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E-Notes provides regular briefings on new developments in global energy and public utility law. May 18, 2001 ANCILLARY SERVICES - THE NEXT FRONTIER Since the issuance of Order Nos. 888-889 by the Federal Energy Regulatory Commission ("Commission") in 1996, market recognition of the value of ancillary services provided in this regulatory initiative, has increased dramatically. Shortly thereafter, the FERC recognized that market-based rates could also be provided for certain of these ancillary services, which include voltage regulation, spinning reserves, non-spinning reserves and reactive power that were critical elements of historically bundled service. This regulatory recognition was intended to serve as a stimulus for market penetration and development of ancillary services in a competitive marketplace. With the formation of independent system operators (ISOs) and the consideration of movement to regional transmission organizations (RTOs), ancillary services have received increased discussion and attention. Frequently, markets do not have yet sufficient market makers to create adequate transparencies in a robust competitive market for certain services. For example, because of market deficiencies in California and New York, ancillary services have come under increased scrutiny. This short history and limited development of ancillary services is about to change with the advent of material consideration of RTOs. It can be expected that a revamped Bush-era FERC will finalize most RTO proposals this summer undertaken by former Chairman James Hoecker and his colleagues on the Commission. That process should conclude by the end of 2001 with increased enforcement and market monitoring, new mechanisms to resolve disputes, increased resolution of seams management concerns, new transmission pricing and return policies, and major market validation of for-profit transcos as the underlying vehicle for regional growth and development of transmission in the future. Key Considerations This market growth and recognition will not come too quickly given the continual demise of transmission investment and development by the regulated utility industry. Over the past 25 years the utility industry has whittled away its transmission legacy, with little real growth and development of the national transmission system to support the advent and movement to competitive markets which has accelerated since 1988. Ancillary services will become a critical element of that market as they become the future call-waiting, *69, and call-forward services of the electric utility industry - borrowing from the telephone industry parallels and paradigm from the prior decade of experience. Formation of RTOs will provide stronger market validation and recognition of ancillary services. This will necessitate the development of separate pricing, new forms of contracting, new revised pricing methodologies for those ancillary services through separate contracts, and pricing opportunities through formal agreements. In many instances, agreements still need to be developed for ancillary service sales or need to be materially enhanced in existing service agreements with the electric utility. Several areas require current consideration at this time to ensure a smooth and effective transition: * Interconnection agreements should fully anticipate the separate provision of ancillary services in their technical review of a generating facility and requirements for that facility with the electric utility. * The interface of utility systems with control areas and RTO's need further understanding and management for risks, liabilities and cost consequences. * Recognition for adequate compensation and market-based pricing for ancillary services should be provided with the opportunity to supplement that pricing with amended and restated schedules in relevant agreements. * Transition of existing transmission and interconnection agreements to the RTOs should be contemplated in current agreements. Assignment of those agreements should only be permitted with appropriate notice and review rights by the generator, and the opportunity to accept, amend or reject the terms of that assignment or transfer depending on whether it provides for enhanced sale and market development opportunities for the market value of ancillary services. * There are other ancillary services yet to unfold that have not been recognized by Order Nos. 888-889 and they should be analyzed and evaluated. Any specificity that can be undertaken to capture recognition of those future services, including development and pricing opportunities for those services, should be separately retained in existing agreements now. Otherwise, the spectre exists that those services may ultimately be provided to the regulated utility at no charge. Future Course of Action Why has this occurred? Individual utilities managing the needs of their systems - with the public utility obligation to serve and paramount reliability responsibilities were not willing to separately recognize the value of ancillary services. Bundled service also disguised this value and did not provide an adequate and accurate platform for such recognition. Utility divestitures of generation resources started the ball running. Moreover, utilities operating in a monopoly, cost-of-service regime did not have the incentive or ability to seek out new revenue streams through creative unbundling and repackaging of ancillary services. With the evolution to RTOs and broader scope and markets, a shift will be undertaken in the provision of ancillary services, such as security, emergency planning, risk management, and reliability from discrete utility systems to all potential players in the competitive market, including generators, regulated utilities, transmitting utilities, power marketers and traders and large scale industrial and commercial users. This restructuring of the market also provides an enhanced opportunity to assess the delivery of critical ancillary services, their recognition as a matter of contract, and the appropriate elements of market-based rates and cost of service analysis (as applicable) and new methodologies justifying pricing for these new, essential products. Enlightened generators and developers will be thoughtfully analyzing this issue at this time with the goal of protecting their interests in anticipation of the evolution of these ancillary services as part of competitive markets, which will allow them to capture contracting and pricing opportunities for the benefit of their owners or shareholders. Michael J. Zimmer John A. Cohen ____________________________________________________________________________ E-Notes is a publication of Baker & McKenzie. It does not constitute legal advice or a legal opinion on any specific facts or circumstances. The contents are intended as general information only. You are urged to consult your attorney concerning your situation and specific legal questions you may have. For further information on the subjects discussed in E-Notes, contact Michael J. Zimmer, michael.j.zimmer@bakernet.com or Jonathan W. Gottlieb jonathan.w.gottlieb@bakernet.com. For more information about BAKER & McKENZIE, click on our business card: <<Baker McKenzie Business Card.htm<< or visit out website at http://bakernet.com. - Baker McKenzie Business Card.htm
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