BEFORE THE FEDERAL ENERGY REGULATORY COMMISSION DEPARTMENT OF ENERGY WASHINGTON, D.C. In The Matter of ) ) Promoting Wholesale Competition Through ) Open Access Non-discriminatory Transmission ) Docket Nos. RM95- Services by Public Utilities, Recovery of ) 8-000 & Stranded Costs by Public Utilities and ) RM94-7-001 Transmitting Utilities; Proposed Rulemaking and ) Supplemental Notice of Proposed Rulemaking ) COMMENTS OF THE U.S. DEPARTMENT OF JUSTICE I. INTRODUCTION AND SUMMARY The Federal Energy Regulatory Commission (FERC or Commission) has proposed a far-ranging plan to encourage competition in the electric utility industry through industry restructuring. The United States Department of Justice encourages the Commission to pursue restructuring in the electric utility industry. Restructuring is a major step to allowing the FERC to rely on the market rather than price regulation to set efficient prices for electric power in the United States. In this context, the Department makes four general points. • Restructuring: The NOPR presents a regime of open access transmission tariffs and functional unbundling of transmission and generation sales by vertically integrated utilities. The Department agrees that some mechanism for vertical disintegration will maximize the potential for competition in the electric generation market. The Department suggests a solution that will produce results closer to the more drastic remedy of complete divestiture of generation from transmission--"operational unbundling." Operational unbundling would divorce operation and dispatch of generating plants from the operation of the transmission system in order to assure that transmission market power cannot be used to distort the market for generation. • Assuring competition in generation: The Commission has suggested that an open access regime in transmission could allow it to decline to monitor prices in wholesale generation markets. The Department suggests strongly that, while open access and operational unbundling will encourage competition in generation and provide new alternative sources of supply for purchases of wholesale power, ownership of generating capacity may still be concentrated in some regions of the country, enough to warrant regulation. The Department urges the Commission, even after restructuring, to examine generation markets rather than assume them to be competitive. • Transmission: After restructuring of the industry, transmission will likely require regulation. It is critical that transmission pricing not be allowed to limit the potential efficiency potential of the newly competitive generation market. Further, the Department encourages the FERC to support the development of a secondary market for transmission capacity. • Collection of "stranded" costs: The Department does not take a position on the method of calculation or the necessity of allowing recovery of stranded costs. But the Department strongly suggests that any mechanism for recovery of stranded costs be designed to minimize distortion of competition for generation and urges the FERC to avoid use of transmission adders as a means of recovery. In addition, the Department suggests that the recovery structure should provide slower economic incentives for utilities to mitigate stranded costs. II. INDUSTRY RESTRUCTURING: OPERATIONAL UNBUNDLING The electric utility industry in the United States is characterized by extensive vertical integration, which may create obstacles to effective competition in the wholesale generation market. As the Department pointed out to this Commission in Comments concerning restructuring of the natural gas industry, vertical integration of regulated and potentially competitive markets can cause significant opportunities for regulatory evasion. Partial deregulation of a multiproduct firm with monopoly power in one product may provide the opportunity and incentive for discrimination. The NOPR suggests that the Commission is concerned with discrimination. Through discrimination, the monopolist creates terms and conditions for the purchase of its regulated service (here, transmission) that may lessen competition for its unregulated or potentially competitive service (here, wholesale power). Such discrimination, if successful, allows the firm to charge a supercompetitive price for the bundle of services that includes both the potentially competitive electric power and the strictly regulated transmission service. Discrimination in the electric industry could take the form of denying competitive operators access to the transmission monopolist's services on terms comparable to the terms the monopolist allows its own generation or denying access outright. In this way, the monopolist can accomplish what the regulation of the monopoly service was designed to avoid--supracompetitive profits. Regulators have several options for dealing with regulatory evasion via discrimination. One option is to force the regulated firm essentially to purchase regulated services from itself on terms and conditions comparable to those available to its competitors. This is the option proposed in the NOPR. Such a requirement allows increased competition for some unbundled services, but requires the Commission to closely monitor and police comparable access requirements, an extraordinarily difficult task. A second option is to allow the regulated firm to offer bundled service, but to regulate the price of the bundled product. This approach preserves any economies of scope inherent in the vertical integration, but does not achieve the potential gains from allowing one of the services to have its prices and terms set in a competitive market. A third option is divestiture. This option achieves the gains from allowing a competitive wholesale generation market to develop at minimal regulatory cost, but may sacrifice some economies of vertical integration that the other options do not. Divestiture is preferable unless the benefits of preserving economies of scale through unbundling exceed the regulatory costs of effective monitoring of comparable access. The electric utility industry presents extremely difficult problems of access regulation. Monitoring and enforcing compliance with regulations against discrimination is particularly difficult when quality of service is as time sensitive as it is in electric power. Because power is sold on an hourly basis, market dynamics -- and thus the incentive and ability to exploit market power -- can shift over the course of each day, making it virtually impossible to intervene before conditions have changed. Containing utilities' anticompetitive behavior at one time and in one part of the system may provide little assurance of containing distortions to the market later or elsewhere. Ensuring that the services and prices the integrated utility charges its competitors are equivalent to what it charges itself, could require virtually transaction by transaction regulatory oversight. A structural solution, complete divestiture, would resolve the competition problem better than this costly, intrusive regulation and ultimately interruption of behavior. Complete separation of both ownership and control, by establishing or restoring competitors' independence, can provide the best assurance against anticompetitive incentive and capability. For this reason, in antitrust enforcement, divestiture is the remedy commonly sought for anticompetitive mergers or monopolization. The only compliance oversight required for such divestiture is ensuring that the divested assets will be operated as a viable ongoing business and that divestiture takes place. By contrast, continued monitoring is required to assure compliance with behavioral or intra-firm structural orders. Ordering a firm to afford access is futile if the costs of monitoring its compliance are too high. Achieving complete corporate divestiture may be costly, especially where assets and operations are thoroughly integrated. The industry is already substantially vertically integrated. The solution cannot be simply to prevent inappropriate vertical integration. Instead, FERC-ordered divestiture could entail potentially great cost as it would require dismembering almost all existing corporate relationships in a vital industry. Divestiture may however be possible to implement on a regional basis and could well be appropriate as a remedy to specific competitive problems. Because functional unbundling, as proposed by the Commission, may not be effective, and divestiture may be difficult and costly to implement industry-wide, the Department suggests that the Commission consider an approach of "operational unbundling." By operational unbundling, we mean structural institutional arrangements short of divestiture that would separate the operation of the transmission grid and access to it from economic interests in generation. The purpose would be to prevent the regulated transmission monopolist from using its market power in transmission to restrict competition in the wholesale generation market. Institutional arrangements to counter the transmission firm's ability to distort competition in generation might include a separate authority to manage and plan the transmission grid and access to it, joint ventures (if competitive conditions warrant), and voluntary pooling arrangements. Separating ownership of generating facilities from control of transmission would reduce the incentives and ability of a utility to exercise transmission market power for the purpose of evading regulation and distorting competition in the generation market. By separating ownership from control, operational unbundling captures a primary advantage of divestiture by assuring that nondiscriminatory practices and rates will prevail. Operational unbundling would do this without costly enforcement of behavioral rules: Because generating firms would lose their ability to discriminate, operational unbundling would rely less on monitoring and thus save the cost of enforcing behavioral rules. III. AFTER RESTRUCTURING: COMPETITIVE GENERATION AND EFFICIENT TRANSMISSION PRICING Restructuring of the industry, whether through functional unbundling as the Commission has proposed, operational unbundling as the Department has proposed, or divestiture, as might be the most efficient where practical, is a vital step but not the only step necessary to achieve a competitive generation market. After separating generation from transmission, the Commission must examine competition in the generation market in order to assure efficient pricing of generation, and must create appropriate transmission rates in the transmission market in order to assure efficient transmission pricing. If the unbundled components, generation and transmission, are not each priced efficiently, restructuring will not achieve the potential available for consumers of electric power in the United States. A. GENERATION MARKETS MUST BE COMPETITIVE. The Commission has asked whether, after imposition of an equal access requirement, price regulation of generation can be relaxed or eliminated, even in the case of "generator dominance." The answer is no. Vertical disintegration of the electric utility industry, if effective, could remove the ability to manipulate the generation market by holders of transmission assets. This will create the potential for a competitive generation market. However, opening markets to entry does not necessarily produce competition if generation assets are concentrated in the hands of only a few owners. Although opening transmission access to a broader range of generators may lead to sufficient competition in some markets, the FERC should still examine actual market concentration and competitive conditions in determining whether to loosen regulation of generation prices in any region of the country. Antitrust analysis looks at concentration in a defined product and geographic area. If concentration of ownership of production is high, both coordinated interaction (collusion) and unilateral market power will be more likely, unless factors such as easy entry, ameliorate the effects of concentration. Entry must be rapid enough and effective enough to limit the ability of a dominant firm or collusive group to exercise market power. Introducing open access would not necessarily prevent a dominant utility of group of utilities from exercising market power. Open access is likely to broaden the relevant geographic market for generation by alleviating some impediments to wholesale wheeling. Broadening geographic markets typically results in lowering concentration and thus reducing the risk of exercise of market power. In determining which firms are in the market, the Commission should look, not only at the legal obligations of utilities such as open access tariffs, but also physical capability for delivery of power into the affected region. Factors such as loading of lines and/or capacity available at interconnection points, may practically limit access regardless of legal obligations to provide equal access to all. For this reason, the FERC must examine generation markets before allowing market-based pricing. It is essential for the Commission to recognize an equal obligation to allow the market to set prices where sufficient competitive conditions prevail. Only then will consumers fully share in the benefits of a more efficient electric utility industry. B. Transmission Pricing Must Be Efficient. The Commission should continue to evaluate its transmission pricing policy even after restructuring. With increased reliance on market forces to allocate generation resources, the price and availability of transmission capacity will have substantial effect on whether the most efficient generation resources are the ones sold. It is essential for the FERC to consider whether transmission price signals provide proper incentives for investing in major new transmission projects and eliminating bottlenecks in the transmission system. 1. Secondary Market for Transmission. The Commission has specifically requested comments on the potential for use of a secondary market in transmission rights. The Department agrees with the FERC s interest in allowing a secondary market for transmission rights. Trading such capacity rights can be an economically efficient solution to a common-property resource problem, and allocate rights of use to those who value them most highly. The secondary market is particularly important in bottleneck areas, where switching from low to high value uses of capacity is likely to produce the greatest benefits. For this reason, the Department has argued in favor of the Commission s efforts to develop a true secondary capacity market for natural gas pipeline capacity. The price signals in the secondary market can provide valuable information for investment decisions, encouraging expansion of transmission capacity where new investment will be most productive. The secondary market may be very important at bottleneck points in the system. Prices must be allowed to rise where there is scarce capacity in order to encourage capacity expansion, but a monopolist or coordinated group of transmission owners might exercise market power to elevate prices even above scarcity rents. By increasing the number of transmission sellers, a secondary market could provide alternative sources and thus help avoid such an exercise of market power. 2. Exceptions From Expansion Order. Efficient expansion of the transmission system will be important to development of the nascent electric generation market, yet the FERC proposes to permit waivers of its expansion orders. A utility could be exempted from a FERC order to expand if the utility showed that it tried in good faith to comply with the FERC's expansion order, but that compliance has been blocked by an inability to obtain regulatory approvals or assemble necessary rights-of-way. The FERC should be particularly careful in examining waiver requests and recognize that local interests may not coincide with national ones. Although market power usually harms a monopoly firm's customers, the customers that remain captive to a utility after other customers have left the system may instead gain from the utility s exercise of market power. The utility might use its market power over transmission-only customers in order to collect some of the utility's stranded costs rather than collecting it from the remaining electricity customers. The utility, its remaining customers, and even its local regulatory authority, could thus share an incentive to favor the exercise of transmission market power in order to recover otherwise stranded costs. A utility might also attempt to take advantage of market power by delaying transmission expansion at critical bottlenecks. A utility might decide not to expand transmission capacity that would be necessary for use by customers to reach competing generation sources. Further, local authorities might independently refuse to authorize such transmission expansion. Determining whether the utility's effort to obtain regulatory approval has been in good faith will be difficult. Furthermore, refusals to approve siting of new transmission projects by local regulatory authorities could hamper competitive open access. Widespread use of waivers could undermine the transition to open- access competition. Congestion on transmission networks will limit customers' access to alternative power supplies regardless of access rules. Operational unbundling would avoid some of these problems. By separating ownership of generation from control of transmission operational unbundling can prevent the transmitting utility from favoring its own generation. For this reason, an owner of a potentially stranded generation plant will find it more difficult to use its transmission system to favor that plant over more economic resources owned by others. Operational unbundling also limits the local regulator's ability to favor collection of potentially stranded generation costs by denying utilities the permits necessary to expand transmission capacity. III. METHODS OF STRANDED COSTS RECOVERY SHOULD NEITHER DISTORT EFFICIENT PRICING NOR DISCOURAGE MITIGATION. FERC believes that after restructuring, increased competition will cause some historic costs of generation to become "stranded." FERC defines these "stranded" costs as legitimate and verifiable historical costs on which suppliers "could not earn a reasonable return in a competitive market." FERC proposes that FERC jurisdictional stranded costs be recovered from customers, rather than be borne by utility investors. Wholesale customers that choose to buy power from a new supplier would be required to pay their former supplier a surcharge on transmission services. The surcharge would be designed to recover the departing customer's share of its former supplier's stranded generation costs. Before a utility would be allowed to include a stranded-cost charge in its transmission tariff, it would be required to demonstrate that it has attempted to mitigate losses caused by the customer s departure. The Department makes no overall assessment of costs and benefits of recovery of stranded costs. Collection of stranded costs presents a difficult policy decision. Although allowing recovery of stranded costs might encourage transmission-owning utilities to enter an open- access regime more quickly, it could also reduce the customers' incentives to switch to suppliers with the lowest prices, slowing the transition to competition. A. Efficiency Gains from Restructuring May Not be Realized if Stranded Costs Recovery Distorts Price. Different methods of stranded-cost recovery can have significantly different economic effects. FERC s goal should be to choose a method for stranded-cost recovery that would not distort the price signals that are critical for efficient decisions about production, consumption, and investment. The ideal stranded cost- recovery method would have a neutral effect on the departing customers marginal price and output decisions. The FERC proposes to recover stranded costs through an additional charge on transmission services for customers no longer purchasing electricity. This charge, based upon future transmission use is analogous to an excise tax. Its effects can be contrasted with the effects of a lump sum tax, which would be based upon past use of electricity. The excise approach would distort pricing signals and customer decisions on the use of electric power. The lump sum approach would not. The excise approach effectively increases the unit price of a customer's future services, likely leading the customer to reduce its future of electricity purchases and to accept substitutes (that is, other sources of generation) that are more costly. The cumulative effect could be to reduce the number of competitive generating suppliers serving the market. By contrast, under the lump sum approach, the departing customer's stranded-cost liability would be fixed, and the charge would not depend upon how much transmission service it used in the future. The lump sum approach, unlike the excise charge approach, would establish a fixed, sunk liability that would not distort the customer's economic incentives at the margin. The FERC maintains that the magnitude of FERC-jurisdictional stranded costs, that is stranded costs at the wholesale level, is relatively small, so inefficiencies from its choice of stranded-costs recovery program should be relatively small. However, the FERC's choice of method may have wider effects. FERC's recommendations for stranded-cost recovery may become a model for states to apply at the retail level. For this reason, the FERC should consider the implications of adopting cost recovery approach carefully. B. Mitigation Savings Provisions May Limit Utilities' Incentives to Use Otherwise Stranded Capacity. The FERC proposal recognizes that utilities may have the ability to mitigate stranded costs that would otherwise be recovered from their ratepayers. Under the FERC proposal, it appears that all of a utility's savings from efforts to mitigate its stranded costs would be applied to reducing the customers' stranded costs liability. Requiring the passthrough of all savings to customers, however, will undercut the utilities' incentives to mitigate their stranded costs through innovative services, marketing, and pricing. If utilities refrain from such innovation, use of new purchasing opportunities could be curtailed and secondary markets for transmission could be delayed. The result will be a higher level of stranded costs paid by the utilities customers. In addition, if the amount of a utility's stranded costs or mitigation obligation remains unsettled over time, there will be pressure for incumbents to use a regulatory adjustment to respond to inroads that would otherwise be countered by competing. Other treatments of mitigation savings would not discourage innovation product and service innovation to the same degree. For instance, the utility might be required to pass through only some fraction of mitigation savings to departing customers. Some states have adopted a similar approach in their rate of return regulations. While incentives to mitigate would be greater under this approach than under a full pass through, they would still be lower than in a competitive market. None of the alternative approaches to mitigation is perfect. Coordination among the FERC and state regulators on the methods chosen may reduce confusion, complexity, and litigation delays, assuring a quicker transition to a competitive environment. VI. Conclusion. There are potential tradeoffs among different approaches to restructuring the electric industry to promote wholesale competition in generation and enable increased reliance on market forces to set prices. The operational unbundling approach, separating control of access to the transmission grid from ownership or operation of generation, could be more effective than functional unbundling and less costly to implement than full divestiture. After restructuring, the FERC is likely to need to continue to monitor certain generation markets until the competition has been achieved. Similarly, it must continue to monitor and encourage efficient transmission pricing if the benefits of wholesale competition are to be obtained. The Department takes no position on the net costs or benefits of recovering stranded costs from future, present, or past customers. However, the Department recognizes that if the FERC adopts such a program, the form it takes will be important, in part because other jurisdictions will look to it as a model. Structuring stranded-cost recovery as excise charges is likely to distort price signals; instead, the Commission should choose a method that would minimize price distortions. Finally, requiring utilities to pass through all savings from mitigation to customers is likely to undermine utility s incentives to minimize those costs through innovation. Respectfully submitted, ___________________ Anne K. Bingaman Assistant Attorney General ___________________ David Turetsky Special Counsel to the Assistant Attorney General Donna N. Kooperstein Assistant Chief Transportation, Energy, and Agriculture Section ___________________ Jade Alice Eaton Attorney Transportation, Energy, and Agriculture Section Antitrust Division U.S. Department of Justice Room 9104 Judiciary Center Building 555 Fourth Street, NW Washington, D.C. 20001 202-307-6349 August 7, 1995