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We all grew up thinking very little about the cost of electricity. Our local utility took care of everything: It generated the power, transmitted it at high voltage to load centers, and distributed it to our homes and businesses. All three functions were handled by one company — a vertically integrated utility (VIU) — and competition was nonexistent. Today we no longer want a noncompetitive electricity industry. But VIUs have served us well and do not need to be dismantled in the name of competition. That said, they must address, once and for all, the legitimately raised, although sometimes unfounded, concerns that many VIUs possess vertical market power. The fear is that VIUs will wield that power to foreclose other electricity generators from accessing the transmission grid and from competing for wholesale purchasers — among the largest of which are the VIUs themselves, given their oftentimes huge load obligations. As market foreclosure claims against VIUs become more common and as regulatory scrutiny grows, the time has come to consider measures that will eliminate the alleged grounds for such claims and avoid the troublesome and costly litigation to which VIUs have become increasingly subject. We propose structural changes — changes to the organization itself rather than a set of difficult-to-police behavioral rules — that will make a VIU all but incapable of foreclosing competitors. AT A CROSSROADS In the spring of 2002, a comprehensive plan was coming together to support the fleet of independent merchant generators that, many believed, would become the centerpiece of competitive wholesale markets and the driving force behind customer savings. The Federal Energy Regulatory Commission was completing an extensive dialogue on its Standard Market Design and was keenly focused on completing the work necessary to establish independent regional transmission organizations (RTOs) across the country. The reality facing the industry two years later is strikingly different. FERC’s initiatives are paralyzed by controversy. In many areas, RTO development is stalled. Many state regulators are concerned that the changes necessary to realize consumer benefits cannot be achieved without undermining their jurisdiction or dismantling the VIUs altogether. What is needed, therefore, is an industry structure to tap the best of both the VIU and the merchant models and, in the process, potentially save customers millions of dollars. We propose a simple and straightforward way for VIUs to put the vertical market power issue behind them. They can immediately capture for themselves and their customers many of the benefits of an RTO by: • establishing both short- and long-term competitive procurement processes, and integrating merchant generating plants into both, thereby creating well-defined and accessible markets from which no seller can be foreclosed; and • vesting an independent third party with sufficient oversight and decisional authority to ensure that all potential sellers and buyers have fair and equal access to the market. Our proposal, the Market Access Plan (MAP), does not advocate sweeping changes. Instead, the MAP builds on existing VIU frameworks with structural improvements that are technically feasible, cost-effective, and politically practicable. THREAT TO COMPETITION The hallmarks of a fully functioning RTO are that it is independent of entities that own generation and that it administers well-structured markets from which no seller can be foreclosed. Specifically, RTOs are intended to prohibit VIUs from exercising vertical market power. But aside from the RTOs (which do not cover the United States), there are no organized markets, and usually no structural mechanisms, to prevent a VIU from denying merchant generators access to the transmission needed to reach wholesale markets. Because the vast majority of wholesale markets for power consist chiefly of the VIU itself, VIUs outside RTO-run markets are also vulnerable to attack if they refuse to purchase wholesale power from merchant generators when that power is cheaper than the power produced by their own plants. The concern is that a VIU may use its position as the dominant wholesale buyer to prevent merchant generators from even entering the market — and thereby protect its own generation assets from competition. Increasingly, there are claims that certain VIUs have indeed exercised buyer market power and that decisions by these VIUs to use their own more expensive generation, while refusing to purchase from their less expensive competitors, amount to market foreclosure, harming competition and ultimately raising costs to customers. No doubt, many VIUs do not engage in market foreclosure. If challenged, however, the best defense by a VIU is that it has established certain structural processes such that it is all but incapable of cutting out competitors — even if it wanted to. The MAP proposes changes that will answer foreclosure charges with minimal impact on the VIU model overall. A MARKET ACCESS PLAN VIUs and merchant generators can capture immediately many of the significant benefits of a fully functioning RTO by taking the following steps that build on existing regulatory frameworks. • Create accessible short-term markets. The VIU would establish a formal mechanism to include merchant generators’ power in economic dispatch decisions. In exchange, the VIU would seek approval from state regulators to retain a portion of the annual savings. The VIU would also offer “parking” services that would provide merchant generators with the kind of trading flexibility that characterizes day-ahead and real-time markets. The VIU would be the default buyer, purchasing the power at, say, 90 percent of its decremental cost if the generator did not line up another buyer. An independent market administrator would oversee these processes on a day-to-day basis. The administrator would assure FERC, state utility commissions, and market participants that the structural protocols were being adhered to. • Create accessible long-term markets. In separate state proceedings, VIUs would establish a formal process to competitively procure all their long-term supply requirements. The structure of the bid proposals, the bid evaluation, and the bid selection would be overseen by the independent market administrator. In exchange, the VIU would be allowed an “adder” on power purchases from third parties. In this way, the VIU would earn a return on purchases in the same manner as it does on assets that it owns outright. • Establish fair and equal access to transmission. The independent market administrator would oversee, process, and administer transmission service requests, including the Open Access Same Time Information System, and interconnection requests, including system impact studies and facility studies. The administrator would not be a mere monitor, but would actually grant or deny service requests. The independent market administrator would also review, in real time, the transmission provider’s operation of its transmission and generation facilities, including the provider’s decisions with respect to line ratings, transmission outages, and generation dispatch. The transmission provider would be required to proceed under the nonrate terms and conditions of its Open Access Transmission Tariff when securing transmission or ancillary services in order to serve its own customers. This too would be subject to the independent market administrator’s oversight. • Improve transmission expansion and pricing. The independent market administrator and the transmission provider together would determine the nature and cost of required network upgrades. The cost of upgrades not already included in the transmission provider’s base plan — that is, upgrades other than those needed to meet existing firm commitments — would be directly assigned to the party, including the VIU, that requested the service for which such upgrades were necessary. In exchange, the entity that is directly assigned the cost of the network upgrade would receive the financial benefits related to that upgrade — such as savings based on reductions in transmission congestion or, possibly, additional transmission revenues that would not have existed but for the new construction. One of the resounding lessons learned from the collapse of FERC’s Standard Market Design initiatives is that the changes needed to eliminate the most obvious impediments to well-functioning power markets require a cooperative effort between FERC and the state utility commissions. Litigation does very little to foster such cooperation. Therefore, we must get away from theoretical “issues” and get back to basics — helping state commissions lower energy bills for customers. The MAP does precisely that by combining the best elements of both the VIU and merchant generator models. These models are not mutually exclusive, and can be integrated in a way that will save customers money, avoid distracting litigation and costly uncertainty and, hopefully, get federal and state regulators back to working cooperatively. The MAP would address the VIU foreclosure issue structurally, encourage transmission expansion, add transparency to the procurement process, improve access to short- and long-term markets, and provide additional revenue sources to load-serving entities. It would also encourage investment by reducing uncertainty regarding the value of generation assets, old and new, and thereby increase investment in low-cost, efficient, and less-polluting technologies. In short, follow the MAP. Larry F. Eisenstat is a partner in the D.C. office of Dickstein Shapiro Morin & Oshinsky and head of the firm’s electric power practice. Patricia M. Alexander and Donald J. Gelinas are energy industry consultants with the firm. This article is derived from an article entitled “A Market-Access Plan for Vertically Integrated Utilities,” appearing in the August 2004 issue of Public Utilities Fortnightly , and is presented with permission of Public Utilities Reports, Inc. (www.pur.com).

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