At: The Texas Conservative Forum’s 2001 Conference September 27, 2001 • Austin, Texas

1. Texas’ Role in theNational Energy Policya presentation by:Dr. John A. AndersonExecutive DirectorElectricity Consumers Resource Council (ELCON)Washington, DC At: The Texas Conservative Forum’s 2001 Conference September 27, 2001 • Austin, Texas

2. Overview • The Texas role in National Energy Policy primarily should be to set an example for the nation by demonstrating that electricity restructuring actually can – and will – work • Thus, I first identify some “fatal flaws” of restructuring • Primarily gleaned from other states” failed state restructuring efforts • Then, contrast the Texas efforts with those fatal flaws

3. What is ELCON? • The national association for large industrial users of electricity • Founded in 1976 • Members from a wide range of industries from traditional manufacturing to high-tech • We advocate an adequate and reliable electric supply – but at competitive prices

4. 10 Examples of Fatal Flaws • Anti-build – NIMBY attitude • Retail rate freeze – or price caps • Stranded cost recovery mechanisms • Generation divestiture and a lack of vesting contracts • Mandatory power exchanges and auctions • Gaming – Under-scheduling load and over-selling transmission • Provider of last resort (POLR) • Unrealistic transition • No curtailable load market • Independent operation of the grid

5. Flaw #1:Inadequate Generation • In spite of significant demand growth: • California maintained a de facto “no build” policy – believing that conservation could meet all the needs • No new generation, and very little transmission, was built in over 10 years • Siting and permitting requirements are very severe

6. Texas’ Response toFlaw #1 • Texas is far ahead of the nation • Some estimates put Texas’ generation reserve margins exceeding 20% in the 2002-04 time frame • Projects are underway to increase transmission capacity and the Texas PUC has worked to streamline the approval process to speed-up construction of transmission projects

7. Flaw #2:Rate Freezes or Caps • California reduced prices by 10% for residential and small commercial customers – then froze them • No matter the cost of power, there was no change in price • Thus, there was no incentive for customers to reduce consumption as costs rose

8. Texas’ Response toFlaw #2 • Utilities were unbundled into: • Generation, wires, and affiliated retail electric providers (REPs) • Affiliated REPs have to offer: • A “price to beat” for small consumers (< 1 MW) for 5 years at 6% below the current bundled rates • Industrials have no rate protection • It appears that competitive REPs can beat the price to beat: • Some small consumers can thus save even more than the mandated 6%

9. Flaw #3:Stranded Cost Recovery • California’s stranded cost recovery mechanism made it impossible for customers to save by shopping – and also impossible for marketers to profit • The utilities fully expected prices to fall • The CTC was defined as the difference between the fixed retail price and the PX price • Consumers are not dumb • With no way to save, they decided not to shop

10. Texas’ Response toFlaw #3 • Very limited stranded cost recovery has been allowed • Although limited recovery will occur through 2004 • A “true up” will result in a final evaluation of stranded costs • Consumers are slated to receive excess stranded cost recovery • In some cases, these credits completely offset the charges

11. Flaw #4Generation Divestiture • PG&E, SCE, & SDG&E were required to divest up to 50% of their fossil fuel generating plants • In actuality: • They sold all of their fossil generators in “blocks” to out-of-state entities without “vesting” contracts from the new owners • The utilities vulnerable to price shocks because of the price freezes • At present, PG&E and SCE have incurred over $13 billion in purchased power costs that cannot be recovered

12. Texas’ Response toFlaw #4 • Utilities in Texas unbundled into separate companies • The affiliated REPs are allowed, but not mandated, to sign supply contracts • They are expected to buy the cheapest generation, not necessarily from their affiliate • The big difference is that Texas has more than adequate generation

13. Flaw #5:Power Exchanges • PG&E, SCE, and SDG&E were required to: • Buy & sell all their energy at the monopoly PX on the Day-Ahead & Hour-Ahead Spot Markets • They were not allowed to buy forward contracts to hedge against volatile wholesale prices • Instead of creating a competitive market • California created an even larger monopoly

14. Texas’ Response toFlaw #5 • Texas has a capacity auction • However, it is limited to 15% of the former utilities installed capacity • There is no mandatory power exchange • All transactions are bilateral

15. Flaw #6:Gaming Behavior • Two kinds of gaming were observed in California: • Under-scheduling load, and • Overselling transmission • Each resulted in artificially-inflated prices

16. Texas’ Response toFlaw #6 • The Texas PUC has instituted a new market oversight division to monitor market power • Time will tell whether it is adequate, but it clearly is a step in the right direction

17. Flaw #7:Provider of Last Resort • Improperly structured, the California “POLR”: • Suppressed price signals • Consumers saw regulated, rather than market, prices • Discouraged long-term contracts • Consumers used POLR as normal service • Prevented incumbent utilities from being transformed into “wires” companies • This inhibited marketers from obtaining customers

18. Texas’ Response toFlaw #7 • Texas’ POLR service was competitively bid • But there were no bidders • The Commission ultimately required some of the utility affiliates to play this role • But the rates are quite high • Thus, they do not appear to provide a haven • As a specific example, the rates are above $.20/kWh for industrial consumers

19. Flaw #8:Inappropriate Transition • Policy makers must be candid – the transition will not be short • Competition must be established – “deregulation” is inadequate • California tried to move very quickly • And in the process was unable to make the necessary corrections

20. Texas’ Response toFlaw #8 • Texas enacted legislation in 1999 • However, the pilot was not planned to begin until June 1, 2000 • It was delayed until July 31, 2001 to allow time to fix some bugs • The market for ERCOT is still planned to open on January 1, 2002

21. Flaw #9:Lack of Demand Response • California reduced rates to residential and small business consumers – and froze them at that level for the transition period • This eliminated customer responses • “Curtailable Load Response” markets must be established that are: • Voluntary • Exempt from any price caps • Nondiscriminatory in size • Open to negotiate price and terms and conditions of service

22. Texas’ Response toFlaw #9 • ERCOT and the PUC are still working on curtailable load response (demand response) markets • At this time, loads cannot bid into the market • Such markets may be created, but they are not yet in place • Loads can set the market price for some ancillary services that are above the $1,000 bid cap that has been imposed on generators

23. Flaw #10:Independent Grid Operation • The operation of the transmission grid • Must be under the control of an independent entity to assure fair and nondiscriminatory operations • California’s “Independent System Operator” was far from independent • FERC tried to force independence, but has not yet been successful

24. Texas’ Response toFlaw #10 • The statute contains an independence requirement for the grid operator • However, there is some concern • Competitive retailers have filed a petition at the PUC to try to get more Commission oversight over the ISO and ERCOT • It is quite clear that the need for independence is understood and is being addressed

25. Observations • Negative experiences in CA, and in other states, demonstrate clearly a failure ofregulation – NOT of competition • All too often, states deregulated monopolies • They did not create competition • The failure of regulation certainly has slowed the movement to restructuring: • This may be good • It is far better for consumers to have no restructuring – than have bad restructuring

26. Observations (Cont.) • The primary lesson learned is adequate capacity – in both generation and transmission – is a necessary, but not sufficient, condition for competition • However, this is a lesson true in both regulation and in competition • Texas certainly appears to have adequate capacity • This is a key to success

27. Conclusions • The best role Texas can play in the National Energy Policy may well be to demonstrate to the nation that electric restructuring actually will work • Texas obviously has learned from the earlier failures – and appears to be on the right track • A Texas success would be a tremendous contribution to the nation