M ' J: M E T M C: Ovin Uice Aking Lectricity Ransmission ORE Ompetitive
M ' J: M E T M C: Ovin Uice Aking Lectricity Ransmission ORE Ompetitive
M ' J: M E T M C: Ovin Uice Aking Lectricity Ransmission ORE Ompetitive
POLICY
STUDY
314
Reason Public Policy Institute
Reason Foundation
Reason Foundation advances a free society by developing, applying,
and promoting the libertarian ideas of individual liberty, free
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policymakers, and opinion leaders.
Executive Summary
The dramatic blackouts in the Midwest and Northeast in August of 2003 have focused our
attention on electricity policy once again. This time the issue is the grid—the transmission network
that transports electricity across regions. Our policies governing electricity transmission—
regulating it and moving slowly toward changes to support competitive wholesale electricity
markets—are getting a sharp look from more people than ever.
Existing long-distance transmission infrastructure is insufficient to support the changes that have
come about in the industry since the deregulation of the early 1990s that led to the dramatic
increase in the trade of generated electricity.
Ways to remedy this situation fall into three categories: build and upgrade transmission, build
generation closer to population centers, or reduce the demand for transmission services. This
study provides an analysis of the institutional changes being proposed and debated, particularly
FERC’s RTO policy. By establishing RTO rules, FERC can move the industry toward building and
managing a national grid network. But at the same time, FERC risks creating an ordered
competition— competition engineered based on an assumption about how competition ought to
be— rather than a competitive order, which arises spontaneously from human action and economic
evolution based on choices and change over time. While ordered competition through the RTO
structure could simply be a step to move the industry toward an institutional structure in which a
competitive order can emerge, it is at best only part of the legislative and regulatory changes that
would produce competition in the industry. To do that, legislative and regulatory changes will have
to focus on removing barriers to entry and to technological change in the industry.
Our recommendations encourage the use of distributed generation technology, innovative forms of
contracting, and other institutional and technological changes that would increase the
contestability of the transmission segment of the electricity value chain, and could do so in a
flexible, open-ended way.
P o l i c y S t u d y N o . 3 1 4
Table of Contents
Introduction .............................................................................................................1
The Issue: Transmission in a Restructuring Electricity Industry....................................4
A. Overview of Regulatory Issues in Electricity...............................................................................4
B. Industry Background and Regulatory History ............................................................................6
C. Transmission Policy ..................................................................................................................8
D. Examples of Early RTO Submissions........................................................................................10
Part 1
Introduction
The dramatic blackouts in the Midwest and Northeast in August of 2003 have focused our
attention on electricity policy once again. This time the issue is the grid— the transmission
network that transports electricity across regions. Our policies governing electricity transmission—
regulating it and moving slowly towards changes to support competitive wholesale electricity
markets—are getting a sharp look from more people than ever.
Each crisis in electricity policy—the California electricity meltdown, the Enron bankruptcy, and
now this blackout—throws up roadblocks to change. People’s natural reaction to crisis is to seize
upon the false security of the past. But competition and the use of markets have continued to
increase in the electricity industry.
This has created some difficult structural issues, particularly involving electricity transmission.
The existing long-distance transmission infrastructure is insufficient to support the changes that
have come about in the industry since the deregulation of the early 1990s that led to the dramatic
increase in the trade of generated electricity. Historically, utilities have owned their own
generation, transmission, and distribution assets, making them “vertically integrated.”
Policymakers are now focusing on the deficiencies of a transmission grid built for the contiguous,
local, vertically integrated monopolies of yesteryear, not for the dynamic markets across time and
place of today.
Ways to remedy this situation fall into three categories: build and upgrade transmission, build
generation closer to population centers, or reduce the demand for transmission services. Both the
Federal Energy Regulatory Commission (FERC) and Congress are in the process of implementing
changes that may lead to both the construction of new transmission and the reduced need for
additional transmission. FERC is promoting institutional change by ordering the formation of
regional transmission organizations (RTOs), through which transmission owners will build and
manage the grid over larger areas than before. FERC is also working with industry participants to
standardize the technical requirements for interconnecting distributed generation (DG) facilities to
the grid, which will lead to more consumers generating their power locally and will help reduce the
demand for transmission services and therefore reduce the amount of additional necessary grid
construction. Congress continues to consider legislation to remove some long-standing legislative
barriers to investment in transmission infrastructure, including repealing the Public Utility
Holding Company Act of 1935 (PUHCA) and its barriers to competition as well as providing
supporting legislation to complement FERC’s activities in standardizing technical DG
interconnection requirements.
2 Reason Public Policy Institute
This study provides an analysis of the institutional changes being proposed and debated,
particularly FERC’s RTO policy. By establishing RTO rules, FERC can move the industry toward
building and managing a national grid network. But at the same time—FERC risks creating an
ordered competition, competition engineered based on an assumption about how competition
ought to be—rather than a competitive order, which arises spontaneously from human action and
economic evolution based on choices and change over time.1 While ordered competition through
the RTO structure could simply be a step to move the industry toward an institutional structure in
which a competitive order can emerge, it is at best only part of the legislative and regulatory
changes that would produce competition in the industry. To do that, legislative and regulatory
changes will have to focus on removing barriers to entry and to technological change in the
industry.
The FERC RTO policy recognizes that improved transmission coordination and investment can
make generation markets more competitive, but it does not recognize that the reverse is also true.
Changes in generation regulation and technology can make transmission more or less competitive,
and therefore indicate that transmission is no longer a natural monopoly. The key to this process is
regulatory change that reduces the barriers to entry that keep transmission from being
contestable.2
Regulation of the electricity industry is evolving away from its traditional “command and control”
treatment toward more use of choice and markets. It does, though, retain the government-granted
monopoly franchise in the transmission and distribution portions of the value chain. In so doing it
overlooks the potential contestability of those segments of the industry, and stifles potential
beneficial technical and institutional change and innovation. Transmission policy decisions at the
federal level continue to be influenced by this natural monopoly theory of transmission, and this
study analyzes those decisions and their likely implications for the adoption of technological and
contractual innovations that would take advantage of transmission’s contestability.
FERC is trying to shape institutional change to reduce transaction costs and bring about the
benefits of competition in a structured, ordered way, but must be conscious of the possible costs of
its decisions and its failure to capture the potential benefits of contestability. FERC’s effort at
institutional and regulatory change to promote competitive electricity markets is a welcome
departure from the historical “command-and-control” forms of utility regulation that are changing
at both the federal and state levels. However, retaining the premise that natural monopoly
conditions characterize transmission, and that such conditions imply the need for ongoing
economic regulation, means that this institutional change is only an incremental step, and may
have some unintended costs as a result of institutional path dependence. Mandating a particular
institutional structure, especially one based on natural monopoly theory, will forestall the discovery
of possibly superior alternatives that exploit decentralized knowledge. Many mechanisms exist by
which a regulatory system (even one undergoing mild liberalizing) based on such a strong
assumption about industry and market characteristics can raise substantial barriers to the
emergence of superior alternatives. One is that it locks in the transaction costs of a regulated
monopoly transmission grid with no mechanism to encourage the lowering of transaction costs. By
mandating the way electricity is transmitted, it also precludes local entities from using local
knowledge to discover new arrangements tailored to their specific needs, such as new ways to
contract for wholesale wheeling of electricity or new distributed generation interconnection
agreements. The combined federal and state regulation of the industry complicates the entry
barrier story even further.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 3
Over the past decade the electricity industry has seen deregulation and privatization in various
nations, and with various degrees of success. No country or state has moved to complete
deregulation; all have retained some vestiges of control over pricing, service, or entry decisions for
some or all parts of the electricity supply chain. These moves have created an ordered competition,
not a competitive order.3 These vestiges of control and desire to manage competition undermine
precisely the highest value benefits associated with deregulation, and incorporating the potential
for transmission’s contestability into federal electricity policy will enable market participants to
capture those benefits.
4 Reason Public Policy Institute
Part 2
The electricity industry is historically characterized by high fixed costs and economies of scale, and
has been regulated as a natural monopoly. Electricity is not storable, and it is difficult and costly to
transport over long distances. As a result of these traits and its historical policy treatment, the
electricity industry tends to be regional, and demand and supply change little with prices.
However, the California experience has taught us how false this view is. Demand turns out to be
more responsive to prices than people thought, when the institutional environment is changing.
When San Diego’s electric rates more than doubled in the summer of 2000, demand fell by an
average of 1.6 percent, and by 6 percent during peak periods.4 People would have cut electricity use
even more if they had not anticipated that rate controls would be reinstated. Under monopoly
regulation, where prices change only very slowly, usually in small bits, and only after public and
political debate, demand and supply of electricity don’t change much even when prices do change.
California’s restructuring also showed that the supply of electricity can change when regulatory
constraints are loosened. California has seen an explosion in the number of generation plant
projects since restructuring and throughout the recent crisis, notwithstanding the existence of
substantial regulatory uncertainty.
The most important defining characteristic of electricity in the United States is known as Kirchoff’s
Law, which states that in an alternating current network, electrons follow the path of least
resistance. Because the physical flow of electrons almost never corresponds to the financial
contracts for its sale and transmission, a seller cannot “label” or specify which electrons he is
sending to which buyer. This technical reality has created the need for sophisticated system
balancing in the network to maintain reliable delivery of electricity to customers, and has
frequently contributed to the rationale for continuing regulation of the industry.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 5
State-level regulation of electric utilities is based on the grant of an exclusive local monopoly
franchise. Historically, utilities have owned their own generation, transmission and distribution
assets, and were responsible for providing reliable bundled service to their “native load,” or service
territory as defined in their franchise agreement with their state public utilities commission or
regulatory agency. Thus, utilities have become isolated “kingdoms unto themselves,” fragmenting
transmission ownership in the electricity industry.
In addition to historical and technical limitations on the openness of electricity markets, the recent
fiasco in California has prompted many observers to claim that electricity markets “can’t be
trusted.” But the aberration of California in the larger picture of electricity deregulation has more
to do with poor policy choices than with market failure.5 The net benefits of electricity deregulation
still seem substantial. But the continuing regulation of transmission investment undercuts even
larger potential benefits that would come from a more market-based approach to the grid itself and
to empowering substitutes and alternatives to grid construction.
The local, vertically integrated and monopolistic form of utilities has historically generated some
concerns that utilities could abuse their power. These concerns led states to introduce rate and
service area regulation under public utilities commissions, thus regulating, but also isolating, the
electricity industry from any market competition that would keep quality high and rates low. Smith
persuasively presents the rent-seeking theory, arguing that state utility regulation arose out of the
interests of incumbents in protecting their industry from competition, not from a public or
consumer concern about monopoly power and possible price increases.6 He cites evidence that
between 1900 and 1920, the states that initially adopted utility regulation actually had lower prices
and profits, not monopoly prices, which would be consistent with a rent-seeking theory of
regulation.7
Monopoly franchises are also justified as a way to avoid duplication of facilities, with such
duplication deemed wasteful by neoclassical theory of industries with economies of scale. Yet a
study of cities with two or more electric utilities competing head-to-head for customers over
parallel systems found that competing utilities do not underutilize capacity or have higher rates, as
natural monopoly theory (and regulators) would have it.8 Even in cases where the neoclassical
story regarding economies of scale holds, it is not clear that regulated monopoly franchises offer
any solution. In fact the capital-intensiveness of the electricity industry increased promptly after
monopoly regulation was imposed early in the 20th century.9 By the 1990s, regulatory regimes that
tied utility profits to capital investment had created considerable wasteful capital investment.10
This excess capacity and over-investment led to higher electricity prices, and in the last decade
several states have moved to introduce competition in the industry to some degree. One important
component of this move is usually the unbundling of the electricity value chain into its generation,
transmission, and distribution components. The Federal Energy Regulatory Commission (FERC)
has facilitated this move through several orders, particularly Order 888 (1987) encouraging open
access to transmission and Order 2000 (1999) mandating the formation of regional transmission
organizations (RTOs).11 These policy decisions are based on the belief that transmission remains a
natural monopoly as such transmission must remain regulated. One consequence of the RTO
implementation will probably be the construction of many miles of high-voltage transmission as a
corresponding evolution to the changes in the generation portion of the industry; and, as stated in
the President’s energy policy proposal in May 2001, RTOs are likely to be able to use eminent
domain to acquire land and rights-of-way for this expansion.
6 Reason Public Policy Institute
The supply of electricity has three components: generation of electricity from a fuel source,
transmission of electricity to its local market, and distribution in the local market to consumers.
Each of these parts of the supply process requires substantial capital investment, and the industry
exhibits network characteristics because of binding physical constraints. Alternating current
electricity cannot be stored, nor can it be “labeled” and delivered from seller to buyer. Thus
electricity networks must operate within small tolerances to maintain reliability, and defining
property rights over electricity on the grid is technically impossible at this time.
At the beginning of the 20th century, many private companies provided electric service under
nonexclusive franchises. These franchises meant that companies could compete, provide different
services, or install systems using different frequencies or voltages over areas as small as a block or
as large as an entire city. Many customers also generated their own power. This fragmentation, in
conjunction with the competing standards of direct current (Edison) and alternating current
(Westinghouse), created messy and chaotic operating environments for electric companies. 12 The
chaos gave entrepreneurs opportunities to consolidate multiple small companies into one holding
company, as did the fact that alternating current enables transmission of electricity beyond two
miles (the then-binding constraint for direct current) at higher voltage.
Samuel Insull was one such entrepreneur, who recognized the importance of load factor and using
peak-load pricing to manage load, used new technology creatively, and helped create an industry
with large economies of scale in generation.13 By 1907 he had consolidated 20 companies in
Chicago into Commonwealth Edison, and became a role model for others in the industry. In that
same year the states of Wisconsin and New York extended their railroad regulation to electric
utilities, in an effort to counteract possible monopoly power on one hand and ineffectual or corrupt
municipal officials on the other. By 1914, 45 states had enacted state public utility regulation.
Insull had also noted that regulation codified and justified the monopoly status of utility companies
and allowed the utilities to sell equity more easily and borrow money at lower interest rates.14
Part of this regulation of electric utilities was the granting of exclusive monopoly franchises for
specific service territories to the utilities. 15 Although the details vary by state, the franchise also
carries with it an obligation to serve all present and future customers in the service territory at a
reasonable cost.16 This obligation to serve all customers in a territory persists to this day as a
fundamental characteristic of the monopoly franchise and has served to eliminate possible
competition that could face utilities, including competition from new technologies for distributed
generation.
Thus for the past 90 years the electricity industry in the United States has been subject to
regulation of its prices and operating decisions, and has been characterized by vertically integrated
local utilities operating as government-granted and government-regulated monopolies. Regulation
primarily has taken place at the state level, although the Federal Power Act of 1935 reinforced the
ability of states to regulate prices and operations. It has taken the form of rate-of-return
regulation, where the state-level public utilities commission or some other rate-making authority
takes input cost and capital cost data from the utilities and determines the rate that they would be
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 7
allowed to charge to different classes of consumer (residential, commercial, industrial). This rate
includes a rate-of-return markup so that the utility earns a return on its capital investment.
Even regulators have long acknowledged that this is a mediocre arrangement at best; this system is
far from capturing the rich and complex web of information that would lead to “efficient” pricing
and supply of electricity. One of the most pernicious and counter-productive incentives inherent in
rate-of-return regulation is the Averch-Johnson effect, where the utility has an incentive to invest
in excess capacity because that investment would increase its rate base and thus increase its
effective return—the “logic” is “if you invest more, you get to charge more.”17 Note that this
correspondence differs dramatically from how we usually think of the effects of investment in a
dynamic economy, where an impetus for capital investment comes from lowering your costs to
create more room for profit margin or for lowering prices.18
Over decades, the cumulative effects of these investment decisions have been more and larger
central power plants and more expensive electricity than we might have seen otherwise. In
California, on the eve of its restructuring legislation in 1996, the three electric utilities had
approximately 25 percent excess capacity and there was capacity to import power equivalent to a
further 20 percent of demand. Electric system engineers recommend 7.5 percent to 15 percent
excess capacity to ensure reliability of service, and some foresight is required when building large
plants in the expectation of demand growth, but customers in California and elsewhere began
thinking that paying higher rates for such excess capacity was unnecessary.
Technological change has also helped bring about the deregulation and restructuring efforts that
we have seen thus far. Electricity generation has become more efficient and cost-effective at smaller
scales, undercutting the historical tendency of large central generating plants to exploit economies
of scale. As the technology of generation has changed, the economics of generation has also
changed, and large power plants are no longer the only way to lower the long-run average cost of
producing electricity. Technological change has made distributed generation possible and more
cost effective over time. It has also improved transmission’s ability to carry electricity over longer
distances with less line loss.
At the same time, deregulation of the wholesale electricity market under FERC Order 888 gave rise
to increasing capacity for trading electricity across broader geographic regions. It also led to more
mature real-time and futures markets and contract mechanisms for trading electricity, and to
improved information technology and software to manage complex trading regimes. A power
trader in California’s restructured and constrained electricity market had to “make over 500
bidding decisions and over 100 decisions on capacity allocation in the course of 24 hours.”19
Other legislative changes shaped the evolution of this industry. In 1978 Congress passed the Public
Utility Regulatory Policy Act (PURPA). PURPA unleashed further change by allowing independent
power generators in the industry for the first time, instead of having power generated either by the
utility or by a federal generation facility.
The primary motivation for PURPA was to encourage improvements in energy efficiency
through expanded use of cogeneration technology and to create a market for electricity
produced from renewable fuels and fuel wastes. It was not motivated by a desire to
fundamentally restructure the electricity sector and to create an independent competitive
generation sector. However, it turned out to have effects significantly different from what
was intended when it was passed. PURPA was largely responsible for creating an
8 Reason Public Policy Institute
independent generation sector and the supporting market and regulatory institutions to
create a competitive market for new generating resources.20
Thus the combination of evolving technological change and the regulatory change that PURPA
engendered enabled a dramatic upheaval in the generation portion of the industry, with
entrepreneurs seizing opportunities to provide goods and services in ways that had not been seen
before, or even conceived of before, in the industry.21 As a result, generation has become more
efficient, and entrepreneurs have developed sophisticated risk management strategies and tools to
hedge the risks (such as the prices of fuels used) of generation. In this way, and in others,
electricity is becoming more like a commodity as market forces change the industry.
C. Transmission Policy
The regulatory changes in PURPA (1978) and the Energy Policy Act (1992) unleashed many
unintended changes in electricity generation, leading to the appearance of competition in
wholesale markets in many states.22 These wholesale market changes and the opening up of some
retail competition have put pressure on the transmission network to evolve into an infrastructure
for transporting an energy commodity. In cases where transmission is scarce and there are
bottlenecks, regional electricity price variations persist and can become more volatile.
Transmission bottlenecks and insufficient network infrastructure provided one of the many causes
of the price volatility seen in California in 2000 and 2001, and FERC has been working diligently
over the past five years to solve these problems by updating transmission regulation and policy.
Transmission policy, though, is still based on the premise that transmission is a natural monopoly,
and therefore should continue to be regulated. While somewhat outdated by now, this statement
captures the fundamental idea underlying the ongoing regulatory treatment of transmission:
And even though economies of scale have disappeared in the generation segment of the
industry and competition is considered workable there, there are still tremendous economies
of scale in transmission that make competition in this segment of the industry unworkable.
Consequently, transmission providers will likely continue providing services as franchised
monopolies subject to cost-of-service regulation at the local, state, and/or federal level23
This statement is outdated because subsequent FERC proposals in Order 2000 would implement
performance-based ratemaking instead of cost-of-service or rate-of-return regulation. However,
the monopoly franchise persists, as does the belief that transmission should continue to be
regulated as a natural monopoly and law should block redundant entry.
The idea that having more transmission capacity than the minimum necessary to carry typical
electricity flows would be unnecessarily costly continues to permeate public policy regarding
transmission, including FERC’s recent decisions. This perspective does not incorporate due
consideration of other alternatives to the existing transmission grid, such as distributed generation,
nor does it acknowledge the security benefits of redundant systems, such as a buffer to help prevent
blackouts like that in the Northeast and Midwest in August 2003.
In the 1990s FERC began considering policy changes that would enable transmission to evolve to
keep up with the changes in the generation sector. FERC was concerned that a lack of transmission
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 9
infrastructure investment would stifle generation markets. To that end FERC passed Orders 888,
889 and 2000.
Order 888 of 1995 requires transmission owners to provide open access to their grid at cost-based
rates to non-owners, and that they participate in an information-sharing system to communicate
their transmission capacity, the terms on which it is offered, and how it will be allocated in the case
of excess demand.
While Order 888 is very long, the basic principles it embodies are simple: transmission
owners must provide access to third parties to use their transmission networks at cost-based
maximum prices and non-discriminatory terms and conditions, make their best efforts to
increase transmission capacity in response to requests by third parties willing to pay for the
associated costs, and shall behave effectively as if they are not vertically integrated when
they use their transmission systems to support wholesale market power transactions.24
Order 889 bolsters 888 by implementing OASIS, or Open Access Same-Time Information Systems,
to operationalize the information sharing. All transmission owners in the United States have filed
open access tariffs with FERC and complied with 888 and 889.
On March 4, 2002, the U.S. Supreme Court upheld the Federal Energy Regulatory Commission’s
right to ensure mandatory open access to transmission for wholesale and interstate retail electricity
transactions through Order 888.25 This decision affirms FERC’s jurisdiction over the transmission
of interstate power sales, an authority it has had since the Federal Power Act of 1935 (FPA) and
reinforced most recently by the Energy Policy Act of 1992. Subsequent regulatory changes have
moved pricing toward performance-based rates, but the rates paid for transmission remain
regulated. In ruling for FERC and writing for the majority, Justice Stevens states that “… the
landscape of the electric industry has changed since the enactment of the FPA, when the electricity
universe was ‘neatly divided into spheres of retail versus wholesale sales.’”26 … There is no language
in the statute limiting FERC’s transmission jurisdiction to the wholesale market, although the
statute does limit FERC’s sale jurisdiction to that at wholesale.”27
Order 2000 is a companion policy to Order 888 in many ways. FERC Order 2000 is an effort to
organize the many transmission owners in the United States into regional transmission
organizations (RTOs). In the interest of encouraging efficient transmission investment and
competitive wholesale markets, Order 2000 requires the formation of regional organizations that
encompass all of the transmission owners in an area. Order 2000 did not dictate the size of the
area, the number of participants or miles of transmission in the RTOs, but has instead left the
determination of the membership and boundaries up to the transmission owners, saying that they
have better information on the optimal configuration than does FERC. Order 2000 lays out the
four minimum characteristics and eight functions that an RTO should possess (as shown in Table 1
below), but leaves the details up to the industry. FERC must approve RTOs (and has been
requesting revisions to some proposals, and rejecting some), and the industry faces firm deadlines
for establishing these organizations.
10 Reason Public Policy Institute
Minimum RTO Functions Administer its own tariff and employ a transmission pricing system that will
promote efficient use and expansion of transmission and generation facilities
Create market mechanisms to manage transmission congestion
Develop and implement procedures to address parallel path flow issues
Serve as a supplier of last resort for all ancillary services required in Order No.
888 and subsequent orders
Operate a single OASIS site for all transmission facilities under its control
with responsibility for independently calculating TTC and ATC
Monitor markets to identify design flaws and market power
Plan and coordinate necessary transmission additions and upgrades
Provide interregional coordination
Source: FERC Order 2000, Docket Number RM99-2-000, pp. 152, 323-324
These guidelines were intended to be sufficiently flexible that the RTO is not a “one size fits
all” policy prescription, which Order 2000 stated would be costly and ineffective at
promoting competitive electricity markets. FERC has even avoided stipulating an ownership
structure, saying that public or private, for-profit or non-profit, organizational structure
decisions should be up to the regional transmission owners.28 In the Final Rule, we noted that
different organizational forms, such as ISOs, transcos, combinations of the two, could satisfy
the characteristics and functions or even new organizational forms not yet discussed in the
industry or proposed to the Commission. Likewise, the Commission did not propose a "cookie
cutter" organizational format for regional transmission institutions or the establishment of
fixed or specific regional boundaries under section 202(a) of the Federal Power Act (FPA)29.
Under Order 2000 the utilities that own existing transmission assets would retain ownership if
they participate in an RTO. The RTO thus becomes a consortium group of owners that manage
access to and reliability of their grid network.30
Orders 888 and 2000 combined to encourage unbundling, yet as written allow for industry
flexibility in the voluntary determination of the terms and length of contract. This combination
recognizes that as organizational forms, vertical integration and long-term contracting are to a
great extent substitutes.31 These changes would contribute to decreasing transaction costs in
transmission, thereby increasing efficiency in the electricity industry.
Over the year and a half leading up to the FERC Standard Market Design proposal in November,
2002, groups submitted RTO proposals to FERC for approval.33 FERC is still evaluating proposals
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 11
carefully and working through an iterative process to make changes based on comments it has
received.
For example, on October 16, 2000, GridFlorida sent FERC a filing to be an RTO serving peninsular
Florida as a for-profit transmission company. The GridFlorida members are Florida Power &
Light, Florida Power Corporation, and Tampa Electric Company. On March 28, 2001, FERC issued
provisional approval of GridFlorida as an RTO. On May 29, GridFlorida submitted a compliance
filing, with more revisions and stakeholder comments into the summer.
At the same time, three utilities in the Carolinas (Carolina Power & Light, Duke Energy, and South
Carolina Electric & Gas Company) proposed GridSouth as an RTO for the Carolinas, submitting
their filing on October 16, 2000. They proposed to operate as a for-profit transmission company.
After comments and responses, FERC issued provisional approval on March 14, 2001. After a
supplementary filing on May 14, 2001, FERC Commissioners then decided in July to order a single
larger RTO for the Southeast region, using mediation processes with a neutral administrative
judge.
In each, the Commission concludes that, while the scope and configuration of the proposals
either are provisionally consistent with Order No. 2000 or do not meet Order No. 2000's
scope characteristic, in order to successfully encompass the natural market for bulk power in
the Southeast, it is necessary that the Southeastern transmission owners combine to form a
single RTO.32
A similar process took place in the Northeast, where three RTO proposals had been submitted:
New England Independent System Operator (ISO), New York ISO, and the Pennsylvania-Jersey-
Maryland Interconnect (PJM). FERC ordered mediation among the three to agree to a single RTO
between July 24 and September 7, 2001, to create “fully integrated Northeastern markets, and a
single Northeastern RTO to administer those markets and promote the development of new
infrastructure.”33 They will have a single RTO and single market, integrating the separate ISOs into
one RTO tariff for the region, based on locational marginal pricing (LMP) as used in the PJM, the
software used in PJM, and one interconnection process for the entire region. The Northeast RTO
will have sole operational responsibility for the entire grid in the region. It will use the PJM model
as its platform and integrate best practices from the other two ISOs into the RTO
implementation.34 The other two regional RTOs, Midwest and West, are expected to evolve
similarly in many respects.35
Attitude changes since July 2001 have shifted the interpretation of Order 2000 and the actual
implementation of RTOs in the direction of “one-size-fits-all” solutions more than was articulated
in the actual Order. This shift detracts markedly from the flexibility contained in Order 2000 and
its promise to use local knowledge to shape institutional change. FERC has articulated its process
as one of institutional experimentation, with the states as laboratories; in fact Pat Wood, FERC’s
chairman, was Chairman of the Texas PUC when it crafted its well-regarded deregulation
legislation. However, the decision to have four RTOs (plus ERCOT), one per region, and that they
should use some pricing method strongly based on PJM seems to indicate that the experiment has
been concluded, and that FERC has determined the optimal institutional structure for transmission
in the industry.
FERC is committing itself to competition by threat, rather than real contention against rivals to
please customers, and so will not allow for the changes in consumer and supplier behavior and the
12 Reason Public Policy Institute
evolution of supply and demand that drive dynamic efficiency in true markets. FERC is
committing to an ordered competition, attempting to engineer a market from the top down. In
contrast, a competitive order would arise spontaneously, and not from the result of government or
regulatory intervention. “The purpose of a competitive order is to make competition work; that of
so-called ‘ordered competition,’ almost always to restrict the effectiveness of competition.”36
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 13
Part 3
The most important argument for the benefits of electricity deregulation arises from dynamism and
the discovery process. Institutional change that would unleash that dynamism in electricity would
focus on ways to decrease monopoly rents, giving possible rent-seeking transmission owners less
incentive to do so. Three mechanisms for achieving that goal exist, two of which are important
institutional changes—use of contracting, technological change, and removing the monopoly
franchises of utilities.
Efficiency over time depends on institutions that are economically and politically flexible enough to
adapt to opportunities and encourage innovation and risk taking.37 Institutions that do not adapt
to discovery will wind up increasing transaction costs as the wedge grows between efficient
practices and behavior accommodated by the static institutions. Increasing transaction costs in
turn obscure or even eliminate opportunities for beneficial discovery and for direct market
evolution. Contestability, for example, can be stifled by high transaction costs caused by static
regulatory schemes that limit contract flexibility.
Technological change and contestability hold the keys to a dynamic electricity industry.
Contestability—the possibility for competition—is an important feature of competitive markets
because it promotes dynamic efficiency. Often the threat of potential competition can deter a
company from raising its prices, because it knows that by doing so it may attract competitors.
Electricity transmission faces some possible competition from entrepreneurs who may be willing to
lay parallel lines. As with natural gas and telecommunications, redundant systems could be
14 Reason Public Policy Institute
profitable and cost-effective, but the more pressing competition could come from transmission of
fuel to distributed generation sites instead of transmission of electricity.38
Technological change holds a lot of promise, as it has throughout history, for promoting
contestability in transmission. Distributed generation and fuel shipment could serve as a
competitive alternative to transmission; superconductors and other technological changes could
change the relative costs of laying redundant transmission lines. Obstacles to technological change
include the ongoing monopoly franchise and the ensuing rent seeking.
Distributed generation (DG) technology could provide substantial contestability for electricity
transmission. Distributed generation uses small-scale power generation that is situated close to
the load being served. Technological change has made DG sources such as gas turbines,
microturbines, and other small-scale generation systems more economically viable. Capacity
constraints and institutional volatility, as seen in the recent California crisis, have also contributed
to the growth of DG alternatives. Distributed generation equipment manufacturers also tout
redundancy as a security benefit that customers would enjoy from implementing DG systems.
Critics of the relevance of contestability in electricity transmission point out that to achieve the
efficient outcome seen in perfectly competitive markets, the industry must have zero sunk costs. In
an industry with sunk costs, the contestability model predicts that the actual outcome will not be
the efficient outcome. 40 Sunk costs are a substantial factor in electricity transmission. That fact
does not imply, that contestability is irrelevant in electricity transmission; rather, contestability in
reality will occur to varying degrees in different industries and under different conditions,
depending on the institutional environment, the regulatory environment, the demand
characteristics in the industry, and technological change. For example, even in the presence of
sunk costs, however, the natural monopolist may have difficulties in sustaining its position if
technology is advancing quickly, or if firms in other industries are making similar advances.”41
Critics who dismiss the potential for contestability to deliver real benefits to consumers and
innovative producers mistakenly compare a situation in reality to an idealized situation that is not
likely to exist. Instead, policymakers should compare a regulatory environment that is sufficiently
flexible to allow market participants to exploit what contestability there is to the real policy
environment of the government-granted monopoly franchise. This real policy environment places
a downward bias on incentives to discover and implement alternatives to electricity transmission,
such as distributed generation.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 15
Contracting and technology matter a great deal in the electricity industry, and technological change
is very likely to shape market structure. Because of the importance of technology and investment
in the electricity industry, the dynamics of the industry have a strong impact on even the short-run
decisions of industry participants. Regulators cannot command the information available to
participants, nor can they anticipate technologies, transactions, and structures that have not yet
been discovered. Market processes encourage dynamic efficiency better than any alternate
institutional structure because markets create a context for comparing expectations over time,
people’s different preferences for risks, and the value of alternate uses of resources and talent. This
industry will change in ways we cannot foresee, and the full potential of human creativity will only
be brought to bear in the physical and financial aspects of this industry by the information and
incentive aspects of the dynamic market process.
The contract path is an important point in the analysis. In most industries, the contract path is
well defined, and property rights are clear as title transfers from seller to buyer. In electricity,
though, the contract path is unclear because of the physical and technical aspects of alternating
current power—again, Kirchoff’s Law means that electrons follow the path of least resistance.
Thus, although a seller in Nevada could agree to sell 50 MW of power to a buyer in California, that
contract really only amounts to the seller’s right to put 50 MW of power on the grid, and the buyer’s
right to take 50 MW of power from the grid (with some adjustments for line loss). For contrast,
consider oil or natural gas transmission, where property rights are clearly defined and easy to
enforce throughout the flow of product from seller to buyer.
The physical characteristics of alternating current electricity serve as a binding constraint on the
extent to which property rights can be defined and enforced over electricity during its transmission.
For this reason, transaction costs in transmitting electricity can be higher than in transmitting fuel
and generating electricity more locally, through distributed generation. The relative costs and
benefits of these choices are complex and depend on local and changing circumstances. At various
times either distributed generation or contracts may provide a lower-transaction-cost means of
getting exchange.
Thus the point of flexible transmission policy should be to allow institutional arrangements that
lower transaction costs (along with regular costs) according to unique, local, and dynamic
conditions. Even with institutional change to decrease transaction costs, such as FERC’s attempts
to create RTOs and implement open access to transmission, transaction costs in electricity
transmission are bounded away from zero because of the physical constraints of Kirchoff’s Law.
But that does not mean existing costs are closer to zero than the competitive alternative.
Transmission policy ought to be seeking institutions that will drive costs right up against the
Kirchoff constraint. The relevant question is: can we better decrease transaction costs through
dynamic competition or regulation? There is a long-standing argument that regulation does so,
that the transactions are too complex and transaction costs too high in a competitive market.
However, consider the California state regulators at the Department of Water Resources, whom
Davis pulled into the electricity-buying business only to learn just how inept and inexperienced
they are relative to private-sector traders. Professional energy traders had built up substantial
transaction-cost-reducing human capital and developed contract paths that reduce transaction
costs in ways that the regulators had never envisioned.
16 Reason Public Policy Institute
Instead of RTOs based on the premise that natural monopoly implies regulation, a more dynamic
institutional change may be to acknowledge that property rights matter, and that the contract path
and its certainty and stability matter. If FERC imposes institutional change in the form of RTOs,
then path dependence may lead to more costly and inefficient electricity provision relative to the
path of institutional change that could evolve out of the flexibility to opt out of RTOs and build
distributed generation, develop new contract paths, or some other unknowable future change that
RTO path dependence would forestall. That path dependence could also lead to the construction of
more transmission grid assets than under a more flexible transmission policy.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 17
Part 4
A policy change that would foster such dynamism would be to move customers away from their
obligation to be served by the local public utility more aggressively than is now being done. This
move would encourage the use of distributed generation technology, innovative forms of
contracting, and other institutional and technological changes that would increase the
contestability of the transmission segment of the electricity value chain, and could do so in a
flexible, open-ended way.
The change that would be most effective in increasing the dynamism of the transmission part of the
value chain, and thus the overall industry, is elimination of the monopoly franchise for public
utilities. What would be the effect of eliminating the monopoly franchise? Most utilities operate
under state regulation, with franchises that amount to government-granted monopolies. These
utilities also own the majority of transmission assets in the United States. While those regulations
persist, electricity transmission is much less likely to be contestable, and the establishment of RTOs
will not change that fact.42 If the monopoly franchises granted to utilities were abolished, then
contractual arrangements could result in the efficient amount of electricity grid being built, which
may be much less than we would build under the RTO structure that FERC is encouraging. As
John Burton points out,
Elimination of the monopoly franchise would also likely shift resources from rent-seeking
and superfluous discovery to more productive uses. Businesses are, of course, not simply
concerned in these settings of ordered competition merely to evaluate the behaviour of
regulators but also, if possible, to influence the policies of the regulatory authority in order to
gain an advantage over their competitors (or to dissuade the regulator from granting such
18 Reason Public Policy Institute
Both the necessity of predicting regulatory developments and the prospective gains from
lobbying to influence them depend, centrally, upon the degree to which the regulator of an
ordered competitive process has discretion in policy evolution, and chooses to exercise it. In
the absence of such discretion and its utilization—in the extreme case, if regulatory rules were
fixed for all time—the need for anticipating regulatory behaviour and the prospect of
influencing it—would be much reduced (in the limit, to zero).
It is, however, a prominent feature of the UK model of utility regulation as it has evolved in
actual practice (as against the rule-like/withering away conception proposed in the original
Littlechild doctrine) that regulators have considerable discretion, and have commonly not
avoided the temptation to utilize it.
Transmission ownership is fragmented, but the benefits of maintaining the monopoly franchise are
concentrated in those owners, while the costs are relatively more diffuse among electricity
consumers.43 There are some possible changes to the franchise agreement, though, that would
create contestability for transmission and reduce its monopoly characteristics (monopoly or
otherwise). Introducing real-time balancing markets, as FERC has done, contributes some. A
simple change could be to allow customers to opt out of the obligation to be served under the utility
franchise, and instead to allow them to connect directly to the grid or to serve themselves. Another
change would be dramatic cutback in the state regulatory agencies’ powers to stop proposed
transmission lines. Polices like these exist in other countries that have successfully implemented
more true electricity deregulation, such as the United Kingdom and New Zealand.
Under such a system, customers could form consortia to, for example, construct a shared
distributed generation facility, perhaps using a combined heat and power (CHP) technology that
uses waste heat to heat homes and offices. This arrangement would exploit the benefits of
contracting and technological change to reduce the monopoly rents available to transmission
owners and provide contestability to electricity transmission.
Transmission’s degree of contestability depends heavily on barriers to entry into ventures that
could compete with transmission. The higher the entry barriers, the lower the contestability and
the more able a firm is to exercise market power and raise prices. FERC’s effort to coordinate DG
interconnection standards across states will reduce technical entry barriers, in keeping with the
technological change that has made DG scale small enough to provide a real threat of competition
to transmission. DG is but an example of the technological possibilities for competition with the
grid.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 19
Adrian T. Moore is Executive Director of Reason Public Policy Institute, the research division of
the Los Angeles-based Reason Foundation, where he oversees all the Institute's policy research. His
own research focuses on government management and regulation. Dr. Moore is co-author of Curb
Rights: A Foundation for Free Enterprise in Urban Transit, published in 1997 by the Brookings
Institution Press, and many policy reports and articles for national and local publications. He holds
a Ph.D. in Economics from the University of California, Irvine.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 21
Lynne Kiesling, Getting Electricity Deregulation Right: How Other States and Nations Have
Avoided California’s Mistakes, Reason Foundation Policy Study No. 281, April 2001, at
www.rppi.org/ps281.pdf.
Adrian T. Moore and Lynne Kiesling, Powering Up California: Policy Alternatives for the
California Energy Crisis, Reason Foundation Policy Study No. 280, February 2001, at
www.rppi.org/ps280.pdf.
Adrian Moore, Integrating Municipal Utilities into a Competitive Electricity Market, Reason
Foundation Policy Study No. 271, June 2000, www.rppi.org/privatization/ps270.html.
22 Reason Public Policy Institute
Endnotes
1 See John Burton, “The competitive order or ordered competition?: The 'UK Model' of utility
regulation in theory and practice,” Public Administration, vol. 75, no. 2, 1997, pp. 157-189.
2 FERC is also currently pursuing uniform generation interconnection standards across the
states. Such a standard would reduce transaction costs and barriers to entry to such new
technologies as distributed generation, and would move toward decreasing barriers to entry
and exploiting transmission’s contestability. This policy, though, is beyond the scope of this
analysis.
3 Burton, “The competitive order or ordered competition?”
4 James Bushnell and Erin Mansur, “The Impact of Retail Rate Deregulation on Electricity
Consumption in San Diego,” POWER Working Paper 082, April 2001, at
www.ucei.berkeley.edu/ucei/PDF/pwp082.pdf.
5 For a discussion of the causes of the failure of California’s electricity restructuring, see Adrian
T. Moore and Lynne Kiesling, Powering Up California: Policy Alternatives for the California
Energy Crisis, Policy Study No. 280, (Los Angeles: Reason Public Policy Institute, February
2001), at www.rppi.org/ps280.pdf. For a comparison of the problems experienced in California
with more successful efforts in other nations and states and examination of the policy
differences between them, see Lynne Kiesling, Getting Electricity Deregulation Right: How
Other States and Nations Have Avoided California’s Mistakes, Policy Study No. 281, (Los
Angeles: Reason Public Policy Institute, April 2001), at www.rppi.org/ps281.pdf.
6 Vernon Smith, “Regulatory Reform in the Electric Power Industry,” Regulation vol. 19, no. 1,
1996.
7 Gregg Jarrell, "The Demand for State Regulation of the Electric Utility Industry", Journal of
Law and Economics, 1978, pp.269-295.
8 Walter J. Primeaux, Jr., Direct Electric Utility Competition: The Natural Monopoly Myth
(New York: Praeger, 1986).
9 Thomas Lyon, “Capture or Contract? The Early Years of Electric Utility Regulation,” Paper
presented at 2001 American Economic Association meetings.
10 Ibid.
11 Federal Energy Regulatory Commission, Regional Transmission Organizations, Final Rule,
Docket Number RM99-2-00, Order 2000, Washington, D.C.; and Federal Energy Regulatory
Commission, Regional Transmission Organizations. Docket No. RM99-2-001, Order 2000A,
Washington, D.C.
12 The standardization conflict between alternating current and direct current was intense and
has led to much of the subsequent public policy regarding the industry, although it is beyond
the scope of this analysis. Interestingly, some for-profit transmission projects are under way in
the United States using direct current transmission. See Edison Electric Institute. “Historical
Background—Electric Utility Industry,” 1991, at www.eei.org/public/history.htm and Energy
Information Administration, U.S. Department of Energy “Historical Overview of the Electric
Power Industry,” in The Changing Structure of the Electric Power Industry 2000: An Update,
at www.eia.doe.gov/cneaf/electricity/chg_stru_update/chapter2.html.
MAKING ELECTRICITY TRANSMISSION MORE COMPETITIVE 23
13 Contrary to today’s assertions that demand is too inelastic for real-time pricing to work,
“[Insuli] he also found that lower-cost power stimulated demand, while still earning healthy
profits for his company.” Richard Hirsh, “Emergence of Electrical Utilities in America” (1998)
at americanhistory.si.edu/csr/powering. The Hirsh essay is the primary source for the
material in this paragraph. See also Richard Hirsh, Power Loss: The Origins of Deregulation
and Restructuring in the American Electric Utility System (Cambridge, Massachusetts: MIT
Press, 1999).
14 “In 1898, in an address before the National Electric Light Association (the forerunner of the
Edison Electric Institute), Samuel Insull proposed that electric companies be regulated by state
agencies that would establish rates and set service standards. The idea became increasingly
appealing to investor-owned companies in the face of public enthusiasm for the growth of
municipal electric systems.” Edison Electric Institute. “Historical Background.” Note the
consistency of this statement with the rent seeking theory of regulation as articulated in Jarrell,
"The Demand for State Regulation.”
15 Energy Information Administration, “Historical Overview of the Electric Power Industry.”
16 Edison Electric Institute. “Historical Background.”
17 Harvey Averch and Leland Johnson, "Behaviour of the Firm under Regulatory Constraint,"
American Economic Review, Vol. 52, 1962.
18 Empirical, particularly econometric, evidence of the Averch-Johnson effect has been mixed,
although industry participants generally acknowledge its existence. A good summary of the
issues and the research on this topic can be found in Kip Viscusi, John Vernon, and Joseph
Harrington, Economics of Regulation and Antitrust (Cambridge, Massachusetts: MIT Press,
1998), pp. 386-91.
19 Nguyen T. Quan and Robert J. Michaels, “Games Or Opportunities? Bidding In The California
Markets,” Electricity Journal, vol. 14, no. 1, January 2001.
20 Paul Joskow, “Deregulation And Regulatory Reform In The U.S. Electric Power Sector,” AEI-
Brookings Joint Center working paper, 2000, p.19.
21 While providing beneficial regulatory change, PURPA also instituted requirements to purchase
electricity generated with renewable energy from qualifying facilities (PFs). While this seemed
like a good idea to policymakers at the time, it saddled utilities with long contracts for
expensively generated power, at a time when natural gas prices were falling to their lowest
levels (due largely to natural gas deregulation). More than any other, this example highlights
the unintended consequence and path dependence problems inherent in such portfolio
standards and regulatory mandates. PURPA is also credited with making California officials
shy away from long-term contracts, and thus not allowing generators and purchasers to enter
into forward contracts when they passed AB 1890 in 1996.
22 The Energy Policy Act removed several regulatory barriers facing independent power
producers, allowing utilities to have ownership interests in independent power producers and
to have ownership interests in power companies in other countries. It also encouraged
transmission-owning utilities to allow more open access to non-owners, which would later be
bolstered by FERC Order 888.
23 Martin Baughman, “Investing in Transmission Facilities,” in Hung-po Chao and Hilliard
Huntington, eds., Designing Competitive Electricity Markets (Boston: Kluwer Academic
Publishing, 1998), p. 137.
24 Joskow, “Deregulation and Regulatory Reform in the U.S. Electric Power Sector,” p.30.
25 U.S. Supreme Court, New York v. FERC, 225F. 3d., March 4, 2002.
26 Ibid at 691.
27 Ibid at 14.
24 Reason Public Policy Institute
28 However, there are several impediments to the formation of for-profit “transcos.” First is the
disincentive of incurring a capital gains tax; many of those who filed comments on Order 2000
said that utilities would want to retain ownership, or at least phase out grid asset sales, to avoid
having to pay capital gains taxes. Another is the substantial cost of capital advantage afforded
to non-profit and government owned transmission assets by federal tax-exempt debt rules.
29 FERC Order 2000A, Docket No. RM99-2-001, p. 3.
30 One important clarification in the ongoing consideration of RTO policy is the extent to which
FERC intends the RTO structure to serve as a system reliability “overlay” institution and will
not separate operational control from ownership. Similarly, clarifying the extent to which
FERC’s proposed institutional structure will still leave room for for-profit transcos would
resolve questions of ongoing efficiency and investment decisions.
31 Benjamin Klein, Robert Crawford, and Armen Alchian, “Vertical Integration, Appropriable
Rents, and the Competitive Contracting Process.” Journal of Law and Economics vol. 21, pp.
297-326.
32 FERC, RT01-100-000, Order Initiating Mediation, July 12, 2001, p. 2.
33 FERC RTO1-99-000, p. 7.
34 There may be reason for caution on many aspects of this shift in interpretation: “… FERC
singled out the operating platform and software of the PJM region and declared it to be the
industry standard … By now, however, we should have learned that public policy decisions can
produce unintended consequences. The California fiasco, alone, should cause warning lights to
go off whenever a public agency decides to impose not only market structures but also software
solutions … [this enforced consolidation] will lock in the Northeast electricity market to
nothing more than a jazzy variation on the old utility paradigm.” Maria Ilic and Leonard
Hyman, “Don’t Rush the Seamstress: Second Thoughts on the Marriage of the Northeast
Grids” Public Utilities Fortnightly September 1, 2001, pp. 28-9.
35 An important exception to these cases is the Electricity Reliability Council of Texas (ERCOT),
which does not fall under FERC jurisdiction because its boundaries are entirely within Texas’s’
borders. ERCOT, though, provides the model upon which many of the characteristics of
FERC’s desired RTO structure are based.
36 Friedrich A. Hayek, Individualism and Economic Order (Chicago: University of Chicago Press,
1948), p.111.
37 Douglass C. North, Transaction Costs, Institutions, and Economic Performance, International
Center for Economic Growth Occasional Paper No. 30, San Francisco: International Center for
Economic Growth, 1992, p.9.
38 For a compelling argument for why transmission is contestable, and why, therefore, for-profit
transmission companies are viable, see James Liles, “Merchant Transmission: Building a Grid
That Wall Street Can Understand,” Public Utilities Fortnightly, September 15, 2001 pp. 24-36.
39 The California Energy Commission provides an example of the regulations governing the
construction, interconnection, and emissions of DG systems, at
www.energy.ca.gov/distgen/permitting.html.
40 William Baumol, John Panzar, and Robert Willig, Contestable Markets and the Theory of
Industry Structure (New York: Harcourt Brace Jovanovich, 1982).
41 Peter Hall, Innovation, Economics and Evolution (New York: Harvester,1994).
42 Integrating real-time balancing markets into RTOs, as FERC has proposed, will remove some
obstacles to distributed generation, wind power, and other intermittent forms of generation.
43 This analysis of rent seeking also applied to generation, though, and we still saw competition in
the industry through legislative and institutional change, so these static relationships and
incentives may not dominate the decision-making process.
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