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Should the victims of illegal economic discrimination have to buy their way out? The Federal Energy Regulatory Commission thinks so. For almost a decade, FERC has been finding that vertically integrated electric firms use their control over transmission wires to improperly favor their own power generation plants over those of competitors. In response, FERC, which oversees the interstate commerce of electricity, has been ratcheting up its remedies: from equal transmission access at cost-based rates, to “functional separation” (under which the wires and generation divisions of utilities may communicate only in public), to plans to make all utilities entrust control of their wires to nongenerating firms. Yet the discrimination continues, say regulators. A Jan. 27 FERC policy statement finds that wires are not being built and operated to fully meet market needs. In its Proposed Pricing Policy for Efficient Operation and Expansion of Transmission Grid,the commission lays out a new remedy: rate rewards for utilities that reorganize their transmission business to stop discriminating against competitors. Specifically, FERC is proposing three rate bonuses, which would take the form of increases in permissible profit when regulators calculate utilities’ costs and profits for purposes of setting rates. Utilities that entrust control of their wires to an independent regional operator would get a bonus of 50 basis points (a 0.5 percent increase in return on equity). Utilities that also sell their wires to an independent transmission company would get an additional 150 basis points. And utilities that invest in new transmission facilities would get an additional 100 basis points on those wires. The first two bonuses would be available to utilities that restructure by the end of 2004 (including the substantial number that have already done so), and would remain in effect through 2012 and 2022, respectively. The third bonus would be available indefinitely. FERC plans to issue a finalized policy soon — perhaps on July 23, when it holds its last summer meeting, at which it traditionally releases major orders. Estimates of how much the rate incentives will cost consumers vary, but one supporter pegs them at $570 million per year. PRICING AT COST Traditional regulation aims to set prices for monopoly energy services at cost (which includes a profit margin reflecting the cost of capital). Of course, that’s easier said than done, and the debates over how to measure costs and attribute them to particular services have spanned decades. The expense and difficulty of replicating a competitive market’s “invisible hand” have helped drive regulatory policy toward reliance on actual competition and market results, rather than administratively determined costs, in setting prices for potentially competitive products, like power generation. But for monopoly services, like electricity transmission, rates are still generally set at cost. Of course, this policy has had exceptions. Numerous state regulators have adopted “performance-based” rate making, under which utility revenues are allowed to vary up or down from cost depending on whether the utilities have exceeded or fallen short of certain performance benchmarks. A 1992 policy statement issued by FERC allowed for similar “cost-bracketing” approaches, but has been little used. In fact, the rare federal departures from setting rates at each utility’s costs characteristically have been born of desperation. The immediate precursor to FERC’s current policy aimed at motivating transmission construction was a measure undertaken during the recent electricity crisis in California. There, FERC approved above-cost rates to encourage transmission development if it was undertaken promptly to widen a key bottleneck restricting power exchanges between southern and northern California. INCENTIVES TO INTEGRATE The first major case in which federal regulators intentionally departed from cost-based rates involved, ironically, an effort to promote the oppositeof the vertical dis-integration now sought by FERC. In April 1954, FERC’s predecessor, the Federal Power Commission (which, like FERC, regulated natural gas and electricity under substantially identical statutes), sought to encourage natural gas pipelines to vertically integrate, producing their own gas rather than purchasing and transporting gas produced by others. The theory then was that vertical integration would benefit consumers by increasing pipelines’ bargaining power vis-à-vis independent producers, stabilizing gas supply, and increasing pipeline throughput. But federal regulators thought that pricing pipeline-produced gas at cost would discourage vertical integration. They assumed that nonpipeline producers would receive market value, in part because regulators assumed that they lacked statutory authority to regulate sales by these producers (a misconception that the Supreme Court dispelled just two months later in Phillips Petroleum Co. v. Wisconsin(1954)). Thus, regulators felt compelled to set rates for pipeline producers at the same above-cost level. The U.S. Court of Appeals for the D.C. Circuit, in City of Detroit v. Federal Power Commission(1955), found that the commission could set rates above cost, but had to quantify the departure from costs and make supported findings that such departure would benefit consumers. After City of Detroitand Phillips Petroleum,federal regulators labored for a decade to set cost-based rates for thousands of independent gas producers, but found that they could not keep up with the caseload and that producers were avoiding federal jurisdiction by selling gas from their new wells only to in-state customers. Accordingly, regulators began to set prices using the average costs of multiple producers, with incentive-based groupings that yielded lower prices for gas produced as an incidental byproduct to oil drilling and a higher cost average for producers of gas newly found and dedicated to interstate use. The Supreme Court affirmed this policy in Permian Basin Area Rate Cases(1968), holding that the commission had responsibilities to future as well as current consumers, and therefore could adopt a price differential intended to encourage exploration and development. Significantly for the current debate, however, the Court noted that “[t]he price differential which the Commission expects to serve as an incentive is the product of differences in the time periods and geographical areas for which costs were computed, and not of noncost additives to cost components.” INCENTIVES TO DIS-INTEGRATE After these attempts to set gas prices based on market value or based on average costs, regulators ultimately arrived at today’s successful approach of requiring that gas production and pipeline transportation be placed in distinct firms, of deregulating the gas commodity price, and of maintaining strict cost-based regulation of gas transportation through open access pipelines. The result has been substantial consumer benefit, as wellhead prices have fallen to roughly half the peak of the early 1980s while volumes consumed have substantially increased. It is the natural gas experience that is driving FERC’s electricity restructuring initiatives — for two reasons. First, FERC wants to replicate its success. And second, inexpensive natural gas has fueled the nonutility generation business, enlarging the political constituency for reform of the transmission infrastructure and creating the conditions for real price competition in the generation sector. After Congress reinforced FERC’s electricity transmission authority in 1992, FERC mandated that electric utilities start providing open access to their wires. But in its Order No. 2000 (approved at the commission’s last meeting of the 1990s, and numbered out of sequence for effect), FERC found that vertically integrated utilities were still giving third-party users of their wires inferior service, and inevitably would continue to exploit regulatory loopholes to favor their own generation divisions. FERC also found that it has the statutory authority to remake the electric industry in the natural gas image, by mandating that vertically integrated utilities entrust control of their wires to regional organizations. Rather than issue a universal mandate, the commission chose to rely on jawboning and voluntary compliance. This had the benefit of postponing judicial review — although FERC’s authority to make sweeping changes was indirectly bolstered by the Supreme Court’s decision in New York v. FERC(2002) that the commission can assert jurisdiction over transmission performed by traditional utilities for their own retail customers. In the same Order No. 2000, FERC stated that it would consider “innovative” rate methods designed to remove disincentives to restructuring, but would not, in its word, “bribe” utilities to comply. It adopted regulations under which nontraditional rates could be adopted only if supported by a detailed cost-benefit analysis showing net consumer benefit (a requirement traceable back to City of Detroit). Many utilities have proceeded to turn over wires control to regional organizations, but others, especially those in the Sun Belt, have not. Apparently surprised that some utilities were reluctant to forgo the opportunity to exploit transmission control for competitive benefit, FERC is now proposing to reward such reform through rate bonuses and to eliminate the requirement that departures from cost-based rate making be shown to help consumers. ONLY THE UNBUNDLED Last week there came a new twist: The bonuses that do not require ownership divestiture lost their rationale when FERC issued a white paper suggesting that it will leave it to states to set rates for transmission over wires owned by vertically integrated utilities and destined for their bundled retail customers. FERC beat its apparent retreat in an attempt to protect its broader Standard Market Design from a congressional cease-and-desist order. But FERC has not yet grappled with the consequences to its bonus policy. If the white paper means that different transmission rates will apply depending on whether bundled or unbundled power is being delivered, then the bonuses will only raise rates for the unbundled competitors that FERC supposedly set out to help. Moreover, the bonus revenues will stand even less chance of outweighing the strategic value that vertically integrated utilities get from controlling the wires. The bonus policy is already affecting competition. Vertically integrated transmission owners from the Mid-Atlantic to the Rockies are including such bonuses in the effective or proposed rates charged to their competitors. What FERC should do is withdraw its proposed policy and make clear that customers will bear the same level of transmission costs whether they buy their power from the local transmission owner or shop around. An agency that sets out to remedy discrimination against competitors and winds up proposing charges levied only on those competitors should not be surprised that its policies face difficulty in Congress. On a personal note, I would like to honor my late legal partner and mentor Alan J. Roth. In a long career that included leading the appellate court defense of thePermian Basin policy discussed here, Alan worked assiduously for consumer-protective rate regulation. His body is being interred this week; his body of work lives on. David E. Pomper is a partner in D.C.’s Spiegel & McDiarmid, with a speciality in transmission organizational structures, access, and rates, both from transacting and from litigating before FERC and other forums. He can be reached at [email protected].

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