Hempling GlennSchool How Achive High Quality Regulation

8/3/2019 Hempling GlennSchool How Achive High Quality Regulation

1/30

High-Quality Utility Regulation: How Do We Achieve It?

Scott Hempling

Director, National Regulatory Research Institute

John Glenn School of Public Affairs

The Ohio State University

Doctoral Colloquium Brownbag

January 26, 2007


2/30

Table of Contents

I. Prerequisites: Regulators and Regulatory Practices . . . . . . . . . . . . . . . 1

A. Regulators: Successful regulators have four indispensable attributes:purposefulness, education, independence and decisiveness . . . . . . . . . . . . . . . . . 1

1. The purposeful regulator aligns private interests with the

public interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2. The educated regulator acquires knowledge about regulation, about

regulated industries and about regulatory process. . . . . . . . . . . . . . . . . . . 4

3. The decisive regulator makes decisions required by the public interest, at

the time those decisions are necessary. . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

4. The independent regulator: Independent of what? There is a difference

between literal independence and effective independence. . . . . . . . . . . . 10

5. Conclusion on the attributes of a successful regulator . . . . . . . . . . . . . . 12

B. Practices: Successful regulators practice high-quality regulation, defined through

six principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1. When dealing with private interests, high quality regulation swallows

many grains of salt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

2. High quality regulation is objective regulation, not subjective regulation.12

3. High quality regulation focuses on the long term. . . . . . . . . . . . . . . . . . . 12

4. High quality regulation is anticipatory. . . . . . . . . . . . . . . . . . . . . . . . . . 12

5. High quality regulation avoids absolutes. . . . . . . . . . . . . . . . . . . . . . . . . 12

6. High quality regulation acknowledges the political need for compromise,but it does not compromise its core. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

II. Impediments: Five Factors Which Weaken Regulation . . . . . . . . . . . . 14

A. Purpose confusion: Five regulatory practitioners will define the purpose of

regulation five different ways. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

B. Politics: Factional tensions divert decisionmakers from the merits. . . . . . . . . . 14

C. Multijurisdictionality: Overlaps and gaps blur the lines of authority and

accountability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

D. Multidisciplinary inputs: Decisionmaking requires multiple professional

disciplines, but the decisionmaking process often fails to involve them. . . . . . . 15

E. Appointments and terms: Regulatory experience is undervalued by appointing

authorities; terms are shorter than decision cycles. . . . . . . . . . . . . . . . . . . . . . . . 16


3/30

ii

III. Examples: Suboptimal Regulation in the Electric Industry . . . . . . . . 17

A. Bulk Power Reliability: Who's In Charge Now? . . . . . . . . . . . . . . . . . . . . . . . . 17

B. Wholesale Competition: What Should States Do About Their Discomfort with

FERC's Market Rate Policies? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

C. Jurisdictional Responsibility: Who Regulates What? . . . . . . . . . . . . . . . . . . . . . 24


4/30

1 B.A. cum laude, Yale University (Economics and Political Science, Music); J.D.

magna cum laude, Georgetown University Law Center.

1

High-Quality Utility Regulation: How Do We Achieve It?

Presentation to

John Glenn School of Public Affairs Doctoral Colloquium Brownbag

January 26, 2007

Scott Hempling1

Director, National Regulatory Research Institute

1. Prerequisites: Regulators and Regulatory Practices

2. Impediments: Five Factors Which Weaken Regulation

3. Examples: Suboptimal Regulation in the Electric Industry

4. Discussion: Ideas for Future Research

I. Prerequisites: Regulators and Regulatory Practices

A. Regulators: Successful regulators have four indispensable attributes:

purposefulness, education, independence and decisiveness

1. The purposeful regulator aligns private interests with the public

interest

a. Regulatory statutes command regulators to make decisions"consistent with the public interest."

b. The premise of regulation is that private interests diverge from the

public interest; absent regulation, the private pursuit harms the

public. Regulation aligns private behavior with public interest.

c. Purposeful regulators therefore approach their jobs with a four-step

analysis:

(1) Define the public interest.

(2) Identify the private interests involved.


5/30

2

(3) Understand how the private interests will diverge from the

public interest.

(4) Determine which forms of regulatory intervention will

align private behavior with public interest.

d. Attendee experiment: What is "the public interest"? (No peeking

at my answer.)

My definition: "The public interest" is a composite of economic

efficiency, social equity and political reality.

(1) Economic efficiency means what it sounds like: seeking

biggest bang for the buck.

(2) Social equity means shaving the hard edges off economic

efficiency, so that the short term pain is not so high as todistort the long term signals that are the purpose of

economic efficiency.

(a) Political reality means that the regulator, while

acting from a foundation of objectivity, must

preserve the political credibility of the regulatory

process. Political reality does not mean caving to

interest groups; it does mean moving gradually --

but moving forward, not backwards -- when

necessary to build support.

(3) Note: In the legal context of utility regulation, "public

interest" is confined to the subject matter of utility

regulation. It does not include economic development,

environmental protection, job protection, protection for the

disabled, protection from discrimination against minorities,

if those values are not within the Commission's statutory

mandate. Compare Gulf States Utilities Company v. FPC

(Federal Power Commission may take into account

antitrust policies even though it has no authority to enforce

antitrust laws); toNAACP v. Federal Power Commission

(Federal Power Commission has no authority to promulgaterules concerning racial discrimination by regulated

utilities).


6/30

3

e. What are the private interests? How do they diverge from the

public interest? Examples:

(1) utility (profit maximization, market domination, market

stability, community presence)

(2) utility CEO (all of the above, plus career enhancement, job

satisfaction)

(3) nonutility competitors (market entry, market share, access

to bottlenecks)

(4) consumer (reasonable prices, reliable service, friendly

customer relations, community presence)

(5) labor (reasonable wages, job stability, job satisfaction)

(6) environmental organizations

(7) shareholders (growth, stability, dividends, community

presence)

(8) bondholders (stability, non-delinquency)

(9) others?

f. Implications of insistence on alignment

(1) Seeking alignment means pulling parties away from

behavior that misaligns, toward the public interest.

(2) The search for alignment differs from a search for

"balance," "consensus" or "compromise." These latter

searches presume the legal legitimacy of all interests at the

table. The search for alignment is different: it involves

judging the consistency of private interests with the public

interest, then elevating the latter over the former.

(3) Purposefulness precludes avoidance of elephants in livingrooms. In utility regulation, what are our elephants?

(a) pricing based on average embedded cost rather than

real cost, and rather than market price


7/30

4

(b) relative insulation of regulatory staff, utility

executives and utility employees from the risk of

employment termination for performance below

standards set by competitive pressures

(c) absence of integration between regulatorydecisionmaking and other state agency

decisionmaking, such as environmental, siting,

union relations

(d) skill differentials between state commission

employees, and counterpart utility employees

2. The educated regulator acquires knowledge about regulation, about

regulated industries and about regulatory process.

a. The educated regulator knows the basics, knows where to learn therest, and engages in continuous learning from a combination of

sources.

b. About regulation: what makes utility regulation different from

other forms of government activity?

(1) The purpose of regulation: why do we regulate? (See Part

I.A.1 above)

(2) The subjects of regulation: what events do we regulate?

(a) industry structure: monopoly or competitive

market; entry and exit

(b) corporate structure: mergers, acquisitions,

divestitures and diversifications

(c) financial structure: issuances of debt and equity

(d) sales of goods and services: electric power,

transmission, demand-side services, customer

services, home audits

(e) quality of service: power quality, reliability,

timeliness


8/30

5

(3) The law of regulation: what powers do regulators have?

what are the limits on those powers?

(a) State substantive law establishes (1) the duties and

powers of the state regulator; (2) the obligations,

rights and powers of the regulated entity; (3) theobligations and rights of the consumer; and (4) the

remedies available to (and against) each of these

entities.

(b) State procedural law establishes the procedures by

which (1) the regulator may or must follow to make

decisions, and (2) an aggrieved interest may seek a

remedy.

(c) Federal substantive law: See state substantive law.

Example are the Federal Power Act, Natural GasAct.

(d) Federal procedural law: See state procedural law.

Example is the federal Administrative Procedure

Act.

(e) Federal constitutional law establishes authorities of

the federal and state governments, and the limits on

those authorities.

i) Commerce Clause establishes Congress'spower to regulate interstate commerce, and

restricts' states' powers to regulate interstate

commerce.

ii) Contract Clause restricts Congress's and

the states' powers to impair existing

contracts.

iii) Takings Clause prohibits government

regulation which "takes" private property

unless there is just compensating to theowner. In utility regulation, this principle

prohibits regulators from interfering with

"legitimate, investment-based expectations."


9/30

6

iv) Supremacy Clause precludes states from

enacting or applying state laws

inconsistently with national policies

declared by Congress, where Congress has

intended to preempt states.

v) Due Process Clause requires regulators,

when using statutorily-mandated

adjudicative procedures, to provide fair

hearing processes; it also prevents a state

from regulating actions occurring outside its

boundaries.

(f) These legal sources of law interact in multiple

ways.

(4) The professions in regulation: What are the professionaldisciplines on which regulation depends? What principles

and tools do they contribute?

(a) law: exclusive right to serve, obligation to serve,

just and reasonable rates, nondiscriminatory rates,

no taking without just compensation

(b) accounting

(c) finance: debt equity ratio, risk

(d) economics: cost causers are cost bearers, price

should equal marginal cost

(e) engineering: capacity must match demand, the best

technology should be available when it is

cost-effective

(f) organization management

(g) politics


10/30

7

(5) The processes of regulation: What the official and

unofficial methods by which regulators gather information

and make decisions?

(a) Who can initiate regulatory processes? The

regulator, the regulated entities, consumers or othercitizens.

(b) Procedural options span a spectrum from informal

to formal: private audits, off-the-record inquiries or

investigations, notices of inquiry or investigation,

rulemakings, adjudications.

c. About the industries you regulate

(1) Subject areas common to all industries: rates; quality of

service; market structure -- the relative vroles of regulationand competition; mergers; state-federal jurisdictional

relations; relations among state agencies; legal principles

(2) Chief characteristics of the industries you regulate: market

structure, corporate structure, stability, pricing, products,

regulatory jurisdiction, common methods of regulation,

revenues, rates and profits, history, engineering basics --

physical constraints and opportunities, life cycle of plant,

technology trends, mix of utility and nonutility businesses,

legal basics -- state and federal law.

(3) Best practices for that industry

d. About the regulatory process

(1) When do regulators act? Reactive regulation; proactive

regulation;, events triggering mandatory regulatory

response (e.g., entry and exit, rates quality problems).

(2) How do regulators act? Formal and informal procedures


11/30

8

3. The decisive regulator makes decisions required by the public

interest, at the time those decisions are necessary.

a. What do we mean by "decisiveness"?

(1) Decisiveness is the quality of making decisions at the timethe public needs them to be made, using the

decisionmaking tools most likely to ensure good decisions.

Decisiveness is not impulsiveness; decisiveness includes

deciding not to decide.

(2) Decisiveness does not mean making all decisions

immediately or at the same time. Decisiveness includes not

only making rulings but also deciding to inquire. To be

decisive, the regulator need not say: "Having just taken the

oath of office, I have determined that competition is not

working; so I will move this month to replace it withmonopoly regulation." A decisive regular might say: "It

has been over 10 years since anyone in the state examined

the mix of competition and regulation in this industry.

Every 5 years we should reexamine. Let's start now."

(3) A decisive regulator does not accept status quo elements

merely because they seem hard to change. A decisive

regulator asks why things are done the way they are.

b. Two components of decisiveness are logical method and active

behavior.

(1) Logical method: Since the purpose of regulation is to align

private behavior with public interest, decisiveness involves

identifying and making those decisions which ensure

alignment.

(a) Determine industry structure that best aligns public

interest and private interest

(b) Establish standards for each player in that industry

structure (e.g., best practices, average performance,or "no decline from last year")

(c) Establish rewards and penalties for performance

that meets, exceeds or falls below those standards


12/30

9

(d) Create processes that produce compliance with

these standards

(e) Create continuous process for re-examination of

premises

(2) Active behavior

(a) Active decisionmaking has at least three

components

i) Anticipate future events, then establish

policies that channel those events toward the

public interest.

ii) Critique present practices, then establish

policies that channel them toward the publicinterest.

iii) When a party initiates a proceeding to

request commission action, determine if

each of the alternative outcomes will

promote the public interest; or whether the

requested proceeding must be modified to

accommodate larger purposes.

(b) Active decisionmaking also involves understanding

the interactions between utility regulation and otherforms of regulation that affect the utility but fall

outside this regulator's domain. Examples: nuclear

safety regulation, labor relations, environmental

regulation, land use policy, tax policy.

(c) Reactive decisionmaking: Reactive means there

still is thoughtful action by the regulator, but it is

action bounded by the requests made by parties.

The regulator considers whether the party's request

is reasonable. But the reactive regulator does not

look beyond the proposed transaction.

(d) Passive decisionmaking: In passive

decisionmaking, the regulator accepts the party's

request without independent thought. Then there is

pure passivity clothed as active decisionmaking, as


13/30

10

in "we'll approve it this time, but if you do it again,

we'll clobber you."

(e) Peter Bradford has analogized regulatory

decisiveness to boxing.

4. The independent regulator: Independent of what? There is a

difference between literal independence and effective independence.

a. Literal independence is unachievable.

(1) The regulator is not independent of pressure --

(a) from legal challenges by aggrieved parties

(b) from the risk of legislative override

(c) of public ire, where public acceptability is a

prerequisite to success

(d) from financial markets, which do not always react

rationally, patiently or public-spiritedly.

(2) Literal independence is unachievable because the regulator

is only one of many decisionmakers.

(a) The lending community lowers the utility's bond

ratings because of the utility will have to incurcapital costs without certainty of revenue recovery.

(b) The utility's engineering staff stalls because they

prefer a different solution to the capacity need.

(c) The utility's large customers, concerned about large

rate increases resulting from the cost, invest in

self-generation options (thereby leaving the utility's

shareholders, or its smaller customers, having to

pick up the costs of the new plant that otherwise

would have been paid for by the large customers.

(3) Literal independence is unachievable because the regulator

must account for these negative possible outcomes.

Successful regulation is regulation that produces a public


14/30

11

interest result. The result is not a public interest result if a

good decision is blocked by other actors.

b. Literal independence is undesirable.

(1) No regulator should be independent of those forces thatmake democracy work: legislative mandates, professional

accountability, judicial review, state economic policy,

administrative procedures, ethical obligations, engineering

principles, economic principles, financial realities, laws of

economics, political boundaries (although one can

distinguish between short-term and long-term boundaries).

(2) A regulator who acts in ignorance of others' reactions

quickly becomes a passenger in someone else's airplane.

c. Effective independence means independent of influences that arecontrary to the public interest

(1) True independence means unbiased by arguments or forces

that seek to block the regulator from making decisions that

align private behavior with public interest.

(2) Independent of what?

(a) of obvious forces like financial or job inducements

(including reappointment)

(b) of arguments not factually verifiable or legally

relevant

(c) of adjectives and adverbs not factually verifiable or

legally relevant

(d) of pre-established opinions -- if those opinions

cannot be changed by observation of facts

(3) Independence is assisted, ironically, by studying all the

forces of which the regulator must be independent.


15/30

12

5. Conclusion on the attributes of a successful regulator

a. The four attributes of successful regulators -- purposefulness,

education, decisiveness and independence -- are professional

attributes: attributes that the regulator can develop in preparation

for or during employment.

b. There also are indispensable personal attributes: courage, honesty,

stamina, patience and impatience (in proportions that vary with the

challenge), collegiality, street-smarts, humor, hopefulness and

faith. These attributes fall within the areas of psychology,

psychiatry and religion, all areas within my experience but outside

my expertise.

B. Practices: Successful regulators practice high-quality regulation, defined

through six principles.

1. When dealing with private interests, high quality regulation swallows

many grains of salt.

a. Most regulatory supplicants describe their private interests as the

public interest.

b. Even public interest groups argue private interests -- the specific

interests of their particular issue focus. Consumer groups, labor

groups, shareholder groups, bondholder groups, environmental

groups -- they all argue public interest. Their interests matter. But

their interests are only inputs to the public interest, they are notthemselves public interest. Public interest regulation cannot

satisfy each of these interests at every point in time.

2. High quality regulation is objective regulation, not subjective

regulation. Subjective regulation asks, "what do the parties want?"

Objective regulation asks, "what is the right answer?"

3. High quality regulation focuses on the long term.

4. High quality regulation is anticipatory.

5. High quality regulation avoids absolutes.

A high quality regulator does not say "I am for competition" or "I

am against competition." A high quality regulator follows Alfred

Kahn view, that the "central, continuing responsibility of


16/30

2 A. Kahn, The Economics of Regulation: Principles and Institutions, Vol. I,

Introduction at xxxvii; Volume II at 114 (1970; 1988 edition).

13

legislatures and regulatory commissions" is "finding the best

possible mix of inevitably imperfect regulation and inevitably

imperfect competition."2

6. High quality regulation acknowledges the political need for

compromise, but it does not compromise its core.

a. It compromises on pace; it does not compromise on the core.

b. It compromises on the angle of change; it does not compromise on

the direction of change.


17/30

14

II. Impediments: Five Factors Which Weaken Regulation

A. Purpose confusion: Five regulatory practitioners will define the purpose of

regulation five different ways.

1. Attendee experiment: Define the purpose of regulation

2. Result: Differences over performance standards for regulated entity

(optimal performance, industry average, lowest feasible cost, do no harm,

other).

3. Result: Differences over the roles of rewards and penalties (fines,

revocation of franchise, rate of return penalty, "if you do that again we'll

clobber you").

4. Result: Challenges to the infrastructure of regulation (commission budget,

commission authority, pay for staff).

B. Politics: Factional tensions divert decisionmakers from the merits.

1. Utility regulation exposes at least 7 traditional tensions:

a. objective vs. subjective judgment

b. technical (engineering, financial, economic, legal) vs. political

considerations

c. short-term vs. long-term values

d. rural vs. urban

e. large customer vs. small customerf. shareholder vs. lender

g. investor vs. customer

2. Since the late 1980s, more interest groups have entered the regulatory

arena.

3. Distinguish utility regulation from the court system: In a court, parties are

allowed to argue their interests, provided they are truthful about the law

and facts. They make no pretense of serving the public interest. In

judicial proceedings there is no third party (other than legal principle);

there is no public interest other than reaching the result required by factsand law. And the judge has no authority to apply her version of the

"public interest." The judge is confined to the dispute brought by the

parties, plus the governing law.


18/30

15

4. In contrast, regulatory agencies must make political decisions -- allocation

of scare resources -- while lacking the traditional indicia of political

stature. Or do they have those indicia?

C. Multijurisdictionality: Overlaps and gaps blur the lines of authority and

accountability.

1. The rules of regulation get made in at least seven different fora, (state

legislatures, state commissions, state courts, Congress, federal substantive

regulatory agencies, Securities and Exchange Commission, Federal courts)

2. These fora make these decisions at different times and for different

reasons. Communications among these fora are awkward and

time-delayed.

a. regulator -- courts

b. regulator -- legislaturec. state regulator -- federal regulator

d. state regulator -- state regulator

3. Result: For almost every issue, it is not clear who will decide, how they'll

decide, when they'll decide. And inertia is a powerful force.

4. Result: Few things ever get settled. With 7 different fora, it's almost

always worth taking one more shot. Even when the highest authority

speaks, questions remains.

a. New York v. U.S. (FERC has authority to regulate the unbundledtransmission of retail power)

b. Duquesne v. Barasch (state commission disallowance of prudent

costs does not violate the Takings Clause of the U.S. Constitution)

D. Multidisciplinary inputs: Decisionmaking requires multiple professional

disciplines, but the decisionmaking process often fails to involve them.

1. Experts must communicate from the field of economics, law, finance,

accounting, engineering, business administration, and political analysis.

2. The hearing processes and internal deliberations allow for

multidisciplinary input, but are not conducive to multidisciplinary

deliberation.


19/30

16

E. Appointments and terms: Regulatory experience is undervalued by

appointing authorities; terms are shorter than decision cycles.


20/30

17

III. Examples: Suboptimal Regulation in the Electric Industry

A. Bulk Power Reliability: Who's In Charge Now?

1. EPACT Title XII, Subtitle A ("Reliability Standards")

a. Background

(1) Because of the interconnectedness of the transmission grid,

electrical events in one region can affect reliability and

costs in other regions.

(2) Until the 2005 legislation, reliability actions of the

individual utilities are largely a product of voluntary

standards they accept when becoming members of the

National Electric Reliability Council and its regional

sub-councils.

(3) There had been a mismatch between the physical reality

and legal responsibility.

(a) Authority over individual utility reliability rested

with individual states. State regulatory options

included defining and enforcing the utility's

obligation to serve and quality of service standards,

placing conditions on the utility's off-system

purchase practices, and defining shut-off policies.

(b) FERC had no direct authority over reliability.

b. Summary of Statute

(1) FERC certification of a single "electric reliability

organization" (ERO). New Sections 215(a)(2), 215(c)

added by Section 1211 of EPAct 2005 (hereinafter Sec.

215). New Sections 215(a)(2), 215(c) added by Section

1211 of EPAct 2005 (hereinafter Sec. 215).

(2) ERO proposes and enforces reliability standards.

(3) ERO enforcement of its reliability standards. Sections

215(e)(1) and 215(e)(2).


21/30

18

(4) ERO optional delegation to regional entities of

standard-setting and enforcement, subject to FERC

approval. Sec. 215(e)(4).

(5) FERC review and approval of ERO-proposed reliability

standards. Sections 215(a)(3), 215(d).

(6) FERC enforcement of reliability standards promulgated by

the ERO and the regional entities. Sec. 215(e)(5).

(7) Dispute resolution. Sec. 215(d)(6).

(8) No FERC authority or ERO authority to order construction

of additional generation or transmission capacity. Sec.

215(i)(2).

(9) No preemption of State actions which are consistent withERO reliability standards. Section 215(i)(3).

(10) Regional advisory bodies. Sec. 215(j).

2. Potential Conflict Areas

a. Generation reserve margin

b. Transmission reserve margin

c. Construction of transmission upgrades in one state vs. another state

d. Allocation of costs and rights associated with transmission

upgrades

e. Cost recovery for reliability investments mandated by national

electric reliability organization, regional transmission organization,

regional entity

f. Ordering and implementing demand side management

g. Choice between generation dispatch vs. transmission construction

h. Curtailment orders


22/30

19

3. Questions

a. Do the conflicts arise from

(1) differences between state objectives and FERC objectives?

(2) differences among states?

b. How does the ERO verify readiness and performance by the

regional entities? How do states maintain influence over

individual utility participation within the regional entities?

c. What is are the appropriate delegations between the national ERO

and the regional entities? What standards should FERC apply to

evaluate these delegations? What role should states have in these

delegation decisions?

d. In light of the new roles for the ERO, regional entities and FERC,

what are the continuing obligations and authorities for the

(1) transmission owner?

(2) state commission?

(a) generation safety, adequacy and reliability?

(b) transmission safety, adequacy and reliability?

(c) distribution safety, adequacy and reliability?

(3) RTO?

e. To what extent is state law authority over reliability now

preempted by the Federal Power Act?

(1) Section 215(i)(3): Nothing in this section shall be

construed to preempt any authority of any State to take

action to ensure the safety, adequacy, and reliability of

electric service within that State, as long as such action is

not inconsistent with any reliability standard, except that

the State of New York may establish rules that result ingreater reliability within that State, as long as such action

does not result in lesser reliability outside the State than

that provided by the reliability standards. (Emphasis

added)


23/30

20

(2) What is the effect of the "New York" clause? If a non-New

York state enacts standards requiring higher reliability, is

such action "inconsistent" with a reliability standard?

f. If there is a reliability violation, who can file a complaint; against

whom, when, and where does the complaint get filed?

g. What is the legal effect of a violation?

(1) violation of rule under the FPA?

(2) judicial enforcement by FERC?

(3) negligence suit in state or federal court?

h. The statute precludes the ERO or regional entity or FERC from

ordering anyone to "enlarge such [bulk power system] facilities or

to construct new transmission capacity or generation capacity,"

Section 215(a)(3) (defining "reliability standard"). See alsoSection 215(i)(2)(stating that Section 215 "does not authorize the

ERO or the Commission to order the construction of additional

generation or transmission capacity or to set and enforce

compliance with standards for adequacy or safety of electric

facilities or services"). Can the same result occur indirectly, e.g.,

the ERO promulgates a reliability standard that can be met only by

enlargement or construction?

i. How do all participants mesh distribution reliability with bulk

power system reliability?

4. Possible State Initiatives

a. Identify actions and events that can enhance or degrade reliability

(1) Establish reserve margins for generation

(2) Establish reserve margins for transmission

(3) Order expansion or construction of generation

(4) Order expansion or construction of transmission

(5) Create curtailment plan

(6) Order curtailment

(7) Create demand side options(8) Order demand side actions

(9) Modify rate structure to reflect cost and scarcity


24/30

21

b. Define regulatory expectations

(1) What standard: prudence, best practices or minimum

practices?

(2) What penalties: rate disallowance, rejection of corporatestructure initiatives, damages for reliability-induced losses

or revocation of franchise?

(3) What rewards: normal return on equity, supranormal return

on equity, accelerated depreciation, or personal bonuses

(for employees or management)?

c. Identify and resolve institutional difficulties

(1) Transmission owner reluctance to build new transmission

(2) State reluctance to order transmission owners to build new

transmission

(3) Generator opposition to new transmission adds litigation

costs

(4) Positive externalities among states: conservation in State X

creates reliability benefits for State Y

(5) Negative externalities among states: failure to site and pay

for transmission in State X causes reliability problems inState Y

(6) Penalties are lower than the costs caused by the behavior

5. Question: How might these state actions interfere with federal

responsibilities?

B. Wholesale Competition: What Should States Do About Their Discomfort

with FERC's Market Rate Policies?

1. Retail utilities have two ways to incur generation costs; build or buy.Either option acts as a cost boundary on the other.

a. If at the time of long-term resource procurement, wholesale firm

contracts look more attractive than utility construction, the utility


25/30

22

should use the contract, or face cost disallowance from its state

commission.

b. And if utility construction looks more attractive than wholesale

firm contracts, the utility should build, or face cost disallowance.

c. If the utility makes the decisions, free of state compulsion, the

utility has to bear the risk of a suboptimal choice.

d. The state commission then must hold the utility accountable for its

decisions.

2. Where the state has exclusive authority to determine retail cost recovery,

what is the relevance of FERC decisionmaking?

a. If the state disagrees with FERC's handling of wholesale markets,

the state can protect its retail customers by requiring its utilities tobuild rather than buy, or by setting retail rates as if the utility had

built rather than bought.

b. Regardless of how FERC does its job, if state commission do their

job the generation cost to the retail ratepayer should never exceed

the lesser of the FERC-authorized market rate or the utility prudent

self-build cost.

c. So why should the state care about FERC's wholesale policies?

Consider two situations:

(1) Divestiture states: Here, the retail customers are dependent

on wholesale markets.

(2) Non-divestiture states: High wholesale prices influence

self-build costs. If the wholesale market price is held to

artificial high levels by FERC policy, then sellers of

generation equipment can raise their prices up to a level

just below the market price.

Probably all non-divestiture states have some dependency on

wholesale markets.

3. Back to FERC:

a. There are several possible state practices that could induce FERC

to authorize high prices in wholesale markets.


26/30

23

b. If FERC sees that --

(1) retail utilities (a) have divested their generation and (b) and

are not building new generation, and

(2) state commissions are not compelling utilities to build fortheir own load,

c. FERC's reaction will be predictable:

(1) FERC is obligated to ensure that transmission service is

just and reasonable and not unduly discriminatory

(2) There cannot be reasonable transmission service if there is

insufficient generation.

(3) If there is insufficient generation, FERC will allow pricesto rise to attract generation.

(4) FERC will find that these high prices, although leading to

supracompetitive process, are just and reasonable because

of a shortage. In this example, the shortage is caused not

by anticompetitive withholding (in which case high profits

would not be lawful) but because insufficient generation is

coming to market.

4. Conclusion

a. Regardless of one's view of the merits of FERC's wholesale market

policies, the state commission, the state remains the power center

for protecting the consumers. For a divestiture state, the

short-term options are limited, since hedging through self-build

requires a multi-year plan. But the state should not

b. Caution: Unlike some, I do not advise giving up on wholesale

markets, through "re-verticalization." A healthy regulatory

environment has multiple benchmarks, with self-build and

wholesale options competing with each other, neither having a

government-granted advantage over the other.

c. I therefore recommend that regulators


27/30

3 The other four events were: The Federal Water Power Act of 1920, the Public Utilities

Act of 1935 (enacting the Federal Power Act and the Public Utility Holding Company Act), the

Public Utility Regulatory Policies Act of 1978 and the Energy Policy Act of 1992.

24

(1) focus continuing attention to both the wholesale and

self-build options, taking into account the different needs of

short term and the long term.

(2) minimize situations where retail customers are served by a

member of a corporate family having ventures in both themonopoly and competitive worlds in the same market.

This simultaneous presence leads to conflicts of interest.

C. Jurisdictional Responsibility: Who Regulates What?

1. With the Energy Policy Act of 2005, Congress has made national policy in

the electric industry for the fifth time in a century.3 Each time, Congress

has entered areas occupied by the states. Simultaneous occupation of

policy territory by federal and state regulators does not always produce a

consistent national electricity policy. The Energy Policy Act of 2005

gives us a new opportunity to address this subject.

2. What is a consistent national electricity policy? It is one where regulators

a. share of a common goal: alignment of the private interests with

the public interest;

b. send consistent signals for economical efficient behavior; and

c. accommodate different market structures provided they can

operate simultaneously without detriment to each other; but

d. where different types of market structures cannot operate

simultaneously without detriment to each other, regulators don't

ignore that conflict but choose one way over the other.

3. Based on what we have discussed thus far, do we have the ingredients of a

consistent national electricity policy?


28/30

25

IV. Discussion: Ideas for Future Research


29/30

Regulatory Complexity: The Electric Industry Example

Ten Areas of Law

Federal Power Act

Federal antitrust lawFederal bankruptcy law

Federal constitutional lawFederal Administrative Procedure Act

State administrative procedure lawState utility lawState tort law

State contract lawState property law

Nine Actors to Regulate

Vertically integrated utility

Distribution-only utilityTransmission-only utility

Independent generating companyIndependent marketer

Holding companyRegional transmission organization

Independent system operatorUsers of the bulk power system

Seven

U.S.Sta

F

State u

Six Types of Transactions*

MergersWholesale sales of power

Retail sales of powerDispositions of generating assets

Dispositions of transmission assetsIssuances of equity and debt

*Affiliated and non-affiliated

Five Subjects to Regulate

Industry structureCorporate structureFinancial structureSales of service

Quality of service

Seven Professional Disciplines

LawAccounting

FinanceEconomicsEngineeringManagement

Politics

Ten Historical Events

1887

InterstateCommerce

Act

1890

ShermanAntitrust Act

1935

PUHCA

1935

FederalPower Act

1978

PURPA

1992

Energy PolicyAct of 1992

1996

FERC Order888

1996

Stateco

sta


30/30

Who Regulates the Bulk Power System Now?

Possible Regulating Entity

Regulatory Action ERO RTO RE RRC State PSC FERC

Set reliability standard

Set generation reserve margin

Order generation construction

Order transmission construction

Designate "must run" units

Order curtailment

Establish DSM programs

Order participation in DSM

Order generation operations

ERO = Electric Reliability Organization

RTO = Regional Transmission Organization

RE = Regional Entity

RRC = Regional Reliability Council

PSC = State Public Service Commission

FERC = Federal Energy Regulatory Commission

Documents

Hempling GlennSchool How Achive High Quality Regulation