First, I want to commend Representative Gannon for sponsoring House Resolution 100 and for scheduling this hearing. The questions surrounding energy prices and supplies in Pennsylvania include economic, environmental, and legal issues that I believe are important to all members of the General Assembly and their constituents. As the statutory representative of your constituents with respect to utility service, I am pleased to appear before this Committee and to try to assist you in obtaining the information called for in House Resolution 100.
Pennsylvania electric consumers have fared well under the 1996 electric restructuring legislation. Today, the reliability and supply of electricity are adequate and structures are in place to provide effective price protection. Most importantly, the consumer protections built into the Act, including long-term caps on the price of service provided by incumbent utilities, have prevented any substantial harm to Pennsylvania consumers during what is necessarily a long transition to more fully competitive retail and wholesale electricity markets.
With respect to natural gas, availability and supply have not been at issue. However, Pennsylvania consumers, and indeed natural gas consumers across the Nation, suffered last year through an unprecedented spike in prices that made it difficult, if not impossible, for many families to pay their winter heating bills. Fortunately, natural gas prices have returned this year to more "normal" levels, but we must try to ensure that last year's catastrophic price rise does not become a recurring event.
I will now turn to a more complete description of the electric and natural gas markets as they affect Pennsylvania consumers.
The question I am asked most often about electric restructuring is whether the horrendous failure of California's electricity market experiment is likely to occur here in Pennsylvania. My answer is that, if Pennsylvania continues to follow the reasoned, measured approach that we embarked upon several years ago at both the wholesale and retail levels, then there is no reason to expect that the California experience of rolling blackouts, bankrupt utilities, and wild price swings, will happen here.
I mention wholesale markets first because it is impossible for a successful retail competitive market to develop unless the wholesale bulk power markets are workably competitive. Pennsylvania is extremely fortunate in that most of its electric utilities (and soon perhaps nearly all of its utilities) are a part of the PJM Interconnection. The PJM (Pennsylvania-Jersey-Maryland) utilities have been working together on a regional basis since 1927, and now operate as part of the Nation's most successful Independent System Operator (ISO). The PJM ISO is responsible for ensuring that reliable and economical service is maintained throughout the region by establishing certain rules and by operating several wholesale electricity markets. The PJM markets are far from perfect but they are, in my opinion, far superior to virtually every other wholesale market region in America. Unlike the recent horrific experience in California, the wholesale prices that are produced in the PJM marketplace -- with some important exceptions -- have been generally consistent with results that one would expect in a competitive market. In addition, PJM maintains strict reliability requirements that must be met by all entities that serve retail customers in the PJM region. The PJM region appears to have adequate generation resources to meet our immediate needs. For the future, plants now under construction or being planned should help to provide continued reliable service.
Building on the PJM foundation, Pennsylvania's own electric restructuring reforms have also provided benefits to consumers. Our rate caps assure that Pennsylvania consumers do not have to pay any more for electricity now than they were paying when our restructuring act was passed in 1996. In addition, more than half a million, or about 10% of Pennsylvania electric consumers, have switched to alternative electric generation suppliers, whether to receive lower prices or to purchase power from generation resources that they believe to be cleaner or "greener" than traditional utility resources. Electric utility programs to assist low income consumers to pay their bills and to conserve energy were also substantially increased across Pennsylvania, without producing rate increases for consumers. Finally, Pennsylvania's leadership role in electric restructuring has helped to attract new types of renewable generating resources, such as wind and solar power, that previously had gone substantially untapped.
It is true that the level of retail competition has decreased from its year 2000 levels. This is substantially a result of increased wholesale electric energy and capacity prices that make it hard for competitors to beat our utilities' capped retail prices and still make a profit. Some market participants and other commentators have suggested that we should abandon our rate caps in Pennsylvania - let our utilities raise their prices well above their 1996 levels - so that it would be easier for competitors to come in and win customers. I think this idea must be rejected in the strongest terms. I do not know of a single state legislator who voted for electric restructuring in 1996 in order to raise Pennsylvania's already high electric rates. It must be recalled that Pennsylvania utilities have been allowed to charge ratepayers for billions of dollars of so-called stranded costs that were expected to arise because competition would force rates to go well below their 1996 levels. What consumers got in return was rate caps that protected them from paying even higher rates during the period in which those stranded costs were being collected. That was the deal. If that deal is broken and consumers lose price cap protection, then the utilities should first give back the $12 billion in stranded costs that Pennsylvania consumers are paying those utilities for anticipated losses. In my opinion, the way to increase retail competition in Pennsylvania is by fixing the remaining flaws in the wholesale market, not by increasing retail rates and violating the rate caps that were supposed to protect consumers during this transition period.
In electricity, therefore, I think our policy goal should be to stay the course and continue to provide protections for consumers while we see how competitive markets develop. That is not to say that the General Assembly should do nothing. For example, I have testified strongly in favor of a series of House Bills, HB 1076 through 1079, that would increase Pennsylvania's commitment to renewable resources and demand-side energy efficiency programs. In my opinion, a broad diversity of energy resources, both on the supply side and on the demand side, is an enormous benefit in and of itself. In addition, I have testified in support of House Bill 1433 that would provide a modest level of state funding to support voluntary low-income programs that have been implemented by Pennsylvania's electric and gas utilities. There is no question in my mind that our energy policy will have failed if we provide an abundance of choices to some consumers, but leave our poorest consumers quite literally out in the cold.
The most severe price shock in recent years occurred last winter when wholesale natural gas commodity spot prices tripled and even quadrupled within the space of several months. The impact of these price increases flowed through to Pennsylvania retail consumers. This problem was a nationwide phenomenon, not limited to Pennsylvania. Fortunately, last year's wholesale gas price increases were immediately followed by a rapid plunge in those prices and these reduced wholesale prices are now being reflected in the retail prices paid by Pennsylvania natural gas consumers. This is providing some needed rate relief to many Pennsylvanians as we enter this winter's heating season.
The fact that wholesale natural gas prices have dropped in recent months, however, does not lessen the importance of this Committee's task under House Resolution 100. The natural gas price roller coaster is not sustainable. Residential consumers were faced with impossible choices when last winter's gas bills reached extraordinary heights. The fact that gas prices have dropped this winter is a welcome development, but it does not assure that Pennsylvania households will not face another gas price crisis in the future. Moreover, for many Pennsylvania consumers the overall price they are paying for natural gas today is still higher than it was a year ago.
It is necessary to understand what happened in the wholesale natural gas markets last year and then to determine what Pennsylvania policy-makers, regulators, and retail gas distributors and marketers can do to keep the prices paid by Pennsylvania gas consumers at a more reasonable level in the future.
First, it must be recognized that the wholesale price of natural gas "at the wellhead" has been deregulated for many years. This has nothing to do with the recent enactment by the Pennsylvania General Assembly that opened a portion of the retail segment of our local natural gas utilities to competition. Wholesale natural gas prices were once regulated at the federal level, but now they are not regulated at all. Rather, the wholesale price of gas is set through the competitive market. In my opinion, that market worked well over the years in assuring an adequate supply of natural gas at reasonable prices. In early 2000, however, the dynamics of the market changed dramatically.
Typically, gas supplies are plentiful in the spring and summer, and gas prices are low. The wholesale purchasers of gas take advantage of this fact by buying large amounts of gas and placing it in storage for the next winter heating season. In the spring of 2000, however, natural gas prices remained higher than normal, and the level of gas in storage became very low. Some gas suppliers deferred the purchase of gas for storage in the hopes that gas prices would go down. Instead, prices continued to climb.
One of the causes of the problems of early 2000 was the fact that gas prices had been so low in prior years that many gas producers had stopped drilling for new gas. The problem was exacerbated by the emergence of an increased demand for natural gas for new electric generation units that are fueled by natural gas. These electric generating units operate during periods of peak summer electric usage when the demand for natural gas was traditionally low.
Prices rose steadily as the winter of 2000-2001 began to approach and then prices simply raced out of control. On January 4, 2000, the spot price of natural gas at the Henry Hub in Louisiana was $2.17 per thousand cubic feet (mcf). By December 29, 2000, the spot price had risen to $10.87 per mcf. As these higher wholesale prices began to work their way into Pennsylvania retail bills, the impact was extreme, leaving many people across Pennsylvania unable to pay their monthly gas bills. Many customers developed large arrearages or debts to their gas utility as their bills mounted up over the winter. In addition, in most of Pennsylvania, the increase in gas prices was coupled with colder than normal temperatures, particularly in the early part of the winter, which caused monthly bills (and monthly arrearages) to rise even higher.
Today, as I noted above, wholesale prices have dropped substantially from last year's levels. Gas producers expanded production and began drilling new wells at a rapid pace; the amount of gas in storage increased to normal levels and above; and wholesale prices dropped to the point where the reported Henry Hub spot price earlier this month (November 14, 2001) was $2.04 per mcf. These wholesale price reductions are now being reflected in the retail bills paid by Pennsylvania natural gas consumers. Substantial gas rate reductions from last winter's highs are now being seen across Pennsylvania, but in some cases, the overall gas prices being paid today are still higher than they were a year ago. Based on current projections, the lower wholesale prices are expected to continue through the next several months, though it has become extremely hazardous to try to predict the future of natural gas prices.
At the retail level, although competition for gas supply is permitted throughout most of Pennsylvania, the great majority of residential consumers continue to be served by their traditional local natural gas distribution companies, and the retail prices that those customers pay are regulated by the PUC. Each natural gas distribution company purchases gas at the wholesale level and essentially passes that gas on to its residential and other retail customers at cost. That is, the local gas distribution companies generally do not "mark up" or profit from the sale of the natural gas itself. Under Section 1307(f) of the Public Utility Code, which was enacted by the General Assembly in 1984, each natural gas distribution company's purchased gas costs are reviewed every year by the PUC and by other parties such as my Office. We work to ensure that each gas utility is serving its customers at the lowest reasonable price; that is, by purchasing its gas through a least cost gas procurement policy.
I would also note that opening up the gas supply portion of Pennsylvania's natural gas distribution companies' retail sales to competition has not been a cure to the volatility in the wholesale gas market. To my knowledge, virtually no residential gas customers in Pennsylvania are being served by alternative competitive natural gas suppliers except in the service territories of three Western Pennsylvania-based gas utilities (Columbia, Equitable, and Dominion Peoples) that had substantial gas competition pilot programs in place prior to the enactment of our Natural Gas Choice Act in 1999. Even if these competitive retail suppliers were active throughout Pennsylvania, however, they would have been subject to many of the same wild swings in wholesale gas prices that have plagued our regulated retail gas utilities.
So what would I recommend? In each of our recent purchased gas cost proceedings, our Office has recommended that the utility purchase more of its gas supplies at fixed prices, rather than purchasing all or most of its supplies under contracts that are "indexed" to the spot price of gas. We believe it is important for the gas utilities to have a diversified gas portfolio that allows the gas utilities the flexibility to take advantage of lower cost supplies when they become available, but also provides assurance that their overall gas supplies will not be as vulnerable to the kind of wild swings that we have seen in the last year and a half. We recognize that this means that at any given point in time, our gas utilities might not be paying the very cheapest prices that are available on the spot market that day, but it also means that they will not be as exposed to the risks that forced them to purchase gas last year on the coldest days of the winter at extraordinarily high prices. Our Office believes that these recommendations are consistent with the current Public Utility Code, especially in light of the amendment to Section 1307 that was made in the1999 Natural Gas Choice Act that allows utilities to include in their purchased gas cost recovery "costs paid for employing futures, options and other risk management tools."
Finally, I want to repeat my endorsement of efforts at the state level, such as House Bill 1433 that I discussed above, to help Pennsylvanians most in need of assistance to withstand the impacts of high or volatile gas prices. High natural gas prices were hard on all Pennsylvania consumers last winter but the impact was particularly harsh on low-income customers, who have difficulty paying their bills in normal times.
Were Laws Violated?
I want to close my testimony by addressing a specific question in House Resolution 100, namely, whether the price spikes discussed above resulted from any violations of federal or state statutes.
With respect to last year's natural gas price spike, I am not aware of any substantial evidence that gas suppliers broke any laws. As I noted above, a number of actions and events coincided to allow the tremendous and sudden increase in natural gas prices, but I do not know that any of those actions were illegal.
The situation is not as clear in relation to wholesale electricity prices. Just last week, the Federal Energy Regulatory Commission (FERC) initiated an investigation into market-based pricing in wholesale power markets. Under market-based pricing, the price of wholesale power is supposed to be kept in check by competition. FERC's recent order calls that assumption into question, particularly for companies that are not part of Regional Transmission Organizations or Independent System Operators such as PJM. Even in PJM, there has been evidence of the use of market power to raise prices, particularly in the market for installed capacity (ICAP). In January, February and March of this year, we saw a substantial and sustained increase in prices for installed capacity in circumstances that did not appear to involve diminished supply or significantly increased demand. PJM's Market Monitoring Unit has concluded that one company was able to exercise market power to raise capacity prices above competitive levels during that period. I am not aware that anyone has concluded that this was a direct violation of law or of the PJM market rules that were then in effect, but I do think it is reasonable to conclude that the ICAP rates resulting from these actions were not just and reasonable as required under the Federal Power Act. The appropriate solution under the existing system, which PJM promptly took, was to obtain permission from the Federal Energy Regulatory Commission to strengthen some of its market rules to prevent a recurrence of this problem in the future.
In my opinion, the energy outlook for Pennsylvania is reasonably bright.
We have recognized that formerly monopoly products like electricity and natural gas cannot simply be deregulated in the belief that perfect competition will arise instantly in order to protect consumers from the exercise of market power and other market flaws. To the contrary, Pennsylvania has kept in place necessary consumer protections to try to ensure that consumers are not harmed during the transition to more competitive energy markets, but rather can benefit from some competitive changes while still retaining some of the benefits of necessary regulation.
I hope this testimony has been helpful to the members of the Committee. I would be happy to answer any questions you may have at this time.