The FERC’s Action Is Good, Bad,Ugly

The Federal Energy Regulatory Commission’s new wholesale price caps will save the Western states literally tens of billions of dollars in electricity bills. As wonderful as that sounds, the FERC order still allows wholesale generators to extract enough windfall profits to drive the region into recession.

The FERC’s approach may also perversely lead to more air pollution and natural gas shortages.

Let’s look at what the FERC did right. First, the order approved Monday establishes price caps on a 24/7 basis rather than simply during power emergencies--a long overdue reform.

Second, the order protects the entire West, not just California. This regional cap will end “megawatt laundering,” whereby in-state generators sold power across California lines and then resold it back into the state to evade caps.

Third, the order closes the ridiculous broker loophole that made the FERC’s previous price caps Swiss cheese. Before, generators could redirect their sales from the market to energy brokers who were exempt from the price caps.

So where did the FERC go wrong? The problem may be traced to the two competing methods of imposing price caps and the all-important concept of “economic rent.”

Economic rent, in the wholesale electricity market, is the market price of electricity minus the producer’s cost, where cost includes not just labor and fuel but a “fair profit” on the invested capital as well. In traditional regulation, this fair profit is calculated very simply as the market cost of the money borrowed to build the power plant.

Under this definition, if the producer’s cost is a nickel a kilowatt hour and he can sell it for 35 cents--as producers in the West have been doing--the producer can extract 30 cents of economic rent from consumers.

In California, the extraction of such economic rent through market manipulation has taken place on a grand-theft scale. In 1999, California’s electricity bill was about $7 billion. Last year, it was almost $30 billion for roughly the same amount of electricity. This year, California’s bill is well on its way to $50 billion annually.

To stop this rip-off, Gov. Gray Davis proposed “cost-based” price caps. Such caps are calculated on a plant-specific basis. Each generator is allowed to recover its cost of production, including the fair profit, but not a penny more.

Thus, for example, a newer, highly efficient plant generating power at a nickel per kilowatt hour would collect a nickel. The oldest, least efficient plant that generated power for 20 cents would be allowed to collect 20 cents.

By setting different prices for different plants, the economic rents are driven to zero. Yet each generator still has a fair profit incentive to produce. From a public policy perspective, it’s the best of all possible worlds. And it was categorically rejected by the FERC. Instead, the FERC sets a single price for all generators based on the cost of the “least efficient plant.”

The obvious problem with this umbrella pricing rule is that it still allows generators to extract billions in economic rent from consumers.

In our previous example, and under the FERC’s rule, the least efficient plant still collects 20 cents a unit to recover costs. However, the most efficient plant producing power at a nickel-per-kilowatt also collects 20 cents rather than a nickel and thus extracts a full 15 cents of economic rent.

Thus, under the FERC’s rule, wholesale generators still will be able to capture tens of billions of dollars more from consumers and businesses than under Davis’ cost-based rule.

The FERC’s approach is still subject to the same kind of strategic gaming that has been the hallmark of this crisis. Generators will ensure that during peak times, when the price cap is being established, the most expensive possible plant is in operation--whether it needs to be or not. This will peg the price at the highest level.

In addition, the FERC provides generators with a perverse incentive to run their least efficient units more often. Since these least efficient plants are also the highest polluting, the result will be dirtier air. Moreover, the excessive running of these plants may also put a strain on already stretched natural gas supplies. These least efficient plants use up to 40% more natural gas to produce a unit of electricity.

The bottom line: The FERC “done good.” But it could have done a lot better. And the way things stand now, there still is a danger that higher electricity costs could push California and the rest of the West--and eventually the nation--into a nasty recession.