The recent price spikes and generation outages in the Midwestelectricity market have undermined the reliability reputation ofelectric suppliers and opened the door wide for the natural gasindustry to capture a greater share of the industrial energymarket, says a senior economist.

Utilities over the years always have used reliability ofelectric service as a key selling point to industrial customers,noted Harry Chernoff of Science Applications International Corp. inMcLean, VA. “But now they’re curtailing electric. So the gascompanies are rightly going to [remind industrials] ‘your electricwas just curtailed,’ or ‘your peak prices just went way up,’ or’you’ve been offered a new combination of rate schedules where firm[service] is a lot more expensive than it used to be and emergency[service] is way more expensive than it used to be..'” In the finalanalysis, “unless you [the industrial] got a load profile that canhandle it, you’re taking a risk.”

Natural gas companies should target “industrials that haveprocesses that require continuous energy supplies,” and that havethe flexibility to consume either gas or electricity, he said. Theupheaval in the electric market in June is “a significant marketingissue [for gas], and I would think that a lot of the industrialsare going to take a look now at what kind of reliability is beingoffered from gas.” Chernoff, a former FERC staff member, believesgas service has become increasingly more reliable over the years,with companies installing a lot of peak delivery capacity – such asstorage.

On a related topic, he said he expects to see a “massive shift”towards natural gas in the electricity industry within the next 10years. “If you look at what the big and shrewd utilities andindependent power producers are doing, it’s gas power plants, it’sgas pipeline investments, [and] in some cases it’s gas production.”

Chernoff’s remarks came at a press briefing last week sponsoredby the American Gas Association (AGA),which unveiled the results ofa study on the impact of electric restructuring on electricityprices. Chernoff, who authored the study, predicts industrialcustomers will see greater rate reductions (20-25%) out to 2015,while rate savings for residential and commercial electriccustomers will be lower – in the 10% range. Specifically, heforesees industrial electric rates dropping from 4.2 cents per kWhin 2000 to 3.4 cents in 2015, commercial rates falling from 7.5cents kWh to 6.9 cents, and residential rates tumbling from 8.2 cents per kWh to 7.7 cents.

But few, if any, of the rate savings for residentials andcommercials will be the result of restructuring, he says. Savingsfor these two customer classes mostly will be due to “systemefficiencies,” such as declining natural gas prices, improvementsin nuclear performance, coal surpluses, and the construction ofcombined-cycle gas turbines by exempt wholesale generators.

The big winners in restructuring will be industrial power users,he said. “Deregulation gets the industrials what they want. And notsurprisingly industrials are the big supporters of deregulation.Deregulation gets the exempt wholesale generators and theindependent power producers what they want, which is access to theexpensive service territories. Deregulation also gets you [the]stranded-cost issue.”

Chernoff contends that industrial customers are trying to”unwind” the regulatory protections that residential customers nowenjoy. “The unwinding is taking place fairly rapidly. The utilitycommissions in the last 10 years have come to realize thatindustrials aren’t making idle threats. There’s been a fair numberof closures of plants where [they] made explicit to the commissionswhy those jobs were lost,” namely high electricity prices. A few ofthe commissions “started really to get religion” after that,Chernoff said.

Residentials Last in Line

His conclusions are in sharp contrast to a recent Department ofEnergy (DOE) study, which found that restructuring would causeresidential electric prices to fall at a faster clip thanindustrial rates. “Well that conflicts with what I call the firstprinciples [of] economics. If you ask yourself how is it that thegroup with the least market power does the best when youderegulate, the answer is that it doesn’t make any sense…”

Just “look at what the states who are deregulating – California,Illinois, Massachusetts – are saying to their ratepayers. They’resaying, ‘deregulation will create these huge savings, immensesavings. And by the way, we’re going to mandate rate reductions forthe residential and commercial classes.’ You’ve got to ask yourselfif these savings from deregulation are huge, why are the ratereductions mandated. Well the answer is they’re not huge for theresidential and commercial sectors. They’re huge for theindustrials.”

Experiments with customer choice at the state level have proventhis to be true so far, Chernoff noted. “In New Hampshire, forexample, the experiments show that most of the savings came aboutdue to companies buying their way into markets to get experience. Iknow for a fact that companies are taking losses just to getexperience and create a presence. We’ve seen that Enron haswithdrawn from the retail residential markets in California, NewHampshire and Massachusetts [citing the losses as the reason]. Ifyou’ve got stranded-cost recovery and everybody’s got to pay it,the savings just aren’t that great.”

Chernoff believes that restructuring is unnecessary to a certainextent. “…[A] lot of what’s taking place under the name ofderegulation[the] states could do if they wanted to underregulation,” he told reporters.

Still, he said restructuring “makes sense” for high-cost states,such as California, New Jersey and states in the New Englandregion. “It doesn’t deliver the residential savings they’reexpecting, but it does deliver the industrial savings.” However, hedoesn’t think it makes sense in low-cost states, especially thosethat have an abundance of hydroelectricity, such as Idaho. Thatwould be the last state where he would expect to see a deregulatedpower market, Chernoff noted. He said he is opposed to a”one-size-fits-all solution” for electricity restructuring.

New Englanders Could Suffer

Separately, Chernoff believes the price spikes that the Midwestelectricity market saw in late June could happen again. His studyfinds that “market power is going to go up and volatility is goingto go up, and they’re both going to go up in a big way” in theyears ahead.

“And the most likely place you’re going to see that is NewEngland,” he said. “…[I]f New England this summer had [had]either Texas temperatures or the midwestern outages, they wouldhave been in the same boat as the Midwest. And it wouldn’t have hadanything to do with the default of anypower marketers. It wouldhave had to do with [the fact that] they got several of their bigplants off line.”

Moreover, he doesn’t agree that the contract defaults by powermarketers were the reason for the short run-up in Midwestelectricity prices to $7,000 per MWh in June. “I don’t really buythat. A lot of utilities [were] complaining that some of theintermediary utilities who could have wheeled in the surplus powerfrom either the East Coast or from further West or South wererefusing to [do so], citing transmission-loading constraints ontheir native load.” He thinks this may be a more plausible reason.

In retrospect, the fact that electricity prices in the Midwestgot as high as they did “seems crazy to me,” Chernoff said. “Ican’t see any utility deciding that its incremental customer’sworth $7,000 [per] MWh.”

Susan Parker

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