Debunking Some Myths About Competitive Electricity Markets

3.4.05

Jack Ellis

Man’s ability to harness electricity is one of the great technological and business achievements of the twentieth century. Whole new industries grew up to build electric production, transmission and distribution equipment; produce, transport and sell power to end-users; and invent and build an enormous variety of machines, appliances and gadgets that would improve our quality of life. Governments eventually set out an extensive regulatory framework that would ensure the benefits of electricity were made universally available at reasonable prices and without some of the competitive excesses that characterized the industry in its infant years.

By the 1970s however, this once-vibrant industry was under assault. Regular price decreases turned into price increases as inflation ravaged the US economy and once robust demand growth suddenly came to a halt. Air and water pollution became major social issues. Together with nuclear power safety and cost concerns, these issues undermined the hard-earned public service image of privately owned utilities. Customers became frustrated and disenchanted. A once-vibrant industry that prided itself on customer service became bureaucratic, hidebound and risk-averse. The flood of technical innovations that kept electricity prices headed downward for many decades slowed to a trickle.

Beginning in the late 1970s, elected officials, regulators, thought leaders, consumer advocates, environmental activists and power industry representatives initiated a debate over the future structure and direction of the electric power industry that continues to this day. Large customers are fed up with what they regard as the excessively high prices being charged by a monopolistic industry that is neither efficient nor sensitive to customer needs. Power industry incumbents see little need for fundamental change and are generally unwilling to surrender their captive customers. Elected officials and regulators are struggling to reconcile competing demands for low prices; reliable service; clean air and water; and a variety of social programs. Consumer advocates argue passionately for the lowest possible price of electricity, especially for those living on limited incomes.

The debate is important, and despite the fact that it has been going on for more than 25 years, many issues remain unresolved. As with any significant policy debate, participants often get so carried away with their rhetoric that facts become obscured or even sacrificed during the struggle to sway public opinion. The discussion that follows is an attempt to cut through some of the resulting fog and help separate fact from fiction. It addresses several popular myths and misconceptions that have evolved around the notion of competitive electricity markets:

“Competition will lead to lower prices”. When proponents of competition make this claim, they run the risk of undermining their own efforts. Customers, opponents and especially the press expect to see prices fall literally the day after a competitive environment is introduced. If price decreases don’t materialize right away, opponents can rightly make the claim that competition doesn’t work.

In fact, there’s absolutely no way to know with certainty how the switch from a regulated monopoly structure to competition will affect short-run electricity prices, which depend on a wide range of factors that include the balance between electric supply and electric demand; prices for coal, natural gas and oil; capital costs; interest rates; the rate of demand growth; government mandates; the cumulative effect of customers’ ability to manage demand around prices; the relative abundance of hydropower; and technological advances. It becomes a daunting task to draw firm conclusions one way or the other based on one or two years worth of data when so many variables can affect the outcome, often in conflicting directions.

Researchers have assembled some evidence to support the claim that competition does induce incumbent utilities to reduce underlying costs associated with providing electric service (1). Where it has been introduced, retail competition has compelled utilities to replace staff with labor-saving technology, implement work process improvements that raise productivity, manage parts inventories more effectively, and replace highly customized parts and systems with less costly off-the-shelf items. At the wholesale level, merchant generators have figured out how to dramatically lower the capital and operating costs of both new and existing generating plants. But fuel prices are still a significant driver of electricity prices and because fuel prices have been rising over the last few years, it isn’t clear how all of the other cost reduction efforts get passed on to customers in the form of lower retail prices.

Moreover, lower prices aren’t the only motivation for restructuring the power industry. For some large customers, the ability to negotiate a better package of terms, conditions and prices may be more important than just the price of electricity taken alone. But under the current business and regulatory structure, customers have to negotiate prices and terms of services in contested regulatory proceedings that are a matter of public record. In effect, customers must take their suppliers to court, perhaps many times and in multiple venues simply to negotiate what for most businesses should just be another supplier agreement. As an executive at a packing products company once noted, “I buy lots of commodities on the open market without the help of lobbyists, lawyers and consultants. I don’t understand why I need them to buy electricity.”

“Electricity deregulation is a failure everywhere it has been tried…” So says Consumer’s Union in an April 9, 2003 letter on their web site opposing the Energy Policy Act of 2003. Other signatories to that letter include the US Public Interest Research Group and the Consumer Federation of America.

Many of the same kinds of complaints outlined in Consumer’s Union’s letter were cited by opponents of the efforts to put airlines and telecommunications providers on a more competitive footing. Billing errors, poor customer service, and anti-competitive behavior by the incumbents were rampant. Several rounds of additional legislation were required to redress competitive consumer abuses, but there is no longer any doubt that both industries are in the midst of radical transformations. Air travelers enjoy an unprecedented range of price and service options, including air fares that are lower in nominal terms than they were 25 years ago and air taxi and fractional aircraft ownership options that provide more convenient point-to-point service and bypass congested air carrier airports. Telecom users have access to data, voice and video services that might otherwise have taken many more decades to make the journey from laboratory research project to commercialization if AT&T’s monopoly had remained intact. Product and services innovations continue to come out of these two industries at a rate would never have been possible under monopoly regulation.

The most negative conclusion one can draw from limited anecdotal evidence in Consumer’s Union’s letter is that it’s too early to know whether “deregulation” of the electric power industry is a smashing success or a dismal failure. Low switching rates, sporadic price increases, gaming in the UK’s power pool during its early days and the California debacle are not the kinds of outcomes proponents of competition were hoping for, but the transformation process is still in its infancy. On the other hand, the rapid adoption of high efficiency, low cost, gas-fired combined cycle plants; dramatic increases in capacity factors and equally dramatic cost reductions at nuclear plants; and the adoption of price responsive demand management programs by several RTOs are all the direct result of regulatory initiatives that were specifically intended to inject a measure of competition in the power industry.

A corollary to this myth is the argument that “…any potential savings are outweighed by implementation costs and in any event, cost savings are too small to be worth the effort.” The potential for competitive markets to drive down costs and prices is only a part of the benefits picture. Moreover, even if the savings only amount to a few dollars each month on a residential electricity bill, those savings are at least as meaningful as the reduction in banking service charges consumer advocates often demand or a few pennies of difference in the price of gasoline.

“Allowing large consumers to shop around will unfairly shift costs to residential and small commercial customers.” This is the response of several influential consumer advocacy organizations in California to calls for a resumption of retail competition.

Traditional cost-of-service ratemaking is much more art than science, and more subjective than objective. The formulas used to allocate costs among customer classes are heavily influenced by local politics and the lobbying skills of various stakeholder groups. They’re not based on fundamental science or mathematics. As a result, there’s absolutely no objective way to determine whether the prices paid by any group of customers is “fair” or to quantify the magnitude of any alleged cross-subsidies. When it comes to dividing revenue pies, we’re typically more than happy to be handed an outsized slice. On the cost side, however, we’d just as soon skip dessert.

Of course, California is a special case prompted by the meltdown of its wholesale market in 1999 and 2000. There the fairness issue is largely about how customer groups pay for the expensive long-term power contracts that were negotiated by political appointees who have since moved on. TURN, UCAN and the Foundation for Taxpayer and Consumer Rights, consumer advocacy groups that purport to represent residential consumers, want the large energy consumers that pushed for “deregulation” to bear all of the above-market costs associated with those contracts. Large consumers, merchant energy companies and competitive retailers oppose exit fees on the grounds that they would remove any economic incentive to leave bundled utility service.

“Electricity is too important to leave to the free market.” This is simply not true. Food is also an essential commodity subject to intense competition throughout a supply chain that starts with seed and fertilizer on one end and puts our dinner on the table at the other. In the face of such competition, food has become so abundant and so cheap in this country that many farmers are in the absurd position of being unable to remain in business without enormous government subsidies.

Limited forms of competition in the electricity sector that are largely independent of Federal and State restructuring efforts already exist. One notable example: utilities with adjacent service territories. To keep large, energy-intensive customers from fleeing, investor-owned utilities like Public Service Company of Colorado work hard to make sure their retail rates are not out of line with neighboring public power agencies. Any retail customer in Lubbock, Texas can take service from either of two different utilities, Lubbock Power and Light or Southwestern Public Service (2). As the history of that city’s electric utility demonstrates, competition can be very effective at keeping prices in check without compromising service.

By attempting to perpetuate this myth, its proponents imply that the only options are government ownership or private monopolies. But governments around the world have embraced private ownership and at least limited competition rather than public spending as the preferred means of attracting investment that increase power supply and upgrade existing facilities.

In conclusion, it is possible the proponents of an industry restructuring that emphasizes competition will ultimately prove correct. It is equally possible that none of the many experiments underway all around the world will yield a new industry model that, upon critical examination, is deemed better than the old. But while the debate rages on, it is important that we focus on the facts and not allow myths to cloud our thinking.

Notes:

1. For example, Kira Markiewicz and Catherine Wolfram of UC Berkeley, and Nancy Rose of MIT determined that investor-owned utilities in jurisdictions with competitive electricity markets achieved generating cost reductions of as much as 10-15% greater than both municipal utilities and utilities that did not face competitive pressure. See their joint paper, “Has Restructuring Improved Operating Efficiency at US Generating Plants?”, UC Energy Institute, July, 2004.

2. http://www.lpandl.com/fullhist.htm

Readers Comments