GAO ON FERC OVERSIGHT

UPDATE: As you can see from the time stamp on this post, I was working way too late last night to remember that GAO is General Accounting Office, not Government Accounting Office. Apologies for the slip, which has been corrected below.

Well … back from celebrating my birthday and my sister-in-law’s graduation with my in-law family to … a GAO report on FERC’s ability to perform oversight functions in burgeoning wholesale electricity markets. No rest for the weary these days when it comes to energy policy.

On Monday the Senate Governmental Affairs Committee released a General Accounting Office (GAO) study that it had commissioned to explore the Federal Energy Regulatory Commissionís (FERCís) oversight abilities. In general, the report found that FERC faces three substantial hurdles to overcome before it can provide the kind of straightforward, flexible regulatory environment consistent with enabling the evolution of a dynamic electricity industry.

The first hurdle is that FERC has a lot on its plate relative to its resources. FERCís electricity jurisdiction, a relic of the old, vertically-integrated, regulated monopoly model, is ensuring that interstate sales and transmission prices in wholesale electricity markets are “just and reasonable,” and the siting of interstate long-distance transmission lines. In the old “command-and-control” mindset, ensuring just and reasonable prices was pretty simple Ė cost plus a rate of return on the vertically-integrated utilityís rate base Ė and long-distance transmission was built for different purposes from transporting competitive generation. It was also not particularly technologically feasible to have economical long-distance transmission because of line loss. But now that the regulatory environment has changed, technology has changed, and business models have changed (and the report does a nice job of summarizing these effects over the past 25 years), the old model and its associated bureaucracy are not suited to a new business environment in the electricity industry.

At some level this conclusion is completely consistent with what both experience and theory tell us about regulatory institutions and market institutions. The major (and boy, are they major, as history has shown repeatedly) benefit of market institutions is that they harness human opportunism to create value through mutually beneficial exchange. That trait makes them flexible and quick to respond to changing environments and market conditions. Market institutions do not exist in a vacuum, though, as we have learned from the whole Enron/Andersen/energy trading experience of the past year. The rules underlying market institutions work best when they promote transparency and in most cases deter bad behavior, such as the exercise of market power. Market institutions where the rules provide transparency are self-correcting as long as they really are transparent and provide good information.

The major benefit of regulatory institutions is a level of stability and certainty in the absence of this combination of market processes and transparency-inducing institutions. One problem with regulatory institutions, though, is that they can harness human opportunism to create value for those with political power. More to the point of the GAO study, regulatory institutions can also get bogged down in bureaucratic processes and be very slow to anticipate changing environments and market conditions. Old procedures persist and are slow to change. The GAO report highlighted precisely this problem in its analysis of FERCís obstacles Ė changing from a “command-and-control” regulator of a vertically-integrated industry to a more transparency-inducing , rule-simplifying regulatory institution that supports the web of formal and informal rules that create good market conditions.

FERC also has had a lot to prioritize Ė building more transmission to support competitive wholesale markets, wholesale market structure and design, and market oversight. In 1999 they chose to prioritize in that order, and only in the past six months have they gotten to working in earnest on the market structure item. In hindsight, if they could go back and change their decisions it is likely that they would have focused a bit more evenly among the three priorities, instead of taking them more sequentially. But, for FERC and for many of us, the important contribution of market oversight to transparency is something we are learning about as we go, and we can admit that if foresight were as good as hindsight, some of the electricity price spikes we have experienced (especially in California) could have been lessened somewhat. But asking humans to have perfect foresight is asking us to be something other than human.

FERCís second hurdle, which the GAO called “daunting,” is its human resources. Attracting energy market analysts would be difficult in any situation because of pay differentials between private sector and public sector labor markets, and these difficulties were exacerbated by the apparent (and looking more apparent and less real) energy trading opportunities of the late 1990s. FERC employees are largely grounded in the traditional regulatory model, a feature that contributes to the inertia and the status-quo path dependence mentioned above. Furthermore, many FERC employees are eligible to retire in the next few years, so now is a good opportunity to be strategic in hiring market analysts with human capital to bring to the market oversight function. FERC is also increasing its training and education activities, bringing in economists and market analysts to familiarize its staff with market processes and the dynamics of this changing industry. The GAO report recommends that FERC incorporate a strategic hiring and human capital management plan into its strategic plan.

The third hurdle highlighted in the GAO study is legislative. The kinds of civil penalties that, for example, the Securities and Exchange Commission (SEC) can bring to bear against rule violators are not part of FERCís toolkit. Again, a relic of bureaucratic inertia Ė who needs civil penalties to regulate vertically-integrated government-granted monopolies? Which brings up an interesting thought: in all of the introspection accompanying the Enron/Andersen debacle, with the rethinking of the SECís enforcement, should we also in that process look for some lessons for FERC? I think so. Changing FERCís enforcement toolkit is a job for Congress, and the GAO report recommends considering such a change.

The GAO report illustrates precisely the concern articulated in a comment that I submitted to FERC in April as part of their market structure and design rulemaking process. A possible consequence of setting up rigid institutions for regional transmission organizations is what economists call institutional path dependence, where institutions and procedures become entrenched through bureaucratic inertia. Thus one thing that FERC needs to watch out for that the GAO report and my comment both highlight is to beware of institutional change being just a ratchet to another locked-in set of regulatory institutions that are likely to become obsolete more quickly than not, and will almost certainly become obsolete more quickly than the existing regulatory institutions have.

This report is not an argument against competition and market processes in electricity, as many market foes and some of the commentaries I have read today would have you believe. Instead it is an argument for FERC to do the strategic planning and implement performance measures to create a set of regulatory institutions that rely on rules that encourage transparency, and focus on deterring the great majority of bad behavior.

The GAO report lacks something that I think is extremely important. It fails to point out that FERC was not to blame for the over-engineered, overtly politicized, dysfunctional rules that the state of California forced into laws governing its “market.” FERC has admitted that in hindsight it would have changed some decisions, but Californiaís politicians have not been so introspective in public.

FERC is learning the importance of a balanced approach to improving transmission networks, creating rules governing wholesale market structure, and market oversight. This approach should use flexible regulatory institutions where necessary, and rely on market institutions and rules to create transparency and deter bad behavior wherever possible. FERC is also learning the importance of human capital in a dynamic, evolving industry. The GAO study is a constructive contribution to that process.

News stories from today on the report are here (registration required), here(registration required), here, and here. Depending on how the other items on my plate are doing tomorrow, I may say more about the divergence between the political rhetoric on this concerning the California situation and the more far-sighted nature of the GAO study.