California is trying partial deregulation

February 2, 1997

By Wayne T. Brough

The electric utility industry is undergoing a major transformation that holds the promise of cheaper electricity and expanded consumer choice as we enter the 21st century.

Historically, the $200 billion industry has been dominated by vertically integrated monopolies with government-protected franchises. Consequently, nobody shops for electricity; captive ratepayers are forced to purchase electricity from their local monopoly provider. As a result, the average price of electricity is considerably higher than the prices generated in a free and open market for electricity.

Advances in both technology and economic theory suggest that the current system of monopoly providers is inefficient and should be reformed. Introducing competitive reforms will free captive ratepayers and provide opportunities for billions of dollars in consumer savings.

Currently, electricity is provided by monopolists under rate-of-return regulations that are written by state public utility commissions. Interstate and wholesale transactions are also governed by the Federal Energy Regulatory Commission. Although utilities are prohibited by law from competing for one another's customers, the utilities are connected to a grid that allows power to flow freely from one region of the country to another. The technology exists to move power freely across the grid; regulatory barriers are the only constraint.

The debate over restructuring the electric utility industry has moved well beyond the drawing board. The United States trails a number of countries, but several states are moving forward with plans to fundamentally change the way consumers purchase electricity. California, along with New York and Pennsylvania, is at the head of the pack. In California, Jan. 1, 1998 has been set for the target date when consumers will have the ability to choose their provider of electricity. From this date on, Californians will have the opportunity to shop for lower prices for electricity, much the same way they choose their long-distance provider.

Why is customer choice important? A competitive market provides substantial savings for all classes of customers, including residential consumers. Citizens for a Sound Economy Foundation commissioned Professors Robert McCormick and Michael Maloney of Clemson University to determine the consumer benefits of competition. Their findings are impressive.

Nationwide, the average price for a kilowatt-hour of electricity is 6.9 cents. This translates into an average residential bill of $69 per month. In a competitive market, producers would lower prices to eliminate any excess capacity while using their facilities more efficiently. For the residential customer, a more competitive electricity market would yield $18 a month in savings off the monthly bill, holding consumption constant. In California, residential consumers can save up to $16 a month in a competitive market.

Over the long run, new technologies will emerge that will make producing electricity even cheaper. Gas-fired turbines are already coming on line that can generate electricity for 3 cents per kilowatt-hour. As these new technologies are adopted consumers can save up to 43 percent. For the average residential consumer, this would translate into a savings of $30 off the monthly bill of $69.

There are substantial savings for commercial and industrial customers as well. As a whole, the savings for all classes of customers throughout the economy add up quickly. In fact, CSE Foundation's study finds that consumer benefits would total as much as $107 billion annually in an open market for electricity.

Competition is also good for the economy. Because electricity is an input into virtually every good and service produced in the United States, a fall in the price of electricity will have wide-ranging benefits for the economy.

Professors McCormick and Maloney estimate that removing regulatory barriers to competition would increase the U.S. gross domestic product by $19 billion annually. In addition, up to 3 million new jobs would be created due to cheaper electricity. Removing electricity regulation also would provide the equivalent of a 2.6 percent reduction in the Producer Price Index, which is similar to eliminating a year's worth of inflation.

Despite the significant gains to the economy from restructuring electric utilities, the actual transition to a competitive market is often contentious. Not all utilities are willing to forego their current monopoly status. A protected market with a guaranteed rate of return is preferably to the uncertainties of the marketplace. Many utilities are using the political market to shore up the status quo rather than invest in the resources necessary to compete in a competitive market.

Perhaps the most important concern that utilities raise is the inability to recoup their investments in a competitive marketplace. Given the non-competitive nature of the electricity industry, past investments may been made that do not pass a market test. In particular, some utilities have made costly investments in nuclear facilities that cannot be recovered in an open market. Utilities have dubbed these investments stranded costs. In fact, stranded costs should be viewed as a situation in which the book value of a utility exceeds its market value. In other words, investors paid more for a plant than it is worth to any potential buyer.

But, it is important to remember that stranded costs are not new costs imposed by the marketplace. These costs show up every month in every utility customer's bill. Because regulation creates captive ratepayers, utilities are able to recoup their investments, whether they are good or bad. Competition, however, will make it difficult for utilities to charge consumers higher than market rates to recover the costs of past investments that cannot compete in an open market. Any attempts to charge above market rates will send customers scrambling to other providers.

Another tactic raised by opponents of a swift move to competition is to frame the debate over electricity as an effort by large industrial users to obtain cheaper electricity at the expense of smaller customers such as residential consumers and small businesses. This is the "big dogs eat first" argument. The problem with this argument is that the big dogs are already eating. Large users have the economic clout to negotiate rock-bottom rates from their utilities. And the threat of competition has led many utilities to offer great deals to their industrial customers in an attempt to lock them in before the markets are fully opened. Unfortunately, these deals are reserved for large customers only. Full competition is necessary to provide the same options to smaller customers.

At the other extreme, some have criticized the move toward competition because it does not go far enough. Electricity production has three main components: generation, transmission, and distribution. To date, discussions of restructuring have focused mainly on deregulating generation, with the assumption that the transmission and distribution systems that bring the power to your house will remain regulated. Without deregulating transmission and distribution systems, some argue that a portion of the monopoly still exists, so consumers could still be overcharged.

While it is obvious that deregulation done badly will yield poor results, it does not follow that deregulating generation alone will not provide consumer benefits. After all, generation is typically the largest cost component in a consumer's electric bill. Ultimately, opportunities may arise to deregulate transmission and distribution. Pennsylvania's move toward electricity restructuring, for example, provides an opportunity to revisit the remaining regulation in the near future. But ignoring the potential for deregulating generation alone is like dismissing a 20 percent tax cut simply because the entire Internal Revenue Service was not abolished.

This is not to make light of the difficulties and potential dangers of the transition to a competitive market. As California is learning, writing the rules to a transition can be complex. There is a significant danger that the transition can be used to expand regulatory authority either at the federal or state level. We are not in a perfect world and there will still be regulated elements in the electricity market. It is important, therefore, that the transition follows the true intent of reform: open competition and customer choice.

The transition to a competitive economy will require a review of state and federal jurisdiction over the transmission and distribution of electricity. In bringing cheaper electricity to consumers, it is important to avoid unnecessarily expanding the authority of FERC or other regulatory bodies. The goal of restructuring is to introduce market forces, not create new regulatory authority.

Introducing competition into the electricity market is an idea whose time has come. The quicker we move to competition, the quicker consumers will save money. As we begin a new century, it is time to eliminate the barriers to competition that have built up over the last century. A competitive electricity market saves money for consumers, businesses, state and local governments, and, ultimately, it provides for a stronger and more competitive U.S. economy in the 21st century.

Source: The San Diego Union-Tribune