Electricity Restructuring Background: The Public Utility Regulatory Policies Act of 1978 and the Energy Policy Act of 1992

Electricity Restructuring Background: The Public Utility Regulatory Policies Act of 1978 and the Energy Policy Act of 1992

98-419 ENR
May 4, 1998
CRS Report for Congress
Received through the CRS Web
Electricity Restructuring Background:
The Public Utility Regulatory Policies Act of 1978
and the Energy Policy Act of 1992
(name redacted)
Specialist in Energy Policy
Environment and Natural Resources Policy Division
Summary
Electric utilities have been subject to comprehensive federal and state economic
regulation since enactment of the Public Utilities Holding Company Act of 1935
(PUHCA) and the Federal Power Act. This regulatory framework remained virtually
unchanged between 1935 and 1978. The oil embargoes of the 1970s created concerns
about the security of the nation’s electricity supply leading to enactment of the Public
Utility Regulatory Policies Act of 1978 (PURPA). For the first time, utilities were
required to purchase power from outside sources.
This first incremental change to traditional electricity regulation started a
movement towards a market-oriented approach to electricity supply. Following the
enactment of PURPA, two basic issues stimulated calls for further change: whether to
encourage nonutility generation and whether to permit utilities to diversify into non-
regulated activities.
The Energy Policy Act of 1992 (EPACT) increased competition in the electric
generating sector by creating new entities that can generate and sell electricity at
wholesale without being regulated as utilities under PUHCA. PURPA began to shift
more regulatory responsibilities to the federal government, and EPACT continued that
shift away from the states by creating new options for utilities and regulators to meet
electricity demand.
As the electric utility restructuring debate evolves, additional policy issues to be
addressed may include federal-state jurisdictional roles, stranded cost recovery, industry
structure, and non-economic regulatory factors.
Congressional Research Service ˜ The Library of Congress

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Electric utilities have been subject to comprehensive federal and state economic
regulation since 1935. Electricity service has been considered a natural monopoly,
meaning that the industry has (1) an inherent tendency toward declining long-term costs;
(2) high threshold investment and (3) technological conditions that limit the number of
potential entrants. The federal regulation scheme was codified in 1935 with the passage
of the Federal Utility Act. Its two components, the Federal Power Act and the Public
Utilities Holding Company Act of 1935 (PUHCA)1, defined the nature of federal electric
utility regulation until the passage of Public Utility Regulatory Policies Act of 1978
(PURPA).2
As the electric utility industry evolved, flaws with the natural monopoly theory
became more apparent. First, there is nothing natural about a utility's monopoly to
provide electric service because exclusive franchises in the utility's service area are
granted by government. Second, several utilities, primarily some municipals, co-ops and
publicly owned utilities, do not own all of their generating facilities. For these utilities,
contractual arrangements, rather than unified control have been adequate to meet their
obligation to serve their customers in an efficient manner.
Basic PURPA Provisions
PURPA was, in part, intended to augment electric utility generation with more
efficiently produced electricity and to provide equitable rates to electric consumers.
PURPA created a new type of wholesale generators called Qualifying Facilities (QFs).
PURPA addressed several major modifications in the economic regulation of electric
power facilities, including: interconnection, planning, cogeneration, rates, and small
hydroelectric facility regulation. PURPA injected the federal government as a regulator
into the domain of economic regulation of electric power that formerly was the
responsibility of the states.
QFs are exempt from regulation under PUHCA and the Federal Power Act (FPA)
by PURPA. Two types of generators can be certified with FERC as a QF to gain PURPA
benefits: a small power producer and a cogenerator. A qualifying small power
production facility is defined in the FPA as an electric generator that meets certain FERC
rules, including requirements regarding fuel use, fuel efficiency, and reliability (16 U.S.C.
791a-825r). Cogeneration is the sequential production of both electric energy and steam,
or other forms of useful energy (such as heat), which are used for industrial, commercial,
heating, or cooling purposes. To be considered a QF, a cogenerator must meet FERC
ownership and operational requirements that are similar to those required of small power
producers.
Avoided Costs
Departing from traditional utility rate regulation, PURPA shifted the price basis for
wholesale electricity from the seller’s cost to the purchaser’s cost. Under PURPA, the
PUHCA
1
is Title I of the Public Utility Act of 1935. 49 Stat. 803 (1935), 15 U.S. Code §§ 79 et
seq.
2P.L. 95-617. (92 Stat. 3117) 116 U.S. Code §§ 2601.

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local utility must purchase all power produced by QFs in their service area at avoided
cost. FERC adopted rules under PURPA to define avoided cost: the likely costs for both
energy and facilities that would have been incurred by the purchasing utility if that utility
had to provide its own generating capacity. PURPA raised some doubt as to whether the
avoided cost concept was consistent with constitutional “just compensation”
requirements, but these Fifth Amendment concerns were obviated in 1986 (Kansas City
Power & Light Co. v. State Corporation Commission). The rules requiring electric
utilities to pay cogenerators and small power producers avoided cost were found not to
take property without just compensation in instances where the electric utility could
charge ratepayers avoided cost and earn a profit.
State rate regulators have wide latitude in establishing the procedure to assign
avoided costs. Initially, avoided costs were frequently set too high, resulting in more QF
power than host utilities could reliably transmit or sell. This became a large problem in
some parts of the United States, particularly California. To avoid this problem, many
states are now using bidding systems to determine avoided costs. In these systems,
non-utility generators bid to provide the cheapest power to utilities. These bidding
systems are intended to substitute for rate-making approvals of power purchase
transactions, but participating state utility commissions still determine ground rules for
these auctions and provide oversight. Bidding results in a more competitively based price,
putting the emphasis back onto the seller’s costs rather than the purchaser’s avoided cost.
New Entrants to Electricity Markets
With the introduction of PURPA, the federal government opened the electricity
generating sector to other entrants and raised questions about the natural monopoly
justification of generation ownership and regulation. The emergence of QFs increased the
diversity of generation ownership to a degree. According to the Edison Electric Institute,
in 1996, non-utility generating capacity was approximately 11% of the U.S. total.
Approximately 77% of this non-utility capacity is from cogenerators and small power
producers (i.e., QFs) .
3
In addition to PURPA, the Fuel Use Act of 1978 (FUA), helped QFs becom
4
e
established. Under FUA, utilities were not permitted to use natural gas to fuel new
generating technology. QFs, which are not utilities, were able to take advantage of
abundant natural gas as well as new generating technology, such as combined-cycle and
fluidized bed combustion. These technologies lowered the financial threshold for entrance
into the electricity generation business as well as shortened the lead time for constructing
new plants. FUA was repealed in 1987, but by this time, QFs and small power producers
had already gained a portion of the total electricity supply market.
This ability to build relatively small but economic generating capacity, along with
the utilities' reluctance to build additional capacity, encouraged some to enter into the
electricity supply business without meeting the requirements to be a QF. These entities,
called Independent Power Producers (IPPs), sell power at wholesale only. However,
3 Edison Electric Institute. 1996 Capacity and Generation: Non-Utility Sources of Energy.
October, 1997. Page 7.
4P.L. 95-620. Signed into law on November 9, 1978.

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because they are not QFs, they are not afforded the protections of PURPA and, most
importantly they were not exempt from PUHCA. Most utilities find regulation under
PUHCA to be restrictive and burdensome. In addition, PUHCA is seen by some to be a
barrier to electricity market entry by non-utility businesses.
The influx of QF power challenged the cost-based rates that previously guided
wholesale transactions. Before implementation of PURPA, FERC approved wholesale
interstate electricity transactions based on the seller's costs to generate and transmit the
power. As more nonutility generators entered the market in the 1980's these FERC
approved cost-based rates were questioned. Since nonutility generators typically do not
have enough market power to influence the rates they charge, FERC began approving
certain wholesale transactions whose rates were a result of a competitive bidding process.
These rates are called market-based rates.
5
This first incremental change to traditional electricity regulation started a movement
towards a market-oriented approach to electricity supply. Currently, most non-QF
cogenerators and small power producers are affiliated with parent utility companies and
are not truly independent of regulated utilities. Independent and affiliated power
producers began to blur the status and obligations of utility regulation at both the federal
and state levels. The issues of whether to encourage independent power producers and
whether to permit utility diversification into non-regulated markets resulted in a call for
further regulatory reform.
Call for Further Reform: EPACT
Following the enactment of PURPA, two basic issues stimulated calls for further
reform: whether to encourage nonutility generation and whether to permit utility
diversification. Independent power producers and some utilities argued that to encourage
competition in electricity supply, IPPs should be exempt from PUHCA regulation. It was
seen that this exemption would encourage investment in IPP facilities. Before PUHCA
reform, companies that operated nonutility and utility businesses had been reluctant to
build independent facilities for fear of having all their operations regulated under
PUHCA. Additionally, independent power producers argued that their corporate structure
was being distorted and made overly complex by the machinations necessary to avoid
regulation under PUHCA. They argued this result (overly complex corporate structures)
was the exact opposite of the purpose of PUHCA.
The Energy Policy Act (EPACT) increased competition in the electric generating
sector by creating new entities that can generate and sell electricity at wholesale without
being regulated as utilities under PUHCA. By creating new options for utilities and
regulators to meet electricity demand, the effect of EPACT on the electric supply system
is potentially more far-reaching than PURPA’s introduction of cogenerators and small
power producers to the electricity supply mix.
5 For a discussion on competitive bidding see, Poling, Parker, Abel, Holt, Kiefer & Kaufman.
Electricity: A New Regulatory Order?, prepared for the House Committee on Energy and
Commerce. Committee Print 102-F. June 1991. p. 101-102.

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How Did EPACT Reform PUHCA?
EPACT established "exempt wholesale generators" (EWGs) and “foreign utility
companies” (FUCOs) as entities that are not considered electric utilities and are therefore
exempt from the Federal Power Act and PUHCA. State regulators can now allow utilities
to purchase electricity from EWGs at contracted market-based rates, rely on traditional
cost-of-service regulation, or a combination of both. EWGs can be constructed anywhere,
including foreign countries. Both registered and exempt holding companies under
PUHCA may own and operate EWGs. A portion of a generating facility can be considered
an EWG if the other part of the facility is not owned by a utility affiliated with the EWG.
Electricity from these facilities that is sold in the United States must be sold at wholesale
to a utility or other generator, not to retail customers. In addition, EPACT provides EWGs
with a system to assure transmission of their wholesale power to purchasers.
On February 11, 1993, the Federal Energy Regulatory Commission (FERC) issued
its final EWG regulations required by §711 of EPACT.6 This rule covers filing
requirements and procedures for applicants seeking EWG status. EWG status is primarily
self-regulating. FERC requires that an applicant file sworn statements that it complies
with the statutory requirements for EWGs.7 Applicants are guaranteed a ruling on their
application within 60 days without any public hearings. FERC acknowledged some
consumer groups' concerns that the proposed rule did not allow for sufficient public notice
and, in the final rule, FERC agreed to consider comments that specifically question the
adequacy or accuracy of an application.
PUHCA reform under EPACT provides protection to consumers against financial
abuses between regulated and unregulated entities, including cross-subsidization. During
the legislative debate, opposing views were expressed on the sensibility of allowing
transactions between affiliates. Consumer groups and state utility commissions argued
that the risks of above-market-cost transactions outweighed possible benefits associated
with vertical integration (including EWGs). Some utilities, however, argued that som
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affiliate transactions would benefit consumers and should be allowed. In the end,
Congress expressed a desire to continue protection of consumers' interests but assumed
that affiliate transactions, if allowed at all, would be subject to very stringent state
regulation. Also, if every state commission that has jurisdiction over the electric utility's
rates approves, an electric utility may purchase electricity from an affiliated EWG.9
FERC
6
docket number RM93-1-00. Appears in Federal Register. Vol. 58, No. 51. Feb. 18, 1993.
p. 8897-8907.
Th
7
ese requirements include: a description of the eligible facility, eligibility for EWG status, any
lease arrangements with affiliated or non-affiliated electric utilities, and any requirements placed
on those affiliates by a state public utility commission.
8 Vertical integration refers to the three components of electricity supply: Generation,
transmission and distribution.
9Affiliate transactions can occur if state regulators determine that: 1)the commission has the
authority in addition to the resources to examine the financial books of the electric utility
company and any relevant affiliates; and, 2) the commission determines that a wholesale transfer
of power between an EWG and an affiliated electric utility would benefit consumers, not violate
(continued...)

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The law also allows for state utility commissions to request financial information
from a regulated electric utility, an EWG, or an affiliate of an EWG that sells electricity
to a regulated electric utility. This will assure state regulators that the wholesale contracts
that a regulated electric utility enters will not degrade the reliability of electric service or
be of greater financial risk than desired. Another consumer protection afforded by the law
is that a registered holding company must seek the approval of the Securities and
Exchange Commission (SEC) when it issues securities to purchase an EWG, guarantees
securities for an EWG, or enters into any type of service, maintenance, or construction
contract.
EPACT allows holding companies and EWGs to have financial interests in foreign
utility companies. The Securities and Exchange Commission was required to issue rules
to protect ratepayers from any harm that might result from holding companies' foreign
investment activities. The SEC issued its final rule on October 1, 1993.10 In issuing its
rule the SEC noted that consumer protection and competition are potentially inconsistent
goals. The Commission noted “that there is an inherent tension between the drive toward
a competitive energy market and the demand for effective consumer protection. The rules
required by the legislation cannot resolve this tension, but must instead operate within it.”
The rule imposes a retained earnings requirement on these diversification activities,
allows SEC access to books and records, and limits the number of domestic utility
employees who could provide services to both affiliated EWGs or affiliated foreign utility
companies.
What is Next?
One unintentional consequence of PURPA was to introduce competition into the
electric generating sector. The main effect of the debate and enactment of EPACT was
to continue a reevaluation of traditional electric utility regulation. PURPA began to shift
more regulatory responsibilities to the federal government, and EPACT continued that
shift away from the states. This occurred without agreed-upon goals for how electricity
should be supplied and regulated in the future. FERC has addressed some of the
unresolved issues created by EPACT, such as transmission access. However, as th
11
e
electric utility restructuring debate evolves, additional policy issues likely to be addressed
include federal-state jurisdictional roles, stranded cost recovery, industry structure, and
non-economic regulatory factors.12
(...continued)
any state law, would not give an unfair competitive advantage to an EWG, and would be in the
public interest.
1 0Securities and Exchange Commission. Adoption of Rules, Forms and Form Amendments
Relating to Exempt Wholesale Generators and Foreign Utility Companies. Federal Register.
Vol. 58, No. 189, October 1, 1993. p. 51488-51507.
For
11
a discussion on transmission access and FERC Orders 888 and 889, see issue brief 96003.
12 Parker, Larry B. Electric Utility Restructuring: Overview of Basic Policy Questions. CRS
Report for Congress. 97-154ENR. January 28, 1997.

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