ICC Did the Right Thing on Electricity Auction

Published January 25, 2006

The Illinois Commerce Commission has just approved a proposal by Commonwealth Edison and Ameren Corporation for competitive bidding on behalf of nearly all of the electricity consumers in Illinois. The ICC also will consider a 6 percent increase in ComEd’s distribution rate in order to maintain the grid. This is the last chapter in the restructuring process that started in 1997.

At that time it was agreed competition would be enhanced if the generation was separated from the distribution of electricity. This would give large energy consumers the opportunity to buy from several generators. In exchange, residential consumers were given a 20 percent reduction in their electricity bills. That was twice the discount California consumers received when its restructuring began. The 20 percent discount will end in January 2007.

The ICC-approved reverse auction would have the generators offering the amount of electricity they could supply over two, three, and five years at a given price. If this is more than the amount expected to be demanded at that price, then the price is reduced until the total amount supplied is just equal to the amount demanded.

If this sounds like Economics 101, you are right. Indeed, the Federal Energy Regulatory Commission decided in mid-December 2005 that such wholesale electricity prices were “just and reasonable.” The long-term nature of the auction bids avoids the major cause of the California fiasco of 2000 and 2001, namely forcing all transactions into the spot market.

The reverse auction is based on a similar system in effect in the Pennsylvania-New Jersey-Maryland (PJM) region. The PJM system also incorporates a distribution regime, allows hedging of risk by both generators and consumers, and signals the consumer when to crank up conservation efforts. There is every reason to believe these features could become a part of the Illinois version under the supervision of the ICC. Even medium-sized consumers and maybe small ones could hedge their bills if the banks and other brokers could divide the natural gas contracts traded on the New York Mercantile Exchange into tailored risk management arrangements. Banks already do a similar service for foreign exchange and interest rates.

Natural gas is the fuel at the margin in most markets and thus plays an important role in price discovery and hedging of electricity. Natural gas contracts traded on the NYMEX are extraordinarily liquid, with daily volumes nine to 10 times daily consumption. These contracts will back up the tailored arrangements.

The reverse auction has attracted the opposition of the Citizens Utility Board, the governor, the new director of consumer affairs, the Illinois attorney general, the Cook County states attorney, and several large consumers. Their stated goal is to restore the regulation of the nuclear power plants belonging to Exelon Generation and keep the discounted electricity rates. While they were all parties to the compromise in 1997, they now want to renege. They want to appear to be the champions of the electricity consumer by pursuing the roll back in rates.

Their rationale is that rates ought to be determined by historic costs. This would put the price of electricity generated by nuclear power plants at a very low level compared with generators using other fuels. While the prices in the next three years will be capped, eventually the wholesale price of electricity generated by nuclear power will reflect its superior environmental and reliability features.

In standard economic theory, factors of production like electricity are paid the value of their marginal product. Thus, the various sources of electricity will be paid the same price for a unit of electricity. To interfere by way of regulation will distort the allocation of resources and send the wrong price signals–especially those that guide future investment in power generation.

Price is not determined by historic cost in an unregulated market. For example, old lawyers and economists do not charge lower fees even though they obtained their degrees when tuition charges were substantially cheaper.

Investment in transmission is also very important in a deregulated environment. The arrangement now is for the local utilities to continue ownership of the transmission and distribution grids. But the dispatch will be controlled by the regional service organizations. While this will guarantee even-handed treatment of all the parties, it does not bode well for the investment in future reliability. The grids not only have to be protected from physical deterioration, they also have to be reshaped to facilitate changes in when and where electricity is generated, transmitted, and sold.

An alternative institutional arrangement, which has worked well for interstate oil pipelines and the intrastate transmission of natural gas in Texas, is the joint venture where the shippers are the owners. It solves two problems. One is that investment is charged to those who put the new demands on the transmission. The other is it reduces the reservation of too much capacity by some of the shippers. Unused capacity during peak demand periods is a waste for which owners must pay. Clearly it is in the interest of all owners to use the asset efficiently. In the popular lexicon, owners take better care of assets than do mere renters. Ask any landlord.

The critics of the reverse auction are threatening to take the decision of the Illinois Commerce Commission to court. If they are successful it will put severe financial pressure on ComEd and perhaps push them into bankruptcy. The state’s consumers, both large and small, will not be served if ComEd is forced into bankruptcy and the reliability of the electric supply is impaired.

The threat calls to mind a similar political assault in the 1930s, when the partisan establishment attacked Samuel Insull and forced ComEd into bankruptcy. The ICC for its part has turned away from this path. Now the courts should take a similar stance and not repeat the mistake of the 1930s.

Jim Johnston is an economist retired from Amoco Corporation and an unpaid policy advisor to The Heartland Institute.