United States Program on Energy Deregulation Institute for Energy Economics, Japan Tokyo, Japan

1. Economic Growth and Energy Security in Electricity Restructuring: Benefits, Issues, and Lessons Learned United States Program on Energy Deregulation Institute for Energy Economics, Japan Tokyo, Japan July 18, 2003 Stephen Bird * Harvard Electricity Policy Group * The views presented here are solely those of the author. Center for Business and Government79 John F. Kennedy StreetCambridge, MA 02138Tel: 617-496-6760 · Fax: 617-495-1635stephen_bird@harvard.edu http://www.ksg.harvard.edu/hepg John F. Kennedy School of GovernmentHarvard University

2. Outline of Presentation Part I - Overview of Competitive Markets • Why restructure? - benefits, limitations Part II - Important Issues in US Japan Context • Wholesale Market Structure / Standard Market Design • US market • Jurisdictional issues • The importance of California • Structure of System Operator • Governance and regulation • Transmission • Resource adequacy and capacity • Fuel Diversity, Energy security, Sector incentives • Renewable Portfolio Standard (RPS) • Nuclear power in the US

3. Part I: Why Move to Competitive Markets ? • Efficiency Savings • Long-term economic savings • Do the benefits exist? – very little hard data • In US, 1992 Energy Policy Act permitted U.S. utilities to own an equity interest in foreign utilities for the first time – restructuring allows utilities to diversify • Risks of forecasting, regulatory error, management error are all moved to market players • Energy Security and Reliability Benefits • Fuel diversity fostered, increased security of supply • more efficient system operations • new product development (innovation) • Need for reliability can incent system investment

4. Efficiency Increases in Market States Source: Catherine Wolfram, The Efficiency of Electricity Generation in the US after Restructuring. UCEI/UC Berkeley, June 2003. Publication forthcoming.

5. Comparison of Pennsylvania and National Rates 1988-2003 • Pennsylvania • 1996 deregulation legislation implemented • 1998-1999: modest initial effects of restructuring begin to be revealed but regulated utility rates for PA were also lowered at this time Source: EIA website, “Electricity Publications”Note: Data are weighted averages for all consumer sectors. Delivery charges for 1999 PA unregulated rates are modeled proportionately; actual data unavailable. Additional source data kindly supplied by Rodney Dunn, EIA.

6. Some Realities • Benefits of restructuring should not be over-exaggerated • Most of the benefits are long-term (5-10 years or more) • Costs to set up market must be paid • Setting up a strong wholesale market is critical • Markets create winners and losers • Subsidies to some customers and/or market participants can be erased, making them unhappy • Residential customers will probably see very few changes

7. How Far Should Competition Go? Small Customers • Should probably remain regulated • Sustained high prices in a volatile market are politically unsustainable • Any benefits are minimal, transactions costs are high Large and Medium Commercial and Industrial (C&I) • Should have option to be in the market • Not necessary to have all players in the market • Most of the load should be dominated by long-term contracts • Excessive exposure to a spot market can be erratic (California) • Demand-Side response can mitigate price spikes

8. Part II: Issues in the US/Japan Context Three areas of concern that have increased relevance for the US and/or Japan: • Wholesale Market Structure / Standard Market Design • US Market • Jurisdictional issues • Lessons from California • Structure of System Operator • Governance and regulation • Transmission • Resource adequacy and capacity • Fuel Diversity, Energy security, Sector incentives • Renewable Portfolio Standard (RPS) • Nuclear power in the US

9. Federal Federal Energy Regulatory Commission US Government Agency with 5 voting Commissioners Regulation of Natural Gas Pipelines (130) Regulation of Electricity – wholesale markets and interstate transmission Hydroelectric licensing Regulation of interstate oil pipelines State Public Utility Commissions (50 states) Structured differently in each state Regulation of all retail transactions including Renewable Portfolio Standard (RPS) Regulation of all local distribution Regulation of US Electricity

10. Wholesale Market Structure Sound models for effective wholesale markets exist • Congestion revenue rights derived from Locational Marginal Pricing (LMP) • Independent system operator for transmission and the wholesale spot market • Spot market and day-ahead market operated in conjunction with long-term contracts • In US, PJM and NYISO provide the most coherent models for relatively reliable, robust, and essentially impartial markets • Japan’s establishment of voluntarily established markets run by private companies • No neutral/independent system operator • Will enough participants become involved if the market is operated by a private company? • Will the markets be large enough to encourage robust competition and minimize market power?

11. Standard Market Design • Main components • LMP – similar to PJM system • Independent system operator for transmission system and markets • Standard tariff for all transmission • Mandatory • Market monitoring staff independent of transmission organization • Reasons for the design • Seams interconnection issues • Size matters – larger regions, greater economies of scale, regional planning • Independent grid operation • Increases incentives for investment • Increases incentives for demand response • Reduces congestion • Pricing system accurately represents grid operations - efficiency increased, gaming reduced

12. US Jurisdictional Concerns Federal/State issues • Seams issues • Relevant to Japan – islands, voltage separation • Transmission expansion • Siting concerns • Regional expansion heavily influenced by multiple states • Differences in regional characteristics • Northwest – heavy hydro • Southeast – plentiful coal, cheap • The “Civil War” … again: Concerns that cheap electricity will be exported to expensive states, raising rates • free rider issues – southern states pay for increased transmission infrastructure (that they contend is locally unnecessary) and lose cheap electricity to northern states • However, long-term benefits may accrue to southern states; if so how to apportion the costs? Serious differences between FERC and the States remain to be resolved

13. System Operator / Transmission System Operation – Independent Transmission Provider (ITP); in US – Regional Transmission Organization (RTO) • Governance issues • Board governance – significant differences • Level of stakeholder influence, who are the stakeholders • Stephen Bird, RTO Governance: A Comparison of ISO Governance Structures in the US. April 3, 2002. <http://www.ksg.harvard.edu/hepg/Papers/Bird%20ISO%20gov%20comparison%20matrix%20App%20A.pdf> • Transmission operations • Incentives for transmission expansion • Market operations • Day-ahead and spot markets operated in coordination with grid functions • Separation a problem (gaming issues – e.g. California) • “The Separation Fallacy” – Bill Hogan “In the successful Northeastern markets, system operations, short-run reliability functions and market operations all flow from the same dispatch functions … all the pieces must work together.” William Hogan. Electricity Market Design and Structure. March 12, 2002, p. 2 http://ksghome.harvard.edu/~.whogan.cbg.Ksg/Hogan_FERC_RTO_Functions_filin_%20only%20031202.pdf

14. California: The Perils of Restructuring Badly • 1999 - The “Perfect Storm” • Low hydro levels - drought • Gas supply volatility, short supply • Zonal pricing mechanism did not reflect pricing realities – gaming opportunities available • Retail price cap, open wholesale market – no such thing as “half a market” • Spot market operated separately from system operator – gaming opportunities available • Political and regulatory uncertainties created a disincentive to invest in new generation • No opportunity for long-term bi-lateral contracts (used to mitigate price volatility)

15. California Price Spikes Day-ahead electricity prices (CA and New York) Jan 00 - Jan 01 California New York City Buffalo, NY Slide Source: Theresa Flaim, Restructuring Wholesale and Retail Electricity Markets in the U.S., May 10, 2003.<http://www.ksg.harvard.edu/hepg/Papers/Flaim_US.Electricity.Restructuring_5-10-03.pdf>

16. California con’t How did such a structurally unsound proposal become reality? • Lack of regulatory oversight • A “lowest-common denominator” solution“Absent strong public oversight, the complex interactions and the competing interests provide a textbook case for sacrificing the public interest and sinking to the least common denominator” – Bill Hogan • No clear regulator; too many cooks – California Public Utilities Commission, California legislature, California Energy Commission, California Independent System Operator? Lessons? - It is imperative to restructure properly • the models exist: PJM (US), United Kingdom, Norway • In the US, California has turned into an overly simplified argument of pro or anti-restructuring. In reality, there are varying models of restructured models just as there are different models of monopolistic regulation. In each case, there is the good, the bad and the ugly.

17. Price Volatility When supplies are tight, both the supply and demand curve can be vertical, leading to price spikes when supplies are short Forecast load = 20,373 MW Data are price bids in the NY ISO Day-Ahead Market for Feb. 7, 2000, Hour 8. Slide Source: Theresa Flaim, Restructuring Wholesale and Retail Electricity Markets in the U.S., May 10, 2003.<http://www.ksg.harvard.edu/hepg/Papers/Flaim_US.Electricity.Restructuring_5-10-03.pdf>

18. Transmission • How to encourage reliability / infrastructure expansion and yet also maintain environmental standards and equitable public participation • The problems of size and regionalism • Transmission lines usually cross many political boundaries • Free-rider concerns • Stephen Bird, Arrowhead and the Cross Sound Interconnector: Implications for Transmission Siting and Expansion. Availability forthcoming; see HEPG website

19. Resource Adequacy and Capacity Concerns • How does one maintain resource adequacy in a market environment to ensure energy security? • A major concern for Standard Market Design (along with regional state/federal differences) • Create a separate “capacity” market? • Some advocate a determination of capacity solely by the market participants • Others say long-term peaks and valleys of such a market are not conducive for such a vital commodity as electricity – there must be some guarantee of supply • Any solution to this problem will be imperfect

20. Fuel Diversity, Energy Security, Sector Incentives Percentage of United States and Japan Net Generation by Energy Source (2001) US Japan Source: EIA website http://www.eia.doe.gov/neic/quickfacts/quickelectric.htm and METI

21. Fuel Diversity, Energy Security, Sector Incentives Over-emphasis on single energy sources can be perilous • Energy security • Price and supply volatility • US – natural gas • 2003 – extremely tight supply • 1999 – contribution to California debacle • Japan • Coal – single source (Australia) • Nuclear – current closures of plants, high dependence • obviously a necessity for Japan under current conditions • New gas deals with Russia seem promising • Demand response??

22. Fuel Diversity, Energy Security, Sector Incentives, con’t • Environmental implications • Renewable Portfolio Standard (RPS) can be used to incent renewable energy sources • Fuel diversity can function as risk mitigation for all these issues • In a regulated model, fuel diversification can be mandated by regulators • Under restructuring, externally applied incentives must be applied: • US: nuclear, RPS

23. The Nuclear Issue • April 10, 2003 - US Senate committee in upcoming energy bill includes several elements to stimulate building of nuclear plants (Bill S 14) • stimulate construction of several new nuclear power plants through loan guarantees or power purchase agreements prior to plant operation - up to $30 billion US • permanently reauthorize the Price-Anderson Act that sets the framework for the liability insurance coverage that nuclear power plant owners purchase • In Japan, nuclear is a forgone conclusion because of high population density and land costs • Recent problems with TEPCO reactors show potential problems of over-reliance on a single source of energy

24. The Nuclear Issue, con’t • In restructured markets, nuclear projects may be more difficult because development is very long term – siting and financial backing can be more problematic than other electricity sources • No nuclear projects developed in United States since 1979 (Three Mile Island) • External insurance liability guarantees probably necessary for nuclear projects to be viable in restructured markets • Regardless of political stance, stringent regulatory oversight of nuclear development and facilities is imperative for public safety and confidence • Particular sources can be encouraged via externally mandated government policies • E.g. RPS (see next slide), or financial stimulus as described in current nuclear legislation in previous slide

25. Renewable Portfolio Standard A regulatory tool to encourage development of new renewables • In US, usually implemented at the state level. • A specific level of defined renewables that is mandated externally by the state utility commission • Benefits • Adds to fuel diversity • Obvious environmental benefits • Problems • Lack of supply even with the RPS • Complaints that it is not a legitimate market player • Wind, solar, small hydro can all be inconsistent in supply

26. Renewable Portfolio Standard • In US, renewables accounted for approximately 2% of total load in 2001 • Although renewables are increasing, their percentage of total load has been relatively stable for the past ten years

27. Conclusion • Electricity restructuring appears to offer some benefits, particularly for larger commercial and industrial market participants • Careful market design, incorporating essential facets of regulatory oversight and properly designed incentives is critical • Both restructured markets and regulated utility models have significant concerns to address