Policy Analysis No. 572

Vertical Integration and the Restructuring of the U.S. Electricity Industry

Executive Summary

Debates on restructuring the U.S. electricity industry are often about the degree to which market relationships should replace transactions that formerly took place within regulated, vertically integrated utilities. Markets for the purchase of energy by vertically unintegrated distribution utilities are clearly feasible, but vertical deintegration of existing systems may eliminate some operational and reliability benefits that are important in light of the unique characteristics of electricity.

Politicians and policy analysts have almost totally disregarded a large body of academic literature regarding the efficiencies that are gained through vertical integration in the electricity sector. At the same time, those parties have enthusiastically embraced other studies that purport to estimate the benefits of switching to a so-called restructured regime consisting of independent generation and integrated transmission and distribution. The result 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.

A review of the debate surrounding electric utility restructuring in California—the first state to embrace restructuring—reveals that legislators and regulators regarded vertical integration primarily as a tool that incumbent utilities could use to perpetuate their market power. They thus disregarded the benefits that might accrue from vertical integration and used the force of regulation to encourage the sale of generating plants to independent power producers. The idea was to create a competitive market structure in the electricity generation sector. Unfortunately, the costs associated with this experiment in California and elsewhere have yet to be compared with benefits in any economically meaningful way.

A proper comparison of the two suggests that restructuring is presently off course.

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Robert J. Michaels is a professor in the Department of Economics at California State University, Fullerton, and an adjunct scholar at the Cato Institute.