A Consumer's Guide to the Issues in the Restructuring of Electric Utilities

The Consumer Energy Council of America Research Foundation
Background to the Issues & Historical Perspective

Contents:

1.Summary
2.Genesis
3.The Seeds of Trouble
4.Reliability
5.Nuclear Investments
6.The Roots of Reform
7.EPAct
8.The Status of Reform
9.Conclusion 

I. Summary

As with other monopolies that were once common features of the American economy, profound changes are being contemplated -- in part already undertaken -- in the business and regulation of U.S. electric utilities. A majority of State public services commissions (PSCs) and the Federal Energy Regulatory Commission (FERC) have launched reforms intended to enhance competition and expand consumer options in an industry last restructured during the first term of the Roosevelt Administration. The public policy consequences of the present process of reform are likely to be wide ranging for investor-owned utilities as well as for the publicly-owned and Federal elements of the Nation's largest energy industry.

Now, as then, the restructuring of the electric industry will raise questions as to the division of Federal and State authority, the distribution of costs and benefits, and the reassignment of economic and social burdens -- now carried by utilities -- that may be stranded by reform.

The CECA/RF Electric Utility Restructuring Forum (The Forum) has been organized for the purpose of examining the impact of reform on those least likely to exercise market or policy power: residential and small business consumers. The Forum's objectives are to:

1.Seek common ground and a policy consensus among the critical stakeholders as to the economic, social and environmental goals that the Federal and State restructuring process should strive to achieve;

2.Enhance the likelihood of participation of ordinary citizens in the restructuring process by developing and disseminating a jargon-free, clear guide to the issues at stake;

3.Conduct briefings and disseminate analytical papers that will sensitize Federal and State decision-makers to the issues of importance to residential and small business consumers of electricity.

This paper provides an historical context for the debate, discusses key elements of what is at stake in the reform of the Nation's last, great monopoly, and seeks to establish a frame of reference for the Forum process ahead. It will eventually constitute one of the chapters in the Forum's Guide to the Interests of Consumers.

II. Genesis

The industry that today comprises over 3,200 distinct private and public enterprises serving 115 million customers, began as a private enterprise capitalizing on Thomas Edison's first generating plant, the Pearl Street station built in Manhattan in 1882. The industry grew rapidly on the parallel track of municipal sponsorship of city lighting companies and of private companies eager to link customers to the small, frequently redundant power stations of the time. It remained free of government oversight until 1907, when the States of New York and Wisconsin took control of the franchises awarded to power companies operating within their respective territories, and established the institutions- State Public Utilities or Service Commissions- and the rules- power rates, returns on investment- by which private utilities would conduct their business as public monopolies.

The private utilities did not resist State regulation. They believed it preferable to what Samuel Insull, one of the industry founders, saw as otherwise debilitating competition and municipal socialism. State regulation did not, in any case, hamper the essentially complete freedom of operation that the industry enjoyed, and eventually abused. In 1932, the Federal Trade Commission found that a mere 13 utility holding companies, known as Trusts, controlled 75% of the U.S. electricity industry. The three largest of these- United, Electric Bond and Share, and Middle West Utilities- controlled fully 40% of the industry.

Utility Trusts proved untrustworthy in terms of their ability to serve customers at reasonable cost, among other reasons because they charged exorbitant fees to their own subsidiaries for corporate oversight. The Trusts were unable to balance fundamental investments to ensuring engineering requirements with profit expectations and takings. Their business structures were unstable, and their financial practices eventually turned disastrous for their shareholders. The Trusts collapsed, along with Wall Street, at the onset of the Great Depression, leaving a trail of what the Securities and Exchange Commission (SEC) described as "...fraud, deceit, misrepresentation, dishonesty, breach of trust."

In response, President Roosevelt dedicated a significant portion of his 1935 State of the Union Address to launch a national campaign for the abolition of what he called "the evils of holding companies." He got his way with Congressional enactment of the Public Utility Holding Company Act (PUHCA) and, later in 1935, passage of the Federal Power Act (FPA). The two statutes, which took two decades to fully implement- the former by the SEC, the latter by the Federal Power Commission- brought investor-owned utilities (IOUs) fully under the joint but separate control of the Federal and State governments.

Roosevelt went further. In line with the positive experience of the New York Power Authority, which he established as New York State governor, he undertook the creation of the Tennessee Valley Authority, and developed the plan that would subsequently establish the five Federal power marketing administrations charged with the sale of electricity generated at Federal dams. In enacting the legislation proposed by the New Dealers, Congress directed the TVA, and later the PMAs, to sell Federal power at the lowest possible price, consistent with sound business practices. Moreover, Congress provided a preference right for publicly-owned utilities and rural electric co-operatives to purchase Federal power.

The achievement of these New Deal goals, and of a multiplicity of other socioeconomic objectives was made possible by Federal treasury financing of the investment in the power generation infrastructure of TVA, of Bureau of Reclamation and Corps of Engineers hydroelectric facilities, and of PMA operations. A part of this investment is carried on the books of the U.S. Treasury as loans which, in recent years, have been subject to controversy as to the degree of federal subsidy that they provide to the Federal utilities and to the customers who are served by them. It should be noted that other forms of Federal subsidy have over time been built into the structure of investment of private investor-owned utilities(IOUs), and that both public and private forms of Federal preferences will likely be subjected to the forces- market competition, in the main- that can be expected to be unleashed as a result of industry restructuring.

III.The Seeds of Trouble

Fateful decisions were made by policy makers at the Atomic Energy Commission (AEC) and regulators at the Federal Power Commission (FPC) during the 1960s with repercussions that remain unsettled to date. In that decade, the AEC undertook to aggressively transfer nuclear technology to the private sector, on the premise- which later proved wholly implausible- that the most complex technology yet devised for the transformation of energy would generate electricity at a cost "too cheap to meter." In the same period, the FPC carried out its first-in-history National Power Survey, which concluded that:

1.The nation would require a near tripling of generation capacity between 1965 and 1980.

2.The industrial sector's self generation capacity, and all other co-generation capacity, would become a costly redundancy.

3.Nuclear capacity would be built at a cost of $100 per kilowatt.

4.Total power costs at the busbar would be 0.005 cents/kilowatt hour by 1980.

The industry -- and State authorities -- took the results of the survey as guidance, and mobilized and authorized the resources deemed necessary to carry out what was perceived as a national objective of ensuring adequate supplies of electric energy at reasonable cost. In the process, they ignored signals from the engineers managing the national grid, also reported in the FPA survey, that reliability trouble loomed ahead.

IV. Reliability

The great NorthEast Blackout took place on November 19th, 1965, affecting thirty million people in an 80,000 square mile territory stretching from Canada to New Jersey. The industry's slow response to the crisis earned it the disdain of the media which characterized it as "incompetent and moribund." Then FPC chairman Joseph Swidler declared that "...the industry would never be the same again."

The industry responded to the Blackout by organizing what came to be known as the North American Reliability Council (NERC). The alternative would have been the imposition- as Congress contemplated- of further regulation by the Federal Power Commission. The NERC, an umbrella organization comprising nine regional councils, was established to ensure voluntary collaboration among utilities for the purpose of planning and having available generating capacity to meet highest expected loads plus a safety margin. The NERC system proved useful not only for purposes of reliability, but for encouraging previously non-contemplated levels of system interconnection and for close coordination of the use of generation and transmission assets.

An understanding of how regionally interconnected the current system is, and of the voluntary means by which reliability is presently ensured, is critical to an understanding of the risks involved in undertaking a restructuring of the industry on a state-by-state basis. The role that the national and regional reliability councils will play in a restructured industry is indeed open to question, as is the economic value of the capacity margins that have been built into the power generation system for the purpose of meeting reliability criteria that may change with the system's reform. It is, in any case, important to note that the duty and cost of ensuring reliability in the current system is carried entirely by utilities, and not by the range of other actors- independent producers, power marketers and brokers- that participate, financially and otherwise, in the system.

V. Nuclear Investments

Nuclear technology has proved costly to private as well as public utilities, and remains an issue of significant proportions in the restructuring process. Once engaged in a nuclear program, utilities have found it difficult to contain the financial and regulatory burden thereby assumed. Among the more notorious examples of disastrous results from nuclear investments are the following. The Shoreham plant in New York's Long Island, which was completed in 1991 at a cost of $4.5 billion, was shut down before producing a single marketable electron. In Ohio, utilities absorbed $246 million in losses for cancellation of plants in progress. In Missouri, the State PSC levied a penalty of $384 million against Union Electric Co. for cost overruns on a $3.0 billion plant that was estimated to cost a third of the final price.

Publicly-owned utilities also misjudged the consequences of the nuclear option. The Washington Public Power Supply System (WPPSS) embarked on the construction of five nuclear plants in the late 1960s, financed by the issuance of $6.0 billion in tax-free bonds. A single unit was eventually completed, but WPPSS defaulted on $2.5 billion in bonds held by 78,000 investors world-wide. The Tennessee Valley Authority also undertook an aggressive nuclear plant program in the 1970s that by 1980 placed the future of the entire agency in jeopardy. Only three of the more than a dozen plants originally contemplated were finally completed, with concomitant sunk costs and cost over-runs assumed by the TVA's ratepayers, and by the national taxpayers through Congressional appropriations.

Among the reasons for the nuclear debacle is the previously noted FPC guidance to the industry on the generation capacity that was forecast to be required to meet robust demand in the 1964-1980 period. With the advent of the energy crisis in 1973- a crisis which though of crude oil was transposed nonetheless by policymakers to the electric industry which could do little about it- evidence became overwhelming that far too many power plants were being built in the United States. Consequently, between 1972 and 1984, a total of 113 nuclear plant projects were scrapped, along with 67 baseload coal fired units.

It is a measure of the confusion that reigned in America's policy-making centers that during the very same period that utilities were scrapping plants, the Nixon and Ford Administrations would launch "Project Independence" which, among other things, called for a crash program to build 200 new nuclear power plants and 150 new coal-fired plants. The Project Independence designers assumed that nuclear and coal-fired plants would somehow substitute electric for fossil energy and thereby reduce American dependence on foreign oil. But this proved infeasible given the concentration of oil use as non-substitutable transportation fuel and industrial feedstock.

The combination of confused policy direction from the White House, the superficiality of prudence reviews on the part of the FPC and of State PUCs, and the belief among privately-owned utilities that investments in new plants were justified by commonly accepted projections of high growth in demand, eventually combined to produce a generation infrastructure comprising substantial un-economic assets. These assets carry economic and social costs of sufficient magnitude as to complicate the process of restructuring the industry while concurrently safeguarding the interests of consumers.

VI.The Roots of Reform

The theoretical models to reform the generation, transmission and local distribution functions of electric utilities date from the energy crisis of the 1970s. The models emerged primarily from research conducted at the Massachusetts Institute of Technology (MIT), initially by Leonard Wise ("monopoly is not inevitable") in 1975, and Matthew Cohen ("divest generation assets, establish regional power brokers") in 1979. The models were later perfected by William Berry (1981) and by Golub et al, who in 1982 made public what came to be known as the MIT Model, a proposal for full deregulation of power generation, a spot market for wholesale power, an independent system operator for power dispatch, and a separate broker/merchant function for transmission.

The electric utilities of the State of New York were the first to attempt in 1975 to translate MIT theory into business practice by proposing to their regulators a re-organization of all the then privately held generation plants, into the Empire State Power Resources, Inc. (ESPRI). This "pure" generation enterprise would have operated independently of transmission and distribution functions, but also of state oversight. The New York PSC rejected the proposal, among other reasons because jurisdiction over ESPRI would have been entirely by the Federal government.

Congress ignored the then-available restructuring models when in 1978 it enacted the Public Utility Regulatory Policies Act (PURPA), a key element of the Carter Administration's National Energy Plan. PURPA opened the door for agents other than utilities to build plants and generate power (and co-generate steam) that would be, however, sold exclusively to established utilities. Although later viewed as the statutory spark for competition, PURPA was intended by Congress to primarily expand fuels and technology options for an economy constrained at the time by extensive Federal/State regulation of supply and price of most fossil fuels. PURPA nonetheless fostered managerial as well as technological innovation, and contributed practical evidence that the generation of power need not, does not, constitute a natural monopoly.

The subsequent growth of experience with independent power producers, and related adoption by numerous State commissions of competitive means for acquiring new capacity, provided something more than anecdotal evidence that the cost of producing electric power could be substantially reduced from levels embedded in rates allowed to utilities. PURPA also provided experience in access to the transmission system by non-utility generators, and in the wheeling of power. Still, facilities licensed under PURPA operated under a number of constraints, including the technology and fuels their owners were permitted to use, and the requirement that the power generated at these facilities be sold, at prices equal to the difficult-to-define avoided cost of the utilities' own power generation costs.

VII.EPAct

It would require an additional decade for Congress to find in the theoretical models and PURPA experience a legislative basis for reform of the industry. This came in the form of the Energy Policy Act (EPAct) of 1992, in which Congress codified a number of policy measures that are the foundation of the reforms being carried out by the FERC at the interstate level and by the States at retail level. The key electric industry reform measures are contained in Title VII, Subtitles A and B, of EPAct, which call for, respectively:

1.The creation of a new category of competitors called Exempt Wholesale Generators (EWGs). As the name implies, these are "exempt" from basic requirements of the PUHCA to be organized as utilities subject to Securities and Exchange Commission jurisdiction. EWGs are also generally free of the operational conditions imposed by law on PURPA facilities, and unfettered by fuel and technology requirements- they can generate electrons from whatever fuel and technology. Most importantly and unlike PURPA facilities, EWGs are not guaranteed a market for their power, at any price.

2.Access to the transmission system by virtually any qualified agent, at non-discriminatory rates, but subject to criteria established by FERC in its Order 888, as to the impact of access on system reliability, full cost recovery by the owners of the transmission system, and consistency with the public interest.

The Congress tread, as usual, lightly on the prerogatives of the States, making it explicit that EPAct, except where otherwise noted, applied to those elements of the electric utility industry historically subject to FERC jurisdiction, e.g., wholesale generation and transactions, and interstate commerce of electricity. Congress did not, in any case, pronounce itself on the possibility that the more competitive regime introduced by EPAct would be extended by the States to encompass local distribution of power, and did not address, or provide any guidance on the issue of plant and investment likely to be stranded by competition.

VIII. The Status of Reform

At the Federal level: In May 1996, the FERC issued its landmark Order 888 on the all-important matter of ensuring open, non-discriminatory access to the national transmission system, and on the recovery of costs stranded by this access. The order requires utilities under the jurisdiction of FERC, and other utilities that wish to adhere to an open access regime, to file with the commission the rates they will charge to themselves and to others for a number of unbundled transmission services. These rates and charges will eventually be posted on an electronic bulletin board system, code-named OASIS, that FERC intends to establish through Order 889. FERC will require open access rates from powerpools as well, and as a condition of approving mergers and acquisitions of IOUs.

In Congress, bills have been introduced in the House and Senate energy committees aimed concurrently at re-designing past statutes, and at influencing the direction of restructuring at the Federal and State levels. Among the legislative proposals are bills to repeal the requirement that IOUs purchase power from PURPA facilities, and to eliminate, or transfer to the FERC, the Securities & Exchange Commission's powers to oversee the business structures of IOUs under the PUHCA law. The three bills so far introduced contain proposals to either direct or foster competition at the retail level of the electric power system and some form of customer ability to choose suppliers of electric service.

At the State level: A majority of States have initiated investigations, or formal and informal proceedings, or actual tests to determine the extent and viability of restructuring processes that will eventually reach down to individual consumers. Some States- California, Rhode Island and New Hampshire- have completed legislative processes that mandate the reform of utilities under their jurisdictions by a date certain, and contain provisions for what has come to be known as retail wheeling, or the establishment of a competitive regime at retail level of power sales. Most other States are undertaking restructuring processes under authority already available to their Public Utility Commissions. Still other groups of States, such as those in New England, have drafted compacts aimed at coordinating the reform of local utilities among jurisdictions linked by established powerpools. Finally, some States, e.g., Oregon, West Virginia, South Dakota, have adopted a wait and see approach.

At the Market Level: Spot markets for power have emerged in virtually every region of the country, at locations generally co-incident with pre-existing powerpools. Power is bought and sold not only among traditional utility members of the powerpools, but also by power marketers and brokers. Trade in power has become more transparent, and prices more reflective of demand and supply conditions in any given hour (or fraction thereof) than was the case barely three years ago. Unlike power rates granted by regulators to utilities after lengthy and usually complex proceedings, spot prices are set almost entirely by market forces, and are immediately made public.

On March 29th, 1996, the New York Mercantile Exchange (NYMEX) launched the power futures trade, with contracts based on power delivery "gates" at the California-Oregon Border (COB), and at the Palo Verde switchyard in Arizona. These paper trades, used mainly for the purpose of hedging against price volatility, while still immature, represent a significant milestone in the process of adding electric power to the well-established commodity markets for natural gas and crude oil.

At the level of individual utilities: Many utilities have undertaken internal re-engineering processes in order to favorably position themselves in what they perceive as a highly competitive power market of the future. In some cases they have developed name brands for the "product" they will sell. In other cases they have sought strength in scope and size by merging with other electric utilities, or with other energy firms. Still others have sought expansion overseas by acquiring utilities or power generation assets in countries that have privatized previously state-owned systems. Most have established non-regulated subsidiaries that, among other things, will be engaged in buying and selling power on the open market.

IX. Conclusion

Changes seem inevitable for the electric utility industry. At the Federal level, the FERC has acted on the matter of opening the transmission system to greater competition, but Congress has yet to act on its view of what should constitute the final restructuring form for the nation's largest energy industry. At the State level, reform is underway, but only in its initial phases for the most part. Opportunities therefore exist for consumers -- individually or collectively -- to influence, perhaps shape the process and the outcome. This is the purpose of the CECA/RF Electric Utility Restructuring Forum.

Page Last Updated: December 7, 2005