The Efficiencies of Vertical Integration in the Electricity Industry

Organizational structure should be determined by market actors, not politicians

July 13, 2006

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WASHINGTON — Electricity deregulation unwisely discourages (and often, prohibits) vertical integration of electric power companies, according to a new study published by the Cato Institute.

In the Policy Analysis “Vertical Integration and the Restructuring of the U.S. Electricity Industry,” Robert J. Michaels, a Cato adjunct scholar, argues that vertical integration is probably the most efficient organizational structure for the electric power industry, and regulators and politicians should reconsider their bias against it.

The result of this prejudice, writes Michaels, has been “the passage of electricity utility restructuring laws that may create production inefficiencies that shrink the net benefits of any move toward market provision of power supplies.”

Neither legislators nor regulators paid virtually any attention to the rich economic literature on the matter and essentially acted “in the dark” from an economic perspective, the paper argues.  “Economists rarely spoke up either during legislative and regulatory hearings on the matter.”

According to Michaels, deintegration has made efficient electricity transmission operation, maintenance, and investment much more difficult than it had been when the industry was vertically integrated.  Deintegration also likely played a role in exacerbating the California electricity crisis in 2000 and 2001.

“[T]he question of how best to organize the electricity industry is a question that should be answered through trial and error by market actors, rather than be decided by politics,” concludes the author.

Policy Analysis Paper no. 572