New York wants to create competitive electricity markets. But who should run them?

Yesterday, I wrote about New York's ambitious effort to rethink its power utilities, which is itself part of a broader, even more ambitious effort by the state to redesign virtually all of its energy systems.

The utility reform effort, known as Reforming the Energy Vision (REV), is an attempt to solve two problems with utilities, both of which are making electricity in the state dirtier and more expensive than it needs to be:

• Though wholesale power generation has been split off into competitive markets in restructured states (including New York), utilities still have a monopoly over the entire retail side of electricity. That has long been considered a "natural monopoly," a sector where it made good sense to have one exclusive provider. Today, however, the justification for a retail-side monopoly has faded. There is a flurry of innovation happening at the "distribution edge" of the grid, including distributed generation (like rooftop solar panels), energy storage (in home batteries or electric cars), and intelligent energy management (like the Nest thermostat). Those rapidly developing products and services are best provided by competitive markets.
• Today, utilities make money by building stuff — new substations, poles, and power lines. All their revenue comes from returns on capital investments. Naturally, they want to build more stuff! And just as naturally, they are opposed to all the grid-edge innovations mentioned above, which reduce their need to build stuff. That's a perverse set of incentives. Somehow, utilities need a way to make money that supports the spread of these clean, distributed electricity products and services.

With REV, New York set out to solve these two problems, the first by creating retail-side electricity markets, and the second by giving utilities a way to profit by supporting those markets.

It's that first problem/solution I want to focus on here, because it is at the core of all utility reform to come (and there is much more to come).

(Shutterstock)

Who should run retail electricity markets?

All right, so the natural monopoly has shrunk, and it's time to open up retail electricity markets. How do you get from here to there?

When it came time to create markets on the wholesale electric-generation side back in the 1990s, here's what regulators did:

1. They stripped utilities of any ownership of generation assets (power plants). Generation could only be owned by unregulated generation companies (gencos).
2. They created independent, nonprofit organizations to oversee wholesale energy markets and run the long-distance transmission grid. These independent system operators (ISOs) were designed to have no business interest at all in the buying and selling of power. Their only incentive was to run the market well.

Should regulators do the same thing on the retail side?

Doing the same thing would mean stripping distribution utilities of any ownership or involvement in markets for retail electricity products and services. And it would mean creating independent distribution system operators (IDSOs) to oversee retail markets for electricity products and services.

Many grid reformers, including former FERC Chair Jon Wellinghoff, support the IDSO model.

But New York utilities argued against it. Instead, they persuaded state regulators to give them the responsibility for overseeing retail markets. Regulators created the equivalent of an ISO function — they call them distributed service providers (DSPs) — but they gave that function to utilities rather than to independent organizations. At least for now, utilities are DSPs in New York.

This makes grid reformers nervous. The danger, obviously, is that utilities have an incentive to run markets in a way that a) protects their ability to build more stuff, which makes them more money, and b) advantages any products and services they might be offering to customers or other market participants.

So why did New York regulators side with the utilities on this question? It's not an open-and-shut case; there are arguments to be made for both sides. Of course utilities' preference for the DSP model involves some politics, innate caution, and vested financial interests. But they also raised some legitimate concerns.

Utilities argue that utilities should run retail electric markets

One legitimate concern: Perhaps the wholesale restructuring model doesn't apply straightforwardly to the retail side. After all, state regulators have a much richer and more varied array of responsibilities than the feds do, at least when it comes to electricity.

Federal regulators that oversee wholesale energy markets — mainly FERC and the ISOs created by FERC — have an extremely restricted purview. Their authority is based on the interstate commerce clause in the Constitution, which tightly limits its scope. The feds don't worry about social goals like equity or carbon reduction, just effective functioning of the market.

The bulk of electricity oversight falls to state regulators, which, unlike their federal counterparts, do have to consider equity, safety, public health, environmental protection, and a number of other social priorities. The state equivalent of an ISO would have to worry about far more than market functioning.

To utilities, this is an argument for giving them the ISO function. They argue that enforcement of social goals and mandates is the proper role of regulated utilities, responsible to the public, and that utilities should therefore be in charge of ensuring that retail electricity markets are run in such a way that they serve those social goals.

Another legitimate concern: When wholesale restructuring took place, there were already generation companies. And there was already demand, from utilities, for the electricity and "ancillary services" they provided. The pieces were in place for a market. All regulators had to do was wave the starting flag. (I am, of course, simplifying matters considerably.)

At present, retail markets for electricity services are largely theoretical. Distributed energy resources remain a tiny, tiny fraction of total power generation. Storage is still nascent. Electric vehicles are still nascent. Services that aggregate and shift demand are nascent. And there are other markets yet undreamt of.

How does one create markets when there is no existing "demand pull"? When there are very few third parties yet prepared to participate? When customers don't even understand what the services are, or could be, well enough to ask for them? If regulators just wave the starting flag, there's some chance nothing will happen, at least for a while.

If it were just about markets, that might be fine, but remember, the whole impetus behind this is to lower prices, increase reliability, and reduce carbon. Regulators are under the gun to achieve those goals quickly; they don't have time to wait.

And it could be a long wait. As utilities point out, in New York, customers spend less than 1 percent of their disposable household income on electricity. That's not a very salient expenditure and doesn't offer much motivation to demand innovation and new market services. Customers, utilities argue, simply don't care about electricity enough to create demand pull for new markets. And they probably won't care until those markets exist, which creates a chicken-and-egg problem.

The solution, utilities argue, is to let utilities themselves create the initial demand pull by administering and participating in these new markets (in a limited, time-bound way). That way, regulators can kill two birds with one stone: ensure that distributed energy resources and energy efficiency are immediately ramped up, while also doing the long-term work of creating and expanding markets.

Another legitimate concern: The two functions of a) maintaining the reliable operation of the distribution grid, and b) running markets that use the grid as a platform are intimately connected. Each depends on the other; communication between them must be clear and in real time. Utilities argue that it's easier if both functions are housed in and coordinated by the same entity.

Relatedly, utilities are terrified of the prospect of being held responsible for reliable service but having no control over markets. And they're terrified of giving up a familiar revenue model for one that is tentative and experimental.

And finally, there's the simple fact that utilities already exist and IDSOs don't, and the fastest way to get reform done is to use the tools at hand.

(Shutterstock)

Reformers argue that it's dangerous to let utilities run retail electricity markets

These utility arguments must be weighed against the concerns of grid reformers.

For one thing, letting a utility participate (own assets and sell services) in markets that the utility itself is administering would be a pretty unavoidable conflict of interest. New York regulators say such ownership by utilities would be the exception rather than the rule, but that still leaves plenty of room for regulatory capture and market-gaming shenanigans.

Even if they don't participate in the markets, it remains true that distribution utilities make money by building stuff. If they also administer the markets, they will have incentive to run them in such a way as to protect their ability to build more stuff (rather than purely for performance or customer satisfaction).

And finally, if each utility runs its own retail markets, there will be six separate markets in New York state. That kind of Balkanization reduces market efficiency.

New York regulators are letting utilities run retail electricity markets, with many caveats

Proposals from New York regulators address many of these concerns. This post from the Rocky Mountain Institute outlines both the concerns and the responses quite well. I was particularly interested in the question of market influence and conflicts of interest. From the post (this was from last year; the "straw proposal" is now an official order):

To balance these various concerns, the straw proposal recommends that utilities be allowed to invest in and own [distributed energy resources] in specific circumstances, such as in cases where a public benefit from their ownership is identified, but those investments should be subject to competitive procurement processes and regulatory oversight. To further reduce utilities’ potential market advantages, the straw proposal recommends that DSP functions be financially, administratively, and operationally separated from other utility functions, including network maintenance and traditional customer relationship management. Strong rules for data sharing and overall transparency in the markets will be critical for mitigating these market power concerns. In the end, [regulators] have also recognized that new forms of regulatory oversight and DSP governance will need to be developed to ensure fair and competitive markets.

This is all positive — it shows that regulators are cognizant of the concerns — but it also highlights the vulnerability of the DSP model: It requires a great deal from regulators. They have to develop "new forms of regulatory oversight" that ensure "fair and competitive markets," even in the face of inevitable lobbying pressure from utilities. And they have to reliably enforce those rules, in perpetuity.

That's fine if you've got skilled, dispassionate regulators. But plans that will forever require skilled, dispassionate regulators are ... reason for some concern. A durable plan needs to work even when the people in charge aren't saints.

New York regulators are aware of that concern as well. They have said explicitly that they reserve the right, if there are problems with utilities serving the DSP function, to yank that function away and hand it over to an independent body. The prospect of losing that function is supposed to keep utilities on the straight and narrow.

Will it work? Will any of REV work? No one knows! But there are lots and lots of people watching closely and taking notes. The stakes could not be higher.

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