FTC Comment Before the Federal Energy Regulatory Commission Concerning Solicitation Processes for Public Utilities; Merchant Generation Assets

Before the
United States of America
Federal Energy Regulatory Commission
Solicitation Processes for Public Utilities 	) 	Docket No. PL04-6-000
Acquisition and Disposition of Merchant 	) 	Docket No. PL04-9-000
Generation Assets by Public Utilities 	)
Comment of the
Federal Trade Commission
July 14, 2004

1For the purposes of this comment, “solicitation processes” refers to the procurement
arrangements of regulated utilities (or their unregulated affiliates). A primary focus of attention
is procurement by regulated utilities of generation contracts. 	Solicitation processes may also
apply to acquisition of generation assets. Typically, the affiliates compete with stand-alone
independent generating firms in making sales of energy and assets to utilities.
Before the
United States of America
Federal Energy Regulatory Commission
Solicitation Processes for Public Utilities 	) 	Docket No. PL04-6-000
Acquisition and Disposition of Merchant 	) 	Docket No. PL04-9-000
Generation Assets by Public Utilities 	)
Comment of the
Federal Trade Commission
I. 	INTRODUCTION
The Federal Trade Commission (FTC or Commission) appreciates this opportunity to
present its views concerning the Federal Energy Regulatory Commission’s (FERC) policies
concerning solicitation processes1 for public utilities and acquisition and disposition of merchant
generation assets by public utilities. This comment addresses whether FERC should reevaluate
its policies governing how utilities procure electric power supply through contracts with
affiliated generators and whether they acquire previously spun-off (unbundled) generation assets.
This comment addresses both topics because they are closely related. Because utilities may have
both incentives and the ability to exercise market power and harm consumers by discriminating
in favor of their own affiliates and against independent suppliers, FERC may wish to reduce the
potential for this harm by using independent third parties to evaluate utility procurement
alternatives and by encouraging utilities to assess the market value of procurement alternatives.
These approaches are likely to reduce the ability of utilities to discriminate in favor of affiliates
and to improve detection of discrimination (and the associated evasion of cost-based rate

2See, e.g., Letter of the Federal Trade Commission to Thomas E. Bliley, Chairman,
House Committee on Commerce, on H.R. 2944, The Electricity Competition and Reliability Act
(Jan. 14, 2000), available at <http://www.ftc.gov/be/v000002.htm>; Comment of the staff of
FTC’s Bureau of Economics and the Office of the General Counsel, In the Matter of Application
for Approval of Asset Transfer Agreements with Affiliated Company Ameren Union Electric
Company, Illinois Commerce Commission, Docket No. 03-0083 (June 18, 2003), available at
<http://www.ftc.gov/be/v030012.htm>.
2
regulation) by regulators.
The Commission and its staff have stated repeatedly that consumers benefit when
electricity markets operate unburdened by substantial and durable market power.2 This
comment focuses on possible harm to consumers from the exercise of market power by regulated
utilities stemming from evasion of economically appropriate cost-based rate regulation.
Regulatory evasion is accomplished through anticompetitive discrimination by regulated utilities
in favor or their unregulated affiliates. This discrimination can occur in purchases from affiliates
at inflated prices or in sales to affiliates at below-market prices. The comment identifies direct
harm to consumers from evasion of cost-based rate regulation as well as indirect harms to
consumers and to competition that may be caused by discrimination in affiliate transactions. It
concludes with a discussion of approaches that FERC may wish to utilize to detect and remedy
discrimination in affiliate transactions.
The FTC is an independent agency responsible for maintaining competition and
safeguarding the interests of consumers through enforcement of the antitrust and consumer
protection laws and through competition advocacy. In the electric power industry, the FTC often
analyzes regulatory or legislative proposals that may affect competition or the efficiency of
resource allocation and reviews proposed mergers involving electric and gas utility companies.
In the course of this work, as well as in antitrust research, investigations, and litigation, the

3FTC Staff Report: Competition and Consumer Protection Perspectives on Electric Power
Regulatory Reform (July 2000), available at <http://www.ftc.gov/be/v000009.htm> (this report
compiles previous comments that the FTC staff provided to various state and federal agencies);
FTC Staff Report: Competition and Consumer Protection Perspectives on Electric Power
Regulatory Reform, Focus on Retail Competition (Sept. 2001), available at
<http://www.ftc.gov/reports/elec/electricityreport.pdf>.
4Related comments include Comment of the Staff of FTC’s Bureau of Economics and the
Office of the General Counsel, In the Matter of Standards of Conduct for Transmission
Providers, FERC, Docket No. RM01-10-000 (Dec. 20, 2001); Comment of the Staff of the FTC
Bureau of Economics, In the Matter of Deployment of Wireless Services Offering Advanced
Telecommunication Capability, Federal Communications Commission, Docket No. 98-147
(Sept. 25, 1998); Comments of the Staff of the Bureau of Economics, In the Matter of
Procedures for Consideration of Contract Rules, Postal Rate Commission, Docket No. RM89-5
(Feb. 20, 1990); Statement of the United States Federal Trade Commission Staff, In the Matter
of Inquiry into Alleged Anticompetitive Practices Related to Marketing Affiliates of Interstate
Pipelines, FERC, Docket No. RM87-5-000 (Jan. 29, 1987).
5When a firm elects to make all of its own inputs, the firm is fully vertically integrated.
Decisions on vertical integration may entail detailed considerations of the alternative risks, costs,
and benefits of making versus buying inputs.
3
Commission applies established legal and economic principles and recent developments in
economic theory and empirical analysis to competition issues. As part of its competition
advocacy program, the FTC has issued two Staff Reports on electric power industry restructuring
issues at the wholesale and retail levels.3 The FTC and its staff have also filed numerous
competition advocacy comments on electricity restructuring efforts with FERC, the states, and
international competition organizations.4
II. 	HISTORICAL AND CONTEXTUAL BACKGROUND
Decisions by firms to make or to buy various inputs required to produce a good or service
are an integral part of market economies and have been a focus of economic research.5 Make-
or-buy decisions that are based on objective analyses and criteria often lead to increased
efficiency that intensifies competition and benefits consumers. The situation FERC currently

6FERC, Boston Edison re: Edgar Electric Company, 55 FERC ¶ 61,382 (1991).
7The federal antitrust agencies generally do not review transactions among closely
affiliated companies. Antitrust does not view affiliates of a firm as the firm’s competitors or as
competitors of each other because the management of the parent firm controls the output and
pricing decisions of all of its affiliates and has incentives and the ability to coordinate affiliated
activities to maximize profits of the parent and all of its affiliates jointly. Hence, if FERC were
not to review these transactions, there likely would be no federal review.
4
confronts is that of a regulated utility that operates in the same geographic market as its
unregulated affiliates and faces a choice of buying from independent suppliers or effectively
making the input by securing it from an unregulated affiliate. FERC already has a policy in
place (the Edgar Policy6) that is intended to promote objective make-or-buy decisions by utilities
regarding contracts for power. Because the issues involved in power supply contracts with
affiliates are similar to those entailed by affiliate asset transfers, FERC may wish to consider a
similar framework for reviewing affiliate asset transfers.
Under its Edgar Policy, FERC reviews purchase power agreements between utilities and
affiliates as part of determining whether to grant market-based rates.7 In the analysis of market-
based rate transactions between an affiliated buyer and seller, the Edgar Policy requires FERC to
ensure that the buyer has chosen the lowest-cost supplier from among the options presented,
taking into account both price and non-price terms. The Edgar Policy addresses the concern that
utilities would choose to purchase power at inflated prices from their affiliates rather than at
competitive levels from unaffiliated entities. Such higher costs could be passed on to wholesale
(as well as retail) customers that pay cost-based rates, absent restrictions on such discrimination.
Recently, with the development of significant amounts of independent generation in every
region, competitive alternatives to affiliate purchases have increased, as have expressions of

8Comment of the Staff of the Bureau of Economics of the Federal Trade Commission,
Public Utilities Commission of Nevada, Regulations Governing Conditions Under Which
Affiliates of Distribution Companies May Offer Potentially Competitive, Discretionary or Other
Competitive Components of Electric or Natural Gas Service, LCB File No. R087-98 and PUCN
Docket No. 97-5034 (Sept. 22, 1998), available at <http://www.ftc.gov/be/v980027.htm>.
9For example, the FTC staff’s central concern with FERC’s approach to transmission
open access was the continued incentives that a transmission operator would have to
discriminate in providing access to unaffiliated generators as compared to its own generation
assets. Comment of the Staff of the Bureau of Economics of the Federal Trade Commission,
FERC, Docket Nos. RM95-8-000 and RM94-7-001 (Aug. 7, 1995).
10 Our companion comment in FERC Docket RM04-7-000 places remedy issues in the
broader context of FERC’s decisions whether to grant market-based rates.
5
concern about discrimination and cross-subsidization in affiliate transactions. These
developments have prompted FERC to review its Edgar Policy.
In previous comments to FERC and the states, the FTC staff has advocated use of a
cost/benefit analysis framework for selecting approaches to discourage discrimination and cross-
subsidization. 8 These comments have emphasized the potential of structural separation to
prevent discrimination and cross-subsidization by directly reducing or eliminating the incentives
to engage in those practices. 9
By contrast, FERC’s Edgar Policy applies in those circumstances in which the incentives
to engage in discrimination or cross-subsidization still exist. Even within the Edgar Policy
framework, however, FERC may wish to consider some remedies that are more structural than
behavioral.10 These include, for example, economically appropriate transmission upgrades that
expand the scope of the geographic market, elimination of impediments that make entry less
likely, divestiture of assets that will reduce the ability and incentive to discriminate or cross-
subsidize, and steps to encourage price-responsive demand (such as economically efficient real-

11 Many of these structural remedies could be most effectively implemented through
cooperation between FERC and the states.
12 The FTC’s antitrust and consumer protection training missions with foreign antitrust
and privatization agencies often focus on these issues. See also the written Contribution from
the United States of America for the Organization for Economic Cooperation and Development,
Working Party No. 2 on Competition and Regulation, Roundtable on “Promoting Competition
in Local Services: Solid Waste Management" (Oct. 18, 1999); written Contribution from the
United States of America for the Organization for Economic Cooperation and Development,
Working Party No. 2 on Competition and Regulation, Roundtable on “Non-Commercial Service
Obligations and Liberalization” (Oct. 13, 2003); John C. Hilke, Competition in Government-
Financed Services (1992).
13 Comments of the Staff of the Bureau of Economics, Postal Rate Commission, Docket
No. RM89-5, supra note 4.
6
time metering and distributed generation).11 We recommend that FERC consider these structural
remedies.
The issues involved in assuring that regulated utilities’ make-or-buy decisions are
objective are not unique to the electric power industry. The FTC staff has been active in two
other contexts in which similar issues arise: privatization and contracting-out decisions of
municipal, state, and federal agencies,12 and the workshare discounts offered by the United States
Postal Service.13
III. 	INCENTIVES TO ENGAGE IN THE EVASION OF RATE REGULATION AND
THE FORMS SUCH EVASION MAY TAKE
The power supply solicitation and asset transfers of regulated utilities often pose no
threat to competition and, in fact, enhance competition and benefit consumers, just as similar
transactions do in other industries. Nevertheless, two types of discriminatory affiliate
transactions in which a utility favors its affiliates could harm competition and customers. The
first source of consumer harm is the purchase of electric power or the transfer of assets from an
unregulated affiliate at inflated prices. This practice increases the utility’s costs (and rates) and

14 Although nearly all utilities have authority from FERC to charge market-based rates for
wholesale electricity sales, FERC’s recently revised market power assessment process may result
in certain utilities’ loss of market-based rate authority.
7
discriminates against independent suppliers that offer lower prices for equivalent service or
assets. A second potential source of harm is preferential sales or provision of services by the
utility to its affiliates. These practices increase the costs (and rates) of the utility, while they
decrease the costs and increase the profits of the affiliate. These practices also discriminate
against the affiliate’s competitors by charging them higher prices (for services supplied by the
utility) than the prices paid by the affiliate.
A. 	Evasion of Utility Rate Regulation Through Inflated Procurement Prices
In a market with economically efficient cost-based regulation of prices14 in which the
regulated utility has market power, some mechanism is appropriate to assure that power
purchases and asset transfers – for example, from an unregulated affiliated generator to the
parent utility – do not take place at inflated prices that will allow the firm to evade these rate
regulations. A rate-regulated parent utility with market power has incentives to engage in such
transactions because, by shifting profits to the affiliate, the firm evades the rate regulations. In
the case of inflated power supply agreements with affiliates, customers of the regulated utility
are harmed because they pay higher rates to cover the utility’s higher procurement costs that are
caused by the inflated prices paid to its unregulated affiliates. In a similar fashion, the costs of
the inflated asset base for the regulated utility would be covered by higher regulated rates, while
the gains from the asset sale at an inflated price would be realized by the affiliate outside of the
scope of the regulator's cost-based rate determination. Both types of actions would be forms of
regulatory evasion and would result in the exercise of market power, with captive customers

15 Cross-subsidization in this context generally means that the utility with regulated rates
is paying more than the market value for the service or asset that it is buying from its unregulated
affiliate or that it is selling to its affiliate at below market value (or other preferential terms).
Cross-subsidization in this context is distinct from issues concerning attributable or incremental
costs, common costs, joint costs, and economies of scale or scope that may arise in determining
whether regulated rates for one type of service are cross-subsidizing the regulated rates for
another type of service offered by a regulated firm. This type of cross-subsidization issue arises
often, for instance in postal ratemaking. See Comments of the Staff of the Bureau of Economics,
In the Matter of Procedures for Consideration of Contract Rules, supra note 4.
8
paying higher regulated rates to cover the regulated utility's inflated costs.
The same framework may also apply where a wholesale customer depends on a regulated
transmission provider (with generation assets in the same geographic market) to act as its agent
in acquiring electric power. In this situation, the dependent wholesale customer pays higher
prices (and its retail consumers pay higher rates) because the regulated transmission provider,
acting as a buying agent, buys at inflated prices for the dependent wholesale customer from the
transmission provider’s generation affiliates.
B. 	Evasion of Rate Regulation Through Below-Market Sales to Affiliates
A utility whose exercise of market power is constrained by cost-based rate regulation
also may find it profitable to evade rate regulation by cross-subsidizing the costs of its
unregulated affiliates. 15 This may entail selling to an affiliate at below-market prices or
providing better service to the affiliate than to competitors of the affiliate.
For example, selling supplies or services to an affiliate at below-market prices could
allow the parent to prevent the affiliate’s bankruptcy by reducing its costs and, therefore,
increasing its profits. With the cross-subsidization, the affiliate may face lower costs than its

16 Incentives for cross-subsidization may also be present in an electricity retail
competition setting. In a retail competition setting, the utility often processes consumers’
requests to switch suppliers, including switches to and from the utility’s retail marketing
affiliates. Here the utility might well have incentives to slow the net switching of retail
customers to independent suppliers. It could accomplish this by devoting additional utility
personnel to processing customer requests to switch to the affiliated retail marketers. In this
scenario, customers would face higher utility prices to pay for these additional personnel.
9
competitors.16 In this example, the utility’s owners could avoid the legal and administrative
costs associated with the bankruptcy process (while increasing the likelihood that owners of
independent generation in the same market would face these costs).
Cross-subsidization of an affiliate by its parent utility also could allow the affiliate to
increase its market share, even if all of the same competitors remain in the market. Because of
the cross-subsidization the affiliate receives, it will be able profitably to take sales from equally
efficient or more efficient independent suppliers. The cross-subsidization allows the parent
utility to transfer higher revenues (due to higher rates) in its regulated operations to higher
profits in its unregulated operations. The affiliate would have higher profits that would not be
constrained by rate regulation (as are the profits of the parent utility). Again the direct harm to
customers is the higher rates charged by the utility in order to finance the cross-subsidization of
its affiliates’ costs.
Because cross-subsidization of affiliates’ costs may have effects similar to those from
paying inflated prices for services or assets of affiliates, FERC may wish to consider amending
its Edgar Policy to enable it to address below-market sales to affiliates as well as inflated prices
of purchases from affiliates. Doing so may help assure FERC that utilities do not substitute
cross-subsidization of affiliates’ costs for inflated procurement prices in order to evade
economically efficient cost-based rate regulation. In general, if two forms of discrimination can

17 Other indirect inefficiencies may result as well. Customers may make investment
decisions based on geographic and temporal distortions in electricity prices caused by rate
evasion.
10
achieve the same evasion of rate regulation and only one is addressed by regulators, utilities will
have incentives to utilize the other form.
IV. 	HARM TO UTILITY CUSTOMERS AND OTHER CONSUMERS DUE TO
DISCRIMINATION IN POWER SUPPLY SOLICITATIONS AND ASSET
TRANSFERS
The previous section discussed the incentives of those utilities with market power that are
subject to cost-based rate regulation to evade this regulation by paying inflated prices to
affiliates or by selling at below-market prices to affiliates. The direct harm to utility customers
from these practices is higher rates caused by higher costs for the utility. There are additional
sources of potential harm to utility customers and other consumers from the impact of these
practices on competition in the markets served by the utility affiliates. We also present three
potentially significant, indirect losses of efficiency and harm to consumers associated with such
favoritism.17
Exit of More Efficient Generators: One potential adverse impact is that discrimination in
affiliate transactions (procurement of generation assets or power supply contracts from affiliates
at inflated prices, or below-market sales to affiliates) may result in the exit of more efficient
generation assets and the retention of less efficient generation assets in the event, for example,
that demand declines enough to force some exit from the market. In a market where capacity
exceeds demand, some assets may exit from the market. Absent discrimination, the least
efficient assets are the most likely assets to exit. In the presence of discrimination, less efficient
assets owned by the utility or its affiliates are more likely to remain in the market while more

18See Jonathan B. Baker, “Responding to Developments in Economics and the Courts:
Entry in the Merger Guidelines,” 71 Antitrust L.J. 189 (2003) (includes a discussion of the
history of the terms “entry barriers” and “entry impediments”). See also John C. Hilke and
Philip B. Nelson, "The Economics of Entry Lags: A Theoretical and Empirical Overview," 61
Antitrust L.J. 365 (1993).
19 The potential combination of exit of more efficient assets and less timely and likely
entry may create an extended period in which production costs of electricity will be higher on
average than they otherwise would be. If the exiting assets are owned by smaller suppliers,
concentration may also be higher than it otherwise would be, and this may contribute to concerns
about the potential for coordinated interaction among the remaining suppliers.
20 Given this incentive, FERC and state regulators may wish to be cautious about
accepting arguments by utilities for vertical rebundling.
11
efficient independent suppliers are forced to exit. As a result, average social costs of production
in the market served by these assets will increase and innovations that would have been brought
to market by the exiting firms may be lost.
Less Timely and Likely Entry: A second potential adverse impact of discrimination is to
make entry less timely and likely by increasing the expected level of unrecoverable costs
associated with entry. 18 Absent discrimination, any specific generation entrant can reasonably
expect to sell its generation assets at the fair market price in the event that its entry fails. In the
presence of discrimination by utilities, the selling price for liquidated stand-alone generation
assets is likely to be lower where the distribution utility in the area is one of the most likely
purchasers of such assets, absent discrimination, or where there are few potential buyers. The
result of this increased risk is that entry becomes less likely. 19
Loss of Benefits from Previous Vertical Unbundling: 	A third potential adverse impact is
that where cost-based regulation can be evaded by affiliate transactions, there is an incentive for
inefficient vertical integration (including rebundling of previously unbundled affiliates).20 When
this occurs, consumers are harmed both by the evasion of efficient rate regulation that may occur

21 Bid solicitation processes are generally appropriate in making market value
determinations for a wide variety of power supply contracts and generation assets. Other
methods may be difficult to apply where the contracts or assets are unusual or transactions are
rare.
22 Similarly, most states that undertook retail customer choice programs were reluctant to
rely solely on book value (generally asset purchase price less depreciation) of stranded
generation assets in evaluating the magnitude of stranded costs, and instead employed a variety
of evaluation techniques to estimate the market value of these assets. The stranded cost recovery
approaches of several states are described in Appendix A of the September 2001 FTC Staff
Report, supra note 3. See also Protest of the Electric Power Supply Association, In re Cinergy
12
and by the higher costs associated with inefficient vertical integration. These costs could include
the loss of innovation, of price discounts, or of service improvements.
V. 	EVASION-DETECTING MECHANISMS
A number of mechanisms to detect and, therefore, help prevent the types of regulatory
evasion discussed above are available to FERC. One widely applied method for detecting
discrimination in supply contracts and asset transfers is to compare the terms of the proposed
transaction with the transaction’s market value. If the terms of the proposed transaction are less
favorable to the regulated utility rate payers than the corresponding market value, then inefficient
discrimination and evasion of rate regulation may be present. Market values for affiliate
transactions can be established in several ways, including holding an open solicitation for supply
bids, putting some of the affiliate assets up for sale, doing a "comparables" analysis (including
using econometric techniques to develop an estimated market price based on recent sales prices
of similar properties), or doing a discounted cash flow analysis of expected earnings. 21 All of
these approaches present challenges in their implementation, but they are likely to be more
accurate than using historic book values or an administrative determination to estimate the
market value of affiliates' assets. 22

Services, Inc., FERC, Docket No. EC02-113-000 at Section 2 (filed Oct. 7, 2002), available at
<http://www.epsa.org/Positions/FERC.cfm?what=796&docBody=3225>.
23 This approach has been applied to situations in which in-house governmental
departments compete with outside private contractors to perform certain government-financed
services. See, e.g., John C. Hilke, Competition in Government-Financed Services, supra note
12, at 16-20, 67-68. For example, in 1979, Phoenix, Arizona, implemented a system of
competitive bidding in which outside contractors compete against government departments for
contracts to provide various services financed by the city. Before a city agency can submit a bid,
however, the Office of the Comptroller – an entity independent of the city administration – must
certify that the bid is realistic. The city has saved substantially through this bidding process. A
description of this program, its procedures, and the cost savings is available at
<http://www.ci.phoenix.az.us/Auditor/public1.html>.
13
To address the ability of utilities to discriminate in transactions with affiliates, FERC
may wish to extend one of its core principles underlying non-discriminatory transmission access.
FERC found in Order No. 2000 that independent control of the operation of the transmission
system is the best method to prevent discrimination. The same insight is likely to apply to
transactions between utilities and affiliates. In particular, FERC may wish to encourage one or
more independent third parties to conduct market value assessments of bids in bidding situations
or to provide market value assessments of offers from affiliates in non-bidding situations. Third-
party assessments also may bring additional objectivity to evaluations of concerns about
preferential services provided by a utility to its affiliates. Independent evaluations are likely to
make the procurement and sales processes involving affiliates more objective. This objectivity,
in turn, is likely to reduce the risk of evasion of economically appropriate rate regulation through
discrimination in purchases from affiliates or in cross-subsidization of affiliates’ costs (by selling
to affiliates at below-market prices).23
VI. 	CONCLUSION
Evasion of cost-based rate regulation associated with discrimination in transactions

24 The September 2001 FTC Staff Report, supra note 3, explains the close relationship
between wholesale and retail electricity markets. Unlike many markets in which inventories
held by retailers or wholesalers have a substantial (if occasionally short-term) role in
determining prices, inventories have only a de minimis role in electricity pricing because
electricity cannot be practicably stored (inventoried) in large quantities. Steven Stoft, Power
System Economics: Designing Markets for Electricity at 40 and Ch. 5.1 (2002).
14
between utilities and their affiliates can harm consumers in wholesale and retail electricity
markets and other markets.24 Although FERC’s Edgar Policy focuses on utility procurement,
similar concerns may arise regarding preferential sales by utilities to affiliates. Either form of
discrimination is likely to harm utility customers directly by increasing utility costs and rates.
Additional consumer harm may stem from the effects of discrimination on competition in the
markets served by the affiliates. Accordingly, FERC may wish to adjust its Edgar Policy to
include sales by utilities to their affiliates. Detecting anticompetitive discrimination in affiliate
transactions is often best accomplished by comparing the proposed affiliate transaction to the
market value of the transaction. Objectivity in this process is often best pursued through the use
of independent third-party evaluators. FERC may wish to adjust its Edgar Policy to more
directly reference market values of affiliate transactions and analysis of market values by
independent third-party specialists in such evaluations. If discrimination concerns persist, FERC
may wish to consider remedies that will make the market structure more competitive and will
thus reduce the incentive and ability to engage in anticompetitive discrimination.