Opinion: Deregulation Advocates Should Support The Refund Orders In California

Opinion: Deregulation Advocates Should Support The Refund Orders In California

June 01, 2001

The Federal Energy Regulatory Commission has changed tack — perhaps because of prevailing political winds — and has now ordered refunds or “potential refunds” by independent generators in at least three instances for power sales made in California. The generators had legal authority to sell at “market-based rates.” More refund orders are expected.

Since I argued in the Newswire last December that FERC’s failure to order refunds — after finding that rates in California were “unjust and unreasonable” — was bad for generators, I should now be arguing that the current refunds are good for generators.

And, with qualifications, I believe that they are.

Although from an independent generator’s perspective it is counterintuitive to applaud FERC’s interference in the bulk power market by means of an after-the-fact determination that refunds are required, such action may be the only thing that can save the bulk power market in the long run. Consumer backlash against deregulation in California is already enormous. This can lead to direct action at the polls in the form of ballot initiatives that can eliminate deregulation in the state overnight. The state has authorized a power authority and is apparently taking over the transmission grid, and some of the most conservative cities in the state are considering municipalization of their utility systems.

In addition, the predicted supply shortage in most of the rest of the country this summer could lead to a quick reversal of deregulation in the nation. Independent generators can easily become an adjunct to state or traditional utility-owned generation, selling under long-term, cost-based contracts. The competitive bulk power market could be dead soon.

The best hope to save the bulk power market is partially and effectively to regulate it. If FERC cannot be relied on to provide a safety net or backstop to keep wholesale electric prices from going through the roof in times of inadequate supply, then political pressure from power customers will probably result in total reregulation. The current commission — with its free-market bent — has apparently also come to this conclusion in deciding to order refunds in California.

Refund Orders

What has FERC done in its recent orders? FERC first determined that some rates being charged for wholesale electricity in California were not “just and reasonable.” This gave it the power to act. It is not obvious what “just and reasonable” means in a market context where prices are set by arm’s-length negotiation. FERC established for the first time a “rate screen” for sales above which refunds will either be required or further investigation will be undertaken. FERC developed this rate screen — in effect — by establishing the market-clearing price that it believes would have been set in a single price auction had competitive forces been at work.

FERC decided that potential market power is most likely to be exercised during “stage 3” emergencies in California, when the system has almost no reserve margin. FERC chose a simple-cycle combustion turbine unit as a proxy for the unit to be bid in a stage 3 emergency. It assumed the combustion turbine has a heat rate of 18,073 Btus per kilowatt hour. It assumed variable costs of operating this unit based on an average January natural gas price, an average of NOx allowance costs, an average NOx emissions rate, and variable operating and maintenance costs as reported by public utility sellers. FERC came up with a proxy clearing price of $273 a megawatt hour for the month of January 2001, and potential refunds or offsets of $69 million.

FERC offered an incentive for generators selling at or above the clearing price of $273 a megawatt hour during stage 3 emergencies to pay refunds voluntarily. The incentive is that generators who wait for a FERC investigation of their situations may find themselves having to pay interest — in addition to the refunded amount. FERC said interest on any refunds that it orders “may be appropriate.” Moreover, if additional information submitted to support charges above the proxy amount — on a cost or “other justification” basis — indicates that charges associated with any other bids are unjust and unreasonable, FERC could order additional refunds.

FERC also announced that it would determine a proxy market clearing price for each month through April 2001, based on the above indices. The proxy amount for February, issued March 16, 2001, is based on the same methodology, but is significantly higher due to higher gas and NOx allowance prices: $430 a megawatt hour. Even so, applied to stage 3 emergencies, use of this proxy should lead to about $55 million of total potential refunds or offsets.

Perhaps more ominously, FERC issued a “show cause order” against Williams Energy Market & Trading Company and AES Southland, Inc. ordering the two companies to show cause why they have not violated the Federal Power Act by failing to make available “must-run units” under must-run contracts on file with FERC. (FERC charged the companies with earning high prices for electricity by shutting down must-run units, thereby forcing Californians to buy higher-priced electricity from the companies’ other power plants.) It was surprising to see AES included as one of the targets of the order since AES sells to Williams under a fixed-price tolling agreement and is subject to dispatch orders from Williams.

FERC said the remedy for these violations, if proven, is an order to refund all revenue the two companies earned above what they would have earned had their must-run units been operating. Williams could also find itself limited in what it can charge for power from non-must-run units when its must-run units are not available.

Wider Significance

What is the wider significance of FERC’s orders — beyond potential refunds for several months in California?

FERC set a precedent for determining a proxy for market-clearing prices that is based on cost. It has also shown that it will not simply sit by when it appears that a bulk power market is dysfunctional, but will step in to impose some upward limits. Further, the show cause order issued to Williams and AES indicates that FERC will seek to enforce the terms of contracts and market monitoring protocols on file at FERC.

All of these attempts to correct a power market that FERC believes is not working properly can be translated to other markets around the country where there are imbalances between supply and demand. While this may trouble electricity sellers who thought an unfettered market would set prices, the FERC actions may provide comfort to consumers and state commissions that are nervous about deregulation in light of California’s experience. If so, they may encourage bulk power markets in the long run.

Of course, one FERC commissioner and many customer groups are complaining that FERC’s refund orders did not go far enough. Commissioner Massey said — in a strong dissent to the methodology used in the refund orders — that by focusing only on power sales during stage 3 emergencies, FERC ignored “80%” of power sales for prices above the “soft cap” of $150 a megawatt hour that FERC set in an order on December 15, 2000. The California ISO, or independent system operator, filed a study with FERC claiming that generators overcharged for power by $6.2 billion from May 2000 through February 2001. Attacks on FERC’s limited refund orders could lead to reversal in the courts of appeal and larger — or smaller — refunds, but such court action would probably take a year or more. The fact that FERC has taken some action to limit wholesale rates might be enough to forestall cases that the California utilities and others have filed in the federal courts against FERC for failing to take action after determining that rates in California were not “just and reasonable.”

To sum up, FERC had to act to correct what it had found to be a “dysfunctional” market. It did so in a conservative manner. Although courts of appeal may ultimately reverse its orders, the fact that FERC acted at all to order some refunds and to investigate some power plant shutdowns — regardless of the outcome — may help the cause of deregulation.