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E-Notes provides regular briefings on new developments in global energy and
public utility law.

May 18, 2001

ANCILLARY SERVICES - THE NEXT FRONTIER

 Since the issuance of Order Nos. 888-889 by the Federal Energy
Regulatory Commission ("Commission") in 1996, market recognition of the
value of ancillary services provided in this regulatory initiative, has
increased dramatically.  Shortly thereafter, the FERC recognized that
market-based rates could also be provided for certain of these ancillary
services, which include voltage regulation, spinning reserves, non-spinning
reserves and reactive power that were critical elements of historically
bundled service.  This regulatory recognition was intended to serve as a
stimulus for market penetration and development of ancillary services in a
competitive marketplace.  With the formation of independent system operators
(ISOs) and the consideration of movement to regional transmission
organizations (RTOs), ancillary services have received increased discussion
and attention.  Frequently, markets do not have yet sufficient market makers
to create adequate transparencies in a robust competitive market for certain
services.  For example, because of market deficiencies in California and New
York, ancillary services have come under increased scrutiny.

 This short history and limited development of ancillary services is
about to change with the advent of material consideration of RTOs.  It can
be expected that a revamped Bush-era FERC will finalize most RTO proposals
this summer undertaken by former Chairman James Hoecker and his colleagues
on the Commission.  That process should conclude by the end of 2001 with
increased enforcement and market monitoring, new mechanisms to resolve
disputes, increased resolution of seams management concerns, new
transmission pricing and return policies, and major market validation of
for-profit transcos as the underlying vehicle for regional growth and
development of transmission in the future.

Key Considerations

 This market growth and recognition will not come too quickly given
the continual demise of transmission investment and development by the
regulated utility industry.  Over the past 25 years the utility industry has
whittled away its transmission legacy, with little real growth and
development of the national transmission system to support the advent and
movement to competitive markets which has accelerated since 1988.  Ancillary
services will become a critical element of that market as they become the
future call-waiting, *69, and call-forward services of the electric utility
industry - borrowing from the telephone industry parallels and paradigm from
the prior decade of experience.  Formation of RTOs will provide stronger
market validation and recognition of ancillary services.  This will
necessitate the development of separate pricing, new forms of contracting,
new revised pricing methodologies for those ancillary services through
separate contracts, and pricing opportunities through formal agreements.  In
many instances, agreements still need to be developed for ancillary service
sales or need to be materially enhanced in existing service agreements with
the electric utility.  Several areas require current consideration at this
time to ensure a smooth and effective transition:

* Interconnection agreements should fully anticipate the separate
provision of ancillary services in their technical review of a generating
facility and requirements for that facility with the electric utility.
* The interface of utility systems with control areas and RTO's need
further understanding and management for risks, liabilities and cost
consequences.
* Recognition for adequate compensation and market-based pricing for
ancillary services should be provided with the opportunity to supplement
that pricing with amended and restated schedules in relevant agreements.
* Transition of existing transmission and interconnection agreements
to the RTOs should be contemplated in current agreements.  Assignment of
those agreements should only be permitted with appropriate notice and review
rights by the generator, and the opportunity to accept, amend or reject the
terms of that assignment or transfer depending on whether it provides for
enhanced sale and market development opportunities for the market value of
ancillary services.
* There are other ancillary services yet to unfold that have not been
recognized by Order Nos. 888-889 and they should be analyzed and evaluated.
Any specificity that can be undertaken to capture recognition of those
future services, including development and pricing opportunities for those
services, should be separately retained in existing agreements now.
Otherwise, the spectre exists that those services may ultimately be provided
to the regulated utility at no charge.
Future Course of Action
Why has this occurred?  Individual utilities managing the needs of their
systems - with the public utility obligation to serve and paramount
reliability responsibilities were not willing to separately recognize the
value of ancillary services.  Bundled service also disguised this value and
did not provide an adequate and accurate platform for such recognition.
Utility divestitures of generation resources started the ball running.
Moreover, utilities operating in a monopoly, cost-of-service regime did not
have the incentive or ability to seek out new revenue streams through
creative unbundling and repackaging of ancillary services.  With the
evolution to RTOs and broader scope and markets, a shift will be undertaken
in the provision of ancillary services, such as security, emergency
planning, risk management, and reliability from discrete utility systems to
all potential players in the competitive market, including generators,
regulated utilities, transmitting utilities, power marketers and traders and
large scale industrial and commercial users.  This restructuring of the
market also provides an enhanced opportunity to assess the delivery of
critical ancillary services, their recognition as a matter of contract, and
the appropriate elements of market-based rates and cost of service analysis
(as applicable) and new methodologies justifying pricing for these new,
essential products.

 Enlightened generators and developers will be thoughtfully analyzing
this issue at this time with the goal of protecting their interests in
anticipation of the evolution of these ancillary services as part of
competitive markets, which will allow them to capture contracting and
pricing opportunities for the benefit of their owners or shareholders.

Michael J. Zimmer
John A. Cohen
____________________________________________________________________________
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