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Recently, Volatility Managers made public a white paper written for the Center for Advancement of Energy Markets Energy Infrastructure, Investment and Incentives Forum (Forum). The goal of this analysis was to provide regulators and market participants with a common framework in which to examine the role of the regulator, to refocus the decisions of the regulator in this time of change and to assist in the process of creating a more stable regulatory structure for the electricity industry- a structure that is capable of attracting the capital and market entrants necessary to allow reliable supply.
The analysis looked at the cost of service regulatory regime as a series of options transactions between the regulator and the utility. These transactions served to allocate risks of utility investment and operations in a manner acceptable to both the utility and the regulator. This structure worked well and evolved a common language that utility senior management and regulatory staff could use to communicate with the regulators and their staff.
When the energy markets restructured and incorporated open market, at risk investment structures, new parties came to the table. These parties are the project financing, trading and merchant investor groups. They speak a different language and look at relationships in a transactional framework.
The issue of inadequacy of infrastructure investment in the natural gas and electricity markets has come to the forefront of public policy in the United States. Regulators, utilities, consumers and investor groups have expressed concerns as to whether the energy industry is able to attract adequate risk capital to maintain existing infrastructure and develop new infrastructure as needed. These concerns are well founded.
However, the language of that utilities and regulators spoke to each other in the cost of service environment creates viewpoints that may not be shared by the new parties at the table. Even more critically, the interaction that regulators and utilities previously used may actually act to deter open market investment. Until regulators can speak to the investing community in their language and until the regulator can perceive the interactions caused by the regulator in the same manner as the investors so, infrastructure investment will remain problematic in the electricity and natural gas industries.
The investor looks at two types of structures: firm obligations and optional obligations – forwards and options in their language. A forward is an unconditional obligation – in regulatory language something that must or will be done. An option is a conditional obligation – in regulatory language something that can or may be done. The investors see the party that owns a conditional obligation as having the right to convert that ownership into an opportunity to impose an unconditional obligation on the party they bought it from. To the investment community conditional and unconditional obligations have different values and different risks. When a regulator uses conditional language with the understanding and intent that the language creates an unconditional obligation, confusion is created. The paper outlines where conditional obligations exist in the infrastructure of the electricity market and how they are dealt with in both cost of service and open market, at risk environments.
The infrastructure issue is also stated in the context of the shift from “supply push” to “demand pull” for infrastructure investment, when shifting from cost of service regulation to open market structures. Infrastructure investment is, to investors, the exercise of their conditional right (an option) to spend their money to build new facilities. The paper explores the difference between these options to build new capacity to supply or consume (building a new generation plant, drilling an oil well, building a manufacturing plant, building a transmission line) and the option to run capacity (operating a power plant, running your air conditioner, dispatching power across transmission lines). The paper’s fundamental premise is that the infrastructure issues revolve around the build options, which rely on forward pricing signals as their economic basis, as opposed to the run options, which rely on the spot market as their economic basis. It is this dichotomy that creates the greatest issues in the restructuring of the regulation of electricity markets.
The cost of service regulatory regime is described in terms of transactions associated with the build options and the shift of risk and rewards for the run options, based on regulatory risk shifting for the recovery of the premiums on the build options. This is contrasted with the risks and rewards under open markets and the attendant change in effective ownership in the run options.
The paper examines how the risk reduction concerning the build option for investors created a constant selling pressure on the regulators- placing them in the position of acting as a brake on investment. The paper contrasts the reality of open markets that require a “demand pull”, unless forward prices reach a level adequate to increase the risk-weighted expected return on the build option to levels adequate to support investment. This shift can create significant political risks for regulators.
The paper also examines the effective “ownership” of transmission run options in the ISO/RTO environment. Pool operation complicates the use and pricing of the run option associated with transmission. The paper also explores the transactional issues that must be resolved to create greater certainty in transmission infrastructure investment.
To the investor the regulator under the cost of service regime is seen as an active participant in the market, setting the price and amount of options available to the utility. Under the cost of service language employed by the regulators and the utility in the past, the regulator is seen as the intermediary between the utility and the consumer interveners. This difference in perceptions has a significant impact on the movement forward into the open market, at risk environment.
If the regulator continues to act in the same manner in the past, using the same language it runs the risk of having the investment community misinterpreting its intent and behavior. If the confusion persists it is possible that the regulator may, unintentionally, create an environment where investment is extremely difficult to attract and infrastructure adequacy may be impacted.
Therefore, it is imperative for the regulators to make the effort to understand the nature of the electricity market and, by analogy, the natural gas market in the way the investment community views it. A common language and decision framework must be developed so that all the parties at the table – not just the regulators and utilities – are talking the same language and making common decisions.
The conclusion of the analysis is that the changes in the underlying market – increased volatility in fuel and construction costs, the increasing complexity and sophistication of the market and other factors – make reliance on the cost of service transaction difficult, if not impossible, to manage in the current environment. However, this means that the regulator must be proactive in creating the playing field, the rules and the roles for the participants. Dynamic regulation – responding to the changes in the marketplace – becomes more critical.
The goal of this analysis was to provide regulators and market participants with the common framework in which to examine the role of the regulator, to refocus the decisions of the regulator in this time of change and to assist in the process of creating a more stable regulatory structure for the electricity industry- a structure that is capable of attracting the capital and market entrants necessary to allow reliable supply.
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