '60s were attempts to customize ceilings for thousands of competitive wells on the basis of their booked costs. The controls produced both a regulatory logjam and a national shortage of gas, in part because the commission seriously underestimated the costs of finding new wells to replace exhausted ones. In electricity, there remains the question of how FERC intends to re-regulate in situations where it has declared market-based rates infeasible.

The Paradox of Reform

Restructuring is driven by a belief that markets can produce benefits that regulation delivers poorly, ranging from operating efficiency to consumer freedom. However, the FERC's California order implicitly assumes the insignificance of another rationale for markets-that they encourage the discovery of new opportunities, whether in the form of underserved purchasers, undervalued resources, or innovative pricing and service designs. Instead, the order seems to posit a well-defined universe of "legitimate" and "verifiable" opportunities that generators can report to the FERC. If the opportunities have transaction designs and pricing provisions that are not straightforwardly comparable, the standard for legitimacy is unclear, as is the showing a generator must make to rebut a charge of illegitimacy.

In truth, many competitive opportunities are costly to uncover. They are valuable only to the extent that they remain private. Underlying a standard of verifiability is a belief that opportunities are easy enough to discover that finders won't mind divulging them. Consider the paradox. The FERC's policies of reform have fostered the growth of markets that cover the West and have encouraged the invention of new types of transactions. However, the sheer size of these markets and the range of possible innovations will make it virtually impossible for any regulatory agency to compare and evaluate these opportunity costs.7

With the proposed elimination of restrictions that California's three investor-owned utilities buy and sell exclusively through the PX and ISO markets, it becomes possible that trade will move in ways that render the FERC's order irrelevant. The soft cap and reporting requirements apply only to transactions in the PX and ISO. Assuming they can reach an accommodation with state regulators and legislators on standards for prudent procurement, California's utilities may be happier transacting outside of the official markets. On the outside, the types of deals they can arrange will be limited only by their imaginations and the availability of willing partners, just like in the days when no one was pushing for a central PX. If utilities can access the entire market, the official exchanges will have to survive on their own, and there is no obvious reason to expect that they will. Even if exchanges remain the transaction venues of choice, competing ones are in operation and the field remains open for more.

FERC's new approach, as revealed in the Nov. 1 market order, may yet achieve what the agency probably should have wanted all along-the transactors will finally be able to shape the markets they really want to deal in.

Robert J. Michaels is professor of economics at California State University, Fullerton, special consultant to Econ One Research Inc. of Los Angeles, and resident scholar at the Center for Advancement of Energy Markets. Views expressed here are not necessarily those of his affiliations or clients.

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Editor's Note: As this issue went to press, the Federal Energy Regulatory Commission was expected soon to announce refinements to the order it issued on Nov. 1, regarding power prices in California.

Yet while this commentary does address that Nov. 1 order, it goes much further. How do markets clear? How do suppliers behave? Which costs matter?

Footnotes:

1 Staff Report to the Federal Energy Regulatory Commission on Western Markets and the Causes of the Summer 2000 Price Abnormalities, Part 1, Nov. 1, 2000, (FE.R.C).

2 Order Proposing Remedies for California Wholesale Electric Markets, Docket Nos. EL00-95-000 et al 93 FERC T61,121, Nov. 1, 2000 (slip opin.).

3 Staff Report at 5-17.

4 Staff Report at 5-17.

5 Id at 37. The commission reasons that "market entry is promoted by simplicity, transparency and stability in pricing rules" and wishes to avoid inserting additional uncertainty. In reality such a rule increases uncertainty by refusing to even attempt an adjustment for market factors beyond a generator's control.

6 11 at 36.

7 Staff explicitly acknowledges this difficulty in its report at 5-20.