1. ELECTRICITY RESTRUCTURING TRENDS AND IMPACTS presentation by George Gross University of Illinois At Urbana - Champaign at the NSF Sustainable Energy Systems Workshop Georgia Tech Campus Atlanta, Georgia November 29 - December 1,2000 © Copyright George Gross, 2000

2. OBJECTIVES  To provide an overview of the environment in which the discussions on sustainability are undertaken  To review the key developments in electricity restructuring  To assess the key trends in the new electricity business and their impacts  To identify specific challenges and research needs

3. OUTLINE  Importance of electricity  Key federal legislative and regulatory developments  Direct access at the state level  Key trends and developments  Dispersed resources  Major challenges

4. Electricity will continue to substitute for less Electricity will continue to substitute for less efficient and less productive energy forms ENERGY CONSUMPTION AND ELECTRICITY USE 50 70 90 110 130 150 Energy/GNP Ratio (Index is 100 for the year 1900) Energy/GNP Ratio (Index is 100 for the year 1900) Electricity use as a percentage of total energy consumed 20001880190019201940196019802020 50 40 30 20 10 % 0

5. 19701980 1990 50% 100% 150% 200% 250% 1970 = 100% Electricity use Total energy use CO 2 Emissions ELECTRICITY / ENERGY DEMAND

6. IMPACT OF ELECTRICITY  The National Academy of Engineering - the nation’s most prestigious collection of outstanding engineers - named electrification - the development of the vast networks of electricity that power the world - as the most important of the twenty engineering achievements that have had the greatest impact on the quality of life in the 20 th century

7. IMPACT OF ELECTRICITY  Electricity ranked ahead of the automobile, airplane, safe and abundant water, electronics, computers and space exploration  The widespread electrification implemented in the 20 th century gave us power for our cities, factories, farms and homes, forever changing the lives of people

8. COMPETITION IN THE GENERATION MARKET  The 1978 Public Utility Regulatory Policies Act (PURPA) unleashes competition through the introduction of qualifying facilities (QF’s)  PURPA mandates each investor-owned utility to purchase power at avoided cost from QF’s located in its service territory  Implementation of PURPA was left to individual states resulting in nonuniform definitions of avoided cost  The once fledgling private power enterprises constitute today a multi-billion dollar industry and play a critically important role in the electricity business

9. ENERGY SOURCES OF NUG CAPACITY Wind 3.4% Waste 7.0% Geothermal 1.8% Oil 2.6% Hydro 5.3% Coal 15.2% Biomass 16.5% Solar 0.7% Natural Gas 47.2% Other 0.3% Source : 1993 Capacity and Generation of Non-Utility Sources of Energy, Edison Electric Institute

10. OWNERSHIP OF NEW GENERATING CAPACITY ADDITIONS 1985198719911992 84 73 51 36 39 66 0% 100% UTILITY OWNERSHIP NON-UTILITY OWNERSHIP 19951994 16 27 49 64 61 34 84 73 5136 3966

11. 1992 NATIONAL ENERGY POLICY ACT  Addresses all major elements of national energy supply and use  Marks the end of a highly regulated and structured period for utilities  Pushes aggressively wholesale competition by changing federal policies governing electric power in the wholesale marketplace  revision of PUHCA of 1935  establishment of the new class of exempt wholesale generators (EWGs)  reform of the FPA broadening the powers of FERC to mandate wheeling

12. Customers Self- generation IPP THE EXISTING ELECTRIC INDUSTRY STRUCTURE Generation Transmission Distribution Customer Service Distribution Transmission Generation

13. THE EXISTING ELECTRIC INDUSTRY STRUCTURE Customers Self- generation IPP Generation Transmission Distribution Customer Service Distribution Transmission Generation

14. RESTRUCTURING IN OTHER INDUSTRIES  The recent past has witnessed major changes in virtually every other regulated industry:  airlines  telecommunications  railroads  trucking  natural gas  Electric utility industry was the last major regulated monopoly to undergo this “been there, done that” phenomenon

15. SOME LESSONS LEARNED FROM RESTRUCTURING IN OTHER DOMAINS  Basic driver was the market -- emergence of real economic opportunities  Breakup of strong vertically integrated industries can be done rapidly  Prices decrease rapidly as products become more like commodities  Decreasing prices encourage product differentiation and innovation

16. SOME LESSONS LEARNED FROM RESTRUCTURING IN OTHER DOMAINS  Far more customer segments emerged than anyone ever imagined or believed possible  Pace of change has continuously accelerated  The winners are the innovators who understand customer needs and effectively apply technology - - they create new opportunities rather than just compete more aggressively for the existing ones

17. ELECTRICITY VS. OTHER SERVICES electricity busy signal airline reservations bumping next available flight obligation to serve telephone

18. DRIVING FORCES OF CHANGE CHANGESCHANGES MARKETS ENVIRONMENT REGULATION TECHNOLOGY

19. FERC ORDERS 888 AND 889  On April 24, 1996, FERC released  Order No. 888 - Open Access Transmission and Stranded Cost Recovery  Order No. 889 - Open Access Same-Time Information System (OASIS)  The orders constitute a generic remedy for the undue discrimination in the industry’s past practices in providing transmission services

20. KEY OBJECTIVES  To promote aggressively robust competition in wholesale markets  To remedy undue discrimination in transmission  To establish standards for recovering stranded costs

21. MAJOR THRUSTS  Utilities must provide non-discriminatory open access through tariffs of general applicability  Utilities must functionally unbundle transmission and generation services  Transmission providers must set up electronic bulletin boards

22. MAJOR THRUSTS  Utilities must abide by the standards of conduct  Standards and procedures provide the recovery of stranded costs resulting from increased competition under the new FERC rules  Limited reciprocity must be provided by nonjurisdictional entities requesting transmission services

23. UNBUNDLING EXAMPLE Baggage Service Takeoffs Landings In-Air Pillow/Blanket Service Oxygen Bath rooms Backup Service * Bundled service available upon customer request FLY THE FRIENDLY SKIES WITH UNBUNDLING ‘R’ US * }

24. SAME INFORMATION AVAILABILITY Transmission Provider Transmission Provider Transmission Customer Transmission Customer Transmission Service: Palo Verde to Midway 200 MW at $4/MWh Call SCE For Sale Transmission Service: Four Corners to Midway 200 MW at $3/MWh Call SMUD Wanted RIN OASIS For Sale Wanted 200 MW at $3/MWh Four Corners to Midway Call SMUD 200 MW at $4/MWh Palo Verde to Midway Call SCE Transmission Service:

25. THE FERC ORDERS NO. 888 AND 889  Signal FERC’s intention to establish universal open access  Aim to aggressively promote the development of a competitive wholesale electricity market by mandating non-discriminatory open transmission access  Provide a generic definition of a utility’s comparable transmission service obligations  Address transition costs associated with industry restructuring  Use the OASIS to provide functional unbundling of transmission and generation services

26. “COMMON CARRIER” TRANSMISSION SERVICE Broker / marketer Broker / marketer Broker / marketer Transmission system Utility generation Other utility QF IPP EWG Broker / marketer Self generation

27. SALIENT CHARACTERISTICS OF CALIFORNIA RESTRUCTURING  Basic principles embodied are  customer choice  competition in generation  open access transmission  Physical direct access: flow based bilateral transactions coexist with the PX spot market  Independence of the ISO and PX: separation of security and economics functions  ISO has primary responsibility to facilitate transactions while maintaining system reliability/security

28. THE CALIFORNIA SYSTEM... load aggregator end user ESP ISO SC... PX AS market D I S T R I B U T I O N (W I R E S) G G G G G G G G G G G G G G G G G G G G G G G G bilateral contracts

29. THE POWER EXCHANGE Seller 1 PX Seller MSeller i Buyer NBuyer j Buyer 1 MWh. $.......... $ $ $ $ $.

30. RETAIL ENERGY COSTS 4/1/98 - 3/31/99 wholesale energy 21% distribution 30% stranded costs 23% rate reduc- tion bonds 13% ISO costs 5% transmission 4% public purpose 5% total costs = $ 28 billion CA ISO estimates

32. ELECTRICITY RESTRUCTURING IN ILLINOIS Electric Service Customer Choice and Rate Relief Law  The Electric Service Customer Choice and Rate Relief Law was enacted and signed in 1997 Law  The Law is a 261 page document which  provides customer choice to all by 2002  lowers residential base rates  addresses utilities’ stranded cost recovery and transition issues  reshapes the utility industry for the competitive environment  refocuses the scope of regulation in Illinois to reflect the future competition in electricity

33. ENERGY SOURCES FOR ELECTRICITY 66,41878,481267 45.7%54.1%0.2% IL Legend coal/ oil/ diesel nuclear natural gas/ biomass/ renewable (hydro, wind, solar) 37,17010,9702,872 72.9%21.5%5.6% 27,933 13,2431,327 65.7%31.2%3.1% 28,6523,7301,120 85.5%11.1%3.4% WI MI IA Source: DoE EIA

34. RENEWABLE ENERGY AND ENERGY EFFICIENCY  A Renewable Energy Resources Trust Fund (RERTF) is established with funding to equal $100 million over 10 years  All customers will be assessed charges starting 1/1/98:  $0.05 on each residential electric customer  $0.05 on each residential gas customer  $0.50 ($37.50) on each nonresidential electric customer with peak load below (above)10 MW  $0.50 ($37.50) on each nonresidential gas customer with annual load under (above) 4 million therms

35. RENEWABLE ENERGY AND ENERGY EFFICIENCY  These amounts will be shared equally by the RERTF and the Coal Technology Development Assistance Fund  The Energy Efficiency Trust Fund is established through the collection of $3 million annually over 10 years from each electric utility and ARES

36. KEY TRENDS IN THE ELECTRICITY BUSINESS  State-by-state patchwork restructuring pattern  Breakup of the vertically integrated utility  Growing importance of energy trading  Underperformance of electric utility stocks  Horizontal aggregation  Generation divestiture  Normalcy of price volatility and price spikes  Grid regionalization  Increasing use of e-commerce in electricity

37. RETAIL ACCESS STATUS 25 states with legislation 1 state with PSC order 19 states with studies 7 states with no activity

38. VERTICALLY INTEGRATED UTILITY STRUCTURE IS DISINTEGRATING Transmission ownership Customer Service Marketing/ trading ISO Ancillary services Power exchange System Operations Generation Distributio n wires Generation Transmission Customer Service Distribution

39. UNIT/PLANT SALES CAPACITY ALLOCATION reserved for real-time balancing market spinning reserve hour-ahead market day-ahead market ENERGY PAYMENTS balancing market energy ( including AGC) hour-ahead energy market day-ahead energy market AGC downward capability

40. WHOLESALE COMMODITY MARKETS Petroleum Aluminum Gold Electricity Cattle/Calves Grains Natural Gas Coal Copper Dairy $ Billions Annually 91.5 53.8 39.6 33.6 31.7 22.4 18.1 34.6 26.6 21.0 UNITED STATES WORLDWIDE

41. THE POWER MARKETING AND ENERGY TRADING EXPLOSION  Utilities, financial houses, marketers, generating entities, brokers, and speculators are buying, selling and swapping power/energy on a huge scale with the total volume of trade worth multiples of the value of the underlying commodity  Electric power marketing is dominated by Houston  each of the top 20 power marketers trades gas  75% of all unregulated power marketing volume is conducted from Houston with 25% of all the power marketers headquartered there  Multimillion dollar bets are placed on how weather can affect demand for gas, heating, oil and electricity

42. Source: Edison Electric Institute, Regulatory Research Services POWER MARKETERS’ SALES 1996 0.2 billion 1999 2.5 billion 1998 2.3 billion 1997 1.2 billion

43. INDEX COMPARISON Data sources for Jan 1, 1995 - Dec 31, 1999

44. KEY IMPACTS ON THE ELECTRICITY BUSINESS  Underperformance of electric utility stocks push companies into adopting new strategies:  diversification, including many nontraditional businesses;  mergers  separation of high and low growth assets  Divestiture of assets of electric utilities by  transfer from regulated to unregulated; or  outright sale

45. THE M&A SCENE  Acquisitions of regulated utilities by IPP’s  Acquisitions of U.S. entities by foreign companies  Mergers of vertically integrated utilities  Purchases of energy businesses by investor groups  Convergence mergers of electric and gas utilities

46. QUICKENING PACE OF M & A Data source : EEI

47. GENERATION DIVESTITURE 27.4 TW 24.1 TW 17.8 TW 19971998 1999 $3.98 B $10.2 B $10.6 B

48. Monday Tuesday Wednesday Thursday Friday MAXIMUM AND AVERAGE HOURLY PRICES FOR JUNE 22 - 25, 1998 purchase price $/MWh 3000 1000 0 1 5 9 13 17 21 1 5 9 13 17 21 1 5 9 13 17 21 1 5 9 13 17 21 1 5 9 13 17 21 2000 4000 5000 6000 7000 8000

49. THE SUMMER 2000 MARKETS monthly totals (Billions) $ average price ($/MWh) 0.0 1.0 2.0 3.0 4.0 MayJune JulyAugust*(1-29 only) 0 50 100 150 200 cap price $750$500$250 average price $/MWh

50. DECLARATIONS OF EMERGENCY BY THE CA ISO stage one appeals (operating reserves ≤ 7%) stage two curtailment of interruptible (operating reserves ≤ 5%) stage three load shedding (operating reserves ≤ 1.5%) 3 3 3 6 1998 1999 2000 3 38 24 14 summer

51. REGIONAL TRANSMISSION ORGANIZATION (RTO)  FERC’s functional unbundling has not resulted in the desired separation of transmission and market functions  Certain structural impediments to greater competition  elimination of pancaked rates  improved congestion management  curbing of market power  undertaking of improved regional planning procedures are best addressed regionally  RTO is a generic term for a new independent transmission management structure that will control transmission operations and planning uniformly in large regions of the US  RTO’s may come in various flavors -- ISO, TRANSCO, grid or some combination

52. DISPERSED RESOURCES  Direct access coupled with advances in fuel cell and microturbine development are leading some to forecast that DR will replace the role played by today’s power plants  The utilization of DR to date is, by and large, limited to specific niche applications  Some DR companies have enjoyed dot - com success in terms of stock appreciation

53. DISPERSED RESOURCES  Emergence of DR represents both opportunities and threats to the restructured business  new sources to help the supply - demand balance  disruptive technology to change the transmission system through generation solutions  The future penetration of DG is uncertain due to factors such as  technology advances  environmental aspects  economics  “integration” into the existing system  The future role of transmission is also uncertain

54. ELECTRICITY AND THE NEW ECONOMY  The electricity business is on the cutting edge of the new economy  new economy runs on electricity  400 million plus web users internationally  62% growth in U.S. internet industry in 1999  over 80 million PC’s shipped annually  Reliable and competitively priced electricity is a key requirement for the myriad applications and the operations of web-based e - businesses

55. MAJOR CHALLENGES  Smoother operations of the balkanized electricity markets  Effective integration of new technology and application of advances in information technology  Monitoring of market performance  Implementation of demand-side responsiveness  Green electricity  Efficient economic signals for robust and reliable transmission system  Market-based congestion management schemes