Monitoring electricity markets What can we learn from the economics of regulation?

1. Monitoring electricity marketsWhat can we learn from the economics of regulation? Robert J. Michaels California State University, Fullerton rmichaels@fullerton.edu Rutgers University Center for Research in Regulated Industries Annual Western Conference San Diego, California June 25, 2003

2. Market Monitors and Regulation • Power markets -- novel institutions and naïve expectations • Efficiency, cynicism and reality in the economics of regulation • California was just “reregulating” • Market monitors: which story fits California? • Virtual bidding in three ISOs: a natural experiment • Whence the collective amnesia of economists?

3. Electricity’s new institutions • Old federal and state regulation continues • Bilateral contracts, energy markets, and ISOs • Market Monitoring Institutions [MMI] • Observe and report to FERC on ISO energy markets • Internal employees or appointed outsiders • To observe market power and functioning of rules • Vague responsibilities: “anomalies” and “gaming” • Unclear investigative powers, abilities to levy sanctions • Order 2000 and SMD – FERC dodges the issues

4. No analogues of MMIs • Not a regulatory body, never contemplated in legislation • Stock Exchanges as Self-Regulatory Organizations • In federal law • Made up of market participants (NASD) • Electrical MMIs must have no market interests • Have powers re new contracts, arbitration, suspension of traders, circuit breakers • Electrical MMIs have ambiguous powers • Due process for SRO prosecutions

5. Economists and regulation I • Regulators inhospitable to economic recommendations re efficiency • But some headway in electricity – tariff designs, peak pricing, rates of return • Regulatory history – producer protection and franchises • Early studies: ineffectiveness, producer protection, cross-subsidies • “Capture” and more general models

6. Economists and regulation II • Later studies: politics and economics v. “public interest” • Mostly reject public interest where tested • FTC, antitrust, etc. and politics • The paradox: When MMIs arrived in electricity, economists played dead • Accepted feasibility of monitoring • Viewed it as a useful supplement to regulation • Despite past research and restructuring politics, no economist on any side has questioned MMMIs • No examination of their origins and performance

7. California’s Origins I • State restructuring under AB 1890 • Utilities must collect stranded cost in residual between market energy prices and frozen retail rates within deadline • Required to purchase all requirements day-ahead (PX) and real-time (ISO) • Political and economic rationales for separating PX and ISO • Required divestitures of major utility assets

8. California’s origins II • PX and ISO are in FERC jurisdiction • Can only have market-based rates if concentration in relevant markets low • Utilities’ studies all show concentration screens violated at times • Utilities propose mitigation • Further generation divestitures • “Must-run” contracts • Market monitoring • No other interested party proposes MMIs or questions why utilities have suggested them

9. California’s Origins III • 1995- 1997: Utilities dominate PX/ISO design “collaborative” • Only parties allowed to vote • All particulars of MMIs only formulated after FERC irreversibly approves concept • Result: four MMIs with vague responsibilities • PX and ISO get internal and external MMIs • To examine “anomalies” and “gaming,” evaluate protocols and report to FERC • Anomalies: things that should not happen in competitive markets – but no specification of what should • Gaming: taking unfair advantage of rules • Will have data-gathering and investigative powers • But are not to evaluate operation of the ISO

11. California’s monitors I • Begin operation with markets opening (4/1/98), soon face ancillary service thinness and must-run problems • Assertions re generators, reformation of must-runs, buyers’ market power no concern • Nearly 90% of PX sales to 3 utilities • “Hockey stick” supply means utilities can lower total cost by demand shifts • In [rare] discussions, MMIs excuse utilities’ conduct as “defensive” • PX MMI shows utilities how to lower price further • 2003: FERC says utilities exercised market power, says refunds not required since no profit resulted

12. California’s monitors II • Reconciling competitive west-wide markets with market power in Calif. • Beyond market analysis to calculating utility stranded cost recovery shortfalls • Market monitors calculate refunds, testify on behalf of state in other FERC refund proceedings • No objection by monitors to active presence of CDWR representatives in ISO trading area • FERC finally orders them out after petition from generators

13. Virtual bidding • Arbitrage by bidding demand or supply into DAM and selling or buying it back in RTM • Promotes efficiency and liquidity • Helps ISO manage buyer load shifts to RTM • In California, undoes misstated schedules • The comparison: RTOs and MMIs with differently-situated utilities will have differing policies re virtual bids

14. Case 1: PJM • Pennsylvania utilities previously reached settlements ensuring stranding recovery • Other PJM states allow cost pass-through • Most PJM transactions are bilateral or self-generation, retail competition is a real threat to Penna. Utilities • Result: PJM opens virtual bidding without problems on same day DAM and RTM open • MMI views virtual bids as integral to success of regional markets

15. Case II: New York • Utilities have unsettled strandings, but no deadlines like Calif., retain generation and contract bilaterally, with small retail threat • Two-year delay in introducing virtual bids • During interim, utilities can shift but others can’t • NYISO MMI believes physicals suffice for arbitrage and virtual bids can destabilize • Result: convergence between DAM and RTM prices, and between transmission-constrained areas • MMI says that volume is sufficient to undo moderate market power exercise by buyers

16. Case III: California • California utilities faced short stranding deadline, restricted to DAM and RTM for all power, retail rate freeze • MMIs reject virtual bid concept, view as generator market power • Some Enron transactions are virtual bids • But today: utilities rescued, bilaterals feasible, retail competition in doubt • New ISO DAM/RTM proposal includes virtual bids, now supported by monitors on efficiency grounds

17. Rethinking monitoring • Politics is trumping economics, like we said • No MMI has ever produced a minority report • But economic experts in dockets have differing views and interpretations • Are MMIs unrepresentative? Or crafting compromise opinions of less value to FERC • Smarter experts not the answer, stakeholder experts may be • Now a motive to explain differences of opinion • FERC’s majority and dissenting members can both put their differences on the record • Market monitoring – too important to be left to the market