Policy Study

Standard Market Design in Wholesale Electricity Markets

Can FERC's Proposed Structure Adapt to the Unknown?

Executive Summary

Fifteen years ago Vernon Smith wrote of electricity markets:

Replacing the entrenched regulatory regime, after eighty-odd years, with a competitive regime will require regulators to be forward looking, politically bold, and cognizant of the disciplinary value of competition.

Today the Federal Energy Regulatory Commission, and many of the state regulatory commissions, can look back with considerable pride at what they have accomplished. Deregulation of electric power generation has proceeded, perhaps not as quickly as in some other industries, and not without some missteps, but with a deliberate and sustained pace. Competition is now deeply entrenched in the nation’s power generation system, and it has made that system more efficient, more adaptable, more resilient, and more reliable. Much of this progress has been driven by technological innovation and also by economic developments outside the industry, but to a considerable extent it is the product of hard work and innovative thinking within the regulatory commissions themselves, at both the federal and state levels.

FERC’s current Standard Market Design (SMD) proposal is a bold-although not final-step in the evolution of electricity markets. It recognizes that, in power generation, competition is now the primary guarantor of “just and reasonable” rates. It seeks to protect and promote that competition by proscribing anticompetitive practices, especially those that take the form of “undue discrimination” by vertically integrated transmission operators. It seeks to expand the scope of competition by erasing the “seams” between different geographic jurisdictions, as well as smoothing some of the seams between wholesale and retail markets. And it seeks to unmask the price signals for transmission investment that will alleviate the troublesome bottlenecks in the existing infrastructure.

These goals are laudable, and some of the features of the proposed SMD are welcome. In our view, however, the current proposal also suffers from several serious flaws, that make us unable to support the current proposal.

1. The SMD is too prescriptive and too quick to impose uniformity for its own sake.

More uniform national, and even international, “ground rules” will provide a better foundation to facilitate exchange and competition, and to encourage investment in new capacity where it is needed. One the other hand, flexibility and variability in market design provide the raw material for evolution and experimentation, both by regulators and by market participants. By locking in a single, detailed, and inflexible market design, the SMD may inadvertently choke off further progress.

Regional variation in market design has created “seams,” transaction costs, and other anomalies that seem desirable to eliminate. But regional variation in market design may also have accommodated legitimate differences in local conditions. And while variation allowed California to walk off a cliff, it has allowed other states, and the Commission, to draw important lessons from that experience.

The proposed rule identifies numerous problems-some theoretical, some anecdotal-in existing markets and asserts that the SMD will fix them. A search of the preamble for “eliminate(d)” and “(re)solve(d)” reveals dozens of problems that will be made, by rule, to vanish. The mixed record of recent experience with market design fails to dent the confidence with which the SMD is proffered:

“In the years since the ISO markets have been operating, dozens of market design flaws have been identified, . . . No region has been exempt from market design flaws of one type or another. . . . Only standardization of electricity market design will solve these problems. Our goal is . . . to raise the quality of all electricity markets simultaneously.”

Unfortunately, standardization also means that unintended consequences of the SMD will affect all electricity markets simultaneously. Good intentions do not prevent errors, unanticipated abuses, or assumptions that turn out later to be misplaced. For this reason, the Commission should proceed with caution. The proposed SMD may appear to be superior to all the others only because it is, so far, untried.

Detailed rules run the risk of regulatory path dependence and lock-in. The new institutional structure in the SMD should be simple, flexible, and reversible, with clear and credible phase-out provisions as technology evolves and market-based retail pricing expands. Robust institutions that will stand the test of time and create value for consumers must be able to adapt to the unknown. Many unknowns exist in electricity, particularly in the regulatory, financial, and technological future. Market design that focuses too heavily on explicit details and not enough on flexible and adaptable rules will be useless at best, and counterproductive at worst.

2. The SMD classifies practices as “undue discrimination” without sufficient examination of economic efficiency.

In policing electricity markets, the Commission faces the same problem faced by antitrust agencies: How can it be sure that its power to intervene is used to protect competition rather than suppress it? In a complex market it can be difficult to distinguish cost-based (and therefore economically efficient) discrimination from “undue” discrimination, and competitive practices from anti-competitive practices. Certainly it will not suffice to rely uncritically on complaints from market participants. Companies will file anticompetitivediscrimination complaints if it is rewarding to do so, regardless of whether the alleged discrimination has an economic basis. And aggressive competition elicits complaints from competitors just as surely as anticompetitive behavior does.

It is the duty of the Commission to ensure that its oversight of markets is not employed to favor one or another participant in the market, but to provide the greatest benefit to consumers as a whole. It should use as its guideposts the notions of economic efficiency and consumer harm that are used to guide antitrust interventions.

The SMD seeks to eliminate discrimination and, in particular, to ensure that a vertically integrated transmission provider will never have competitive advantage over independent generators. In its zeal to eliminate competitive advantage, however, the Commission needs to be careful not to throw the baby out with the bathwater: i.e., not to eliminate real economic efficiencies from the system.

For example, in its discussion of scheduling advantages (paragraphs 45-47) and in its discussion of imbalance resolutions (paragraphs 48-49), the SMD proposal appears to proceed directly from the observation that a practice confers competitive advantage to the conclusion that it should be banned. We do not have enough information to say whether these particular practices are anticompetitive, but surely there are some cases where competitive advantage flows from real economic efficiencies; the Commission needs to make more of an effort to examine this possibility before it bans a practice.

3. The SMD does not recognize the value of competition, or potential competition, in transmission services.

While the SMD recognizes the disciplinary value of competition in power generation, it appears to embrace-and to codify-the status of transmission as a “regulated natural monopoly.” But FERC could accomplish many of the proposal’s objectives regarding transmission investment and congestion pricing by reducing entry barriers in transmission. The standard market design structure as currently envisioned does not address the fundamental supply-side problem that makes transmission a bottleneck-the combination of fragmented ownership and the persistence of artificial barriers to entry facing the grid’s potential competitors. The proposed SMD acknowledges that improved transmission coordination and investment can make wholesale generation markets more competitive, but does not incorporate the insight that the reverse is also true. Changes in generation regulation and technology can make transmission more competitive, so that transmission need no longer be treated as a natural monopoly.

The proposed SMD does not reduce the regulatory barriers to entry that prevent us from putting transmission to a market test. In the absence of these barriers, transmission faces potential competition, or is contestable. Reducing artificial barriers to entry in transmission, and observing the extent to which and the timeframe over which transmission really can be contestable, would create real benefits from dynamic efficiency and optimized investment. Furthermore, reduced entry barriers would enable investors to create redundancy and increased grid security when and where it makes economic sense. Such beneficial redundancy does not exist with transmission regulated as a natural monopoly, as natural monopoly theory is premised on removing redundant infrastructure.

4. The SMD does not recognize that market pricing for retail customers can exert considerable competitive discipline on transmission as well as generation.

Market-based retail pricing is another simple concept that would reduce the need for FERC and independent system operator (ISO) market monitoring functions and associated bureaucracies. Market-based retail pricing connects demand and supply, maximizing information transmission in markets and disciplining supplier exercise of market power better than any other known institution. Clearly, retail pricing is beyond the scope of this rulemaking and beyond the scope of the Commission’s jurisdiction. However, states are slowly moving toward market-based retail pricing and retail choice. It is important for FERC to recognize that retail pricing reforms will make loads responsive to scarcity at peak times, and will thereby alleviate many of the transmission bottlenecks and rigidities that the SMD is designed to address.

Thus the proposed FERC and ISO market monitoring should have sunset provisions as the percentage of retail load on competitive contracts increases. Market-based retail pricing is more likely than market monitoring to create value for consumers, and one reason for that advantage is that market monitoring is almost certain to suppress dynamic investment incentives.