gradualism in retail restructuring

Editor’s note: The following is the second article in a three-part series discussing electricity industry restructuring in the United States. The first article (EL&P July/August 2005) examined the drivers behind restructuring and its current state; this second article looks at jurisdictional issues that often result in divergence of state and federal regulatory frameworks.

Between 1996 and 2000, policymakers in 18 states passed laws and issued regulatory orders calling for the introduction of retail competition in their electricity sectors. Following the California electricity market crisis (2000-2001), however, there has been a sharp directional change in state policy. Since 2000, no state has passed a law or issued a regulatory order calling for retail competition for small customers; and in 2001, Arkansas, Nevada, and several other states acted to delay or cancel plans for retail competition.

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From the beginning, the controlling vision of restructuring has seen the greatest benefits as emanating from the wholesale power sector. Competitive, market-driven generation pricing, it has been hoped, would allocate existing generation capacity and output to where it is in greatest demand, and would ensure efficient, prudent, and reliable investment of the size, type and location most needed. Retail competition would then ensure that competitive, market-driven prices were passed through to ultimate consumers. State regulators would be able to abandon the cost-of-service apparatus they historically used to determine maximum retail power prices, as merchants used open access to still-regulated distribution lines to chase customers, and their competition ensured that consumer prices were “just and reasonable.”

In moving toward retail competition, concerns over the inexperience of small retail consumers and the prospects of market power abuse in infant retail markets compelled states to adopt gradualist approaches. While plans have varied among states, most transition plans have included a requirement that the incumbent utility continue offering price-regulated retail generation service for, generally, a defined period of time to ensure that customers would always have the safe harbor of utility service. Regulators frequently marked down the price of safe-harbor service as a means of settling challenges to restructuring by representatives of customers and organized consumer groups. Safe-harbor prices often have been frozen at these marked-down levels, or scheduled to increase in defined increments with the expectation that, at some point, relatively high safe-harbor prices would drive customers to move to unregulated marketers. After the end of the transition period, the utility has been expected to continue providing safe-harbor service at a price determined by a market process, such as an RFP for safe-harbor service.

Gradualism in retail restructuring by the states creates vested interests in the transition itself. As a result, in many cases “transition” appears to have become the long-term policy equilibrium. In particular, the regulated price of utility safe-harbor service has generally not ended up being market-based, but instead has been set by regulatory mechanisms in a way that impedes competition from non-utility suppliers. For example, safe-harbor prices often have been set at a discount (e.g., 15 percent in Massachusetts) from the prices incumbent utilities were charging prior to restructuring. Not surprisingly, most residential and small commercial customers have opted to receive safe-harbor service, and retail competition for small customers has not flourished in any state (see figure 1.) There is no widespread cry for restructuring from such customers, and safe-harbor service at regulated prices for these customers seems unavoidable for the foreseeable future.

safe-harbor service regulated intently

The move toward electric industry restructuring at the state level in the 1990s was driven largely by concern over the retail prices some state’s electricity consumers were paying. By the late 1990s, when restructuring got under way in a number of states, average national retail electricity prices had declined substantially from their peak levels in the early 1980s and were near their historic lows in real terms.

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However, these national data mask the fact that there was substantial regional differentiation in retail pricing. Retail prices in states such as California, Massachusetts and New York were much higher than the national average, and these high prices were perceived as a source of competitive disadvantage to local business. State officials in these high-price states were under particular pressure from consumers and businesses to find ways to reduce retail electric prices. By contrast, retail electricity prices in some states, such as those in the Southeast and Northwest, were lower than the national average, and, in those states, restructuring initiatives received much less political support. Figure 2 shows retail electricity prices for residential customers in high-price states that implemented restructuring (Massachusetts, New York and California) and low-price states that did not (Georgia, Florida and Washington).

As is evident in figure 1, states in the Northeast and Southwest were more likely to implement restructuring. Policymakers in states that implemented retail competition for electricity service understood the changeover from a regulated retail market to a competitive retail market would not happen instantaneously; it would take time for competitive marketers to become functional, for retail customers to learn to navigate the market, and for the retail market to begin functioning competitively. Thus, there would be a “transition” period for the market to begin working. During this time period, regulators would have a role in ensuring the orderly transition from regulation to competition, especially to ensure that retail customers would be able to get service. However, policymakers envisioned very little scope for continued retail market regulation beyond the transition period, and, thus, the restructuring rules provided for very little continued regulatory structure following the mandated transition. As it turns out, this reflected a certain naiveté about the post-reform political and economic environment.

As noted, in all states where retail competition was attempted, regulators required that a safe-harbor retail electricity service be made available to all customers. Safe-harbor service was to be available during the transition period for customers who had not yet switched to competitive suppliers and, in some cases, was to be available indefinitely for customers who were unable to find competitive suppliers. Called variously “standard offer,” “default,” or “provider of last resort” service, these service offerings were generally expected to be “basic” with none of the value-added services that were expected from competitive market development. Safe-harbor service provision has been a subject of intense regulatory activity at the state level, as policymakers have attempted to find a balance between protecting customers while not removing their incentives to shop.

In many instances, regulators have failed in their attempt to induce customers to switch to competitive suppliers while simultaneously ensuring the availability of safe-harbor service with full regulatory protections. Generally, they have regulated safe-harbor service as intensively as any other regulated service. For example, in many states safe-harbor services were initially required to be priced at a substantial discount that made it problematic for competitive marketers to beat or even match these subsidized prices-especially against significantly increased fuel prices.

As the terms of these initial subsidized prices have expired, regulators have generally required some form of “least-cost” procurement for safe-harbor service. For example, some states have required utilities to use auctions or requests for proposals to solicit the lowest priced wholesale service on behalf of their safe-harbor service customers. In addition, some states have begun requiring safe-harbor service options with value-added services such as “green” energy and locked-in prices. By applying the same regulatory standards to safe-harbor service that they have traditionally applied to utility provision of retail electricity service, regulators have tended to render retail competition irrelevant for some classes of customers.

ratepayers may bear risk

Thus, the competitive retail market experience has been decidedly mixed. Generally, lower demand level customers have shown less propensity to shop for retail service than policymakers envisioned, while the only notable retail competition success stories are where customers have faced real-time pricing.

Because retail markets have generally not developed as policymakers expected, the transition from regulated to competitive markets has not yet been completed in any of the states. As a result, regulators and policymakers have generally extended the “transition” period either to some new date-or indefinitely-until they deem that the competitive market is sufficiently developed that retail electricity consumers no longer require regulatory protection. In practice, this has meant continued regulatory scrutiny of utilities’ procurement of wholesale electricity products to provide safe-harbor service, as well as pass-through cost-of-service regulation of that service’s pricing.

In addition, slow retail market development has required regulators in some states to begin grappling with the resource adequacy issue. Proponents of restructuring envisioned that competitive wholesalers and retailers would build new generation capacity in response to price signals generated by the competitive market. It was expected that competitive wholesalers would invest in new plants and use long-term contracts with competitive retail marketers to manage market risks. Thus, unlike under the older regime of planning and rate-basing of new investments, the bulk of the risk of these capacity investments was seen as not falling on the shoulders of ratepayers. However, in most restructured states, competitive retailers are small in number and competition is at the wholesale level to provide existing utilities with safe-harbor service. Utilities purchase these electricity products for safe-harbor service on a time horizon that is very short relative to the normal power sector investment cycle, meaning that much of the generation built following the implementation of open access has difficulty selling for terms longer than a year.

In addition, regulatory policy has suppressed prices in wholesale power markets, dampening incentives to invest in now-needed new capacity. Accordingly, discouraged investment implies risks may ultimately be borne by ratepayers in the form of possible resource inadequacy, sharply higher prices, and/or supply curtailments. The impact of the restructuring effort on end-use customers now turns on policymakers’ and regulators’ decisions affecting the shape of the long-term investment environment.

Joseph Cavicchi is a vice president at Lexecon, an FTI Company. He provides wholesale and retail electricity market regulatory economic analyses related to the restructuring of the U.S. electricity industry.

Charles Augustine is a managing consultant with Lexecon, an FTI Company. He specializes in the analysis of regulated markets, particularly natural gas and electricity.

Joseph Kalt is a senior economist with Lexecon, an FTI Company. Dr. Kalt is also the Ford Foundation Professor of International Political Economy at the John F. Kennedy School of Government at Harvard University.

All three authors can be reached by phone at 617-520-0200.

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