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carrots and competition: shouldn’t utilities earn a “return” on purchased power?

Issue 4 and Volume 82.

Larry Eisenstat and Christopher O’Hara, Dickstein Shapiro Morin & Oshinsky, LLP

Some industry observers are rushing to declare wholesale competition ailing, if not dead. While these pronouncements appear a bit premature, the continued existence of the merchant model is, at the very least, threatened by the understandable preference of investor-owned utilities (IOUs) to meet their needs by acquiring or building assets that can earn them a return on equity, rather than by entering into power purchase agreements (PPAs) with merchant generators that generally do not earn the IOUs any such return, even when a given PPA is a more economical alternative. This disparity should be eliminated.

The earnings of an IOU are driven by the allowed rate-of-return on its rate base. It should be no surprise, therefore, that utilities prefer to increase rate base by constructing or acquiring generating assets and shy away from PPAs where no returns are allowed. In almost every other business sector, a company has the financial incentive to buy from suppliers that can provide a component of a product, or the product itself, at the lowest possible cost, because doing so will help boost earnings; the lower the company’s costs, the higher its profit. This is not always the case, though, in the regulated utility world. Because an IOU is generally not allowed a markup on purchased power, the benefit of purchasing low cost energy from merchant generators is passed on entirely to customers. Bluntly stated, by entering into a PPA at the expense of enhancing its own asset base, an IOU is foregoing an opportunity to make money for its shareholders. Although regulatory oversight provides some measure of control over imprudent or anticompetitive acquisitions, it still is unrealistic to expect a for-profit company to prefer to forego its own economic self-interest. Indeed, its shareholders might argue it has a fiduciary responsibility not to do so.

The Federal Energy Regulatory Commission (FERC) needs to address this economic reality. Otherwise, all of its many regulations designed in theory to foster competition could prove in practice to be but an empty gesture. FERC must ensure that companies are rewarded for supplying power at least-cost, regardless of whether the power comes from an owned-asset or a PPA. If not, one of the most highly touted benefits of competition-low cost energy from merchants-never will achieve its promise.

Certainly, FERC recognizes the need to incent transmission owners to join competitive markets, providing for an increase in the allowed rate of return for participation in a regional transmission organization. And, to some extent, FERC has recognized the need to eliminate economic disincentives that may discourage IOUs from making economically efficient purchases. For example, in Order No. 352, FERC revised its fuel adjustment clause (FAC) regulations to permit the pass through of both energy and capacity charges. Previously, FERC had allowed companies to pass through only the energy charges, but not the capacity charges, even though purchases with a capacity component were often less expensive. This created a bias for some companies to buy higher-priced power simply because it was billed on an energy-only basis-much like today’s bias of allowing IOUs to earn a return on assets they own, but not on power they purchase.

Indeed, recent proceedings before FERC reflect just what we should expect: IOUs, acting in their own economic self interest, are attempting to increase their asset base in lieu of entering into PPAs. But, whether or not FERC can or should police power procurements in order to determine whether they were biased in favor of utility-owned projects, these investigations are not an efficient way to address this distortion in the wholesale market. It is a time-consuming process which, even if successful at detecting an above market choice in a particular case, does nothing to get at the structural root of the problem.

Likewise, a state-only solution also is inadequate, given the multi-state nature of markets today. Hence, FERC and the states must undertake a collaborative effort to allow an IOU to earn a profit substantially equivalent to what it would earn (via a return) on its own asset when it makes an economically efficient decision to purchase energy. FERC can take a big first step by including such a return in FERC-approved wholesale rates, and by offering this incentive as a central component of any market restructuring or required procurement process. Obviously, the method for determining this return will have to be carefully designed. One approach would be to base the return on some sharing of the benefits from the PPA. Production cost models could be used to determine the IOU’s production costs before and after the PPA, and the difference could then be divided among the IOU’s shareholders and customers. However, this case-by-case approach might encourage parties to inflate or deflate their projections in order to increase the potential return.

The better approach may be simply to allow a return margin as a flat percentage of all purchases, much like a return on rate base. As such, this return would also serve to compensate the IOU for the cost of carrying longer-term PPAs on its books. One way or the other, though, if FERC wants customers actually to realize the benefits of the market, it must remove the IOU preference for ownership of assets and recognize that the best transmission access in the world will not alone deliver lower-cost, competitively priced power to customers.