Congress and Electricity

June 26, 1998 • Commentary

A draft bill to restructure the regulation of the electric utility industry is being circulated by the staff of the House Commerce Committee. The bill is modeled on the restructuring legislation already enacted by California, Massachusetts, and Rhode Island that creates stock‐​exchange‐​like markets for the sale of electricity from generators and the treatment of transmission and distribution lines as “common carriers” that deliver power from any generator to consumers at regulated rates and conditions.

Congress should not use the California legislation as a model. Despite months of intense advertising and promotional campaigns from third‐​party marketers, only 38,000 consumers — less than 5 percent of the California ratepayers — have taken advantage of their ability to choose a different electricity company. Enron Corp. — the giant natural gas, electricity, and renewable energy conglomerate perhaps most responsible for the successful campaign to restructure the electricity industry — recently announced that their nearly decade‐​long quest to enter the residential electricity market has turned to ash and that they would henceforth get out of the California market. Other would‐​be utility competitors are expected to follow Enron’s lead, leaving California residential consumers back where they began at the beginning of this exercise. Soon, it appears that they will have nowhere to turn but to the very utilities that just a few months ago were written‐​off as the relics of a by‐​gone era of regulation and monopoly. What went wrong?

The short answer is that politicians rather than market forces designed the restructured California electricity system. Politicians, while paying lip service to deregulation and the magic of the market, could not bring themselves to simply let go of the industry. Reflecting the fear of both consumer activists and electric utilities that real markets would prove disastrous, the California legislature placed constraints on the restructured industry whose net effect was to stifle the very forces necessary to drive down California’s utility rates. Consumer choice thus became a meaningless exercise.

Utilities worried that in a free market most of their high‐​cost nuclear and renewable sources of electricity would prove so uncompetitive that bankruptcy could result. The California legislature accordingly allowed utilities to impose a transition charge on customers who abandon their high‐​priced power for the greener pastures of lower‐​cost non‐​utility power generators. Consumers, not utilities, would thus pay for those white elephants regardless of which company ratepayers choose to buy from.

Consumer activists worried that prices might rise in a free market. Thus, they lobbied successfully for a provision that froze retail rates at 1996 levels. As a result, customers who switch from a traditional utility to a new power marketer pay the wholesale price for power plus a delivery charge plus a variable “transition charge.” The sum of these charges cannot exceed the 1996 rate for electricity.

But since a rate freeze did not offer anything to consumers that they did not already have under the old regime, the legislature decided to mandate a 10 percent rate cut for all residential and small business customers. The legislature paid for this rate cut by selling 10‐​year bonds issued by an off‐​budget agency of the California State government.

The bonds are essentially another device to shift the costs of the uneconomic nuclear and renewable power from the utilities to the ratepayers, stretching out the payments over a longer period of time at slightly lower interest rates. Now, if all of us could refinance our VISA bills with state bonds over a longer period of time, our monthly payments would go down, but the total bill due would actually rise because we would be paying interest for a longer period of time. This sort of politically clever sleight‐​of‐​hand is costly not only for consumers but also for the economy as a whole. Capital that would have been used to finance new private investment is used instead to finance uneconomic power plants. Moreover, you don’t need to switch from a traditional utility to get the rate cut.

The net effect of California’s market meddling is to severely reduce the incentive for customers to switch companies. And because the benefits from switching for consumers in the politically designed system are low, the overwhelming majority of them have chosen to stick with the devil they know rather than switch to the devil they don’t.

What Congress should do is use its own legislation on intrastate trucking regulation as a model for electricity restructuring. Congress deregulated interstate trucking in 1980, but state regulation of intrastate trucking continued. The main effect of the continued state regulation was to restrict entry by new firms and raise the price of shipping for consumers. For example, a shipment of tobacco from Texas to Louisiana (125 miles) cost $450 in 1994 while the same shipment cost $750 to cover 85 miles within Texas.

The seeds for change in these cozy cartel arrangements were sown by a court case affecting Federal Express. California attempted to regulate Federal Express’s extensive truck operations within that state. Federal Express sued saying it was regulated under federal airline regulation. The initial judgement went against Federal Express, but the Ninth Circuit Court of Appeals overturned the California regulations in 1991, and the Supreme Court refused to hear the case letting the Appeals decision stand in the Ninth Circuit.

In the short run the bulk of the explicit gains from electricity deregulation will probably go to industrial users that alter their operations to take advantage of low off‐​peak electricity prices.

United Parcel Service was regulated as a motor carrier rather than an airline, but it wanted the same exemption as Federal Express. In 1994 other trucking firms also wanted an exemption, not wanting the two giants to gain an advantage, and Congress exempted all motor carriers, except household movers, from state regulation.

Two lessons for electricity, one normative and one positive, flow from the case of intrastate trucking regulation. First, Congress intervened to overturn the anti‐​consumer state regulation of trucking firms and no constitutional questions were raised. Second, the policy status quo quickly switched from regulation to deregulation once one firm was given the right by the courts to be treated differently from its competitors. The role of unregulated cogenerator facilities in electricity is very analogous to the role of Federal Express in intrastate trucking regulation. Initial exemption of an exception leads to an unraveling of the political support for regulation.

The existing regulated vertically integrated electric utility industry wastes resources. High‐​cost nuclear and independent sources of electricity supply electricity even though their prices are above current market rates and 25 percent of coal‐​fired baseload capacity is not utilized at off‐​peak times.

Policy makers have decided to restructure rather than eliminate the monopoly‐​franchise state‐​regulated system that gave us our currently inefficient electric power system. The usually correct belief that choice is good has lead policymakers to believe that generators and consumers should meet in a stock‐​exchange‐​like setting and buy and sell power using the existing grid as the equivalent of United Parcel Service to ship the product between generator and consumer.

The problem is that transmission and generation are substitutes. The proper mixture of generation and transmission is an economic, not an engineering, question, and little attention has been given to the development of efficient transmission prices. Without efficient transmission prices appropriate choices between transmission and generation will not be made.

A more promising alternative than mandatory participation of generators in a stock‐​exchange‐​like setting using the grid as a common carrier is to respect the economic benefits of vertical integration but not use regulation to manage vertically integrated utilities. Just repeal the monopoly franchise restrictions that prevent competition and eliminate public utility regulation.

Both electric utilities and consumers object to such a proposal. Utilities object because without the guaranteed revenue stream provided by state regulation, the market value of certain high‐​cost electric generation assets would drop. But markets compensate investors ex ante for the risk of policy change, particularly in regulated markets, because everyone knows that the privileges granted by government can also be withdrawn. Compensation after the fact is neither efficient not equitable.

Consumers object because they believe that market forces will not constrain the behavior of the current monopoly transmission and distribution systems. Scholarly evidence suggests that regulation does very little to constrain utility pricing. In those few areas of the country where actual competition exists, electric prices are lower. In addition competition from decentralized natural‐​gas fired electric generators seems likely to be a viable alternative to conventional electric service.

Even if consumer and electric utility objections to deregulation are unwarranted, other objections are raised by various groups, but these objections also do not undermine the case for true deregulation. Cross subsidies to rural customers, real‐​time prices, the distributions of benefits between commercial and residential customers and between states, increased air pollution, and public power subsidies present obstacles of varying difficulty to genuine deregulation.

The costs of rural service may be higher although research suggests that rural telephone costs are not higher. If subsidies to rural customers are politically necessary, the subsidies should be transparent, like food stamps, rather than hidden in overcharges to other utility customers.

Current electricity prices reflect average rather than marginal costs. Peak power prices are now too low and off‐​peak prices are too high. If efficiency gains from deregulation are to be realized, the political pressures to maintain a flat‐​rate pricing option should be resisted.

In the short run the bulk of the explicit gains from electricity deregulation will probably go to industrial users that alter their operations to take advantage of low off‐​peak electricity prices. But the gains will be passed through to consumers in the form of lower product prices. In the long run electricity prices will converge to 3 or 4 cents per kWh for all users.

Current low‐​cost states worry that their electricity costs will rise as their cheap power is shipped elsewhere. Indeed price differences across space in excess of transportation costs cannot persist, but constraints in the transmission connections between regions will prevent all prices from converging to the current U.S. average of 6.6 cents per kwh in the short run.

The air pollution concerns are motivated by the likely increased use of coal‐​fired plants under deregulation. Aggregate SO2 emissions are already capped under provisions of the 1990 Clean Air Act. NOx emissions may rise slightly but relative only to an underlying downward trend.

Public power subsidies present the greatest difficulties to true deregulation. Subsidized consumers, those who use food stamps for example, are compatible with market competition but subsidized firms are not. If current public ownership and subsidies cannot be terminated for political reasons, then subsidies should be limited to existing operations so that expansion occurs on a level playing field.

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