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Toward A Consumer-Oriented Electric System: Assuring Affordability, Reliability, Accountability and Balance After a Decade of Restructuring 2004-07-30 Download the full report.

Executive Summary

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America’s electric system is on the verge of a crisis. After more than a decade of rapid structural change – characterized by the deregulation of parts of the industry – the reliability of the electric system has been degraded, rates in many parts of the country are going up, and events such as the California energy crisis and the August 2003 blackout have cost consumers and businesses billions of dollars.

There is strong disagreement among policymakers and experts as to the way out. Federal regulators continue to push for increased liberalization of wholesale electric markets at the same time that officials in many states are pulling back from the deregulation of retail electric sales. The electric industry and some policymakers speak of the need for massive ratepayer investment in new capacity for the transmission of electricity, despite the acknowledged potential of improved energy efficiency and local generation of electricity to ease current transmission constraints.

Unfortunately, much of the current discussion glosses over the impact that restructuring of the electric industry has had – and will have – on ordinary consumers. In this paper, we present a consumers-eye-view of the current regulatory structure of the electric industry, the experience of the past decade of restructuring, and the critical problems facing the industry today. We also propose a series of guiding principles and policy options for protecting the interests of electricity consumers, and map out a long-term vision in which a shift to a more balanced mix of cleaner energy options leads to long-term cost savings for consumers.

America’s electric system is in a state of limbo – caught between the traditional regulatory structure that has governed the industry for the last century and increasingly tentative moves toward market-based structures.

• The framework of laws and regulations that has delivered affordable and reliable electric service for decades remains largely in place – even after a decade of industry restructuring. Federal law and statutes in many states still require government to uphold the public interest in the provision of electricity and assure “just and reasonable” rates for electricity service.

• The 17 states that adopted retail restructuring allowed electricity suppliers to compete for the business of small consumers. The western energy crisis of 2000-2001, however, stalled the drive toward retail restructuring and many states are now reconsidering their restructuring policies amid a persistent lack of competition for residential customers.

• Nearly a decade after the opening of wholesale markets to competition, federal officials continue to struggle to develop and implement regulations to ensure a fair, efficient wholesale market in electricity.

A decade of electric industry restructuring has led to few benefits for the majority of consumers, and any benefits consumers have experienced are likely to be short-lived.

• Retail electricity rates for residential consumers declined by 18.3 percent in inflation-adjusted terms between 1993 and 2002 – a decline broadly consistent with long-term historical trends. In 2001 and 2003, however, residential rates increased in inflation-adjusted terms – the first such year-to-year increases in nearly two decades

• Declining real energy prices – particularly for coal – appear to have played a major role in causing the rate decline. Coal prices declined by about 40 percent in real terms between 1993 and 2002. Natural gas prices were at their lowest point since the mid-1970s for several years during the 1990s, before spiking in 2000.

• States in which consumers may choose their retail electricity provider experienced greater reductions in residential electricity rates than states without retail choice (21 percent vs. 16 percent) between 1993 and 2002. But the restructured states experiencing the greatest decreases were those in which very few consumers chose competitive suppliers, leading to the conclusion that other factors – including the imposition of mandatory rate reductions that accompanied restructuring in most states and the fact that most restructured states had higher rates to begin with – are responsible for the greater rate of decrease in restructured states.

• The gap between the rates paid by residential customers and those paid by industrial customers has been rising. In 1993, the average residential customer paid 71.5 percent more per unit of electricity than the average industrial customer. By 2002, residential customers were paying 74.9 percent more for each unit of electricity they used.

The average American household’s electricity use increased over the last decade, while funding for utility- and state-supported energy efficiency programs was slashed – leading to increased energy consumption and strain on the electric grid.

• The size of the average residential consumer’s monthly electric bill declined by 10 percent between 1993 and 2002 in inflation-adjusted terms. The decrease in the average bill was lower than the decrease in average rates (18.3 percent), meaning that the amount of electricity used by the average consumer increased significantly over the last decade.

• Spending on energy efficiency programs has a significant impact on residential electricity usage. On average, for every $10 spent on efficiency programs per capita from 1996 to 2000, the average state reduced residential electricity usage by 0.3 percent. This does not include savings from industrial or commercial efficiency programs

• Between 1993 and 2000, spending on state- and utility-sponsored energy efficiency programs decreased by approximately 38 percent, as many utilities – in states both with and without retail restructuring – scaled back their energy efficiency investments.

Restructuring has also been accompanied by the degraded reliability of the electric grid and greater reliance on increasingly expensive natural gas. These developments – along with the impending removal of rate caps in some states that have undergone retail restructuring – will likely lead to higher costs for consumers in the years to come.

• The increase in wholesale electricity trading that resulted from industry restructuring is placing unprecedented strain on the nation’s electric grid. The average number of reported disturbances (service interruptions and other “unusual occurrences”) in the interstate transmission system during the 1998 to 2001 period was double the average number reported from 1992 to 1996.

• Federal officials and the electric industry have proposed tens of billions of dollars worth of upgrades to make the transmission system – which was never designed to accommodate wholesale markets – an appropriate platform for the restructured industry. Ratepayers would likely pay the vast majority of the costs of such an upgrade.

• Natural gas prices have doubled since the mid-1990s, due in part to the restructuring-fueled boom in the construction of natural gas power plants during the 1990s. Prices are likely to remain well above historic levels for at least the next two years, and may lead to persistently high rates for customers of utilities that are heavily dependent on natural gas.

• Mandatory rate reductions and rate caps that benefited consumers in many states with retail deregulation are scheduled to be removed over the next several years. The removal of rate caps in New Jersey in 2003 led to an immediate 19 percent increase in rates. Utilities in Michigan and Maryland are already predicting double-digit rate increases when rate caps are removed in those states. In addition, many state rate caps allow utilities to recover the expense of complying with the rate caps (with interest) once the caps expire – providing further upward pressure on rates in the years to come.

The past decade of restructuring has created or exacerbated seven critical problems that must be resolved in the coming years if consumers are to be well-served by the electric system.

• The failure of retail competition – One of the most highly touted benefits of restructuring was to be consumers’ ability to choose an electricity provider. But in no state that deregulated retail sales of electricity is there currently an active, competitive market for the business of residential consumers In most restructured states, less than 5 percent of consumers have switched electricity providers. Even in states that experienced a greater amount of switching – such as Pennsylvania – the number of consumers receiving electricity from competitive suppliers has been going down, not up. States face the option of prioritizing competition – likely at the expense of higher rates – or protecting consumers from rate increases and volatility by requiring the provision of a regulated electricity product.

• Failures in the wholesale market – The scarcity of transmission capacity at times of peak demand impairs the workings of the wholesale market in fundamental ways. The two main solutions proposed by the electric industry and the federal government – the expansion of transmission capacity and market-based (as opposed to flat-rate) pricing of transmission – both have the potential to negatively impact ratepayers. Meanwhile, the scarcity of generation or transmission at peak periods continues to provide wholesale electric suppliers with incentives to withhold capacity in order to achieve higher profits, as occurred during the western energy crisis.

• Lack of effective and coordinated planning – Smooth operation of the electric grid requires extensive planning, and responsible operation of the grid requires planning that is responsive to public needs. Yet, system planning too often neglects less-expensive solutions to problems (such as energy efficiency); fails to provide for long-term stability in electricity costs; fails to coordinate the activities of various parts of the system; ignores resource, environmental and political constraints; and increasingly takes place out of the public domain.

• Failure to account for external costs and impacts – Decision-making in the electric industry often fails to take into account the costs imposed on society by electricity generation – including impacts on the environment, public health and other sectors of the economy. As a result, resource options that might provide the greatest aggregate benefits to society, such as the expanded use of renewable fuels and improved energy efficiency, are routinely ignored.

• Financial instability – The restructuring of the electric industry – together with the loosening of traditional financial controls over public utilities – has led to bankruptcies and bond rating downgrades for a variety of players in the industry. These developments may make it more difficult for some utilities to obtain credit, resulting in delayed capital expenditures and higher rates for consumers, who ultimately pay for utility debt service.

• Lack of attention to traditional regulation – The resources devoted to developing, implementing and correcting rules for industry restructuring have diverted time, energy and focus away from the task of protecting consumers through traditional regulation.

• Lack of accountability – Critical decisions for the future of the industry – including transmission planning and the rules governing the operation of wholesale markets – are increasingly being made by organizations with no direct accountability to the public. Both federal regulators and those in many states have given increasing deference to independent system operators and regional transmission organizations which, in most cases, have no explicit obligation to protect the public interest.

To address these challenges, the states and the federal government should govern the electric industry in keeping with a series of principles that put the interests of ordinary consumers first. Specifically:

• States should acknowledge that retail deregulation is unlikely to ever provide significant benefits to small consumers, and should consider terminating their deregulation experiments. States that opt to retain retail deregulation should give consumers the ability to choose a reasonably and stably priced, regulated electricity product and allow communities to negotiate electric service on behalf of their citizens through municipal aggregation.

• The federal government should firmly guide wholesale markets toward solutions that benefit consumers, while not intruding on the prerogatives of the states. Specifically, the federal government should impose mandatory reliability standards on operators of the electric grid, clamp down on market manipulation through mandated refunds and fines, and assert its authority to set “just and reasonable” rates whenever wholesale markets are not truly competitive.

• All levels of government should adopt policies that maximize cost-effective energy efficiency and clean distributed generation and encourage the development of renewable sources of energy. Some of these policies may result in higher short-term costs, but the long-term benefits dwarf those costs.

As the attached analysis by Synapse Energy Economics demonstrates, a policy that emphasizes the development of efficiency, distributed generation and renewables would:

• Save money compared with a business-as-usual scenario that relies on construction of new fossil fuel-fired generation capacity and transmission lines. Savings would begin within just a few years, with annual savings reaching $36 billion by 2025.

• Reduce greenhouse gas emissions from electricity generation to below 1990 levels by 2025 – or 45 percent below what emissions would be under a business-as-usual scenario.

• Lead to additional savings in other areas, such as reduced expenditures for environmental compliance, reduced public health costs due to air pollution, and reduced price volatility and pressure on fossil fuel supplies.

Consumer Principles for the Electric System

1) Preserving universal access to safe, reliable, affordable electricity service should remain a national goal.

2) The public interest must guide all decisions with regard to the electric system.

• The goal of electricity regulation should be to provide adequate, reliable service to consumers at the lowest cost – including “external” costs such as environmental, public health, and social and economic impacts. Ratepayers must only be required to pay for investments that serve a legitimate public need and that could not otherwise be met through lower-cost means.

• Electricity rates should be designed to promote economically efficient and socially responsible outcomes – including energy efficiency, rate stability and the protection of low-income consumers

• The public interest can only be preserved through an open, accountable regulatory system that is explicitly charged with safeguarding the public.

• An effective regulatory system must guarantee due process and freedom of access to relevant information, allow and encourage the participation of all stakeholders, and preserve a right of appeal.

• An effective regulatory system must balance the long-term and short-term needs of consumers, as well as the interests of various classes of consumers. To balance long- and short-term needs, system planning must take place in the public sphere, include ample opportunities for public participation, and explicitly consider resource, political and environmental constraints. To balance the interests of various consumer classes, regulators must encourage broad participation in decision-making and ensure that the views of small consumers are adequately represented in the process.

3) Market mechanisms should be employed when they benefit the public interest and supplanted by regulatory decision-making when they do not.

• The conditions for effective and fair markets in the electric industry – particularly in the transmission and distribution of power and the sale of electricity to small consumers – do not currently exist and are unlikely to exist in the foreseeable future. Regulation of rates and terms of service in these areas of the industry (and perhaps others) is necessary to protect the public interest.

• Where market mechanisms are established, consumers’ basic rights must be protected. These include the right to choose an electricity provider, to switch providers in a timely and convenient manner, and to receive accurate and timely information about rates and service.

• Where market mechanisms are established, government retains a role in ensuring that markets operate fairly. This includes the need to prevent the accumulation and exercise of market power and to safeguard consumers’ collective investments in the electric grid.

• The interests of consumers cannot be abandoned during any “transition” from regulated to open markets. Consumers should not be subjected to higher-than-warranted rates in order to encourage the entry of competitive suppliers to the market.

• Consumers must retain the ability to pool their resources through cooperatives or municipal governments in order to negotiate better rates and service or to provide power themselves.

• Private, unregulated entities must not be permitted to shift costs or risks to the regulated entities that serve consumers. Similarly, ratepayers must not be forced to make infrastructure investments that primarily serve private interests.

4) Decisions with regard to the electric system should be made at the level of government most accessible and responsive to the public, keeping in mind the need for broader coordination across jurisdictional boundaries.

• Ideally, decisions should be made at the lowest level of government possible in order to maximize the public’s ability to participate in the decision-making process and hold decision- makers accountable to public interest goals.

• All levels of government must engage in comprehensive energy and electricity planning that establishes a long-term vision for the nation’s energy future. Such plans should be developed in public and invite participation from all stakeholders.

• New structures may be required to allow democratic governance of regional energy pools and markets in order to bridge the gap between national and state decision-making.

5) Improved energy efficiency and increased use of renewable resources are in the long-term national interest and often have short-term benefits for consumers. Government policy should actively promote the development and use of these resources.

• Market and regulatory barriers that deter the use of energy efficiency, renewable energy, or distributed generation technologies should be removed.

• The long-term benefits of these technologies must be considered in system planning, ratemaking and other regulatory decisions.