1. Energy Bar Association Market Approaches in Energy Sonny Popowsky Consumer Advocate of Pennsylvania December 3, 2009 Washington, DC PA Office of Consumer Advocate 555 Walnut Street Forum Place, 5th Floor Harrisburg, PA 17101-1923 (717) 783-5048 Telephone spopowsky@paoca.org www.oca.state.pa.uswww.oca.state.pa.us 118053 1

2. Regulation and Competition Alfred Kahn from The Economics of Regulation: Principles and Institutions (1988): “The ‘central institutional issue of public utility regulation’ remains … finding the best possible mix of inevitably imperfect regulation and inevitably imperfect competition.” 2

3. Retail Competition What Were We Thinking? After the federal Energy Policy Act of 1992 laid the groundwork for greater competition in the wholesale electric generation industry, several states, starting with California and then Pennsylvania, began to consider the possible benefits of retail competition. Pennsylvania passed its landmark electric restructuring law in 1996. 3

5. Why Did We Restructure The Electric Industry in Pennsylvania? Electric rates were higher in Pennsylvania than in most of the country. Rates for utilities in places like Philadelphia and Pittsburgh were higher than rates in the rest of Pennsylvania, and were indeed among the highest in the United States. The differences in rates were largely due to differences in the embedded cost of generation, and generation was no longer considered to be a natural monopoly. 5

6. What Did We Think Would Happen? 6 Competition would drive down wholesale electric generation costs and that would drive down retail generation rates. Competition would therefore “strand” existing utility generation investments. That is, market prices would not cover the high costs of utility generating plants that were built under the protection of regulation. Pennsylvania utilities therefore were permitted to recover billions of dollars of stranded costs.

7. PA Final Stranded Cost Allowances PECO$5.26 Billion PPL$2.97 Billion Duquesne$1.33 Billion Met Ed$1.00 Billion West Penn$670 Million Penelec$429 Million Penn Power$224 Million TOTAL (Major Utilities)$11.88 Billion

8. But Just in Case… Just in case the predictions of significant retail competition and lower electricity prices didn’t come true, the Pennsylvania electric restructuring legislation included retail rate caps that prevented the utilities from charging higher generation rates than they had been charging prior to restructuring. The rate caps were a defense against over-charging by the utilities. That is, the utilities should not be allowed to charge stranded costs (resulting from expected lower market prices) at the same time they were charging higher market prices for their generation. When stranded cost recovery ends for each utility in Pennsylvania, the corresponding rate caps end. 8

9. 9 What Actually Happened? The actual price of generation was higher than the anticipated market prices that were used to estimate stranded costs. Much of the increase in wholesale generation prices resulted from unanticipated increases in the cost of fossil fuels, particularly natural gas. When combined with the “single market clearing price” methodology used by PJM, in which all units dispatched in a particular period are paid the price bid by the highest cost marginal unit operating in that period, the increase in natural gas and other fossil fuel prices has had a dramatic effect on wholesale prices.

10. 10 Projections of PJM Energy Prices Used by PPL to Estimate Stranded Costs vs. Actual (Nominal $ per mwh) YearPPL EstimatePJM Load Wtd. Avg. LMP 1999 $ 22 $ 34.07 2000 $ 23 $ 30.72 2001 $ 24 $ 36.65 2002 $ 24 $ 31.58 2003 $ 25 $ 41.23 2004 $ 26 $ 44.34 2005 $ 26 $ 63.46 2006 $ 27 $ 53.35 2007 $ 29 $ 61.66 2008 $ 30 $ 71.13 2009 $ 31 $ 42.48 (January - June) 2010 $ 32 2011 $ 32 2012 $ 33 2013 $ 35 2014 $ 35 2015 $ 36 2016 $ 37

11. Results of New Jersey Generation Auctions 3-Year Bids (¢ per kwh) 200420052006200720082009 PSEG5.5156.54110.2519.88811.15010.372 Rockland5.5977.17911.11410.99912.04911.270 Atlantic Electric 5.5136.64810.3999.95911.65010.536 JCPL5.4786.57010.0449.96411.40910.351 Source: http://www.bgs-auction.com/bgs.auction.prev.asp 95548.ppthttp://www.bgs-auction.com/bgs.auction.prev.asp

12. 12 What About Retail Shopping for Residential Customers? In areas of Pennsylvania where customers are still protected by generation rate caps, there are currently few or no residential customers who are being served by alternative electric generation suppliers. In areas where rate caps have expired, as of October 2009, 20.2% of Duquesne residential customers, and 13.9% of Penn Power residential customers were being served by alternative suppliers. Even when rate caps have ended and rates have gone up substantially in surrounding states like Maryland and New Jersey, there has been very little residential competition and very little switching by residential customers.

13. Maryland Residential Shopping As of September 2009 Total Residential Customers Residential Customers Served By Competitive Suppliers Allegheny Power218,0551550 Baltimore Gas & Electric 1,111,20641,139 Delmarva Power & Light 173,4432,012 Potomac Electric Power 478,28437,679 Statewide Total1,980,98882,380 (4.2%) 13

14. New Jersey Residential Shopping As of September 2009 Total Residential Customers Residential Customers Served By Competitive Suppliers PSEG1,818,39746 Rockland63,2355 Atlantic Electric480,87371 JCPL968,51191 Statewide Total3,331,016213 14

15. What About Industrial Customers? Carlisle Tire & Wheel According to the Carlisle PA Sentinel of July 22, 2009: “Not even a last-ditch phone call from Gov. Ed Rendell could convince Carlisle Tire & Wheel executives to continue manufacturing in Carlisle.” “One factor that tipped the scales in favor of Tennessee is the Tennessee Valley Authority … According to the Nashville Area Chamber of Commerce, the TVA ‘offers substantial credits on power bills…to companies expanding in the Tennessee Valley.’” “In contrast, the impending electricity deregulation has Pennsylvania businesses scrambling to find ways to keep power costs from rising too dramatically.” “’We don’t have that same ability to offer that as Tennessee does,’ [the Governor’s spokesman] said of the power costs.” 15

16. What About New Generation? PJM Reliability Pricing Model (RPM) In order to provide incentives for new generation capacity, PJM established a new capacity market called the Reliability Pricing Model (RPM). The question is whether RPM overcompensates existing generators, while providing inadequate incentives for new generation. New Jersey 2008 Energy Master Plan: “RPM does not target new plants, but instead spreads capacity payments amongst all new and existing plants… The first five years of RPM’s capacity prices will cost New Jersey customers more than $7 billion – more than enough to fund the construction of several new power plants outright. Unfortunately, that money is being spread amongst all capacity resources, with only a sliver reaching new power plants or demand response.” 16

17. What Now? “Unscrambling the Omelet” While some restructured states – like Virginia – have returned to full regulation, other states – like Maryland – are considering a hybrid approach, including requiring utilities to enter into long-term contracts for new generation. Maryland Public Service Commission December 2008 Report to the Maryland General Assembly: While not “seeking to unscramble the omelet” by recommending a full re-regulation of all previously divested power plants, “the Commission believes that the public interest compels some re-regulation of Maryland’s electricity markets – or, put another way, that the public interest is not served by de-regulation that requires the Commission to wait passively for market forces to deliver a reliable supply of electricity at reasonable rates.” 17

18. What About Pennsylvania? In 2008, Governor Rendell signed legislation that maintains Pennsylvania’s competitive generation framework, but places greater emphasis on the utilities’ obligation to provide least cost service to “default service” customers, that is, the great majority of customers, particularly residential customers, who do not switch to competitive generation suppliers. Under the 2008 law, after rate caps expire, our utilities must secure a “prudent mix of contracts … on a long- term, short term, and spot market basis” that will provide “adequate and reliable service” at “the least cost to customers over time.” 18

20. One Last Point: Interplay of Markets and Climate Change Legislation In restructured states, in which electric generation rates are based on marginal market clearing prices, the initial costs to consumers of a cap and trade program for carbon emissions will be far higher than the costs of such a program to consumers in regulated states where electric generation rates are based on the cost of service. That is because when carbon-emitting units set the market clearing price in restructured markets, the cost of carbon allowances will be included in the price paid to all operating generating units, including nuclear units that have no carbon compliance costs. Based on an assumed $20 per ton CO 2 allowance price, a report by Synapse Energy Economics estimates that PJM nuclear units with market-based rates will receive over $2.6 billion of increased annual revenue through cap and trade even though they incur no carbon compliance costs. 20

21. Adding Insult to Injury: Free Allowances to “Merchant Coal” Plants The Waxman/Markey legislation passed in the House adopted a proposal made by EEI that free allowances be allocated to “merchant coal” plants, based on 50% of their base year emissions. See, Testimony of Jeffry Sterba, House Hearing of April 23, 2009, at page 12. The basis for the EEI proposal was that “in most unregulated markets the market price of electricity is determined by natural gas, and natural gas emits approximately 50% of the carbon from coal.” The free allocation of allowances for 50% of emissions would allow merchant coal plants to recover “the portion of their increased costs that is not recovered through market prices.” 21

22. Merchant Coal Allocation The Markey/Waxman legislation allows merchant coal plants to recover their “cost” of compliance, while allowing merchant nuclear plants to charge “market” prices that include the market value of allowances, even though the nuclear units incur no compliance costs. In other words, unregulated generators will charge the higher of cost or market. What is the principled argument for that? 22

23. Conclusion We continue to seek “the best possible mix of inevitably imperfect regulation and inevitably imperfect competition.” But charging consumers the higher of cost or market is not an acceptable option. 23