CHAPTER ONE

Background on Electric Industry Competition and Restructuring

1.0 Introduction

Passage of federal Energy Policy Act in 1992 set the stage for a transformation of the nation's electric industry from a regulated monopoly to a competitive market system.

The core of that transformation would expand competition among generating companies at the wholesale level through greater transmission access and participation of new suppliers. It would also create competition for customers at the retail level through an opening of the distribution systems to power marketers. For many of the nation's electric utilities the shift to competition implies a corporate and operational restructuring into separate distribution, transmission, and generation functions.

Following passage of the Energy Policy Act, the Federal Energy Regulatory Commission established rules to enhance competition at the wholesale level and encouraged states to establish laws and rules that would facilitate competition at the retail level. Twenty-four states have undertaken such action to establish retail competition. Another 24 states are studying the issue to determine possible impacts and options. States with high-cost electricity have taken early and aggressive action in the belief that competition may succeed in reducing costs and rates where regulation has failed to do so. Low-cost states, however, have expressed concern that their costs may rise as a result of establishing competitive retail markets for electric power.

Nebraska has long been recognized to have some of the lowest electric rates in the nation. In 1997 Nebraska was 6^th lowest in the nation for commercial consumers; 7 ^th lowest for industrial consumers; and 9^th lowest for residential consumers. Due to the weighting of various customer mixes, Nebraska was 11^th lowest for an average of all customer classes. (See Map M1-1 on page 12 for the average for all customer classes.)

Nebraska is also recognized as the only state in which all consumers are served by consumer-owned municipal systems, public power districts and rural cooperatives whose core principle is delivering electricity as a non-profit service.

Although one may debate whether any change is warranted, the state's electric systems are interconnected with other utilities in the region through regional power grids. the Mid-Continent Area Power Pool and the Western Systems Coordinating Council. Changes in federal requirements, changes in the regional markets, and changes in utilities with whom the Nebraska systems conduct business, as well as the desire of some customer segments, require that the state examine and address the transformation taking place.

While expansion of wholesale markets is underway, Congress has currently left the issue of retail competition up to the states to determine. Proposed federal legislation would allow any state to develop its own plan to prepare for competition in the electric industry. Nebraska has an opportunity to develop a plan to address its unique situation. As Nebraska citizens and policy-makers consider a plan for the future of their electric utilities, it is important to understand the context and key issues concerning deregulation and restructuring of infrastructure industries.

For the purpose of providing a broad context, Chapter One examines the background of restructuring of the electric utility industry; deregulation of other infrastructure industries in the United States, including impacts on Nebraska; electric utility industry restructuring in other nations; and proposed changes at the federal level to restructure the U.S. electric utility industry.

Subsequent chapters provide an overview of completed and anticipated developments in wholesale and retail electric competition and possible impacts and alternatives for Nebraska's consumer-owned electric systems. The result is a proposed framework for development of Nebraska's plan to address electric utility competition and restructuring.

1.1 Background on Electric Industry Restructuring

For the last 60 years, the electric utility industry in the United States has consisted primarily of vertically integrated electric utilities which include generation, transmission and distribution functions. Nationally, it is a mixed system of private investor-owned companies, and federal, state, and local consumer-owned facilities. In 1995 there were 244 investor-owned private electric utilities providing power to 75 percent of the nation's consumers; 931 rural electric cooperatives providing power to 11 percent of the nation's consumers; and 2,020 public power systems providing power to nearly 14 percent of the nation's consumers. Although some public power systems and rural cooperatives own generating plants, most function only as distribution systems. In addition to these utilities directly supplying consumers at the retail level, federal power agencies and independent power producers generate and sell power at the wholesale level.

The nation's power supply and distribution companies are organized into 26 power supply regions operating as part of three major grids of transmission lines, one east of the Rocky Mountains, one to the west, and one in the Texas region. They are also organized into nine regional electric reliability councils. Nebraska's electric systems in the eastern two-thirds of the state are part of the Mid-Continent Area Power Pool (MAPP) which covers a geographic region including South Dakota, North Dakota, Montana, Minnesota, western Wisconsin, Iowa and parts of Saskatchewan and Manitoba. Nebraska electric systems in the western part of the state are members of the Western Systems Coordinating Council (WSCC).

The organization and structure of the nation's electric industry that evolved during the 1935-1995 period resulted from a previous restructuring of the industry prompted by the federal Public Utility Holding Company Act of 1935 (PUHCA). The Holding Company Act broke up 16 major utility holding companies, which had come to control 75 percent of the nation's power output by the late 1920s. It addressed financial and market power abuses of the utility holding companies by creating barriers to limit market power and the potential for future abuse. This had specific significance for Nebraska. Several of these holding companies owned subsidiaries in Nebraska which had bought out more than one-third of the state's municipal electric systems, prevented the formation of rural electric cooperatives, and also hampered development and management of irrigation resources. Statewide initiatives and laws passed in Nebraska in the 1930s, complementary to the federal Holding Company Act, fostered a movement to buy out these holding company subsidiaries and structured the consumer-owned electric industry in the state today.

The state's 121 municipal electric systems, 31 public power districts and 11 rural electric cooperatives were organized as city departments, by petition, or by incorporation, respectively. Local boards of elected or appointed representatives govern these agencies. The municipal systems are regulated by the city council or village board (12 have boards appointed by the city council and mayor). These boards set rates, oversee quality of service, and make financing and budget decisions. The boards often operate in coordination with the city or village council. Major policy questions can be brought to voters as referenda questions in general elections.

Each public power district is governed by an elected board of directors who serve for a term of six years, with no limitation on the number of terms an individual may serve. The boards must have at least five members and no more than 21. Similar to municipal electric boards, the public power district directors oversee decisions on budgets, power supply, rates, and other policies. Board membership is not a full time job. Each board appoints a chief executive officer to manage the district's affairs as directed by the board.

Rural distribution cooperatives are governed by similar boards of directors elected by the member/consumers at annual meetings. Candidates do not appear on the general election ballot like public power district candidates. Because the rural distribution cooperatives are organized under laws for non-profit organizations they are not subject to the same statutory requirements as municipal and public power district systems.

The state's municipal systems, public power districts and rural electric cooperatives are further organized by voluntary coordinating bodies and associations such as the Nebraska Power Association, the Nebraska Rural Electric Association, and the Municipal Energy Agency of Nebraska. They also utilize cooperative and contractual relationships to gain operational efficiencies. At the wholesale level, these systems participate in a power supply market that operates as a voluntary contractual arrangement between interconnected utilities to facilitate reserve-sharing and to market surplus capacity and energy coordination.

Nebraska's locally-directed electric systems face potential changes in organization, principles, operations and governance in order to address expanded wholesale competition and new retail competition. Cooperative arrangements and principles of non-discriminatory, non-profit power delivery and local control utilized by the Nebraska systems are not compatible with the principles of a competitive market which are focused on service to selected high-use customers or selected groups of customers and market-based pricing. Competitive pressures could undermine cooperative arrangements utilized by Nebraska systems, unless they committed to methods to preserve those arrangements. Increased competitive pressure to alter non-profit, cost-of service pricing to market-based pricing could also raise Nebraska's wholesale and retail power costs.

Market pressures and the perception of market pressures are already engendering consideration of certain changes in response to events happening nationally and in the MAPP and WSCC regions.

1.1.1 Changes in the Electric Utility Industry After the Energy Policy Act of 1992

The transition now going on nationally and in the MAPP and WSCC regions was set in motion by passage of federal laws in 1978 and 1992, and subsequent federal regulatory actions.

Deregulation of the electric industry began with the passage of the Public Utility Regulatory Policies Act in 1978. This established the basis for independent, competitive companies to enter the power generation business at the wholesale level. During the 1980s federal regulatory efforts sought to enhance access to transmission lines for these new generators and to help establish competitive wholesale markets. In 1992, passage of the Energy Policy Act (EPAct) mandated broad open access to transmission lines and encouraged greater competition in generation. The EPAct set the stage for the most significant change in the electric utility industry since implementation of the Public Utility Holding Company Act of 1935.

The Energy Policy Act did not mandate retail competition and the Federal Energy Regulatory Commission (FERC) was specifically prevented from ordering retail competition. However, FERC efforts to expand wholesale markets has been accompanied by encouragement of states to establish competitive retail markets. The first major step in expanding wholesale markets and setting up retail competition is developing non-discriminatory transmission access.

In April 1996, FERC issued landmark orders 888 and 889 to implement open access to jurisdictional high voltage electric transmission systems. These orders also set in place the process to develop independent system operator (ISO) organizations and independent transmission companies (commonly known as Transcos or Independent Transmission Companies). The central issue is to create non-discriminatory open access for all suppliers and elimination of the ability of transmission owners to use the lines and facilities for their own strategic purposes.

For Nebraska and other states in the region, events to date can be characterized by efforts to form regional ISOs and transmission companies, expansion of the wholesale energy and transmission markets, upward price volatility in new wholesale markets, major utility mergers and reorganizations and the emergence of new competitive energy service companies, retail competition pilots, and limited retail markets opening in several states. In summary, for an industry that has relied upon joint planning of transmission and generation and relatively stable planning horizons, the transition to competition has created general uncertainty concerning the future.

In order to address the broad long term changes ahead, it is important to understand the key forces driving electric industry restructuring, experience with deregulation in other infrastructure industries, and changes proposed at the federal level and in other states.

1.1.2 Forces Driving Electric Industry Restructuring

Electric industry restructuring can be attributed to several key factors. It has generally been recognized that once transmission access began to open up and allow more wholesale transactions in the early 1990s, large industrial users and competitive wholesale suppliers in high-cost states pressed for access to develop competitive contracts at the retail level. Supporting these efforts were advances in generating plant and transmission technologies, electricity price disparities between states and regions, and political support for the philosophy of deregulation.

As competition evolves in the electricity industry, market forces could create additional new technologies currently unforeseen as well as marketer packages of combined energy services (i.e. natural gas and electricity), or combined "wires" services including telecommunications, Internet, and cable television, or even more diverse packages including home security and lawn services.

As wholesale markets expand, there is an expectation that the price of wholesale power will decline from previous levels in high-cost states and remain stable or slightly increase in low-cost states as the market prices reflect demand and as market risk is incorporated into price. However, early experience shows a high level of volatility in these markets and an increase, rather than a decrease, in wholesale prices of high-cost states. Recent studies conducted in low-cost states have indicated the potential for substantial increases in power prices. Other national studies, which will be discussed later in this report, indicate conflicting results as to whether Nebraska's consumers would experience price increases or decreases as a result of retail competition.

The opportunity for a low-cost state's generators to sell into the wholesale market can create pressure on low electric rates, depending upon the extent to which proceeds from these sales are returned to maintain or reduce current retail electricity prices. Of special significance and concern will be the extent to which a low-cost state's generating facilities are used to sell to customers outside the state of the detriment to electric rates within the state.

Expectations concerning lower costs from competitive markets are based on the assumption that market forces can bring about efficiencies and reduce costs better than a regulated market system.

Comparisons are often made between efforts to establish competitive retail markets in the electric industry, and deregulation and competition that is evolving in other infrastructure industries such as airlines, telecommunications, and natural gas. The electric industry is often viewed as the last major infrastructure industry to be deregulated.

The magnitude of the changes involved in creation of competitive markets and restructuring of electric companies dwarfs all other deregulation. No other industry approaches the complexity of issues and the amount of capital in transition. Because of the differences in each industry, great care must be taken in attempts to project parallel results.

1.2 Deregulation of Other U.S. Infrastructure Industries and in Other Nations

During the last two decades, deregulation of the major transportation and utility industries was brought about in part by the following deregulation initiatives:

• Natural Gas Policy Act of 1978 and FERC Orders
• Airline Deregulation Act of 1978
• Motor Carrier Reform Act of 1980
• Staggers Rail Act of 1980
• Telecommunications Act of 1996 and Court Ordered Divestiture

While direct comparisons to the electric industry are limited, experience in the deregulation of these industries offers lessons that may prove useful.

The results of deregulation of other infrastructure industries are mixed at best. As seen in telecommunications and natural gas, much of the competitive structure remains to be put in place for small commercial and residential consumers. There have clearly been changes in structure of the industries, and technological advances have been fostered, but this must be weighed against the "winners-and-losers" experience at the local level, and corporate consolidations that may undermine viable competition.

General findings that may be applied to the electric industry from the experience in other infrastructure industries: 1) small commercial and residential consumers and those in rural areas face questionable benefits from deregulated markets; 2) it will take time for a competitive system to evolve to serve all consumers; 3) technological advances and new packages of services may be anticipated; 4) prices may not decline as anticipated; 5) greater and not less regulatory oversight may be required; 6) in particular, market power restrictions and regulatory oversight will be needed to prevent anti-competitive behavior.

In addition to the U.S. experience in deregulating and restructuring key infrastructure industries, such general findings are supported by experience of deregulation and restructuring the electric industry in other nations that began in advance of the U.S.

Deregulation and restructuring of the electricity industry in the U.K. was accompanied by a major extension of economic regulation.

In general electric industry restructuring in other nations indicates that:

1) expanded wholesale competition does not necessarily equate to lower cost power prices, 2) retail competition does not assure equal access for all customers and broad-based "customer choice", 3) transitions to competitive markets will require on-going legislative and regulatory involvement and are likely to take a decade or more to mature.

1.3 Activity at the Federal Level

At the federal level there are a number of bills before Congress to restructure the electric industry. In addition to these proposals, regulatory activity at FERC could affect Nebraska systems. The formation of Independent System Operators or regional transmission companies and expanded authority for FERC, could place increased pressures on Nebraska systems to adopt certain practices or policies related to transmission access and wholesale competition. FERC Orders 888 and 889, issued in April 1996 to implement the requirements of the Energy Policy Act of 1992; require all jurisdictional transmission owners to provide non-discriminatory open access to transmission to all current and potential users. It is important to note that FERC orders apply to "public utilities" that are generally defined as private investor-owned companies under FERC's jurisdiction. Public power and rural cooperative systems in Nebraska are not currently subject to FERC jurisdiction. However, because public power and rural cooperative systems own transmission lines that are interconnected with jurisdictional utilities and because they are members of regional power pools (such as MAPP), they are impacted by the FERC orders

FERC's goal is to eliminate the remaining patchwork of closed and open jurisdictional transmission systems and ensure that all these systems, including those that already provide some form of open access, cannot use monopoly power over transmission to unduly discriminate against others.

As noted earlier, Congress has initially left the timing and nature of electric industry restructuring up to the states to decide. States are moving forward on varying schedules and differing proposals for competition. As of October 1, 1999, 21 states have passed legislation to establish retail competition. Three states have established competitive markets by regulatory order, and 24 states and the District of Columbia, are studying the issue. In addition, 24 low-cost states, including Nebraska, have petitioned Congress to allow states to make their own determinations concerning the timing and form that competition and electric industry restructuring will take.

Both direct and indirect pressures resulting from federal actions and evolution of the market can be expected to increase. While federal consensus has not yet emerged, it is anticipated that after the year 2000 elections, Congress will be much more likely to act on this issue.

In the meantime, Nebraska has an opportunity to develop a plan based on its own conditions concerning the timing and elements of electric competition. The following summaries of each chapter outline the key points that may help to inform Nebraska's plan.

CHAPTER TWO:   Electric Industry Restructuring in Other States

This chapter reviews activity to establish wholesale and retail competition in other states. It looks at experience in states that have established retail markets and at preconditions for market and key issues being addressed by other states. The chapter also examines market transformation that is occurring with a focus on merger activity of significance to Nebraska. It concludes with a review of the pressures that may face Nebraska from neighboring states, regional agencies, and federal agencies.

1. All states are facing major changes in the electric industry, even without state legislation or rules for competition being passed or promulgated.
2. Twenty-one states have enacted legislation to establish retail competition; three states have issued comprehensive regulatory orders; twenty-four states and the District of Columbia are studying restructuring and formation of competitive retail markets; two states have undertaken little preliminary action to date.
3. The states which had opened markets for retail competition by June 1, 1999 showed opportunities for large customers, but difficulty in creating market conditions that allow small commercial and residential customers to be served. The market has also been characterized by private deal-making and non-transparent pricing which prevent market forces from functioning effectively.
4. Early common problems in the open-market states indicate certain key issues must be fully addressed and certain preconditions should be met before undertaking retail competition aimed at benefiting all consumers.
5. New business structures, alliances and multiple service providers are under consideration or forming
6. Electric utilities in Nebraska and neighboring states will all engage in an expanded wholesale power supply market, but no determinations have been made in Iowa, Kansas, South Dakota, Wyoming, or Colorado to establish retail competition.
7. While states are taking varied approaches, common problems are apparent both in wholesale and retail markets. It is essential that preconditions be met in structure and market conditions prior to Nebraska systems making a transition to retail competition. These conditions include: a fully functioning ISO and mature wholesale market; business transaction and consumer protection rules; market pricing that indicates savings on power costs significant enough to offset costs of the transition; a safety net in place to assure that no consumers suffer net harm from the transition.
8. Major mergers and extensive structural change are occurring in the industry, even in states which have not passed legislation or regulatory orders. For Nebraska several major mergers in surrounding states could affect wholesale markets and increase the pressure to initiate retail competition
9. The broad effect of mergers in the Nebraska region is to create two large electric utility holding companies in Iowa where there were originally six, and to create one large electric utility holding company in Missouri/Kansas where there were originally three utility companies. Typical concerns that arise from electric utility mergers: 1) increased market concentration in generation and/or transmission ownership; 2) significantly increased growth in number of retail customers under single entity; 3) significantly increased corporate size of merged entity; 4) "convergence" of various services in new entity.