oversight

Electricity Supply: The Effects of Competitive Power Purchases Are Not Yet Certain

Published by the Government Accountability Office on 1990-08-23.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                                                                       1
           linitecl   States   General   Accounting   Office


GAO        Report t,o t,he Chairman, Subcommittee
           on Oversight and Investigations,
                                                               I ‘:.
           Committee on Energy and Commerce,
           House ol’ Representatives


           ELECTRICITY
           SUPPLY
           The Effects of
           Competitive Power
           Purchases Are Not Yet
           Certain




      S--Not                to be released outside the
       General Accomting Office unless specif’ica&
       appmved by the Office of Congressional
       Belations,
_‘lm.__   _.-.-.--.   I_-_.I   .--   -_._.   ---l.-----
                   united   states
                   General Accounting offlice
                   Washington, D.C. 20648

                   Resources, Community, and
                   Economic Development Divifdon

                   B-240066

                   August 23,199O

                   The Honorable John D. Dingell
                   Chairman, Subcommittee on Oversight
                     and Investigations
                   Committee on Energy and Commerce
                   House of Representatives

                   Dear Mr. Chairman:

                   In response to a request made during an April 1989 discussion with your
                   office, we agreed to review plans for meeting part of the nation’s future
                   electric power needs through utilities’ use of competitive power
                   purchases. This report examines electric utilities’ use of competitive bid-
                   ding to purchase electricity from nonutility generating sources and iden-
                   tifies how such purchases might affect the reliability and cost of electric
                   power.

                   Competitive bidding is a relatively recent development in the utility
                   industry; the first competitive bid solicitation for purchases of elec-
                   tricity occurred in 1984. To respond to your request, we reviewed, as
                   case studies, the experiences of three utilities-Boston    Edison, Central
                   Maine Power, and Virginia Power-that        are among the first U.S. utilities
                   to use competitive bidding for purchases of electricity.


                   Because several years are often required to construct generating
Results in Brief   sources, utilities have little operating experience with competitively
                   purchased electricity. Thus, the effects of competitive power purchases
                   on the long-term reliability of electric service-which    is affected by the
                   reliablity of all sources and transmission and distribution facilities-are
                   not yet certain and difficult to assess. Among the three utilities
                   reviewed, only at Central Maine Power have sources of competitively
                   purchased power entered service, and they have operated reliably. How-
                   ever, each utility reviewed has accepted bids that were subsequently
                   withdrawn, for financial or other reasons, prior to scheduled service
                   dates. When selecting nonutility generators, these utilities act to ensure
                   the reliability of service through establishing project selection criteria
                   and contract terms, which consider, for example, a source’s ability to
                   dispatch power on demand and to demonstrate sound financing. These
                   utilities also have contingency plans if competitively purchased power is
                   not delivered as planned.



                   Page 1            GAO/RCED4@182   J3ffecta of Competitive   Power Farcm   Are Uncertain
             Determining competitive bidding’s long-term effects on the cost of elec-
             tricity requires estimating the future costs and demand for electricity.
             These estimates are uncertain because they rely on assumptions about
             unknown factors like future fuel prices. All three utilities estimated the
             cost of competitively purchased power to be less than the cost of gener-
             ating it themselves or purchasing it from another source, such as a
             neighboring utility. Potential impacts on cost depend in part on how util-
             ities design their bidding systems, for example, on whether utilities
             announce a ceiling price they are willing to pay. Also, potential impacts
             on cost could be affected by constraints that limit the number of eligible
             participants in wholesale markets, such as a lack of access to transmis-
             sion facilities.


             Most electricity in the United States is produced by utilities that own
Background   and operate facilities for the generation, transmission, and distribution
             of power. Utilities traditionally have operated as regulated monopolists,
             each within an established geographic area. In return, utilities have an
             obligation to provide reliable electricity to all consumers in their terri-
             tory at a reasonable price. Many utility companies also participate in
             power pools, under which they may purchase electricity from one
             another to meet requirements. Utilities are allowed to earn a return on
             plants they own and operate, while the costs of purchased electricity are
             passed directly to consumers.

             To encourage the development of alternative energy resources, the
             Public Utility Regulatory Policies Act of 1978, as amended, (PURPA)
             required utilities to purchase power offered by qualifying facilities’ at a
             price not exceeding the utilities’ “avoided cosVz of generating it or
             purchasing it from another source. In part to help state regulators and
             utilities determine utilities’ avoided costs and to help sort through a
             flood of bids, competitive bidding, which allows market forces to help
             determine prices, has emerged as a means of purchasing power from
             nonutility generators (see app. I).



             ‘Qualifying facilities are (1) those that use renewable resources to produce a relatively small amount
             of electricity and (2) cogenerators, which use a single fuel to produce steam for industrial or commer-
             cial purposes (such as paper production) and for electricity production (through a steam turbine).

             “PURPA states that rates for such purchases shall not exceed the incremental cost of alternative
             electric energy. In implementing PURPA, the Federal Energy Regulatory Commission defined avoided
             cost as the cost an electric utility would otherwise incur to generate or purchase power if it would not
             purchase electricity from the qualifying facility.



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                         E240966




                         Nonutility generators could account for 25 percent of all increases in
                         US. electric generating capacity between 1989 and 1998, according to
                         the North American Electric Reliability Council (NERC),” and competitive
                         bidding is expected to play a larger role in procuring this power than it
                         has played in the past. According to the National Independent Energy
                         Producers4 since 1984 utilities or public utility commissions in 27 states
                         have adopted or developed competitive bidding systems, and as of
                         December 1989,41 competitive bid solicitations have been issued in 19
                         states.

                         Because obtaining approval for and constructing a plant take time, a
                         substantial time period-up to 5 years or more-may elapse between a
                         bid solicitation and the date that a selected project is scheduled to enter
                         service. As of March 1990, the three case study utilities had completed a
                         total of eight solicitations and had awarded contracts to purchase 3,053
                         megawatts (MW) of electricity,” but sources capable of producing only
                         225 MW had entered service. Central Maine Power is the only case study
                         utility with projects generating competitively purchased power.


                         Because the purchase of electricity from nonutility generators is a rela-
Impacts on Reliability   tively recent development and competitive bidding even more recent,
                         assessing the long-term effects on reliability is difficult. In 1987 NERC
                         cautioned that competitively purchasing electricity from nonutility gen-
                         erating sources could affect the reliability of electric power in the future
                         because (1) utilities may have less operating control over the sources
                         and (2) nonutility generators, unlike utilities, are not required by regula-
                         tion to serve the public. On the other hand, reliability could be enhanced
                         because nonutility sources have tended to be relatively small plants,
                         whose unexpected outage (temporary loss) generally would have less
                         impact than that of a large plant. Further, as profit-making enterprises,
                         nonutility generators have an incentive to operate reliably.

                         The competitively purchased power from projects that have entered ser-
                         vice at Central Maine Power has been reliable. However, each utility has
                         accepted bids that were subsequently canceled or withdrawn prior to
                         scheduled service dates, generally because the developers of the projects

                         “NERC an organization of nearly all of the electric utility systems in North America, was formed in
                         1968 td promote the adequacy of the power supply and the reliability of the electric system.
                         “The National Independent Energy Producers is an organization representing nonutility generators.

                         “A watt is the basic unit of measuring electrical power. A megawatt is 1 million watts.



                         Page 3                GAO/RCED-90-182      Effects   of Competitive   Power Purchases     Are Uncertain
J3.2400136




were financially or otherwise unable to continue development. Canceled
projects account for only 1.4 percent of the generating capacity of all of
the projects awarded contracts through competitive bidding at Central
Maine Power, but 19.8 percent at Virginia Power and 21.0 percent at
Boston Edison. However, the remaining projects for all three utilities are
expected to provide about the same or more power than the utilities
originally solicited.

The three utilities we reviewed have taken steps to help ensure the relia-
bility of competitively purchased power, employing bid selection criteria
and designing contracts to favor projects that appear most likely to
enter and remain in service in accordance with the utilities’ operating
needs. For example, in choosing among the projects from which the utili-
ties have received bids, ranging from projects that are still in the plan-
ning stage to fully operational ones, utilities consider as part of their
selection criteria the bidders’ progress in obtaining permits, a site,
financing, and an adequate fuel supply.

Contracts typically require nonutility generators to make security
deposits, which are forfeited if the project fails to enter or remain in
service. Other contract terms foster utilities’ control over the power; for
example, bidders offering to supply electricity to Central Maine Power
and Boston Edison must agree to make their facility available, under
certain conditions, for use by the regional power pools. Additionally,
projects are subject to periodic audits to ensure that they are operating
at their claimed capability. Central Maine Power’s contracts also impose
a charge on generating sources if they fail to provide the prescribed
quantity of electricity.

The utilities have also developed contingency plans should they lose any
significant amount of power produced by nonutility generators. For
example, in such a circumstance Central Maine Power would use the
security deposits posted by owners of nonutility projects to purchase
replacement power. At Virginia Power, some contracts give the utility
the right to purchase a failing project from the owner at fair market
value so that the utility could operate the generating source if the non-
utility operator fails. Boston Edison is reducing the potential amount of
time it would need to replace lost power by prelicensing a former plant
site on which it could build its own generating plant. (See app. II for
more details on the impacts of competitive power purchases on
reliability.)




Page 4          GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
                  B240066




                  Determining the effects of competitive bidding on the cost of power
Impacts on Cost   requires comparing estimates of what the future costs and demand for
                  electricity will be. First, an estimate must be made of the utility’s total
                  costs if it would generate the power itself or would purchase it through
                  noncompetitive means (the avoided cost). Next, this estimate must be
                  compared to an estimate of the utility’s total costs if it would purchase
                  the power competitively. Estimating these future costs is difficult since
                  many factors affecting both estimates, such as fuel prices, can fluctuate.

                  Each of the utilities we reviewed estimated the cost of power purchased
                  through competitive bidding to be less than its avoided cost. For
                  example, Boston Edison estimated an 18 percent savings for the power
                  purchased in one bid solicitation. According to Virginia Power officials,
                  the cost of the power purchased from the projects selected in the
                  utility’s first solicitation will be between 5 and 10 percent less than the
                  utility’s estimated cost to provide the power itself. At Central Maine
                  Power, savings from early solicitations may not be as great as originally
                  estimated, in part because the estimated avoided cost included fuel
                  prices higher than those subsequently encountered; however, the com-
                  pany estimates that the cost of electricity from projects selected in its
                  third solicitation will be 5 to 12 percent lower than its avoided cost.


Bidding Systems   In fulfilling their requirement to be reliable suppliers of electricity, utili-
                  ties may incur extra costs to replace a lost generating source. Thus,
                  there is an inherent relationship between the cost and reliability of elec-
                  tric service, and the bid evaluation criteria utilities use to ensure the
                  reliability of a proposed generating source potentially can affect the
                  ultimate cost of purchased power. For example, a proposed source with
                  an experienced management team, sound financing, and/or a secure fuel
                  contract may be more likely to enter and remain in service when speci-
                  fied-and thus ultimately be less costly-than         a proposed source
                  without these characteristics that is offering the power at a lower price.
                  Therefore, potential impacts on cost depend, to some extent, on how
                  utilities design and implement their bidding systems.

                  The three utilities have designed their bidding systems to enhance the
                  reliability, and thus minimize the cost, of the projects selected. Each has
                  developed evaluation systems to account for both price and non-price
                  factors. For example, Central Maine Power requires bidders to demon-
                  strate the feasibility of a project; the adequacy of the fuel supply; and
                  the capability to finance, construct, and operate the project. Factors
                  incorporated in bid evaluations at Central Maine Power include the bid


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                 B.240066




                 price, the ability of the project to meet the regional power pool’s stan-
                 dards, the amount of security deposits, and the ability of the proposed
                 source to dispatch power when requested.

                 The cost of purchased power can also be affected by the information
                 made available to bidders and the bid selection procedures used by utili-
                 ties. For example, announcing a ceiling price that the utility will pay for
                 electricity may affect the prices submitted by bidders: Some bidders
                 may submit bids somewhat higher than they otherwise would have in
                 order to increase potential profits, while others may be induced to lower
                 their bids to increase their chances of selection. The amount and type of
                 information available to potential bidders varied among the three utili-
                 ties; for example, Boston Edison and Central Maine Power published
                 ceiling prices in their solicitations, while Virginia Power did not.


Constraints on   The degree of competition can also affect the cost of competitively pur-
Competition      chased power. The degree of competition, and thus the effect on cost, in
                 part depends on the number of buyers and sellers involved in a market.
                 Several factors, including a lack of access to transmission facilities, eligi-
                 bility criteria specified by utilities, and certain regulatory restrictions,
                 limit the number of participants in wholesale electric generating mar-
                 kets and thus limit the potential for competition to affect cost.

                 In order to purchase or sell electricity, both the generating source
                 (seller) and the utility (purchaser) must be connected via electrical
                 transmission and/or distribution systems. Access to these systems can
                 be limited by utility or state regulatory policies, economic considera-
                 tions, and physical constraints. Inability to access transmission facilities
                 may limit the number of participants in bidding programs. For the three
                 utilities reviewed, state regulatory commission and utility officials
                 stated that access to transmission has not been a problem in obtaining
                 bids for the amount of power solicited; in each case, more electricity was
                 offered than the utilities solicited. However, many transmission facili-
                 ties in the utilities’ areas are near full capacity.

                 Utilities may specify for potential bidders certain eligibility characteris-
                 tics, which may limit their numbers. For example, Central Maine Power
                 and Boston Edison limited their initial solicitations to nonutility genera-
                 tors that were cogenerators or small power producers qualifying under
                 PURPA. Central Maine Power now employs “all source” bidding; that is, it
                 also solicits bids from nonqualifying nonutility generators (those non-
                 utility generators that do not qualify under PURPA); U.S. and Canadian


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                   8240066




                   utilities; and energy conservation projects, which reduce electricity
                   demand rather than increase supply. All source bidding has also been
                   proposed for Boston Edison.

                   In addition, potential power producers may be excluded from bidding
                   competitions by regulatory restrictions on the activities of utilities and
                   power producers. The Public Utility Holding Company Act of 1935, as
                   amended, gave the Securities and Exchange Commission authority over
                   the structure, finances, and operations of holding companies that own
                   more than 10 percent of an electric utility. Firms may decide not to pro-
                   pose generating projects if doing so would subject them to this oversight.
                   However, because it is difficult to know how many potential bidders are
                   dissuaded because of regulatory requirements, it is impossible to deter-
                   mine their impact precisely. (See app. III for more details about the
                   effects of competitive power purchases on the cost of electricity.)


                   While the lack of operating experience with competitively purchased
Observations       electricity makes drawing conclusions about the impact on reliability
                   and cost difficult, observations can be made.

               . The three utilities we reviewed have learned from their initial bidding
                 solicitations and have refined bid evaluation criteria to favor projects
                 with the greatest likelihood of entering and remaining in service. To the
                 extent that other utilities adopt the successful practices of their prede-
                 cessors in designing competitive bidding programs, the reliability of
                 competitively purchased power will be enhanced.
               l While regulators allow utilities to earn a return on their investments in
                 plants they own, utilities are not allowed to earn a return on power pur-
                 chased from nonutility generators; rather, the costs are generally passed
                 directly to consumers. This circumstance may limit utilities’ incentives
                 to rely on purchased power, and thus limit the use of such power
                 purchases.
               l The calculation of avoided costs plays a major role in competitive bid-
                 ding programs. Estimated avoided costs are used as a basis for prices
                 for-and projected savings from- competitively purchased power.
                 Thus, the impact of competitive power purchases on cost depends in
                 large measure on the extent to which these estimates reflect true
                 avoided costs.
           Y




                   To respond to your concerns, we interviewed Department of Energy and
                   Federal Energy Regulatory Commission officials. We also interviewed


                   Page 7          GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
    Et-240066                                                                              r'




    officials at each of the three utilities selected as case studies and
    reviewed the utilities’ requests-for-proposals, selection criteria and
    processes, and model contracts. We did not review actual signed con-
    tracts. We also interviewed public utility commission officials in Maine,
    Massachusetts, and Virginia (the states in which our three selected utili-
    ties operate) and reviewed pertinent state legislation, regulations, and
    policies. In addition, we discussed competitive bidding issues with offi-
    cials of the Cogeneration and Independent Power Coalition of America
    and the National Independent Energy Producers, organizations repre-
    senting nonutility generators, and NERC. We also reviewed studies and
    reports by other organizations regarding competitive bidding issues.
    (App. V contains more details on our objectives, scope, and
    methodology.)

    Utility officials reviewed the technical information in the report. How-
    ever, as you requested, we did not obtain formal agency comments on
    this report. We performed our work in accordance with generally
    accepted government auditing standards. Our review was conducted
    between May 1989 and April 1990.

    As arranged with your office, unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days from
    the date of this letter. At that time, we will provide copies to appro-
    priate House and Senate committees; the Secretary of Energy; and the
    Director, Office of Management and Budget. Copies will also be made
    available to other interested parties who request them.

    Should you have questions or need additional information, please con-
    tact me on (202) 276-1441. Major contributors to this report are listed in
    appendix VI.

    Sincerely yours,



p-w
u
    Victor S. Rezendes
    Director, Energy Issues




    Page 8             GAO/RCED90-182   Effects   of Competitive   Power Purchases   Are Uncertain
Page 9   GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
Contents                                                                                                      ,



Letter
Appendix I
Background               Purchasing Power Through Competitive Bidding
                         Competitive Bidding at Three Selected Utilities

Appendix II
Impacts of               Reliability of Electrical Systems
                         Competitive Power Purchases Could Affect Reliability
Competitive Power        Utilities Have Limited Experience With Competitively
Purchases on Long-              Purchased Power
                         Utilities Have Taken Steps to Ensure Reliability
term Reliability Are
Uncertain
Appendix III                                                                                                       24
Effects of Competitive   Savings Estimates Rely on Assumptions About Future
                             costs
                                                                                                                   24
Power Purchases on       Utilities Estimate Cost Savings From Competitively                                        25
Cost Are Difficult to           Purchased Power
                         Design and Implementation of Bidding Systems Can                                          26
Determine                       Affect Potential Cost
                         Constraints on Participation in Bidding Programs Limit                                    29
                                Potential Effects on Cost

Appendix IV                                                                                                        32
Differences Between      The Efficiency of Cogeneration
                         Capital Costs
                                                                                                                   32
                                                                                                                   32
Utilities’ and           Other Theories                                                                            33
Nonutility Generators’
Cost of Production
Appendix V
Objectives, Scope,and
Methodology




                         Page 10         GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
      .


                        Contents




Appendix VI                                                                                                         36
Major Contributors to
This Report
Tables                  Table 1.1: Utilities’ Solicitations, Bid Offers, and Awards                                 15
                        Table II. 1: Status of Power Projects Selected Under                                        19
                            Competitive Bidding
                        Table 11.2:Power Projects Awarded, Canceled, and                                            20
                            Remaining




                        Abbreviations

                        GAO        General Accounting Office
                        MW         megawatt
                        FERC       Federal Energy Regulatory Commission
                        NEPOOL     New England Power Pool
           Y
                        NERC       North American Electric Reliability Council
                        NIEP       National Independent Energy Producers
                        PUHC4      Public Utility Holding Company Act of 1935, as amended
                        PURPA      Public Utility Regulatory Policies Act of 1978, as amended


                        Page 11          GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
Appendix I
                                                                                                                    ,
Background


                      The U.S. electric power industry is a combination of privately, publicly,
                      federally, and cooperatively owned electric utilities. Privately owned
                      utilities, also referred to as investor-owned utilities, account for more
                      than 76 percent of the generating capability of all U.S. electric utilities.
                      The majority of these companies are organized as integrated monopolies.
                      An integrated utility is one that owns and operates the facilities used for
                      all three stages of supplying electricity: generation, transmission, and
                      distribution. As a monopoly, an electric utility provides electricity in its
                      designated geographic service area, with no competition from other
                      suppliers.

                      To obtain a franchise, electric utilities must provide service to all con-
                      sumers in their territory at a reasonable price. Traditionally, utilities
                      have relied on their own generating equipment to satisfy their electric
                      power needs, but many utility companies have also joined “power
                      pools,” under which they coordinate plans for facilities and arrange
                      purchases of power from one another to meet their obligations. Regula-
                      tors permit utilities to earn a return on plants they build, while the costs
                      of purchased electricity are passed directly to consumers.


                      The Public Utility Regulatory Policies Act of 1978, as amended, (PURPA)
Purchasing Power      was enacted in part to encourage efficiency in generating electricity. In
Through Competitive   addition to providing incentives to utilities to use alternative fuel
Bidding               sources, the act encouraged the development of nonutility generators,
                      that is, sources of electric power not primarily owned by utilities. PURPA
                      promoted this development by requiring that utilities purchase power
                      offered by qualifying facilities. Qualifying facilities are (1) small power
                      production facilities with a generating capacity of less than 80 mega-
                      watts (MW)' using renewable energy resources such as geothermal or
                      wood waste sources and (2) cogeneration facilities, which use one fuel
                      source to produce heat or steam for industrial or commercial purposes
                      and for electricity production. An example of a cogenerator is a univer-
                      sity facility that produces steam in a central plant for heating campus
                      buildings and also generates electricity with the steam.

                      The utilities are required to buy electricity from qualifying facilities at a
                      price that does not exceed the utilities’ “avoided cost,” or the utilities’
                      cost of generating power or obtaining it from another source, such as a
                      neighboring utility. State utility commissions determine avoided costs

                      'A watt is the basic unit of measuring electrical power or the rate of doing work. A megawatt is 1
                      million watts.



                      Page 12               GAO/RCED-90-182      Effects   of Competitive   Power Purchases Are Uncertain
Appendix I
Background




following guidance issued by the Federal Energy Regulatory Commis-
sion (FERC), which is responsible for regulating wholesale electrical
power transactions.

In part to help state regulators and utilities determine utilities’ avoided
costs and to help sort through a flood of bids, competitive bidding,
which allows market forces to help determine prices, has emerged as a
means of purchasing power from nonutility generators. Subsequently,
competitive bidding has become a means of purchasing power from
other sources, such as other utilities, and for selecting projects that are
designed to conserve electricity by reducing demand.

Recognizing that some states were experiencing difficulty in determining
avoided costs, in 1988 FERC proposed regulations endorsing competitive
bidding as a tool in setting a utility’s avoided cost. Competitive bidding
is useful in determining avoided costs because it facilitates the identifi-
cation of a utility’s supply alternatives. The regulations included spe-
cific guidance on the use of competitive bidding and sanctioned such
bidding as an option for purchasing power from qualifying facilities
under PURPA. However, the regulations were issued in conjunction with
other proposed regulations allowing changes in the electric generating
industry that were controversial. The Commission has not taken final
action on the proposals.

The use of competitive bidding to purchase electricity from nonutility
sources has increased in recent years. According to the National Inde-
pendent Energy Producers,2 since 1984 utilities or public utility commis-
sions in 27 states have adopted or developed competitive bidding
systems, and as of December 1989,41 competitive bidding solicitations
have been conducted in 19 states. Further, the amount of power
acquired from all nonutility sources is expected to increase in the future.
The North American Electric Reliability Council (NERC>~estimates that
nonutility generators will supply a small but increasing share of U.S.
power in the coming years, growing from 2 percent in 1989 to 3.9 per-
cent by 1998. NERC also estimates that between 1989 and 1998 these
generators will supply 18,100 MW, or 25 percent of all projected
increases (72,000 MW) in U.S. electric generating capacity.



“The National Independent Energy Producers is an organization representing nonutility generators.

:‘NERC, an association of nearly all the electric utilities in North America, was formed in 1968 to
promote the adequacy of the power supply and the reliability of the electric system.



Page 13                GAO/RCED-90-182      Effects   of Competitive   Power Purchases   Are Uncertain
                                                                                                                       ,
                      Appendix 1
                      Background




                      Boston Edison, Central Maine Power, and Virginia Power were among
Competitive Bidding   the first utilities in the nation to use competitive bidding for purchasing
at Three Selected     electricity. Each is a regulated investor-owned utility operating as a
Utilities             franchise monopoly.

                      Central Maine Power is Maine’s largest electric utility, serving about 70
                      percent of the state’s population. It provides electricity for approxi-
                      mately 475,000 customers in an 1 1,000~square-mile service territory. In
                      1989 the utility had approximately $1.3 billion in total assets and $704
                      million in operating revenue.

                      Boston Edison serves a population of about 1.5 billion in its 590-square-
                      mile service territory, which encompasses Boston and surrounding
                      towns and cities within a 30-mile radius. In 1989 Boston Edison had
                      approximately $2.9 billion in total assets and $1.3 billion in operating
                      revenue. Like Central Maine Power, Boston Edison is a member of the
                      New England Power Pool (NEPOOL), a voluntary association of electric
                      utilities that generate about 99 percent of the electricity generated in
                      the region. NEPOOL coordinates power generation throughout the region,
                      distributing the most economical power first, as if the members’ facili-
                      ties were elements of a single system.

                      Virginia Power, a subsidiary of Dominion Resources, Inc., serves over
                      1.7 million customers in Virginia and North Carolina. The company
                      serves 80 percent of Virginia’s population. In 1989 the company’s total
                      assets were $10 billion, and operating revenues were $3.5 billion. Vir-
                      ginia Power is a member of the Virginia-Carolinas Subregion, a group in
                      which each member utility dispatches power within its own system.

                      Each of these utilities expects to rely increasingly on nonutility genera-
                      tion sources to meet future needs. In 1989 Virginia Power, the largest of
                      the three, had a system capability of 13,714 MW, of which only 2 percent
                      was supplied by nonutility generators.4 By the year 2000, the utility
                      estimates that such sources could account for 19 percent of its capa-
                      bility. In 1989 Central Maine Power had 14 percent of its system capa-
                      bility of 2,077 MW provided by nonutility sources, while Boston Edison
                      received less than 1 percent of its 3,483 MW capability from such
                      sources. Both utilities estimate that nonutility generation could account
                      for as much as 25 percent of their capability by the year 2000.


                      ‘System capability refers to a system’s total generating station capability, plus capability available
                      from other sources through firm contracts at the time of the system’s peak demand.



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            .


                                               Appendix1
                                               Background




                                               As shown in table 1.1, the three utilities have completed a total of eight
                                               solicitations for generating capacity and have awarded contracts to
                                               purchase 3,053 MW and to save an additional 18 MW of power through
                                               energy conservation projects. As of March 1990, two solicitations were
                                               in progress.


Table 1.1:Utilities’ Solicitations, Bid Offers. and Awards
                                                                Solicitations                     Bid Offers                        Awards
                                                                                Capacity     Capacity    Number of           Capacity    Number of
Utility                                                Number         Date         PW           WV          projects            (MW)       projects
Boston                                                        1st      l/07           200          1,850                61          341                    8
Edison
                    __   ..~-..--.---                        2nd      4189            200          2,836                48          200                     2
Central         -
                                                             --1st    5184            100            462                65          150                   27
Maine
                                                             2nd      9/84            100            314                26          153                     a
Power
                                                             3rd      6187            100          1,444                51          123                     8
                                                              4th    12187            100            908                45           laa                  -G
                                                              5th     5189            700          2,841                50                b                   -b
Virginra                                                      1st     3188          1,750         14.653                95        2.086                       19
Power
                                                             2nd     11188            300          2,139                26            OC                       0"
                                                             3rd      a/09          1,100         11,600                78                b                     b



                                               ‘Central Maine Power awarded these contracts to energy conservation       projects and requested that
                                               remaining bidders offer proposals in its fifth solicitation.

                                               “At the completion of our review, bids were still under consideration

                                               “The solicitation was completed, but no awards were made


                                               For each solicitation, the utilities issue a request for proposals that typi-
                                               cally indicates how much power the utilities will need and when they
                                               will need it, as well as any technical specifications the utilities require.
                                               After the utilities evaluate the bids, they award contracts to the winning
                                               bidders. The final terms of these contracts are often determined through
                                               negotiations. Boston Edison, Virginia Power, and Central Maine Power
                                               have used competitive bidding for long-term power purchases for
                                               periods of up to 20,25, and 30 years, respectively.

                                               The competitive bidding process at Boston Edison differs from the pro-
                                               cess at Central Maine Power and Virginia Power. Boston Edison pro-
                                               vides more detailed information to the prospective bidders in its
                                               solicitation and is more tightly constricted by the results of the bidding
                                               process; Boston Edison’s bidding process is the result of regulations the
                                               Massachusetts public utility commission has issued governing competi-
                                               tive bidding. The Maine and Virginia commissions have allowed utilities
                                               to develop their own bidding programs.


                                               Page 16                 GAO/RCED-90-182       Effects   of Competitive   Power Purchases       Are Uncertain
                                                                                       ,
Appendix I
Background




The extent to which utility management has discretion in final selection
and contract negotiation differs among the three utilities. Boston Edison
must award contracts to those bidders with the highest project scores.
However, the utility has discretion in determining bid evaluation criteria
and scoring systems. The utility can only exercise the right to reject bids
in limited circumstances. Massachusetts commission regulations do not,
in most instances, allow Boston Edison to initiate contract negotiations
with the winning bidders; the utility must normally use a standard con-
tract that has been approved in advance by the commission. Boston
Edison is only allowed to negotiate on the specific provisions of a con-
tract if the winning bidder initiates negotiations.




Page 16         GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
         .
Appendix II

Wpacts of Competitive Power Purchaseson
Long-term Reliability Are Uncertain

                     Because competitive bidding for purchasing electricity is a relatively
                     recent development and time for construction is necessary for bringing
                     new sources into service, assessing how power purchased competitively
                     will affect the reliability of electric service in the long term is difficult.
                     For the utilities that served as our case studies, the few sources that
                     have entered service from which the utilities have competitively pur-
                     chased electricity have operated reliably; however, each utility has
                     accepted bids that were subsequently withdrawn before the projects
                     entered service. The utilities have taken precautions to ensure the relia-
                     bility of nonutility generators by specifying certain conditions in project
                     selection criteria and contract terms. The utilities also have developed
                     contingency plans.


                     Utilities are responsible for providing reliable electric service to their
Reliability of       customers. As defined by NERC, the reliability of a bulk electric power
Electrical Systems   system is the degree to which system elements deliver power to con-
                     sumers within accepted standards, in the amount desired and at the
                     time desired. Components of reliability include the system’s ability to
                     supply the aggregate electric power demanded by consumers at all
                     times, and its ability to withstand sudden disturbances such as short
                     circuits or the unexpected failure of components.

                     NERC establishes operating guidelines and reliability standards for North
                     American utilities. Because utilities are interconnected and the actions
                     of one utility can affect others, NERC'S regional councils and utilities
                     have planning and operating guides to help coordinate utilities’ actions
                     and thus ensure reliable electric service.

                     Utilities employ a mix of generating facilities to maintain service,
                     including “baseload” and “peaking” facilities. The former are those that
                     utilities run more or less continuously to meet daily electricity demand.
                     The latter type are those used during periods of peaking demand, such
                     as on the hottest or coldest days, Achieving reliability in the generating
                     portion of their electric systems requires utilities to maintain a certain
                     amount of excess capacity, which must be sufficient to cover unex-
                     pected reductions in generating capability or unforseen increases in
                     demand. The difference between a utility’s generating capacity and its
                     forecast peak demand is called its capacity margin.

                     In periods of growing electricity demand, utilities must secure additional
                     generating sources to maintain an adequate capacity margin and ensure
                     reliable service. The availability of a particular electricity generating


                     Page 17          GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
                     Appendix II
                     Impacts of Competitive    Power Purchases     on
                     Long-term Reliability  Are Uncertain




                     source, the degree to which it can be counted on to provide power when
                     needed, can affect the reliability of the electrical system. While U.S. util-
                     ities have good records of supplying power when needed, they have
                     experienced problems with the availability of individual plants.


                     The increase in the use of nonutility generators has led to concerns
Competitive Power    about how the reliability of electric service may be affected. Utilities
Purchases Could      have traditionally controlled source availability by owning the gener-
Affect Reliability   ating facilities; thus, contracting for electricity from a nonutility source
                     introduces a new element of uncertainty. Furthermore, a source’s “relia-
                     bility” depends not only on how it performs once on-line, but also on an
                     assurance that it will actually come into service on time.

                     NERC'S 1987 guidelines for incorporating    nonutility generators into the
                     nation’s bulk electric system point out ways in which utility companies’
                     use of nonutility generators may affect reliability. First, utilities buying
                     power from nonutility sources do not necessarily have direct control
                     over the nonutilities’ operational decisions that can affect the long-term
                     availability of the sources and, in turn, the reliability of the system.
                     Second, utilities’ obligation to serve the public may not coincide with
                     nonutility generators’ interests. States obligate utilities to provide reli-
                     able service to all customers in their service territory; in contrast, non-
                     utility generators are responsible only for fulfilling contract terms to
                     provide power to utilities. Officials at one of the utilities we reviewed
                     noted that without the obligation to serve the public, nonutility genera-
                     tors may have an incentive to abandon the enterprise if it should
                     become unprofitable.

                     However, the use of nonutility generators also has the potential to
                     enhance reliability in some ways. For example, most nonutility genera-
                     tors have tended to be relatively small units (the average generating
                     capacity of units receiving contracts in the three utilities’ first solicita-
                     tions was 48 MW; in comparison, many coal and nuclear powered units
                     are designed to produce 800 to 1,000 MW). By relying on a number of
                     small plants rather than one large plant, utilities reduce the potential
                     effects of the failure of a single plant because the temporary loss of a
                     smaller unit has less impact on the stability of the entire system than an
                     outage of a larger unit has. And, of course, the simultaneous outage of a
                     number of plants is less likely than the temporary loss of a single plant.
                     Further, because sales of electricity to utilities are the only source of




                     Page 18              GAO/RCED-99-182        Effects   of Competitive   Power Purchases   Are Uncertain
-.-
                                                     Appendix It
                                                     Impacts of Competitive   Power Purchases    on
                                                     Long-term Reliability  Are Uncertain




                                                     revenue for most nonutility generators (excluding cogeneration facili-
                                                     ties), nonutility generators have a strong incentive to keep their units
                                                     operating reliably.


                                                     Although among the first US. utilities to competitively purchase power,
Utilities Have Limited                               the three utilities we reviewed have had little experience incorporating
Experience With                                      competitively purchased power into their operating systems. The utili-
Competitively                                        ties first began soliciting bids 2 to 6 years ago, but, because there is a lag
                                                     in time of up to 5 or more years between the contracting for and the
Purchased Power                                      delivery of power, only one of the utilities has begun receiving competi-
                                                     tively purchased power. However, utility and commission officials have
                                                     a favorable view of the reliability of nonutility sources that have come
                                                     into service.

                                                     Table II. 1 shows that among the three utilities’ competitive purchases of
                                                     electricity, 30 projects, with a generating capacity of 225 MW, have
                                                     entered service. Of the three utilities in our case studies, Central Maine
                                                     Power is the only one with operating projects that are generating com-
                                                     petitively purchased power.


Table 11.1:Status of Power Projects Selected Under Competitive Bidding
                                                                Number of projects and their trenerating capacity (MW)
                                                      Under development              In operation                   Total
Utility                -   ~-..             _____-    Number Capacity             Number Capacity            Number Capacity
Bost&      Edison                                                         2         268                      0               0                  2          268
                                                      ______---.
Gritral    Maine Power                                                    9         195                     30             225                 39          420
                         ^“I..- ...--_____   __--~       ---_.-___-
Virginia   Power                                                         14       1,672                      0               0                 14        1,672
Total       ..                                                          25        2,135                     30             225                 55        2,360


                                                     Although they have limited experience in purchasing power from non-
                                                     utility sources, the three utilities are expecting to rely increasingly on
                                                     such power. For example, at Virginia Power and Central Maine Power,
                                                     the amount of electricity purchased from nonutility generators is
                                                     expected to be larger than their anticipated capacity margin in the year
                                                     2000, which suggests that the utilities plan to rely heavily on purchased
                                                     power.




                                                     Page 19              GAO/RCED-90-182       Effects   of Competitive     Power Purchases    Are Uncertain
                                                                                                                                                    ,
                                          Appendtv II
                                          Impacts af Competitive   Power Purchases         on
                                          Lung-term Reliability  Are Uncertain




Early Projects Have Been                  The nonutility sources that have entered service have operated reliably,
Reliable                                  according to utility officials. At Central Maine Power none of the 30
                                          projects contracted under competitive bidding that have come into ser-
                                          vice has subsequently failed although three projects did not meet their
                                          initially scheduled dates for entering service. However, many of these
                                          sources existed prior to the advent of competitive bidding. Central
                                          Maine Power officials stated that their operational nonutility sources
                                          have done well and have generally been able to provide power when
                                          requested to do so. According to a Virginia Power official, nonutilities’
                                          performance for projects contracted before the advent of competitive
                                          bidding has been excellent. A Virginia public utility commission official
                                          noted that some nonutility generators have had greater availability than
                                          those owned by Virginia Power, but he noted this might be because the
                                          nonutility generating sources generally are newer.

-
SomeAccepted Projects                     Each of the utilities we reviewed has selected projects that have subse-
Have Failed to Enter                      quently been canceled, as shown in table II.2 Further, more projects
                                          could be canceled, because many are not scheduled to come into service
Service                                   until the early to middle 1990s.


Table 11.2:Power Projects Awarded, Canceled, and Remaining
                                    Number of projects and generating capacity (MW)
             Solicited        Awarded                  Canceled                  Remaining                                   Percent canceled
Utility      capacity Number          Capacity Number           Capacity Number          Capacity                          Number        Capacity
B&On
Edson            200        8              341             6                    73              2                    268      75.0                      21.0
Fa;;z'
Power            300       43              426             4                     6           39                      420        9.3                      1.4
Vlrgmia
Power          1,750        19           2,086             5                  414            14                  1,672        26.3                      19.8
                                          Note: The table reflects only the results of completed solicitations-Boston       Edison’s and Virginia
                                          Power’s first solicitations. and Central Maine Power’s first three solicitations.


                                          Projects have been canceled for a variety of reasons, including devel-
                                          opers’ (1) problems in obtaining financing, permits, or sites; (2) failure
                                          to post security deposits; (3) finding projects economically unfeasible;
                                          and (4) failure to meet interim project milestones. Still, the remaining
                                          projects for all three utilities are expected to provide about the same or
                                          more power than the utilities solicited.




                                          Page 20                 GAO/RCED-90-182        Effects    of Competitive    Power Purchases Are Uncertain
                             Appendix II
                             Impacta of Competitive    Power Purchases    on
                             Long-term Reliability  Are Uncertain




                             In developing competitive bidding programs, each of the utilities has
Utilities Have Taken         taken steps to help ensure the reliability of power purchased from non-
Steps to Ensure              utility generators. These steps include devising project selection criteria
Reliability                  that favor more reliable projects and contract terms that specify certain
                             conditions designed to promote reliability. The utilities also have devel-
                             oped contingency plans to compensate for the unexpected loss of a non-
                             utility source.


Project Selection Criteria   Each of the utilities uses project selection criteria to favor projects that
Foster Reliability           not only will come into service as planned, but that will remain in ser-
                             vice. For example, in choosing among the projects for which the utilities
                             have received offers, ranging from projects that are still in the planning
                             stage to fully operational ones, utilities consider before awarding con-
                             tracts bidders’ progress in obtaining permits, a site, financing, and an
                             adequate fuel supply.

                             The utilities also use selection criteria to favor those nonutility genera-
                             tors that can best meet the utilities’ operating needs. Because utilities
                             desire to control the amount of power that nonutility generators deliver
                             at any given time so the utilities can respond to fluctuations in demand,
                             each of the three utilities favors projects that will dispatch power in
                             response to demand.

                             The utilities have used their early experiences with competitive bidding
                             to incorporate additional safeguards to ensure reliability. For example,
                             in developing its selection criteria for its second solicitation, Boston
                             Edison increased the weight of factors that ensure reliability. It also
                             required that selected projects meet certain development milestones in
                             order to keep them on schedule and to increase the likelihood of success.


Contract Terms Encourage     The utilities have adopted various contract provisions designed to
Availability of Sources      increase the likelihood of reliable service. For example, contracts require
                             nonutility generators to make security deposits, which are forfeited if
                             the project fails to enter or remain in service. Model contracts used by
                             Boston Edison and Virginia Power require security deposits of $15 and
                             $36 per kilowatt, respectively, which are forfeited if the project fails to
                             enter service. Central Maine Power’s standard contract imposes a
                             security deposit of $68 per kilowatt, in accordance with NEPOOL
                             requirements.




                             Page 21              GAO/RCED-90-182        Effects   of Competitive   Power Purchases   Are Uncertain
                         Appendix II
                         Impacts of Competitive    Power Purchases     on
                         Long-term Reliability  Are Uncertain




                         Once a project comes into service, the contracts Central Maine Power
                         uses require owners to triple the security deposit to offset the possible
                         costs of immediately replacing a lost power source. Boston Edison’s
                         selection process favors nonutility generators that volunteer to provide
                         a deposit once a project is completed.

                         Other contract terms encourage the utilities’ control over the power.
                         Bidders offering to supply electricity to Central Maine Power and
                         Boston Edison must agree to make the power their facility generates
                         available, under certain conditions, to be dispatched by the regional
                         power pools. Additionally, the projects are subject to periodic audits to
                         ensure that they are operating at their claimed capability. The contracts
                         Central Maine Power uses also impose a charge on generating sources if
                         they fail to provide the prescribed quantity of energy, or if they fail to
                         achieve a capacity factor averaging 80 percent.]

                         Virginia Power’s contracting procedures generally ensure that power
                         purchased through competitive bidding is dispatched in accordance with
                         the needs of the utility’s operations center. For example, project opera-
                         tors must provide daily information on project availability and must
                         submit maintenance schedules to Virginia Power.


Contingency Plans A.re   The utilities have also developed contingency plans to replace power
                         should they experience any significant loss from nonutility generators.
Designed to Ensure       For example, in such a circumstance, Central Maine Power would use
Replacement Power        the security deposits posted by nonutility projects to purchase replace-
                         ment power, if the power is available. According to utility officials, how-
                         ever, it is difficult to know whether security deposits would completely
                         cover the costs of replacing the power.

                         At Virginia Power, some contracts give the utility the right to purchase
                         a failing project at fair market value; through such a purchase, the
                         utility could operate the generating source. Also, to compensate for the
                         potential loss of projects, Virginia Power has contracted to purchase
                         about 20 percent more power than it requested under its first bid solici-
                         tation In addition, Virginia Power assumes in its planning process that
                         half of the projects will be delayed past their originally established ser-
                         vice dates.

                         ‘The capacity factor indicates the percentage of electricity (measured in kilowatt hours) a generator
                         actually produces during a specific time period compared to the amount it could have produced if it
                         had operated continuously at full capacity.



                         Page 22               GAO/RCED-90-182       Effects   of Competitive   Power Purchases   Are Uncertain
.


    Appendix II
    Impacts of Oompetitive   Power Purchases     on
    Long-term Reliability  Are Uncertain




    Boston Edison is reducing the potential amount of time it would need to
    replace lost power by prelicensing a former plant site on which the
    utility could build its own generating plant. In its long-range planning
    efforts, Boston Edison also considers the probability that some con-
    tracted projects will fail.




    Page 23              GAO/RCED-SO-182       Effects   of Competitive   Power Purchases   Are Uncertain
Appendix III

Effkcts of Competitive Power Purchaseson C&t
Are Difficult to Determine

                      Competitive bidding’s effects on cost are difficult to determine because
                      they require assumptions about future costs and demand for electricity,
                      which are uncertain. The utilities serving as our case studies estimated
                      the cost of power purchased through competitive bidding to be less than
                      the cost of generating the power themselves or purchasing it through
                      existing practices from another source, such as another utility. The
                      potential impacts on cost are affected to some extent by the design and
                      implementation of bidding programs. The impacts on cost may also be
                      affected by factors that limit the competitiveness of wholesale elec-
                      tricity markets, such as constraints on the number of market
                      participants.


                      Determining the impact of competitive bidding on cost involves com-
Savings Estimates     paring (1) the utility’s ultimate cost of providing electricity, including
Rely on Assumptions   the cost of purchasing it from projects awarded contracts through com-
About Future Costs    petitive bidding with (2) the cost the utility would have incurred had it
                      provided power under an alternative approach. To make this compar-
                      ison, both of these future costs must be estimated and there are uncer-
                      tainties affecting each option.

                      Estimates of the impact of competitive bidding on cost depend upon pro-
                      jections of up to 30 years into the future for a variety of factors that
                      could influence the future cost of power. For example, two important
                      factors affecting the cost, whether the power is competitively purchased
                      or not, are the anticipated demand for electricity and the cost of fuel.
                       Demand for electricity depends primarily on economic activity and elec-
                      tricity prices; thus, utilities must estimate these variables in order to
                      estimate demand. However, these factors are in turn uncertain; for
                      example, electricity prices are influenced by fuel prices, which have
                       fluctuated in the past. According to a utility official, actual demand fre-
                      quently differs from what is forecast because of unforeseen factors such
                      as weather and changing economic conditions.

                      Uncertainty also surrounds estimates of future construction costs. Each
                      of the utilities has based the estimated costs and operating characteris-
                      tics of unbuilt plants on generic industry cost data, rather than on cost
                      studies for specific projects in specific locations. Central Maine Power
                      has also used the estimated cost of a coal-fired thermal generating unit
                      planned by a neighboring Canadian utility. The utilities have stated that
                      it would not be cost-effective to conduct detailed cost studies for plants
                      they do not reasonably expect to build. However, relying on generic cost
                      data may add further uncertainty to the estimates.


                      Page 24         GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
                          Appendix III
                          Effects of Competitive   Power Purchases    on
                          Coat Are Dif’flcult to Determine




                          Additionally, the long-term cost of power, whether or not it is competi-
                          tively purchased, depends on the reliability of the generating sources.
                          Utilities incur additional costs if their own generating plants prove unre-
                          liable since they must replace the power a plant being repaired would
                          have generated, generally with higher cost power from other plants
                          within their system or with purchased electricity. Similarly, utilities
                          may also have to replace the power nonperforming nonutility generators
                          would have generated. Consequently, bidding systems may favor bids
                          offering many features that would indicate reliability over bids with a
                          lower price and fewer such features. (As noted in app. II, the utilities
                          that were our case studies incorporate an assessment of the reliability of
                          proposed sources into their bid evaluation criteria; thus, the cost of
                          ensuring reliability is to some extent reflected in the price the utility
                          agrees to pay.) The reliability of both utility and nonutility sources must
                          be estimated in calculating the cost impact of competitive bidding.


                          Each of the three case study utilities estimated the cost of power pur-
Utilities Estimate Cost   chased through competitive bidding to be less than their avoided costs.
Savings From              The calculations of avoided costs are not the same among the three utili-
Competitively             ties. We did not analyze in detail the methodologies or assumptions the
                          utilities used to calculate their avoided costs or the projected cost sav-
Purchased Power           ings from competitive bidding. However, each avoided cost calculation is
                          subject to review by each utility’s state regulatory commission.

                          Boston Edison determined that power purchased in its second solicita-
                          tion would cost 18 percent less than its estimated cost to provide the
                          power itself over the life of the contracts. According to Virginia Power
                          officials, the power purchased from the utility’s first solicitation was
                          between 5 and 10 percent less than the utility’s estimated cost to pro-
                          vide the power itself, but the utility rejected all bids from its second
                          solicitation because they came in above the utility’s estimated cost to
                          provide the power.

                          At Central Maine Power, the avoided cost is estimated annually. At the
                          time of its first two solicitations, Central Maine Power awarded con-
                          tracts to purchase electricity at rates below its avoided cost. However,
                          officials at Central Maine Power and the Maine Public Utilities Commis-
                          sion stated that the approved avoided costs have turned out to be some-
                          what high because of certain underlying assumptions, such as higher oil
                          prices than those subsequently encountered. Therefore, savings from
                          the early solicitations may not have been as great as anticipated. Central



                          Page 25              GAO/RCED-90-182       Effects   of Competitive   Power Purchases   Are Uncertain
                                                                                                                          7---
                          Appendix ID
                          Effects of Competitive   Power Purchases    on
                          Cost Are Difficult  to Determine




                          Maine Power calculated that the costs of contracts from its third solici-
                          tation were 5 to 12 percent below its estimated costs to generate the
                          power itself.


                          The potential impacts of competitive bidding on cost depend in part on
Design and                how utilities design and implement bidding systems. Important consider-
Implementation of         ations are the bid evaluation criteria, the type and amount of informa-
Bidding Systems Can       Lion made available to potential bidders, and the bid selection process.

Affect Potential Cost

Bid Evaluation Criteria   When evaluating bids to purchase power through competitive bidding,
                          utilities employ non-price factors as well as bid prices. One of the most
                          important factors, as noted in appendix II, is the reliability of the
                          bidder’s proposed generating source. Because they are obligated to pro-
                          vide reliable electric service, utilities may incur extra costs to be able to
                          supply power when a generating source fails to perform as expected.
                          (Perhaps equally important, when a source fails, electricity consumers
                          face potentially large costs from significant power interruptions since
                          many modern conveniences depend on electricity.) Thus, there is an
                          inherent relationship between the cost and reliability of electric service,
                          and the emphasis placed on ensuring the reliability of a proposed gener-
                          ating source potentially can affect the ultimate cost of purchased power.

                          The relationship between reliability and cost enters utilities’ bid evalua-
                          tion process in utilities’ consideration of non-price factors. For example,
                          utilities need to coordinate output from generating sources with demand
                          fluctuations so as to ensure a supply of electricity when and where it is
                          demanded; thus, one non-price factor may be the ability of a proposed
                          project to coordinate operations with the utility. Other desirable non-
                          price factors might include an experienced management team, sound
                          financing, and/or a secure fuel contract (if the source is a thermal gener-
                          ating unit). A proposed source with these non-price characteristics may
                          be more likely to enter service when specified and to remain in service
                          over the period of the contract than a proposed source without them.

                          Boston Edison, Central Maine Power, and Virginia Power have devel-
                          oped evaluation systems to account for both price and non-price factors.
                          For example, Central Maine Power requires bidders to demonstrate the




                          Page 26              GAO/RCED-90-182       Effects   of Competitive   Power Purchases   Are Uncertain
                       Appendix Ill
                       Effects of Competitive   Power Purchases    on
                       Cost Are Difficult  to Determine




                       feasibility of the project; the adequacy of the fuel supply; and the capa-
                       bility to finance, construct, and operate the project. Factors incorpo-
                       rated in project scoring at Central Maine Power have included the price
                       of the bid, the ability of the project to meet power pool standards, the
                       ability to post security deposits, and the ability of the proposed source
                       to dispatch power when requested.

                       Boston Edison specifies in its solicitations the evaluation criteria it will
                       use to choose successful bidders and the weight each criterion will
                       carry. Factors used by Boston Edison when evaluating bids include the
                       bidder’s proposed cost, the economic risk to ratepayers, the likelihood
                       that the proposed source will enter service, and the likelihood that the
                       proposed source will operate efficiently over the life of the contract.

                       Virginia Power, when evaluating bids, assigns a weight of 70 percent to
                       price and a total of 30 percent to non-price factors. The non-price fac-
                       tors include project viability, the proposed type of fuel, and the ability
                       of proposed generating sources to dispatch power when requested.


Information Made       The information utilities make available to potential bidders when solic-
Available to Bidders   iting bids can affect cost. For example, announcing a ceiling price that
                       the utility will pay for electricity may affect the prices submitted by
                       bidders. Some bidders may submit bids somewhat higher than they
                       otherwise would have in order to increase potential profits. Conversely,
                       some bidders may be induced to lower their bid prices to increase their
                       chances of selection. A utility’s selection of bids that have been lowered
                       unrealistically (whether or not in response to an announced price) ulti-
                       mately could increase the utility’s cost if the selected projects fail to
                       enter service or to operate reliably. Boston Edison and Central Maine
                       Power have published ceiling prices in their solicitations, while Virginia
                       Power has not.

                       Other types and the amount of information made available to potential
                       bidders varied among the three utilities we reviewed. Massachusetts
                       utility commission regulations require that Boston Edison’s solicitations
                       contain information on how the utility will determine eligibility, the
                       selection criteria it will use to choose successful bidders, and the relative
                       weight of each selection criterion. Consequently, potential bidders can
                       determine if their projects are eligible before they submit their pro-
                       posals, and each can calculate its score and make adjustments to
                       increase the likelihood of its selection.



                       Page 27              GAO/RCED-SO-182       Effects   of Competitive   Power Purchases   Are Uncertain
                                                                                                                    .

                           Appendix III
                           Effects of Competitive   Power Purchases    on
                           Cost Arc Difficult  to Determine




                           Central Maine Power included its avoided cost in its first four bid solici-
                           tations. The utility did not do so for the fifth solicitation; however, the
                           avoided cost was available to the public at the Maine Public Utilities
                           Commission. Central Maine Power will also provide bidders with enough
                           information so that they can determine their project score; however,
                           officials stated that the project score is not necessarily the determining
                           factor in deciding to award a contract for power. Officials also observed
                           that it would be difficult to determine whether stating the avoided cost
                           in a solicitation increased or decreased the bid prices.

                           While Virginia Power informs bidders about the factors it uses to eval-
                           uate project proposals, bidders do not have enough information to calcu-
                           late their project score. Like Central Maine Power, Virginia Power
                           employs a computer model to perform analyses that bidders cannot rep-
                           licate. In contrast with Boston Edison’s scoring approach, Central Maine
                           Power’s and Virginia Power’s approaches use non-price factors more
                           subjectively to differentiate bidders, making it more difficult for bidders
                           to evaluate their proposal.


Bid Selection Procedures   The collective impact on cost of a group of generating sources selected
                           through competitive bidding depends in part on the process utilities
                           employ in bid selection. Generally, if bids are evaluated independently
                           of one another (incorporating both price and non-price factors), the
                           projects are ranked and then selected beginning with those with the
                           highest rankings. However, this process does not recognize bid interde-
                           pendence, that is, the possibility that two or more projects with signifi-
                           cantly different rankings may complement one another, or collectively
                           complement the utility’s system, costing less overall and/or enhancing
                           the system’s reliability. For example, a group of geographically dis-
                           persed projects might better serve a utility’s scattered centers of
                           demand than a group of projects in a single location.

                           Among the three utilities, both Virginia Power and Central Maine Power
                           consider bid interdependence when evaluating bids. Both utilities eval-
                           uate groups of bids, assigning values to both price and non-price factors,
                           rather than each bid independently, and use a computer model to deter-
                           mine the optimal composition of projects.




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                          Appendix III
                          Effects of Cbmpetitlve   Power Purchases   on
                          Cost Are Diffkult   to Determine




                          Competitive bidding for electric power sources represents a movement
Constraints on            away from the traditional noncompetitive industry structure in which
Participation in          utilities have relied on their own generation facilities. The degree of
Bidding Programs          competition and thus the effect on cost in part depend on the number of
                          buyers and sellers involved in a market. Several factors limit the
Limit Potential Effects   number of participants in wholesale electric generating markets, and
on Cost                   thus the potential for competition and its effects on cost. These factors
                          include the lack of access to transmission facilities, specific eligibility
                          criteria, and certain regulatory restrictions.


Accessto Transmission     In order to purchase or sell electricity, both the generating source
Facilities                (seller) and the utility (purchaser) must be connected via electrical
                          transmission and/or distribution systems. Access to the transmission
                          system can be limited by utility or commission policies, economic consid-
                          erations, and physical constraints. For the three case study utilities, a
                          lack of access to the transmission system has not been a problem in
                          obtaining the quantity of power solicited, according to state regulatory
                          commission and utility officials; in each case, more electricity was
                          offered than the utilities solicited. However, according to a Central
                          Maine Power official, the utility might have received even more bids if
                          transmission access were completely unconstrained.

                          The extent to which a utility controls the transmission of electricity in
                          its service territory can, from a potential bidder’s point of view, limit
                          the number of buyers for the bidder’s electricity. For example, if a
                          utility does not allow “wheeling” (the practice of using the utility’s
                          transmission facilities to send power to another utility or purchaser),
                          then the utility in effect is the only available buyer. (Being forced to sell
                          to a single buyer could lead to inefficiency if another potential buyer is
                          willing to pay more for the same electricity). Similarly, from a utility’s
                          point of view, a lack of access to transmission facilities can also restrict
                          the number of bidders. For example, the utility may be unable to obtain
                          electricity from a potential bidder located outside the utility’s service
                          area if an intervening utility does not allow wheeling.

                          Both the public utility commissions of Maine and Massachusetts require
                          utilities to wheel power from nonutility generators qualifying under
                          PUHPA. However, a Boston Edison official noted that some northeast util-
                          ities offer wheeling only when they are not fully using their transmis-
                          sion systems themselves. The Virginia commission has not required
                          wheeling, but in its bid solicitations, Virginia Power offered to wheel



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                                                                                                                    ,

                          Appendix III
                          Effecta of Competitive   Power Purchases    on
                          Coat Are DifWult    to Determine




                          power from nonselected qualifying facilities to neighboring utilities to
                          which it is interconnected.

                          Transmission access is also subject to physical constraints, which could
                          limit the number of potential bidders. For example, officials told us that
                          transmission facilities in parts of New England, particularly southern
                          New Hampshire and northern Massachusetts, and facilities neighboring
                          Virginia are being used nearly at full capacity. As a result there are con-
                          straints on wheeling additional power through these areas.

                          Even when capacity is available, wheeling may not be economical for
                          the bidder to arrange; that is, the price may be prohibitive. For example,
                          a Central Maine Power official noted that the amount of electricity
                          imported to the utility from outside NEPOOLcould be limited because of
                          fees charged by intervening utilities.


Utility Eligibility       In bid solicitations, utilities may specify certain characteristics that bid-
Requirements              ders must meet to be eligible to participate. Such eligibility require-
                          ments, many of which are designed to enhance the reliability of
                          contracted sources, may limit the number of potential sellers.

                          Two of the utilities studied-Central     Maine Power and Boston Edison-
                          limited their initial solicitations to nonutility generators qualifying
                          under PURPA. Central Maine Power now employs “all source” bidding;
                          that is, it also solicits bids from nonqualifying nonutility generators,
                          US. and Canadian utilities, and energy conservation projects. Central
                          Maine Power also requires that bidders finance their proposed projects
                          with a minimum of 26 percent equity. Although this requirement could
                          increase the cost for the bidder, the bidder’s investment of its own funds
                          gives added incentive for it to bring the project into service and operate
                          the project reliably. The Massachusetts Department of Public Utilities
                          has proposed requiring Boston Edison (and other Massachusetts utili-
                          ties) to use all source bidding, which would include generating sources
                          or conservation projects proposed by the soliciting utility itself.

                          Virginia Power solicits bids from both nonutility generators and other
                          utilities but does not solicit bids from energy conservation projects or
                          from affiliates.
               Y

Regulatory Restrictions   Some potential power producers may be excluded from bidding competi-
                          tions by regulatory restrictions on the activities of utilities and power


                          Page 30              GAO/RCED-30-182       Effects   of Competitive   Power Purchases   Are Uncertain
Appendix III
EfWcts of Competitive   Power Purchsses    on
Cost Are Diffknlt  to Detkmnine




producers. For example, state commissions may restrict power pro-
ducers affiliated with a regulated utility from participating in competi-
tive bid solicitations of that utility, in order to guard against possible
improprieties. The Public Utility Holding Company Act of 1936, as
amended, (PUHCA) also restricts utility owners in ways that could dis-
suade potential bidders from participating in the bidding process.
Enacted to protect investors and consumers from potential abuses of
utility holding companies, PUHCA gave the Securities and Exchange Com-
mission broad authority over the structure, finances, and operations of
holding companies that own more than 10 percent of an electric utility.
Firms may decide not to propose generating projects if doing so would
subject them to this oversight.

The costs imposed by regulatory requirements may also affect the
number of potential bidders. We noted that the winning bidders in one
solicitation by Virginia Power included a disproportionate percentage of
nonutility generators that are qualifying facilities under PURPA. As quali-
fying facilities, these generators are exempt not only from certain PUHCA
requirements but also from certain Virginia state regulations, such as
regulation of their rate-of-return, According to a Virginia Power official,
the exemptions may give these projects advantages that allow them to
submit lower bids.

Because it is difficult to know how many potential bidders are dis-
suaded because of regulations, it is impossible to determine their impact
precisely. Further, the impact regulatory restrictions have on cost is a
matter of some debate. Appendix IV discusses additional reasons for
possible differences between utilities’ and nonutility generators’ cost of
production.




Page 31             GAO/RCED90-182        Effects   of Competitive   Power Purchases   Are Uncertain
Appendix IV

Differences Between Utilities’ and Nonutility -
Generators Cost of Production

                    The proliferation of small nonutility generating sources following pas-
                    sage of the Public Utility Regulatory Policy Act of 1978, as amended,
                    (PURPA)has raised questions about the costs of generating electricity and
                    has led to some debate among economists and others. For those con-
                    cerned with minimizing electric rates for consumers while ensuring suf-
                    ficient reliability, the reasons for such cost differences may be
                    important.

                    A traditional economic argument for allowing electric utilities to exist as
                    integrated franchise monopolies is that such an arrangement results in
                    the lowest cost to consumers. This argument relies on the existence of
                    certain economies of scale (declining unit costs as the scale of operations
                    grows larger) in generation, transmission, and distribution. However,
                    the trend in the sizes of plants constructed by utilities, as well as the
                    existence of a number of nonutility generating sources, has raised some
                    question about this argument for electricity generation.

                    We reviewed available literature and questioned utility and commission
                    officials and representatives from associations of nonutility generators
                    as to why nonutility generators were able to provide power at a lower
                    cost than the utilities’ cost of generating it themselves. The following
                    summarizes some of the principal explanations.


                    Utility officials noted that cogenerators- one class of nonutility genera-
The Efficiency of   tors qualifying under PURPA-have an inherent advantage because they
Cogeneration        use the same fuel to produce steam for industrial or commercial pur-
                    poses as well as for electricity production, and receive revenues from
                    both sources. Utilities generally do not sell steam. This enables cogener-
                    ators to market electricity at a lower cost; for example, a cogenerator
                    can cover its cost with revenues from selling electricity and from selling
                    excess steam to an industrial plant, or from selling a product which
                    requires steam in its manufacture, such as paper.


                    Some argue that nonutility generating facilities that qualify under PURPA
Capital Costs       may enjoy lower capital costs (the costs of financing the construction of
                    generation facilities), because PURPAexempts them from provisions of
                    the Public Utility Holding Company Act that require power producers to
                    maintain a certain debt-to-equity ratio. Qualifying facilities can there-
                    fore finance their projects with a higher percentage of debt, according to
                    this argument, so their cost of capital is lower than a utility’s would be.



                    Page 32         GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
                     Appendix N
                     MfPerences Between Utilities’  and Nonutility
                     Generators’ Cost of Production




                     In contrast, others, such as the National Independent Energy Producers,
                     suggest that nonutility generators do not have lower capital costs.
                     According to this view, nonutility generators must borrow at a higher
                     interest rate than utilities because, unlike utilities, nonutility generators
                     are not guaranteed the opportunity to earn a minimum financial return
                     by regulators. However, some utilities may enjoy lower interest rates
                     because they have a history of successful financial operations.


                     Officials we contacted during our review offered several other possible
Other Theories       explanations as to why bidders in the solicitations reviewed may be able
                     to provide power at a lower cost than the utilities themselves. The
                     explanations include the following:

                 . Some industrial bidders can issue their own debt or are involved in con-
                   sortia of architect/engineering firms, equipment firms and/or fuel sup-
                   pliers. Such economies of integration may lower these bidders’ costs.
                 . Nonutility generators have less corporate overhead cost than utilities.
                   For example, the utilities must follow more regulatory procedures,
                   which increases their costs.
                 9 Nonutility generators may spend less on maintenance, especially during
                   periods when other costs are increasing.
                 l In increasing generating capacity, cogenerators adding a boiler to an
                   existing cogenerating facility may comply more easily with environ-
                   mental regulations than would utilities constructing a new generating
                   source. However, this may depend on the size of the addition.

                     It is important to note that the differences in the costs of generating
                     electricity between utilities and nonutilities may be caused by institu-
                     tions surrounding the industry. For example, rate-of-return regulation
                     may provide utilities incentives to use an inefficient combination of
                     inputs (capital, labor, and fuel), which may raise costs unnecessarily. In
                     the case of cost of capital, differences in the tax treatment of debt
                     versus the tax treatment of equity may make debt cheaper than equity;
                     however, utilities’ monopoly status and protection from competition
                     may provide minimum financial returns.




                     Page 33              GAO/RCED-90-182      Effects   of Competitive   Power Purchases   Are Uncertain
Appendix V

Objectives,Scope, and Methodology                                                                  -


               In April 1989 the office of the Chairman, Subcommittee on Oversight
               and Investigations, House Committee on Energy and Commerce, asked
               us to review a number of issues relating to utilities’ plans for meeting
               the nation’s future electric power needs. On the basis of that request and
               a subsequent discussion, we agreed to examine selected utilities’ exper-
               iences with purchasing electricity through competitive bidding and iden-
               tify the potential impacts of purchasing from nonutility generating
               sources on the reliability and the cost of electricity.

               We used a case study approach to identify how three selected utilities-
               Central Maine Power, Boston Edison, and Virginia Power-have con-
               ducted competitive bid solicitations for purchases of electric power and
               to identify factors that may influence the cost and reliability of power
               purchased competitively. In reviewing potential impacts on cost, we
               focused on the utilities’ costs of supplying power, rather than on the
               ratepayers’ prices because consumers’ prices for electricity can be
               affected not only by the utilities’ costs, but also by the ways in which
               state regulatory commissions treat utilities’ costs.

               The three utilities were selected because they were among the first utili-
               ties in the nation to use competitive bidding for purchasing power. We
               supplemented the information from these cases by reviewing the pub-
               lished literature on power purchases from nonutility generators,
               including reports, studies, and journal articles.

               At each of the three utilities, we interviewed utility officials for infor-
               mation on their experience with competitive bidding. We reviewed
               utility requests-for-proposals from bidders, selection criteria, and model
               contracts. We did not analyze the methodologies or assumptions utilities
               used in estimating the costs they avoided by competitively purchasing
               power, nor did we review actual signed contracts.

               Because the three selected utilities are investor-owned utilities subject
               to state regulation, we interviewed public utility commission officials in
               Maine, Massachusetts, and Virginia. We also reviewed pertinent state
               legislation, regulations, and policies.

               We discussed competitive bidding with officials at the U.S. Department
               of Energy, the Federal Energy Regulatory Commission, and of two orga-
               nizations representing nonutility generators: (1) the Cogeneration and
               Independent Power Coalition of America and (2) the National Indepen-
               dent Energy Producers. We discussed concerns about the reliability of



               Page 34         GAO/RCED-90-182   Effects   of Competitive   Power Purchases Are Uncertain
    .,
.
         Appendix V
         Objectives, Scope, and Methodology




         nonutility generators with officials of the North American Electric Reli-
         ability Council and reviewed the organization’s relevant reports.

         Although we did not obtain official comments from those entities
         included in our review, we discussed the report’s factual contents with
         appropriate utility and commission officials. We performed our work in
         accordance with generally accepted government auditing standards. Our
         audit work was conducted between May 1989 and April 1990.




         Page 35              GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
Appendix VI

Major Contributors TVThis Report                                                                                       *


                                  Judy England-Joseph, Associate Director
Resources,                        David G. Wood, Assistant Director
Community, and                    Charles W. Bausell, Jr., Senior Economist
Economic                          Philip G. Farah, Staff Economist
                                  Alice M. Alexander, Staff Evaluator
Development          Division     Peter H. Griffes, Doctoral Research Fellow
Washington, D.C.

                                  James S. Jorritsma, Regional Manager’s Representative
Boston     Re@ona1       Office   Bruce Skud Evaluator -in -Charge
                                  Linda W. Dunbrack, Staff Evaluator




(006388)                          Page 30         GAO/RCED-90-182   Effects   of Competitive   Power Purchases   Are Uncertain
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