Office of the Ohio Consumers' Counsel

Home Skip Navigation Go to Section Menu

Integrated Portfolio Management in a Restructured Supply Market

Introduction

Background

Evolution of Utility Generation

In the first part of the 20th century, a substantial portion of the nation’s electric generation was in the form of what we would now call self-generation or combined heat and power. Industrial operations often ran large boilers that could readily be adapted to produce electricity for the factory’s own needs and much more besides for sale to utilities. Others, originally located near water power for their own use, began to sell electricity at wholesale. Some even provided electricity to worker housing. This self-generation sector became much less important as generating technology advanced, non-industrial demand for power grew, and the economies of scale of central-station generation began to dominate the electric industry.

For about a century, consumers have relied on utilities with monopoly franchises to provide them with electricity; the rates of those utilities were generally set based on their cost of service plus an allowed rate of return on the capital they invested, but that situation began to change in the 1970s. Up to that time, investor owned, municipal, or cooperative utilities owned and operated most of the electric generation needed, and construction of generators was financed on the basis of reasonably assured revenue streams from retail monopolies and, for some companies, expected wholesale sales. ³ Declining real prices for fossil fuels and increasing economies of scale for capital-intensive steam-generating plants kept retail rates acceptable, while making entry into the wholesale generation business difficult.

Between the mid 1970s and the late 1980s, several trends led to a drive for better planning and resource choices by utilities. Among those trends were higher prices for fossil fuel, slower sales growth, stagnation in economies of scale, increased inflation and cost of money, and extraordinary cost overruns for some very large power-plant projects. Greater public demands for environmental protection also led to a greater level of scrutiny of generation and transmission siting. Many states, including Ohio, implemented policies requiring some kind of long-term (often referred to as “least-cost” or “integrated resource”) planning policy. Those policies usually mandated a long-term view of the cost of various alternatives and equal consideration of power purchases, renewable energy and energy efficiency. ⁴ Many planning policies incorporated environmental impacts or costs, allowed greater public involvement, and raised standards for permit approval. While the breadth, depth, and formality of these planning requirements varied widely among the states, most states developed some sort of long term planning function, at least for their larger electric utilities. We refer to this form of utility planning procedures as integrated resource planning or IRP.

The Rise of Wholesale Competition

Along side this trend, changes in technology made small generation units relatively cheaper and more competitive with large units. Technological progress also made long-distance transmission of bulk power cheaper and more practical. Utility territories and power pools became less isolated. Successful operations by non-utility generators—the so-called qualifying facilities—under the 1978 federal law called PURPA (the Public Utility Regulatory Policies Act) and apparently successful deregulation of the airline and telecommunications industries led to calls for deregulation of wholesale and eventually retail electric sales.

After 1988, the Federal Energy Regulatory Commission (FERC) began to further promote competitive wholesale electricity markets, using both rulemakings and case-by-case orders to advance that idea. FERC established various mechanisms to allow generators to charge market (that is, non-cost-based) rates and to provide transmission access to independent power producers, power marketers, and others. A key part of this evolution was a set of new FERC rules allowing generators to gain non-discriminatory access to bulk transmission. To further promote this kind of access, Congress enacted the Energy Policy Act of 1992. The Act also created a whole new class of “exempt wholesale generators” who did not need to comply with cost-based ratemaking at all and eliminated certain legal barriers faced by utility-affiliated and nonaffiliated power producers. For the same reason, FERC encouraged formation of independent system operators (ISOs) and regional transmission operators (FERC Orders 888; 888-a; 889; 2000). The Energy Policy Act of 2005 has further enhanced federal law supporting competitive mechanisms in the wholesale power industry.

The Appearance of Retail Competition

During the 1990s, interest in opening retail electric service to competition began to grow, especially in states with high retail electricity rates. It was argued that retail competition would reduce such rate disparities.

California, as well as many New England and mid-Atlantic states, and a few others adopted retail competition. As of July 2000, 24 states and the District of Columbia had moved to restructure retail electric service, with 18 others either considering or moving towards restructuring. However, since the 2000–2001 electricity crisis in the Western markets, no further action has taken place, and a few states have suspended, scaled back, or cancelled retail competition.

Retail choice exists in 16 states and the District of Columbia; however, nearly ten years into the restructuring of some of those states, only a small fraction of residential customers rely on competitive power suppliers. Large commercial and industrial customers “shop” much more frequently and have more choices and options than residential customers, but many are still seeing price increases.

The States Provide for Standard Service

Most retail-choice states provide customers the option of taking power supply from a standard service offer at a regulated price to ensure universal access to generation. In some states, the price was determined by competitive wholesale bidding from the time of restructuring. In many cases, however, the initial SSO was discounted below previous regulated rates or capped for a period of years. As a consequence, many retail-choice states now face steep rate increases for the SSO as generation rates transition to full dependence on the wholesale generation market. In many retail choice states, utilities providing SSO service have sold their generation assets or transferred them to unregulated affiliates. ⁵

More recently, a series of events have led some states to reconsider their approach to retail choice and standard service. During 2000–2001, California saw wholesale prices jump above levels that could be supported under its fixed SSO rates. Ultimately, one large investor-owned utility filed for bankruptcy protection, and the State had to intervene to acquire wholesale electricity supply on behalf of two utilities, locking in very high supply prices for some time. Subsequently, California suspended retail competition for most customers.

Most SSO procurement falls into one of two categories. Many states (e.g., Massachusetts, Pennsylvania, and Maryland) provided that standard service was delivered by the incumbent utility at fixed prices, often set so that total rates were discounted from the pre-restructuring retail rate, for a set number of years. The discounted fixed rates were sometimes mandated by state law. In other cases, the incumbent utility agreed to the discounted rates for a transition period as part of a settlement that included collection of so-called stranded costs. In many cases, the utility guaranteed the availability of the discounted rate by requiring a contract at that price as a condition for the purchase of its generation assets. Advocates of restructuring generally expressed confidence that retail competitors would be able to beat the fixed price by the end of the transition period. Consumer advocates were often reassured that consumers would get some savings in power-supply prices for some period of time.

Other restructured states (e.g., New York, Connecticut, California) focused on using wholesale competitive forces to set the SSO rate early in the restructuring process. As the initial transition contracts end, additional states (or in some cases, individual utilities within states) have started to acquire SSO supply from the competitive market, by variations on the following approaches:

• Short-term purchases from the short-term market, largely through the ISO (California, prior to the Western power crisis of 2000–2001).
• Purchases of standard products from the wholesale market, such as fixed blocks of around-the-clock energy, peak-period energy, and capacity, supplemented by transactions with the short-term market (e.g., New Jersey until mid-2002).
• Purchases of full-requirements service for the entire SSO load in forward contracts ranging from a few months to a few years, selecting the low-cost bidder in response to a Requests for Proposals (RFP) or similar solicitation (e.g., United Illuminating). ⁶
• Full-requirements purchases for slices (tranches) of the SSO load through RFPs (Maryland, DC, Delaware, Massachusetts, Maine, Rhode Island, Connecticut Light and Power, Duquesne).
• Full-requirements purchases for tranches of SSO load through fast-paced, multi-round, declining-clock auctions (New Jersey).

Rules for these auctions or RFPs and the rules for converting the resulting wholesale power costs into retail SSO rates were debated at length, with the regulators trading off minimizing the costs to SSO customers against encouraging retail competition.

One important aspect of these competitive SSO procurements was the period for which power as procured at one time. One approach was to make SSO a minimal short-term transitional product, for customers who had not yet selected a competitive supplier or were between suppliers. This view leads to short-term acquisitions (from California’s monthly ISO prices to the procurements of three to six months in Massachusetts, to New Jersey’s and Duquesne’s real-time pricing for large customers at ISO energy prices), with the expectation that volatile SSO prices would encourage more customers to move to competitive suppliers. If customers were likely to leave SSO in large numbers, longer-term SSO contracts might well be very risky to the supplier, and hence considerably more expensive than short-term contracts. Other states (e.g., Maine, Maryland and New Jersey for small customers, Connecticut) chose to procure SSO load in contracts lasting a year or more.

Regulators (and in many cases legislators) assumed that SSO consumers were best served or, at least, adequately served by short-term procurement that followed the wholesale market, and that retail competitors would offer more stably priced products as a value-added service. In fact, it seems that neither of those assumptions was valid, at least for small consumers. Instead, retail suppliers have largely withdrawn from serving small customers, leaving SSO consumers have been exposed to considerable price volatility, as power prices have followed the rapid rise in natural-gas prices and responded to congestion and market manipulation.

Even where retail suppliers have been willing to serve small consumers, they have not offered much variety of products. Few small consumers have been presented with competitive choices other than rates structured similar to that of the utility’s standard offer or offers of so-called green supply at higher prices.

A number of retail-choice states have begun to diversify their SSO procurements slightly, such as acquiring power in multiple solicitations within a year and purchasing supplies for overlapping periods. This kind of diversification, however, addresses only the timing of the procurement, which still depends on one kind of purchased product—all-requirements, fixed-price contracts with similar term lengths—and ultimately on wholesale markets driven by one fuel price. The cost and risks of SSO procurement from the short-term market are no longer minor problems and cannot be ignored. For the wholesale and retail power markets to work for all customers, significant changes in SSO planning and procurement are needed.

A few states (e.g., California and Delaware) have recently mandated a return to some sort of deliberate resource planning for procurement of SSO supply. In this report, we consider the strategies adopted in those jurisdictions and the latest types of integrated resource planning in use in non-restructured states. We also discuss additional tools that could be used to address better the need of SSO consumers for reasonably and stably priced power while improving wholesale competition and maintaining the opportunity for effective retail competition in electric power supply.

Advancing Generation Service for Ohio Consumers

As discussed in more detail in Chapter II, Ohio faces a difficult situation at both the retail and wholesale levels of the electric industry. Most Ohio electricity consumers now receive their generation service through the SSO and are likely to continue to do so. Further, the way SSO supplies have been acquired and priced through the rate stabilization plans has not contributed to the development of either competitive wholesale markets or competitive retail supply. The uncertainty of how Ohio will frame its post-2008 SSO regime does not help move those markets in constructive directions.

Unless a new approach is taken to procuring power for SSO service, small consumers will continue to suffer multiple losses. First, they have lost access to traditional, cost-based power in the transition to SSO service. Second, very few have been offered competitive retail supply. Third, SSO prices have been set at the prices that the incumbent utility has been willing to offer, rather than at competitive wholesale market prices. Fourth, the utilities have been allowed to make large parts of the SSO supply cost non-bypassable, and to adjust upward SSO rates for a variety of cost charges (including non-market prices, such as environmental-compliance costs at the utility’s power plants), further discouraging competition. ⁷ Fifth, even these flawed transition-service offerings are likely to be replaced by more volatile market-priced rates.

Moreover, in the post-transition regime, consumers will likely face prices based on market clearing prices, that is, all their power would be priced by reference to the cost of the most expensive source in any given hour. That clearing price is likely to be set much of the time by natural-gas prices that are at very high levels now and are likely to remain so for some time to come. To the extent that those markets are not completely competitive or have any other structural problems, the problem would be even more serious.

As discussed in Chapter II, long-term purchases of SSO supply from new resources can contribute to ensuring the adequacy of regional power supply. In the current Ohio regulatory structure, no entity has responsibility for ensuring regional supply adequacy. The utilities are no longer responsible for power-supply planning, the generation owners (including utility affiliates) have no long-term responsibility to customers (and actually benefit from supply shortages), neither PUCO or the Ohio Power Siting Board (OPSB) is legally required to take on this function, and the ISOs only do transmission planning and occasionally offering incentives to keep existing power plants on-line. ⁸ Even if a shortage of power supply were emerging, it is not clear how Ohio could ensure construction of new generation, under current arrangements.

Ohio can best minimize costs and risks for ratepayers while creating an opportunity for a competitive retail market to develop, by pursuing the following steps:

• Revising the wholesale procurement process, so that customers who continue to receive SSO power pay prices that reflect the prudent procurement from the competitive market.
• Ensuring that the SSO rate recovers all categories of costs paid by competitive suppliers, and that all such costs are recovered in SSO charges bypassable by shopping customers, so that each customer pays for either SSO or competitive supply, but not both.
• Diversifying the SSO supply, to minimize costs and risks for SSO customers and competitive customers as well.
• Developing long-term planning, to ensure an adequate, low-cost, and stable regional power supply and the availability of those supplies for Ohio consumers.

In order to achieve those goals, Ohio must take the following steps:

• Encourage wholesale competition by reforming SSO procurement.
• Level the playing field for retail competition by pricing SSO to be consistent with the wholesale market on which retail competitors depend.
• Encourage clean energy and energy efficiency in a manner consistent with the further development of retail competition by (1) renewable-portfolio and energy-efficiency-resource standards and (2) additional procurement of clean and renewable energy for SSO supply but with costs shared by all consumers.
• Promote wholesale-market stability and reduced retail volatility for all consumers by (1) using SSO load as an “anchor tenant” for development of new clean baseload generation and (2) serving SSO with a managed portfolio of short- and long-term purchases of new clean or renewable generation.

Currently, most residential and small commercial consumers lack options for shopping and there is little reason to think this will change in the near future. Residential consumers in other states, with only a few exceptions (largely temporary), have not seen significantly better opportunities to save money or control volatility through retail competition. Blumsack, Apt, and Lave (2005, 12) sum up the situation as follows:

With a few exceptions, residential switching activity in the competitive retail market has been minimal at best. Even if residential consumers wanted to switch, many service areas simply don’t have any competitors to the incumbent utility. Nineteen states currently offer some form of retail competition to at least some of its consumers, but in some areas (such as most of Pennsylvania) there are no alternatives to the incumbent utility. Residential activity in competitive retail markets has been low, with the exception of some traditionally high-cost urban areas.

As of mid 2005, among those states that had implemented retail choice, only Texas and the FirstEnergy companies in Ohio reported residential switching greater than 10%. ⁹ In Ohio, residential switching was driven primarily by a statewide opt-out aggregation program. ¹⁰ In Texas, the “price to beat” was set administratively but, despite the “price to beat” being adjusted upward an average of 43% in two years, only approximately 20% of residential customers had switched to competitive retail suppliers (Rose and Meeusen 2005, 36). Meaningful retail competition for residential consumers is rare and shrinking. Increases in default service prices are not simply a reflection of natural-gas prices, but also strongly reflect structural difficulties with the relevant markets.

Residential switching has been very low all along and there is no reason to suspect that residential consumers’ behavior will change, given the high transaction costs required to acquire customers, the uncertainties and risks involved, and the small annual consumption of each customer. As Blumsack, Apt, and Lave (2005, 13) observe, default service providers and competitive retail suppliers “face the same market price for bulk power.... Particularly in the case of the residential sector, there is little room for efficiency gains (and therefore vigorous price competition).”

The problem of securing the power needed for adequate and reasonably and stably priced SSO service can be addressed through careful resource planning, updating traditional IRP with a more-extensive use of the financial portfolio management techniques that have been adopted in SSO procurement in many states. By adopting this approach, Ohio can develop adequate power resources, obtain lower, more stable prices, and reduce consumer risk, while continuing its progress towards competitive wholesale and retail electricity markets. We will call that combination of portfolio management and IRP integrated portfolio management, or IPM. ¹¹

Traditional IRP evaluates a wide variety of supply- and demand-side resources to identify the combination of resources expected to meet current and future needs at the least cost. Integrated resource plans typically looked at planning periods of twenty years and were updated every two to three years.

Financial portfolio management comprises the guidelines that sophisticated investors and commodity purchasers utilize for determining their product mix. An investment manager must select the appropriate mix of cash, stocks of various kinds (large cap, small cap, foreign, etc.), bonds of various maturities and issuers (corporate, municipal, federal, foreign), futures and hedges, mutual funds, and so on. State-of-the-art portfolio management uses detailed quantitative analysis, to assess how different combinations of investments with varied kinds of uncertainty affect the return and risk profile of the total portfolio.

Similarly, the managers of power portfolios have multiple options, including buying power under various contractual arrangements (short- and long-term, full requirements or baseload, firm or unit-specific), building and running generation and of reducing need through demand-side management (DSM). Traditional vertically integrated utilities used portfolio-management approaches for some fuel and short-term power transactions, but did not generally see portfolio management as relevant to their major efforts, focused on building or buying generation and on DSM. Two recent changes have made portfolio management techniques more relevant to power-supply planning. First, the growth of market trading of futures and options for power, natural gas, weather, and emission permits, has expanded utility choices in resource planning, in a manner that resembles the financial and commodity markets in which portfolio management is commonplace. Second, utilities that have divested their generation and must procure power for SSO service have begun to use elements of portfolio management, such as contract laddering.

Debates about how to structure electricity markets and retail SSO procurement often become very theoretical. Ohio does not face an exercise in theory; the problem of ensuring adequate, reasonably and stably priced SSO will affect real people with real problems. Failure to do careful, integrated resource planning on how to meet that need is a planning decision, but not a very sound one! Failure to carefully choose and actively manage an appropriate portfolio of resources for that purpose is a portfolio management decision, but not a well thought out one.

---

³ The transmission and distribution systems were funded in the same way.

⁴ In Ohio, the IRP process led to development of some energy efficiency, but little or no renewables.

⁵ The transfers were often at prices below current market value for such assets.

⁶ These full-requirements contracts shifted many risks (price, load, migration to and from SSO) to the utility’s supplier for the period of the contract.

⁷ The Ohio Supreme Court has recently remanded to the PUCO two of the cases implementing rate stabilization plans. The specific item mentioned by the Court that must be addressed is the Competitive Bidding Process (4928.14(B)).

⁸ PJM’s Reliability Pricing Model and MISO’s Scarcity Pricing Model are attempts to grapple with this issue, but would rely on raising prices to all generators to encourage construction when and where it is needed.

⁹ Rose and Meeusen (2005, 2). Ohio’s opt-out program no longer contains a large number of residential shoppers.

¹⁰ Ohio residential aggregation has declined dramatically since late 2005, due to the below-market bypassable generation rates in the FirstEnergy utilities’ rate-stabilization plan.

¹¹ Chapters II through IV explain in detail how the IPM approach can integrate with continued competitive retail marketing. Chapters V and VI detail the energy-efficiency and renewable-energy implementation part of the IPM approach recommended for Ohio.