Federal Restructuring News
Fall 2002

The Federal Energy Regulatory Commission:
Flexing Its Deregulatory Muscle

Until about 10 years ago, the electricity transmission network in the United States was largely built by and for regulated electric utilities, which produced, transmitted and sold power in precisely defined areas. Most utilities operated in one or two states, and their transmission facilities were regulated by state agencies. Today, transmission lines transport local power and move wholesale electricity from one region to another, as part of the new competitive energy environment that emerged during the 1990s.

As energy transmission became a national issue, regulation of the network began moving from state purview toward federal oversight under the Federal Energy Regulatory Commission (FERC). In July 2002, FERC issued a formal proposal to adopt what it calls the Standard Market Design to further transform the nation's transmission network. The proposed rules set forth a nationwide $1,000 MWh wholesale price cap, create a single transmission tariff, require that regional boards ensure the construction of sufficient transmission and generation infrastructure, and require regional forecasts of future demand. If approved, SMD will be the third order in a series of FERC initiatives "to harness the benefits of competitive markets."

Rules under the SMD and other recent FERC orders would be applied coast to coast, requiring that transmission lines be operated by independent entities, regardless of line ownership, charging power-delivery fees to reflect the true costs of transmission, allowing transmission owners to recover their transmission costs, and establishing procedures to encourage construction of new transmission and generation.

FERC argues that the new system is essential because of the increasingly national nature of energy sales. Without a national transmission regulatory system, state regulatory agencies could be making decisions about transmission lines that serve regional and/or national needs. Hypothetically, this could mean that one state would bear the environmental and economic costs of transmission lines that primarily serve other states. FERC's stance is that national regulation of transmission networks would balance the needs of different states and regions and encourage competition among energy producers and suppliers.

Within days of the FERC announcement, 15 states (AL, AR, CA, GA, ID, KY, LA, MI, NH, NC, SC, OR, SD, WA, WY) issued a joint statement denouncing the Standard Market Design rule and promising to file a lawsuit if FERC adopts it. Pacific Northwest states are particularly concerned that state and regional utilities will have to compete with energy traders for access to transmission lines. These traders might have access to cheaper power, which would allow them to pay higher prices for transmission access and thus drive up the price of power for utilities and consumers. California regulators are also concerned that FERC will not be able to provide the vigilant monitoring of energy marketers that will be essential if Standard Market Design is adopted.

How Did It All Begin? 
The move toward national electric competition began almost by chance. The 1978 Public Utility Regulatory Policies Act (PUHCA) requires electric utilities to purchase power from "qualifying facilities" (QFs) -- alternative energy sources and industrial cogeneration systems. Facilities with cogeneration systems use excess heat from other industrial processes to produce steam for electricity production. PUHCA allows them to sell that excess electricity and requires utilities to buy it.

The QF provision was designed to encourage energy efficiency and use of alternative energy sources, but it had an unexpected consequence: Because qualifying facilities could sell power into the local transmission grid whenever they wanted to, utilities no longer had total control of their transmission facilities. This gave rise to the idea of opening transmission lines to entities other than the companies that owned the lines.

The problem was that there was no legal or regulatory mechanism to force utilities to open the transmission lines to energy marketers. Although the 1932 Federal Power Act gave responsibility for wholesale power market regulation to FERC, Congress also refused to allow the agency to order open access for third parties to a utility's power grid, except under very limited circumstances (such as a finding of antitrust violation).

The Energy Policy Act of 1992 changed all that, by giving FERC the authority to require open access as long as the affected utility is engaged in wholesale power sales. (Wholesale power can be bought only by other utilities, municipal power systems, and rural electric networks, which can then resell the electricity to industrial, commercial and residential consumers.) Because most wholesale power sales involve interstate commerce, FERC has the authority to monitor transmission systems and promote competition.

The legislation was designed to encourage the beginnings of competition in the electric industry without infringing on state rights. FERC now has considerable authority over access to and regulation of transmission grids, but it is specifically forbidden from ordering retail competition. That decision is left to the states, so state legislatures and regulatory commissions now determine whether to allow competitive suppliers to market power to electricity consumers.

FERC began flexing its regulatory muscle in the late 1990s, when it issued a series of orders to "remedy undue discrimination in transmission services . . . and provide an orderly transition to competitive bulk markets." Order 888 requires transmission line owners to offer access to the grid at prices comparable to those they charge to themselves. Order 2000 began the process of setting criteria for new, regional transmission organizations (RTOs) to maintain reliability, avoid congestion, coordinate power flow among different regions, and plan new transmission construction and upgrades. The RTOs are designed to eliminate bottlenecks on the U.S. transmission grid where, some analysts believe, congestion in high-demand areas has meant higher electricity bills.

A RTO is responsible for coordinating power flow through transmission lines and maintaining its short-term reliability -- that is, preventing congestion that could limit supplies to high-demand areas and/or lead to power outages. Another major RTO goal is to encourage competition by making sure that competitive suppliers have access to the grid at reasonable rates.

A RTO can be a for-profit or non-profit entity, but it cannot have ties to utilities or other entities that would be affected by its decisions. Some states, like California, as well as regions like the Northeast states, already have ISOs -- independent system operators that perform the duties of a RTO on a state or limited regional scale. These smaller entities may be combined or expanded to create a regional transmission organization.

Order 2000 does not require utilities to turn control of their power lines to the FERC-monitored RTOs that can, in turn, decide whose power will flow through what lines at any given time. However, utilities that do not join a RTO will lose the right to sell wholesale power on the open market. In June 2002, FERC Chairman Pat Woods said that he may try to make utility membership in RTOs mandatory.

In July 2001, FERC announced that it would begin mediation talks among utilities, states and other affected groups to begin formation of four RTOs for the contiguous United States -- in the Northeast, Southeast, Midwest and West. Initially, the agency set a December 15, 2001 deadline for formation of the RTOs, but it has since acknowledged that the process will take much longer. As of July 2002, only one RTO -- in the Midwest -- has received FERC approval. However, in June, the New York ISO and ISO New England issued a joint statement announcing their intention to create a Northeast RTO.

As the move toward RTOs advanced, Western states objected to being included in a RTO with crisis-plagued California. FERC Commissioner Linda Breathitt has announced that there will probably be three RTOs in the West -- one in California, one in the Pacific Northwest, and one in the Southwest.

Objections and Acclamation  
Some states have objected to FERC's expanded authority. Nine states, led by New York, filed suit in 1999 to overturn the FERC order that opened transmission lines to wholesale power transaction, arguing that the agency was trespassing into state regulatory territory. In March 2002, the U.S. Supreme Court disagreed, affirming the federal agency's authority to regulate transmission facilities across the U.S.

In another regional show of defiance, 41 Pacific Northwest public utilities formed a public coalition -- Northwest Power Works -- to oppose plans for a RTO in the West. In June 2002, the coalition filed a formal protest against the RTO plan, claiming that it would add a layer of costly federal bureaucracy and strip control of the power grid from local governments and utilities that are responsible to voters and/or customers. When FERC issued its proposed Standard Market Design for national transmission regulation, Northwest Power Works responded with a statement that "Power rates determined under the proposed SMD system would no longer be based on the actual costs of producing power but on what markets would bear, shifting advantages toward power marketers and producers and away from consumers."

Governors of 16 Southern states approved a resolution in August opposing part of the SMD plan. The governors said they fear FERC’s new policy on transmission pricing will raise electricity costs in the South. The Southern Governor's Association resolution says the governors "oppose the FERC’s move toward socializing all costs of transmission system expansions and upgrades and urge FERC to utilize a pricing policy . . . that requires the costs to be paid for by the customers proportionate to the benefits received."

The Wall Street Journal (August 1), on the other hand, applauded the Standard Market Design proposal, because it would open the transmission network to all generators under a single tariff structure set by FERC: "The SMD rules would prevent transmission line owners from discriminating against new generators trying to break into the market." The Journal also noted that the new SMD pricing rules would create more transmission "space" and eliminate electricity bottlenecks. California, for example, has three congestion pricing zones; under SMD, it would have 1,500.

Even if all three FERC initiatives survive without legal challenge, state regulators will still have authority to regulate utility grids in their jurisdictions as part of determining the price of transmission for retail (as opposed to wholesale) customers. They will also retain control over the expansion of the power grid through their power of property taking and land use and environmental regulation.

Particularly important is the fact that FERC cannot mandate that particular investments be made to expand the grid. One of the issues being discussed in the debate over the massive federal energy policy bill is whether FERC should be given authority to mandate the construction of transmission lines if they are considered of national importance. In other legislation, language in a bill passed in September by the U.S. House Appropriations Committee would require to Secretary of Energy to analyze the costs and benefits of FERC's SMD plan.

FERC clearly hoped to limit state objections to SMD by including a proposal to "create a formal role for state representatives to participate in the decision-making processes of regional transmission organizations . . ." FERC Chairman Pat Wood recently endorsed the concept of a Multi-State Entity (MSE), proposed by the National Governors Association Task Force on Electricity Infrastructure. The MSEs would be advisory committees, representing different regions of the country, and would help develop transmission planning guidelines and exchange information between states and the RTOs.

The Office of Market Oversight and Investigations, created by FERC in April 2002 in response to the national energy trading scandal, is the agency's answer to fears that energy marketers could exploit a national transmission network. The new office, made up of economists, engineers, attorneys, auditors, data management specialists, financial analysts, regulatory policy analysts, energy analysts and support staff, is supposed to monitor energy markets and risk management, measure market performance, analyze market data, and investigate compliance violations.

The Standard Market Design Rule was open for comment until mid-October but FERC recently expanded the comment period to December 15.  FERC is conducting a seven-city "SMD Road Show" to gather feedback on the proposal during August and September. The agency is also continuing its drive to implement regional transmission organizations and expects RTOs to be operating across most of the nation by the end of 2003.

Web Resources   
The Federal Energy Regulatory Commission maintains a web page on its Standard Market Design proposal, including a history of the rule making process, the original SMD press release (which provides a detailed and well-written explanation of the proposal), and all subsequent documents.

The report of the National Governors Association Task Force on Electricity Infrastructure provides an overview of state concerns about federal authority over transmission lines, particularly the recent effort by the Federal Energy Regulatory Commission to form Regional Transmission Organizations (RTOs).

Northwest Power Works is a campaign sponsored by a coalition of utilities and other organizations opposed to federal proposals to bring "California-style electricity market restructuring"—and electric rate increases—to the Pacific Northwest. Its website provides information and resources to the public, grassroots campaign leaders, and the media.

Synapse Energy Economics, a research and consulting firm that specializes in energy, economic and environmental topics, has a website that features research papers focused on wholesale electric markets, ISOs and RTOs, and electric system reliability, among other topics.

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