Whether it’s rising electricity bills, reliability concerns, an impetus for decarbonization, or the related importance of grid modernization, power systems in the U.S. and around the world are struggling with change. In this series on regional transmission organizations (RTOs), I’m digging in to the institutional aspects of these challenges.
Last time I started with history. The institutional structure and governance of RTOs have shaped the evolution of wholesale electricity markets in the United States. Initially conceived to enhance competition and reduce entry barriers, RTOs were established under a framework rooted in Federal Energy Regulatory Commission (FERC) Orders 888, 889, and 2000. These orders required electricity companies to separate their power generation business from their transmission, fostering competition in generation while preserving regulation over natural monopoly (wires) components of the grid.
In general over the past 25 years, wholesale markets have improved operating efficiency of generators and, correspondingly, have reduced the energy cost component of electric service. However, the institutional design of RTOs—modeled on historical power pool arrangements among incumbent investor-owned utilities (IOUs)—has embedded structural challenges that create perverse incentives, particularly for transmission-owning IOU members. The rules governing our electricity grid are outdated and favor traditional energy companies, making it harder to innovate.
My analysis here relies on three important and valuable journal articles—Joskow (1997), Yoo and Blumsack (2018), and Macey and Salovaara (2020)—with different perspectives on RTO governance and the incentives facing incumbent utilities under the institutional changes that established RTOs and wholesale power markets.
Institutional Path Dependence and Governance Framework
The origins of RTOs in historical power pools illustrate institutional path dependence: how historical decisions or institutional structures constrain or influence present options and outcomes. Imagine building a house on a foundation that’s already there. You have to work around the existing structure, even if it’s not ideal.
FERC’s late-1990s regulatory reforms aspired to standardize rules for non-discriminatory transmission access and to establish independent entities to oversee market operations. These reforms relied heavily on the existing structure of IOUs, whose vertically integrated business models included generation, transmission, and distribution, and the established operations and procedures embedded in their historic power pools. But wholesale power markets were more than just a scaling up of power pools, particularly with respect to non-IOU participants.
As Paul Joskow highlighted in his 1997 analysis of this impending institutional change, the structural separation of generation from transmission was a critical step to enable competitive markets (Journal of Economic Perspectives 1997). Critically necessary, but not sufficient.
Note that Joskow is prospectively analyzing the institutional changes that would be conducive to competition before any of the FERC orders and the establishment of RTOs. A central theme for Joskow is the governance of transmission systems, which are important for enabling competitive electricity markets for the reasons I discussed in my previous post. In discussing the need for independent system operators to manage transmission networks impartially and prevent vertically integrated utilities from favoring their own generation assets, he explores alternative governance structures and emphasizes the importance of regulatory oversight in ensuring efficient network operations and investments.
Joskow viewed restructuring as a complex but potentially transformative process that could deliver long-term efficiency gains. He emphasized that achieving these benefits depends on creating well-designed competitive markets, effective regulatory frameworks, and institutional mechanisms that balance competing interests and ensure reliability.
The ensuing 28 years have shown that the reliance on IOU-dominated power pools entrenched a governance framework that allowed these entities to retain significant influence within RTOs. RTOs are designed as stakeholder-driven organizations, where decisions are shaped through participatory processes involving diverse interests, including generation owners, transmission owners, electric distributors, end-use customers, and other suppliers. These stakeholders vote on proposed rules, which are ultimately subject to FERC approval.
RTO governance processes rely on these participatory stakeholder mechanisms with voting structures that distribute authority across predefined sectors. Yoo and Blumsack (Journal of Regulatory Economics 2018) focused on the democratic processes used to develop market rules in RTOs, using PJM Interconnection as a case study to model and analyze the stakeholder-driven decision-making processes that govern its capacity markets.
Yoo and Blumsack adapted concepts from voting theory and political economy to develop a framework for modeling coalition formation, voting behavior, and the distribution of political power among stakeholders. In PJM Interconnection, five stakeholder groups—including generation owners, transmission owners, and end-use customers—vote on market rules and policies. PJM uses a sector-weighted voting system, where each sector’s votes carry equal weight, regardless of the number of participants within each group. It’s like a town council where a few large landowners have more power than all the residents combined. Decisions require support from at least two-thirds of the voting sectors.
While ostensibly democratic, this system favors existing power companies and makes it hard to change the rules. Coalitions among generation and transmission owners can block reforms that threaten their market position. Abstentions and swing voters complicate outcomes further, amplifying the influence of minority interests in critical decisions. They also find that this structure often prevents significant rule changes, as strong structures, combined with the high voting thresholds and unpredictable behavior of swing voters, result in systemic inertia. Their analysis highlights the tension between participatory governance and effective decision-making in RTOs, emphasizing the need for institutional changes to ensure that market rules evolve to support reliability, competition, innovation, and new technology integration.
Embedded Incentives and Perverse Outcomes
Macey and Salovaara argue that RTOs and FERC have broadly failed to align market rules with the principles of competitive neutrality (University of Pennsylvania Law Review 2020). They critique FERC and RTO responses to challenges posed by competitive electricity markets and the increasing penetration of renewable energy over the past two decades, arguing that these responses have effectively reintroduced inefficiencies associated with cost-of-service regulation under the guise of maintaining market principles.
One prominent manifestation of these incentives is the persistence of the “missing money” problem, which arises when market-clearing prices in energy markets fail to provide sufficient revenue for generators to recover their fixed costs. Price suppression in the form of price/offer caps have been used since the beginning of wholesale power markets as an administrative mechanism for deterring the owners of peaker power plants from submitting high offers and exercising the market power that they realize they possess.
To address the missing money problem, FERC and RTOs have implemented interventions, such as this administrative pricing and mandatory capacity markets. These measures often involve forcing load-serving entities to transact with specific generators or administratively repricing resources, which undermines competitive market principles.
Technological Change and Amplified Perverse Incentives
Recent technological advancements have exacerbated the misalignment of incentives within RTOs. Over the past decade the missing money problem has been exacerbated by renewables, whose low marginal costs reduce market-clearing prices and jeopardize the financial viability of higher-cost generators. To address these challenges, RTOs and FERC have introduced measures such as minimum offer price rules (MOPRs) in capacity markets, ostensibly to prevent market distortions. As Macey and Salovaara observe, these measures often disadvantage renewables and state-sponsored clean energy initiatives (and the PJM MOPR and similar policies have been modified or repealed since the article’s publication).
To the extent that these jeopardized generators can provide dispatchable energy, particularly in times of low wind or sun, these lower prices can undermine the reliability that RTOs as grid operators are obligated to provide. Macey and Salovaara emphasize, though, that measures like price suppression and capacity mechanisms often amount to a return to cost-of-service regulation, favoring incumbent fossil fuel generators and undermining the efficiency gains promised by competitive markets.
Macey and Salovaara contend that these actions not only recreate the inefficiencies of traditional rate regulation but also disproportionately favor incumbent generators, impede state clean energy initiatives, and hinder renewable energy integration. Such interventions, they argue, are legally questionable and encroach on states’ jurisdiction over generation resources under the Federal Power Act.
The governance framework’s failure to adapt to these technological shifts has significant implications for market efficiency and decarbonization. By privileging incumbent interests, RTOs inhibit the integration of clean energy resources and delay necessary grid modernization. The resulting market distortions undermine both economic efficiency and environmental objectives.
Reforming RTO Governance and Incentive Structures
Addressing the perverse incentives embedded in RTO governance requires fundamental institutional change, as I alluded to in my motivation in the previous post. Yoo and Blumsack’s analysis underscores the limitations of stakeholder-driven processes in achieving consensus on transformative market changes. Their modeling of PJM’s capacity market deliberations demonstrates that entrenched coalitions and voting thresholds often result in systemic inertia, preventing meaningful institutional change as technologies evolve. Adjusting voting thresholds or adopting alternative decision-making mechanisms, might mitigate these challenges; simplifying governance structures, reducing the influence of incumbent-dominated coalitions, and incorporating broader public interest considerations into decision-making processes are essential steps toward aligning RTO operations with market and policy goals.
Macey and Salovaara advocate for a shift away from administrative interventions that mimic cost-of-service regulation. Instead, they propose market-based solutions that empower load-serving entities to procure resources through competitive processes, balancing state decarbonization policies with reliability needs. Such reforms would decentralize decision-making, enhance market flexibility, and create opportunities for innovation in resource adequacy and grid management.
Overcoming Path Dependence
The institutional structure and governance of RTOs reflect a legacy of path dependence that continues to privilege incumbent IOU interests at the expense of competition and innovation. By embedding control in transmission-owning IOUs and relying on stakeholder-driven decision-making processes, RTOs have created a governance framework that resists adaptation to technological change and market evolution. Addressing these challenges requires a rethinking of both governance structures and regulatory approaches. Institutional change that prioritizes competitive neutrality, support decarbonization, and enhance market efficiency are essential for realizing the economic and environmental potential of competitive electricity markets.
This article was originally published on Lynne’s Substack, Knowledge Problem. If you enjoyed this piece, please consider subscribing here.