California's Independent System Operator...
Bringing Competition to the Electricity Industry

William M. Chamberlain
Chief Counsel
California Energy Commission

Note: This essay originally appeared in the Winter 1998 issue of the
California Manufacturers Association's magazine, California Manufacturer

On March 31, 1998, California became the first of the fifty states to provide most of its electricity consumers the ability to choose their retail supplier of electricity. Providing this simple, but important, choice has required significant changes to the electricity market structure that has been in place for over 60 years. It has involved a major restructuring of California's investor-owned utilities and the creation of two new institutions designed to promote fair and open competition among all those who generate electricity and even among those who use it. Those new institutions are the California Independent System Operator ("ISO") and the California Power Exchange ("PX") which are both public benefit non-profit corporations, created by the California Legislature. Each of these new organizations have a key role in implementing a competitive electricity market in California. The task of the ISO is to operate the high voltage transmission grid in California in a way that allows all generators fair and equal access to the transmission system. Very roughly, this transmission system can be thought of as the electricity "highways of commerce." Access to the high voltage grid is critical to allow power plants to move their product, electricity, to the market. The task of the PX is to provide an auction setting where buyers of electricity can be matched with sellers of electricity to allow buy/sell transactions. Auctions will be held daily to meet market needs for the next day and for the next hour. The PX will publicly report the resulting spot prices of electricity for each hour of every day.

In order to appreciate the importance of the tasks of these new institutions, one must understand the basics of how the electricity industry has been structured since the 1930s. The majority of electricity customers in California and elsewhere have been provided a "bundled service" by one of three investor-owned utilities (Pacific Gas & Electric Company, Southern California Edison Company, and San Diego Gas & Electric Company). By "bundled service," we mean that customers have been delivered kilowatt hours for a regulated price that was set to include all costs associated with electricity services: the cost of generating the energy; the cost of transporting it over long distances at high voltage; the cost of distributing the electricity at useable voltages for various types of consumers; and the cost of meters, meter-reading, billing, and repairs to the system. The business of providing electricity services has long been considered by economists to be a "natural monopoly." That is, it was accepted as fact that one firm could provide all parts of the service over a large area more cheaply than many smaller firms. Public utility commissions regulated the prices the monopoly electric utilities could charge. The allowable electric rates were set to cover the companies' costs plus a fair return on their shareholders' investment.

About thirty percent of California's electricity customers receive service from municipal utilities governed by locally elected or appointed boards. The development of these publicly-owned utilities was encouraged in the first half of this century by the state and federal government in order to provide a "yardstick" for measuring whether the investor-owned utilities were operating efficiently and providing service at reasonable cost. Municipal utilities also provide "bundled" service, though many of them are dependent on the larger investor-owned companies for transmission services and, in some cases, for some of their energy needs.

In 1978, in response to the oil shocks of the early 1970s, federal laws were enacted that promoted the development of an independent power industry. Although Congress's primary objective was to encourage power generation that did not rely on oil or that used fuel more efficiently, the result was creation of a viable non-utility power industry and the demonstration that electricity generation does not need to be part of the monopoly utility structure. Power generation could be opened to competition. The rigor of the marketplace could be substituted for government regulation of the price of electrical energy. Transmission and distribution services continue to be cheaper for one firm to provide in a given area and will therefore remain regulated monopoly functions. California's electricity restructuring is designed to allow generators to sell their product, electricity, at whatever they can obtain in a fair and open competitive market while continuing the regulated monopoly provision of transmission and distribution services.

The problem restructuring had to address is a fundamental one: How do we ensure that the owners of key transmission facilities--the facilities that allow generators to get their product to market--do not bias access to those facilities in favor of their own generation or that owned by affiliated companies? While some theorists have advocated that in order to provide for fair competition, all vertically integrated utility companies should be split along the functional lines of generation, transmission, and distribution so as to create separate non-affiliated entities, the combination of utility opposition to proposals for their dismemberment and customer demand for a rapid transition to a competitive generation market resulted in a different method of protecting generators from potential bias. The solution embodied in California's restructuring is for the utilities to be permitted to continue to own transmission facilities subject to continued rate regulation by the Federal Energy Regulatory Commission, provided that they turn over operational control of these essential facilities to an Independent System Operator, the ISO. The utilities will also continue to be "Utility Distribution Companies" ("UDCs"), subject to rate regulation by the Public Utilities Commission, but they will be required to provide distribution services to all of their customers. The UDCs are also required to separate customer bills into the components of service in order that those customers may choose whether to continue to receive all of the electricity services from the utility or whether to receive only distribution and transmission services while selecting a different supplier of energy.

Because the ISO must provide completely unbiased access to the transmission grid, its Board of Governors and employees are subject to codes of ethics designed to prevent conflicts of interest. Employees will be required to divest all economic interests in market participants within their first six months of employment. The California Legislature provided by statute that the Board of Governors would be made up of representatives of many market participant classes including both producers and consumers of electric services, and thus it is impossible for most of the members of the Board to be completely free of any market interest, but they are required by California Corporations law to place the interests of the ISO ahead of personal interests and to disclose any specific interest they or their company may have in any ISO decision. Furthermore, they must not participate in Board decisions if they have a specific conflict of interest.

The ISO Board of Governors currently consists of twenty-six voting members: (1) three members selected by the investor-owned utilities, (2) four members selected by publicly-owned utilities, (3) one member selected by state or federal agencies who are market participants, (5) two members selected by non-utility electricity sellers, (6) one member selected by public buyers and sellers or electricity, (7) one member selected by private buyers and sellers of electricity, (8) nine members selected to represent several types of end users of electricity, (9) two members selected by public interest groups, (10) two members who are non-market participants, and (11) the Chief Operating Officer of the corporation. The Federal Energy Regulatory Commission (FERC), which regulates the activities of the ISO insofar as they affect the interstate transmission and sale of electrical energy, has approved the Board's market participant structure as an "experiment" in industry self-regulation. (In other parts of the nation, ISOs are being formulated with primarily or completely disinterested governing boards.) FERC will review the structure in three years to determine if changes need to be made at that time based on operating experience.

The ISO, based in Folsom, California, but having a completely redundant back-up facility in Alhambra, will have direct operational control of the transmission grid and, under emergency conditions, the energy dispatch from each of the (approximately) 1000 generators in California. About 400 large users of power in California take their service at the transmission level and will also have their power metered by the ISO. The ISO will also work with market participants to alleviate congestion on transmission lines. This occurs when too many generators in one area want access to the same transmission lines. The method for allocating transmission under these circumstances is very different from the methods used in the past. Instead of allocating fixed rights to move power to a given set of rights holders who have, in the past been said to possess "physical rights" to the transmission capacity, the ISO's allocation system focuses on the economic benefit of transmission and allocates it to those who value it the most. This system allows generators and loads to provide bids that help the ISO to know who would be willing to pay the most in order to have the ability to move power instead of having to buy it locally to serve local loads at a higher price. When transmission is congested, this economic competition for the right to use it allocates the limited capacity, and all those who win this auction pay an extra transmission Usage Charge set at the lowest possible price--the bid of the last user who receives transmission.

In order to maintain the manageability of the number of entities (both generators and loads) that the ISO must deal with, a new kind of energy scheduling entity--the Scheduling Coordinator--has been created. The Power Exchange, mentioned above, will be one of these Scheduling Coordinators. In addition, "energy service providers" or "ESPs" will offer a broad array of new kinds of contracts and services to energy users. They might offer cheaper power from low cost resources, particularly to loads that are flexible in scheduling or have very steady demand. To some customers who place special value on protecting the environment, they might offer power that is generated from renewable sources. They might also help aggregate the loads of small customers in order to give them more clout in the competitive energy market. ESPs may also offer combinations of services (e.g. electricity, energy efficiency services, natural gas, and telecommunications services) that meet their customers needs in new ways. These ESPs will work, in turn, with the PX or with other Scheduling Coordinators to implement the electricity portion of these contractual arrangements through schedules calling for transmission of energy between points in the interconnected transmission grid.

Although the new competitive market will commence in 1998, much of its benefit will not be fully felt until 2002. Part of the compromise that led utilities to cooperate in this restructuring (e.g. voluntarily agree to turn over their transmission assets to the ISO) was the understanding that they would have four years in which to try to recover "stranded" investments that remain from the period in which such investments were required by regulation. Under the regulatory regime, utilities had a duty to serve all customers, and when their efforts to fulfill that duty were approved by regulators, the resulting investments became part of the utility "ratebase." Rates were then approved to allow amortization of the ratebase and a reasonable rate of return on these investments. Some of the generators utilities have built in the past will not be economic in a competitive market because the cost of new generation has been dropping rapidly in the past several years. Thus, the utilities are being given the right to collect, for four years, the equivalent of continuing to provide service at their 1996 bundled rate until 2002. Those customers who choose a different energy supplier during this transition period will be required to pay a nonbypassable "competition transition charge" ("CTC") in addition to regulated transmission and distribution rates. Therefore, unless the customer manages to pay significantly less for energy than the utility would have charged for equivalent energy service, there will be little immediate savings. At the end of the four year transition, however, with a few minor exceptions all CTC charges will expire and the full benefits of competition should be realized.

In addition to the transition for recovery of stranded investment, there will also be further transitions of less clear duration to a fully competitive market throughout California. Municipal utilities, for example, are encouraged by the statutes that established the ISO to join the ISO and provide their customers full retail access to competition, but they are not required to do so and there is no clear timetable for them to conform their operations to the market structure that will prevail in most of California. Some of the municipal utilities face the same "stranded investment" problems as the investor-owned utilities, and they also know that their customers will grow to expect equivalent access to the competitive market if it appears to them that there is economic advantage in such access. Therefore, municipal utilities are working out their own strategies for recovery of these costs so that they can survive the coming competitive world in the long term. Many of these entities also own transmission assets of their own and have existing contractual rights to transmission service from the current investor-owned utility transmission owners. All of these existing contracts must be honored for the duration of their term, and in some cases they last for many years into the new century. Efforts are being made to convert these contractual rights to equivalent contractual arrangements under the new system administered by the ISO, but the transition in this regard will involve much contract-specific negotiation and could take several years to complete.

As the various transitions are completed, the ISO should eventually manage virtually all of the California electricity market, and it is even possible that the ISO will merge someday with ISOs being created in the Pacific Northwest and the Desert Southwest to form one Western regional ISO. In the meantime, the focus has been on opening the market this year according to the requirements of California law. In this regard, many hundreds of people worked extremely hard for many months to develop the facilities and install the hardware and software systems necessary to allow the market to function smoothly while maintaining reliable service. Because the original deadline of January 1, 1998 was extremely ambitious, software development that would normally require two years or more was compressed into less than a year. Although the ISO and PX were not able to commence operations by this statutory deadline, they have successfully begun market operations as of March 31, 1998.

The author gratefully acknowledges the assistance of Daniel Nix in improving the readability of this article. Mr. Nix is the Chief of the Energy Information and Analysis Division of the Energy Commission and is an advisory member of the Boards of Governors of the ISO and PX.

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