Competition and power supply: threats and opportunities for distribution systems.

There has been an increase in wholesale competition since the passage of the Energy Policy Act in 1992. In wholesale competition, distribution entities get to choose the power supplier. But we now face retail competition, where consumers make that choice.

Retail wheeling and wholesale competition can both have dramatic impacts on G&T and distribution cooperatives. Approximately 728 distribution co-ops own and have all-requirements contracts with G&Ts. One-hundred and twenty three coops buy most or all of their wholesale power from TVA or power marketing administrations. And 56 distribution co-ops buy power from IOU suppliers.

The key questions are these.

* How has wholesale competition impacted the G&T-distribution system relationship?

* How are cooperatives that are members of G&Ts impacted in states with retail wheeling?

* And how are co-ops that don't own G&Ts impacted by wholesale and retail competition?

The Energy Policy Act revolutionized the wholesale power market by giving wholesale customers vastly increased access to transmission, opening up new competitive power supply options. Wholesale customers include cooperatives and other utilities that buy power for resale to end-use consumers.

FERC Order Numbers 888 and 889, issued in 1996, set out general conditions on how wholesale customers can obtain transmission service. One result has been an increase in the number of power marketers and independent power producers seeking to profit in this new market. Another result is the availability of new power supply options, typically shorter-term in nature and often at lower cost.

Significantly, FERC did not nullify existing long-term power contracts, such as G&T all-requirements contracts. For the 728 distribution co-ops that are members of G&Ts, we can say something definitive. The passage of the Energy Policy Act and the emergence of wholesale competition did not directly impact the G&T-distribution system relationship with regards to the all-requirements contract. It has, however, had an indirect impact.

But the passage of state retail wheeling, while it does not directly impact the contract, it does impact the relationship - at least in one significant sense. If consumers have a choice and buy power from a supplier other than the G&T, the distribution cooperative will still recover its "wires" charge, but its power requirements will have decreased. In retail wheeling, the distribution co-op is still contractually obligated to buy all of its power from the G&T. It just may have fewer requirements, and that could be a problem for both the G&T and the distribution system.

Since the passage of the Energy Policy Act, the price of power in the interruptible economy and short-term markets has fallen significantly. In 1992, one G&T's average purchase price for this type energy was $25 per megawatt hour. By 1996, this fell to under $21 per megawatt hour. In addition, in some regions of the country, new 5-year firm wholesale power contracts are said to be available at 29-35 mills per kilowatt hour.

Cooperatively owned G&T firm wholesale power delivered to member co-ops has also fallen in price - from an average of 44.9 mills per kilowatt hour in 1990 to 43.2 mills in 1995 - a 4% decrease. But some G&T power prices have not fallen to the levels now said to be available, at least in the short run, in the wholesale power market.

The situation is this. Wholesale competition, combined with large amounts of surplus generating capacity, new lower cost, more efficient generation technologies, current low natural gas prices, and the existence of new players with deep pockets willing to build market share by selling at or below cost, have resulted in extremely low prices in the bulk power market.

In some regions, many G&T's are weil positioned to meet - and beat - this competition. But these low, shorter-term prices have led some co-ops to ask if the benefits achieved through joint ownership of generating assets through a G&T still exist. At the same time, some power marketers and IOUs are courting co-ops, raising questions about the unity and future of our program.

A similar discussion is occurring among some co-ops that buy power from TVA or power marketing administrations. Such cooperatives don't face all of the same legal obligations as those that are members of a G&T, but the planning and risk factors that must be faced are similar.

We do not preach unity for its own sake. Distribution systems lie at the core of our program, and they and we must act to ensure their competitive advantage and long term success. However, the wholesale power issues that impact distribution co-op competitiveness must be carefully examined. These are the issues we will address:

1. The nature of the all-requirements contract. What is the contract, and what are the rights and risks inherent in the distribution/G&T relationship?

2. The changing environment. Why has it changed, and what wholesale power purchase options are available to distribution systems and under what conditions?

3. Assessing a change in your power supply relationship. What factors should be addressed when considering a contract buyout? If going it alone, what capabilities must a distribution co-op have in place to manage its power requirements? And what legal issues should be addressed in assessing a change in its relationship with its G&T?

4. Assessing future opportunities. For systems that own a G&T, how can it be managed as an asset to ensure the highest level of performance? What new opportunities will be presented to distribution systems as a result of participation in a G&T; and how are systems addressing the issue of more flexibility in the all-requirements contract?

On the surface, the G&T all-requirements contract is a contract between a distribution entity and a power supply entity whereby the distribution system pledges to purchase all of its power supply needs from the G&T and the G&T pledges to provide them. But it's much more. To see the contrast, consider that in the wholesale market, utilities can enter into power purchase contracts as buyers and sellers. As such, they are independent parties capable of evaluating their own needs and market opportunities. Exhibit 1 presents an image of this relationship.

This description does not apply to the G&T/distribution system relationship. The all-requirements contract is not between two independent parties, and is unlike others in the industry. The distribution systems created the G&Ts, own them and control their operations. This relationship does not exist between typical buyers and sellers in the bulk power market. Distribution coops are in effect contracting with themselves and each other. Conceptually, the relationship is like that in Exhibit 2.

The most significant federal ruling to clarify the unique nature of the all-requirements contract is the Shoshone ruling, decided in the 10th circuit Federal court in 1989. This suit was brought when Shoshone, a distribution system member of Tri-State G&T, attempted to negotiate a sell-out to PacifiCorp, an Oregon-based IOU. The issue addressed by the court involved the consequences of the proposed sell-out to Tri-State and its other members. In considering this question, the court reached at least three significant conclusions. First: "The all-requirements contract is not a routine arm's length requirements contract between unrelated, private, for-profit parties. Shoshone's participation in the Tri-State system and its interrelationship with Tri-State and the other members of the Tri-State system make the parties' contractual relationship a unique one. The all-requirements contracts which form the Tri-State system are not simple requirements contracts but rather interdependent, joint and mutual contracts with a common purpose of securing the REA loans and thereby effectuating the REA policy to provide the economic means for supplying electricity to rural areas."

Thus, the court ruled that unlike two-party buyer/seller contracts typically entered into with or by investor-owned utilities, the cooperative all-requirements contract is a multi-party agreement creating interlocking relationships among the G&T and all of its member systems, designed to secure a long-term debt.

The second conclusion is that REA - now RUS - is materially connected to the contract. The distribution system's promise to purchase requirements for a definite term is explicitly related to the G&T's indebtedness to RUS. The obligation to pay the G&T's debt implies that the distribution system will remain in business and maintain its power purchase requirements throughout the term of the contract, as long as there are sufficient consumers requiring electric power. The court said that if Shoshone were to eliminate its requirements by simply transferring its member subscriptions to PacifiCorp, the contract couldn't be carried out in the way it was intended, and would leave the other members of Tri-State holding the bag.

Hence, the contract imposes two related but independent obligations:

* An obligation by the distribution system to buy all of its power requirements only from the G&T;

* A financial obligation to repay the G&T's long-term debt.

The third conclusion involved the assessment of damages owed to Tri-State. To quote the court's ruling again, "If Tri-State is awarded in damages the present value of what it would have realized over the life of Shoshone's all-requirements contract; Tri-State is presumably made whole under the contract. Other members of the Tri-State system would not be adversely impacted by Shoshone's leaving the system because the damages awarded could cover the revenue stream that would have come in under the Shoshone contract."

The Shoshone case provides a framework for understanding the all requirements contract. It also clarifies the status of co-ops that purchase power from TVA or from power marketing administrations. They have requirements contracts that must be fulfilled, but they do not have the same legal obligation to other distribution entities that also receive power from that source.

What are the rights of distribution members of a G&T? There are at least five rights:

1. That the G&T will operate on a not-for-profit basis.

2. The distribution system has a fight to representation on the board.

3. Working with other members, it has the right to set G&T rates.

4. It has the right to receive a pro rata share of the margins of the corporation as prescribed by the mortgage, and a share of the proceeds upon its dissolution.

5. It shifts to the G&T the obligation to make certain the distribution co-op has sufficient power supply to meet the needs of its consumers. Being granted a franchise to serve retail customers requires the distribution system to provide adequate, reliable electric power, generally in accordance with state service rules and regulations. By joining a G&T, the distribution system essentially "delegates" this obligation to the power supplier. (This may become significant to systems contemplating leaving their G&T and will be discussed later.)

If these are the rights that result from membership in a G&T, what are the risks?

1. There may be an inequitable sharing of benefits among the members of the G&T. For example, a rate structure may be approved that favors some members more than others.

2. The average price of the G&T power may be higher at times than that available on the open market. This can be a short-term problem, requiring a careful assessment of short term versus long term risks and benefits.

3. The embedded costs of G&T generating assets may be substantially higher than the incremental cost of new generating capacity. This is a long-term problem that will intensify if retail customer choice is fully implemented. This may create the need for radical solutions, and in fact there have already been three major write-downs of G&T debt, and there may be more coming.

4. The G&T management may lack the initiative, innovation or flexibility to address problems such as those mentioned above.

5. The G&T board may be unable to focus on strategic issues or deal with internal policy-based disputes. Ultimately this is a distribution problem. If there are problems, distribution coops - those who own the G&T - must openly discuss and resolve them. This is the only way our system can work.

Changes in the wholesale power market and the potential for customer choice have led some co-ops to examine their power supply options, including questioning G&T membership. As noted, there are reports that wholesale power is available on a five year basis to distribution systems in some regions for a price in the range of 29 to 35 mills. While many G&Ts can readily meet the competition, some, as yet, cannot. And what really determines "meeting" the competition? Would you prefer 5 years at 35 mills, or 10 years at 38 mills from your own resources? And what value-added and other services are included in the price?

In response to the opportunities presented in the new marketplace, some co-ops have bought out of their G&Ts. What are the issues that must be addressed by distribution systems in assessing their membership in a G&T, or that must be addressed by systems wishing to alter the traditional contractual relationship with TVA, a PMA, or even an IOU? No list of questions is complete, but systems reviewing their options should discuss at least the following.

First, evaluating the marketplace. Twenty-nine to thirty-five mill power is said to be available on a firm 5-year basis. Such an option may initially appear attractive, depending on your wholesale rate today. But distribution systems must clearly understand and confirm the terms of such marketplace offers:

* Whether the power is guaranteed on a firm basis, and what penalties will be paid for non-delivery,

* Whether all required ancillary services are included in the price, and if not, who will provide them, and at what cost? (Exhibit 3 presents the FERC Ancillary services.)

* Whether the contract price includes transmission to the high or low side of the distribution substation.

* And then compare all of this with the value - the costs and risks - of the bundled packages of services provided by the G&T or existing supplier on a long term basis.

There are a number of additional issues that must be addressed. Any unaffiliated distribution system must ensure it has access to sufficient transmission capacity, both today and at the end of the short-term contract period. Contracting directly for transmission with a FERC regulated transmission provider may require involvement in that provider's FERC cases. It may also require the distribution co-op to provide "reciprocal" transmission service to that provider. This will present an additional set of administrative requirements and legal costs.

Another issue is reliability. Can the distribution system ensure it can meet its obligation to provide reliable power as required by a service franchise? G&Ts now fulfill this obligation on behalf of their members. Is the proposed power contract tied to dedicated generation assets, or is it a proposal from a power marketer based on its alleged ability to secure energy in the future on the open market?

This leads to the issue of penalties for non-delivery of power. Are there limitations on the resulting damages? To what extent is the distribution system willing and prepared to go to court for 18 months if the supplier does not deliver? And what will that cost? Further, what are the penalties for non-delivery backed by? A letter of credit? A bond or some comparable security that can be drawn down in the event of a breach of contract? Lacking such a security increases the distribution system's risk. In addition to non-delivery of power, distribution systems want to ensure that the contract spells out liability responsibilities in the event of power system failures or voltage surges.

These questions are not idle. One distribution system that recently bought out of its G&T had signed a memorandum of understanding with a power marketer. But then, after departing the G&T, it found that the power marketer would not sign a contract according to the conditions previously agreed to in the memorandum of understanding. The distribution system wound up buying power from its original G&T at class-B membership rates.

The risks in the wholesale electricity business will be great, and raise the specter that even with contract guarantees and penalty clauses, a power marketer may find it profitable to back out of its guarantee and simply pay the damages, or worse, tie you up in court for several years.

Systems without firm long-term power requirements contracts will also need to have contingency plans that identify how they will find and what they will pay for power tomorrow. While it is true that during normal conditions, non-firm economy energy currently can be bought on the market for 15 to 25 mills, during emergency conditions prices often jump to 90 to 100 mills or more, if it is available at all. This summer in the Midwest, market prices shot up to over 200 mills during emergency conditions: over 20 cents per kilowatt hour.

The next issue involves projections about the next contract after the current proposed alternative power supply arrangement. A five-year contract will pass quickly. The distribution system must be able to project the firm price of electricity and the length of the next potential contract after the completion of the contract provided by the alternative power supplier. Market prices today are low. But what will they be in the year 2002?

Evaluating the value of an all-requirements contract also entails calculating the value of the services provided by the G&T on a bundled basis. There are significant market efficiencies that result from the joint procurement of power. Even the largest distribution cooperative's power requirements may be insufficient to exercise market leverage, or to diversify its power supply portfolio.

Many G&Ts provide additional services such as load forecasting, special rates for and assistance in economic development, energy marketing, engineering studies, operating and maintenance services, and substation investment. While any distribution system can perform these services - and several do successfully - there are still significant economies of scale that result from doing them on a joint basis.

There are a few final issues that should be considered by any distribution system evaluating alternative power supply arrangements. IOUs represent a significant threat to co-ops because we represent a threat to them. In a retail choice environment, they have more to lose than we do. We offer an attractive approach to customers who want to aggregate themselves as cooperatives. We believe that many IOUs are eager to disrupt any unifying forces in our program.

A competitive G&T can be one such unifying force. The IOU strategy is to divide and conquer. Distribution systems that depart the G&T will lose such protections as the right of first refusal protection many distribution cooperatives have through their G&T, or the encumbrances an all-requirements contract provides that can be used against takeovers.

Another issue relates to the distribution system's ability to take counter actions against competitors in a retail wheeling environment. If a competitor takes retail customers from a co-op, the G&T is one mechanism to go compete for some of the competitor's customers.

So far, we have reviewed the all-requirements contract, the changing energy marketplace, and ways to assess the benefits and risks of membership in a G&T. This part of the discussion has primarily focused on G&Ts that offer, or that have firm plans to offer, rates that are within a competitive market range. G&Ts with costs substantially beyond that competitive range will be forced to examine other options, particularly if customer choice is on the horizon.

Similar points can be made to systems that purchase power from TVA or from power marketing administrations. Those power suppliers will also have to offer, or have firm plans to offer, rates within the competitive range that is developing within regional energy markets.

For those who are members of G&Ts that are now or soon will become competitive, there remains one final set of issues, namely an assessment of the opportunities that may emerge in tomorrow's even more competitive environment. G&Ts and distribution systems acting in concert will be able to aggressively compete for new customers. G&Ts working together should be able to take better advantage of existing resources, supply aggregation and the transmission network.

For example, ACES, the Alliance for Cooperative Energy Services, is an alliance of Midwestern, Eastern and Southeastern G&Ts along with distribution system representatives formed to consider shared resource approaches in the deregulated wholesale power market. Boards of participating G&Ts will soon be considering the risks and benefits of creating a combined power marketing capability to optimize assets, future power purchases and hedging potential in order to extend greater value to member systems.

There is nothing in this article to suggest that distribution cooperatives should not explore all of their options. But this must be done carefully, with an understanding of the fiduciary responsibility, and with the perspective of how we can best serve our members. Perhaps most important, it's time to focus on our strengths as well as our opportunities. There are new opportunities, and some may involve changes to the traditional way distribution co-ops and G&T's have done business. For example, some distribution systems have become de facto partial requirements customers, while maintaining G&T membership and an effective working relationship.

To address this opportunity and others, one thing is critical: strategic planning. For G&Ts, this should be a process involving all of its members to ensure that there is a common vision and direction. A lack of joint planning means there is no effective mechanism to identify and resolve divisive issues. Unless divisive issues are resolved, the strategic issues can't be explored with a sense of mutual trust.

For systems that are not members of G&Ts, they might consider a planning process with other systems to explore opportunities to do things on a joint basis and to achieve market leverage. Working together makes us stronger.

If NRECA has a core value to express, it is that our competitive advantages are not served by internal conflict or by reducing market leverage achieved through joint action. Even the largest of us is small. It is by working together that we will remain a strong competitive force.

EXHIBIT 3

* Scheduling, system control and dispatch 

* Reactive supply and voltage control

* Regulation and frequency response service

* Energy imbalance 

* Spinning operating reserve 

* Supplemental operating reserve