7/30/2001

KUFM / KGPR

T. M. Power

The Importance of the Incentives Built into Utility Regulation

Electricity markets continue to baffle the experts. Just as we reached the middle of a summer that was expected to bring new electric price spikes and rolling blackouts, Pacific Northwest electric prices declined dramatically. Instead of facing 75 cent per kilowatt hour prices, in late July firm, on-peak, prices dipped as low as 3.5 cents.

One might have assumed those unexpectedly low electric prices would have brought cheers from energy company officials who have been struggling to balance supply and demand. Instead we heard cries of pain from a different set of players, those who had purchased relatively expensive supplies as protection against the expected price spikes and shortages. They are now stuck with supplies that are much more costly than what can be bought on the market. Companies that have purchased or leased portable diesel-powered generators and utilities that have signed high priced contracts fall into that category. One lesson is that unstable prices, whether falling or rising, cause problems. That instability and the uncertainty associated with it can cause economic disruptions.

The sudden decline in electric prices and the financial threat those declines pose for utilities that have signed long-term contracts were among the concerns that led the Montana Public Service Commission to hesitate when it was asked to give its quick blessing to a contract Montana Power had proposed to sign with a company that wants to build a coal-fired electric generating facility in Hardin. That firm was offering to provide electricity at 4 cents a kilowatt-hour, a price that sounds very good when compared the 50 cents to a dollar per kilowatt-hour price that some Western utilities paid at the peak of the crisis and also when compared to the electric prices that were projected to reach 30 cents per kilowatt hour this summer in the Pacific Northwest. On the other hand, 4 cents is almost 80 percent above the costs associated with the generating equipment that Montana Power used to own and the price we are now paying for that power under a four-year buy-back agreement that will end next summer. From one point of view the Hardin-MPC proposal looks like a great deal; from another, it looks risky, even dangerous.

Equally interesting about this proposal to build new coal-fired electric generation in Montana was the intense involvement of government and regulation in the deal despite the fact that the state government and Montana Power have been the chief advocates for competitive markets and deregulation. The partners proposing to build the new generation made clear that they could not raise the money to do so unless they had a long-term contract from Montana Power to buy the output. Without that purchase contract, no one will take the risk of investing in the facility. Montana Power, on its part, is not willing to sign such a contract unless the government underwrites it by promising to make customers pay for the electricity whether it turns out to be a good deal or not. Note that no one wants to take any risks in this unstable market. They want to pass all of the risk on to electric customers and use the government to force customers to pay.

This should sound familiar. This was the regulatory arrangement that was used for most of the twentieth century to get investors to put up the money for new generation at a reasonable cost. It was partially the dismantling of this arrangement that led to the lack of building of new supply during the 1990s. It is interesting that the architects of deregulation are back embracing the system they dismantled with disastrous consequences to the Montana economy.

But how is the Montana Public Service Commission to evaluate proposed new electric supplies that Montana Power brings to it? This is not a simple question. Any regulatory structure creates an incentive system that will guide the utility one way or another as it pursues electric supplies for its customers. But customers do not want only one simple thing. They want a mix of things: low prices, to be sure, but also stable prices and secure sources of supply. In addition, most of those customers would like those energy sources to be environmentally safe. Sometimes several of these objectives coincide; often they do not, and tradeoffs have to be considered. To get stable prices or secure supply, a higher price usually has to be paid. So what is the appropriate balance? That is one of the questions that the Public Service Commission will have to ask and answer as it provides guidance to the Montana Power Company.

How the Commission regulates the Power Company will change how the utility proceeds to obtain supply. If electric price fluctuations are automatically passed on to customers, the utility will minimize its risks and costs by simply purchasing market- indexed supplies. Customers will always pay the prices set by the market, never more, never less. But those prices may be astronomically high at times. Some Puget Sound utilities have done just that over the last year and their customers faced steep price increases. Other regulatory commissions have insisted that utilities try to stabilize prices and protect customers against sudden increases in price. Oregon utilities have been regulated in this way, and they signed long-term contracts that have protected their customers during the California-induced price spikes. Now, however, as prices fall, the tables may be reversed. Finally, if the Commission ties the utility’s recovery of its costs to its kilowatt-hour sales, the utility may try to promote as much electric consumption as possible and may oppose conservation efforts and self-generation, possibly compounding supply problems and keeping electricity bills higher than necessary.

The point is that public regulation creates an incentive system that guides utility behavior for better or worse. The Montana Public Service Commission has to face up to that and be careful of the incentives it puts in place because we electric users and the Montana economy will have to live with the consequences.

The Commission was correct to refuse to be stampeded into approving immediately the first contracts brought to it by Montana Power. The existing law correctly contemplates that Montana Power will present to the Commission for approval a full portfolio of supplies to serve customers’ needs beginning next summer. The Commission should review that complete portfolio against the complex of interests that electric customers have. Only then can it make an informed judgment.

Meanwhile, however, it has to be engaged in a dialogue with both the utility and consumers about how to weight those various, potentially conflicting consumer interests while also acknowledging the legitimate interests of the Montana Power Company’s stockholders.

Appropriate regulation consists of far more than passively approving, in a piecemeal manner, each source of supply Montana Power proposes.