Electric
Industry Restructuring:
Opportunities and Risks for West Virginia
Interim Report No. 1:
Executive Summary of the First Year of the Project
Submitted to:
Director of
Operations
Governor’s Office
1900 Kanawha Boulevard East
Charleston, WV 25305
Submitted by:
West Virginia
University
Electric Industry Restructuring Research Group
P.O. Box 6064
Morgantown, WV 26506
July 31, 1997
Table of Contents
1.0.0 Executive Summary of the First Year of the Project
1.2.0 Summary of Major Concerns
1.2.1 Will Electricity Prices Increase?
1.2.2 Will Industrial Consumers Gain at the Expense of Residential Consumers?
1.2.3 What Will be the Effect on West Virginia Employment and Development?
1.2.5 What are Other Important Issues that Must be Considered?
Attachments to Interim Report No. 1
On April 24, 1996, the Federal Energy Regulatory Commission (FERC) issued its Order 888, "Promoting Wholesale Competition Through Open Access Non-discriminatory Transmission by Public Utilities," which orders the separation of electric utilities’ generation and transmission functions, asserts increased Federal control over the electricity transmission system, and asserts a Federal commitment to competition in free and open wholesale markets for electric power. (Congress is considering further fundamental change, including the imposition of fully competitive retail electricity markets.) This signals an epochal change in the regulation of an industry that is vital to every citizen’s daily life, and crucial to West Virginia’s current economy and future economic development.
Though Order 888 marks the end of this phase of FERC’s deregulatory initiative, it leaves open many questions that can be addressed only at the state and regional level. Who will control the transmission system, and on what basis? Will the attractiveness to industry of West Virginia’s relatively low electricity rates be eroded? Will electricity exports boom or decline? Will residential rates rise? Decisions made at the state and regional level in the next two years will largely determine the answers to these questions for decades to come.
The goal of this project is to develop an informational and analytical framework within which public and private decision makers in West Virginia can understand the implications of electricity market deregulation for West Virginia, and develop positive strategies for the future. We assess what we currently know about these issues, and identify key areas in which future research will have a role.
Information for this study was obtained through literature review, discussions with electricity producers and consumers, and participation in a Task Force created by the West Virginia Public Utility Commission. Information was also obtained through a workshop entitled, " Competition in the Electricity Industry: Implications for the West Virginia Region," held at West Virginia University on April 11, 1997. The workshop involved various electricity industry stakeholders and significantly added to the information base for this research effort. A Workshop Agenda, Participant List, and preliminary draft entitled, "Visions of the Electric Industry in the Year 2010," are attached to this report.
Research was conducted by the West Virginia Electricity Restructuring Group, which consists of West Virginia University researchers affiliated with the Department of Economics, the Division of Resource Management, the Department of Electrical and Computer Engineering, the Bureau of Business and Economic Research, and the National Research Center for Coal and Energy. Funds for the research were provided by the West Virginia Governor’s Office and the National Research Center for Coal and Energy. The April 11 workshop was co-funded by the U.S. Department of Energy, Office of Industrial Technologies.
As their policy makers ponder the move to a competitive model for electricity markets, West Virginians have five big concerns: 1) Will rates go up? 2) Will industrial consumers gain at the expense of residential consumers? 3) What will be the effect on West Virginia employment and development?, 4) Why do anything?, and finally, 5) What are other important issues that must be considered? While it is true that the nation as a whole is currently moving rapidly to a deregulated generation system, West Virginians have a certain amount of flexibility as to when we make a similar move. In this Executive Summary, we summarize more detailed information contained in the remainder of this report in relation to these questions, and we conclude with a summary of the policy recommendations to be found in the text.
Not until new generation capacity is needed, and not if the markets are truly competitive. When and if prices do start edging up, there is reason to be optimistic that they will not rise as much as they would under a regulated system. However, there is also reason for concern that West Virginia prices may begin to edge up sooner within our regional market than they would if we kept our system regulated. And if the markets are not sufficiently competitive, prices could go up very soon.
Those who argue that rates will rise say the following. West Virginia electricity prices are currently among the lowest in the nation. Other states have higher electricity prices, and if we are thrown into the same market with those states then our electricity prices will go up as theirs go down, and we’ll meet somewhere in the middle.
This argument is incorrect because competitive market prices are set, not by an average of regulated prices, but by marginal cost of production. The main reason why states such as Pennsylvania and New York have higher electricity prices is because of the large capital costs that utilities in those states incurred in years past—primarily to build nuclear power plants. Regulators there have set prices high enough to recover the historical fixed cost of existing plants, plus the variable costs of running them.
In a competitive market, historical capital costs of power plants do not affect price. Our electricity prices can not be raised by excessive nuclear plant costs or other misfortunes of our neighbors. When, as is true today, excess production capacity is available, the competitive market price equals the marginal operating cost only, and does not reflect any capital cost at all. Marginal cost in other states in the region is close to that in West Virginia (in fact marginal costs are substantially lower in Kentucky and Virginia), so there will be little or no pressure for the regional price to rise above West Virginia’s marginal cost as long as excess capacity exists. As low as the generation price currently is in West Virginia, it is higher than marginal cost, so overall electricity rates should go down, not up, as long as the market is competitive and generation capacity continues to be available.
How about when the excess generation capacity dries up? Eventually, in perhaps five to ten years, excess generation capacity will dry up due to load growth and plant retirements. At this point the price of electricity may rise, but the rise will be less under competition than under regulation. If we build new capacity under a regulated system, the monopoly utility would submit a plan for expansion to the state Public Service Commission, which would make some modifications and then raise rates sufficiently to pay the projected capital cost of the new plant, plus a reasonable rate of return. If on the other hand we have moved to a market system by that time, a number of potential producers will consider building new plants or marginally expanding existing ones. These producers will have a powerful incentive -- the desire to undercut rivals and make as much profit as possible -- to find the absolutely lowest total cost method for serving the growing generation demand. Experience in other industries indicates that expanding and improving existing plants significantly postpones the need for new plants, and keeps prices at low levels. Economic theory, and common sense concur that a competitive market system will find a lower cost solution than would regulation.
The only way that a competitive regional generation market could raise prices is if it makes capacity dry up sooner in West Virginia than it would have under regulation. If the regional market reaches its capacity before an isolated West Virginia market would have, West Virginia consumers could see their electricity prices rise sooner than they would have under a regulated system.
This is a reasonable concern, but it is far from certain that this scenario will actually occur. For one thing, transmission constraints will limit the extent to which other states will be able to rely on West Virginia generation capacity, especially for their peak load needs. For another, it has become very inexpensive to build new gas-fired capacity in small increments near the loads, so much of other states’ incremental demand may be served by their own power plants. Also, West Virginians will continue to have an advantage in using West Virginia generation capacity because of their proximity. Finally, it is quite possible that capacity additions, including possible new gas-fired generation in West Virginia, will continue to keep the price at or below the current regulated price, even when existing plants are fully utilized.
None of these arguments in favor of markets carries much weight, however, if the markets for electricity are not fully competitive. It is well known that a monopolist or oligopolist has an incentive to restrict output, to raise prices, and to be lax about cost containment. If we move to a market system for electricity, our public policy makers have a duty to take vigorous action to prevent the accumulation of market power by monopolistic or oligopolistic firms. At a minimum, we need to make sure that the system is truly open to entry by new firms. If market power appears to be a serious problem there will be a need for vigorous antitrust action, perhaps including a divestiture of generation assets by the owners of transmission and distribution assets.
Possibly. According to utilities, the standard methods used by traditional regulatory cost accounting show that there is a significant amount of "cross-subsidization" built into the current rate system. That is, cost accounting methods show that industrial customers pay more than their share of the common capital costs of generation and distribution, and residential customers pay less. This difference in regulated rates is due to a perception of fairness.
A truly competitive market system will erase these subsidies, for the market does not assign payment for common capital costs according to principles of regulatory fairness. It assigns payments according to supply (marginal cost of service) and demand (willingness to pay for service). Producers are willing to charge lower prices to customers who add less to their costs. Customers with alternatives, such as self-generation or alternative suppliers, are willing to pay less and hence will usually end up with a lower price. Both of these considerations favor industrial customers in a competitive market, who tend to be both cheaper to serve and more willing and able to choose among alternatives. Thus, it is true, that competitive markets inherently favor large customers.
In this competitive environment, residential customers have at least four sources of comfort – overcapacity, aggregation, efficiency, and regulation during the transition. As long as the current period of overcapacity persists, it is difficult for owners of capital assets to recover any of their capital costs at all. When there is a surplus of any good, generation capacity included, the competitive market price of that good tends to be bid down below its full cost.
Aggregation of residential customers by marketers is often touted as a method for increasing their clout and therefore increasing the range of alternatives available to them. This solution makes sense, because a single household may not find savings through shopping the energy market sufficient to justify its shopping costs, but an aggregator could efficiently find savings for many households at once. But if consumers do not shop aggressively among aggregators, the aggregators may end up capturing most of the savings for themselves. Many consumers will find even the effort of shopping among aggregators to be too much effort. The Public Service Commission may choose to play a role in assigning these choice-averse customers among aggregators, perhaps by supervising a competitive bid for their patronage.
There are two phases in the impending deregulation process; a transition phase and a final degregulation phase. It is possible for the Public Service Commission to impose rate caps on electricity prices within the State during the transition phase to insure price stability without significantly impeding the transition to competitiveness. Such a price cap scheme would likely be linked to the recovery of stranded costs that are claimed by utilities. For example, California legislation requires a 10% reduction in residential rates.
Whatever benefits residential consumers achieve from electricity market restructuring in the long run will come from the markets’ ability to increase the efficiency with which electricity is produced. That depends, in turn, on the actual competitiveness of the markets.
The answer to this question can be considered in two parts. The first is the effect of electric industry restructuring on West Virginia as a producer of electricity and other forms of energy. The second consideration is the likely impact on West Virginia industries that consume large quantities of electricity.
West Virginia is a major producer and exporter of energy. This takes the form of West Virginia-generated electric power transmitted out-of-state, coal shipped to generating plants in other states and around the world, and moderate quantities of natural gas shipped out-of-state. West Virginia's plentiful energy resources and power generating capacity put the state in a position to benefit from the broadening of energy markets brought about by restructuring and competition in the electric power industry.
The 14 utility-owned, coal-fired steam plants in West Virginia account for nearly all the state's generating capacity C 15,039 MW. In 1995 these 14 plants generated over 77.1 million MWH while burning 30.8 million tons of coal and employing over 2,750 workers. Two-thirds of this electricity is sold outside the state.
As large as West Virginia's electric power generation industry is, it could produce much more under competitive electricity markets. The average capacity utilization rate in the 14 utility-owned, coal-fired steam generating plants was only 58.5 percent in 1995. Most of these power plants could sell additional power profitably for less than $20 per MWH (before transmission and distribution charges). Because West Virginia has excess power generating capacity with low marginal costs, the state's power plants will be better off the fewer regulatory, institutional, and physical barriers there are to electricity sales in nearby states.
The bulk of the employment opportunities that electric industry restructuring creates for West Virginians will be in coal mining rather than directly in the electric industry. For every additional million dollars of coal purchased from West Virginia mines, 12.9 additional West Virginia jobs are created. Considerably more West Virginia coal is consumed in electric utility generating plants in the rest of the country than in West Virginia itself. Coal consumption at West Virginia utility power plants was 30.7 million tons in 1995 compared to out-of-state domestic shipments of 91.8 million tons from West Virginia. This means that the impact of electric industry restructuring on West Virginia's economy will depend on what happens to coal-burning power plants throughout the region, not just in West Virginia. Demand for West Virginia coal is likely to increase under restructuring because coal-fired generating plants throughout the region will be well positioned to increase the quantity of power they sell.
The impact on West Virginia's economic development of industrial consumers' reaction to electric industry restructuring is less obvious. The state is very specialized in several electricity-intensive industries, including primary metals; stone, clay, and glass products; chemicals; and coal mining. In addition, sawmills and miscellaneous plastics products are among the top twenty-five electricity-consuming sectors in the state economy. In combination primary metals; chemicals; stone, clay, and glass; wood products; and rubber and miscellaneous plastics products account for 56.4 percent of total West Virginia manufacturing employment in 1996 and 71.7 percent of manufacturing GSP in 1994.
In 1995 West Virginia utility revenues for sales to industrial customers averaged 4.03 cents per KWH. This price is lower than the national average and the averages in all of the adjoining states except Kentucky. The effects of competition will probably drive down industrial electricity prices in West Virginia, but not by as much as in nearby states with higher prices. The net impact of these shifts in industrial electricity prices on the state's competitive position is likely to be small. Electricity will become a smaller part of businesses' overall operating costs, West Virginia's relative price advantage compared to higher price states will not disappear entirely, and most of the economic development impacts will operate through new investments spread over many years. Finally, West Virginia's economy is not isolated from the health of the economies of nearby states. When other states in the region flourish, West Virginia's economic development benefits as well. The overall decrease in electricity costs makes the entire region more competitive, benefiting West Virginia along with the other states.
If the main reason for restructuring the electricity industry is to reduce cost and price, especially for industrial customers, and West Virginia’s electricity prices and costs are already relatively low, why should West Virginians change anything about our current system, especially since change may bring a price increase for residential consumers?
It is true that if conditions in the rest of the country were as they are in West Virginia, we would not be seeing the national move to an electricity market. But there is such a national movement, and a competitive market should increase the overall economic efficiency of the electric system and provide benefits to all consumers in the long run. This increase in efficiency will reduce costs to all consumers including categories of consumers such as residential whose price may rise but whose costs of other goods affected by electricity costs would go down. The later effect would more than offset the price increase in electricity.
The national movement to competitive markets is likely to result in national legislation prescribing retail competition. Because federal legislation usually defers to state-level action, states that have a plan in place are more likely to be able to retain the characteristics of that plan that are well suited to their own conditions. Energy that could be mis-spent simply reacting to or resisting inevitable change might be more productively invested in recognizing and adapting to that change.
A state that already exports more than two-thirds of the electric power that it generates can not afford to ignore the new opportunities and risks that these changes present. State actions are necessary to encourage competition, to encourage creative development of the state’s power generation potential, and to encourage efficient transmission access, transmission enhancement, and transmission pricing to get that power to the markets where it can command a high price. If we do nothing, we may lose our natural advantage in interstate markets to producers in other states. We may also create an artificial backwater in which an inefficient electricity industry can survive only because it is insulated from competitive pressures.
The status quo is not an option, but there is no reason and no great time pressure for West Virginians to rush to action. Because of our situation in the electricity industry we can take a little more time than "high price electricity" states to observe developments in neighboring states, adopt what makes sense for us, and reject what does not. We do not need to accept a plan that brings deregulation without competition, or one that imposes regulation without reason.
There are a number of other important issues that must be considered by West Virginia. These issues include what to do about stranded costs and benefits, and the length of time required for a transition period.
Utilities claim that deregulation will cause the value of certain generation assets to fall below the present book value and that customers should pay for these stranded assets. Consumers claim that deregulation increases the value of the generation assets to above market value creating negative stranded costs (or stranded benefits) to the consumer. In fact, the determination of stranded costs is very controversial in practice. While the issue of stranded costs relates only to the transition period, it presents a major impediment to implementing the competitive process. It appears to be more desirable to reach closure on this issue and to accelerate the transition phase than to spend time debating over the size and disposition of stranded costs.
In this report we recommend several courses of action that we believe make sense for West Virginia. We recommend prudent movement toward creation of a retail market for electricity generation in West Virginia. We recommend transmission pricing that reflects cost, including congestion cost and cost advantages that flow from proximity of generation to load. We recommend participation in the formation and establishment of a regional transmission system that includes an Independent System Operator in order to assure fair access to the grid and efficient transmission enhancement. We also believe that a Regional Power Exchange could be structured to provide both an efficient auction market for electric energy and a nexus for economic dispatch.
In regard to the disposition of stranded assets issue, we recommend that rather than engage in a negotiated determination of stranded assets, other approaches should be considered. Other options may include forced partial divestiture of utility generation assets or the institution of a negotiated rate cap mechanism.
We also recommend that the State recognize impediments to competition, such as transmission constraints, that may prevent a truly open access environment or retain monopoly influence over a large portion of generation capacity. Impediments to competition are an ongoing concern which will require oversight by the Public Service Commission.
We recommend that if the regulatory authorities seek to protect residential consumers from the effects of retail competition, they should do so in a manner that is consistent with the operation of that market, and we suggest one method for doing so. Since competitive market forces provide the primary protection for consumers in a market environment, we recommend that West Virginia’s regulatory authorities focus their attention on assessing and enhancing the competitiveness of electricity generation markets in West Virginia.