Electricity Restructuring
Key Challenges Remain Gao ID: GAO-06-237 November 15, 2005The electricity industry is in the midst of many changes, collectively referred to as restructuring, evolving from a highly regulated environment to one that places greater reliance on competition. This restructuring is occurring against a backdrop of constraints and challenges, including a shared responsibility for implementing and enforcing local, state, and federal laws affecting the electricity industry and an expected substantial increase in electricity demanded by consumers by 2025, requiring significant investment in new power plants and transmission lines. Furthermore, several recent incidents, including the largest blackout in U.S. history along the East Coast in 2003 and the energy crisis in California and other parts of the West in 2000 and 2001, have drawn attention to the need to examine the operation and direction of the industry. At Congress's request, this report summarizes results of previous GAO work on electricity restructuring, which was conducted in accordance with generally accepted government auditing standards. In particular, this report provides information on (1) what the federal government has done to restructure the electricity industry and the wholesale markets that it oversees, (2) how electricity markets have changed since restructuring began, and (3) GAO's views on key challenges that remain in restructuring the electricity industry.
Over the past 13 years, the federal government has taken a variety of steps to restructure the electricity industry with the goal of increasing competition in wholesale markets and thereby increasing benefits to consumers, including lower electricity prices and access to a wider array of retail services. In particular, the federal government has changed (1) how electricity is priced--shifting from prices set by regulators to prices determined by markets; (2) how electricity is supplied--including the addition of new entities that sell electricity; (3) the role of electricity demand--through programs that allow consumers to participate in markets; and (4) how the electricity industry is overseen--in order to ensure consumer protection. Federal restructuring efforts, combined with efforts undertaken by states, have created a patchwork of wholesale and retail electricity markets; broadened electricity supplies; disconnected wholesale markets from retail markets, where most demand occurs; and shifted how the electricity industry is overseen. Taken together, these developments have produced some positive outcomes, such as progress in introducing competition in wholesale electricity markets, as well as some negative outcomes, such as periods of higher prices. We have identified four key challenges to the effective operation of the restructured electricity industry: making wholesale markets work better together so that restructuring can deliver the benefits to consumers that were expected; providing clear and consistent signals to private investors when new plants are needed so that there are adequate supplies to meet regional needs; connecting wholesale markets to retail markets through consumer demand programs to keep prices lower and less volatile; and, resolving divided regulatory authority to ensure that these markets are adequately overseen. The theme cutting across each of these challenges is the need to better integrate the various market structures, factors affecting supply and demand, and various efforts at market oversight.
GAO-06-237, Electricity Restructuring: Key Challenges Remain
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Report to the Chairman, Subcommittee on Energy and Resources, Committee
on Government Reform, House of Representatives:
November 2005:
Electricity Restructuring:
Key Challenges Remain:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-237]:
GAO Highlights:
Highlights of GAO-06-237, report to the Chairman, Subcommittee on
Energy and Resources, Committee on Government Reform, House of
Representatives:
Why GAO Did This Study:
The electricity industry is in the midst of many changes, collectively
referred to as restructuring, evolving from a highly regulated
environment to one that places greater reliance on competition. This
restructuring is occurring against a backdrop of constraints and
challenges, including a shared responsibility for implementing and
enforcing local, state, and federal laws affecting the electricity
industry and an expected substantial increase in electricity demanded
by consumers by 2025, requiring significant investment in new power
plants and transmission lines. Furthermore, several recent incidents,
including the largest blackout in U.S. history along the East Coast in
2003 and the energy crisis in California and other parts of the West in
2000 and 2001, have drawn attention to the need to examine the
operation and direction of the industry.
At the Committee‘s request, this report summarizes results of previous
GAO work on electricity restructuring, which was conducted in
accordance with generally accepted government auditing standards. In
particular, this report provides information on (1) what the federal
government has done to restructure the electricity industry and the
wholesale markets that it oversees, (2) how electricity markets have
changed since restructuring began, and (3) GAO‘s views on key
challenges that remain in restructuring the electricity industry.
What GAO Found:
Over the past 13 years, the federal government has taken a variety of
steps to restructure the electricity industry with the goal of
increasing competition in wholesale markets and thereby increasing
benefits to consumers, including lower electricity prices and access to
a wider array of retail services. In particular, the federal government
has changed (1) how electricity is priced”shifting from prices set by
regulators to prices determined by markets; (2) how electricity is
supplied”including the addition of new entities that sell electricity;
(3) the role of electricity demand”through programs that allow
consumers to participate in markets; and (4) how the electricity
industry is overseen”in order to ensure consumer protection.
Federal restructuring efforts, combined with efforts undertaken by
states, have created a patchwork of wholesale and retail electricity
markets; broadened electricity supplies; disconnected wholesale markets
from retail markets, where most demand occurs; and shifted how the
electricity industry is overseen. Taken together, these developments
have produced some positive outcomes, such as progress in introducing
competition in wholesale electricity markets, as well as some negative
outcomes, such as periods of higher prices.
We have identified four key challenges to the effective operation of
the restructured electricity industry: making wholesale markets work
better together so that restructuring can deliver the benefits to
consumers that were expected; providing clear and consistent signals to
private investors when new plants are needed so that there are adequate
supplies to meet regional needs; connecting wholesale markets to retail
markets through consumer demand programs to keep prices lower and less
volatile; and, resolving divided regulatory authority to ensure that
these markets are adequately overseen. The theme cutting across each of
these challenges is the need to better integrate the various market
structures, factors affecting supply and demand, and various efforts at
market oversight. This theme is illustrated below.
Integrating Restructuring Efforts is Important:
[See PDF for image]
[End of figure]
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[End of section]
Contents:
Letter:
Results in Brief:
Background:
The Federal Government Has Taken Steps to Increase Competition in the
Electricity Industry and Wholesale Markets:
Electricity Markets Have Changed in Several Important Ways Since
Restructuring Began:
Four Key Challenges Remain Unresolved:
Concluding Observations:
Appendix:
Appendix I: GAO Contact and Staff Acknowledgments:
Related GAO Products:
Figures:
Figure 1: Functions of the Electricity Industry
Figure 2: Areas Served by Entities Subject to FERC Jurisdiction, 2002:
Abbreviations:
FERC: Federal Energy Regulatory Commission:
PUHCA: The Public Utility Holding Company Act of 1935:
ISOs: Independent System Operators:
RTOs: Regional Transmission Organizations:
Letter November 15, 2005:
The Honorable Darrell E. Issa:
Chairman:
Subcommittee on Energy and Resources:
Committee on Government Reform:
House of Representatives:
Dear Mr. Chairman:
Since 1992, the electricity industry has been in the midst of many
changes, collectively referred to as restructuring. Before
restructuring, electric service was provided primarily by federally and
state-regulated electric utilities. A utility typically owned the power
plants, transmission system, and local distribution lines that supplied
electricity to all of the consumers in a geographic area. Under this
system, the Federal Energy Regulatory Commission (FERC) regulated,
among other things, sales of electricity for resale and the
transmission of electricity over high-voltage power lines in interstate
commerce.[Footnote 1] The states regulated retail markets by
participating with utilities in forecasting growth in demand, planning
and building new power plants, reviewing and approving utility costs,
and establishing rates of return. Since restructuring began, there has
been a shift from a highly regulated environment to one that places
greater reliance on competition.
This restructuring effort is occurring against a backdrop of
constraints and challenges. First, it is occurring within a context of
numerous federal and state laws and regulations that address clean air
and water, fish and wildlife management, and irrigation and flood
control. Second, responsibility for implementing and enforcing these
laws and regulations is distributed across a wide range of federal,
state, and local agencies. Third, electricity demanded by consumers is
expected to rise 36 percent by 2025, requiring significant investment
in new power plants and transmission lines. Furthermore, several recent
events, including the largest blackout in U.S. history along the East
Coast in 2003, the energy crisis in California and other parts of the
West in 2000 and 2001, and rolling blackouts as recently as August 25,
2005, in southern California, have drawn attention to the need to
examine the operation and direction of the industry.
In this context, you asked us to provide information on (1) what the
federal government has done to restructure the electricity industry and
the wholesale markets that it oversees, (2) how electricity markets
have changed since restructuring efforts began, and (3) our views on
key challenges that remain. As you requested, this report is based on
our previous work, including 17 reports issued since 1998,[Footnote 2]
which was conducted in accordance with generally accepted government
auditing standards. As a result, we did not seek additional comments on
this report.
Results in Brief:
Since at least 1992, the federal government has pursued a policy to
restructure the electricity industry with the goal of increasing
competition in wholesale markets and thereby increasing benefits to
consumers, including lower electricity prices and access to a wider
array of retail services. In particular, federal restructuring has
changed how electricity is priced--shifting from prices set by
regulators to prices determined by markets; how electricity is
supplied--including the addition of new entities that sell electricity;
the role of electricity demand--through programs that allow consumers
to participate in markets; and how the electricity industry is
overseen--in order to ensure consumer protection.
Federal restructuring efforts, combined with efforts undertaken by
states, have fundamentally changed key aspects of how the electricity
sector operates. First, because many of the changes have been made by
FERC, which has limited jurisdiction over wholesale markets and no
jurisdiction over retail sales, the changes have created a patchwork of
wholesale and retail electricity markets. Some of these markets feature
a greater role for competition, while others do not. Second, the
introduction of a greater role for competition has broadened
electricity supplies by allowing new suppliers to participate in
markets. Some of these suppliers sell electricity across wide
geographic regions and multiple states, which has broadened supplies
and made markets more regional. Third, while actions taken at the
wholesale level have encouraged prices to be set by the direct
interaction of supply and demand, there have not been widespread
similar efforts on retail prices, resulting in a disconnection of
wholesale markets from retail markets. Fourth, although regulatory
authority remains divided between federal, state, and local entities,
restructuring has shifted the way electricity markets are overseen.
Taken together, these developments have produced some positive
outcomes, such as progress in introducing competition in wholesale
electricity markets, and some negative outcomes, such as periods of
substantially higher prices in some areas of the country.
We have identified four key challenges to achieving the goals of a
restructured electricity industry: (1) making wholesale markets work
better together so that restructuring can deliver the benefits to
consumers that were expected, (2) providing clear and consistent
signals so that there are adequate supplies to meet regional needs, (3)
connecting wholesale markets to retail markets through consumer demand
programs to keep prices lower and less volatile, and (4) resolving
divided regulatory authority to ensure that these markets are
adequately overseen. Not adequately addressing these issues could
result in an electricity industry that does not provide consumers with
the sufficient quantities of reliable, reasonably priced electricity
that has been a mainstay of our nation's economic and social progress.
Background:
The electricity industry is based on four distinct functions:
generation, transmission, distribution, and system operations. (See
fig. 1.) Once electricity is generated--whether by burning fossil
fuels; through nuclear fission; or by harnessing wind, solar,
geothermal, or hydro energy--it is sent through high-voltage, high-
capacity transmission lines to electricity distributors in local
regions. Once there, electricity is transformed into a lower voltage
and sent through local distribution wires for end-use by industrial
plants, commercial businesses, and residential consumers.
Figure 1: Functions of the Electricity Industry:
[See PDF for image]
[End of figure]
A unique feature of the electricity industry is that electricity is
consumed at almost the very instant that it is produced. As electricity
is produced, it leaves the generating plant and travels at the speed of
light through transmission and distribution wires to the point of use,
where it is immediately consumed. In addition, electricity cannot be
easily or inexpensively stored and, as a result, must be produced in
near-exact quantities to those being consumed. Because electric energy
is generated and consumed almost instantaneously, the operation of an
electric power system requires that a system operator balance the
generation and consumption of power. The system operator monitors
generation and consumption from a centralized location using
computerized systems and sends minute-by-minute signals to generators
reflecting changes in the demand for electricity. The generators then
make the necessary changes in generation in order to maintain the
transmission system safely and reliably. Absent such continuous
balancing, electrical systems would be highly unreliable, with frequent
and severe outages.
Historically, the electric industry developed initially as a loosely
connected structure of individual monopoly utility companies, each
building power plants and transmission and distribution lines to serve
the exclusive needs of all the consumers in their local areas. Such
monopoly utility companies were typically owned by shareholders and
were referred to as investor-owned utilities. In addition to these
investor-owned utilities, several types of publicly owned utilities,
including rural cooperatives, municipal authorities, state authorities,
public power districts, and irrigation districts, also began to sell
electricity. About one-third of these publicly owned utilities are
owned collectively by their customers and generally operate as not-for-
profit entities. Further, nine federally owned entities, including the
Tennessee Valley Authority and the Bonneville Power Administration,
also generate and sell electricity--primarily to cooperatives,
municipalities, and other companies that resell it to retail consumers.
Because the utilities operated as monopolies, wholesale and retail
electricity pricing was regulated by the federal government and the
states. The Public Utility Holding Company Act of 1935 (PUHCA) and the
Federal Power Act of 1935 established the basic framework for electric
utility regulation. PUHCA, which required federal regulation of these
companies, was enacted to eliminate unfair practices by large holding
companies that owned electricity and natural gas companies in several
states. The Federal Power Act created the Federal Power Commission--a
predecessor to FERC--and charged it with overseeing the rates, terms,
and conditions of wholesale sales and transmission of electric energy
in interstate commerce. FERC, established in 1977, approved interstate
wholesale rates based on the utilities' costs of production plus a fair
rate of return on the utilities' investment. States retained regulatory
authority over retail sales of electricity, electricity generation,
construction of transmission lines within their boundaries, and
intrastate transmission and distribution. Generally, states set retail
rates based on the utility's cost of production plus a rate of return.
The Federal Government Has Taken Steps to Increase Competition in the
Electricity Industry and Wholesale Markets:
The goal of federal efforts to restructure the electricity industry is
to increase competition in order to provide benefits to consumers, such
as lower prices and access to a wider range of services, while
maintaining reliability. Over the past 13 years, the federal government
has taken a series of steps to encourage this restructuring that
generally fall into four key categories: (1) market structure, (2)
supply, (3) demand, and (4) oversight.
Regarding market structure, federal restructuring efforts have changed
how electricity prices are determined, replacing cost-based regulated
rates with market-based pricing in many wholesale electricity markets.
In this regard, efforts undertaken predominantly by FERC have helped to
encourage a shift from a market structure that is based on monopoly
utilities providing electricity to all customers at regulated rates to
one in which prices are determined largely by the interaction of supply
and demand. In prior work, we reported that increasing competition
required that at least three key steps be taken: increasing the number
of buyers and sellers, providing adequate market information, and
allowing potential market participants the freedom to enter and exit
the industry.[Footnote 3]
In terms of supply, federal restructuring efforts have generally
focused on allowing new companies to sell electricity, requiring the
owners of the transmission systems to allow these new companies to use
their lines, and approving the creation of new entities to fairly
administer these markets. The Energy Policy Act of 1992 made it easier
for new companies, referred to as nonutilities,[Footnote 4] to enter
the wholesale electricity market, which expanded the number of
companies that can sell electricity. For example, we reported that from
1992 through 2002, FERC had authorized 850 companies to sell
electricity at market-based rates. To allow these companies to buy and
sell electricity, FERC also required that transmission owners under its
jurisdiction, generally large utilities, allow all other entities to
use their transmission lines under the same prices, terms, and
conditions as those that they apply to themselves. To do this, FERC
issued orders that required the regulated monopoly utilities--which had
historically owned the power plants, transmission systems, and
distribution lines--to separate their generation and transmission
businesses.[Footnote 5] In addition, in response to concerns that some
of these new companies received unfair access to transmission lines,
which were mostly still owned and operated by the former utilities,
FERC encouraged the utilities that it regulated to form new entities to
impartially manage the regional network of transmission lines and
provide equal access to all market participants, including
nonutilities. These entities, including independent system operators
(ISOs) and regional transmission organizations (RTOs), operate
transmission systems covering significant parts of the country. One of
these, the California ISO, currently oversees the electricity network
spanning most of the state of California. Another important effort to
facilitate the interaction of buyers and sellers was FERC's approval of
the creation of several wholesale markets for electricity. These
markets created centralized venues for market participants to buy and
sell electricity. Finally, FERC has undertaken efforts to improve the
availability and accuracy of price information used by suppliers, such
as daily market prices reported to news services, and has established
guidelines for the conduct of sellers of wholesale electricity,
requiring these entities to, among other things, accurately report
prices and other data to news services.
Federal efforts to affect demand at the wholesale level have focused on
encouraging prices in wholesale markets to be established by the direct
interaction between buyers and sellers in these markets. We previously
reported that there were several centralized markets in which suppliers
and buyers submitted bids to buy and sell electricity and that other
types of market-based trading were also emerging, such as Internet-
based trading systems.[Footnote 6] However, there have been few federal
efforts to directly affect prices at the retail level, where most
electricity that is consumed is purchased, because states, and not the
federal government, have regulatory authority for overseeing retail
electricity markets. As part of its efforts to have prices set by the
direct interaction of supply and demand, FERC has approved proposals to
incorporate so-called "demand-response" programs into the markets that
it oversees. These programs, among other things, allow electricity
buyers to see electricity prices as they change throughout the day and
provide the choice to sell back electricity that they otherwise would
have used. For example, we reported that FERC had approved one such
program in New York State that allows consumers to offer to sell back
specific amounts of electricity that they are willing to forgo at
prices that they determine.[Footnote 7] More recently, the Energy
Policy Act of 2005 requires FERC to study issues such as demand-
response and report on its findings to the Congress.
Finally, restructuring has fundamentally changed how electricity
markets are overseen and regulated. Historically, FERC had ensured that
prices in wholesale electricity markets were "just and reasonable" by
approving rates that allowed for the recovery of justifiable costs and
providing for a regulated rate of return, or profit. To ensure that
prices are just and reasonable in today's restructured electricity
markets, FERC has shifted its regulatory role to approving rules and
market designs, proactively monitoring electricity market performance
to ensure that markets are working rather than waiting for problems to
develop before acting, and enforcing market rules.[Footnote 8] As part
of its decision to approve the creation of market designs that include
ISOs and RTOs, FERC approved the creation of market monitoring units
within these entities. These market monitors are designed to routinely
collect information on the activities in these markets including
prices; perform up-to-the-minute market monitoring activities, such as
examining whether prices appear to be the result of fair competition or
market manipulation; and can impose penalties, such as fines, when they
identify that rules have been violated. More recently, the Energy
Policy Act of 2005 granted FERC authority to impose greater civil
penalties on companies that are found to have manipulated the market.
Electricity Markets Have Changed in Several Important Ways Since
Restructuring Began:
Federal restructuring efforts, combined with efforts undertaken by
states, have created a patchwork of electricity markets, broadened
electricity supplies, disconnected wholesale and retail markets, and
shifted how the electricity industry is overseen. Taken together, these
developments have produced some positive and some negative outcomes for
consumers.
In terms of market structure, we previously reported that the combined
effects of the federal efforts and those of some states have created a
patchwork of wholesale and retail electricity markets.[Footnote 9] In
the wholesale markets, there is a combination of restructured and
traditional markets because FERC's regulatory authority is limited. As
a result, some entities--including municipal utilities and
cooperatively owned utilities--have not been required to make the
changes FERC has required others to make.[Footnote 10] As shown in
figure 2, collectively the areas not generally subject to FERC
jurisdiction span a significant portion of the country. In addition,
even where FERC has clear jurisdiction, it has historically approved a
variety of different rules that govern how each of the transmission
networks is controlled and what types of wholesale markets may exist.
In the retail electricity markets, state utility commissions or local
entities historically have controlled how prices were set, as well as
approved power plants, transmission lines, and other capital
investments. Because each state performed these functions slightly
differently, these rules vary. In addition, many states also have
shifted the retail markets that they oversee toward competition. As we
reported in 2002, 24 states and the District of Columbia had enacted
legislation or issued regulations that planned to open their retail
markets to competition.[Footnote 11] As of 2004, 17 states had actually
opened their retail markets to competition, according to the Energy
Information Administration. One of these states, California, opened its
retail markets to competition but has taken steps to limit the extent
of competition.
Figure 2: Areas Served by Entities Subject to FERC Jurisdiction, 2002:
[See PDF for image]
Notes:
Areas served by entities generally not subject to FERC jurisdiction
include areas served by publicly owned entities, such as municipal
utilities, cooperative utilities, and others.
Data on service territories include some overlaps, indicating that some
areas are served by both entities subject to FERC jurisdiction and
entities not generally subject to FERC jurisdiction, particularly some
areas in Pennsylvania, Michigan, Wisconsin, and Iowa. Data reflected
above depict those areas of overlap as not generally subject to FERC
jurisdiction.
Unshaded portions of the map indicate either that no electric service
is provided or the service area is very small.
[End of figure]
In terms of supply, efforts to restructure the electricity industry by
the federal government and some states have broadened electricity
markets overall--shifting the focus from state and/or local supply to
multistate or regional supply. In particular, efforts at wholesale
restructuring have led to a significant change in the way electricity
is supplied in those markets. The introduction of ISOs and RTOs in many
areas has provided open access to transmission lines, allowing more
market participants to compete and sell electricity across wide
geographic regions and multiple states. In addition, in some parts of
the country, overall supply has grown as a result of the large increase
in new generating capacity that has been built by nonutility companies,
while other regions have witnessed smaller increases in supply. For
example, we reported that, by 2002, Texas had added substantial amounts
of generating capacity--more than double the forecasted amount needed
through 2004.[Footnote 12] In contrast, in California only about 25
percent of the forecasted need had been built over the same period, and
the region witnessed a historic market disruption costing consumers
billions of dollars. Similarly, the opening of retail markets has also
widened the scope of electricity markets by allowing new and different
entities to sell electricity, which works to further broaden markets
because these retail sellers must either build or buy a power plant or
rely on wholesale markets. Finally, FERC has improved the transparency
of wholesale markets, a key requirement of competitive markets, by
increasing the availability and accuracy of price and other market
information.
In terms of demand, while federal efforts have encouraged price setting
by the interaction of supply and demand, this approach has not been
widely adopted in retail markets. Even though FERC and other
electricity experts have determined that it is important for demand to
be responsive to prices and other factors for competitive markets to
operate efficiently, as we reported in 2004, the use of these programs
remains limited.[Footnote 13] In many retail markets, including some
states where retail markets have been opened to competition, prices are
still set so that rates are either flat or have been frozen. In either
case, prices are not reflective of the hourly costs of providing
electricity. In some cases, demand-response programs are in place but
are aimed at only certain types of customers, such as some commercial
and industrial customers. Overall, these customers account for only a
small share of total demand. As a result, in this hybrid system,
wholesale and retail markets remain disconnected, with competition
setting wholesale prices in many areas, and state regulation setting
retail prices in many states.
Regulatory oversight of the electricity industry remains divided among
federal, regional, and state entities. As we have previously reported,
FERC initially did not adequately revise its regulatory and oversight
approach to respond to the transition to competitive energy
markets.[Footnote 14] However, it has made progress in recent years in
defining its role, developing a framework for overseeing the markets,
and beginning to use an array of data and analytical tools to oversee
the market. In particular, FERC established the Office of Market
Oversight and Investigations in 2002, which oversees the markets by
monitoring its enforcement hotline for tips on misconduct; conducting
investigations and audits; and reviewing large amounts of data--
including wholesale spot and futures prices, plant outage information,
fuel storage level data, and supply and demand statistics--for
anomalies that could lead to potential market problems. In addition to
FERC's own efforts, substantial oversight also now occurs at the
regional level, through ISO and RTO market monitoring units. These
units monitor their region's market to identify design flaws, market
power abuses, and opportunities for efficiency improvements and report
back to FERC periodically. Finally, states' oversight roles vary. Those
states that have not restructured their markets retain key roles in
overseeing and regulating electricity markets directly and indirectly
through such activities as setting rates to recover costs and siting of
power plants and transmission lines and other capital investments
needed to supply electricity. The ability of states that have
restructured their retail markets, to oversee their markets is more
limited, according to experts.
The effects of restructuring on consumers have been mixed. While most
studies evaluating wholesale electricity markets, including our own
assessment, have determined that progress has been made in introducing
competition in wholesale electricity markets, results at the retail
level have been difficult to measure. For example, in 2002, we reported
that prices generally fell after restructuring and fell in particular
in many areas that had implemented retail restructuring.[Footnote 15]
However, we were unable to attribute these price decreases solely to
restructuring, since several other factors, such as lower prices for
natural gas and other fuels used in the production of electricity,
could have contributed to the price decreases. Furthermore, while some
consumers had benefited by paying lower prices, others have experienced
high prices and market manipulation. For example, in 2002, we reported
that nationally, consumers benefited from price declines of as much as
15 percent since federal restructuring efforts began.[Footnote 16]
However, as consumers in California and across other parts of the West
will attest, there have been many negative effects, including higher
prices and market manipulation. More recently, electricity prices have
risen, potentially the result of higher prices for fuels such as
natural gas and petroleum, and other factors.
Four Key Challenges Remain Unresolved:
We have identified four key challenges that, if addressed, could
benefit consumers and the restructured electricity markets that serve
them.
Making Wholesale Market Structures Work Better Together:
With several fundamentally different electricity market structures in
place simultaneously in various parts of the country, it is important
that these markets work together better in order to meet regional
needs. As we previously reported, two aspects of the current
electricity markets serve to limit the benefits expected from
restructuring.[Footnote 17] First, FERC's limited authority has meant
that significant parts of the market and significant amounts of
transmission lines have not been subject to FERC's effort to
restructure wholesale markets--creating "holes" in the national
restructured wholesale market. These gaps, where efforts to open
wholesale markets have not been undertaken, may limit the number of
potential participants and the types of transactions that can occur,
thereby limiting the benefits expected from competition.[Footnote 18]
Second, where FERC has clear authority, it has historically approved a
range of rules for how the different transmission systems and
centralized wholesale markets operate--creating "seams" where these
different jurisdictions meet and the rules change. We have previously
noted that the lack of consistent rules among restructured wholesale
markets limits the extent of competition across wholesale markets and,
in turn, limits the benefits expected from competition.[Footnote 19]
California experienced this firsthand, as it tried to "cap" wholesale
electricity prices in its state market--establishing rules different
from those in the markets surrounding California. The lower price cap
in California, coupled with an exemption for electricity imports,
created incentives to sell electricity to areas outside the state
(where prices were higher) and later import it (because imports were
exempt from the price cap).
FERC has acknowledged that the lack of consistent rules can lead to
discrimination in access, raise costs, and lead to reliability
problems. As a result, FERC made an effort to standardize the various
wholesale market designs under its jurisdiction. However, these efforts
met with sharp criticism from some industry stakeholders. FERC ended
its effort to require a single market design in all regions and has,
instead, promoted voluntary participation in RTOs and having the RTOs
work together to reconcile their differences. In the end, today's
patchwork of wholesale market structures, with holes and seams, is at
odds with the physics of the interdependent electricity industry, where
electrons travel at the speed of light and do not stop neatly at
jurisdictional boundaries. Successfully developing markets will require
the alignment of market structures and rules in order to reconcile them
with these physical certainties.
Providing Timely, Clear, and Consistent Signals to Help Ensure Adequate
Regional Supplies:
Broadening of restructured electricity markets has made the federal
government, the states, and localities more dependent on each other in
order to ensure a sufficient supply of electricity. We previously
concluded that, as federal and state restructuring efforts broaden
electricity markets to span multiple states, states will become more
interdependent on each other for a reliable electricity
supply.[Footnote 20] Consequently, one state's problems acquiring and
maintaining an adequate supply can now affect its neighbors. For
example, in the lead up to the western electricity crisis in 2000-2001,
few power plants were built to meet the rising demand in California,
which became dependent on power plants located outside the state.
However, when prices began to rise, this affected consumers, both
inside and outside California. We previously reported these higher
prices had implications for California consumers such as higher
electricity bills, as well as others located outside the state, costing
billions of additional dollars. Because of these negative outcomes,
some have questioned whether restructuring will eventually benefit
consumers.
More broadly, rising interdependence has significant implications for
many industry stakeholders, especially in light of the shift in how
plants are financed and built. In the past, monopoly utilities
proposed, and regulators approved, the construction of new power plants
and other infrastructure. Today, policymakers at all levels of
government must recognize that providing consumers with reliable
electricity in competitive markets requires private investors to make
reasoned investments. We have reported that these private investors
make decisions on investing by balancing their perceptions of potential
risk and profitability.[Footnote 21] Further, we concluded that the
reliability of the electricity system and, more generally, the success
of restructuring, now hinges on whether these developers choose to
enter a market and how quickly they are able to respond to the need for
new power plants. The implications of this broadening of electricity
markets are important, since it has occurred while most of the primary
authorities associated with building new power plants, such as state
energy siting or local land use planning, still rest with states and
localities. As we have reported, there is sometimes considerable
variation across states and localities in how long these processes take
and how much they cost, and building new power plants can take a year
or more once all the approvals are obtained. Because of the broader
electricity markets, one state's or locality's processes and decisions
provide signals affecting private investors' perceptions of the risk or
profitability of making investments in local areas and can have long-
lasting implications for the entire region. In this context of growing
interdependence for adequate electricity supplies, our work shows that
it is important for federal, state, and local entities to provide
timely, clear, and consistent signals that allow private developers to
make the kinds of reasonable and long-term investments that are needed.
Connecting Wholesale and Retail Markets:
As we have previously reported, for competitive wholesale electricity
markets to provide the full benefits expected of them, it is essential
that they be connected to the retail markets, where most electricity is
sold and consumed.[Footnote 22] Otherwise, hybrid electricity markets-
-wholesale prices set by competition and retail prices set by
regulation--will be difficult to manage because consumers at the retail
level can unknowingly drive up wholesale prices during periods when
electricity supplies are limited. This occurs when consumers do not see
prices at the retail level that accurately reflect the higher wholesale
market prices. Seeing only these lower electricity prices, consumers
use larger quantities of electricity than they would if they saw higher
prices, which raises costs and can risk reliability. We have noted
that, in this environment (consumers seeing low retail prices during
periods of high wholesale prices) consumers have little incentive to
reduce their consumption during periods when prices are high or
reliability is at risk. The appeal of seeming to insulate retail
consumers from wholesale market fluctuations may be compelling, but
most experts agree that the lack of significant demand response can
actually lead to higher and more volatile prices. In 2004, we concluded
that this system makes it difficult for FERC to ensure that prices in
wholesale markets are just and reasonable.[Footnote 23] We further
concluded that connecting wholesale and retail markets through demand-
response programs such as real-time pricing or reliability-based
programs would help competitive electricity markets function better,
enhance the reliability of the electricity system, and provide
important signals that consumers should consider investments into
energy-efficient equipment.[Footnote 24] Such signals would work to
reduce overall demand in a more permanent way.
While FERC has been supportive of increasing the role of demand-
response programs in the wholesale markets that it oversees, there have
been limited efforts to do so in retail markets--these markets are
outside FERC's jurisdiction and overseen by the states. Some states,
such as California, have a long history with demand-response programs
and have conducted more recent experiments with using it in more
widespread ways. Sharing and building upon these and other examples
could help develop efficient ways to bring the consumers who flip the
light switches into the markets responsible for ensuring that their
lights go on. Since electricity travels at the speed of light, retail
markets where electricity is consumed are tightly connected to the
wholesale markets that supply these retail markets. As a result, much
of the success of federal restructuring of the wholesale markets relies
on actions taken at the state level to bring consumers into the market.
Resolving Divided Regulatory Responsibilities:
Significant changes in how oversight is carried out in competitive
markets, combined with the divided regulatory authority over the
electricity industry, has made effective oversight difficult. We
previously reported that FERC, the states, and other market monitors
were neither fully monitoring the overall performance of all wholesale
and retail markets nor collecting sufficient data to do so, thus
limiting the opportunity to meaningfully compare performance.[Footnote
25] At the federal level, FERC protects customers primarily through
ensuring that prices in the wholesale markets are just and reasonable.
In prior work, we found that FERC did not initially revise its
oversight approach adequately in response to restructured markets,
resulting in markets that were not adequately overseen.[Footnote 26]
However, more recently, we reported that FERC has made significant
efforts to revise its oversight strategy to better align with its new
role overseeing restructured markets, has taken a more proactive
approach to monitoring the performance of markets, and has better
aligned its workforce to fit its needs in these new markets.[Footnote
27] Recent actions will require further changes to FERC's role. The
Energy Policy Act of 2005 provided FERC additional authority to
establish reliability rules for all "users, owners, and operators" of
the transmission system. We had previously reported that this change
would be desirable, but it is too early to judge its success.[Footnote
28] At the state level, oversight varies widely. States that have
retained traditionally regulated retail markets continue to require
substantial amounts of information to help them set the regulated
prices that consumers see. The states that now feature restructured
retail markets face a sharply different oversight role of policing
their state-level retail markets for misbehavior and signs of market
malfunction. The introduction of the market monitoring units within
ISOs and RTOs adds a new layer of regional oversight to the existing
federal and state roles. While authority over the electricity industry
is divided, restructuring has served to make the success of each of the
oversight efforts more interdependent, and FERC and the states will
have to rely on each other, as well as on new entities, to a greater
degree than before to be successful.
Concluding Observations:
It is becoming increasingly clear that many of the challenges facing
the electricity industry are rooted in the interdependence of actions
taken by federal, state, local, and private entities, as well as
consumers. Accordingly, the individual challenges we have discussed
follow a central theme--the need to integrate the various ongoing
activities and efforts and harmonize them in a way that improves the
functioning of the marketplace while providing adequate oversight to
protect electricity consumers. This will not be easy because it
requires what is, at times, most difficult: collaboration and
cooperation among entities with a history of independence.
Successfully restructuring the electricity industry is an ongoing
process that will require rethinking old issues, such as jurisdictional
responsibilities, and applying new and creative ideas to help bridge
the current gap between wholesale and retail markets. Only if
interdependent parties work together will electricity restructuring
succeed in delivering benefits to U.S. consumers by way of healthy,
viable, and competitive markets. Not adequately addressing these issues
could result in an electricity industry that does not provide consumers
with sufficient quantities of the reliable, reasonably priced
electricity that has been a mainstay of our nation's economic and
social progress.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution until 15 days after the report
date. At that time, we will send copies of this report to appropriate
congressional committees. We will also make copies available to others
on request. In addition, the report will be available at no charge on
the GAO Web site at [Hyperlink, http://www.gao.gov].
If you or your staff have any questions about this report, please
contact me at (202) 512-3841 or [Hyperlink, wellsj@gao.gov]. Contact
points for our Office of Congressional Relations and Office of Public
Affairs may be found on the last page of this report. GAO staff who
contributed to this report are listed in the appendix.
Sincerely yours,
Signed by:
Jim Wells:
Director, Natural Resources and Environment:
[End of section]
Appendixes:
Appendix I: GAO Contact and Staff Acknowledgments:
GAO Contact:
Jim Wells, (202) 512-3841 or [Hyperlink, wellsj@gao.gov]
Acknowledgments:
In addition to the contact named above, Dan Haas, Jon Ludwigson, and
Kris Massey made key contributions to this report. Barbara Timmerman,
Susan Iott, and Nancy Crothers also made important contributions.
[End of section]
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Washington, D.C. March 16, 2005.
Electricity Markets: Consumers Could Benefit from Demand Programs, but
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Electricity Restructuring:
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Electric Utility Restructuring: Implications for Electricity R&D. T-
RCED-98-144. Washington, D.C. March 31, 1998.
Western Electricity Crisis:
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California Electricity Market: Outlook for Summer 2001. GAO-01-870R.
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California Electricity Market Options for 2001: Military Generation and
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2001.
Energy Markets: Results of Studies Assessing High Electricity Prices in
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Federal Power:
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[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-694]
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Bonneville Power Administration: Long-Term Fiscal Challenges.
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(360645):
FOOTNOTES
[1] FERC does not regulate most of Texas' electricity system because it
is an independent transmission region that does not engage in
interstate commerce.
[2] See the list of related GAO products at the end of this report.
[3] GAO, Lessons Learned from Electricity Restructuring: Transition to
Competitive Markets Underway, but Full Benefits Will Take Time and
Effort to Achieve, GAO-03-271 (Washington, D.C. December 17, 2002).
[4] Companies that generate, buy, and/or sell electricity but do not
transmit electricity.
[5] A process referred to as "unbundling."
[6] GAO-03-271.
[7] GAO, Electricity Markets: Consumers Could Benefit from Demand
Programs, but Challenges Remain, GAO-04-844 (Washington, D.C. August
13, 2004).
[8] While FERC is the principal federal regulator for the electricity
industry, other federal agencies also play important roles in
regulating energy markets, including the Commodity Futures Trading
Commission.
[9] GAO-03-271.
[10] Municipal utilities are city-owned electricity suppliers, such as
the Los Angeles Department of Water and Power. Cooperatively owned
utilities are customer-owned electricity suppliers, historically more
common in rural areas.
[11] GAO-03-271.
[12] GAO, Restructured Electricity Markets: Three States' Experiences
in Adding Generating Capacity, GAO-02-427 (Washington, D.C. May 24,
2002).
[13] GAO-04-844.
[14] GAO, Energy Markets: Additional Actions Would Help Ensure that
FERC's Oversight and Enforcement Capability Is Comprehensive and
Systematic, GAO-03-845 (Washington, D.C. Aug. 15, 2003).
[15] GAO-03-271.
[16] GAO-03-271.
[17] GAO-03-271.
[18] GAO-03-271.
[19] GAO-03-271.
[20] GAO-02-427.
[21] GAO-02-427.
[22] GAO-04-844.
[23] GAO-04-844.
[24] Real-time pricing refers to markets where consumers see retail
prices that are closely linked the frequently changing wholesale
prices. Reliability-based programs refer to any of a variety of
programs that allow the operators of the electricity system to enter
into voluntary agreements with electricity consumers, who are
compensated, that allow the grid operator to reduce overall demand on
short notice.
[25] GAO-03-271.
[26] GAO, Energy Markets: Concerted Actions Needed by FERC to Confront
Challenges That Impede Effective Oversight, GAO-02-656 (Washington,
D.C. June 14, 2002).
[27] GAO-03-845.
[28] GAO-03-271.
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