PUC's Diminishing Role

Finding 3: The PUC, while it will play a transitional role in nurturing competition, could jeopardize the success of the energy restructuring plans if it were to assume oversight of the competitive aspects of energy markets.

The Public Utilities Commission envisions itself continuing its rate regulation of monopolies, performing a variety of tasks essential to developing competitive markets and taking on the state functions associated with a competitive market.

The PUC vision was based in part on an assessment of what functions would be required of the State as the investor-owned monopolies were broken apart and competition was induced among generators. The PUC saw itself as the natural heir to these functions -- following the monopolies into the marketplace.

The State functions required by more competitive energy markets -- and the Little Hoover Commission's conclusions that the redefined Energy Commission is best suited to assume those duties -- are described in previous findings. Assuming those recommendations were followed, the PUC would continue to have critical tasks -- in the transition to competitive energy markets, in redefining rate regulation of remnant monopolies and in facilitating the evolution of distribution services.

How well those challenges are met will greatly influence the success of the policy choice to replace regulation with competition. How that competition unfolds will, in turn, shape the ultimate structure of the State's energy oversight agency.

The PUC Vision

The Public Utilities Commission has sought to establish its own role in future markets through its electricity restructuring policy decisions and its Vision 2000 process. In both efforts, the PUC did not seriously consider the role of any other state agency in facilitating competition, providing market oversight or protecting consumers from unfair business practices. The PUC also did not seriously consider any significant changes that should be made to the Public Utilities Code or other statutes.

Commissioners have stated that they see the PUC playing a smaller regulatory role in future energy markets. They acknowledge that much of the PUC's economic regulation will have to be transformed, simplified or eliminated to match the needs of a competitive market.

But the PUC also sees itself taking on competition-related functions, such as monitoring for possible market power abuses in the generation market. And it sees its mission of protecting captive customers from monopoly abuses naturally evolving into protecting consumers from the perils of aggressive marketing.

The PUC -- in its Vision 2000 plan, its industry restructuring policy decisions and in testimony to the Little Hoover -- described the functions it plans to perform during the transition to competitive markets, in the long-term distribution market and in the long-term competitive market. Among them:

In the Transition ...

The PUC will collect and administer the Competition Transition Charge used to reimburse utilities for investments that will be rendered uneconomic by the advent of competition. Because of the PUC's extensive involvement in regulating the expenditures of the investor-owned utilities, it is well equipped to accelerate reimbursement for those investments through the transition charge fashioned under its restructuring decision and refined by the Legislature in the electricity restructuring act of 1996.

The PUC also will work with the Federal Energy Regulatory Commission (FERC) and others to create the Independent System Operator and the Power Exchange -- two new institutions that will handle the financial and electric transactions of the new market. Some of the most important regulatory decisions on the path to competitive electricity markets are being made by FERC, based on applications by the investor-owned utilities, at the behest of the PUC. The PUC, in its policy decisions, and the Legislature in its restructuring bill, established parameters for those new institutions.

In the Long-term Distribution Market ...

The PUC is establishing and refining performance-based rate-making procedures for the distribution monopolies. California is following a national trend by seeking to replace inefficient rate-of-return regulation with a system of incentives intended to hold down utility expenditures while meeting minimum service standards. The goal is to create a rate-making structure that provides incentives for utility managers to improve service and hold down expenses rather than trying to justify expenses to increase revenue.

The PUC also will be registering new entrants. The electricity restructuring act of 1996 refined the PUC's plans to register marketers and other new service providers as a way of protecting consumers from fly-by-night companies.

Similarly, the PUC will protect consumers from over-aggressive marketing. The PUC, using its experience in telecommunications competition as its guide, envisions overzealous marketers tricking customers into switching service providers. As in telecommunications, the PUC is preparing to enforce marketing standards.

In the Long-term Competitive Market ...

The PUC envisions itself remaining a dominant venue for making state energy policies. The PUC has correctly recognized that its restructuring and similar decisions radically shape state energy policy -- and certainly more than the policy recommendations made by the Energy Commission or the funding decisions made by the Legislature. The PUC sees its role in situational policy making continuing as monopoly markets yield to competitive markets.

The PUC sees itself as a watchdog against market abuses. The PUC -- in concert with federal authorities -- plans to monitor the incumbent utilities, which they regulate, and new independent producers, which they do not regulate, to make sure they are not manipulating the market.

The PUC also envisions a continuing role in serving as the State's ambassador and negotiator in venues outside of the State. The PUC believes it will need to work with the Federal Energy Regulatory Commission, the Congress, and a variety of regional forums to protect the State's interests in generation and transmission matters that will influence the competitive market.

The PUC sees a need for the State to resolve disputes between market players and it believes it is best suited for that role. The PUC believes that to facilitate competition it should take on a role as a referee among competitors to resolve disputes that otherwise might end up in court.

The PUC's Critical, But Diminishing Role

Some of the functions the PUC plans to perform are essential to establishing competitive markets. The PUC, for instance, has pioneered the policy debate and brokered the specific plan with the investor-owned utilities to break up the monopolies and create the institutional framework for making electricity transactions. The Legislature, other state agencies and the market players all see the PUC as uniquely suited for implementing that strategy.

In assessing the long-term role for the Public Utilities Commission, however, policy experts, market players and consumer advocates have differing views on the PUC's appropriate role -- particularly its role in the competitive aspects of the market. Among their concerns:

• PUC's Bias Toward Intervention. A number of market players testified that the PUC lacks the restraint to forbear from intervening in the market. And while consumer interests have legitimate concerns about the PUC prematurely ceding control over remnant monopolies, the experience in telecommunications and transportation supports the view that the PUC will continue regulation after it is in the best interest of consumers. This concern is supported by the PUC's broad definition of market power abuse as any "unfair treatment of consumers by any of the firms operating in a competitive market."
• PUC's Bias Toward Investor-owned Utilities. Independent energy producers and municipal utility districts, which have never been regulated by the PUC, fear that the PUC will continue to protect the economic viability of the former monopolies when resolving disputes between competitors. That fear was bolstered in part by the PUC's position that investor-owned utilities should be reimbursed for 100 percent of their investments that will be stranded by the switch to competition.⁽⁴⁵⁾
• PUC's Slow Decision-making. The PUC's overwhelming workload will make it difficult to swiftly respond to issues. As the issues before the Commission have taken on the complexities of competitive markets, the PUC has not been able to decide cases quickly enough for new entrants.

These issues raise significant concerns about the PUC's ability to evolve from a heavy handed, interventionist economic regulator into a nurturing and neutral parent of competitive markets -- particularly when there is no agreement that any state agency should take on some of the functions the PUC plans to assume. Pacific Gas and Electric Company testified:

Although under certain circumstances, the CPUC now has an obligation to oversee the maturing of the competitive electricity market, we question whether this is the proper role for the PUC. While certainly it is important to ensure that all participants in the market are able to compete on an equal footing, it is not clear that the CPUC has an expertise to regulate the competitive arena, nor is it clear that the CPUC has the authority to effect any remedies for violations which have been deemed to have occurred. On balance, we believe that the CPUC may not be the proper place to house this market referee function.⁽⁴⁶⁾

Rather than assuming the market will fail and providing the PUC with the tools for rapid intervention, the utility advocated a structure that would minimize government intervention of any kind to when the market "clearly fails."

The PUC is well suited to retain and refine some critical functions, at least in the near term -- all of them revolving around the break up of the vertical monopolies and the evolution of the distribution market where or a horizontal monopoly is expected to remain.⁽⁴⁷⁾ But how well the PUC executes these functions will depend in part on whether the PUC tries to take on new functions, or tries to hold onto functions that are no longer needed or could be better performed by another agency. Among the challenges facing the Public Utilities Commission:

Performance-based rate-making: Between 30 and 40 percent of a customer's bill pays for distribution-related services -- nearly twice the costs associated with generating the electricity in the first place. As a result, the ability to control distribution costs will have a large impact on energy prices. The PUC's plan to control those costs with performance-based rate-making (PBR), however, may be more complicated than expected.

The PUC in August 1994 adopted a performance-based rate for San Diego Gas and Electric Company that critics say worked out better for the utility than for ratepayers. In the plan's first year, critics say San Diego Gas and Electric achieved $55 million in before-tax cost savings -- $32 million in additional after-tax profits. The utility received $7 million for improving its quality of services, while ratepayers benefited by $1.1 million.⁽⁴⁸⁾

The consumer group Toward Utility Rate Normalization (TURN) believes the PUC will have to make significant revisions to its performance-based regulations before they simultaneously will protect consumers and shareholders. TURN testified:

PBR represents far more untested theory than successful practice. Many of the experiments with PBR that have been conducted to date have turned out to be unmitigated disasters from the consumer perspective.... TURN submits that it is far too early to assume that the traditional regulatory role will somehow be dramatically reduced through the magic of PBR.⁽⁴⁹⁾

Unbundled distribution services. One task of the distribution oversight agency will be to "unbundle" the distribution-related services to encourage the development of competition and further reduce the inefficiency of monopoly regulations.

Real-time metering might allow some customers to capture savings from off-peak energy use, and create a niche market for companies that will help consumers achieve this savings. New associations are expected to emerge to aggregate the energy demands from a number of customers and give them more leverage to seek lower rates.

New technologies are expected to expand the opportunity for self-generators, who might then sell power and buy it, and companies will form to facilitate those transactions. Low-income assistance programs now performed by the utilities could be done by government agencies or nonprofit community groups.

The California Energy Institute testified that the State will need to take an active role in encouraging the technologies needed for customers to reap the benefits of competition that may occur at the generation level, but will be experienced by consumers at the distribution end.⁽⁵⁰⁾

One Energy Commissioner asserted it will take an "extensive government effort" if the distribution system is going to evolve from one where a regulated monopoly provides all of the distribution-related services to one where private companies or community groups compete for all energy and social services but for maintaining the line delivering electrons.⁽⁵¹⁾

Resolving complaints. The Legislature in 1996 affirmed the PUC's plan to take on the role of registering new entrants into competitive electricity markets and resolving consumer complaints that the PUC expects to arise from over-aggressive marketers.

But the Legislature acted after considerable debate about whether the function is needed, and whether it is needed over the long term. The consumer group TURN, in advocating that the PUC take on the role, recognized the harm that could come if in the name of protecting consumers, the PUC regulated too much. TURN testified:

The objective should not be to create barriers to entry into the business, but rather to assure that consumers who are used to purchasing solely from a regulated monopoly are not abused by unscrupulous operators in the newly opening marketplace.⁽⁵²⁾

Eventually, however, consumers will be used to selecting energy suppliers. And unless the unscrupulous operators are more prevalent in energy than in other businesses, the State will be able to rely on existing law enforcement mechanisms. In addition to these known challenges, complex and unpredicted issues will likely emerge and require resolution.

The Complications of Uncertainty

In looking to see how these issues will play out before the PUC, investor-owned energy utilities have examined how the Commission resolved similar issues in opening telecommunications markets to competition. That history concerns them.

Their overriding anxiety is that, left in a position to regulate, the PUC will regulate. More specifically, they are concerned that the slower and more ad hoc the deregulation process, the more revenue will be earned or lost in the regulatory venue rather than the market place. San Diego Gas and Electric Company testified:

If the history of telecommunications deregulation provides us with any perspective of where energy regulation is headed in California, we should all have cause for concern. Despite the past decade of so-called telecommunications deregulation, there is not now, nor will there be in the foreseeable future, real or fair competition among suppliers. Instead new entrants are using the regulatory process to their competitive advantage.⁽⁵³⁾

On the same issue, TURN has the exact opposite concern: that deregulation will happen faster than competition -- and that organizational restructuring will happen before the interested parties understand and can agree upon the role of the government:

As long as the distribution utility remains the only readily available source of electricity for most small consumers, there will be little opportunity for reducing or eliminating the role of the regulator in this portion of the market.⁽⁵⁴⁾

No one can say for sure how the market will develop for average consumers. While marketers may be as aggressive as in the long-distance business, the retail market at the residential level may develop slowly.

In the case of natural gas, most smaller users have seen the benefits of competition at the wholesale level without having the experience of retail competition. The PUC's role has been to fashion rules that allow for retail competition for large consumers, to ensure that smaller consumers are not stuck with an unfair amount of the fixed costs, and to develop performance-based rate-making to reduce the inefficiencies of regulation. While retail competition is legal for all classes of customers, and may be percolating down to smaller consumers, the transition to competition has been slow.

Southern California Gas, which has undergone a slow and lurching march toward competition, articulated the need for a more strategic regulatory retreat on the part of the PUC in all of these markets:

In order to fully capture the benefits of restructuring, the regulator must actively measure competition in the various energy market segments and determine when adequate competition exists. The agency should issue a rule-making order with general guidelines for judging utility markets to be "competitive," then work with parties on a case-by-case basis to further refine the definitions. Once a finding of full competition is made, oversight and audit of utilities' management decisions relative to serve those markets should be discontinued.⁽⁵⁵⁾

One of the most difficult chores facing the PUC will be to determine when it should stop doing what it was created to do. One of the best ways to accomplish that will be to establish rules to determine when competition exists and eliminate regulation as that occurs. And as the regulator retreats, the prevailing public interest can be re-examined and the government's role can be reassessed.

One former PUC Commissioner warned that it will be too easy for the PUC to take on a different role in the market rather than a smaller role:

The key is to design even more aggressively for the future by setting out specific milestones for specific regulatory withdrawal, and accepting the fact that there is no such thing as perfect regulation, just as there is no such thing as perfect competition.⁽⁵⁶⁾

Great attention has been paid to the actions government will need to take in the transition to competitive markets and the role of government after competition arrives. The difficulty is knowing specifically when the sun will set on the monopolies and rise on a new market. One consumer advocate quips that the transition is the foreseeable future and the long-term is the unforeseeable future.

The local distribution services provided by investor-owned monopolies are expected to remain fundamentally monopolistic for the foreseeable future. In that sense, the need to regulate rates charged by these companies is the only direct descendent of the PUC's current authorities.

It is tempting to immediately consolidate all energy-related regulatory functions in one agency. But to do so would jeopardize potential market efficiencies worth billions in return for potential government efficiencies worth millions. It will take an extraordinary effort by the PUC to administer the competition transition charge, oversee the divestiture of generation by the investor-owned utilities, institute performance-based rate-making and unbundle the distribution monopoly to invite competition into that sector.

Moving those responsibilities to a new agency in the middle of implementation would jeopardize the success of those efforts. And to make firm decisions now on the State's long-term role in the distribution sector would invite error.

However, it appears that after the PUC implements new regulatory strategies and after market forces have been brought to bear on distribution services, oversight of that sector could be transferred to the same agency overseeing the generation and transmission aspects of the industry. Similarly, oversight of natural gas would be more portable once performance-based rate-making procedures are refined.

Recommendations

Recommendation 3-A: The Governor and the Legislature should enact legislation establishing benchmarks and a time line for delineating when and how the PUC will eliminate economic regulation of competitive aspects of the market and when and how it will encourage competition for distribution-related services.

While the Legislature should expeditiously divest the PUC of functions that will be obsolete with the advent of competition, other regulatory functions will become obsolete over time. Thresholds should be established in statute ahead of time determining when the PUC will cease regulating in a given arena. The benchmarks also will serve to better coordinate activities between the Energy Commission and the PUC.

Recommendation 3-B: After the transition -- after all customers have access to competitive electricity providers and performance-based rate-making is instituted for distribution monopolies -- the Governor and the Legislature should transfer the PUC's remaining energy-related functions to the Energy Commission.

The goal of the State should be a single agency with energy oversight authority. But the State should pursue this goal in a way that does not jeopardize emerging markets or compromise consumer protection. The first step is to consolidate those new functions over the expanding competitive market into a single agency. The second step is to consolidate the regulation of remnant energy monopolies at the Energy Commission. The precise timing and scope of the government restructuring will depend upon market developments. But the transfer will be smoother after performance-based rate-making has been refined and it becomes more clear which aspects of the distribution market will remain monopolistic, In any event, establishing rates for the distribution market should be a simple and limited task compared to the PUC's historic role in regulating every aspect of a monopoly power provider.