National Energy Policy, Blackouts and Sustainable Energy Programs

Greg Aliff and Branko Terzic

THE NATIONAL INTEREST

Special Energy Supplement

Winter 2003/04

On August 14^th, blackouts crippled the Canadian province of Ontario and the eastern United States, making it the largest power failure in American history: over 50 million people and more than 9,300 square miles were affected. Then, on August 28, London was plunged into darkness. One month later, Italy’s entire electrical grid shut down. These highly visible blackouts have called into question a global trend in the electric power industry. Whatever one calls it—”de-regulation”, “competition” or “liberalization”—the notion, at its core, is that certain elements of the electric supply industry can better meet national energy goals if existing monopolies are weakened and some levels of competition is introduced.

An international consensus has been built around the idea that sustainable energy policy should be based on three pillars: 1) competitive markets (where markets are possible) are superior to monopolies; 2) adequate private capital must be available to build infrastructure; and 3) governments must institute sound regulatory and energy policies. Indeed, virtually all Organization for Economic Cooperation and Development (oecd) member-countries allow competition in their electric utility markets. At the same time, the efficacy of these changes is now being called into question as states reevaluate their security situations and infrastructure vulnerability in the wake of 9/11 and the recent blackouts.

The importance of identifying a successful sustainable energy strategy at the international level is illuminated—pardon the pun—by the fact that, at present, only a third of the world’s population has adequate electric supply, a third is inadequately supplied, and a third has no electric service. In this context, international aid agencies and multilateral lending agencies have been advancing the competitive market, private capital/regulation model as the answer to the world’s energy needs. This leads naturally to the question: Does implementing this model run the risk of increased blackouts?

In all likelihood, the cause of the recent blackouts will be shown to have been a unique and timely (or untimely) combination of physical events and operational decisions unrelated to changes in grid ownership structures or regulatory policies in the affected countries. However, the blackouts did occur in states that have introduced some form of competition in their electricity markets: the interconnected eastern United States and Ontario grid, the uk and Italy. How the issue of “liberalization” or “competition” was approached on opposite sides of the Atlantic may be instructive in determining why the lights recently went out.

Blackouts and Competition in the United States

The U.S. electric system was predominantly built by private capital exercising local monopolistic policies. Competition was only gradually implemented for wholesale purchasers, and was more limited on the retail end (no federal law or directive ever required retail competition). While electric rates in the United States have ranked among the lowest in the world, and the electric system has been among the most modern and reliable, the nation has witnessed deep regional variation in both costs and rate levels for the various classes of customers. This is partly due to jurisdictional issues: Wholesale electricity rates and tariffs for transmission service for wholesale customers are regulated by the U.S. Federal Energy Regulatory Commission (ferc); Retail rates paid by residential, commercial and industrial customers are set by state regulatory agencies (usually called public service or public utility commissions).

Initially, local electric companies provided electric generation transmission to load centers as well as local electric power distribution to customers. Later, limited transmission facilities were built connecting neighboring systems so as to access power during emergencies and when it was economically sensible to do so. As the years passed, the amount of wholesale purchases increased as regulators encouraged or required electric power companies to seek the lowest cost supply price rather than to build their own facilities.

With the 1978 Public Utility Regulatory Policies Act (purpa), Congress responded to rising electric prices by creating a class of subsidized and independent power producers with the intention of encouraging nontraditional fuels and the entry of non-utility generating companies into the marketplace. State regulators in some states took steps to require attractive rates for the new purpa entrants. They also established binding mechanisms to force local electric companies to buy on the wholesale market rather than generate electricity locally with their own power plants. At the same time, some industrial customers and consumer groups appealed for direct access to cheaper power. Legislatures in some states responded by allowing consumers direct access to competitive electric suppliers under the condition that the incumbent utilities be permitted, or in some cases be required, to sell their electric power plants. Any losses incurred by the electric utilities due to these sales were usually covered by “stranded cost” surcharges on the delivery portions of customer bills or other methods. The consequence for all of this was that “restructuring” was initiated at the state and not at the federal level. (About half of the states have taken some steps to introduce competition at the retail level.)

California was an early pioneer in allowing competitive access to electric consumers, yet the highly publicized California experiment resulted in dramatic price increases during the summer of 2001. In retrospect, most would agree that the California legislature passed a flawed law, that the California Public Utilities Commission instituted flawed retail pricing policies, and that ferc approved a flawed market design. This did not prove that “liberalized” electricity markets were impractical, but merely that badly designed markets would work badly.1

However, other states with high comparative retail electric rates—such as Pennsylvania, Massachusetts, New York, Maine and Maryland—have also demonstrated that one can have competition in electric markets without creating the problems of insufficient supply and extremely high prices experienced in California. Granted, this has been a recent development. In these areas, supply problems are due not to competition but the reality that the basic electric infrastructure has been in place for some time with known deficiencies in transmission capabilities and local generation capacity. This was particularly true in New York, where an April 2003 report of the New York Independent System Operator warned of facility shortages and the danger of blackouts.

The recent U.S.-Canada blackout is still under investigation. Certainly, the states and provinces affected had all undertaken some restructuring within the past few years. The main changes affecting the ownership of power plants had resulted in increased wholesale purchasing of electricity and the selective introduction of retail competition. It would not appear likely that recent changes in ownership and limited competition increased the risk of failure in the infrastructure that led to the blackout. After all, the last major blackout in New York (in 1965) occurred under the prior model of local monopoly electric providers.

The eu’s Experience

Reliable access to electric power is an indispensable condition for sustained economic growth. Therefore, as individual American states weigh the pros and cons of various initiatives, European policies have come under greater scrutiny in the ongoing American debate over the future of U.S. energy policy. The European Commission (ec) adopted an Electricity Directive on December 19, 1996, to establish a single European electricity market with the aim of introducing cross-national competition in electricity generation and retailing. European policymakers were in agreement with the notion that “liberalization” would enhance consumer welfare by reducing prices.

In its most simplified form, the ec directive requires that electric supply customers have access to competitive retail supply. The 1996 directive, however, will be superceded in July 2004 by a new directive that requires industry “unbundling” or legal separation and separate accounting for Europe’s electric transmission operations. The forthcoming directive will further specify that all consumers have the right to access competitive supply by July 1, 2007. Each member-state is required to have an independent regulatory authority and new electric supply entrants are to be allowed in on a mandatory authorization procedure with published criteria and rights of appeal.

The ec’s decision to implement a new directive follow a series of studies that examine the results of the 1996 directive, including such reports as the March 2001 “Overview of European Gas and Electricity Sectors Liberalization and Regulation.” The decision to enhance the 1996 directive reaffirmed the ec’s commitment to liberalization based on a positive evaluation of price and service quality changes experienced in member-states to date. But, in the aftermath of the blackouts in Italy and the uk, is this still the case?

Italy has had the highest generation costs in Europe, and the Italian government responded by forcing enel—one of the national power companies—to create competition by divesting at least 23 percent of its installed capacity. The government also approved the Marzano decree of April 3, 2002, which expedited the process for approving the construction of new power generating plants in excess of 300 megawatts. (Italy’s two state-owned power companies—uni and enel—are considered to have underinvested in generation capacity and to have been too reliant on power imports.) To provide for an appropriate level of independent regulation, Italy also established a new regulation office (the Autorita per l’Energia Elettrica). So, by September 2003, the government had taken steps to open markets and encourage private power development.

The September 28, 2003, blackout was the largest in Italy since the electric system was nationalized in the 1960s. The cause, it is thought, stems from a break in a major transmission line from Switzerland that caused lines coming from France to become overloaded and “trip off”, shutting down the network. This highlighted the fact that Italy still continues to import a great deal of power. Despite this catastrophe, the Italian government remains confident that the effects of deregulation and liberalization will lower domestic generation costs by 2005: some observers expect a 25 percent fall in prices for Italian consumers between 2005 and 2008. Indeed the advent of competition in new capacity generation is expected to alleviate future power blackouts rather than contribute to blackout problems.

London’s blackout occurred at the end of the workday, lasted about 38 minutes and affected 250,000 commuters stranded in the Underground. The cause of the outage was discovered quickly and attributed to two transformer failures at a single electric substation. While the blackout was a minor event compared to the North American experience, critics of the uk’s energy policy were quick to point out that the grid operator also owned an electric system involved in the U.S. blackout a month earlier. Yet, other than that coincidence, there is not much else in common, since the British grid system is among the most competitive in the world.

During the Thatcher era, Britain’s nationalized electric, gas, water and telephone utilities were both privatized and restructured. The electric system was divided in 1989 between a number of generation companies, a single national grid company and multiple electric distribution companies. New entrants into the power supply and marketing markets were also encouraged, and a national electric power market was established. To facilitate the attraction of private investment and to monitor the electric power markets, the uk established an independent regulator: the Office of Gas and Electric Markets.

Britain has experienced problems in establishing a viable wholesale power market exchange. The initial power pool was closed because of declining generator costs and after it both failed to reflect demand/supply balances and remained unable to evolve to meet new market realities. In response to the power pool’s failure, the government replaced it with the New Electricity Trading Arrangements (neta). This was implemented a year ago, and prices have fallen by as much as 25 percent.

So, the uk’s decade-long experiment with privatization, competition and regulation is a success. There has been a demonstrable decrease in electric rates in addition to an increase in efficiency. (There is a debate, however, over the share of the efficiency gains attributable to privatization versus that attributable to the restructuring and separation of generation, transmission, distribution and marketing.) Since the uk has had Europe’s longest and most successful experience with a competitive electric power market regulated by an independent office, the European Commission was emboldened to move ahead with its dramatic proposals for the liberalization (coupled with regulation) of Europe’s electric power markets.

DROP CAP

Notwithstanding the summer 2003 blackouts in North America, the uk and Italy, the proposition that a sustainable energy policy can be obtained by relying on competition, the availability of private capital and appropriate regulatory policies remains viable. In no case has it been demonstrated that the implementation of these policies was the cause of the power grid failures. Certainly, each country has had problems introducing competition into the electric energy markets. (Consider California’s rolling blackouts, the uk’s original power pool and Italy’s lack of native power generation.) Nevertheless, both the United States and the European Union are modifying their regulatory policies to allow markets to operate more efficiently and to encourage private investment in critical infrastructure. Any sustainable energy policy requires attracting private investment at reasonable terms to build and maintain the critical energy infrastructure necessary for the maintenance of national security and competitive economies. In turn, the needs of both consumers and investors require balancing competition with responsible regulation.

Though the emerging international consensus in favor of “regulated competition” may not be perfect, it has been proven to work. As the World Energy Council concluded in its 2000 report Energy for Tomorrow’s World: “The experience of liberalization in the energy sector will on balance prove beneficial.” Of course, mistakes will be made, but the current model for sustainable energy development is the best way to extend reliable electric service to the rest of the globe. After all, the occasional rolling blackout is far better than no power at all.

Greg Aliff is national managing partner of the Energy & Resources Group at Deloitte. Branko Terzic, a former ferc Commissioner, is director of regulatory services for Deloitte.

1A study commissioned by the Electric Power Supply Association released in July 2001 claimed significant benefits in the form of inflation-adjusted electric price decreases of 30 percent for all customer classes during the fifteen year period 1985-1999 as a result of limited competition.