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

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Executive Summary

Debates on restructuring the U.S. electricityindustry are often about the degree to whichmarket relationships should replace transactionsthat formerly took place within regulated, verticallyintegrated utilities. Markets for the purchaseof energy by vertically unintegrated distributionutilities are clearly feasible, but verticaldeintegration of existing systems may eliminatesome operational and reliability benefits that areimportant in light of the unique characteristicsof electricity.

Politicians and policy analysts have almosttotally disregarded a large body of academic literatureregarding the efficiencies that are gainedthrough vertical integration in the electricity sector.At the same time, those parties have enthusiasticallyembraced other studies that purport toestimate the benefits of switching to a so-calledrestructured regime consisting of independentgeneration and integrated transmission and distribution.The result has been the passage of electricityutility restructuring laws that may createproduction inefficiencies that shrink the netbenefits of any move toward market provision ofpower supplies.

A review of the debate surrounding electricutility restructuring in California—the first stateto embrace restructuring—reveals that legislatorsand regulators regarded vertical integration primarilyas a tool that incumbent utilities coulduse to perpetuate their market power. They thusdisregarded the benefits that might accrue fromvertical integration and used the force of regulationto encourage the sale of generating plants toindependent power producers. The idea was tocreate a competitive market structure in the electricitygeneration sector. Unfortunately, the costsassociated with this experiment in Californiaand elsewhere have yet to be compared with benefitsin any economically meaningful way.

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

Robert J. Michaels

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