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FERCs MARKET BASED RATE AUTHORITIES A WORK IN
PROGRESS OR PERMENENTLY FLAWED?

• A presentation by
• Dr. John A. Anderson
• President CEO
• Electricity Consumers Resource Council
• Washington, D.C.
• At The
• 2006 NASUCA ANNUAL MEETING
• November 14, 2006
• Miami Beach, FL

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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

• Outline FERCs proposed new MBR process
• Discuss our view of the FPAs requirements for
  MBR
• Suggest some significant flaws in FERCs process
• Offer some recommendations and conclusions

4
FERCs Current MBR Process

• Evolved in a series of highly contested
  proceedings
• It did not benefit from the broader and more
  balanced review afforded by a generic rulemaking
• ELCON believes that
• The seller is routinely given the benefit of the
  doubt with respect to its actions
• The process unduly shifts the burden of proof to
  potential victims of market power abuse
• The concern would only be academic if the market
  structures were truly competitive and there were
  strong structural protections against the
  exercise of market power

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FERCs Proposed MBR Process

• FERC says that1
• It believes that it is now appropriate to revise
  and codify the standards for market-based rates
  (MBR) for wholesale sales of electric energy,
  capacity and ancillary services
• Refining and codifying effective standards for
  MBR will help customers by ensuring that they are
  protected from the exercise of market power
• The changes will provide greater certainty to
  sellers seeking MBR authority
• FERC thus issued a notice of proposed rulemaking
  (NOPR) to revise Subpart H to Part 35 of Title 18
  of the Code of Federal Regulations governing MBR
  for public utilities pursuant to the Federal
  Power Act (FPA)
• The NOPR for all practical purposes, focuses on
  those areas that have not been restructured
• 1 Market Based Rates for Public Utilities, 107
  FERC 61,019 (2004) Herein the Notice of
  Proposed Rulemaking (NOPR) at Page 7

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The NOPR2

• Proposes to use two indicative screens for
  assessing whether a seller raises any generation
  market power concerns
• If the seller passes both screens, there is a
  rebuttable presumption that the seller does not
  possess market power in generation
• If the seller fails either screen, a rebuttable
  presumption is created that the seller has market
  power. The seller then may
• File a more robust market power study (the
  Delivery Price Test or DPT)
• File a mitigation proposal of the sellers own
  design that would eliminate its ability to
  exercise market power or
• Adopt the default cost-based rates and submit
  cost support for such rates
• 2 NOPR at Page 19

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FERC Does Recognize

• MBRs may not be sustained in the absence of
  market power
• Market-based rate authority is not a right. The
  Commission may grant such authority under the FPA
  only to applicants who demonstrably lack market
  power3
• Where a MBR applicant is found to have market
  power, it is incumbent upon the Commission either
  to reject such rates or to ensure that adequate
  mitigation measures are in place to ensure that
  the rates are JR4
• 3 AEP Power Marketing, et al, 108 FERC 61,026
  at 25 (2004)
• 4 Id. at 144

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FPA Requirements for MBR

• FERCs duty under the FPA is
• To protect consumers6
• This requires FERC to ensure that market-based
  rates are just and reasonable. (JR)7
• JR rates must fall within a zone of
  reasonableness where they are neither less than
  compensatory nor excessive8
• JR rates should strike a fair balance between
  the financial interests of the regulated company
  and the relevant public interests, both existing
  and foreseeable9
• 6 Electrical Dist. No. 1 v. FERC, 774 F.2nd
  490,493 (D.C. Cir. 1985)
• 7 Order Revoking Market-Based Rate Authority,
  Establishing Hearing and Settlement Judge
  Procedures, and Terminating Section 206
  Proceeding, 113 FERC 61,124 ap Page 2 (2005)
  (herein November 3 Order)
• 8 Id, See also 16 U.S.C. 824d(a) and Farmers
  Union Cent. Exch. V. FERC, 734 F.2nd 1486, 1502
  (D.C. Cir. 1984)
• 9 Farmers Union, Id

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FPA Requirements for MBR

• In interpreting 205 of the FPA, the courts have
  stated
• The overriding purpose of prohibiting unjust and
  unreasonable rates and charges is to protect
  consumers from exorbitant prices and unfair
  business practices.10
• The prevailing price in the marketplace cannot be
  the final measure of just and reasonable rates
  mandated by the FPA11
• 10 Public Systems v. FERC, 606 F.2nd 973,
  979, n.27 (D.C. Cir. 1979)
• 11 FPC v. Texaco, Inc. 417 U.S. 380, 387 (1974)

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FPA Requirements for MBR

• The courts also have ruled
• In a competitive market, where neither buyer nor
  seller has significant market power, it is
  rational to assume that the terms of their
  voluntary exchange are reasonable, and
  specifically to infer that the price is close to
  marginal costs, such as the seller makes only a
  normal return on its investment12
• Further, when there is a competitive market the
  FERC may rely upon market-based prices in lieu of
  cost-of-service regulation to assure a JR
  result13
• 12 Tejas Power v. FERC, 908 F.2d 998 (D.C. Cir.
  1990)
• 13 Elizabethtown Gas Co., v FERC, 10 F.3d. 866
  (D.C. Cir. 1993)

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Consumer Impacts Of FERCs Grants of MBR

• FERCs questionable grants of MBR
• Set in motion forces that can do substantial
  damage to state and local economies
• Transfer billions of dollars of wealth from
  consumers to suppliers
• Expose retail customers to rate shock and
• Leave those injured without meaningful or timely
  remedies
• Has effectively shifted the burden of proof
  regarding the existence/absence of competition to
  consumers

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FERCs Approach To MBR Is Based On Fallacious
Assumptions

• FERC seems to assume that the simple existence of
  an organized market is adequate evidence of a
  markets competitiveness and a lack of market
  power
• We believe strongly that this assumption is
  incorrect
• The simple existence of an organized market
  does not in any way guarantee a lack of market
  power
• In face, in some instances, entities in organized
  markets may have more market power than entities
  outside of the organized markets
• FERC also seems to assume that the MBR NOPR (and
  the proposed fixes to the OATT) will protect
  consumers from the exercise of market power in
  areas that have not restructured
• We believe that these fixes are not sufficient
  although they are a step in the right direction
• I address each in turn

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What Is Required For True Competition?

• At a minimum, true competition requires
• A direct interaction between supply and demand
  Price responsive load must be treated
  symmetrically with supply
• Prices must be set by market forces not
  administratively established
• Prices must not be administratively capped or
  artificially mitigated
• There must be ease of entry and exit by both
  buyers and suppliers
• There must be an adequate infrastructure to allow
  the necessary movements of power and energy and
  the mitigation of market power
• Suppliers and consumers must be able to hedge
  future prices with bilateral contracts

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What Is Required For True Competition?

• True competition requires a direct interaction
  between supply and demand in price setting
• If prices are set in real time or day-ahead,
  demand MUST be in those markets
• It simply is not sufficient to have LSEs in
  markets as proxies for actual consumers
• That is, price responsive load must be treated
  symmetrically with supply
• Why isnt it?

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What Is Required For True Competition?

• There are many reasons why today we do not have
  inclusion of demand response
• 1. The jurisdictional split between Federal and
  state regulators
• State regulators often think that allowing retail
  consumers to participate in wholesale markets
  results in a loss of state jurisdiction
• But as long as retail consumers are prohibited
  from participating in the wholesale markets,
  there cannot be a true interaction between supply
  and demand
• The supply side doesnt want the competition
• The market urgently needs DR from residential
  and commercial consumers (low load factor a/c and
  heating loads)
• Unfortunately, these loads have been slow to
  participate

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What Is Required For True Competition?

• Bit no matter the reasons, demand response
  PROGRAMS administered by utilities simply are not
  adequate
• DR will never be a significant contributor to
  truly competitive markets until DR is treated
  symmetrically with generation
• IT should be OK to pay DR the same as generation
  whether these prices are low or high
• Decoupling utility revenues from sales will
  only make the situation worse

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What Is Required For True Competition?

• True competition requires prices set by market
  forces not administratively established
• Capacity markets are inconsistent with true
  competition
• Capacity markets arent markets at all they
  are simply a new form of regulation
• In this case, ISOs and RTOs administratively
  determine a price that they hope will stimulate
  enough new capacity to assure resource adequacy
• Not only are capacity markets not competition,
  they dont work
• While they do take billions of dollars from
  consumers, they simply do not incent new
  baseload generation

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What Is Required For True Competition?

• True competition requires that prices must not be
  administratively capped or mitigated at
  unreasonable levels
• Politicians often say that consumers must be
  protected from price spikes and volatility
• They then implement administratively determined
  price caps, automatic bid mitigation procedures,
  etc.
• Such actions then require capacity markets
• These actions reduce the market incentives that
  would assure resource adequacy
• We certainly cannot have true competition with
  such administrative intrusions

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What Is Required For True Competition?

• It is often asserted that relatively low price
  caps and mitigation measures are needed to
  protect consumers from price spikes and
  volatility
• However, it seems to us that the price caps and
  mitigation measures are really needed because too
  many LSEs are short in the markets
• If LSEs were securing their consumers needs under
  long-term contracts, they would not need price
  caps or mitigation measures
• Unfortunately, in is nearly impossible to
  negotiate reasonable bi-lateral contracts in
  todays LMP markets as generators know that they
  can sell in the day-ahead and spot markets and
  make tremendous profits

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What Is Required For True Competition?

• True competition requires an ease of entry and
  exit by both buyers and suppliers
• Market forces must be allowed to discipline
  inefficient suppliers
• However, increasingly it appears that if failing
  generators play the R-card, they will be
  propped up by a variety of financial mechanisms
  and revenue streams
• Even though it is quite obvious that generators
  can still provide electricity as long as their
  assets remain in operative condition
• Policy makers thus create the classic catch 22
  situation
• Price caps and bid mitigation schemes eliminate
  the market incentives for resource adequacy
• Administrative props eliminate the market forces
  attempting to force efficient construction
• Recent attempts to fix this problem with a
  forward capacity reserve market are inadequate
  because they focus on the short term

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What Is Required For True Competition?

• True competition requires an adequate
  infrastructure to allow the necessary movements
  of power and energy from a variety of sources to
  a variety of loads (sinks)
• Unfortunately, the present transmission system is
  characterized by a tremendous number of
  significant congestion points
• While advocates of the LMP pricing scheme
  asserted that the LMP prices would incent the
  construction of new generation or transmission to
  mitigate the constraints
• The facts simply do not support such assertions
• Nodal pricing actually creates a greater
  DISINCENTIVE to build
• And todays financial transmission rights
  (FTRs) do not adequately protect consumers from
  the very significant congestion costs of the
  transmission constraints
• Maintaining congestion becomes a lucrative profit
  center for the generation affiliates of
  transmission owners

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What Is Required For True Competition?

• True competition requires the mitigation of
  market power
• Suppliers with local market power can game the
  markets at the expense of consumers
• The larger the number of nodes in an LMP
  environment, the greater the opportunities for
  the exercise of local market power
• Simply, there are fewer suppliers at each node
  the greater the number of nodes
• The Organized Market today with LMP have
  thousands of nodes!
• The Organized Markets market monitoring units
  are paid by the markets that they monitor
• It is no wonder that they do not find the
  exercise of market power
• They know where their next paycheck comes from

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What Is Required For True Competition?

• True competition requires the ability of
  consumers to hedge future prices with bilateral
  contracts
• Such contracts would provide price certainty
• Unfortunately, todays Organized Markets do not
  provide anything near adequate ability to
  negotiate fair contracts
• Most generators know that they can ride the LMP
  market and make tremendous returns
• For them, the LMPs are simply the price to beat!
• The bilateral contracts that exist today are a
  combination of legacy contracts left over from
  the sale of generation and the imposition of rate
  freezes and newer contracts for POLR service

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Consumer Impacts Of FERCs Grants Of MBR

• ELCON believes strongly that todays electricity
  markets are not competitive
• Retail markets in most restructured states are
  trainwrecks in the making
• Many actions taken pursuant to state
  restructuring legislation have failed and state
  legislators are only slowly awakening to the
  dilemma facing state regulatory commissions
• Many customers with shopping rights were
  literally thrown into the market without any
  assurance that a real retail market was awaiting
  them with competitive alternatives
• Most customers in restructured states are now
  captive to default service that is procured
  with bid-based auctions in which the bidders have
  market power

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Consumer Reaction To Todays Markets

• Increasingly, consumers are facing very
  substantial increases in prices
• As frozen or capped rates expire
• And as prices determined in the single-price
  auction markets are passed along
• Certainly, part of this increase is due to higher
  fuel (i.e., natural gas) prices
• But a very significant part is due to the lack of
  true competition
• And the exercise of market power of generators
• As consumers face the high prices
• The process becomes politicized
• And the results of a politicized process on
  electricity is not pretty
• Examples include CA and most recently MD
• Will IL and PA be next?

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The Opposition To The Organized Markets is Growing
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The Rebellion Now Includes Many States

• Very strong negative reactions recently have come
  from Delaware, Kentucky, Illinois, Maryland,
  Montana, New Jersey, Ohio, Pennsylvania, Texas
  and Virginia
• And the list will likely grow

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So Where Are We?

• It seems to me that we are at a critical junction
  a fork in the road. Collectively, FERC can
  either
• Fix the problems both in the organized markets
  and in the MBR NOPR
• Or face the wrath of consumers

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ELCON Has Made The Following Recommendations RE
MBR

• FERC should fix the organized markets
• This will not be either easy or quick but it is
  essential
• Regarding the MBR NOPR, FERC should
• Establish a test for generation market power that
  would eliminate any benefit of the doubt the test
  or subsequent mitigation gives to sellers
• NOT presume that the OATT, as modified as a
  result of the pending OATT reform rulemaking,
  adequately mitigates transmission market power
• Not back-off its recommendation in the NOPR to
  include a provision that expressly prohibits
  power sales between a franchised public utilities
  and any of their non-regulated affiliates without
  first receiving authorization of the transaction
  under section 205 of the FPA
• Define captive customers as all end-users that do
  not have real competitive opportunities

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ELCON Has Made The Following Recommendations RE
MBR

• FERC should (Cont.)
• Establish a uniform code of conduct to govern
  interaffiliate power sales
• Revoke or mitigate a sellers MBR authority in
  ALL control areas if the seller is found to have
  market power in any one area
• Establish a single MBR tariff for entire
  corporate families and review these tariffs on
  a regular basis
• Establish a market-based rate tariff of general
  applicability that all sellers authorized to sell
  wholesale electric power at market-based rates
  would be required to file as a condition of MBR
  authority

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Conclusions

• FERC faces an opportunity to address the rising
  crisis of confidence
• The backlash against electric restructuring is
  growing and growing rapidly
• FERC must seize the opportunity
• And not simply hide behind issues like the MBR
  NOPR to defend markets that have failed to
  benefit end-use consumers
• Increasingly, we sense that FERCs solutions to
  problems is to create yet another revenue stream
  for suppliers
• That raises prices to consumers
• Its time for real FERC action that will benefit
  consumers
• If ELCON and NASUCA can join together we form a
  substantial force
• Now is the time for action

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Questions?
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To Contact ELCON

• Phone [phone]
• E-mail elcon_at_elcon.org
• Web site www.elcon.org
• Address 1333 H Street N.W., 8th Floor, West
  Tower
• Washington, DC 20005