Deregulation or Managed Competition?

Capitol Hill is currently engaged in one of the most significant regulatory struggles in decades: the proposed restructuring of the $200 billion electricity industry, the last of the great regulated monopolies. Industrial electricity consumers want to end the power monopolies and argue that rates could be cut 25 percent or more by doing so. Electricity companies have a soft spot in their hearts for laws that criminalize competition, and many marshal a legion of rationales for why consumers are made worse off by free markets. Finally, the political coalitions that control state public utility commissions are desperate to preserve their ability to dictate the terms, conditions and subsidies of electricity service and consumption.

At first glance, then, the upcoming debate will be a classic argument about whether deregulation benefits the economy and the consumer. Yet “deregulation” is not the mantra of reformers — “competition” is — and the distinction is far from semantic. For the sort of competition envisioned by most restructuring advocates is the sort that might be dreamed up by Clinton aide Ira Magaziner: heavily managed, government supervised and bureaucratically bounded.

The central idea of the managed-competition agenda is to force utilities to transmit third-party power under heavily regulated rates and conditions (an arrangement known within the industry as mandatory retail wheeling). The privately owned electricity transmission and distribution network would be turned into a public highway, with contracts made directly between power generator and electricity consumer. To keep the utility companies from “unfairly” using their market position as owners of the grid to impede competition, reformers propose various degrees of vertical disintegration (euphemistically termed “unbundling”) and the mandatory employment of “independent system operators” who would manage the grid under the direction — not of the utility companies that actually own the grid — but of public utility commission bureaucrats.

Consider how such proposals would look if applied to another retail industry: merchandising. Reformers might well argue that Wal-Mart, for instance, has a de facto monopoly in many small towns; that they refuse to carry all but a few select brands of merchandise (predominantly their “house” brands); that, in the interest of competition, Wal-Mart should be forced to sell the merchandise of any manufacturer that requests the retail space regardless of economic considerations; that the rates Wal-Mart can charge for those services must be neutral, nondiscriminatory and approved by regulators; that the store manager must be independent from Wal-Mart and answerable only to government bureaucrats; that all Wal-Mart operations must be forced to operate at arm’s length from each other or even be divested from the company completely; and that regulators should be empowered to force the construction of additional retail space at any store to accommodate third-party merchandisers whether Wal-Mart approves of the expansion or not. Whatever happened to capitalism?

The potential benefits of retail competition would be more than offset by the massive expansion of regulation of other segments of the electricity industry. The de facto nationalization of transmission and distribution facilities will undoubtedly lead to degradation of the grid and loss of innovation. Access and service decisions will be made by political agencies, not market actors. Price controls and related regulatory interventions will hinder, not help, the emergence of a competitive industry. Criminalizing the consideration of economic efficiency in transmission and distribution service will raise, not reduce, electricity prices. Breaking up the power companies (whether implicitly through unbundling or explicitly through direct vertical disintegration) threatens to give birth to even less efficient corporate structures than those in existence today. Finally — as the lesson of telecommunications reform is already teaching us — the inevitable legal wrangling surrounding the terms and conditions of mandatory grid access will paralyze indefinitely the onset of even this brand of managed competition. As industry consultant Charles Cicchetti noted at a recent utility conference, “Taking all of the above into account, two things should be obvious. First, none of this should be called deregulation. Second, it is difficult to see how any of these myriad regulatory schemes, unless altered significantly but perhaps not fundamentally, will lower prices.”

Yet proponents of managed competition counter that, since the transmission and distribution grid is a natural monopoly, the only alternatives to mandatory retail wheeling are (1) the current regime, with all its known faults, or (2) unrestrained robber baronry. But the power grid is not a natural monopoly. Before the advent of public utility regulation at the turn of the century, the electricity industry was hotly competitive. Power companies established parallel private grids and delivered power at a lower cost than that delivered subsequently by the “regulated” monopoly franchises. Even today, several dozen communities, for unique historical reasons, can choose between various power companies — each with their own grid — and those communities find that rates are typically significantly lower than in other communities without such competition. That would not be if the natural monopoly diagnosis were correct.

Simply put, there are no longer significant economies of scale in the electricity business. Spot and futures markets for electricity have eroded any lingering monopoly. Advances in micro-turbine technology have made self-generation a viable alternative to the grid and threaten to render central station power generation obsolete. Extensive distribution networks and grids are almost impossible to monopolize, by their very nature, and user-owned transmission and distribution facilities are a proven way for consumers to protect themselves against the exercise of monopoly power. Finally, as long as markets are theoretically contestable, monopolists invariably price as if competition were a present reality (that is the reason, incidentally, that Wal-Mart doesn’t jack up prices once its competitors are neutralized; it doesn’t want to tempt others into the market).

For those and other reasons, investigations by the late Nobel laureate economist George Stigler found that “the individual utility system is not possessed of any large amount of long-run monopoly power. It faces the competition of other energy sources in a large proportion of its product’s uses, and it faces the competition of other utility systems, to which in the long run its industrial (and hence many of its domestic) users may move.” Likewise, the dean of institutional economics, UCLA economist Harold Demsetz, agrees: “To the extent that utility regulation is based on the fear of monopoly price, merely because one firm will serve each market, it is not based on any deducible economic theorem… . Economic theory does not, at present, provide a justification for [regulatory] commissions insofar as they are based on the belief that observed concentration and monopoly price bear any necessary relationship.”

Electricity service is not a natural monopoly — it is an artificially created and legally sustained monopoly. The proper path of reform, then, naturally suggests itself: repeal of all utility regulation directed at the electricity industry. Accordingly, Congress should repeal the Public Utility Holding Company Act, the Public Utility Regulatory Policies Act, and the Federal Power Act. Citing the Constitution’s Interstate Commerce Clause — which prevents states from erecting barriers to free interstate commerce — Congress should further declare that states have until date certain to repeal any regulation of the generation, transmission, distribution or retail sale of electricity across state lines, save for regulations addressing safety matters.

If the last several decades have taught us anything, it is that the best regulator of markets is dynamic, free and open competition. Politicians must be awakened from their dogmatic slumbers and persuaded to just let go of the industry. Milton Friedman, not Ira Magaziner, should be the inspiration of the 105th Congress.

Jerry Taylor is director of natural resource studies at the Cato Institute and is senior editor of Regulationmagazine.