Getting Standard Market Design Right Means Getting Transmission Planning and Expansion Right

Frank Felder | Oct 13, 2002

The Federal Energy Regulatory Commission’s proposed rule to standardize electricity markets recognizes that transmission planning and expansion are part and parcel of electricity markets and provides the foundation for a process that will serve the public interest. To advance this issue further, though, the FERC needs to build upon the foundation it has already laid and avoid being distracted by some false issues.

Before articulating the next steps that the Commission should take to define further expansion policy, it’s worth taking a step back to remind ourselves why transmission planning and expansion is difficult. Transmission projects are expensive, long-lived, sunk investments. It’s not easy to rectify erroneous transmission investment decisions. Transmission facilities cannot be reconfigured to produce other products or serve other industries or be redeployed to another part of the country except at a large expense, if at all. While newer transmission technologies are reducing the costs of redeploying transmission, which should reduce some business risk, these investments cannot be made lightly. And who should pay for these expensive investments? Usually new transmission projects reduce congestion between low-cost and high-cost regions, potentially providing disproportionate economic benefits to each region, although both regions may obtain more similar reliability benefits.

There are also some important federal-state governance issues to consider that purposely divide political power between these levels of governments. Consequently, transmission expansion policy has to conform to our federal system and accommodate potentially conflicting governmental interests. The split of jurisdiction between siting transmission facilities and the federal government’s authority over electricity markets illustrates this point. Finally, at a more basic level, the amount, location, and type of infrastructure investments such as transmission are part of a larger societal debate over the nation’s energy policy, the use of society’s limited resources, and how to accommodate competing environmental values.

These difficulties are substantial, and must be accounted for in any transmission expansion policy. This does not mean that they cannot be surmounted or that there is no room for a rational, consistent, and primarily market-driven process. Nor does it suggest that these difficulties are unique to transmission and that we don’t find them in other parts of the energy industry or even in other industries. The key point is that there are no shortcuts: any attempt to circumvent, rather than surmounting, these difficulties will only lead to more problems.

Given these fundamental difficulties in expanding the transmission system, it is not surprising that policy shortcuts have been proposed. One such shortcut is simply to provide performance-based or incentive-based rates that create strong encouragement for transmission owners to overbuild the transmission system. The false logic behind this policy proposal is that because more transmission needs to be built, and it is existing transmission owners that build transmission, what is needed is stronger incentives to encourage these existing transmission owners to do the building. No worries should this lead to excess transmission, argue its advocates: the transmission system should be overbuilt anyway, because it is necessary for reliability and proper functioning electricity markets.

In many areas of the country, additional investments are necessary. But that does not mean that those investments must be regulated transmission projects. In some cases, more generation, load management, and market-based transmission projects would serve the needs better than would traditional transmission projects. Furthermore, it is no longer the case that only existing transmission companies are capable of planning, siting, building, and operating transmission facilities. While the right incentives are necessary, there must also be multiple developers able to compete with multiple projects to provide customers with low-cost power. The view that overbuilding should occur, and the gold-plating and large cost overruns of utility projects it spawned, was largely responsible for spurring a regulatory and public backlash that led to restructuring.

The Commission also needs to avoid the temptation to socialize the costs of transmission expansion. A socialization policy — assigning to all customers within a given region the costs of a mandated transmission project built because the market failed to perform — is fundamentally inconsistent with standard market design. It should not be that all customers are charged, regardless of whether and to what extent that project benefited specific types of customers. Markets perform best when costs are aligned with genuine benefits and those costs reflect the marginal or incremental cost of providing the desired product or service. Reliability and efficiency are not served when transmission policy is based on spreading the costs pro rata of transmission over all customers while energy prices are based on competitive outcomes between competing suppliers and consumers pay prices based on their contribution to congestion costs. A transmission expansion policy where costs are socialized specifically undercuts a system of locational marginal prices. Why would electricity customers in a load pocket – a high-cost region – contract with generators or merchant transmission providers to build generation in the load pocket or reduce the amount of congestion, if it is known that policy would trigger a transmission expansion wherein costs would be spread across a large region of users?

The Commission’s proposed rules for standard market design correctly note that costs and benefits must be aligned for the important practical reason of encouraging greater regional cooperation to get needed facilities sited and built. A low-cost region is more likely to site a facility that benefits a high-cost region if that low-cost region is not paying any of the costs of the facility. Of course, in some instances, the benefits of a mandated facility will accrue to the region, and it would be appropriate to recover those associated costs regionwide.

Furthermore, transmission both complements and competes with generation units and load management service providers. Another misguided policy is to ignore the competitive aspect between transmission on the one hand and generation facilities and load management on the other. Under such a framework, transmission is analogous to the federal highway system. But completing this analogy does not support the position taken by its advocates of a single transmission provider building lots of transmission and being paid a lot of money if success is achieved.

Here are some of the reasons that this analogy breaks down. The federal highways were not built by a single entity but by numerous contractors that, at least in theory, had to submit proposals and be selected through a competitive solicitation process. The proponents of organizing transmission expansion policy like the federal highway system are vehemently against any competitive solicitation process to meet transmission needs that are not satisfied by the market. Also, does anyone believe that the location and type of federal highways that were built were not motivated, at least in substantial part, by politics rather than genuine need? In addition, funding for federal highways is based on gasoline and diesel taxes: those that most benefit from the highway — that is, those that drive the most — provide most of the funding. This alignment of costs and benefits is not what the proponents of this policy analogy have in mind. Instead, they support socialization. Plus, since congestion is a major problem on many federal highways, it may not be a good model if the goal is to eliminate congestion in transmission.

The last policy shortcut to discuss is the misleading position taken by some that because “markets are not perfect” there ought to be strong, interventionist transmission expansion policies led by existing transmission owners and funded by all ratepayers . It is true that markets are imperfect. But neither is regulation. Had regulation worked well, there would have been no need to introduce competition and restructure the industry. The problem is that regulation, like competition, is an imperfect means, and it is naïve to assume that regulators, guided by transmission planners working on behalf of companies that stand to gain from getting their projects built, will unequivocally produce better results than imperfect competition.

The challenge is to design a transmission planning and expansion process that relies on markets but, when markets do not perform – and there will be disagreement, of course, on when this occurs – incorporates some type of backstop mechanism. More meaningful than the observation that “markets are not perfect” is understanding that if a backstop is designed improperly, it can undercut the performance of markets. Socialization of projects built via the backstop mechanism will reduce the incentive for the market to respond, resulting in less market activity and more need for the backstop.

Rather than trying to short-circuit the difficult problem of transmission expansion, the Commission has established the foundation for a rational policy that will serve the public interest. As the Commission correctly notes, its approach to regional planning and expansion is fully consistent with the goal of standard market design, which is to induce efficient investment by relying primarily on price signals and independently administered Congestion Revenue Rights. The Commission proposes locational marginal prices, which send the right price signals to locate load, generation, and transmission, combined with Congestion Revenue Rights to enable market participants to hedge and to capture the property rights associated with reducing congestion, which is necessary to finance projects. It proposes the development of Independent Transmission Providers (ITPs), not transmission owners, that would engage in regional transmission planning open to all industry segments. These ITPs would be able to issue request for proposals when the planning process determines that additional resources are needed, permit direct competition among all types of investments, and include all market participants equally.

Even under the Commission’s standard market design and transmission planning and expansion proposal, siting and building new transmission will be difficult. To its credit, the Commission does not assume that the fundamental problems inherent in transmission expansion can be circumvented or ignored. Instead, the Commission has crafted a policy that works within the existing constraints. The next step for the Commission is to affirm its proposal, add the necessary clarity and details to start moving the industry in that direction, and remove all doubt that it will continue to consider some or any shortcuts.

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I believe what FERC is doing is getting us ready for the needed modern energy infrastructure, and I applaud that.

Ask yourself if you would like Europe’s transmission mess our present hodgepodge, and the answer is clear, we’d take our hodgepodge any day. Now, should we improve on the integration of this hodgepodge so that someday we might send solar power from the east to the west and back efficiently? I think the answer is a resounding yes. Thus, FERC is doing the right thing to pressure for change now, not later, in transmission design and openness.

Further, deregulation allows the low cost power entrepreneur to outfox their rival with new low cost power technology, and hence gain their market share. Ultimately, what I think de-regulation will make possible in the US is the world’s lowest cost cleanest power across the board, shipped east and west, north and south, wherever there’s a buyer for that entrepreneur’s low cost, clean power. That’s what I hope is going to happen, and that’s what I think is going to happen if we finally finish with opening up the grid and improving upon its switching technology, which is already considerable. When that day arrives, I feel that clean-coal IGCC power will crush the competition for quite some time, but ultimately, I believe solar power will rule the roost. We will be glad FERC did its job and integrated America’s lines and switching systems, whatever the power source.

FERC is on the right track.