Retail Competition in Electric Power

What are four basic types of stranded costs?

1. Undepreciated investments in power plants that are more expensive than generators today. 2. Long-term contracts—most if not all mandated by PURPA. 3. Generators built but not used, primarily nuclear. 4. Expenses related to DSM and other conservation programs that, as substitutes for new plant construction, were charged to the generation side of the business.

Low Cost Power State

State in which retail electric prices are fully regulated and capped, suggesting that retail competition is far off on the regulatory horizon. Includes states in the Southeast.

What eight issues does a state's restructuring laws typically address?

1. Choice of alternative provider. Retail electricity customers in most states have their choice of electricity generators but not choice of distribution utility. 2. "Standard offer" or "default" service and protections for customers not selecting alternate providers. Four models: (a) the incumbent utility continues to provide service to non-switchers under a rate that essentially passes through the utility's wholesale cost of power; (b) the utility remains a service provider to some customers but not to others; (c) the utility continues to provide service but does so under a rate structure designed to gradually wean customers away from utility service and towards market-based prices; and (d) the privilege of serving non-choosing customers is bid out, while the utility's role is to deliver power. 3. Stranded costs. Most states established some sort of "competitive transition charge" (CTC) that customers pay to incumbent utilities to cover stranded costs. 4. Consumer rate protections. Many state restructuring plans promised consumers rate reductions or attempted to hold residential consumers harmless, recognizing from the outset that retail power markets would not begin full operation immediately or for a period of years. 5. Other consumer protections. Most restructuring states set up systems designed to protect consumers in their states from abusive behavior by marketers of electricity (e.g., slamming and cramming). 6. System benefits charges. Either in the restructuring law itself or in a separate law, a number of states have established system benefits charges designed to ensure that the environmental programs underway in the electric utility industry would be continued in a restructuring environment. 7. Exit fees and switching penalties. If too many customers "switch"—leave the incumbent utility to purchase in a competitive market—or switch power supply providers due to short term changes in price, this could cause serious problems with the reliability of distribution. 8. Functional separation (unbundling). States typically require that utilities separate the generation function of their businesses from the transmission and distribution functions, with detailed rules about conduct to prohibit inappropriate self-dealing.

Securitization

All or a portion of the utility's right to receive future competition transition charges could be converted into a current, fully vested property right that could be pledged or sold as security for the issuance of transition bonds. The PUC would then issue a "qualified rate order" permitting the utility to issue "transition bonds" to investors. The proceeds of these low-cost bonds go directly to the electric utility, allowing the utility to immediately recoup all or part of its stranded costs. The qualified rate order would provide for the intangible transition charge (ITC), whose purpose was to fund the bonds' principal and interest costs. By statute, neither the order nor the ITC could be altered or revoked by current or future PUCs. Because the revenue stream supporting the bonds was ironclad, the bonds could be issued at a very low interest rate since there is little to no risk.

Retail Competition

By the mid-1990s, state retail wheeling plans were being displaced by much more comprehensive efforts to implement "retail competition." Unlike retail wheeling, which focuses solely on the issue of retail transmission access, retail competition plans address a range of additional issues, including consumer protection, stranded cost recovery, and green pricing. The basic approach has been to encourage competitive markets to evolve through the "unbundling" of generation, transmission and distribution: splitting the incumbent utility company into its component parts either functionally or legally. In a competitive retail market, the incumbent distribution utility continues to provide service to retail customers and remains a regulated natural monopoly. On the other hand, retail customers are afforded the opportunity to choose the company from which they buy electricity—customers choose generators, in other words. Generally, retail restructuring was more likely to happen where retail prices were high, due to smaller, balkanized utility systems, greater state-imposed obligations to buy power from renewable sources, and the cost burden of imprudent investments. Thus, electricity prices were higher in California, the Northeast, and the upper Midwest than in the Northwest, lower Midwest, and Southeast.

What is a key indicator of the vitality of a retail market?

Customer switching

Retail Wheeling

Direct access to electricity supply markets.

Standard Offer Service/Default Service/Provider of Last Resort Service

Electricity service the incumbent utility must offer to customers who opt not to take service from an alternative provider. Rebundled service. Standard officer service in effect rebundles generation, transmission, and distribution service for non-switching customers. The integrated retail utility is the entity that provides stander offer service to non-switching retail customers. Divestiture of power plants. Utility restructuring plans or state law either required or encouraged the incumbent utility to divest ownership of its power plants. Standard offer service is "sourced" through competitive procurements of generation in the wholesale market. Utilizing wholesale competitive procurements to source standard offer service benefits customers by driving down the cost of wholesale power purchases to the utility providing standard offer service, as compared to the cost of the utility's own generation portfolio. Wholesale competitive procurements to source standard offer service benefits the utility because, if fairly conducted, the competitive procurement process immunizes the utility against prudence challenges and disallowances.

What were the two consequences of Pennsylvania's approach to divestiture?

First, utility default service had to be sourced through wholesale market purchases from utility and non-utility power plants. The act required neutral competitive procurements. Second, because Pennsylvania utilities sold their power plants to affiliates, there was no market mechanism for determining stranded costs by examining arm's length transactions (sale price minus book cost). The net result was that stranded costs had to be determined administratively by the PUC, and the Act so required.

How are stranded costs calculated?

Forecasting a stranded cost could be done ex ante—before the start of competition—or ex post, after competition began. Using the ex ante approach could lead to windfall gains or losses if calculations were incorrect; using the ex post approach might be more accurate but leave the uncertainty to be worked out down the line. Calculations could be done "bottom-up" (computing the value of each investment that would be stranded) or "top-down" (calculating the difference in revenue likely to occur with competition). Some states permitted stranded cost recovery to be "securitized," an approach whereby all or a portion of the utility's right to receive future competition transition charges could be converted into a current, fully vested property right that could be pledged or sold as security for the issuance of transition bonds.

Regulatory Taking

Governmental regulation that goes so far as to deprive the regulated party of the economic value of its property interest as to be the equivalent of the government physically taking property for public use without just compensation (prohibited by the Takings Clause of the Fifth Amendment as applied by the Fourteenth Amendment to the states).

Non-Bypassable CTC

In most states, the charge was to apply both to non-switching and switching customers. CTCs would apply during the entire transition period, during which rates were frozen or subject to commission-mandated reductions.

Stranded Costs and Recovery

Incumbent utilities contended that they would not be able to recover the cost of prudent investments they had made in a regulated monopoly environment if there were a transition to a competitive marketplace for electricity commodity service. They argued that the excess of cost of service-determined rates over market-based prices, reflected in asset values, constitutes stranded costs. They argued that competitive prices wouldn't allow them to recover a return of and a return on prudently invested power plant capital. The opposing concept is that market prices are cyclical in nature and could well exceed cost of service-determined prices in the future (positive stranded costs could turn negative). The corollary is that some stakeholders argued that positive stranded costs often resulted from imprudent decision-making (over-investment or overly costly investment) by the incumbent utility. Most states established some sort of competitive transition charge (CTC) that customers were required to pay to incumbent utilities to recoup stranded costs.

In re PECO Energy Co., 87 Pa. PUC 184 (May 22, 1997)

PUC approved PECO's request to securitize $1.098 billion of stranded costs. PUC order directed the utility to reduce its rates to reflect the lower cost of capital associated with the securitized assets. Securitization worked.

FERC Order No. 888

Requires public utilities to provide fair and open access transmission service to utility and non-utility owned generators and wholesale shippers, as well as unbundle transmission from wholesale sales service. The purpose was to promote competition in the wholesale bulk power market. Status quo ante was that in a traditionally regulated retail market, vertically-integrated regulated utilities owned and/or contracted for generation, owned and operated transmission and distribution systems, and provided electricity to their retail customers within specific service territories at regulated rates established by state regulators. Around 1996, state utility commissions and legislatures got into the act of promoting retail competition because industrial customers in high-cost states demanded direct access to cheap wholesale power sources via retail wheeling.

Electricity Generation Customer Choice and Competition Act (1996)

Restructured Pennsylvania's retail electricity market. Two key features: (1) divestiture of power plants owned by the state's electric utilities and (2) recovery of stranded costs and securitization. Whereas some states required complete divestiture of utility power plants to unrelated companies, Pennsylvania took a more moderate approach. No power plant costs (capital or expenses) allowed in regulated utility retail rates. Electric utilities could still earn revenues by selling power plant output at wholesale. Electric utilities were ultimately permitted to transfer their power plants to their generating company affiliates. The result was that Pennsylvania's electric utilities divested their power plants to affiliates. The Act defined stranded costs as including: the difference between cost and market value of generation assets; prudently incurred costs relating to buy-out or buy-down of above-market PURPA contracts; unrecovered portion of regulatory; unfunded nuclear power plant decommissioning costs; and other costs incurred under former regulated regime that couldn't be covered in a competitive market. The Act granted Pennsylvania's electric utilities the right to recover stranded costs through the imposition of a non-bypassable CTC, as determined in a PUC stranded cost proceeding. Under the Act, an electric utility is allowed to apply to the PUC to securitize all or part of its authorized stranded costs.

Anti-Slamming Rules

Restructured states established consumer protection rules against deceptive practices by alternative providers, such as "slamming" and deceptive advertising. PUCs and People's Counsels (statutorily-appointed residential customer representatives) offered customers dispute resolution services and conducted consumer education campaigns.

Choice of Alternative Provider

Retail customers can choose among alternative suppliers offering various fixed and variable "rate plans" for commodity electricity. Distribution service must be purchased from incumbent utility in whose service territory the customer meter is located. Today, alternative suppliers purchase their power supplies via bilateral contracts or RTO capacity and energy markets and transmit electricity over the transmission system to the inlet of the utility distribution system. Distribution service competition was foreclosed under state and local service territory and franchise laws. An alternative provider cannot create its own mini-distribution grid and sell electricity at retail to homes and businesses connected to the grid. Unbundled rates. States that restructured retail service required unbundling of retail service into generation, transmission, and distribution service components. There was a separate charge for each component of service, and customers' invoices for retail service reflected such charges. Customers that chose an alternative provider in effect (1) continued to take distribution service from the incumbent electric utility and (2) switched to the alternative provider for generation and transmission service.

Waiting Periods, Exit Fees, and Billing and Collection Services

Switching supplier limitations were implemented. Utilities required alternative providers to register with the utility and offer "coordination" service to handle metering and billing. If customers frequently switched between the utility and an alternative provider or between alternative providers, coordination problems could result. Many states imposed waiting periods or exit fees to deter such behavior.

Stranded Costs

The inability of utility shareholders to secure the return of, and a competitive rate of return on, their investment. Utilities most directly affected by a transition from a regulated monopoly environment to a competitive marketplace contend they would not be able to recover investments they had made under the assumption that state regulation of their activities would continue. Most states allow utilities to recover all or most of their stranded costs. The most common mechanism is a nonbypassable charge imposed on all utility customers for a transitional period of time.

Consumer Protection Rules

The onslaught of new businesses led to a new genre of market behavior with aggressive solicitation of new customers by a new breed of business entities. There were light-handed licensing regimes. Alternative providers, many of whom operated in numerous states, were required to obtain operating licenses. Applications forms required only basic information like consumer support phone numbers and contacts and rudimentary information about the alternative provider's business plan and track record in other states.

Transition Period Rate Caps or Rate Freezes

Unsure of how retail competition would play out in the real world, many state commissions implemented utility rate caps, rate freezes, or rate reductions, some for as long as five years. The primary purpose was to hold residential consumers harmless during the transition period to competitive retail power markets. The secondary purpose was to create "headroom" to allow for imposition of the CTC in connection with stranded cost recovery. Rate caps and rate freezes had a dampening effect on nascent competitive market. If customers have the protection of guaranteed low rates from the incumbent utility, there is less incentive to switch electricity providers. The result was that there were low switching rates during the rate freeze period, and in some states, severe price spikes for standard offer service when they expired.

Do states have authority over retail rates, local distribution of electricity, and construction and siting of power plants and transmission lines within their boundaries?

Yes.