November 13, 2002 — The Federal Energy Regulatory Commission’s (FERC) Standard Market Design proposal is a bold attempt to simplify the regulation of electricity markets. However, a new report contends that the plan risks locking the electricity industry into a regulatory structure that ignores technological advances and is unable to adapt to changing market conditions.

The study, released by Reason Foundation, a Los Angeles-based think tank, finds that the best way for FERC to monitor electricity markets, discipline suppliers, and provide optimal investment motivation is to allow demand-side and supply-side incentives to interact.

“The delivery of electricity to the home consumer is trapped in old technology and surrounded by unrealized opportunities for gains in investment efficiency, energy efficiency, and reduced environmental emissions,” said Lynne Kiesling, senior lecturer in economics at Northwestern University and director of economic policy at Reason Foundation.

“The spirit of the standard market design is a great starting point. Unfortunately, the proposal only addresses supply-side issues and that’s like trying to clap with one hand. The standard market design should focus on the long-term benefits and objectives of creating a truly collaborative regulatory environment. The current approach treats the segments of the industry – generation, transmission, and distribution – separately, weakening the potential benefits that changes in one segment can create in another.”

In addition to highlighting some of the positive features of FERC’s proposal, the report illustrates several potential problems in the standard market design and offers recommendations to correct them, including:

1. The Standard Market Design is too quick to impose uniformity. By locking in a single, detailed, and inflexible market design the plan may inadvertently chock off further progress. The new plan should be simple, flexible and reversible, with clear and credible phase-out provisions as anticipated markets (such as the expansion of demand response at the state level) and technology changes.

2. The SMD classifies practices as “undue discrimination” without sufficient examination. Companies will file anticompetitive discrimination complaints if they find it is rewarding to do so. FERC must ensure its oversight of markets is not employed to favor one or another participant in the market, but must also provide the greatest benefit to consumers as a whole.

3. The SMD does not reduce the regulatory barriers to entry that prevent us from putting electricity transmission to a market test. The government-granted monopoly franchise in the transmission portion of the chain overlooks the potential contestability of those markets and stifles beneficial technical innovation. For example, distributed generation might be attractive to industrial customers who could build in whatever reliability and redundancy needed for their operations, reducing the need to build additional transmission.

4. The SMD does not recognize that market pricing for retail customers can exert considerable competitive discipline on both transmission and generation. Market-based retail pricing is more likely than market monitoring to create value for consumers and it is important for FERC to recognize that retail pricing reforms on the state level will alleviate many of the transmission problems that the SMD is trying to address. Furthermore, ignoring retail market price signals will lead to bad transmission investment decisions.

“Standard Market Design in Wholesale Electricity Markets: Can FERC’s proposed structure adapt to the unknown?” is available online at https://rppi.org/ps301.pdf.

Lynne Kiesling is director of economic policy at the Reason Foundation and senior lecturer in economics at Northwestern University. Co-author Brian Mannix is senior research fellow in the regulatory studies program at the Mercatus Center.

Source: Reason Public Policy Institute, www.rppi.org