Cascade Policy Institute

Introduction

Recently, BPA announced a public review of the agency's role in the region. Expected to last through 1996, this process may result in new federal legislation in early 1997 that would alter the federal role in the region's electricity market. The last time the Northwest went through a similar exercise, in the late 1970s, it produced the Northwest Power Act, which expanded BPA's prior legal authorities, created programs responsible for the transfer of hundreds of millions of dollars annually, spawned a now-outdated experiment in centralized power planning, and helped stimulate an expensive but so far not very successful effort to protect endangered Northwest salmon populations. This time, the region should really confront the most fundamental questions. Given the expense and failures of the current fish protection efforts, and the dubious record of centralized power planning, should the traditional federal solutions, which permit only a small number of decision-makers, be replaced with decentralized property rights and decision-making? Should the citizens of the Northwest continue to fund Congressionally-mandated agencies through their electric rates, or should they shift to a reliance on decentralized market forces instead to generate and deliver electrical power, fund energy conservation activities, and protect the region's environment?

In order to answer these questions, there must be a review of the BPA's functions and a determination of likely candidates for activities to be transferred to the market.

Power Marketing

(1) BPA assumed the responsibility for collecting funds to pay the debt of the region's development of nuclear power;

(2) BPA was required to "internalize" environmental costs associated with protecting anadromous salmon (salmon migrating from salt water to spawn in fresh water), collecting funds through its rates to pay for an expanded program of hatcheries, research, barging of juvenile fish downstream, and a host of other activities;

(3) BPA was directed to fund a variety of income-transfer programs; and

(4) BPA's rates were low enough in 1980 that there was no pressure to develop internal operating efficiencies that could offset the external cost pressures imposed by the first three obligations.

Since the early 1980s, BPA's costs have skyrocketed and the cost of alternative power supplies has collapsed. Where BPA once enjoyed an insurmountable price advantage, competitors now threaten the agency with a significant loss of market share. BPA proposes to sell firm, uninterruptible electrical power for about 2.5 cents per kilowatt-hour, delivered to the region's utilities, for five years starting in October 1996. Depending on the kinds of price risk the buyer is willing to take, it is possible to find firm medium-term supplies below BPA's price, and spot market power is regularly available at one-half of BPA's firm price. New sources of generation, such as gas-fired combustion turbines, can produce power at a delivered price below BPA's, and without the risk of political influence over that price for the next five years.

BPA's competitive advantage is gone, providing an opportunity (and an obligation) to ask, who should be charged with selling the output of these resources? If BPA, should the agency have the unique legal protections and unilateral discretion of a federal entity in a market that is increasingly competitive? Conversely, are there good reasons to forbid a federal entity to exercise its discretion and use its unique legal powers over concerns that this would interfere with the development of competitive power markets in the Northwest? Based on BPA's decisions regarding many contracts in 1995, the answer at this point appears to be "yes".

When the extent of its exposure to competitive markets became evident in early 1995, BPA began terminating many contracts previously signed with power and conservation suppliers, including agreements to buy the output of a large combustion turbine in western Washington and a small hydroelectric project in Oregon, and to pay for conservation investments around the region.[1] According to trade journals, the spectacle of a U.S. government agency refusing to honor contracts has outraged project financiers, including Japanese banks.[2]

If BPA is allowed to decide unilaterally when commercial contracts should be terminated, the Northwest may suffer a higher cost of capital and thus a higher than necessary cost of new generation facilities, in order to cover the risk of conducting business with am agency of the federal government. In addition, BPA's inability to commit to commercial-grade contracts for the sale of electricity imposes a similar handicap, substantiated by recently signed agreements under which BPA will sell power to most of the region's aluminum smelters over the next five years. These customers, representing about $500 million in annual revenues to the agency, have negotiated the right to terminate their contracts on seven days' notice if BPA does not agree with the decision of an arbitrator in the case of a dispute. This kind of recourse was apparently necessary given that prior contracts with the BPA have proven to be less reliable than contracts with private or even other public agencies. However, it also carries a significant risk to U.S. taxpayers: a future Administrator of BPA may decide that the unilateral ability to exercise discretion is paramount, in which case the agency's ability to cover its costs could be jeopardized, and the U.S. taxpayers could be required to pay for this discretion if as a result BPA defaults on its debt payments to the Treasury. Changes appear to be necessary to put BPA under the same commercial obligations as other power suppliers.

Costs

There are three groups who might bear this "cost": ratepayers, shareholders, and utility officers and employees. First, consumers could be required to cover this possible loss through higher electric rates. In this case, the investment is not "stranded", but consumers do not gain the benefits of competition either. Second, the shareholders of private utilities could be required to absorb a loss through write-offs of the assets, thereby reducing the value of their outstanding shares. In this case, shareholders could argue in response that the investments were originally approved by the regulatory agencies, are now worth less because of new regulatory actions, and so they should be compensated for taking on this risk when they invested in the company. Third, the utility itself could be required to "internalize" the costs: management and other employees could bear some of the pain, through downsizing, reductions in bonuses, salaries or benefits, or greater effort in finding markets for these assets, but without greater reward. In reality, some combination of higher rates, write-offs, and downsizing is likely, depending on the state regulatory climate, and most utilities are preparing for this eventuality by already beginning the painful transition.

As other utilities around the country have looked for internal cost savings, BPA's efforts to reduce its costs up till now have appeared to focus on external suppliers and its major creditor, the U.S. Treasury.[3] So far, BPA has terminated several contracts with external suppliers and has increased the chance that its "mortgage payments" to the U.S. Treasury will be missed. However, BPA has also threatened to impose "exit fees" on customers who choose to purchase power from alternative suppliers. One of the most difficult issues in 1996 will be whether BPA will be permitted to continue on a relatively slow path to downsizing, requiring Northwest consumers to subsidize BPA's new "business lines" through at least the turn of the century. At this point, there is no obvious reason why these subsidies should be required: although there is no obligation on BPA's part to return any profits to those making the investments, BPA expects Northwest consumers to cover the losses that the new business lines will sustain.

So, what to do? Given contractual uncertainties and the desire or need for subsidies, there is no obvious advantage to retaining BPA as the marketer of the region's major hydroelectric and nuclear resources. Simply looking for a marketing agent is a clear area where relying on some degree of competition appears to have promise.[5] With the environmental liabilities of the hydroelectric system, private ownership of the dams is an unlikely and unrealistic alternative. However, even if the ownership of the resources remains in federal hands, the marketing function could be put out to bid, and many operational aspects could also benefit from an injection of competition.

In any event, the existing institutional structure may well succumb to the effort to operate the Columbia River in a more "fish-friendly" manner. If environmental restrictions on dam operations become even more stringent, BPA's electricity may be forced onto the spot market (daily, weekly, and maybe monthly), significantly reducing the price that could be charged. If this occurs, BPA could face as much as a billion dollar annual gap between its fixed costs, including overheads, and its revenues, and restructuring will be inevitable. Instead of confronting that crisis cold in 1997 or later, one of the debates in 1996 should address replacing BPA's marketing function with a competitively provided brokering arrangement, which might be better able to respond to dramatic and abrupt changes in the electrical potential of the dams.

Transmission

What should happen to the region's transmission system? One way of addressing this question is to consider structures that would increase incentives for efficient construction, operation and use of the transmission grid. Costs can generally be kept under control either by competitive market forces or by regulatory oversight, although both have imperfections. In the near term, there is a need to have both. More effective regulation than in the past can force BPA to offer to sell transmission rights that could be assigned or resold, thus stimulating the development of a secondary market in the right to transmit or wheel power over BPA's lines. A decentralized secondary market in transmission rights would be more likely to promote the redefinition of transmission services and the sale of such services in ways that would maximize their value than would continued centralization. In addition, more value from the existing transmission system would help postpone the need to build new transmission lines, which can raise both esthetic and environmental issues.

How should the operation and maintenance (O&M) of the transmission system be organized? Over the years, BPA's customers have amassed considerable anecdotal evidence of the inefficiencies associated with the current organization of maintenance activities. Evidence submitted in the current BPA rate case suggests that BPA's O&M costs may be two or three times as high as those of comparable utilities. Also, BPA now reportedly views its transmission system as a source of potential profits, and has simply refused to allow local utilities to purchase federal substations and transmission lines in their areas. This suggests two changes.

First, BPA could be required to use competitive bidding for all maintenance activities; more competition is likely to lead to reduced costs. Second, BPA could be required to offer to sell any low-voltage transmission asset through an expedited negotiation or bidding process. (Low voltage facilities would be a good place to start because of a likely comparative advantage on the side of non-federal entities.) These actions might move tens of millions of dollars of substations and low-voltage transmission lines into the hands of those who are most directly affected by the quality and cost of these facilities: the region's utilities and industries.

Energy Conservation, Renewable Resources, and Research

Many environmental and public interest groups believe that markets alone cannot be relied on to provide the "right" level of conservation, and that utilities should be required to collect and spend money on this particular activity. Given the currently low level of power prices, less conservation is probably a natural consequence of the operation of the market, at least in the short run. However, if some amount of conservation activity should be mandated, there are more efficient ways to conserve electricity than relied on to date. Instead of giving a federal agency the authority to effectively tax and then spend the resulting funds, it would be more efficient to raise the required money through some kind of across-the-board sales tax on electricity, and then require that the funds be disbursed only through a competitive bidding process. The effective tax rate could be quite small if the tax base were large enough (e.g., total retail sales of electricity in the region), which would not distort consumers' choices among competing suppliers. The overheads associated with this mechanism could also be quite small, and thus get much more energy conservation for the dollars spent.

Protection of the Northwest Salmon

Unfortunately, this is not a simple issue. Where property rights are ill-defined, as they are for a species that migrates hundreds of miles and lives for much of its adult life in the ocean, markets are an imperfect way of allocating rights to use the resource. Survival of this species is subject to a wide variety of human actions, and the "externalities" associated with these human activities clearly interfere with any attempt to define property rights. For example, how much is the decline in survival rates of juvenile fish passing downstream due to grazing, logging, dams, water pollution, predators (some of which are also protected by federal laws), road-building, competition from federally-mandated and sometimes federally-funded hatchery fish, or activities not yet considered? Notwithstanding this complexity, surely it can be concluded by now that the federalized approach to decision-making on this issue has failed. It is time to experiment with depoliticized decision-making and decentralized incentives whenever possible. The upcoming public debate should focus on some basic issues.

First, there need to be independent scientific judgments that are free of politics. Despite a centralized source of funding (revenues from BPA's sale of federal power), a system has been sustained with decision-makers at both the state and federal levels. This Balkanization of the fish recovery effort has spawned bureaucratic disputes and judicial actions, keeping many lawyers and biologists employed but contributing little to the goal of protecting the fish. Some have called for a "super-agency" to "coordinate" the separate state and federal environmental agencies. Although that approach might help avoid some political disputes, calls for a super-agency miss an important point: the multiplicity of state and federal agencies and other interested groups helps stimulate competing ideas, which is good, but the political nature of the decision-making bodies thwarts neutral decision-making.

What is needed is a group of disinterested decision-makers with the scientific background necessary to weigh the biological evidence and the economic trade-offs at stake. Ideas can be allowed to compete much more than they have, if the decision-makers are insulated from political pressures. A group of empowered scientists (mainly biologists but with a few economists as well), could evaluate all ideas under two constraints: the resulting decisions could not have a total cost above some set amount, which would presumably be collected from those using hydroelectric power, and the decisions could not be appealable except on limited grounds, such as not being given the opportunity to be heard. This scientific approach is already contemplated by the Endangered Species Act, but has been basically ignored in the heat of recent political battles.

Second, more and better-organized information is needed. One real tragedy of the 1980s was the inability to collect data on the costly experiments that were conducted on fish migration, because state and federal agencies could not agree on protocols for collecting data and, according to some observers, because the agencies had made up their minds and did not want to be confused by the facts. Independent scientists could be given the authority to engage in the kind of research and data-collection that would help find solutions, even if those solutions contradicted preconceived notions of the truth.

To complement the independent scientific judgments about what should be done, the authority to implement these decisions needs to be moved from the state and federal levels wherever possible and to individuals who will have a stake in the outcome. Two promising ideas include local watershed conservation groups and tradable fishing rights, which would address very important stages of the life cycle of the fish: spawning habitat and survival as adults in the ocean. The process would require the definition of property rights, the creation of legal forms of those rights, the auction or assignment of such rights to individuals or groups who will be responsible for the fish, and permission for the rights to be traded on secondary markets. If the government can create the right to a narrow portion of the radio-wave spectrum, or the right to put a ton of sulfur dioxide into the atmosphere over a year, and trust those holding their rights to protect them through the operation of standard contract law, then why not at least try to do something similar for the fish?

Instead of assuming that property rights are impossible to create and thus must be managed by political agencies, we could hold contests for the most creative approaches to defining property rights in anadromous fish. These rights could differ by species, watershed, geographical area, spawning habitat, migration path, and so forth. Once defined, we need procedures for transferring those rights initially. Certain rights could easily be auctioned off, such as those associated with ocean fisheries, because of their inherently commercial nature, but another approach is necessary for spawning habitat and migration paths. Instead of competing to pay for these rights, environmental groups, governmental agencies and others could compete against each other to be paid to protect the fish, by submitting bids stating their qualifications and commitments. Contracts could be written under which the winning bidders would agree to provide tangible services and deliverable results, such as the restoration of a specific spawning habitat. In order to have some reasonable prospect of continued funding, the winning bidders would have to demonstrate that their ideas had some positive effect on the fish; we could hope to see evidence that good ideas are triumphing over bad. Because of the life cycles involved, the initial contracts might have to last several years, but would carry no guarantee of renewal or continued funding after expiration. Again, it would help if the decisions on funding were made by scientists with the appropriate expertise.

Income Transfers

In addition, BPA funds the activities of various state and inter-state agencies, including the Washington State Energy Office, the Oregon Department of Energy, and the Northwest Power Planning Council. These are also income transfer programs, because there are few enforceable obligations, if any, on the part of any of these agencies to produce particular services in return for the funding. Most ratepayers in Oregon would probably be surprised to find out that some of the money they send their local utilities each month is going to support agencies of state government in Washington, Idaho, and Montana. The questions here are, which of these activities should be continued, if any, and if so how should they be funded? Should Northwest consumers pay for these agencies through their electric rates, or should the electorate be given a more direct degree of control over this portion of their incomes, for example by requiring appropriations from state legislatures?

One common victim of deregulation is the income transfer, and it should not be surprising if transfer programs in electricity disappear as well over the next few years. Many transfers mandated by state regulators (and by BPA) would survive a direct test of voter action, and thus should be continued. Others may not. However, instead of funding these programs through raising some electric rates and perhaps reducing others, why not ask the voters directly if these activities are worth while? If they are, either state legislative funding could be used, or a tax could be assessed and the proceeds disbursed through some kind of competitive process.

Summary

The real debate should start with the fundamentals: what system of incentives and ownership is most likely to result in an efficient outcome? Individuals operating via markets and within smaller institutions could be relied on to a greater extent than previously in almost every aspect of BPA's business, from the maintenance of the high-voltage transmission system to the restoration of endangered species, from the marketing of electricity from federal dams to the investment in energy conservation programs. Every function currently performed by BPA should be examined from the perspective that competitively structured markets may be a more efficient means to the end.

About the Author

Endnotes