Electric Utilities Face Increased Competition

Major changes will confront electric utilities for the rest of this decade and probably beyond. Still reeling—both on the balance sheet and on the public relations front—from the impact of cost overruns and construction delays at new power plants, utilities recently have had to begin adapting to a more competitive market in electric power generation. Within the next few years, companies which for most of the century have been generating and distributing power as "natural" monopolies under relatively benevolent state regulation may find themselves operating in an increasingly deregulated and more fully competitive marketplace.

Proposals for such an open market in electric power generation are just now starting to receive serious attention and debate among regulators and legislators. In large part, these proposals are an outgrowth of the Public Utility Regulatory Policies Act (PURPA) of 1978, which was passed in reaction to the "energy crisis" that had occurred several years earlier. The act was designed primarily to promote conservation, reduce oil imports, and encourage the use of renewable energy sources.

One of PURPA's major impacts has been the introduction of increased competition in the electric utility industry. In essence, the act has forced utilities to accept and work with designated nonutility suppliers of electricity in two respects.

First, utilities are required to accommodate selected nonutility generating facilities, which has entailed establishing transmission lines between these generators and the power grid. In addition, and more disturbing to the utilities, they are obligated to purchase any excess electric power from this group of generators at state-approved, "avoided cost" rates. In general, these rates are equivalent to the price that a utility would have to pay for providing such power, either by generating the power itself or by purchasing it from another utility.

Requirements for special status

Not all nonutility-owned electric generating facilities are accorded preferential status under PURPA's provisions. In the parlance of the act, only "qualifying facilities" (QFs) receive this and several other benefits, including tax incentives to spur their development and a guarantee that they will not be regulated as "utilities." Thus, they can operate as private-sector entities with relatively few restrictions.

Generating facilities that do not have QF status can also sell excess power to electric utilities. A major difference between this group and QFs, however, is that non-QF generators sell their power at market rates rather than at avoided-cost rates.

Under PURPA provisions, a generating plant receives QF status from the Federal Energy Regulatory Commission (FERC) only if it meets certain operating and efficiency standards. These standards were established for each of two classes of plants. Small power producers, the first class, run plants fueled primarily by renewable energy sources (e.g., wind, sun, water) or by burning such combustible products as municipal trash or waste products resulting from manufacturing or agricultural processes.

Cogenerators, the second class, are facilities designed to produce both electric and thermal power (steam or heat) for use in industrial or commercial applications. Replacing a conventional generator with one configured to capture both electric and thermal outputs can result in substantial fuel savings. Such generators are common both at large industrial plants that require substantial amounts of steam or heat for production processes and at small commercial sites, such as schools and shopping malls, where the steam is generally used for space heating.

A cogeneration plant must meet certain standards before it receives QF status: thermal output must equal no less than 5 percent of total energy output and, if fueled by oil or gas, the facility must meet an operating efficiency standard requiring useful energy output of these two fuels to be approximately 45 percent of their energy input.

Slow but significant reaction

Although PURPA was enacted in 1978, five years passed before FERC guidelines for implementing its provisions were finalized, thus enabling generators to apply for and receive QF status. In any case, being forced to deal with potential unknowns was a most unwelcome change for the utilities, which for many years had obtained all their power needs from their own generators or through purchase from neighboring utilities. Furthermore, they strongly objected to the avoided-cost principle by which the rates for the purchase of QF power were set, particularly since each state was allowed to use its own method of calculating the costs that a utility avoided when purchasing QF power.

PURPA did not fully take effect until 1983, when the Supreme Court responded to legal objections from the utility industry and upheld the validity of both the act and FERC's guidelines for its implementation. Since that time, several thousand nonutility generators have obtained QF status.

In the meantime, utilities have continued to complain that states, sometimes intentionally, have set avoided costs too high, resulting in extremely high payments from utilities to QFs. In 1986, for instance, California lowered its avoided-cost rates after determining that utility customers had suffered as the result of artificially high prices for QF power; this action, in turn, attracted thousands of nonutility generators and forced some utilities to substitute power from their own, lower-cost generating plants with higher-priced QF power. In other cases, however, utilities have come to rely on QFs as a source of generating capacity that allows them to avoid building costly new generating stations.

The Edison Electric Institute (EEI), an association of the nation's major private electric utilities, conducted a survey of its members in 1986 to determine the level of nonutility electric power generation in the United States. The survey included not only QFs but also other nonutility facilities that generate power but do not meet the standards set under PURPA for QF status.

The survey findings show that nearly 95,000 gigawatt-hours (GWh)—1 GWh is equivalent to 1 million kilowatt-hours—of electricity were generated outside the U.S. electric utility industry in 1985 (see table). This figure represents 3.7 percent of the more than 2.5 million GWh generated in the country. Of the 95,000 GWh, utilities purchased over 27,000 GWh of power from nonutility sources. Initial EEI data for 1986 indicate that the amount purchased rose significantly above that purchased in 1985, suggesting progressively greater reliance by utilities on nonutility generators.

Regional variations in development of nonutility power are quite striking. Texas and California are clearly the leaders among the states, the former because of widespread development of cogeneration facilities in the petroleum refining and petrochemical industries. In fact, much of this capacity in Texas was already in existence when PURPA was enacted. California is a leader for two other reasons: broad acceptance of alternative power sources and the initial calculation of high avoided-cost rates by state regulators.

New England also has a sizable amount of nonutility production, much of which stems from the region's reliance on small hydroelectric dams and several wood-burning facilities. In each of these areas—Texas, California, and New England—between 4 and 10 percent of all power is generated outside the utility industry. By contrast, throughout the rest of the country, the figures range from less than 1 percent to 3 percent.

Perhaps the most striking figure is found in the data that the utilities provided to the North American Electric Reliability Council in 1985 on their ten-year plans. Nearly 10 percent of all planned additions to generating capacity were expected to come from non utility sources through 1995. This figure contrasts sharply with the information that the utilities had supplied only a year or two earlier, when utilities did not state that they were planning to meet any future demand with nonutility sources—even though they were already obtaining approximately 2 percent of their supplies from such sources.

Changes under debate

During the spring of 1987, prompted in particular by criticism about the avoided-cost pricing mechanism, FERC began to hold hearings on the need for changes in PURPA. It was generally agreed that the commission must establish more specific guidelines regarding avoided costs, since the states now rely on a wide range of methods for calculating these costs—some methods based on rigorous economic analysis but others apparently arbitrarily fixed.

Utilities have also complained about insufficiently stringent efficiency standards set for cogenerators. Also, many utilities object to being obligated to purchase power from so-called PURPA machines: nonutility generators that produce only the minimum required thermal output and thus do little to further the intent of the law with regard to energy conservation.

Criticism of PURPA and the existing system by QFs primarily relates to the lack of a provision for the mandatory "wheeling" of their power. Wheeling customarily refers to the transfer of power from one utility to another via the transmission lines of a third utility. Currently, most utilities are willing to provide wheeling services over their transmission networks to other utilities but not to QFs. Most QFs are therefore limited to one buyer for their excess power.

Clarification is also needed on the role of nonutility generators that do not qualify either as cogenerators or as small power producers and therefore do not receive QF status. This group of facilities would clearly become a player in a deregulated and competitive market for electric power. Yet PURPA, as enacted, leaves the status of these non-QFs undefined.

In general, there is little consensus among affected groups—utilities, QFs, non-QFs, generating equipment manufacturers, regulators, and consumers—on the impact of PURPA to date beyond the fact that the development of nonutility generators has turned out to be much greater than was anticipated. It is widely acknowledged that much more information is needed to guide modification of the existing system.

What does appear certain, however, is that PURPA has produced results that go well beyond its original goals. It seems to have taken on a life of its own as a stepping-stone to what may ultimately emerge as a fully competitive electric power generation market. Some utilities, primarily those with large and costly nuclear plants soon to come on-line, appear to wish that PURPA would simply go away, while other groups, primarily those representing cogenerators' interests, are in favor of keeping PURPA as it is.

Neither of these extremes is likely to occur for three reasons. First, partly as a means of diversification, private utilities' parent companies are themselves establishing "nonutility subsidiaries" under the provision of PURPA that allows a utility to own a minority share in a QF. Of the approximately 175 major American investor-owned utilities, some 35 already have a nonregulated subsidiary formed to undertake joint QF ventures.

Second, FERC, as well as several of the larger state public utility commissions, appears to be convinced of the wisdom of a more competitive, market-based electric power industry, though not necessarily under PURPA existing provisions. Several states have already put into effect a system whereby QFs must bid competitively to supply utilities with power, as opposed to selling their power at rates calculated by state regulators.

This emphasis on competition reflects the belief (or bias) of economists at FERC and elsewhere that only such a competitive market can efficiently and "correctly" determine electricity rates, supply, and demand. Comments during the past year from FERC officials have made it clear that while there is a definite intention to remedy some of the complaints about PURPA, these corrections will be accompanied by a decisive movement toward a more economically efficient electric power industry.

The third reason, evident throughout the past decade in the United States and other Western economies, is the trend toward deregulation of state or state-regulated enterprises. Increased deregulation has occurred when technological advances have begun to render the "natural monopoly" argument unconvincing (as in the case of long distance telecommunications) or when the regulatory scheme has proven to be grossly inefficient, as with natural gas pipelines.

Arguments for deregulation of electric power generation have been made on both counts. Recent advances in technology, partly spurred by environmental considerations, have made it clear that smaller, cleaner, and cost-effective generating plants can compete with the very large-scale generating stations operated by utilities.

Undoubtedly, PURPA already has introduced a dose of competition into the electric power industry. From a broader perspective, it is not yet clear just how far federal and state authorities are willing to go toward deregulating the market for electric power generation, particularly in light of the problems and confusion that many associate with the deregulation of other U.S. industries.

Before wide-ranging policy decisions on these matters can be made, FERC must decide how to deal with PURPA on two fronts: that is, how to remedy the many complaints about the act and how to reconcile PURPA's energy conservation and security objectives—for which special benefits are provided to certain generating facilities—with the current objective of a more efficient market-place. Such efficiency would require placing all generating facilities, irrespective of ownership, size, and technology, on an even and competitive footing.