Electricity Restructuring: Key Challenges Remain (15-NOV-05,	 
GAO-06-237).							 
                                                                 
The electricity industry is in the midst of many changes,	 
collectively referred to as restructuring, evolving from a highly
regulated environment to one that places greater reliance on	 
competition. This restructuring is occurring against a backdrop  
of constraints and challenges, including a shared responsibility 
for implementing and enforcing local, state, and federal laws	 
affecting the electricity industry and an expected substantial	 
increase in electricity demanded by consumers by 2025, requiring 
significant investment in new power plants and transmission	 
lines. Furthermore, several recent incidents, including the	 
largest blackout in U.S. history along the East Coast in 2003 and
the energy crisis in California and other parts of the West in	 
2000 and 2001, have drawn attention to the need to examine the	 
operation and direction of the industry. At Congress's request,  
this report summarizes results of previous GAO work on		 
electricity restructuring, which was conducted in accordance with
generally accepted government auditing standards. In particular, 
this report provides information on (1) what the federal	 
government has done to restructure the electricity industry and  
the wholesale markets that it oversees, (2) how electricity	 
markets have changed since restructuring began, and (3) GAO's	 
views on key challenges that remain in restructuring the	 
electricity industry.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-237 					        
    ACCNO:   A41478						        
  TITLE:     Electricity Restructuring: Key Challenges Remain	      
     DATE:   11/15/2005 
  SUBJECT:   Competition					 
	     Economic analysis					 
	     Electric energy					 
	     Electric power generation				 
	     Electric power transmission			 
	     Electric powerplants				 
	     Electric utilities 				 
	     Independent regulatory commissions 		 
	     Prices and pricing 				 
	     Utility rates					 

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GAO-06-237

     

     * Report to the Chairman, Subcommittee on Energy and Resources,
       Committee on Government Reform, House of Representatives
          * November 2005
     * ELECTRICITY RESTRUCTURING
          * Key Challenges Remain
     * Contents
          * Results in Brief
          * Background
          * The Federal Government Has Taken Steps to Increase Competition in
            the Electricity Industry and Wholesale Markets
          * Electricity Markets Have Changed in Several Important Ways Since
            Restructuring Began
          * Four Key Challenges Remain Unresolved
               * Making Wholesale Market Structures Work Better Together
               * Providing Timely, Clear, and Consistent Signals to Help
                 Ensure Adequate Regional Supplies
               * Connecting Wholesale and Retail Markets
               * Resolving Divided Regulatory Responsibilities
          * Concluding Observations
     * GAO Contact and Staff Acknowledgments
     * Related GAO Products

Report to the Chairman, Subcommittee on Energy and Resources, Committee on
Government Reform, House of Representatives

November 2005

ELECTRICITY RESTRUCTURING

Key Challenges Remain

Contents

Figures

November 15, 2005Letter

The Honorable Darrell E. Issa Chairman Subcommittee on Energy and
Resources Committee on Government Reform House of Representatives

Dear Mr. Chairman:

Since 1992, the electricity industry has been in the midst of many
changes, collectively referred to as restructuring. Before restructuring,
electric service was provided primarily by federally and state-regulated
electric utilities. A utility typically owned the power plants,
transmission system, and local distribution lines that supplied
electricity to all of the consumers in a geographic area. Under this
system, the Federal Energy Regulatory Commission (FERC) regulated, among
other things, sales of electricity for resale and the transmission of
electricity over high-voltage power lines in interstate commerce.1 The
states regulated retail markets by participating with utilities in
forecasting growth in demand, planning and building new power plants,
reviewing and approving utility costs, and establishing rates of return.
Since restructuring began, there has been a shift from a highly regulated
environment to one that places greater reliance on competition.

This restructuring effort is occurring against a backdrop of constraints
and challenges. First, it is occurring within a context of numerous
federal and state laws and regulations that address clean air and water,
fish and wildlife management, and irrigation and flood control. Second,
responsibility for implementing and enforcing these laws and regulations
is distributed across a wide range of federal, state, and local agencies.
Third, electricity demanded by consumers is expected to rise 36 percent by
2025, requiring significant investment in new power plants and
transmission lines. Furthermore, several recent events, including the
largest blackout in U.S. history along the East Coast in 2003, the energy
crisis in California and other parts of the West in 2000 and 2001, and
rolling blackouts as recently as August 25, 2005, in southern California,
have drawn attention to the need to examine the operation and direction of
the industry.

In this context, you asked us to provide information on (1) what the
federal government has done to restructure the electricity industry and
the wholesale markets that it oversees, (2) how electricity markets have
changed since restructuring efforts began, and (3) our views on key
challenges that remain. As you requested, this report is based on our
previous work, including 17 reports issued since 1998,2 which was
conducted in accordance with generally accepted government auditing
standards. As a result, we did not seek additional comments on this
report.

Results in Brief

Since at least 1992, the federal government has pursued a policy to
restructure the electricity industry with the goal of increasing
competition in wholesale markets and thereby increasing benefits to
consumers, including lower electricity prices and access to a wider array
of retail services. In particular, federal restructuring has changed how
electricity is priced-shifting from prices set by regulators to prices
determined by markets; how electricity is supplied-including the addition
of new entities that sell electricity; the role of electricity
demand-through programs that allow consumers to participate in markets;
and how the electricity industry is overseen-in order to ensure consumer
protection.

Federal restructuring efforts, combined with efforts undertaken by states,
have fundamentally changed key aspects of how the electricity sector
operates. First, because many of the changes have been made by FERC, which
has limited jurisdiction over wholesale markets and no jurisdiction over
retail sales, the changes have created a patchwork of wholesale and retail
electricity markets. Some of these markets feature a greater role for
competition, while others do not. Second, the introduction of a greater
role for competition has broadened electricity supplies by allowing new
suppliers to participate in markets. Some of these suppliers sell
electricity across wide geographic regions and multiple states, which has
broadened supplies and made markets more regional. Third, while actions
taken at the wholesale level have encouraged prices to be set by the
direct interaction of supply and demand, there have not been widespread
similar efforts on retail prices, resulting in a disconnection of
wholesale markets from retail markets. Fourth, although regulatory
authority remains divided between federal, state, and local entities,
restructuring has shifted the way electricity markets are overseen. Taken
together, these developments have produced some positive outcomes, such as
progress in introducing competition in wholesale electricity markets, and
some negative outcomes, such as periods of substantially higher prices in
some areas of the country.

We have identified four key challenges to achieving the goals of a
restructured electricity industry: (1) making wholesale markets work
better together so that restructuring can deliver the benefits to
consumers that were expected, (2) providing clear and consistent signals
so that there are adequate supplies to meet regional needs, (3) connecting
wholesale markets to retail markets through consumer demand programs to
keep prices lower and less volatile, and (4) resolving divided regulatory
authority to ensure that these markets are adequately overseen. Not
adequately addressing these issues could result in an electricity industry
that does not provide consumers with the sufficient quantities of
reliable, reasonably priced electricity that has been a mainstay of our
nation's economic and social progress.

Background

The electricity industry is based on four distinct functions: generation,
transmission, distribution, and system operations. (See fig. 1.) Once
electricity is generated-whether by burning fossil fuels; through nuclear
fission; or by harnessing wind, solar, geothermal, or hydro energy-it is
sent through high-voltage, high-capacity transmission lines to electricity
distributors in local regions. Once there, electricity is transformed into
a lower voltage and sent through local distribution wires for end-use by
industrial plants, commercial businesses, and residential consumers.

Figure 1: Functions of the Electricity Industry

A unique feature of the electricity industry is that electricity is
consumed at almost the very instant that it is produced. As electricity is
produced, it leaves the generating plant and travels at the speed of light
through transmission and distribution wires to the point of use, where it
is immediately consumed. In addition, electricity cannot be easily or
inexpensively stored and, as a result, must be produced in near-exact
quantities to those being consumed. Because electric energy is generated
and consumed almost instantaneously, the operation of an electric power
system requires that a system operator balance the generation and
consumption of power. The system operator monitors generation and
consumption from a centralized location using computerized systems and
sends minute-by-minute signals to generators reflecting changes in the
demand for electricity. The generators then make the necessary changes in
generation in order to maintain the transmission system safely and
reliably. Absent such continuous balancing, electrical systems would be
highly unreliable, with frequent and severe outages.

Historically, the electric industry developed initially as a loosely
connected structure of individual monopoly utility companies, each
building power plants and transmission and distribution lines to serve the
exclusive needs of all the consumers in their local areas. Such monopoly
utility companies were typically owned by shareholders and were referred
to as investor-owned utilities. In addition to these investor-owned
utilities, several types of publicly owned utilities, including rural
cooperatives, municipal authorities, state authorities, public power
districts, and irrigation districts, also began to sell electricity. About
one-third of these publicly owned utilities are owned collectively by
their customers and generally operate as not-for-profit entities. Further,
nine federally owned entities, including the Tennessee Valley Authority
and the Bonneville Power Administration, also generate and sell
electricity-primarily to cooperatives, municipalities, and other companies
that resell it to retail consumers.

Because the utilities operated as monopolies, wholesale and retail
electricity pricing was regulated by the federal government and the
states. The Public Utility Holding Company Act of 1935 (PUHCA) and the
Federal Power Act of 1935 established the basic framework for electric
utility regulation. PUHCA, which required federal regulation of these
companies, was enacted to eliminate unfair practices by large holding
companies that owned electricity and natural gas companies in several
states. The Federal Power Act created the Federal Power Commission-a
predecessor to FERC-and charged it with overseeing the rates, terms, and
conditions of wholesale sales and transmission of electric energy in
interstate commerce. FERC, established in 1977, approved interstate
wholesale rates based on the utilities' costs of production plus a fair
rate of return on the utilities' investment. States retained regulatory
authority over retail sales of electricity, electricity generation,
construction of transmission lines within their boundaries, and intrastate
transmission and distribution. Generally, states set retail rates based on
the utility's cost of production plus a rate of return.

The Federal Government Has Taken Steps to Increase Competition in the
Electricity Industry and Wholesale Markets

The goal of federal efforts to restructure the electricity industry is to
increase competition in order to provide benefits to consumers, such as
lower prices and access to a wider range of services, while maintaining
reliability. Over the past 13 years, the federal government has taken a
series of steps to encourage this restructuring that generally fall into
four key categories: (1) market structure, (2) supply, (3) demand, and (4)
oversight.

Regarding market structure, federal restructuring efforts have changed how
electricity prices are determined, replacing cost-based regulated rates
with market-based pricing in many wholesale electricity markets. In this
regard, efforts undertaken predominantly by FERC have helped to encourage
a shift from a market structure that is based on monopoly utilities
providing electricity to all customers at regulated rates to one in which
prices are determined largely by the interaction of supply and demand. In
prior work, we reported that increasing competition required that at least
three key steps be taken: increasing the number of buyers and sellers,
providing adequate market information, and allowing potential market
participants the freedom to enter and exit the industry.3

In terms of supply, federal restructuring efforts have generally focused
on allowing new companies to sell electricity, requiring the owners of the
transmission systems to allow these new companies to use their lines, and
approving the creation of new entities to fairly administer these markets.
The Energy Policy Act of 1992 made it easier for new companies, referred
to as nonutilities,4 to enter the wholesale electricity market, which
expanded the number of companies that can sell electricity. For example,
we reported that from 1992 through 2002, FERC had authorized 850 companies
to sell electricity at market-based rates. To allow these companies to buy
and sell electricity, FERC also required that transmission owners under
its jurisdiction, generally large utilities, allow all other entities to
use their transmission lines under the same prices, terms, and conditions
as those that they apply to themselves. To do this, FERC issued orders
that required the regulated monopoly utilities-which had historically
owned the power plants, transmission systems, and distribution lines-to
separate their generation and transmission businesses.5 In addition, in
response to concerns that some of these new companies received unfair
access to transmission lines, which were mostly still owned and operated
by the former utilities, FERC encouraged the utilities that it regulated
to form new entities to impartially manage the regional network of
transmission lines and provide equal access to all market participants,
including nonutilities. These entities, including independent system
operators (ISOs) and regional transmission organizations (RTOs), operate
transmission systems covering significant parts of the country. One of
these, the California ISO, currently oversees the electricity network
spanning most of the state of California. Another important effort to
facilitate the interaction of buyers and sellers was FERC's approval of
the creation of several wholesale markets for electricity. These markets
created centralized venues for market participants to buy and sell
electricity. Finally, FERC has undertaken efforts to improve the
availability and accuracy of price information used by suppliers, such as
daily market prices reported to news services, and has established
guidelines for the conduct of sellers of wholesale electricity, requiring
these entities to, among other things, accurately report prices and other
data to news services.

Federal efforts to affect demand at the wholesale level have focused on
encouraging prices in wholesale markets to be established by the direct
interaction between buyers and sellers in these markets. We previously
reported that there were several centralized markets in which suppliers
and buyers submitted bids to buy and sell electricity and that other types
of market-based trading were also emerging, such as Internet-based trading
systems.6 However, there have been few federal efforts to directly affect
prices at the retail level, where most electricity that is consumed is
purchased, because states, and not the federal government, have regulatory
authority for overseeing retail electricity markets. As part of its
efforts to have prices set by the direct interaction of supply and demand,
FERC has approved proposals to incorporate so-called "demand-response"
programs into the markets that it oversees. These programs, among other
things, allow electricity buyers to see electricity prices as they change
throughout the day and provide the choice to sell back electricity that
they otherwise would have used. For example, we reported that FERC had
approved one such program in New York State that allows consumers to offer
to sell back specific amounts of electricity that they are willing to
forgo at prices that they determine.7 More recently, the Energy Policy Act
of 2005 requires FERC to study issues such as demand-response and report
on its findings to the Congress.

Finally, restructuring has fundamentally changed how electricity markets
are overseen and regulated. Historically, FERC had ensured that prices in
wholesale electricity markets were "just and reasonable" by approving
rates that allowed for the recovery of justifiable costs and providing for
a regulated rate of return, or profit. To ensure that prices are just and
reasonable in today's restructured electricity markets, FERC has shifted
its regulatory role to approving rules and market designs, proactively
monitoring electricity market performance to ensure that markets are
working rather than waiting for problems to develop before acting, and
enforcing market rules.8 As part of its decision to approve the creation
of market designs that include ISOs and RTOs, FERC approved the creation
of market monitoring units within these entities. These market monitors
are designed to routinely collect information on the activities in these
markets including prices; perform up-to-the-minute market monitoring
activities, such as examining whether prices appear to be the result of
fair competition or market manipulation; and can impose penalties, such as
fines, when they identify that rules have been violated. More recently,
the Energy Policy Act of 2005 granted FERC authority to impose greater
civil penalties on companies that are found to have manipulated the
market.

Electricity Markets Have Changed in Several Important Ways Since
Restructuring Began

Federal restructuring efforts, combined with efforts undertaken by states,
have created a patchwork of electricity markets, broadened electricity
supplies, disconnected wholesale and retail markets, and shifted how the
electricity industry is overseen. Taken together, these developments have
produced some positive and some negative outcomes for consumers.

In terms of market structure, we previously reported that the combined
effects of the federal efforts and those of some states have created a
patchwork of wholesale and retail electricity markets.9 In the wholesale
markets, there is a combination of restructured and traditional markets
because FERC's regulatory authority is limited. As a result, some
entities-including municipal utilities and cooperatively owned
utilities-have not been required to make the changes FERC has required
others to make.10 As shown in figure 2, collectively the areas not
generally subject to FERC jurisdiction span a significant portion of the
country. In addition, even where FERC has clear jurisdiction, it has
historically approved a variety of different rules that govern how each of
the transmission networks is controlled and what types of wholesale
markets may exist. In the retail electricity markets, state utility
commissions or local entities historically have controlled how prices were
set, as well as approved power plants, transmission lines, and other
capital investments. Because each state performed these functions slightly
differently, these rules vary. In addition, many states also have shifted
the retail markets that they oversee toward competition. As we reported in
2002, 24 states and the District of Columbia had enacted legislation or
issued regulations that planned to open their retail markets to
competition.11 As of 2004, 17 states had actually opened their retail
markets to competition, according to the Energy Information
Administration. One of these states, California, opened its retail markets
to competition but has taken steps to limit the extent of competition.

Figure 2: Areas Served by Entities Subject to FERC Jurisdiction, 2002

Notes:

Areas served by entities generally not subject to FERC jurisdiction
include areas served by publicly owned entities, such as municipal
utilities, cooperative utilities, and others.

Data on service territories include some overlaps, indicating that some
areas are served by both entities subject to FERC jurisdiction and
entities not generally subject to FERC jurisdiction, particularly some
areas in Pennsylvania, Michigan, Wisconsin, and Iowa. Data reflected above
depict those areas of overlap as not generally subject to FERC
jurisdiction.

Unshaded portions of the map indicate either that no electric service is
provided or the service area is very small.

In terms of supply, efforts to restructure the electricity industry by the
federal government and some states have broadened electricity markets
overall-shifting the focus from state and/or local supply to multistate or
regional supply. In particular, efforts at wholesale restructuring have
led to a significant change in the way electricity is supplied in those
markets. The introduction of ISOs and RTOs in many areas has provided open
access to transmission lines, allowing more market participants to compete
and sell electricity across wide geographic regions and multiple states.
In addition, in some parts of the country, overall supply has grown as a
result of the large increase in new generating capacity that has been
built by nonutility companies, while other regions have witnessed smaller
increases in supply. For example, we reported that, by 2002, Texas had
added substantial amounts of generating capacity-more than double the
forecasted amount needed through 2004.12 In contrast, in California only
about 25 percent of the forecasted need had been built over the same
period, and the region witnessed a historic market disruption costing
consumers billions of dollars. Similarly, the opening of retail markets
has also widened the scope of electricity markets by allowing new and
different entities to sell electricity, which works to further broaden
markets because these retail sellers must either build or buy a power
plant or rely on wholesale markets. Finally, FERC has improved the
transparency of wholesale markets, a key requirement of competitive
markets, by increasing the availability and accuracy of price and other
market information.

In terms of demand, while federal efforts have encouraged price setting by
the interaction of supply and demand, this approach has not been widely
adopted in retail markets. Even though FERC and other electricity experts
have determined that it is important for demand to be responsive to prices
and other factors for competitive markets to operate efficiently, as we
reported in 2004, the use of these programs remains limited.13 In many
retail markets, including some states where retail markets have been
opened to competition, prices are still set so that rates are either flat
or have been frozen. In either case, prices are not reflective of the
hourly costs of providing electricity. In some cases, demand-response
programs are in place but are aimed at only certain types of customers,
such as some commercial and industrial customers. Overall, these customers
account for only a small share of total demand. As a result, in this
hybrid system, wholesale and retail markets remain disconnected, with
competition setting wholesale prices in many areas, and state regulation
setting retail prices in many states.

Regulatory oversight of the electricity industry remains divided among
federal, regional, and state entities. As we have previously reported,
FERC initially did not adequately revise its regulatory and oversight
approach to respond to the transition to competitive energy markets.14
However, it has made progress in recent years in defining its role,
developing a framework for overseeing the markets, and beginning to use an
array of data and analytical tools to oversee the market. In particular,
FERC established the Office of Market Oversight and Investigations in
2002, which oversees the markets by monitoring its enforcement hotline for
tips on misconduct; conducting investigations and audits; and reviewing
large amounts of data-including wholesale spot and futures prices, plant
outage information, fuel storage level data, and supply and demand
statistics-for anomalies that could lead to potential market problems. In
addition to FERC's own efforts, substantial oversight also now occurs at
the regional level, through ISO and RTO market monitoring units. These
units monitor their region's market to identify design flaws, market power
abuses, and opportunities for efficiency improvements and report back to
FERC periodically. Finally, states' oversight roles vary. Those states
that have not restructured their markets retain key roles in overseeing
and regulating electricity markets directly and indirectly through such
activities as setting rates to recover costs and siting of power plants
and transmission lines and other capital investments needed to supply
electricity. The ability of states that have restructured their retail
markets, to oversee their markets is more limited, according to experts.

The effects of restructuring on consumers have been mixed. While most
studies evaluating wholesale electricity markets, including our own
assessment, have determined that progress has been made in introducing
competition in wholesale electricity markets, results at the retail level
have been difficult to measure. For example, in 2002, we reported that
prices generally fell after restructuring and fell in particular in many
areas that had implemented retail restructuring.15 However, we were unable
to attribute these price decreases solely to restructuring, since several
other factors, such as lower prices for natural gas and other fuels used
in the production of electricity, could have contributed to the price
decreases. Furthermore, while some consumers had benefited by paying lower
prices, others have experienced high prices and market manipulation. For
example, in 2002, we reported that nationally, consumers benefited from
price declines of as much as 15 percent since federal restructuring
efforts began.16 However, as consumers in California and across other
parts of the West will attest, there have been many negative effects,
including higher prices and market manipulation. More recently,
electricity prices have risen, potentially the result of higher prices for
fuels such as natural gas and petroleum, and other factors.

Four Key Challenges Remain Unresolved

We have identified four key challenges that, if addressed, could benefit
consumers and the restructured electricity markets that serve them.

Making Wholesale Market Structures Work Better Together

With several fundamentally different electricity market structures in
place simultaneously in various parts of the country, it is important that
these markets work together better in order to meet regional needs. As we
previously reported, two aspects of the current electricity markets serve
to limit the benefits expected from restructuring.17 First, FERC's limited
authority has meant that significant parts of the market and significant
amounts of transmission lines have not been subject to FERC's effort to
restructure wholesale markets-creating "holes" in the national
restructured wholesale market. These gaps, where efforts to open wholesale
markets have not been undertaken, may limit the number of potential
participants and the types of transactions that can occur, thereby
limiting the benefits expected from competition.18 Second, where FERC has
clear authority, it has historically approved a range of rules for how the
different transmission systems and centralized wholesale markets
operate-creating "seams" where these different jurisdictions meet and the
rules change. We have previously noted that the lack of consistent rules
among restructured wholesale markets limits the extent of competition
across wholesale markets and, in turn, limits the benefits expected from
competition.19 California experienced this firsthand, as it tried to "cap"
wholesale electricity prices in its state market-establishing rules
different from those in the markets surrounding California. The lower
price cap in California, coupled with an exemption for electricity
imports, created incentives to sell electricity to areas outside the state
(where prices were higher) and later import it (because imports were
exempt from the price cap).

FERC has acknowledged that the lack of consistent rules can lead to
discrimination in access, raise costs, and lead to reliability problems.
As a result, FERC made an effort to standardize the various wholesale
market designs under its jurisdiction. However, these efforts met with
sharp criticism from some industry stakeholders. FERC ended its effort to
require a single market design in all regions and has, instead, promoted
voluntary participation in RTOs and having the RTOs work together to
reconcile their differences. In the end, today's patchwork of wholesale
market structures, with holes and seams, is at odds with the physics of
the interdependent electricity industry, where electrons travel at the
speed of light and do not stop neatly at jurisdictional boundaries.
Successfully developing markets will require the alignment of market
structures and rules in order to reconcile them with these physical
certainties.

Providing Timely, Clear, and Consistent Signals to Help Ensure Adequate
Regional Supplies

Broadening of restructured electricity markets has made the federal
government, the states, and localities more dependent on each other in
order to ensure a sufficient supply of electricity. We previously
concluded that, as federal and state restructuring efforts broaden
electricity markets to span multiple states, states will become more
interdependent on each other for a reliable electricity supply.20
Consequently, one state's problems acquiring and maintaining an adequate
supply can now affect its neighbors. For example, in the lead up to the
western electricity crisis in 2000-2001, few power plants were built to
meet the rising demand in California, which became dependent on power
plants located outside the state. However, when prices began to rise, this
affected consumers, both inside and outside California. We previously
reported these higher prices had implications for California consumers
such as higher electricity bills, as well as others located outside the
state, costing billions of additional dollars. Because of these negative
outcomes, some have questioned whether restructuring will eventually
benefit consumers.

More broadly, rising interdependence has significant implications for many
industry stakeholders, especially in light of the shift in how plants are
financed and built. In the past, monopoly utilities proposed, and
regulators approved, the construction of new power plants and other
infrastructure. Today, policymakers at all levels of government must
recognize that providing consumers with reliable electricity in
competitive markets requires private investors to make reasoned
investments. We have reported that these private investors make decisions
on investing by balancing their perceptions of potential risk and
profitability.21 Further, we concluded that the reliability of the
electricity system and, more generally, the success of restructuring, now
hinges on whether these developers choose to enter a market and how
quickly they are able to respond to the need for new power plants. The
implications of this broadening of electricity markets are important,
since it has occurred while most of the primary authorities associated
with building new power plants, such as state energy siting or local land
use planning, still rest with states and localities. As we have reported,
there is sometimes considerable variation across states and localities in
how long these processes take and how much they cost, and building new
power plants can take a year or more once all the approvals are obtained.
Because of the broader electricity markets, one state's or locality's
processes and decisions provide signals affecting private investors'
perceptions of the risk or profitability of making investments in local
areas and can have long-lasting implications for the entire region. In
this context of growing interdependence for adequate electricity supplies,
our work shows that it is important for federal, state, and local entities
to provide timely, clear, and consistent signals that allow private
developers to make the kinds of reasonable and long-term investments that
are needed.

Connecting Wholesale and Retail Markets

As we have previously reported, for competitive wholesale electricity
markets to provide the full benefits expected of them, it is essential
that they be connected to the retail markets, where most electricity is
sold and consumed.22 Otherwise, hybrid electricity markets-wholesale
prices set by competition and retail prices set by regulation-will be
difficult to manage because consumers at the retail level can unknowingly
drive up wholesale prices during periods when electricity supplies are
limited. This occurs when consumers do not see prices at the retail level
that accurately reflect the higher wholesale market prices. Seeing only
these lower electricity prices, consumers use larger quantities of
electricity than they would if they saw higher prices, which raises costs
and can risk reliability. We have noted that, in this environment
(consumers seeing low retail prices during periods of high wholesale
prices) consumers have little incentive to reduce their consumption during
periods when prices are high or reliability is at risk. The appeal of
seeming to insulate retail consumers from wholesale market fluctuations
may be compelling, but most experts agree that the lack of significant
demand response can actually lead to higher and more volatile prices. In
2004, we concluded that this system makes it difficult for FERC to ensure
that prices in wholesale markets are just and reasonable.23 We further
concluded that connecting wholesale and retail markets through
demand-response programs such as real-time pricing or reliability-based
programs would help competitive electricity markets function better,
enhance the reliability of the electricity system, and provide important
signals that consumers should consider investments into energy-efficient
equipment.24 Such signals would work to reduce overall demand in a more
permanent way.

While FERC has been supportive of increasing the role of demand-response
programs in the wholesale markets that it oversees, there have been
limited efforts to do so in retail markets-these markets are outside
FERC's jurisdiction and overseen by the states. Some states, such as
California, have a long history with demand-response programs and have
conducted more recent experiments with using it in more widespread ways.
Sharing and building upon these and other examples could help develop
efficient ways to bring the consumers who flip the light switches into the
markets responsible for ensuring that their lights go on. Since
electricity travels at the speed of light, retail markets where
electricity is consumed are tightly connected to the wholesale markets
that supply these retail markets. As a result, much of the success of
federal restructuring of the wholesale markets relies on actions taken at
the state level to bring consumers into the market.

Resolving Divided Regulatory Responsibilities

Significant changes in how oversight is carried out in competitive
markets, combined with the divided regulatory authority over the
electricity industry, has made effective oversight difficult. We
previously reported that FERC, the states, and other market monitors were
neither fully monitoring the overall performance of all wholesale and
retail markets nor collecting sufficient data to do so, thus limiting the
opportunity to meaningfully compare performance.25 At the federal level,
FERC protects customers primarily through ensuring that prices in the
wholesale markets are just and reasonable. In prior work, we found that
FERC did not initially revise its oversight approach adequately in
response to restructured markets, resulting in markets that were not
adequately overseen.26 However, more recently, we reported that FERC has
made significant efforts to revise its oversight strategy to better align
with its new role overseeing restructured markets, has taken a more
proactive approach to monitoring the performance of markets, and has
better aligned its workforce to fit its needs in these new markets.27
Recent actions will require further changes to FERC's role. The Energy
Policy Act of 2005 provided FERC additional authority to establish
reliability rules for all "users, owners, and operators" of the
transmission system. We had previously reported that this change would be
desireable, but it is too early to judge its success.28 At the state
level, oversight varies widely. States that have retained traditionally
regulated retail markets continue to require substantial amounts of
information to help them set the regulated prices that consumers see. The
states that now feature restructured retail markets face a sharply
different oversight role of policing their state-level retail markets for
misbehavior and signs of market malfunction. The introduction of the
market monitoring units within ISOs and RTOs adds a new layer of regional
oversight to the existing federal and state roles. While authority over
the electricity industry is divided, restructuring has served to make the
success of each of the oversight efforts more interdependent, and FERC and
the states will have to rely on each other, as well as on new entities, to
a greater degree than before to be successful.

Concluding Observations

It is becoming increasingly clear that many of the challenges facing the
electricity industry are rooted in the interdependence of actions taken by
federal, state, local, and private entities, as well as consumers.
Accordingly, the individual challenges we have discussed follow a central
theme-the need to integrate the various ongoing activities and efforts and
harmonize them in a way that improves the functioning of the marketplace
while providing adequate oversight to protect electricity consumers. This
will not be easy because it requires what is, at times, most difficult:
collaboration and cooperation among entities with a history of
independence.

Successfully restructuring the electricity industry is an ongoing process
that will require rethinking old issues, such as jurisdictional
responsibilities, and applying new and creative ideas to help bridge the
current gap between wholesale and retail markets. Only if interdependent
parties work together will electricity restructuring succeed in delivering
benefits to U.S. consumers by way of healthy, viable, and competitive
markets. Not adequately addressing these issues could result in an
electricity industry that does not provide consumers with sufficient
quantities of the reliable, reasonably priced electricity that has been a
mainstay of our nation's economic and social progress.

As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution until 15 days after the report
date. At that time, we will send copies of this report to appropriate
congressional committees. We will also make copies available to others on
request. In addition, the report will be available at no charge on the GAO
Web site at http://www.gao.gov.

at (202) 512-3841 or [email protected] . Contact points for our Office of
Congressional Relations and Office of Public Affairs may be found on the
last page of this report. GAO staff who contributed to this report are
listed in the appendix.

Sincerely yours,

Jim Wells Director, Natural Resources     and Environment

GAO Contact and Staff Acknowledgments Appendix I

Jim Wells, (202) 512-3841 or w  [email protected]

In  addition to the contact named above, Dan Haas, Jon Ludwigson, and Kris
Massey  made key contributions to this report. Barbara Timmerman, Susan
Iott, and Nancy Crothers also made important contributions.

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Electric Utility Restructuring: Implications for Electricity
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California Electricity Market: Outlook for Summer 2001. GAO-01-870R. 
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(360645)

www.gao.gov/cgi-bin/getrpt? GAO-06-237 .

To view the full product, including the scope

and methodology, click on the link above.

For more information, contact Jim Wells, 202-512-3841 or [email protected].

Highlights of GAO-06-237 , report to the Chairman, Subcommittee on Energy
and Resources, Committee on Government Reform, House of Representatives

November 2005

ELECTRICITY RESTRUCTURING

Key Challenges Remain

The electricity industry is in the midst of many changes, collectively
referred to as restructuring, evolving from a highly regulated environment
to one that places greater reliance on competition. This restructuring is
occurring against a backdrop of constraints and challenges, including a
shared responsibility for implementing and enforcing local, state, and
federal laws affecting the electricity industry and an expected
substantial increase in electricity demanded by consumers by 2025,
requiring significant investment in new power plants and transmission
lines. Furthermore, several recent incidents, including the largest
blackout in U.S. history along the East Coast in 2003 and the energy
crisis in California and other parts of the West in 2000 and 2001, have
drawn attention to the need to examine the operation and direction of the
industry.

At the Committee's request, this report summarizes results of previous GAO
work on electricity restructuring, which was conducted in accordance with
generally accepted government auditing standards. In particular, this
report provides information on (1) what the federal government has done to
restructure the electricity industry and the wholesale markets that it
oversees, (2) how electricity markets have changed since restructuring
began, and (3) GAO's views on key challenges that remain in restructuring
the electricity industry.

Over the past 13 years, the federal government has taken a variety of
steps to restructure the electricity industry with the goal of increasing
competition in wholesale markets and thereby increasing benefits to
consumers, including lower electricity prices and access to a wider array
of retail services. In particular, the federal government has changed (1)
how electricity is priced-shifting from prices set by regulators to prices
determined by markets; (2) how electricity is supplied-including the
addition of new entities that sell electricity; (3) the role of
electricity demand-through programs that allow consumers to participate in
markets; and (4) how the electricity industry is overseen-in order to
ensure consumer protection.

Federal restructuring efforts, combined with efforts undertaken by states,
have created a patchwork of wholesale and retail electricity markets;
broadened electricity supplies; disconnected wholesale markets from retail
markets, where most demand occurs; and shifted how the electricity
industry is overseen. Taken together, these developments have produced
some positive outcomes, such as progress in introducing competition in
wholesale electricity markets, as well as some negative outcomes, such as
periods of higher prices.

We have identified four key challenges to the effective operation of the
restructured electricity industry: making wholesale markets work better
together so that restructuring can deliver the benefits to consumers that
were expected; providing clear and consistent signals to private investors
when new plants are needed so that there are adequate supplies to meet
regional needs; connecting wholesale markets to retail markets through
consumer demand programs to keep prices lower and less volatile; and,
resolving divided regulatory authority to ensure that these markets are
adequately overseen. The theme cutting across each of these challenges is
the need to better integrate the various market structures, factors
affecting supply and demand, and various efforts at market oversight. This
theme is illustrated below.

Integrating Restructuring Efforts is Important
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