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Electricity Markets: Lessons Learned from California.
Subcommittee on Energy and Air Quality
Mr. Robert Levin
Mr. Chairman, my name is Bob Levin. I am Senior Vice President for Planning and Development for the New York Mercantile Exchange ("NYMEX" or the "Exchange"). On behalf of the Exchange, I want to thank you for the opportunity to participate in today's forum concerning events in the California electricity marketplace. The New York Mercantile Exchange "NYMEX," established in 1872, is the largest energy futures exchange in the world and the only futures market in the United States devoted exclusively to pricing, hedging, and trading industrial commodities. The merger in mid-1994 with Commodity Exchange, Inc ("COMEX,") which provides a forum for trading gold, silver and high grade copper futures contracts, created the world's largest physically-based commodity exchange. The Exchange pioneered the development of energy futures and options. From a modest 34,000 heating oil contracts traded in 1978, NYMEX energy futures and options volume grew to more than 89 million contracts in the year 2000 and now includes crude oil, gasoline, natural gas, electricity and propane in addition to heating oil. NYMEX provides the world's most efficient forum for energy price risk management. The visible and highly competitive daily trading of energy futures and options on the exchange provides a true world reference price for each of the commodities traded. NYMEX has no stake in the direct outcome of the electricity market. It draws no direct benefit from either higher prices or lower prices. NYMEX only seeks the opportunity to compete in the provision of marketplace services, having never sought the role of government granted franchise to provide these services. In fact, NYMEX has expressly fought against the establishment of government created or sanctioned franchises to serve as marketplaces for electricity, believing those institutions should develop in response to market forces alone competing for the business of market participants in the same way that market participants should be competing with each other. With this motivation, NYMEX has been an active participant in regulatory and legislative proceedings related to electricity deregulation and restructuring at both the state and federal levels since 1994. In this capacity, NYMEX provided scheduled testimony four times before the California Public Utilities Commission ("CPUC"), two times before the appropriate California Legislature committees, and more than a half dozen times before the Federal Energy Regulatory Commission ("FERC"). NYMEX has provided formal written comments in these proceedings on about two dozen occasions. The theme of our testimony and comments has been consistently to support true market competition. The debate that has taken place over the years regarding electricity deregulation or restructuring has been largely one between supporters of government intrusion to induce prescribed results and the supporters of unmolested competition. To date, there are no examples of a truly competitive free market for electricity in the US. What went wrong in California? It is the Exchange's belief that California missed the opportunity in the mid 1990's to foster the creation of a truly competitive electricity marketplace. NYMEX's comments are designed to address three implicit questions: what was wrong with California, how can it be remedied, and how does this apply to other markets, PJM in particular? To answer each of these questions, the most relevant factor is to what degree was direct access, the actual competition between sellers of electricity to directly serve end-users, supported. Direct access is key because it represents the core of what is meant by market competition. The engine of competition in any market is the head-to-head competition for customers that takes place between suppliers of the market's underlying product. Rivalries develop in such head-to-head competition and these rivalries lead to experiments to better serve customers through innovations in product and service or the lowering in cost. The competitive process cannot take place unless the seller directly serves customers -- otherwise there is no market whatsoever and no sales. This is how competitive free markets operate for virtually every product and service. This might seem obvious to the average person, but under "deregulation," electricity has operated according to a different paradigm. One notable exception, however, is the "deregulating" electricity market, which has relied to a varying extent on market artifices to serve in the middleman function. The artifices are state-created or mandated franchises to serve simultaneously in the role as buyer for any (sometimes all) sellers and seller for any (sometimes all) buyers. They have consistently been formed to serve the spot market (i.e. next day market, hourly market over the next 36 hours) and to clear offers to sell at one price. It is no accident that where electricity markets have been structured to rely more heavily on this type of artifice, the development of direct access has been more inhibited and the level of real market competition has been muted. As a case in point, California was expressly designed to frustrate the development of direct access. The consequence of this action was eventual disintegration of competition, higher prices, and virtually no customization to better serve customers. It may seem ironic, but direct access has not been the central consideration in either state or federal proceedings to date to "deregulate" electricity. In some venues, it has been accorded serious consideration, but even in these circumstances, the major focus has been on developing competition in generation. This has been conducted without regard precisely to how end-users would directly participate. NYMEX is of the opinion that direct access is the most critical component of deregulation. In fact, without direct access, there can be no deregulation. With respect to competition in generation, suppliers would have at least as great an incentive to reduce their generating costs in serving a direct access market as one where they are steered into selling to a government franchised artificial buyer. Furthermore, direct access is the only vehicle through which the customized needs of end-users would be served. Under the alternative to direct access, transactions are concentrated in the state-franchised spot market pool which is subject to greater overall price volatility and higher incidence of spiking prices. Tending towards the extreme, California adopted policies that drove the overwhelming majority of their transactions into the spot market. A market centered around direct access transactions would never find itself at the mercy of the spot market to the extent California was. There would be far greater reliance on forward contracting. California's major flaws were that it undercut the development of direct access and forced its market to rely artificially on the spot market. It did this through mandating participation in the spot market by utilities, applying the add-on competition transition charge ("CTC") to artificially render direct access transactions as uneconomic, and not providing an effective program for firm transmission. The result has been very limited participation in direct access in California. PJM (Pennsylvania- New Jersey- Maryland Interconnect), in these Mid-Atlantic states' approach to electricity competition in the electricity marketplace, has promoted direct access to a much greater extent than California and they will benefit accordingly. Nonetheless, it has incorporated some programs which hinder direct access and, to the extent this is done, has introduced a level of artificiality to its market. In particular, PJM has adopted a policy governing transmission congestion that introduces a substantial level of confusion to participants in the direct access market. Though well-intentioned, it was adopted over the expressed objections of supporters of direct access. Any perceived benefits (and there is a debate as to whether there are benefits) are exceeded by the very real commercial costs. One of the impacts of this program is that increases the exposure of market participants to uncertain spot prices, the very structural flaw that has unraveled the California market. This is not to say that PJM is as exposed as California - its support of direct access programs provided some insulation -- but it is by no means immune. Critical Market Considerations Have Been Ignored The area of consideration where NYMEX has provided most of its input has been on market
structure. NYMEX has advocated allowing market structure to develop on its own without
government interference. NYMEX has not been very successful in this pursuit. California, in
particular, rejected this position. In response to this, NYMEX predicted the ultimate outcome of
California's policies to be lower competition, higher prices, and lower consumer value. The past eight
months these predictions have become manifest. Conclusion Perhaps the single most important thing that California failed to do in avoiding a supply and price crisis was to remove impediments in the electrical grid to true competition among buyers and sellers of electricity. Any California plan that addresses this issue should support direct access to the market for all buyers and sellers-the current system still greatly restricts access. California's plan relied on market artifices, frustrating the development of direct access and driving an overwhelming majority of transactions onto the "spot" market, where one is forced to trade only "day-ahead." The result of the monopoly Power Exchange's "spot" market was higher volatility and higher prices for electricity. Buyers and sellers of power could not be reasonably assured that they could make or take delivery of electricity in forward contracts. The California plan stressed developing competition among generators, but failed to provide for the most critical component -- direct access. This and many other critical factors which support truly competitive markets were omitted in the California plan. PJM has promoted direct access to a somewhat greater extent than California but it is still exposed to the same structural problems that are plaguing the California market. Mr. Chairman, once again thank you for the opportunity to testify. I will be glad to answer any questions.
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