The Goldilocks Dilemma – What’s the Retail Regulatory Framework That’s “Just Right”?

1. The Goldilocks Dilemma – What’s the Retail Regulatory Framework That’s “Just Right”? A presentation by: Dr. John A. Anderson President & CEO Electricity Consumers Resource Council Washington, D.C. At The: The Santa Fe Conference Center for Public Utilities, NMSU Santa Fe, NM – March 20, 2007

2. What Is ELCON? • The national association for large industrial users of electricity in the U.S. • Founded in 1976 • Members from a wide range of industries from traditional manufacturing to high-tech

3. What I Plan To Do Today: • Assert that a truly competitive electricity market would be the best way to satisfy the Goldilocks Dilemma • Consumers would vote with their dollars for the amounts of new generation, transmission, energy efficiency, environmental investments, etc. that they desire • Clearly, a truly competitive electricity market would assure a consumer focus • Certainly, there were problems with traditional regulation • Tradition regulation would not meet the Goldilocks Dilemma • Due to the many problems, many states tried to change • But there are also critical problems with today’s FERC-jurisdictional “organized markets” • They are far from being competitive • They do not bring net benefits to consumers, much less result in satisfying the Goldilocks Dilemma • States face a dilemma of their own on how to proceed • Unfortunately, I think we will be in a very unsettled state for some time

4. The Question Before Us Today Is Difficult – But Important • What is the recipe that will result in: • New baseload generation • New transmission investment • New demand response and energy efficiency objectives • New environmental and national security objectives and • A rational deployment of limited capital • And all in a consumer oriented environment

5. A Little (But Only A Little) History: • In the beginning there were vertically-integrated utilities that: • Provided generation, transmission and distribution of electricity • Had exclusive service territories granted by governments • Regulators were their “customers” • Consumers had few options other than to purchase from the local utility • There certainly was no end-use consumer focus

6. Traditional Regulation Meant: • Most utilities had: • Little incentive to either offer lower prices or better service • Little incentive to even ask consumers what they really wanted • Every incentive to protect their own investments in generation (which was often inefficient) and transmission • Every incentive to “gold plate” their expenditures to increase their returns • And returns all but guaranteed by state PUCs

7. The Traditional Regulatory Model: • Seemed to work for some time • End-use consumer rates: • Steadily fell for many years as economies of scale were realized • Then were relatively stable • Most consumers had no idea whether they were or were not fair • Service seemed relatively good • What do you compare it to? • Consumers didn’t complain a lot • What options did they have?

8. But Then….. • Costs rose dramatically for some, but certainly not all, utilities: • Nuclear costs skyrocketed • Interest rates spiked • Inflation grew • Environmental costs rose dramatically • Rate increases and very significant price differentials caused a re-evaluation of the industry

9. It Is Important To Note That Regulation Was Inconsistent: • For consumers, traditional regulation worked much better in some areas than in others • Some states seemed to try to turn electric utilities into social service agencies or environmental advocacy entities • This made their territories much more expensive • But others stuck to traditional COS principles • This created price disparity between geographical areas • The relatively expensive areas tried “restructuring,” while the relatively low cost areas stuck to their business models • The results were even greater price discrepancies between geographical areas • Which fueled the opposition to restructuring • And it has the potential to do so with other “creative” regulatory actions

10. Many Folks Thought That A Healthy Dose Of Competition: • In the high-cost areas would produce favorable results: • ELCON was one of the first – and one of the strongest – advocates for competitive electricity markets • We believed then – and still believes now – that “true” competition would discipline artificially high prices that came from some forms of regulation • But it also should bring technological innovation, new products and services, a customer focus and allow customers to be in control of their risk • Unfortunately, we have not seen these expected results

11. The Problem Is We Did Not Get “Real” Or “True” Competition: • What we got lacked several critical preconditions of competition: • There is no direct interaction between supply and demand – Price responsive load is ignored – At best, we have “competitive bidding” of generation, which existed under traditional regulation • Prices are not set by market forces – Rather, we have “capacity markets” that are not markets, but are another form of regulation • Price caps and artificial bid mitigation measures commonly implemented • Too many inefficient suppliers that were propped up with overuse of RMR contracts and other such devices • A transmission infrastructure not adequate to allow the necessary movements of energy and power and a failure to mitigate market power caused by congestion – In fact, we got DISincentives for the mitigation of some congestion • Consumers unable to hedge future prices with bilateral contracts

12. ELCON Still Believes That “Real” or “True” Competition: • Would best satisfy the “Goldilocks Dilemma”: • Real or true competition would allow consumers to “vote with their dollars” for: • The amounts and types of new generation and transmission that consumers want • The energy efficiency and environmental investments that they are willing to pay for • Real or true competition certainly would result in a consumer oriented environment • Suppliers would have to be sensitive to what consumers want – or they would not be able to sell their products and services

13. Will We Get “Real” Or “True” Competition Anytime Soon? • There is VERY significant opposition to changes in the “organized markets” that would bring real competition • Some entities are making obscene returns – especially on depreciated coal and nuclear generating units • Obviously, they do not want to see changes that would reduce these returns • They are willing and able to spend very large amounts of both human resources and money protecting these earnings • However, FERC has now said that it understands that opposition to the organized markets is substantial – and growing • Thus, there seems to be a light at the end of the tunnel • The real question: Is it daylight – or the headlight of the oncoming locomotive? • And further, will FERC actually make the hard decisions necessary to protect consumers?

14. So Overall Where Are We? • Without strong FERC leadership, we believe that retail regulation, at least for the foreseeable future, will be whipsawed by a set of increasingly contradictory public policies: • A patch quilt of quasi-competitive and quasi-regulatory “markets” • Growing NIMBYism • A rush to do something about climate change • A failure of the stakeholder process so the problems are not self-correcting • I discuss each in turn

15. Hybrid Markets: • Industry restructuring has been an economic disaster due in large part to the lack of a federal and state cooperation in, or agreement on, a common model for the industry • Consumers are increasingly at a disadvantage in “hybrid” markets because of enormous transactions costs – both in time and money • Failure of the Day 2 market design (do we dare call it SMD???) results in a frequent need for regulatory intervention and “patches” • Investors do not like regulatory uncertainty or regulatory confusion, and have respond accordingly with a very high cost of capital – if they agree to finance at all • Solutions are very difficult to get implemented: • The stakeholder process is stacked against consumers • The whole issue is very complex – Have you ever tried to explane to your local Congressional representative that you don’t have enough FTRs!

16. NIMBYism: • There is a serious lack of political leadership necessary to overcome opposition to new energy infrastructure • The public has to understand that their economic well-being depends on the siting of new transmission corridors and baseload generation • FERC’s effort to cajole infrastructure investments with punitive locational prices has grossly backfired. The LMP prices simply tell the monopolists (that own high-cost generation protected by transmission constraints that they also own) where NOT to build • The “free lunch” crowd were guilty of asserting that supposedly “win-win” solutions (e.g., DSM, energy efficiency, etc.) would be both adequate and inexpensive. They are not – and such assertions just put off the inevitable

17. Climate Change: • If climate change was not a real issue before this year, it certainly is here today • All indications are that the US Congress will do something on climate change – In this Congress • But we still are not having the right debates. A few examples: • What do individual states or regions expect to accomplish if they curtail certain GHG emissions in their states or regions? • What are the costs associated with such measures? • How do we compare the real or total costs and the end-use consumer benefits? • How will individual state actions fit with future US Congressional actions? • Unless questions like these are answered, doing anything will probably be a token exercise without any cost accountability • Perhaps more important to us here, are such actions legal under state public service laws and regulations?

18. Finally, The Stakeholder Processes: • The use of the stakeholder processes has gained traction in restructured areas • Examples include: ISOs and RTOs; NERC; NAESB; FERC settlement proceedings • They involve such critical issues as resource adequacy • They seem to be growing as “regional planning” is implemented • But unfortunately, the stakeholder process is broken • Thus, the problems are not self-correcting • End-use consumers have only a small proportion of the votes – but they have to pay all of the bills • Consumers are unable to stop the implementation of proposals that they do not believe are in their best interests • The growing consumer rebellion signals (at least to us) the impending “train wreck”

19. So What Should State Regulators Do? • Go back to basics: • Implement sound economic policies • Use real accounting • Doubt those proposals that seem too good to be true • Recognize that today the default fuel for future generation is natural gas • And find ways to promote fuel diversity to prevent runaway “scarcity pricing” in natural gas markets • Get retail price signals correct – and be sure that they are fair and nondiscriminatory to ALL consumers – BEFORE experimenting with risky measures directed at issues such as climate change

20. So What Should State Regulators Do? (Cont.) • Recognize that trying to make a single entity both sell and “unsell” energy simply won’t work • And “decoupling” makes things worse, not better • Join the debate on whether end-use consumers are receiving net benefits from the “organized markets” • We must recognize the value of truly independent operation of the transmission grid and of regional planning that conforms to real power flows • But we must carefully balance the total costs of ISOs and RTOs against the end-use consumer benefits

21. Conclusions • ELCON believes that “real” or “true” competition would be the best solution to the Goldilocks Dilemma • However, today’s “markets” are far from competitive • And such markets are failing to achieve the stated goals • We believe that today’s “market” structure is not competitive and not sustainable • If stakeholders collectively do not choose to fix the problems with the markets • There will be a serious attempt to move back in the direction of regulation • This will be very difficult • And may do no better in achieving the stated Goldilocks goals • However, under no circumstances should we follow the Maryland, Virginia and other state experiences to date

22. Conclusions (Cont.) • The real problem, to us, is that neither traditional regulation nor today’s organized markets have a consumer focus • Thus, neither meet the Goldilocks Dilemma’s stated goals • The real challenge will be to find a way to truly respond to the needs of consumers • This is difficult • And I am not optimistic

23. Questions?

24. To Contact ELCON Phone: 202-682-1390 E-mail: elcon@elcon.org Web site: www.elcon.org Address: 1333 H Street N.W., 8th Floor, West Tower Washington, DC 20005