How Not to Make Electricity Cheaper

August 21, 1998 • Commentary

Prices for wholesale electricity in the Midwest recently skyrocketed from $30 a megawatt‐​hour to $7,500 a megawatt‐​hour. The causes of this 250‐​fold price increase included a storm that knocked out three major electric transmission lines in Ohio and reduced access to supply, some generator outages and the failure of two power marketing companies to fulfill supply contracts. As the power supply was reduced, prices rose rapidly.

Predictably, various interests have argued that the incident provides evidence for their point of view. Some have said that deregulation was dangerous. For example, Illinois Power asked the Federal Energy Regulatory Commission (FERC) to put a cap on the price of wholesale power during emergencies. Others argued that California‐​style deregulation was the answer.

Neither view is correct. The prices observed during the shortage serve a very important function: they tell firms how much they should spend to avoid supply emergencies. Commonwealth Edison, a Chicago utility, for example, spent $4 million an hour for electricity that normally would have cost $200,000.

[P]rices are an essential component of efficient transmission [of electricity]. Without them, inappropriate decisions about the relative use of local and distant power will be made.

One hundred percent service reliability is expensive to provide. The peak‐​demand generating units that were called into service during the Midwest emergency have to earn what they cost during the few hundred hours a year that they may operate. The prices observed during the shortage allow utility planners to estimate the net benefits of new transmission and generation capacity and compare them to the costs of buying scarce surplus power from other suppliers during infrequent supply outages. The planners may determine that new transmission and standby generation capacity is cheaper than buying power at $4 to $10 a kilowatt hour. Or they may decide that buying power is cheaper because the supply shortages are so rare. But planners cannot make informed choices in the absence of market prices.

California‐​style deregulation also will not solve this problem because it only creates a market for electricity generation. Most analysts accept the view that generation can become competitive but that transmission and distribution still require regulation. Mandatory open access, in which all generators have access to the transmission and distribution system at rates determined by regulation, is the way electricity markets are typically restructured by the states, including California.

But transmission and distribution deserve as much attention as generation. Designing a system to place market prices on electricity transmission, however, is difficult because power added anywhere in an interconnected electricity transmission system affects lines and generators everywhere in the system.

Three solutions exist for the effects that generators impose on a transmission system: vertical integration (the ownership of generation, transmission and distribution facilities by traditional utilities); taxes and subsidies imposed by central planners (regrettably, this would require something like omniscience); and decentralized bargaining and property rights. Imagine a world in which electricity had never been regulated. Which organizational form would predominate: vertically integrated utilities or separate generation, transmission and distribution companies along with brokers who facilitated myriad transactions? The answer is unknown. But in the real world, we already have vertically integrated electric utilities.

Rather than respect the virtues of vertical integration, all deregulatory proposals under active consideration at the state or federal level are for a system of mandatory access in which deregulated generators of electricity compete for the right to sell electricity to the grid, which is managed as a common carrier by an independent systems operator. Under those proposals, the allocation of transmission capacity among users is viewed as an engineering rather than an economic problem. Hence, the use of prices to allocate scarce capacity is suppressed.

But prices are an essential component of efficient transmission. Without them, inappropriate decisions about the relative use of local and distant power will be made. For example, both the British and Argentine mandatory access systems lack appropriate transmission prices. The result has been costly electricity. High prices, in turn, have induced entrepreneurs in Argentina to enter the market for generation, resulting in excessive generation capacity but inadequate transmission systems. In one area of Argentina, for example, 5,100 megawatts of generation capacity exists but only 2,600 megawatts of transmission capacity connects the generators to energy‐​hungry Buenos Aires.

Neither the status quo nor California‐​style restructuring is the answer, because they both rely on regulation rather than markets. And regulation has not protected consumers in the ways that populist rhetoric suggests. Regulation has given us excessively costly nuclear power, for example. For lower prices, we must let vertically integrated utilities compete without state‐​provided protection from competition and allow the market to discover the most efficient forms of industrial organization.

About the Author