Full text of Chicago Fed Letter : Shaping Electricity Policy in the Midwest, No. 178b

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MIDWEST INFRASTRUCTURE

THE FEDERAL RESERVE BANK
OF CHICAGO

JUNE 2002
NUMBER 178b

Chicago Fed Letter
Shaping electricity policy in the Midwest
by Richard Mattoon, senior economist

Despite the challenges raised by the California energy crisis and the bankruptcy of
Enron, efforts continue to increase competition and restructuring in electricity markets.
Of the five states in the Seventh District, Illinois and Michigan have been aggressively
pursuing restructuring, while Iowa, Indiana, and Wisconsin have adopted a more cautious
approach. A recent Chicago Fed conference brought policymakers and industry leaders
together to discuss the status and prospects of electricity policy in the region.

An uncertain regulatory
climate and volatile
financial conditions may
be discouraging needed
investment in basic
electricity infrastructure.

On January 17, 150 participants from
business, government, and academia
came to the Federal Reserve Bank of
Chicago to discuss the current status
and future prospects of electricity policy in the Midwest. This conference was
the first part of a bank initiative to study
the infrastructure of the Midwest economy. The program focused on policy
issues that require multi-state regional
cooperation. In particular, federal, state,
and industry representatives discussed
how to create the proper regulatory
environment to encourage needed investment in generation and transmission facilities.

Michael H. Moskow, president and chief
executive officer of the Federal Reserve
Bank of Chicago, opened the conference by underlining the importance
of electricity policy in promoting the
health of the region’s economy. Moskow
noted that there are few things as basic
to an industrial and information-based
economy as the terms on which we acquire our electric power. However, he
noted that many analysts feel that an
uncertain regulatory climate and volatile financial conditions may be discouraging needed investment in basic
electricity infrastructure. In particular,
Moskow said that promoting an efficient

electricity grid and the movement toward
a less regulated and more market-oriented system requires the coordinated
development of regional infrastructure
that addresses interstate transmission
and interconnection. Developing or
adapting institutions to guide this regional approach is a clear challenge to
electricity policymakers.
Moskow suggested that conference participants should focus on the following
critical questions:

• Are we developing the necessary
regional electricity infrastructure to
support the economic development
needs of the Midwest?

• What is the relationship between
meeting new air emissions goals and
generating power? Can electricity
capacity be increased even as we improve air quality?

• What are the roles and institutions
that are needed to guide electricity
policy? Are new institutions needed?
How can they be successfully organized so as to have the proper resources and incentives to meet the
long-term requirements of the increasingly less regulated and more
market-oriented environment?
Federal Reserve Bank of Chicago

1

A federal perspective on electricity
policy

Presenter: Robert Dixon, deputy
assistant secretary, U.S. Department
of Energy
Robert Dixon began by suggesting that
the energy industry will need to make
significant capital investments in the next
ten to 20 years to replace aging infrastructure and meet rising demand.
Dixon noted that the President’s National Energy Plan, released in May
2001, details the need for hundreds
of new power plants and thousands of
miles of power transmission lines and
natural gas pipelines. The total capital
requirement for these energy resources
could reach into the hundreds of billions
of dollars. Given that these investments
are in long-lived capital assets, it is critical that the best technology choices
are made to ensure that the cleanest,
most efficient, reliable, and affordable
electricity is produced.
Dixon acknowledged that most electricity policy decisions are made at the state
level. In the broadest sense, the federal
role in electricity policy is to develop a
national energy plan and to work with
the state and private policymakers to
implement the plan. To this end the
President’s National Energy Plan recommends that the “Secretary of Energy
propose comprehensive electricity legislation that promotes competition, protects consumers, enhances reliability,
promotes renewable energy, improves
efficiency, repeals the Public Utilities
Holding Company Act of 1935 and reforms the Public Utilities Regulatory
Policy Act of 1978.”
The revisions to the basic federal electricity laws are necessary to reflect the
new conditions in electricity markets.
In 1935, electricity markets were local,
with virtually no interstate transmission
grid. Power generation was built near
consumers and electricity provision was
considered to be a natural monopoly.
Today, the transmission grid is not only
interstate but also international. Electricity markets include large multi-state
regions, and interstate bulk power transactions are becoming an increasingly
large share of the electricity trade.
2

Dixon suggested that it is the federal
role to focus on core federal issues in
electricity legislation that are beyond
state control. These core issues include:
regulation of interstate commerce,
electricity transmission, ensuring reliability of the interstate transmission
system, protecting against the use of
market power, ensuring consumer
protection, defining the role of federal electric utilities, reforming existing
electricity laws, and defining regulatory jurisdiction.
In elaborating on the federal role, Dixon
noted that investments in new transmission capacity have failed to keep
pace with the growth in demand and
the changes in industry structure. Since
1989, electricity sales have increased
at a rate of 2.1% per year, while transmission capacity has increased by only
0.8% per year. Dixon suggested that
since the transmission system is both
interstate and international, regulation
of the grid is a federal responsibility.
To provide economic incentives for
investment in new transmission, the
National Energy Policy proposes encouraging the Federal Energy Regulatory Commission (FERC) to advocate
incentive rates to promote transmission expansion. In addition, transmission investments could be promoted
by improvements to the siting process.
This could include permitting siting
by the federal government for facilities used for interstate transmission.
In the area of jurisdiction, Dixon noted
that the boundaries between the federal
and state regulators have increasingly
blurred. While it is important that federal jurisdiction in matters of interstate
commerce is recognized, the states
should still be able to tailor their electricity policy to consumers’ interests.
For example, public purpose fees for
utilities are often proposed to promote
programs such as conservation and
low-income assistance.
Dixon believes that it is best to let states
determine which public purpose fees
suit them best.
Dixon concluded his presentation with
some comments on the direction of

Chicago Fed Letter Midwest Infrastructure June 2002

electricity policy following the Enron
bankruptcy. He suggested that a return
to a more tightly regulated electricity
markets would be a mistake. The lesson
to be learned from Enron is to do a
better job setting the rules of the road
and to continue to move forward with
open and competitive electricity markets. Dixon noted that in the past, heavy
regulation had led to such abuses as
utility construction programs unrelated to consumer needs, billions of dollars of “stranded costs”1 imposed on
ratepayers, and bloated utility budgets.
Emissions policies for utilities

Presenter: Brian McLean, director,
Clean Air Markets Division, U.S.
Environmental Protection Agency
Brian McLean’s presentation focused
on the development of emissions policies
for the power sector. Electricity power
generation is a major source of such
air emissions as sulfur dioxide (SO2),
nitrogen oxides (Nox), and mercury.
Current policies favor individual strategies for addressing each type of pollutant (see figure 1.) New policies in
development by the Environmental
Protection Agency (EPA) favor a comprehensive, multi-pollutant strategy.
A multi-pollutant strategy has the ability to address multiple environmental
issues, including particulate matter,
visibility, ozone, acid rain, eutrophication,2 and mercury. This approach can
also help reduce costs by consolidating
regulations, increasing flexibility for
meeting standards, and creating a predictable regulatory outlook for emissions
sources. This type of program (with
appropriate measures to address local
concerns) would provide significant
public health benefits even while increasing electricity supplies.
McLean noted that adopting marketbased incentives is an important part
of moving to a multi-pollutant strategy
whose goal is to cut SO2, Nox, and
mercury emissions from power generators by 70% to 80% over the next 15 to
20 years. In particular, this means establishing a national emissions trading
and banking program for these pollutants. Establishing a national cap and
trade system would provide assurance

1. Timeline: Electric power sector faces numerous Clean Air Act regulations

NSR permits for new sources & modifications that increase emissions
Ozone
1-hr severe area
attainment date

NOx
SIP call
reductions
Designate
areas for
8-hr ozone
NAAQS

1-hr serious
area attainment
date
OTC
NOx
trading

99

NOx
SIPs
due

00

01

02

03

05

04

Proposed
utility
MACT

Assess
effectiveness
of regional
ozone
strategies

8-hr ozone
attainment
demonstration
SIPs due

Section
126 NOx
controlsa

Mercury
determination

Phase II
acid rain
compliance

Marginal
8-hr ozone
NAAQs
attainment
date

06

Final
utility
MACT

Designated
areas for
fine PM
NAAQS

07

08

Moderate
8-hr ozone
NAAQS
attainment
date

Possible
regional NOx
reduction?
(AIP call II)b

09

10

11

Serious 8-hr
ozone NAAQS
attainment date

13

12

Compliance
for BART
sources

Compliance
with utility
MACT

New fine PM NAAQS
implementation plans

14

Latest attainment
date for fine
PM NAAQSc

15

16

17

18

Compliance for
BART sources
under the
trading program

Second regional
haze SIPs due

Regional haze
SIPs due

Interstate transport rule
to address SO2/NOx
emissions for fine PM
NAAQS and regional haze

Acid Rain, PM2.5, Haze, Toxics
NOTES :

Dotted lines indicate a range of possible dates. The EPA is required to update the new source performance standards (NSPS) for boilers and turbines every eight years. In developing
the timeline of current Clean Air Act requirements, it was necessary for the EPA to make assumptions about rulemakings that have not been completed or, in some cases, not even started. The EPA’s
rulemakings will be conducted through the usual notice-and-comment process, and the conclusions may vary from these assumptions.

a

The Washington DC Circuit Court has delayed the May 1, 2003, EGU compliance date for the section 126 final rule.

b

Further action on ozone would be considered based on the 2007 assessment, as well as on the success of states in attaining the new ozone NAAQS by 2009.

c

The SIP-submittal and attainment dates are keyed off the date of designation; for example, if PM or ozone is designated in 2004, the first attainment date is 2009.

of environmental protection, while
permitting the replacement or streamlining of a variety of existing regulations, including new source review,
regional haze BART (best available
retrofit technology), mercury MACT
(maximum achievable control technology), Nox SIP (State Implementation
Plan) call, and Title IV requirements.
In establishing such a program,
McLean suggested that the EPA’s acid
rain trading program has provided a

useful example for how these markets
can operate. This trading program has
reduced SO2 emissions by 50% from
1980 levels, with a compliance rate of
nearly 100%. Compliance costs for the
acid rain program have been low, and
the program has created incentives for
innovation. In addition, the program
has not led to pollution “hot spots”
from trading activity. A multi-pollutant
program would lead to savings of $9
billion per year by 2020 as compared

with a “business as usual” emissions program. McLean also noted that additional benefits of this approach include
greater compatibility with utility industry restructuring efforts and state and
local air quality programs. Finally, since
this program would be patterned after
the existing acid rain program, much
of the infrastructure is already in place
to facilitate trading and monitor reporting on emissions levels.

Federal Reserve Bank of Chicago

3

Industry perspectives on
restructuring

Presenters: John Rowe, president and
co-chief executive officer, Exelon
Corporation; Karl McDermott, vice
president, National Economic Research
Associates; and Robert Schainker,
product manager, Electric Policy
Research Institute
The final panel of the morning provided a perspective from the power industry on electricity restructuring. John
Rowe began by noting that the vision
for electricity restructuring was to promote efficiency through a competitive
generation market, while maintaining
regulation for electricity transmission
and distribution. Prompting this policy shift was the concern that during
the late 1970s and the 1980s, excess
generating capacity was being created
and this in turn was leading to rising
electricity prices. Rowe endorsed the
continuing efforts to increase competition and restructuring in electricity
markets, despite the challenges raised
from the California energy crisis and
the bankruptcy of Enron. He suggested that there is evidence that restructuring has made progress. Between
1999 and 2001, more than 65,000 megawatts of new generating capacity was
built, and wholesale power markets
were created. Annual wholesale power
market sales increased from 27 million
megawatt hours (MWhs) in 1995 to 2.7
billion in 1999. Consumers have also
been beneficiaries of restructuring, with
electric competition in Pennsylvania
having saved employers and consumers
nearly $4 billion since it was enacted.
Finally, regional transmission organizations (RTOs), critical to efficient grid
operations and a vital wholesale market,
are beginning to evolve.
Rowe commented that utilities, customers, and competitors do not want a return to the days of monopoly utilities.
He cited several factors that would
help make electricity competition
work. First, he endorsed FERC Chairman Pat Wood’s objective of “making
competition work.” Second, he noted
that it is critical that policymakers permit flexibility as competitive markets
help define the intersection between
4

regulated and unregulated services.
Third, Rowe said that FERC should use
its authority to ensure the development
of robust wholesale markets that operate efficiently and competitively. Finally, state authorities should ensure that
the benefits of competition are passed
on to retail customers without unacceptable risks to reliability or price volatility.
Rowe went on to detail some of his recommended policy actions. The first
touched on the role of FERC in implementing RTO policies. While Rowe objected to FERC’s selection of the Midwest
Independent Transmission System Operator (MISO) as the Midwest RTO, he
said he was hopeful that arrangements
could be made to effectively integrate
Alliance RTO and achieve the broader
policy goal of an effective transmission
system. Rowe argued that large scale
RTOs need to be created for the southeast and western United States as well.
Proper RTO design will help encourage
much needed transmission infrastructure investment.
A second objective that FERC should
pursue, Rowe said, is establishing a
standard market design for wholesale
electricity markets. This should include a bid-based, real-time balancing
market using locational marginal pricing. FERC should also insist on the use
of standardized business rules and
could model these rules after the Gas
Industry Standards Board.
A third objective would be to clarify market power rules. Rowe objected to the
new market power test approved by
FERC on November 20 and suggested
that the previous “hub and spoke” test
would be sufficient for generating companies that have demonstrated progress
in working with RTOs and standardizing
market designs. Finally, Rowe endorsed
efforts by FERC to standardize rules
for interconnections and to make it
clear that new generators pay for the
facilities necessary to serve them.
Rowe concluded his remarks by asking,
“how can we strike the correct balance
between supply and price security versus developing a thriving marketplace
with multiple suppliers to chose from?”

Chicago Fed Letter Midwest Infrastructure June 2002

The solution from Rowe’s perspective
is developing a market-oriented method
of limiting the delivery company’s supply
obligation and stimulating competition
by taking advantage of important differences between large customers and
mass market customers. Mass market
customers would continue to be offered
a fixed price energy supply. Utilities
would be obligated to plan for load
growth for mass market customers and
would assume the price risk for changes in wholesale markets. In contrast,
default service for large customers would
be at wholesale market prices. The large
customer would assume the price risk.
Rowe believes that this default-supply
solution would promote the development of a mature competitive market,
while maintaining electricity stability
and reliability.
Next, Karl McDermott, a former commissioner of the Illinois Commerce
Commission, observed that there is a
current mismatch between power industry objectives and the regulatory
paradigm. The regulatory model still
favors an insular approach, while what
is needed is a more multi-state strategy
that recognizes that electricity is an interdependent system. McDermott suggested that the wholesale power market
should be viewed as a commons and
that regulatory philosophy should look
outward, emphasizing how best to serve
customers. An important aspect of this
regulatory shift is a focus on wholesale
rather than retail production in the
electricity system.
McDermott noted that the electricity
system is facing many issues but suggested that one of the most critical is
the failure to optimize the transmission
system. An efficient national grid is
critical to the functioning of the wholesale market and is necessary to allow
the greater interdependence that is
occurring in the electricity business.
McDermott argued that several policies
could help better align industry needs
and the regulatory paradigm. These policies include: using performance-based
regulation that provides benchmarks
and incentives for electricity provision
and the increased use of real-time

metering, in order to send price signals to customers. McDermott stressed
the importance of getting the demand
side of the market working better—one
way to do this is to expose consumers
to price signals in the electricity market. It is particularly important that
prices charged by the “provider of last
resort” are permitted to reflect some
of the dynamics of wholesale markets.
McDermott suggested that an increasing challenge for regulators will be trying to measure the rates of substitution
between competing policy options. For
example, investments in transmission
may reduce the need for investments
in generation. Efforts to promote distributed generation may reduce the
need for investments in both transmission and generation. Making these determinations will be a difficult task as
new technologies will affect these choices. Finally, McDermott touched on the
topic of infrastructure siting. He suggested that FERC should take responsibility for infrastructure siting, such as
transmission. This would promote a better planned national grid and reduce
the local opposition that often accompanies transmission projects where the
primary benefits flow to another state.
The final presenter on this panel was
Robert Schainker, who emphasized that
investment in electricity infrastructure
is falling behind. Annual generation
expansion lags demand growth by 30%.
Transmission expansion is less than half
the rate needed to meet forecast demand
growth. As a result, electricity generation capacity margins have fallen from
25% of capacity to less than 10% over
the last two decades. Schainker indicated
that capacity margins in the Midwest are
estimated to be slightly better at 13.1%
(see figure 2.) This infrastructure investment lag has also led to increased
transmission congestion, jeopardizing
the ability to execute wholesale power
contracts. Transmission infrastructure
investments have fallen by about 10%
in real terms over the last decade.
Improvements in the electricity infrastructure are also needed to improve the
reliability of electric power. Schainker
noted that the costs of electricity

disruptions are very high for a digitized
economy. Power disruptions or power
quality problems can have severe impacts on computer operations in particular. The electricity demands of
“Internet hotels” (facilities that host
computer network servers), are particularly high. These facilities require 100
watts to 200 watts per square foot, compared with 5 watts to 8 watts in most
commercial buildings. These types of
facilities may add 10 million to 20 million square feet in 2002, and significant infrastructure improvements are
required to serve these types of loads.
Schainker suggested that the solution
to these issues lies in a national electricity policy that provides stable rules
and financial incentives for the industry. In particular he noted that electricity policy needs to reflect the complexity
and integration of the transmission and
generating system. This means having
national reliability and operating standards and eliminating transmission bottlenecks that prevent the seamless
movement of power from electricity generation centers to electricity load centers.
Schainker pointed to several positive
changes. For example, FERC has proposed consolidating the North American electric grid into four large RTOs.
FERC has also shown a willingness to
consider innovative transmission pricing
that could reduce pricing barriers in
the transmission of electricity. In addition, Congress is examining new electricity legislation and the National
Governors’ Association and the U.S. Department of Energy have formed a task
force to study transmission problems.
Schainker suggested that there is both
a technical and economic paradox that
must be resolved as part of the restructuring debate. On the technical side,
there is the need to expand an infrastructure that is complex and expensive to serve an electricity system where
supply and demand must be in instantaneous balance at all times. On the
economic side, there is the theory that
deregulation will lead to the lowest electricity prices versus the market reality
that deregulation will encourage power
companies to seek the highest profits.

Schainker concluded with a series of
recommendations. First, he suggested
that investments in transmission infrastructure should be financed in the same
manner as the federal interstate highway system. Second, he expressed support for establishing a comprehensive
grid security program to deal with the
vulnerability of the grid to possible disruptions. Third, he suggested incentives be provided to automate and
increase asset utilization and maintenance of the existing grid components.
Finally, Schainker noted, there is a need
to provide incentives to overcome market barriers and improve efficiency in
electricity generation, storage, system
operation, transport, distribution, and
use of electricity.
2. Electricity generation capacity margins

United States
California
West
Texas
Midwest
Southeast
Mid Atlantic
New York
New England

9.4%
1.3
8.3
16.8
13.1
3.9
13.3
12.1
16.1

Keynote address

Speaker: Patrick Wood III, chairman,
Federal Energy Regulatory Commission
As the nation’s top electricity regulator,
Patrick Wood provided a perspective on
developments at FERC that are shaping
electricity restructuring. He began by
emphasizing FERC’s continuing efforts
to create incentives for electricity infrastructure investments that will enhance
the reliability and security of the electricity system. In particular, this means
promoting the development of an improved national transmission grid
through the formation of RTOs. Wood
said he was optimistic about recent developments in the Midwest, suggesting
that this region is at the cutting edge
of developing many of the basic rules
needed to implement effective electricity policy. In particular, he noted that
the recent approval by FERC of the
Midwest Independent Transmission
Systems Operator (MISO) as the regional grid operator for much of the
Federal Reserve Bank of Chicago

5

Midwest would help to promote fair
and smooth access to the electricity
grid and bolster the development of
the region’s wholesale market. Wood
also indicated that talks are underway
to join MISO with the Mid-Atlantic
based PJM Interconnections, which
would create an even larger regional
transmission operation.
Wood stated that FERC is not looking
to over-run state authority in electricity
matters, but wants to actively partner
with state utility commissions in promoting policies that support local customization. However, FERC is committed to
policies that will optimize the performance of the nation’s electricity grid
and contends that this can only be accomplished through a more regional
approach. In carrying out this policy,
FERC is trying to set the standards for
grid performance and establishing performance measures. FERC is not attempting to suggest what type of RTO
structure is best for meeting these
standards. Many variations in organizational structure or business plan are
permissible as long as the performance
standards are met.
Wood also noted that FERC has recently revised its test for determining market
power by electricity providers. Suppliers
are only allowed to charge market rates
for electricity if they demonstrate that
they do not have market power. He acknowledged that this new market power test is controversial and has already
led to the removal of market pricing
authority for three large utilities. Wood
argued that protecting the wholesale
market from market power abuse is a
fundamental function of FERC.
Wood further suggested that efforts such
as distributed generation and other efforts that create small-scale, decentralized power generation hold great
promise for improving the quality of
the nation’s electricity system. Regulators need to support these efforts as
they move forward. Regulators also need
to develop a keener understanding of
emerging market and competition issues
in electricity restructuring. The experience from California’s electricity crisis
and the failure of Enron demonstrates
6

that regulators need to have strategies
for resolving these issues quickly, while
decreasing the current tendency for regulatory actions to end up in litigation.
Wood concluded his remarks by citing
some organizational changes at FERC
that are aimed at dealing with the
changes in electricity markets. One
of the most fundamental changes has
been expanding FERC’s market monitoring capability. FERC has added staff
to examine electricity trading in order
to understand how trading patterns
are affecting electricity prices and
market operations.
Report from the Midwest
Independent Transmission
Systems Operator

Presenter: John Catlin, director of client
relations, MISO
John Catlin began by noting that MISO
was approved by FERC as the first RTO
in the nation on December 19, 2001.
MISO’s current geographic footprint
includes 15 states and one Canadian
province, consisting of more than $9
billion in transmission assets. MISO’s
service territory covers more than 13
million customers through 86,000 miles
of transmission lines. The peak electricity load carried over the system is
75,000 megawatts. Catlin characterized MISO as a confederation of transmission and non-transmission owning
members that is actively interested in
partnering with other organizations.
In addition to potentially merging with
the Southwest Power Pool, MISO is investigating an agreement with PJM Interconnections and has developed a
memorandum of understanding with
the federal Tennessee Valley Authority.
Catlin noted that as of December 15,
2001, MISO’s operations include security coordination, maintenance coordination, long-term planning, market
monitoring, dispute resolution, operations planning, generation interconnection agreements, and scheduling. On
February 1, 2002, MISO began offering
point-to-point network tariff service.
Catlin said that a clear challenge for
MISO is developing a plan to integrate
the Alliance RTO. The December ruling

Chicago Fed Letter Midwest Infrastructure June 2002

by FERC that granted MISO official
RTO status suggested that the Alliance
group could not function as a standalone organization and should come
under the MISO umbrella. Negotiations
are underway to develop a plan to integrate the two groups.
If MISO can effectively merge with the
Southwest Power Pool, Alliance, TVA,
and PJM, it will create a super-regional
RTO with an enormous geographic footprint. Catlin emphasized that MISO is
trying to offer transmission owners flexible options for joining MISO. These
can include membership, a coordination
agreement, and joining MISO as part
of a for-profit transmission company.
Catlin concluded by identifying the three
roles MISO will play as an RTO. First,
it will be responsible for long-term
planning. This will include identifying
areas of constrained transmission capacity and identifying options to relieve
transmission congestion. These options
could include building new transmission, recommending the location for
new generation or promoting demandside management. Second, MISO will
order new construction to support grid
reliability. Third, MISO will address
long-term congestion management
issues through its tariff structure.
View from Seventh District Public
Utility Commissions

Presenters: Ken Rose, senior economist,
National Regulatory Research Institute;
Richard Mathias, chairman, Illinois
Commerce Commission; David Ziegner,
commissioner, Indiana Utility Regulatory
Commission; Diane Munns, chairman,
Iowa Utility Board; Ave Bie, chairperson,
Public Service Commission of Wisconsin;
and Laura Chappelle, chairman,
Michigan Public Service Commission.
The final panel of the day provided
a perspective on electricity policy from
public utility commissioners of the five
states in the Seventh Federal Reserve
District. Of the five, Illinois and
Michigan have been the most aggressive in their restructuring activities,
while Indiana, Iowa, and Wisconsin
have adopted a more cautious approach.
First, Ken Rose provided a context for
state policy actions by noting that

3. Corporate structure before electric restructuring
Utility holding company
(public traded)

Electric utility
• Generation
• Transmission
• Distribution

Residential
customer

Business
customer

recent events in electricity markets have
cooled state enthusiasm for certain
aspects of restructuring. According to
the most recent National Regulatory
Research Institute survey, four states
have delayed restructuring efforts. In
addition, Rose noted that the number
of competitors in the retail market has
shrunk, which has reduced the retail
choices available to customers in states
that have restructured. Rose concluded
by posing two questions to the panel
of commissioners. First, has California’s
failed experiment in restructuring affected electricity policy in their states?
Second, has the slow development of
retail competition in states that have restructured influenced electricity policy?
Next, Richard Mathias provided an overview of the Illinois Customer Choice and
Rate Relief Law that has guided the restructuring of the Illinois electric market. The law has phased in customer
choice across different classes of customers over several years and will allow retail choice in May 2002. The act will not
be fully phased in until January 2005,
when utilities will be permitted greater pricing freedom. Mathias noted that
Illinois’ interest in restructuring was
driven in part by the high cost of power in the state and the desire of large
customers to be able to shop for their
electricity provider, thereby lowering
their costs.
Mathias noted that restructuring has
had several effects. First, the utility industry has restructured, with every investor-owned utility in Illinois having
been sold. Incumbent Illinois utilities

Electric utility customer
(non-affiliate)

still own generation facilities; however,
these have generally been spun off to
affiliated companies. Restructuring has
also encouraged the development of
new holding company organizations
for utilities (see figures 3 and 4). This
has narrowed the scope of companies
that are under the regulatory authority
of the Illinois Commerce Commission
(ICC); however, it has not decreased
its workload. Restructuring has also
shifted more regulatory oversight to
Washington, DC. The federal government is having a much larger role in
the wholesale system, with the state’s
role being more focused on retail issues.
Mathias noted that currently only
spotty competition for customers has
emerged in Illinois and virtually no
competition is present outside of the
ComEd (an Exelon company) service
territory. In addition, many of the details of implementing the law are still
being addressed and these will have a
significant influence on how electricity markets develop. Mathias also suggested that it is important to develop
clear goals and quantitative and qualitative measures for assessing the success of Illinois restructuring law. These
measures should include establishing
the number of competitive suppliers
available to customers (as well as the
price they charge), along with measuring the quality of the service provided.
In addition, it is important to gauge
the ease of entry for power suppliers
to the Illinois market.
Mathias noted that the real challenge
in the Illinois restructuring effort will

come in 2005 when the rate cap for
retail customers expires and electricity
prices are allowed to reflect market conditions. He stressed that a key to restructuring is understanding that different
electricity customers have different desires. Most residential and small business
customers want stable and reasonable
prices and reliable service. Issues of
choice are less important than predictable service. Large customers are more
likely to be interested in accessing
wholesale markets and negotiating
their own electricity contracts. Mathias
concluded by noting that the development of a wholesale market may not
be the same as the development of
wholesale competition.
The next presenter, David Ziegner,
addressed developments in Indiana’s
electricity policy. He noted that Indiana
is a relatively low cost state for electricity. The combination of good access to
natural gas and coal supplies, sound
regulatory policy, and the ability to attract new generation has allowed the
state to maintain this advantage.
Ziegner stressed that low-cost power is
a critical aspect of the state’s economic
development policy, and this has helped
guide the state’s restructuring efforts.
Indiana expects to maintain this lowcost advantage, despite an anticipated
increase of 1.9% in power usage per
year. Indiana is actively adding new
generation capacity and the commission
has created incentives for demand-side
management that have helped with load
management. In addition, the recession
has reduced electricity demand from
industrial customers, particularly in
the steel industry. Ziegner noted that
future electricity demand growth will
be concentrated in the residential and
commercial market rather than being
driven by industrial demand.
Ziegner stressed that the state has welcomed competition in the wholesale
electricity market. However, he argued
that retail competition should only occur once a fully functional wholesale
market has developed in the Midwest.
Ziegner noted that the UK waited until
wholesale competition was established
before it embarked on retail open
Federal Reserve Bank of Chicago

7

4. Corporate structure after electric restructuring
Utility holding company
(public traded)

Service company
• Telecom
• Energy trading
• HVAC
• Other

Retail Electric
Supplier (RES)

Residential
customer

access. He suggested that experience
with rail and telephone deregulation
has left some state policymakers skeptical of the benefits of restructuring.
In a state where customers have low
electricity prices, expanding generation
supply, and profitable utilities, it is unclear why one would want to change
the current structure. However, Ziegner
noted that if states elect to allow retail
competition, they must allow price
changes in wholesale markets to be reflected in retail prices. He endorsed
the development of real-time pricing
as a mechanism for achieving this goal.
Finally, Ziegner endorsed the work by
FERC to create a regional transmission
system and a standardized market design. In particular, he said that the
success of the RTO process will be the
ability to monitor electricity market
activity and serve as a “cop” to enforce
market rules.
Iowa has also taken a cautious approach
to restructuring, according to the next
speaker, Diane Munns. She noted that
three legislative sessions failed to pass
a restructuring plan for the state. The
experience in California has made it
unlikely that active restructuring will
occur in the near future, but Munns
noted that this has not reduced the
need for the state to respond to changes
in the electricity market. Some of these
market changes include corporate
mergers that have led to fewer Iowa
based utilities, deregulation efforts in
neighboring states, and efforts to encourage investment in new generation and
8

Others

Business
customer

Electric utility customer
(non-affiliate)

transmission. The challenge, Munns
suggested, is determining how to adapt
a regulatory structure based on traditional rate of return pricing principles
to a changing electricity market.
In response to these market changes,
Iowa has taken measures to improve
its climate for new investments. This
has included streamlining siting procedures for new transmission and generation facilities, establishing binding
rate-making principles during preconstruction of facilities, and generally trying to introduce more certainty
into the regulatory process. Munns
suggested this approach has demonstrated some success, with new generation facilities proposed once many of
these measures had been put in place.
Munns also noted that there has been
a drive toward a greater federal role in
electricity provision. She stressed that
cooperation between the states and the
federal government will be critical to
the success of this strategy. In particular,
she expressed the hope that litigation
between the states and the federal government can be significantly reduced.
However, she argued that certain functions, such as consumer protection and
reliability and service standards, should
be left primarily to the states. Transmission siting would be an exception,
since this would need to be a regional
effort with the states working in cooperation with FERC.
Next, Ave Bie discussed Wisconsin’s efforts in electricity policy development.

Chicago Fed Letter Midwest Infrastructure June 2002

Delivery company
(vestige of
electricity utility)
• Transmission
• Distribution

Generation
company

She explained that Wisconsin has been
careful in its approach to restructuring,
given the state’s low power cost and
aging infrastructure, which has led to
concerns about its ability to compete
in a more deregulated market. Bie
also noted that the state has a special
problem when it comes to increasing
regional transmission opportunities,
because its geographic isolation bordering two Great Lakes) limits easy interconnections.
Bie noted that much of Wisconsin’s
electricity policy development has been
driven by concerns over power shortages that occurred during the summer
of 1997. The immediate response to
this problem was the passage of Act 204,
which was designed to increase generation capacity and streamline and increase certainty in the regulatory
process. Bie stressed that it is critical
to establish clear ground rules for utilities so that they know what they can and
cannot expect. Act 204 also encouraged
the development of independent power producers and transferred transmission responsibilities to an independent
systems operator. This has been complemented by the passage of reliability
legislation. Bie agreed with Mathias of
Illinois that most consumers are primarily interested in getting reliable
electricity service at reasonable prices.
Bie concluded by suggesting that taking
an interest in the fiscal health of utilities is also an important commission
function. Healthy utilities are in a

better position to provide low prices to
their customers. Bie also emphasized
the desire to develop better regional
transmission connections and suggested
this will require regional cooperation.
She noted that the process of creating
new transmission infrastructure is difficult but necessary. Wisconsin has just
approved 250 miles of new transmission
infrastructure that is critical to the reliability of the state’s electric system. The
state has also received an application
to build a new coal-fired plant that Bie
said demonstrates its success in encouraging new electricity investment.
The final panelist, Laura Chappelle,
suggested that Michigan’s approach to
restructuring has fallen somewhere in
between those of Illinois and Wisconsin.
Like Illinois, Michigan has adopted a
phased-in approach to deregulation,
with full retail choice available on
January 1, 2002. In preparation for this,
Michigan has been running several pilot customer choice programs since the
mid-1990s. Like Wisconsin, Michigan
has been concerned about transmission
constraints and increasing generation,
particularly in the state’s baseload. While
interest on the part of merchant power
producers in Michigan has been favorable, most of this generation is designed
only to serve intermittent needs during
periods of peak demand. Michigan has
also required the addition of 2,000 megawatts of new transmission capability.
Chappelle agreed with Bie that taking
an interest in the financial viability of
state utilities was an important consideration in the work of the commission.
Chappelle reported that since the retail market opened in January, only 1%
of load has switched suppliers. She also
identified several issues facing the
Michigan Commission. These include

adopting a code of conduct for utilities,
working with utilities to resolve disputes
over performance standards, and making stranded cost determinations.
Chappelle suggested that the real success of restructuring would depend on
creating confidence that electricity
markets will work.
Conclusion

The views of the presenters at the conference clearly demonstrate the complexity and challenges facing electricity
policy. In the Midwest, transmission
issues are particularly important, and
it is hoped that MISO will emerge as
the organization best able to manage
the regional transmission needs of the
Midwest. An important aspect of transmission policy will be identifying needed infrastructure investments in the
electricity grid. It is also clear that the
rules of the road for electricity policy
are still being created. Federal and state
regulators are sorting out new roles
and responsibilities in response to the
many changes that have occurred in
the electricity sector. While wholesale
electric market restructuring has been
embraced, extension to retail markets
is occurring at a much more cautious
pace. What is clear is that the utility industry has vigorously restructured; and
returning to the old paradigm, that involved closely regulating vertically integrated monopoly utilities, seems
highly unlikely.
An additional issue for the Midwest,
given its dependence on coal-fired generation, is how to deal with utility plant
emissions. Movement toward a cap and
trade emissions reduction market may
enable power suppliers to achieve multipollutant emissions reductions more
cost effectively, while increasing electricity generation.

Finally, the need for electricity policy
that addresses the changing market is
not going away. While the national recession lowered electricity demand, and
lower fuel prices have helped provide
some breathing room over the past year
for electricity policymakers, fundamental infrastructure investments and rules
governing emerging electricity markets
still need to be determined. Without
critical infrastructure upgrades and investments in the national electricity grid,
it is uncertain whether a strained electricity system will be adequate to support future economic growth.
1

Stranded costs are investments made by
regulated utilities that may not be recovered through utility rates as a result of
changing regulatory or market conditions.

2

Eutrophication is the process by which
lakes gradually age and become more
productive. However, human activity, including air pollution, has accelerated
this process causing water pollution from
excessive plant nutrients.

Michael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; Charles
Evans, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department
is provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
60690-0834, tel. 312-322-5111 or fax 312-322-5515.
Chicago Fed Letter and other Bank publications
are available on the World Wide Web at http://
www.chicagofed.org.
ISSN 0895-0164

Federal Reserve Bank of Chicago

9