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The electric industry, with revenue of $250 billion per year, is undergoing a revolution. This last bastion of cost-based rate regulation is rapidly moving toward reliance on competitive forces. The Federal Energy Regulatory Commission, which has jurisdiction over wholesale electricity sales by investor-owned utilities, is moving toward market pricing in many circumstances. Many states are at some stage of the process of restructuring the industry to enable retail customers to purchase electricity from the nonregulated supplier of their choice. And Congress is considering legislation to enhance wholesale competition and facilitate retail competition. Supporters say restructuring could save consumers up to $20 billion a year. They assume that while transmitting and distributing electricity will remain natural monopoly functions requiring regulation, competition on the generation side can do a better job than regulation to ensure abundant supplies of electricity, lower electricity prices, and better service. But consumers will not benefit from restructuring if competitive forces are squelched by market participants who have market power — the ability to raise prices for a significant period above the level that would be achieved in a truly competitive market with many suppliers. Given electricity’s essential role in our economy and standard of living, market power abuses can significantly harm consumers and must be addressed. As noted in a February 2000 paper, “Electricity Restructuring: Deregulation or Reregulation,” by Severin Borenstein and James Bushnell of the University of California Energy Institute, “In restructured electricity markets, some level of market power seems likely to persist. Given the enormous size of this industry, even small amounts of market power imply large transfers from consumers.” One form of market power that can be exercised in electricity markets is vertical market power, where a transmission owner that is also involved in the production or sale of electricity can deny, restrict, or overprice access by competitors to transmission, thus favoring its own power sales. As FERC recently recognized in Order No. 2000, vertical market power can be mitigated if transmission owners transfer ownership or control over their facilities to regional transmission organizations that are truly independent of any interest in the generation market. For this reason, Order No. 2000 seeks to induce the voluntary formation of RTOs, while acknowledging FERC authority to require RTOs in certain circumstances. However, the electric industry is plagued with a second form of the market power disease that is largely resistant to even RTO medicine: horizontal market power, where a supplier drives up prices through control over a single activity. In the electric industry, horizontal market power can be exercised by dominant generation owners or owners of strategically located generation. By withholding some of its output, or offering it only at an extremely high price, such an owner can drive prices up, while losing little demand and boosting its own profits. While large RTOs are critical to addressing vertical market power and can to some extent mitigate horizontal market power by eliminating artificial barriers that now restrict generation markets (e.g., “pancaking” of individual transmission owner charges), RTOs alone are not likely to eliminate market power. More direct and comprehensive mitigation measures are needed if consumers are to be assured the benefits of competition. HISTORICAL CONCENTRATION Competitive markets simply do not come naturally to the electric industry. For one thing, the industry is saddled with extraordinarily high levels of concentration, leaving few viable supply choices in many markets. The Department of Energy’s March 2000 report, “Horizontal Market Power in Restructured Electricity Markets,” found concentration levels significantly exceeding Department of Justice and Federal Trade Commission guidelines for “highly concentrated” markets in 90 percent of the 112 markets examined using 1994 data. And these concentration levels do not even reflect the impact of recent merger mania. Since 1997, 44 investor-owned utility mergers or acquisitions, involving assets totaling $468 billion, were announced or completed. The pernicious effect of these concentration levels is highlighted by DOE simulations demonstrating that “market power can be profitably exploited in some parts of the United States.” These unusually high concentration levels stem from the industry’s history as regulated monopolists. As explained in the DOE report: “[C]ompanies often own many plants in a region that cannot receive large flows of power from other areas, potentially allowing them to restrict output at one plant and receive higher prices for power produced at all their other units.” The report notes recent congressional testimony by the Department of Justice that “the antitrust laws do not outlaw the mere possession of monopoly power that is the result of skill, accident, or a previous regulatory regime.” And the report concludes: “Antitrust remedies are thus not well-suited to address problems of market power in the electric power industry that result from existing high levels of concentration in generation.” Other factors contribute to a “competitively challenged” electric industry. It is a complex, networked industry, in which electricity must be produced at the same time consumers need it and in amounts that vary widely over the course of a year, or even a single day. Dynamic electricity markets, according to the DOE report, “change dramatically over the course of just a few hours, creating opportunities to exercise market power even though the market may be very competitive under most circumstances.” It explains: “[C]ertain plants may be required to run at certain times in order to meet reliability needs, effectively giving them market power during those periods, because no other plants can act as substitutes.” Those generators are in a position to name their price. Because electricity typically cannot be stored, inventories are not available to counteract those seeking to hike up the price during shortages, as is the case in many industries. As Borenstein and Bushnell observed, “the non-storability of electricity, combined with very little demand elasticity and the need for real-time supply/demand balancing to keep the grid stable, has made restructuring of electricity markets a much greater challenge than was inferred from experience with natural gas, airlines, trucking, telecommunications, and a host of other industries.” New market entrants are a less potent curative to market power in electricity than in other industries, according to the DOE report. Lags in plant siting and permitting and a new competitor’s need to recover substantial capital costs as well as variable costs leave ample room for incumbent generation owners to exercise market power without triggering new entry. TRANSMISSION LIMITS Market power is also enhanced by transmission limitations, which block access to competitive electricity supplies and create “load pockets” (such as San Francisco) that must be served by the generators located within the pocket. As explained by Borenstein and Bushnell: “This is not an isolated phenomenon: over half of the 288 generation units in the California ISO system have been designated as ‘must-run’ for reliability purposes under some conditions. What electrical engineers call reliability concerns, economists call local market power.” Transmission limitations are dynamic, affected by the generation operating at a given time, as well as demands on the system, and are subject to manipulation. Without even owning transmission, a supplier “could increase generation at particular plants in order to create congestion on the transmission system, thereby restricting imports and limiting competition,” according to the DOE report. In this way, a supplier can use its control over strategically located generation to keep competitors out of the market, enhancing its ability to sell its own generation at inflated prices. Likewise, in a March 15 order conditioning approval of the merger of giants American Electric Power Co. and Central and South West Corp., FERC found that the intervenors had “appropriately identif[ied]” mechanisms, such as “ strategic manipulation of transmission or generation,” by which the merger enhanced the ability of the merged company to adversely affect prices or output by frustrating competitors’ access to transmission. See 90 FERC para. 61,242 (2000). Electricity markets also suffer from information deprivation. As the stock market illustrates, competitive markets thrive on — indeed, require — information availability. Electricity markets are more susceptible to abuse if some participants have superior information regarding, for example, generation availability or price offerings. According to FERC staff, the absence of accurate market information contributed to the extreme price spikes (up to $7,500 per megawatt hour) experienced in the Midwest during the week of June 22-26, 1998 (as compared to average Midwest summer prices, excluding “abnormalities,” of $40 per mWh). It found “the market itself could benefit if more information about electric power transactions were available on a real-time basis,” noting that “there are currently no clearinghouses for real-time reporting of information on market-based sales. No one has available accurate and timely information on current markets — neither the market participants … nor the Commission.” See “Staff Report to the Federal Energy Regulatory Commission on the Causes of Wholesale Electric Pricing Abnormalities in the Midwest During June 1998.” While progress has been made since then in a number of markets, public, transparent pricing will go a long way toward minimizing opportunities for information-based manipulation. Mounting evidence demonstrates that horizontal market power continues to be a serious problem, even where transmission is controlled by independent regional entities. For example, on April 4, the Boston Globe reported: “Suspecting possible price-fixing and collusion, the organization that runs New England’s power grid [the New England Independent System Operator, or ISO] has voided an entire month’s worth of wholesale market prices and is considering asking for a federal investigation. … Industry sources said yesterday potentially millions of dollars in improper, excess revenues for so-called capacity charges are involved.” While the ISO’s March 31 FERC filing does not reveal precisely how the installed capacity market may have been manipulated, it points to abruptly increased bids and other actions by several unnamed market participants in January that, absent ISO intervention, would have raised the market clearing price by orders of magnitude. In various orders, FERC has granted the New England ISO (as well as the California ISO) authority to impose interim price caps to correct market flaws when prices have the potential to be manipulated. Numerous studies document continued opportunities for abuse of market power in California markets. The DOE report summarized analyses showing that at certain times, prices were 75 percent above competitive levels, with estimated excessive payments to generators of $800 million during the summers of 1998 and 1999 taken together. An $800 million market power overcharge is no small matter, even by inside-the-Beltway standards. It would substantially erode the benefits of restructuring for California consumers (who are currently shielded from the impact by the transition regimen). In their March 2000 report, “Diagnosing Market Power in California’s Restructured Wholesale Electricity Markets,” Severin Borenstein, James Bushnell, and Frank Wolak concluded that market power was a significant factor in California’s wholesale market during the summers of 1998 and 1999, producing a 16 percent markup above competitive levels from June 1998 to September 1999. The California ISO Market Surveillance Committee’s March 9, 2000, report echoed the finding that California energy markets have not been workably competitive during the last two summers. Likewise, the United Kingdom’s decade of experience with competitive electricity markets reveals the intractability of market power. The U.K.’s Office of Gas and Electricity Markets issued “The Prevention of Wholesale Market Abuse: Guidelines for Generators” in January 2000, in which it provided for enforceable license conditions on generators to prohibit conduct amounting to an abuse of market power in the setting of wholesale electric prices in England and Wales. OFGEM described market power as a recurrent, detrimental problem where it has a substantial effect on price over a prolonged period or produces excessive price spikes. OFGEM observed: “Changes to [market] rules may sometimes be effective in preventing certain types of abusive behaviour but the result can often be that the abuse of market power simply re-emerges in another form.” LEGISLATIVE REMEDY What does this mean for the current congressional debate? Market power is a real problem that threatens to siphon off potential consumer savings. It won’t go away simply by declaring markets to be competitive. To the contrary, Borenstein and Bushnell have commented that “if firms of noticeable size are not exercising market power, they are doing so out of the goodness of their heart, and against the interest of their shareholders.” To combat this intrinsic ill, Congress should enact comprehensive federal legislation that expands FERC’s authority to remedy the market power problems that threaten emerging competition. A good start would be a provision directing FERC to investigate, mitigate, and remedy the abuse of market power where it exists in wholesale power markets, as suggested on April 6 by the Pro-Competition Stakeholder Group (a diverse group that includes AARP and the Consumer Federation of America, as well as industrial consumer representatives, state consumer advocates, public power, competitive generators, marketers, and a number of investor-owned utilities, among others). To be effective, this key directive needs to be supported by express authority providing FERC the tools required to get the tough job done right. Also crucial to achieving competitive markets is preserving and enhancing FERC’s authority to reject mergers that conflict with that objective. The commission should not be hamstrung with rigid time limits or other restrictions that would serve only to foster market power, stymie competition, and increase consumer electricity prices. In short, if consumers are to benefit from competition, FERC must be responsible for ensuring vibrant and liquid electricity markets. It should be empowered to act as a neutral referee, ready, willing, and able to move decisively to prevent and remedy the exercise of market power and to penalize market manipulation.

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