Turning On The Lights: Deregulating The Market for Electricity

Studies | Regulations

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

The Danger of Reregulation

The advantages of deregulation are increasingly clear, even to many who have taken for granted the need for electric regulation. A prominent fly in the ointment, however, is the possibility that reform can produce reregulation instead of deregulation.

Deregulation or Reregulation? Reregulation can produce new regulations that might adopt the language of deregulation but would ultimately rely on regulators more than consumers to direct the growth of the electric utility industry. Managed competition, by which government concocts a limited menu of choices for customers and manages those who supply the choices, is as much a contradiction in terms in electric utility reform as in health care reform.

The prudent course at both the state and federal levels is to establish as flexible a legal framework as possible so that competition and contractual solutions can evolve freely in the marketplace. However, some proposals under consideration fall short of this goal. The reason: there is some consensus on the competitive opportunities of electricity generation, but little agreement concerning electricity delivery.

Some policymakers support reregulation that separates transmission and distribution along the current state and federal lines and regulates transmission more heavily than ever. For example, in the name of increasing competition in electricity generation, FERC orders 888 and 889 expanded regulation of electricity transmission and strongly encouraged, if not implicitly required, the restructuring of utilities subject to its jurisdiction.

Another example of reregulation is the establishment of independent system operators (ISOs), which are nonprofit organizations set up under the regulatory oversight of the FERC. ISOs are thought to be necessary to deal with monopoly market power questions that arise when transmission and generation are combined.40 ISOs operate but do not own the transmission lines and equipment of utilities in some states. They control vast transmission networks - without ownership responsibility or market discipline. Thus new regulatory policies replace older ones.

"In California, deregulation has turned into reregulation."

California Case Study: How Not to Deregulate. On March 31, 1998, California became the first state to allow all residential customers to buy competitive retail electric power. The state's experience is a lesson in what happens when deregulation turns into reregulation.

  • Initially, more than 300 companies expressed interest in marketing electricity directly to consumers, and the nation's largest competitive electricity provider, the Enron Corporation of Houston, Texas, spent millions of dollars on advertising to consumers.
  • A year later, all but 33 marketers had pulled out, including Enron, and according to the California Public Utilities Commission only 144,000 households - just 1.2 percent of utility customers - had switched from their local utility to a competitor.

The reasons are clear. California's retail competition plan lowered existing residential and small business electric rates by 10 percent from 1996 levels and capped them for up to four years, so utilities could recoup stranded costs. The rate rollback was financed with some $6 billion in state bonds to be paid off by charges on all electric customers' bills. In addition, all electric bills carry a charge to pay $28 billion to the utilities, under an agreement with the state to compensate them for their stranded costs.

A typical family using 500 kwh a month saw its bill reduced from $60.99 to $54.89 before taxes, for a savings of $6.10. But a customer with close to that electricity usage saw added charges of $7.13 to pay off the bonds and $14.78 to cover the stranded costs - making the total bill more than it was before deregulation!

One large utility, Pacific Gas & Electric, announced that once its stranded costs were paid off, it would trim residential rates by another 11 percent, with another cut of 5 percent to 10 percent likely in 2008. PG&E also sold some of its generating assets, at prices above depreciated cost, which may help it pay off its stranded costs and cut rates before 2002.

The rates charged by competitors are close to the rates charged by PG&E - with the exception of "green power" providers. Green power - produced by wind, solar, geothermal, biomass or small hydroelectric plants - costs more than power generated by the utilities, even though the state offers customers who switch to green power a rate cut up to 1.5 cents per kwh through 2001.

"One reason there is little price competition is the extra charges on every retail customer's bill."

So one reason why there is little price competition in California is the extra charges on every retail customer's bill. Another is that electricity generation is the only part of the system that is subject to competition, and generating costs are only about one-fourth of the cost of electricity. Thus, for a customer with a $61 monthly electric utility bill, only $15.25 is for the cost of generating the power. An efficient independent provider might be able to charge 25 percent less for generation, say $11.43, for a potential saving to this consumer of $3.81 a month. But with an average of $25 in extra charges and taxes (which nationally average about 11 percent), the consumer's potential saving is only 4 percent - not enough price differential to convince most consumers to switch.41

A third reason why consumers are not switching is uncertainty about future electricity prices. Customers will see a lot of price fluctuation, says Terry Winter, president of Cal-ISO. "You may get a $20 bill in April and a $1,000 bill in August. It's called supply and demand."42

Reregulation in California. Not only have California consumers not benefited from competition, they have faced more regulation in some areas. Specifically, the restructuring plan created a new regulatory body, the California Independent Service Operator (Cal-ISO). Acting for "stakeholders" - rather than owners of transmission lines and facilities - Cal-ISO controls electricity transmission throughout California and between California, neighboring states and Mexico.

California's electricity restructuring law required the state's three major investor-owned utilities to release control, but not ownership, of their-long distance transmission lines to Cal-ISO. Thus Cal-ISO controls over 75 percent of the electricity grid. Operating under the supervision of federal regulators at the FERC, Cal-ISO controls the prices and terms under which electricity generators move power across the grid to consumers.

"Independent system operators control vast transmission networks -- without ownership responsibility or market discipline."

Cal-ISO has effectively taken over the role of the Western Systems Coordinating Council (WSCC), an industry group that set guidelines and governed transmission and power flows through decentralized coordination. Research by economists Arthur S. De Vany and David Walls found that the "impressive efficiency and stability of pricing indicate that the decentralized coordination employed by the WSCC is highly effective."43 But supporters of ISOs argued that because the major investor-owned utilities (Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric) own generating plants and transmission and distribution lines, control over transmission should be invested in an "unbiased, not-for-profit corporation," that would act in the interest of consumers and independent producers. This same argument is being made nationally for ISOs. It echoes the arguments for scientific management made almost 100 years ago.

Cal-ISO also in charged with planning, enforcing and overseeing future electric grid improvements and expansions. Experts have noted that ISOs already are showing "the same inefficiencies and strategic behavior that characterize existing regulatory institutions."44

Transmission pricing is crucial to determining whether capital is allocated to new transmission capacity or to new generating capacity. That is because long-distance transmission takes place only because of regional differences in generating costs. "If transmission prices do not accurately reflect the costs of transmission, including transmission constraints, participants in the market will not be able to correctly determine whether those constraints are best addressed through expansion of transmission capacity or the installation of new generation capacity closer to the customers," economist Thomas Lenard has pointed out.45

The pricing distortions caused when regulators preempt the market increase over time, leading to less competition if transmission prices are too high - or less reliability of electric service if needed transmission grid improvements are undercapitalized. In either case, consumers suffer the consequences.

How California Could Have Done Better. Since restructuring began, sales of generating assets by utilities in California and other states have shown stranded assets are mostly a political issue. Generating assets have consistently sold above their book value. Some companies are even buying nuclear power plants - although at discounted prices. And as previously discussed, transmission lines almost certainly are undervalued.

Thus if California and other states took the divestiture route we have proposed, most - or even all - of the stranded costs utilities claim would disappear. And because electricity can be transmitted by various paths over the grid, and an increasing proportion of customers can bypass the grid altogether by generating their own power, the market places an upper limit on both generating and transmission pricing. Thus no expansion of state or federal regulatory powers is necessary to manage competition - it will occur naturally.

If residential and business consumers are not saddled with utility stranded cost claims, green power subsidies and mandates or the inefficiency of increased regulation, they can realize the full benefits of market competition - better service at lower cost.

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