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Monday, February 21, 2011

Competitive Transmission Providers?

One of the hot topics in California at the moment is the CAISO’s apparent favoring of incumbent utilities in approving new transmission projects.  Proponents of alternative transmission system developers claim that the ISO’s purported preference diminishes competition and ultimately increases cost to consumers.  They claim that they can build transmission facilities better, cheaper and faster than the big incumbent IOUs (Pacific Gas & Electric, Southern California Edison and San Diego Gas and Electric), and that the ISO is unfairly discriminating against the competitive developers just to keep the utilities happy.  If you look back at the development of non-utility generation and the merchant generation business, the competitors have a good point.  Over the last dozen years or so, the competitive market has put downward pressure on generation development and operating costs, shortening the development process, and shifting risk from the utility ratepayer to the developer.  This has been good for the generation business so surely it would benefit the transmission side of the business.

There is no doubt (except maybe in the “Southern” states and among the APPA) that the competitive generation business has been good for consumers, so we should strive to bring competition to other aspects of the business as well, right?  Maybe not.  The generation business clearly benefited from reduced costs and increased efficiencies brought about by competition.  However, one of the primary reason was not increased efficiency compared to bloated vertically integrated utilities (though it certainly was), but a completely different profit paradigm.  Merchant generations make their profits from selling energy at prices higher than their costs.  The most effective way to increase profits is thus to reduce costs and increase efficiency over both the short and long-term.  This encourages practices like hedging gas price risk and minimizing heat rate.  Utilities, on the other hand, were able to pass through “reasonable” expenses and recover a specified return on equity.  In other words, the more they invested in rate-base the more earnings they were able to return to their shareholders.  This peculiar “regulated cost of service ratemaking” was a function of the “natural monopoly” compact that was developed by Samuel Insull and implemented in the early 1900s. It was very effective for most of the century as electrification spread and marginal costs decreased.  But when competition is an option it makes little sense to reward companies for convincing regulators that they should build more stuff.

Unfortunately, that’s where we are in the transmission part of the business.  Because of the inter-connected and integrated nature of the transmission grid and the variety of impacts a transmission upgrade may have, it’s not reasonably feasible to charge for usage.  Also, the operating costs of a transmission line are trivial compared to the capital cost to build it, so that reduced operating costs have an insignificant impact.  Then there’s the fact that transmission covers a huge geographic area, making franchise agreements and access to eminent domain important characteristics.  So what exactly is it that “merchant” transmission developers have to offer that make them better suited to develop transmission projects?  Virtually all rely on the “go to FERC and get a guaranteed rate of return approved and have the ISO include the costs in its transmission rates” model, which bears a very strong resemblance to the utility model they’re proposing to replace.  Some might argue that it’s just a different set of shareholders.   

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