THE REGULATION AND RESTRUCTURING OF THE US POWER SECTOR

TSINGHUA UNIVERSITY LAW SCHOOL BEIJING, PRC

3 NOVEMBER 2006

ROBERT W. GEEPRESIDENT

GEE STRATEGIES GROUP LLC

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Overview• Current projection for electricity demand in the United

States, and forecast of resources required

• Steps taken to restructure U.S. electric sector to introduce greater competition in wholesale and retail markets, and outcomes

• Gaps or issues created as markets evolved, and how newly enacted federal legislation addresses them

• Lessons learned

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Basic Cornerstones of U.S. Energy Policy

• Secure supply – generally maintained through diversity of fuel types and source locations

• Safe – no threat to public health and welfare

• Reasonably affordable

• (For electricity) Always available (i.e., reliable and not subject to unintended interruption)

• Clean (non-polluting to air or water)

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Projection From 2004 Through 2025: The U.S. Thirst for Energy Will

Continue Unabated

• U.S. electricity demand expected to grow by 1.6 percent annually (from 3,729 billion Kwh to 5,208 billion Kwh)

• Demand for natural gas expected

to grow from 22.4 Tcf to 27.7 Tcf

• Coal consumption will grow by 1,104 million short tons to 1,592 million short tons

Source: Energy Information Administration / Annual Energy Outlook 2006

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U.S. Electricity generation by fuel, 1980-2030

(billion kilowatthours)

• Coal’s share of electric generation escalates, ramping up from 49 percent in 2020 to 57 percent by 2030

• Natural gas’ share of electric generation peaks at 22 percent before falling to 17 percent by 2030 when displaced by new coal-fired generation

• This projection does not factor in US’ adoption of carbon emission controls

• Nuclear generation expected to grow from 100 Gw in 2004 to 109 Gw in 2019 and remain static until 2030

• Renewable generation will grow at average annual rate of 1.7 percent per year, from 358 billion kwH to 559 kwH by 2030

Source: Energy Information Administration / Annual Energy Outlook 2006

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Key Milestones Over The Last Half Century

• For most of the last century, natural gas and electric power have been highly regulated by government as public utilities

• These services were considered “natural monopolies”, unable to draw competition because of high costs of market entry

• Both the infrastructure-related delivery service and the commodity costs were regulated, based primarily on historic acquisition cost:

– Natural gas prices subject to ceilings– Electric wholesale & retail power prices subject to regulated tariffs

• However, by the 1970’s, natural gas shortages occurred because of lack of financial incentives for producers

• Eventually, federal government chose to phase in deregulation of interstate natural gas prices; gas pipelines became transporters, rather than owners of gas volumes

• Natural gas supplies grew and prices stayed level for almost a decade

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Electricity Sector Market Reforms

• Until 1990’s, electric utilities held monopolies for transmission, distribution and generation services in all markets

• However, electric power generation technology advances made generation of efficient, affordable power from independent owners of power plants feasible

• Previously successful reforms of natural gas sector influenced movement toward restructuring and reforming power sector

• Early 1990’s: Federal government allowed creation of independent power producers, thereby creating a competitive wholesale power market and deregulating the generation sector; transmission and distribution remained regulated monopolies

• Mid-1990’s: states began to require unbundling of services or functional separation of services/ some generation was sold to independent power producers

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Some States Opened Retail Power Markets To Competition

• “Retail Choice” gave customers (industrial, commercial, and residential) direct access to power generators

• Approach favored generally in states with higher-than national-average power costs

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Status of State Retail Restructuring Efforts (2003)

Source: Energy Information Administration

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The Picture Today

• Steep escalation in natural gas prices

• Over reliance on natural gas as fuel for power generation for peaking capacity

• New baseload generation needed

• Underinvestment in transmission capacity

• Mixed record of success of retail “experiments”

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U.S. Natural Gas Markets Today: Higher Prices

• Initially, experienced higher spot prices and greater volatility than during the 1990’s when gas prices were around $2.00 – 3.00 per MMBtu

– $6.50 – 8.00 per MMBtu in summer– $10.00 per MMBtu in winter

• Although allegations of market manipulation were claimed by some, and state and federal investigations were triggered, reason was attributed to economic forces of supply (which is declining) and demand (which is increasing)

• Current spot prices are within $7.00 – 8.00 per MMBtu range, and expectation is that prices will continue to be high for foreseeable future

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Electricity Generation’s Growing Dependence on Natural Gas

• Natural gas became the “fuel of choice” for new power generation – Environmental advantages– Shorter lead times of completion– Improved efficiencies

• From 2000 to 2004, 200,000 Megawatts (MW) of new power plant capacity was added to existing capacity base of 903,000 MW

• 94 percent of this new capacity was natural gas fired

• This has meant higher risks for power plant developers:– Exposure to higher fuel costs– Exposure to price volatility

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Natural Gas: The Fuel of Choice For Electric Generation in late 1990’s – early 2000’s

Source: Energy Information Administration / Annual Energy Outlook 2004

Annual Additions To Electricity Generation Capacity By Fuel, 1950-2002 (Gigawatts)

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The Generation Outlook: From “Boom to Bust” to “Boom

Again” • Initially, markets were vastly oversupplied by much as 25-40% excess and some by as

much as 100%

• Surplus plants were “mothballed”, and reserve margins brought back into reasonable balance

• However, current forecasts indicate new generation needed– 130 GW over next 10 years– Possibility of near-term shortages in certain urban areas (i.e., New York City,

Washington) and subregions– Most will be new baseload– High gas costs mean any new gas capacity will be used for peaking only

• 150 coal plants currently under development, but will face environmental challenges

• New nuclear capacity also being proposed

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An Electricity Delivery System In Need of New Investment

• Transmission investment declined in real dollar terms for 23 years from 1975 to 1998, while load has more than doubled

• Estimated 25 percent increase in transmission investment necessary to meet anticipated growth in customer demand over next two decades

Source: E.Hirst, Source: E.Hirst, “Transmission “Transmission Crisis Looming?” Crisis Looming?” Public Utilities Public Utilities FortnightlyFortnightly, , September 15, September 15, 20002000

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Current Status of State Retail Power Market Reforms

• Successful in providing commercial and industrial customers choice of providers– Higher magnitude of volumes purchased conferred bargaining leverage– Sophistication driven by desire to lower costs of doing business

• Less successful doing likewise for residential customers – Smaller volumes purchased per customer– Savings negligible for time expended to shop for alternative providers

• Some states designed markets poorly, unduly exposing customers to price risk (i.e., California)

• Some states erred in imposing 5 – 6 year price caps or conferring discounts on rates provided by incumbent utility, disincentiving customers from switching to new provider, and discouraging new market entrants

• No additional states will embark on “experiment”

• In states where price caps are being lifted, political controversy has ensued

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Energy Policy Act of 2005 (EPAct): Alteration of the State-Federal

Relationship

• Legislative thrust is remedial in areas where issues have persisted or gaps have emerged:– Transmission siting– Responsibility for “reliability”

• Legislation clarifies responsibility between states and federal government, creates new decision-making mechanisms, and establishes procedure for resolving conflicts

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The Transmission Issue• During previous decades, utility service was primarily local, and

transmission was built to suit local needs

• States and local entities held authority to site transmission

• Markets have now assumed, multi-state, regional proportions

• Concern is that states would behave parochially in deciding whether to allow new transmission to be built, if no immediately discernible benefit for state

• Past instances cited of state resistance to -- or delay of -- siting of interstate transmission lines ( Example: 765-kV line proposed by American Electric Power in Virginia and West Virginia which took 16 years)

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The Energy Policy Act Remedy• Grants Federal Energy Regulatory Commission (FERC) authority to approve the siting

of electric transmission facilities located in “national interest electric transmission corridors” :

– if states lack authority to do so or they cannot consider interstate benefits of a project;– or when the applicant is essentially a wholesale-only transmitter; – or when states have withheld approval for more than a year or have conditioned approval in

such a way that the project will not significantly reduce congestion or would not be economically feasible

• The Department of Energy (DOE) must identify such corridors, which may include any geographic area experiencing electric transmission capacity constraints or congestion, within one year of enactment and every three years thereafter

• Holders of a FERC siting permit may exercise eminent domain authority in federal court, allowing court to preempt state decision

• DOE has identified “critical congestion areas” for comment and is expected to designate “national interest electric transmission corridors” by end of year

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Reliability Responsibility: Now Federalized

• Pre-Energy Policy Act Enactment– Reliability responsibility rested primarily with states at local distribution level (regulating outage

frequency, continuity of service) – Industry reliability requirements for planning and operation of bulk power system were

voluntary

• Northeast-Midwest power outage was a watershed

• Energy Policy Act Federalizes Reliability– Congress directed development of mandatory, federally (FERC) approved, enforceable

reliability standards– FERC will certify a single Electric Reliability Organization (ERO) to oversee reliability of US

portion of interconnected North American Bulk-Power System, subject to FERC oversight – The ERO may delegate enforcement responsibilities to a Regional Entity, but only after the

FERC approval of delegation agreement– Either ERO or Regional Entity may propose reliability standards, monitor compliance, or

impose a penalty on user, owner or operator for standard violation, subject to review by, and appeal to, FERC

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FERC’s Reliability Standards : Balancing National Vs. Regional Interests

• FERC seeks standards uniformity “as much as possible” across interconnected North American bulk power system

• Will permit regional differences to extent more stringent than continent-wide or necessitated by physical system

• Will not defer to ERO or Regional Entity with respect to the effect on competition of proposed reliability standard

• North American Electric Reliability Council applied for, and has been designated by, FERC to be the ERO

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The States’ Authority : No Preemption, But FERC Resolves

Alleged Conflicts

• Energy Policy Act savings clause: State action to ensure the safety, adequacy, and reliability of electric service within that state not preempted as long as such action is not inconsistent with any [federal] reliability standard

• FERC rule: sets out procedure for resolving before

FERC all federal/state conflicts upon petition by ERO, Regional Entity, or other affected person

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State Authority to Form Regional Advisory Bodies

• Upon petition of at least two-thirds of the states within region with more than one-half of their electric load served within the region

– Requires member from each participating state in the region, appointed by governor of each state – May include representatives of agencies, states and provinces outside of US

• Regional Advisory Body may provide advice to ERO, Regional Entity, or FERC concerning:

– Governance of an existing or proposed Regional Entity within the same region; – Whether reliability standard proposed to apply within the region is just, reasonable, not unduly

discriminatory or preferential, and in the public interest; – Whether fees for all activities proposed to be assessed within the region are just, reasonable, not

unduly discriminatory or preferential, and in the public interest; and – Any other responsibilities requested by the FERC

• FERC may give deference to Regional Advisory Body that is organized on an Interconnection-wide basis

• Regional Advisory Body comprised of 10 Western states has been formed

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What does the Power Sector Look Like Today?

• The power sector is no longer a declining cost industry

• Cost of fuel for electricity (coal & natural gas) will continue to rise, and for natural gas could be volatile

• Lack of transmission investment in prior years will require significant upgrades to meet demand expectations, further boosting consumer energy costs

• The need for higher rates will place extraordinary pressure on state utility commissions charged with regulating electric utility companies

• Rate increases will likely be “politicized”, heightening risk for investors

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Lessons Learned• Power sector reform has had mixed outcomes:

– Induced utilities to operate more efficiently and to focus on core capabilities (good)– Created “boom/bust” generation cycles in the absence of long-term planning (bad)– We will likely be thrust into more robust long-term resource portfolio management

• Reforms have spawned a variety of utility business models– Traditional vertically integrated– Distribution companies with competitive wholesale but closed retail markets– Distribution companies with competitive wholesale and open retail markets– Generation-only companies– Transmission-only companies

• These various business models could pave the way for learning which are optimum from a consumer and investor standpoint

• We learn from our mistakes – since we have made many, we must be learning!

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Thank You For Your Attention

Xie Xie

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Robert W. GeePresidentGee Strategies Group LLC7609 Brittany Parc CourtFalls Church, VA 22304U.S.A.703.593.0116703.698.2033 (fax)rwgee@geestrategies.comwww.geestrategies.com