Turning On The Lights: Deregulating The Market for Electricity

Policy Reports | Regulations

No. 228
Friday, October 01, 1999
by Vernon L. Smith and Stephen Rassenti

Executive Summary

Consumers, industry and business have reaped enormous benefits from increased competition and innovation following the deregulation of major industries in the United States and other countries. In the U.S. deregulation of five major industries - natural gas, trucking, long-distance phone service, railroads and air travel - provides total annual benefits to consumers from price reductions and service quality improvements exceeding $50 billion.

Currently, state legislatures and the U.S. Congress are debating deregulation of the largest, most highly regulated monopolistic industry: electric power. Commercial and residential customers spend more than $200 billion a year for electricity. Of that amount $20 billion to $50 billion is unnecessary spending caused by regulatory inefficiencies. Regulation also causes electricity prices to vary widely from state to state. Thus:

  • The annual cost of electricity for a typical family can vary by as much as $950 from one section of the country to another.
  • The average cost of electricity is 10 cents per kilowatt hour (kwh) in New York and almost 10 cents in California, but is only 5 to 7 cents per kwh through much of the country's midsection.
  • In Chicago electricity costs 13 cents per kwh, compared to 6 cents in neighboring cities in Indiana.

The Department of Energy's Energy Information Administration has estimated that just allowing competition in retail sales to consumers - without eliminating the costly inefficiencies of federal regulations - could lower electricity prices on average by as much as 6 percent to 13 percent within two years. A Clemson University study estimates that broader deregulation measures and competition would lower electricity prices by at least 13 percent and perhaps as much as 26 percent. This implies:

  • A typical household would see its monthly electric bill fall $18, from $69 to $51.
  • The average monthly bill for a business would drop $109, from $415 to $306.
  • The average monthly bill for an industrial customer would drop $1,793, from $6,860 to $5,067.

When residential and business customers alike can buy their electricity from more than one source, experience suggests that electricity prices will fall, service quality will improve, and the prices of other goods and services will fall as overhead costs from electricity decrease. Additional retail price reductions will become possible because of rapid technological improvements that have cut the potential cost of electricity production in half.

Falling costs and technological innovations were the norm before local electric companies became monopolies - firms with the power to make money by restricting production and raising prices. Before 1910, the United States had competing local electric companies:

  • In 1887, six electric companies organized in New York City alone.
  • By 1907, 25 electric companies were operating in Chicago.
  • Duluth, Minn., had five electric lighting companies operating before 1895, and by 1906, Scranton, Pa., had four.
  • As late as the 1930s, Cleveland and Columbus, Ohio, each had direct competition between two private electric companies.

In exchange for monopoly franchises, utilities accepted regulated pricing that provided a "fair" return on capital invested. The federal government became involved in electric power beginning in the 1930s, as both regulator and producer. Today about 25 percent of electricity in the U.S. is generated by local, state and federal governments.

Most states are moving toward retail competition, which will allow consumers to purchase electricity from competing generators. However, retail competition will not be effective if all consumers are required to pay arbitrary fees to reimburse utilities for their so-called stranded costs - utility investments that, while apparently justified under regulation, are uneconomical under competition. Nor is there much consumer choice if there are price controls on power transmission or if local distributors are able to exercise monopoly power.

A solution to these difficulties is divestiture. Today's electric utilities should divest themselves of power generation facilities and restructure the industry. Divestiture would create two discrete kinds of businesses.

  • "Supply" companies involved in power generation.
  • "Wires" companies involved in transmission and distribution.

Divestiture will encourage the transition from regulated monopolies to competitive markets by driving down costs and attracting new entrants. States could require utilities to separate into wires and supply companies in order to get compensation for stranded assets.

Since much of the cost of electric service is related to generation, deregulating that end of the business will produce immediate and substantial benefits to consumers and open new opportunities to entrepreneurs.

Consumers will have a variety of service and pricing plans to choose from, as with long-distance and cellular telephone service. They will have access to the latest price information, so they can make intelligent decisions about buying for the short term or contracting for the longer term.

New service options tailored to the consumer's needs will be available, such as interruptible power - allowing the utility to cut off or reduce power during peak demand periods. For example, in New Zealand and Australia consumers pay less for electricity under a service option that allows utilities to turn off residential hot water heaters by remote control at peak demand periods.

Also, customers will be able to bypass the grid and generate their own electric power. Efficient gas generators, fuel cells and sun-powered cells are available now, and entrepreneurs already are working on other power sources. Competition will spur innovation and hasten the introduction of new technologies.

The primary focus of local wires companies will be on service. Competition will prevail in the production of the commodity (electricity), but familiar local hands will restore power in emergencies.

However there is the danger that reform can produce reregulation instead of deregulation. In California, the first state to allow all residential customers to buy competitive retail electric power, many consumers saw their electricity bills increase after reform, due to fees for utilities' stranded costs, subsidies for green power, and more regulators to manage competition.

If Congress and the states took the divestiture route we propose, most - or even all - of the stranded costs utilities claim would disappear. No expansion of state or federal regulatory powers is necessary to manage competition - it will occur naturally - and consumers can realize the full benefits of market competition: better service at lower cost.

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