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How Electricity Market Regulations Affect Clean Energy Development

Amidst the partisan gridlock at the federal level, we at the Brookings Metro Program have been trying to think of ways for state and local governments to pursue policies that advance the country towards greater opportunity, enhanced innovation, growth in exports, and a cleaner economy. As my colleague Mark Muro pointed out on these pages recently, one domain of state policy has a significant impact on the success of efforts to create a less carbon and pollution intensive economy: the structure and regulation of electricity markets.

While Byzantine in regulatory variation and complexity, it is of critical importance to get utility regulation right. For context, electricity accounts for 40 percent of carbon emissions, and over 70 percent of commercial and residential emissions. Moreover, the importance of electricity to emission is likely to grow even further in upcoming decades as electric and hybrid-electric cars become more common with improvements in battery and battery storage technologies. Unfortunately, fossil fuel still dominates electricity production, with 70 percent coming from coal and gas, and less than 10 percent coming from renewables in 2008. With that said, as I’ll explain below, there is evidence that the alternative or non-fossil fuel share would be higher if all states embraced the regulatory reforms promoted by the Federal Energy Regulatory Commission (FERC).

Since the 1930s, the electricity market has been dominated by state-regulated vertically integrated utilities. This means that the generation of electricity, its transmission to power companies, and its final retail sale to customers in homes and businesses were all controlled by the same company. The regulations prevented price gauging but did not prevent a host of other problems, as concluded by the Federal Energy Regulatory Commission (FERC) in 1996. Chief among them was price discrimination against competitors or refusals to even transmit their power. That year, FERC passed Order 888 to outlaw price discrimination and encourage the voluntary use of Independent System Operators—who would buy and sell bulk power openly at fair rates—and the “unbundling” of market operations from single companies.

In 1999, FERC took a step further and laid out rules governing regional entities that are designed to combine the provision of market information and operations into one entity called a Regional Transmission Organization (RTO). As MIT’s Paul Joskow has explained, the federal-regulated RTOs would handle all aspects of the wholesale electricity market, where economies of scale are most important, and the other providers of electricity market functions would be substantially deregulated and forced to compete with one another—such as generation and retail providers.

According to many key market players (who issued formal comments to FERC when the rules regarding RTOs were proposed), RTOs would foster competition, enhance grid investments, lower prices, and encourage innovation relative to the older monopolistic system. Indeed, subsequent literature reviews and empirical studies by William Hogan and others have confirmed that markets operate more efficiency under RTO or ISO management (ISOs perform the same functions as RTOs, but are classified differently by FERC mostly because their scope is not as regional).

Currently, roughly two-thirds of the U.S. electric grid is operated by RTOs or ISOs, but twenty-two states have not embraced the reforms, especially in the West (except California) and Southeast. Given the importance of regional scale in balancing wind and solar production with demand and the difficultly of breaking into new markets under monopolistic conditions, it is worth asking if this is an obstacle to the deployment of renewable energy.

To analyze the effects of market re-structuring on electricity market outcomes, I compiled data covering the years 1990 to 2008 for each state and the District of Columbia from the Energy Information Agency. I used a standard analytic model along the lines of those used by Joskow, who supports the reforms, and other energy policy experts like Thomas M. Lenard of the Technology Policy Institute, who has been critical of FERC.

The results of the analysis show that states operated by ISOs or RTOs have been significantly more likely to adopt alternative sources of energy than non-reformed states governed by regulated monopolies. The effect is likely caused by the advantages of having an ISO or RTO, since the analysis adjusts for any state-specific characteristics (like natural resources), the presence of renewable portfolio standards, market conditions such as the cost of generation, the share of revenue from publicly owned utilities, the number of customers, and the degree of competition; by adjusting for year effects, the analysis also accounts for national changes in technology and commodity prices.

For each year a state is operated by an ISO/RTO, the share of alternative energy use—meaning energy that does not come from fossil fuels—increases by 0.5 percentage points. The effect remains significant if nuclear excluded from “alternative energy.” States with ISOs are particularly effective at increasing their supply of wind energy, which, except for hydro-electricity from dams, is the largest source of alternative energy. Each year with an ISO increases the state’s wind share by 0.02 percentage points. That may sound small, but consider that in 2008, the nation generated just 1.3 percent of its electricity from wind. Moreover, the share of electricity produced by wind for the average state has been just 0.2 percent from 1990 to 2008, so the cumulative effect of having an ISO/RTO eventually adds up to a significant difference between reformed states and those that have not.

On the state policy side, having a renewable portfolio standard is associated with a higher share of wind energy, but overall alternative energy has no relationship to whether or not a state has an RPS in place for a given year. Though this may seem surprising, energy analysts argue that renewable standards are divorced from the realities of utility market regulations—especially cost allocations that ignore transmission capacity constraints—and the difficulties of breaking into the supply market.

Aside from the overall ISO/RTO reform adoptions, market structure also matters. As it turns out, higher concentration is associated with less solar and wind energy, where capital costs are low and suppliers tend to be small. This implies that easing barriers to entry—especially when it comes to linking up production with transmission—would enable solar and wind producers to play a larger role. As it turns out, re-structured markets are associated with more utilities per customer and more competitive retail markets, a sign that smaller players are infiltrating the grid more readily.

So then, one costless but significant way to increase renewable energy use in this country would be to compel un-reformed state utility commissions or utilities to form Regional Transmission Organizations, despite their reluctance in certain states.

FERC recognizes these problems and despite constitutional constraints on regulating totally intrastate market, it is pushing ahead with a reform agenda. One encouraging proposal by FERC, issued in June of 2010, would reform the costs of transmission so that the benefits of new transmission lines are more closely aligned with costs. It would also prohibit owners from holding veto power to block new lines. This would be an important step. Such efforts should be supported by Congress and leaders in Washington.

For environmental and diplomatic purposes, if no other, it is clear that the U.S. will need to become less carbon intensive, and many on the political right would like to see the country rely much less on foreign oil. Electricity, which uses almost zero petroleum, is less carbon intensive than oil already, and could cut those emissions even further if state utility commissions and politicians adopted FERC’s reform agenda and moved towards competitive, independently and regionally operated electricity markets, with more efficient cost accounting. Finally, the technology needed to realize these reductions is more likely to be produced in the United States if it can be readily implemented in the United States.