Knowledge Problem

Michael Giberson

Lon Peters has an article, “The Impact of FERC Orders on the Value of Bidders in PJM,” in the August/September 2009 edition of the Electricity Journal that tries to assess the effects of regulatory actions on the market value of publicly traded companies participating in the PJM wholesale power market. The analytical approach taken should help reveal whether the regulatory actions were interpreted in the stock market as increasing or decreasing the profitability of the companies in PJM, and can help determine whether the decisions made were “good” or “bad,” at least by that metric.

It is an interesting exercise. Most of the time the closest thing to an assessment of the effect of a regulation comes in the form of complaints filed after the fact.  Maybe an editorial will show up in the trade press.  The “event study” approach offers the possibility of a somewhat objective assessment of the effect of a regulatory change on the profitability of companies involved.  Of course company profitability is not the primary gauge of the correctness of a regulatory policy, but changes in company value can provide some insight into the consequences of a policy.

One big finding in his analysis is that the initial FERC order granting PJM provisional RTO status, but conditioning that grant on PJM’s integration into a joint Northeastern RTO with the NYISO and ISO-NE, caused a distinct fall in the value of bidders in the PJM market.  On the other hand, a subsequent order that removed the integration requirement and granted PJM full RTO status caused a distinct increase in the value of bidders.  Of eight other FERC orders studied, only one also showed a distinct, reliable event response, an order which allowed PJM to institute a market for “regulation service” (also termed “automatic generation control service”, it is a service some generators provide to help the transmission system operate reliably).

The problem is I don’t trust the analysis.

First, his analysis compares the returns earned by a set of 19 electric power suppliers to market returns as measured by the S&P index.  So any outside influences that tend to affect electric power suppliers differently than the rest of the S&P companies, and happened at about the same time, would get counted as part of the effects of the regulatory action.  For example, a change in the price of natural gas would likely be more important to electric generation companies than to the market as a whole.  For this kind of analysis, it would likely be better to compare electric supply companies participating in PJM to electric supply companies not involved in PJM.  With a better set of “controls”, the event study would be more discriminating.

Second, the 19 companies included in his sample were based in part on sales of generation services in PJM during 2005.  Because PJM grew significantly between 2000 and 2005, not every one of the 19 companies was a PJM market participant during most of the 10 events studied (including the three events identified as showing statistically reliable effects).  For example, from the list of 19, Allegheny Energy joined in 2002, AEP and Dayton Power & Light joined PJM in 2004, and Duquesne didn’t join until 2005.  Much of FirstEnergy’s assets remain in the Midwest ISO markets even today, though the company is seeking to consolidate operations within PJM beginning in 2011.  None of these companies were heavily involved in PJM’s markets in 2001, during the first of the three regulatory events cited as showing a significant effect.  Of these companies, only Allegheny Energy was part of PJM in 2002, during the other two of the three regulatory events cited.  Cleaning up the list of affected companies would also improve the analysis.

I liked the article despite these problems, because it takes a new and potentially useful approach to assessing the impact of regulatory changes.  Obviously there is more work to be done.

Besides cleaning up the problems mentioned, the approach could be expanded to include companies on the consumption side of the PJM market.  This will be harder, because while some companies specialize in supplying electric power, few companies on the demand side are similarly specialized.  That is to say, most of a power consumer’s market value will be determined in some other market, and power markets are relatively minor.  However, measuring the supply side and demand side of the market at the same time can help the analyst discriminate between policy actions which appear increase overall efficiency (both producers and consumers see profitability increased) and policy actions which enhance market power (which increase producer profitability at the consumers expense).  A one sided analysis will have a hard time telling the difference.

The regulation market event is particularly interesting, because regulation markets have proven hard to design well. (In any case, such markets have been subjected to numerous tweakings in various RTO markets.)  It may be possible to refine the study in this case by examining the generation portfolios of the companies supplying the market.  Not all generators are equally capable of providing cost-effective regulation service – typically hydropower and natural gas generators are good, but not coal or nuclear plants.  Since the generating companies in PJM have diverse generation portfolios, the relevant regulatory approval should have had differing effects on the companies’ market valuations.

Given that these policies and market designs have significant effects on a multi-billion dollar industry, sometimes the basis for decisions is surprisingly thin.  Insights gained from theory, statistical analysis, experimental economics, studies of other markets and so on, all can help build understanding of what works. I hope that Peters or other analysts will continue this approach to understanding FERC regulatory policy and especially RTO market design.