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Subject: FERC Enacts Major Constraints on Wholesale Market


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November 27, 2001 



FERC Enacts Major Constraints 
on Wholesale Market



By Will McNamara
Director, Electric Industry Analysis








AEP, Entergy Corp. and Southern Company told by FERC to charge cost-based prices instead of market-based prices for wholesale spot transactions. 

[News item from Reuters] The U.S. Federal Energy Regulatory Commission (FERC) voted 3-1 last week to adopt new rules to measure market power, as a condition for approving mergers and granting utilities the right to trade power in the wholesale market. FERC commissioners said the new test would improve a system that allowed a meltdown to take place in the California market last winter, when wholesale power prices soared to record highs amid tight supplies. FERC commissioners agreed to produce a new market power test based on supply margin assessments, which examines a company's importance in serving peak electricity loads. "If you're big enough to control the market at the time we look at it, you'll have mitigation put on you," said FERC Chairman Pat Wood. 

Analysis: Many participants in the wholesale sector of the energy industry are still reeling from FERC's new ruling, which may have slipped past some radar screens considering that it was issued right before the long holiday weekend. This is a mammoth ruling on FERC's part, however, and it holds tremendous impact for those companies that increasingly find the lion's share of their profits coming from wholesale transactions. In addition, state regulators have also started gauging the impact of the ruling on retail rates, which some utilities may seek to increase as a way to compensate for shrinking profits in their wholesale operations. While FERC has presented this ruling as an attempt to circumvent on the national level problems experienced in the California market, the new limits on wholesale transactions can also be seen as another example of the "big stick" that the commission is using to force utilities into participating in regional transmission organizations (RTO). Further, the ruling is another striking indication that Chairman Wood is following through with his promise to monitor rampant wholesale markets while still attempting to support competition. The objective represents a tall order, and the new ruling from the commission is certain to prompt intense resistance among companies involved in wholesale trading. 

Put into a nutshell, FERC has ruled that some companies can no longer charge unregulated, market-based rates for spot market wholesale transactions. Instead, companies identified as having market power and that aren't part of an approved RTO must charge cost-based prices for power that isn't committed in a long-term contract, and publicly disclose those cost-based prices. Columbus, Ohio-based American Electric Power (NYSE: AEP), Atlanta-based Southern Company (NYSE: SO) and New Orleans-based Entergy Corp. (NYSE: ETR) have been singled out as case studies on which FERC will be immediately applying its new standards for wholesale transactions. Note that Mirant Corp., a former subsidiary of Southern Company, has also been identified as having to submit information to FERC in order to gauge its level of market power separate from its former parent. The commission has essentially determined that these three utilities hold an unacceptable level of market power in the areas in which they operate. Under FERC's new market power "test," a generator or marketer is viewed as having too much market power if its electricity is "pivotal" during peak demand, which enables the company to demand a price above competitive levels. Regional transmission constraints will also be considered now as a measurement of a company's market power. This is a dramatic departure from previous standards, by which (under one of FERC's main criterions) a company that supplied less than 20 percent of the power needed in a particular region was freed from rate regulation on the federal level. 

There are some important exceptions to the ruling. First, FERC has not eliminated the utilities' ability to charge market-based rates in areas where the grid and markets are controlled by a FERC-approved RTO. This is significant, as I will expand upon subsequently, because it indicates that there are secondary objectives in FERC's new ruling. In addition, the current ruling only impacts short-term sales transactions in which these three utilities are involved. In other words, long-term contracts that the three companies may have previously established or will establish in the future are not impacted by the ruling. However, the three companies named in the ruling will have to post pricing information related to long-term contracts, and FERC has retained the possibility that further price mitigation for long-term contracts may be necessary. Also note that the Western market, which already is under a price mitigation policy that FERC imposed in June, was not included in the new ruling. 

The three utilities named in the ruling now have 15 days to submit proposals to FERC outlining a transition to charging cost-based wholesale rates for all power not currently committed to a buyer. Specifically, the utilities will have to post on their open-access same-time information systems (OASIS) the incremental cost of producing the uncommitted power during each hour in a 24-hour period. Moving forward, the price that the utilities can charge for non-committed power on the spot market will be the difference between their cost of production and the bid of more expensive power in the region that their power displaces. The new cost-based rates must be administered by an independent third party. 

The new pricing standards revert back to an older, cost-based technique known as "split the savings." The methodology for this standard can get rather complicated, but essentially under FERC's new ruling the three companies identified will have to post their cost-based, incremental costs for spot power into the OASIS system for viewing by potential purchases. Purchasers who want to make a bid will post their decremental energy bid for not producing or buying the power on their own. The final price for the transactions will be the split between the seller's incremental cost and the buyer's decremental bid. For instance, if Southern Company bids its incremental cost at $20/MWh and a purchaser bids its decremental cost at $30/MWh, the transaction price would be $25/MWh. Assuming a midnight-to-midnight trading day, sellers would have to submit their incremental bid by noon on the previous day and buyers would submit their decremental bids by 6 p.m. What this potentially creates is an "information advantage" for buyers who have six hours to evaluate and respond to the incremental bids from some sellers. Some of the drawbacks to this system are that it requires both parties to post price information that may not be readily available and it potentially allows the purchaser to game the system by having access to the seller's original incremental bid and competing around the seller's price. 

Note also that in a separate development FERC simultaneously opened a broad investigation under Section 206 of the Federal Power Act to apply the new market-based-sales policy to all U.S. sellers nationwide. What this means is that, although only three utilities are mentioned in this initial order, it is expected that FERC will continue to take steps to constrain what it believes to be erratic wholesale markets. Reportedly, some 30 companies are awaiting similar reviews by FERC to determine if the commission believes they exert market power. The 206 investigation reportedly also requires power providers with market-based sales authority to amend their tariffs within 60 days to provide FERC with open-ended authority to order refunds if the commission determines that market manipulation has occurred. 

I made a previous reference to the "big stick" that FERC is carrying related to participation in RTOs. Remember that a few months ago, Chairman Wood had threatened to deny utilities that refused to join an RTO the benefits of charging market-based wholesale rates and swift approvals for merger applications, advantages that the chairman equated with the "new world" of the deregulated energy market. With this in mind, note that only Southern Company, Entergy and AEP are included in the present ruling (although it may be subsequently expanded). Southern Company and Entergy in particular have exhibited some resistance in following FERC's consolidation mandate regarding national RTOs, so it is probably not a mere coincidence that these three utilities have been singled out. This must be particularly painful for Southern Company, which gains a good part of its profits from wholesale trading and previously expressed plans to double the size of its generation assets over the next five years. 

Interestingly, Commissioner Linda Key Breathitt represented the single dissenting vote in the ruling. Breathitt's concern was that the ruling had been pulled together too quickly and not enough time had been provided to evaluate the impact on wholesale markets. This issue will undoubtedly be contested, and to a certain extent the utilities impacted by the ruling appear to have been caught off-guard. AEP, Entergy and Southern Company all issued statements to the effect that they were uncertain about the extent to which the ruling would impact them, and that they were reserving the right for possible litigation. 

Moreover, to summarize the commission's rulemaking, I think there are a handful of important points that should be considered. First, the ruling illustrates the steps that FERC is taking to revoke market-price authority that was for the most part unrestricted prior to the time that Pat Wood assumed his post as chairman. Second, FERC is implementing cost-based prices on the spot market only, and in only very defined circumstances. However, this could be an indication that the commission may extend cost-based pricing to other wholesale transactions, including long-term contracts, at a later time. Third, the "split the savings" cost-based formula could become fraught with its own problems. Its requirements are rather complex and it offers the potential to give power purchasers a market advantage on the spot market over power sellers, which will now be required to post incremental costs in the bidding process. Finally, one of the inherent drivers of FERC's new ruling is its desire to have large utilities join the RTOs that the commission has approved. It is very significant that the new ruling immediately impacts AEP, Entergy and Southern Company, utilities that have not only been deemed by the commission to have market power in their regions but which have also not yet joined an approved RTO. However, even though only three companies are immediately impacted by this ruling, it should not be overlooked that the ruling holds impact for the market as a whole as other sellers now will gain important pricing information about the major suppliers in certain areas. Thus, overall this is a very significant ruling and one that could substantially change the manner in which transactions in the wholesale power market are conducted. 


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