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Study: Changes needed for U.S. power markets to become workable

WASHINGTON, D.C., March 5, 2002 — A series of twelve policy and structural changes are the minimum steps needed to move the U.S. electric power industry beyond its current crisis of confidence into a workable, deregulated industry, according to “Energy Restructuring at a Crossroads,” a new study by Cambridge Energy Research Associates (CERA) sponsored by Accenture and involving more than 40 energy companies, industry associations and regulators.

“The time has come for political leadership to build a consensus around the lessons from the power markets that are working,” said CERA Senior Director of North American Electric Power Larry Makovich. “This is not the time to reinvent the wheel. It is not a coincidence that wholesale power markets such as PJM Interconnection (Pennsylvania-New Jersey-Maryland) and ERCOT (Electric Reliability council of Texas) are working well because these markets evolved with legacy rules and institutions reflecting the unique underlying characteristics of the power business.”

“Complex underlying industry conditions and required structural elements have caused integrated bulk power systems to adopt rules and institutions over decades to make these systems work properly. Even though no power market is perfect, the common structural elements found in working power markets provide a set of minimum structural requirements for workable power markets,” the study concludes.

“The power business in the U.S. is too important to continue to restructure on a trial-and-error basis. Pragmatism should prevail over experimentation in power market design,” said Francis X. Shields, Accenture, Partner in the Competitive Energy Markets practice. “The focus should be on markets that do work, not those that do not.”

“The power industry is at the crossroads of three paths: it can continue to muddle along the path of experimental deregulation, backtrack to comprehensive regulation or move forward to power markets that work,” Shields said. “The United States needs to avoid slipping back to the ‘devil it knows’ – comprehensive regulation. A move forward requires accepting that power markets are complex, unlikely to evolve on their own accord, and need structure to work properly.”

“A specific minimum set of market, regulatory, financial and strategic requirements must be met for the competitive electric power industry to emerge, supporting the country’s future growth,” the study concludes. Deregulation is losing momentum and a strong and deliberate move is needed to lead toward power markets that work.”

Recommendations

The study recommends action in twelve areas — at least some potentially requiring Congressional action — to build the necessary structural elements of power markets:


1. Define bounds of wholesale markets – FERC should use the boundaries of existing regional transmission grids to draw regional power market boundaries. Although markets larger than existing grids may be possible, FERC should not try to force consolidation into four or five markets.

2. Design wholesale markets to achieve critical mass participation – Participation levels need to ensure rivalry and to involve voluntary bidding with mandatory registration, scheduling, dispatch, settlement and disclosure. FERC should not implement competitive power markets if the regional market lacks critical mass in participation.

3. Expand RTOs’ mission to tightly integrate systems operations and market operations – Because economic dispatch of energy is integrally tied to constraints of network topology and electricity system physics, RTOs must act as auctioneer, conductor, traffic cop and referee, and must be governed by a strong, independent executive entity rather than a stakeholder committee.

4. Create regional wholesale spot markets – It is not enough just to set up a RTO and guarantee open access; real-time and day-ahead spot markets must be established proactively with standard products and procedures to promote commercial convenience and minimize seams issues across markets. FERC should require that each RTO set up spot markets within its wholesale market region.

5. Create capacity markets – Capacity markets balance supply and demand in the long run. Beyond providing long-run reliability, they mitigate extreme price volatility and thus help avoid political intervention. Capacity markets require rules for capacity requirements, capacity measurement and verification as well as capacity deficiency penalties.

6. Adopt pricing mechanisms to manage transmission congestion – Transmission systems are complex and network services require complex pricing mechanisms, particularly to provide price signals for congestion. An approach working in some networks utilizes locational marginal pricing (LMP) to locationally price energy and thus also price transmission congestion. LMP should be accompanied by a system of financial (or firm) transmission rights (FTRs), which allow locational price differences to be hedged, and thus provide transmission price certainty. For the sake of market standardization and efficiency, FERC should encourage RTOs to move toward LMP/FTR.

7. Stimulate appropriate transmission system planning and investment – Transmission planning must be done at the grid level. Measures need to be adopted to encourage greater investment in the transmission system. Incentives need to be sufficient, which may require improving the allowed rate of return on transmission assets, and the introduction of a greater level of performance-based rate making.

8. The CFTC should retain and expand its oversight of energy derivative markets – Given the common body of participants, the commonality of trading methods, and market linkages, the Commodities Futures Trading Commission should be the common regulator of all commodity markets, including power. To improve market oversight, private marketplaces should be subject to limited regulatory requirements, reporting certain trade volumes and prices to the CFTC. Non-cleared multi-lateral electronic exchanges should be required to publicly report the same price and volume information as cleared exchanges are required to report to the CFTC.

9. FERC should backstop RTO market monitoring – FERC should look for abuses across cash markets that any single RTO might not detect, deal with serious cases, and seek harmonization of regulatory arrangements between cash and forward markets.

10. Rationalize energy infrastructure siting and permitting – To avoid de-facto barriers to entry and forced technology choices that have resulted from past state siting and permitting review processes, states and the RTO must set siting and permitting targets in line with supply needs, as well as demonstrating annually that targets are being met. To reconcile conflicts, FERC needs eminent domain authority to address transmission siting issues.

11. Coordinate wholesale and retail transitions – Big bang deregulations are too risky in an industry as complex as electric power. In moving to wholesale markets, vesting contracts that expire gradually over the first years of the market to provide time for participants to move up the learning curve. Once wholesale markets are in place (which may include large industrial and commercial customers), retail markets should be opened as quickly as possible, but in phases to reduce the technical stress on the system. The first phase can include large industrial and commercial customers participating at the opening of the wholesale market.

12. Minimize distortions of market price signals – Price caps have the effect of distorting economic activity in any market. If wholesale price caps exist in any form, they should be set above the highest possible incremental cost of production. Similarly, price freezes at the retail level should be thawed in order to reconnect demand to the market. Prices need to convey information clearly in order to coordinate economic activity in a market. Governmental public policy objectives — such as fuel mix, rural cross-subsidization, obligation to serve and low income initiatives — should be kept independent of the spot and forward trading mechanisms in the wholesale market, and be clearly identified as separate charges on consumers bills in the retail market.

“One lesson is clear,” according to the study. “Close is not good enough. Getting most but not all of the structural elements in place can still lead to major, even catastrophic failures. The bankruptcy of PG&E and the California power shortage are both outcomes of flawed market designs arising from the process of experimental deregulation. The problems of experimental deregulation have destroyed momentum in power restructuring and may cause a rebound to regulation.”

Cambridge Energy Research Associates is a advisor to major international companies, financial institutions and organizations, delivering strategic knowledge and independent analysis on energy markets, geopolitics, industry trends and strategy. CERA is headquartered in Cambridge, Mass., and has offices in Bangkok, Beijing, Calgary, Houston, Mexico City, Moscow, Oakland, Oslo, Paris, Sao Paolo, Seoul and Washington, D.C.

Accenture is the world’s management and technology services organization. Through its network of businesses approach — in which the company enhances its consulting and outsourcing expertise through alliances, affiliated companies and other capabilities — Accenture delivers innovations that help clients across all industries quickly realize their visions. With more than 75,000 people in 47 countries, the company generated net revenues of $11.44 billion for the fiscal year ended August 31, 2001. Its home page is www.accenture.com.