We introduce competition to the California electricity market with the conviction that it will deliver desirable market characteristics that have not been delivered by the regulated market regime of the past. But because competition is the foundation of this restructuring, we must be concerned that market power could undermine this foundation and negate the benefits of competition. This concern has served as a screening device in our review of policy options and the choices reflected in today's decision. This concern also compels us to take additional steps to ensure that market power does not impede development of a competitive electricity market in California. (Fn. 1)
Market power is the ability of a particular seller or group of sellers to maintain prices profitably above competitive levels for a significant period of time. (Fn. 2) The higher prices reduce economic efficiency because they do not reflect an accurate societal valuation of resources given actual resource supplies. An equally important concern is that high prices stemming from market power abuse cause an inefficient transfer of wealth from the consumer to the producer.
Market power in itself is not necessarily costly. It is the abuse of market power that reduces the societal efficiencies of competition. Practically speaking, however, the mere existence of market power can undermine our goals for electric restructuring and should be avoided. The presence of market power carries with it the threat of market power abuse. This threat can stifle entrepreneurial innovation and diversity of customer choice, and requires continued monitoring for market power abuse. For this reason, our restructuring mechanisms and mitigation programs are designed to eliminate or reduce market power to the greatest practicable extent.
A competitive market mitigates market power abuse by means of contestability. Contestability is the threat that other competitors and new industry entrants will steal market share from any competitor attempting to abuse market power by raising prices. In this instance, if market entry is timely, likely, and sufficient, higher profit margins from the price increase are more than offset by loss of sales volume or market share. Ensuring contestability, therefore, is a direct approach to employing natural market safeguards to protect against market power abuse. The primary means of ensuring contestability are to eliminate any undue competitive advantages to existing competitors and eliminate barriers to entry of prospective competitors.
Our restructuring program involves a transition from cost-of-service regulation to a fully competitive market for generation. In the early stages of this transition, the utilities might retain market power, and a continued regulatory presence might cause market distortions. If our transition is successful, distortions will be minimized and market power abuses will be thwarted until the threat of timely, likely, and sufficient entry is firmly established to ensure a workably competitive electric market.
A. Potential for Market Power in California's Future Electric Industry
1.Vertical Market Power
Vertical market power can arise from ownership or control of more than a single step in the process of production and delivery of a particular product. Control of vertically integrated assets results in barriers to entry if an entity at one stage of the production and delivery process gives preferential treatment to an affiliated entity operating at another stage of the production and delivery process.
In the electric industry, vertical market power generally refers to a single utility controlling generation, transmission, and distribution functions in a specific geographic market. Vertical market power abuse could arise, for example, if system operators gave priority to affiliated generation assets in dispatch and transmission. For purposes of market power analysis, the transmission function is a key link in the chain of production. To a certain extent, the potential for transmission-level market power depends on the success of the FERC's development and implementation of comparable and nondiscriminatory open access tariffs.
Mitigation: Our restructuring program incorporates two features that are crucial for effective mitigation of vertical market power. First, it isolates control of transmission in the ISO. Second, it establishes an independent dispatch ordering mechanism. For independent and transparent dispatch ordering, we create the Power Exchange, which develops purely price-based dispatch rankings. We also allow for development of direct access contracts markets and other markets. Provision for an ISO and independent dispatch results in an operational unbundling, in which vertically integrated electric processes are separated and operational control is spread among entities that are independent of the owners of assets in other levels of the chain of production.
The issue of jurisdiction with respect to the regulation of California's investor-owned utilities in a restructured environment has been discussed in our hearings and in this order. As we indicated, we find the institution of the vertically integrated utility seeking to be self-sufficient with respect to generation, transmission and distribution to be rooted in the past and incompatible with emerging markets and opportunities. It is our desire to see California's investor- owned utilities evolve and prosper in those arenas in which they will compete for markets as well and in those areas in which they will retain the functions and responsibilities of a natural monopoly. In our view, generation is an activity remitted to a competitive market in which utility and nonutility entrants and participants will vie for customer allegiance. Transmission retains the attributes of a natural monopoly and will be consolidated, from an operational perspective, in the Independent System Operator. We view distribution as a natural monopoly with respect to serving those customers who do not opt for self-generation or construct transmission and distribution facilities to serve their consumption.
The issue we now confront is whether our jurisdictional utilities ought to adopt a corporate structure which reflects these distinctions. We direct PG&E, SCE and SDG&E to submit written comments on the feasibility, timing and consequences of a corporate restructuring which would be premised on distinguishing their activities and assets with respect to generation, transmission and distribution. Without seeking to limit the form in which such a restructuring might take, we ask them to address a holding company with three wholly owned subsidiaries.
Based on our experience in dealing with transactions between different competitively provided and monopoly services in other industries, separation of transmission, distribution, and generation assets and operations into affiliates would reduce regulatory oversight needed to protect against self-dealing and allow for easier monitoring of any discriminatory preferences to affiliates. Separation would also help facilitate a bright line between state and federal jurisdiction with respect to transmission and distribution. That separation may, however, impose costs. Those costs may include changes in bondholders' credit positions, possible interest rate changes, and changes in tender offer cost or premiums. We want to consider those costs in reviewing utilities' comments.
These comments would be due 90 days after the effective date of this decision. We will await the initial comments of the utilities to gauge the obstacles or disadvantages of increased separation, and weigh them against the potential benefits.
a. System Planning and Upgrades Under the ISO
If a transmission-owning utility were to build new transmission facilities, the new facilities might, by eliminating existing transmission constraints, create a new opportunity for competition from nonutility-owned generation. The additional competition might reduce the opportunities for the transmission-owning utility to profit from generation it also owns.
Even if the ISO controls the operation of the transmission system, if ownership of the transmission system remains with the vertically integrated transmission-owning utility, that utility might be reluctant to build needed new transmission which would allow additional competition with its own generation.
Planning decisions for new transmission facilities and upgrades are necessarily somewhat subjective and are subject to constant updating and second-guessing. If the vertically integrated transmission-owning utility has control or influence over the planning of new transmission or upgrades, the utility might create additions that favor its own generation or harm competitors.
Mitigation: If the ISO could collect costs above the embedded or marginal cost of construction of new transmission facilities, and could use that income to build and own the new transmission facility, it might be possible to build and upgrade economically justified transmission.
b. ISO Balancing Services
A critical question is whether the ISO, in performing its load-balancing functions, will be able to procure services on a competitive basis from any source or whether it will be required to procure generation services only from generators bidding into the Power Exchange. Load balancing is an ancillary service and FERC will set rates for that service. We intend to participate in the applications before FERC to establish the ISO to ensure that load balancing can, as currently contemplated by FERC, be self-provided, provided by a third party, or provided by the ISO at competitively procured rates, and that the protocols for provision of load following are nondiscriminatory.
c. Utility Ownership of Natural Gas
SDG&E and PG&E have a further potential to exercise vertical market power because they are dual utilities, having interests both in the generation of electricity and in segments of the natural gas market. Natural gas fuels the most efficient and accessible generation technologies available to existing industry participants and prospective industry entrants. Discrimination in the price and availability of delivered natural gas could create a significant barrier to entry to industry contestants who depend on reasonable and fair gas prices and availability to compete.
Mitigation: In general, existing conditions in the market for natural gas make it unlikely that dual utilities could effectively engage in vertical market power abuse. We will monitor this in conjunction with our regulatory responsibilities for gas services, and respond if the circumstances change.
d. Utility Energy Procurement and Ownership of Generation Facilities
After restructuring, the distribution utility will still perform an energy procurement function for customers who so choose. The distribution utility and its affiliate generators might share an interest in dealing with each other to the exclusion of other industry contestants.
Mitigation: Until the market structure is fully implemented, all the CTC has been collected and all customers are eligible for direct access, a distribution utility affiliated with a generation company will be prohibited from entering contracts with an affiliated generator. (Fn. 3)
2. Horizontal Market Power
Market power can take place at any level of the production chain if there are significant barriers to entry or few market participants. This kind of market power is usually referred to as horizontal market power and can be manifested as an ability either to influence prices or to create or maintain effective barriers to entry.
The most common example of horizontal market power is when a single competitor or a small group of competitors owns or controls most of the competitive resources at a particular level of production. Horizontal market power abuse can take several different forms that concern us in evaluating the future competitive market. Our focus is on the generation sector.
a. Market Concentration Analysis
An analysis of horizontal market power begins with an assessment of market concentration. By market concentration we mean how much market participation is dominated by a small group of firms. Without a sufficient level of market concentration, it is unlikely that potential and existing competitive advantages or market abuses will harm the overall market enough to warrant potentially distorting interventions by us or other government agencies. Many parties have a reasonable suspicion that there is excessive market concentration in electric generation. (Fn. 4) While this suspicion alone justifies the discussion of potential market power abuses and mitigation options in this decision, we recognize the need for a rigorous empirical market concentration analysis to establish strong conclusions and to verify or disprove this suspicion.
b. Concentration of Generating Facility
Ownership or Control
Concentrations of ownership or control of generation facilities can result in market power because a single competitor might control enough assets to alter the supply-demand equilibrium and thus be able to increase prices by withholding generation from the market (decreasing supply). Another manifestation could take place if a single competitor controls an asset or specific block of assets that is indispensable for meeting demand. Many parties, including the FTC and Paul Joskow, note the importance of the "mid-merit order" generating units which are likely to be the units providing the final increment in the supply portfolio. The concentration of ownership of this group of assets might be more important than overall generation concentration. In both cases the powerful entity may control the final increment in the market-clearing supply portfolio and thus control the marginal price for generation.
In addition to mid-merit order generating units, some units may be located relative to the transmission system such that they have an inherent potential for abuse of market power. Some areas, which may be identified and defined by the transmission system once the restructured market is in place, may not be susceptible to immediate entry of lower priced competitors. Entry of competing generation in the near term may not be an option because of the need to upgrade transmission or build new generation in that area. We are concerned the mere divestiture of such units to entities other than investor-owned utilities will not decrease the potential market power or exercises of that power that lead to excessive prices.
Mitigation: We are severely limiting utilities' ability to obtain operating costs through the transition cost balancing account for their nonnuclear units. The only operating costs eligible for that account must be demonstrably necessary for reactive power/voltage control. Further, that recovery is limited in time: as soon as market based rates for reactive power/voltage control are established, or the unit is market valued (no later than 2003), that recovery ceases. Utilities may request that operating costs related to reactive power/voltage control be established under a PBR mechanism, which would be designed to further mitigate market power of the units primarily used for reactive power/voltage control. Without these limitations, discussed in Section V, some of the utilities' nonnuclear units would benefit from their location, and could be used as strategic assets to manipulate Exchange prices in certain transmission-constrained areas.
Concerns about the concentrated ownership of generation units by the utilities and the potential for anticompetitive effects resulting from that concentration are particularly acute in the early stages of the restructured industry. The issue of concentration must be addressed early and effectively or the competitive market we envision will not get off the ground. We conclude that market power problems almost certainly will require the existing investor-owned utilities to divest themselves of a substantial portion of their generating assets, particularly their fossil generating plants located within their service territory. Therefore, we will require PG&E and SCE to file within 90 days of the effective date of this order a plan to voluntarily divest themselves through a spinoff or outright sale to a nonaffiliated entity of at least 50% of their fossil generating assets. Ideally this divestiture would resolve many, if not most, of the market power problems identified by the Department of Justice and FERC, and allow for a competitive market.
To provide an incentive for the utilities to voluntarily divest these assets, we will tie the utility's allowed rate of return on the equity component of the non-nuclear and non-hydroelectric equity component of its transition cost CTC balancing accounts. We will grant an increase in the rate of return for the equity component of up to 10 basis points for each 10% of fossil generating capacity divested.
Utilities will file applications for the voluntary divestiture of fossil generating assets under 851. In those proceedings, we will review the potential that asset has for exercising locational market power, and will address mitigation strategies intended to relieve or eliminate the exercise of such power.
Additionally, we retain the ability to assess market power concerns should utilities seek authorization for acquisition of new generation or generation rights.
Cross-subsidization takes place when a competitor is able to subsidize competitive operations with revenues from another part of its business or chooses to shift funds from one part of its business to another in order to gain a competitive advantage. In an environment where utilities participate in both the regulated and unregulated sides of an industry, a utility might attempt to use funds from its stable and profitable regulated business to gain an advantage in its unregulated businesses through cross-subsidies.
Specifically, utilities can exploit their regulated markets to obtain leverage in the competitive markets in two ways: they can shift revenues properly attributable to their regulated services to their competitive services, or they can shift costs properly attributable to their competitive services to their regulated services. In both cases, such improper shifting effectively subsidizes the utilities' unregulated services with monopoly profits from its regulated services to the detriment of both monopoly ratepayers and competitors.
Mitigation: Again, limiting CTC recovery of operating expenses is one effective means of preventing cross-subsidization. Additionally and as discussed above, we want to consider the feasibility of separating the transmission, distribution, and generation functions into separate wholly owned subsidiaries, which would allow easier detection of cross-subsidies.
d. Design of PBR/Transition
Parties to our proceedings have devoted considerable attention to problems associated with ongoing transition cost determination based on a market price, in conjunction with PBR treatment for utility assets. Several problems were identified in the transition cost hearings last December. The problems involve the potential that utilities might use transition costs to subsidize operation of plants that are not competitive in the Exchange. This problem concerns us because the subsidization of inefficient generation assets results in a barrier to entry for more competitive industry contestants. (Fn. 6)
This problem arises because regulatory revenue requirements are based on an average of the operating costs of individual generating units. At any particular moment in utility operations, this averaging means that efficient generating units are subsidizing the operating costs of inefficient generating units. Although this was a prudent regulatory practice in the past, in our transition to competition it conflicts with our intent to ensure optimal market outcomes in the future, return the full value of efficient generating assets to consumers, and ensure market contestability.
Although averaging operating costs of production facilities might occasionally be necessary due to lumpy production increments or other factors, competitors are generally inclined to avoid this practice because of the increased costs they absorb. (Fn. 7) Generally, this disincentive ensures efficient societal outcomes in competitive markets. But ongoing transition cost determination, in conjunction with PBR, has the potential of creating incentives for a utility to subsidize the operating costs of assets that are not cost-competitive in the Exchange if the CTC included those costs.
Mitigation: Our proposal severely limits subsidization of any costs other than the undepreciated, book value (rate base) of nonnuclear, nonhydroelectric generating units. The potential to recover any operating costs at all will be constrained to particular units and particular times when reactive power/voltage support is not yet procurable at market-based rates in locations where it is needed. We need to safeguard the stability of the transmission system to the extent Exchange prices are sufficiently low that a generator critical for reactive power/voltage support could not recover sufficient costs from the Exchange to run.
Further mitigation of this problem might be addressed in design of the PBR mechanisms which utilities may seek to have applied to such units and those limited operating costs.
e. Manipulated Market
Critics of the May pool proposal to create a single mandatory spot market for energy cite, among other things, the ease with which powerful market participants could manipulate prices in such a market. As discussed above, parties have also raised general concerns that the utilities might be able to manipulate prices in the Power Exchange through control of vertically integrated assets, horizontal market concentration, and strategic assets. Parties feared that the potential for these problems might be magnified by a mandatory spot market.
Mitigation: Our proposal mitigates problems of market manipulation by provision of an independent system operator, for fair, nondiscriminatory provision of transmission to all suppliers. Furthermore, through contracts for differences and direct access contracts, customers will have opportunities to curb the impact of price fluctuations of the Exchange or avoid them entirely.
f. Thin Markets
Parties commenting on previous proposals to create such a market also raised concerns that we refer to as thin market concerns. A thin market is a market that is not sufficiently broad to provide a price that reflects the true societal value of the relevant product in the relevant geographic market. NYMEX, ENRON, the Attorney General of California, the Energy Producers and Users Coalition (EPUC), and others have expressed doubts that the Power Exchange price would accurately reflect the true market value, and thus would promote anticompetitive activities.
Parties have identified an instance in which a thin market might be a problem in the single mandatory spot market scenario. This instance is related to proposals to require the spot market to take the output of certain generation resources, regardless of their cost-competitiveness, to meet contractual obligations or policy goals. (Fn. 8) In this case there is a possibility that the quantities of market competitors' generation will be sufficiently small relative to the must-take resources that market-clearing prices will fail to reflect actual societal resource values.
g. Predatory Pricing
Predatory pricing is an illegal pricing strategy that a firm undertakes to drive current competitors out of the market and to prevent new entrants by selling a product below cost. (Fn. 9) It is a short-term strategy firms undertake to meet their long-term goal of sustaining market power. Firms that already have market power have also used the threat of predatory pricing as a strong barrier to entry. Certain circumstances are necessary for a firm to engage in or threaten predatory pricing. In particular, a firm must have the ability to withstand the short-term losses and to absorb the increased demand stimulated by the low predatory price. Furthermore, the firm must be able to profit from the venture by eventually earning sustainable monopoly profits. This generally requires that the market have strong barriers to entry, such as prohibitively high initial capital or other investment costs. Several parties, including EPUC, have expressed concern that the utilities might be able to use predatory pricing or the threat of it to increase or maintain their market power.
We will be alert to specious allegations of predatory pricing made by unhappy rival firms to protect their own competitive interests. In many healthy competitive markets firms will temporarily price below average total cost for good reasons and with insignificant harm to the industry. These instances include low-priced introductory offers, expiring inventory sales, sales from firms exiting the industry, and incremental sales needed to reach minimum efficient scale. The duration of these activities, the concentration of the market, the competitive importance of the firm, and the reason for the pricing must be considered before we or other governmental industries should contemplate intervening in the market.
Mitigation: By the creation of an ISO, the strict limitations on recovery of operating costs for nonnuclear, nonhydroelectric units through the CTC, and our further consideration of utilities' applications or comments on divesting up to 50% of their fossil generation and separation into three subsidiaries, we are satisfied that we are taking adequate steps to curb this form of market power abuse. Additionally, we retain our ability to react to particular instances of market power abuse through our complaint procedures, monitoring of the market structure we establish, and reforms that may become necessary as the market evolves.
As a monopoly provider of integrated generation, transmission, and distribution services, the incumbent utility has access to considerable information about its customers, including individual load profiles and billing histories. In a competitive arena, access to such information is quite valuable for marketing purposes. Because this information is not automatically available to the utility's competitors, the incumbent utility has a major marketing advantage that could allow it to target and sign up preferred customers before its competitors can. The Framework Parties voice significant concern about this possibility.
Mitigation: We will require that customer specific information necessary for the distribution (accounting and billing) functions of the utility be made available on terms that are fair to all competitors in the generation sector. Because customer confidentiality concerns attach to this information, customer consent will be a prerequisite for all suppliers that obtain access. Separation of a separate distribution subsidiary would assist our efforts to make customer information available on equal terms and conditions; however, it is not essential. The implementation of this policy should be addressed by the Working Group.
Access to information about transmission will be largely resolved through the protocols of the ISO and FERC's efforts to establish transmission information networks (call the RIN NOPR). All market participants will have the same access to information about the transmission system.
1. For the most part we are concerned with potential market power on the part of incumbent investor-owned utilities. We have also considered market power as it applies to other future industry participants.
2. cf. Department of Justice (DOJ)/Federal Trade Commission (FTC) Horizontal Merger Guidelines.
3. A generator may indirectly provide power to an affiliated distribution company if it is a winning bidder in the Power Exchange. The neutral mediation of the Power Exchange removes market power concerns.
4. Framework Parties, DRA, Enron Capital and Trade Resources, Inc. (ENRON), and many others have mentioned the problem of generation concentration. Also, as mentioned in the May pool proposal, we recognize problems attributed to the concentration of generation in the United Kingdom pool.
5. By referring to fossil units, we specifically exclude other sources of nonnuclear and nonhyrdoelectric generation like Helms and geothermal units. SDG&E's so-called steam units would be considered fossil units, should we subsequently find that mitigation is necessary in its service territory as well.
6. We are also concerned with the loss of societal efficiencies associated with such an outcome.
7. An exception might be predatory pricing. See later discussion on this topic.
8. Resources that might be provided this treatment are QF contracts, nuclear generating facilities operating under settlement provisions, and long-term import energy contracts.
9. The practice is illegal under the Clayton Act of 1914.