By Robert F. Shapiro

The Federal Energy Regulatory Commission issued two orders at the end of November that mark a significant change in its tests for approving market-based rates for public utilities.

With a few exceptions, all public utilities in the lower 48 states must have their wholesale power rates on file and accepted at FERC. “Public utilities” include not only vertically-integrated investor-owned utilities, but also power marketers and independent power producers. The exceptions are municipal or other state or federal systems, utilities in ERCOT in Texas and certain electric cooperatives.

In recent years, FERC has been permitting these utilities to file to make wholesale sales under a market-based rate tariff instead of a traditional cost-of-service tariff if they could demonstrate an absence of market power in generation and transmission. Under a market-based rate tariff, the seller can sell at any rate that it can negotiate with any wholesale power purchaser, that is, whatever the market will bear.

In the November orders, FERC jettisoned a “hub and spoke” test that it has used until now for determining whether the applicant has too much market power to be allowed to sell at market rates. The commission introduced in its place an interim, supply margin assessment or “SMA,” test. The commission also sought comments on a proposal to modify all existing market-based rate tariffs and to include in new tariffs a requirement that each utility agree to give refunds if it exercises anticompetitive behavior. Finally, it imposed a refund condition on all existing market-based rate tariffs beginning on January 28, 2002. This is clearly not your grandfather’s Republican administration.

The scope of the decisions took the power industry by surprise.

The declared rationale for these actions was the concern that the dysfunctional California power sector was subject to potential market manipulation and that other markets could face similar problems. However, FERC itself never completed an investigation of market manipulation by power sellers in any other market in the country. Moreover, the new, interim market test was announced in the context of a triennial rate review of the market-based rates of three power marketers who, not coincidentally, happened to be affiliates of the three of the largest vertically-integrated public utility holding companies controlling vast transmission assets.

The FERC chairman made no effort to conceal the fact that the commission’s actions, which applied the new market test to the detriment of each of the three applicants, were designed to prod these entities to join large regional transmission organizations, or “RTOs.”

Interestingly, the commission did not invite interested persons to comment on its new market test, the SMA, which it announced in the order that conducted the triennial review of the three applicants. Rather, it issued a companion order that sought comments only on the modification of existing tariffs and the inclusion in all new tariffs of the requirement for refunds in the event the power marketer engages in anticompetitive behavior. Parties who were not involved in the triennial rate review proceeding will probably file for late intervention in that proceeding and submit requests for rehearing on the new market test.

SMA – The New Market Test

Under the old hub-and-spoke analysis, the commission usually approved market-based rate tariffs if the applicant could show that it had less than a 20% share of installed and uncommitted generation in the relevant market, and either owned no transmission or had an open-access transmission tariff — called an “OATT” — on file. Under this new SMA test, the commission intends to determine “whether an applicant is pivotal in the market,” and the applicant will be deemed pivotal, and thus denied market-based rate approval, “if its capacity exceeds the market’s surplus of capacity above peak demand — that is, the market’s supply margin.” The commission will also consider transmission constraints in the relevant market.

The SMA test appears to boil down essentially to this — if the capacity that the applicant controls in the relevant market exceeds the reserve margin in that market, then the applicant cannot sell at market-based rates but must use a form of cost-based rates. So, for example, if the reserve margin in a region is 20% and the applicant’s capacity in that region exceeds 20% of the total available capacity, the applicant will not pass the screen. However, the SMA screen will not apply to any applicant that makes its sales in a market that utilizes an independent system operator or an RTO with a FERC-approved market monitoring and mitigation plan. Thus, this new interim approach to market analysis is clearly intended to serve as an incentive for big utilities to join RTOs, since only big utilities with a large capacity portfolio are likely to violate the new test.

The three utilities evaluated by FERC — affiliates of American Electric Power, Entergy and the Southern Company — were each found to have a capacity portfolio in the regions in which they have franchised service territories — their “control areas” — that exceeded the region’s reserve margin by between one and one-half times and four times. Accordingly, they each flunked the market screen.

For the uncommitted capacity, each applicant was required to use a “split the savings” approach — a method traditionally used by investor-owned facilities when making spot or economy energy sales to each other. Under a “split the savings” approach, the rate is the average of the seller’s incremental operating costs and the buyer’s decremental operating costs. For example, if the seller’s incremental cost is $30 a mWh and the buyer’s decremental cost is $50 a mWh, the split-the savings-rate is $40 a mWh.

It remains to be seen whether this cost-based approach will cause heartburn for the investor-owned utilities that fail to satisfy the new test. However, there is little doubt that it will produce major ulcers for power marketers, who have traditionally refused to disclose their fuel and other operating costs to anyone for competitive reasons.

The commission went on to find that the uncommitted capacity that each of the three applicants owned and sold outside its control area satisfied the SMA screen and thus the applicants can continue to sell such power at market-based rates.

The three applicants have until early January to file revised tariffs that include the new rate mitigation plan. Further, Mirant, which was formerly an affiliate of the Southern Company but is now wholly independent, was directed to submit a standalone SMA analysis.

One of the FERC commissioners wrote a dissent to the decision in which she argued that the move to the SMA was premature since it was adopted without any industry input and the commission has already initiated a rule-making into the continued viability of the “hub and spoke” market analysis. She was also disturbed that the SMA was created for use as a “stick” to encourage large, investor-owned utilities to join RTOs. Again, she would have preferred to use a rulemaking approach to mandate participation in RTOs.

Whether FERC’s requirement that a refund condition for anticompetitive actions be added to all market-based rate tariffs will prove to be a significant, added risk for power marketers will depend upon FERC’s willingness to investigate market irregularities and to place responsibility on individual market participants. Thus far, FERC’s track record has been primarily to try to stop the bleeding in California rather than to try to target specific market manipulators.

It should be noted that these orders do not affect existing, long-term agreements in which the capacity is committed to specific offtakers.