A Short Honeymoon for Utility Deregulation

Energy Resurfaces as a Major Concern

PETER FOX-PENNER

GREG BASHEDA

A Short Honeymoon for Utility Deregulation

The California crisis shook public faith in restructuring, but that path is still the best route to follow.

During the more than 100 years from the inception of the electric utility industry in the latter part of the 19th century through 1995, the inflation-adjusted price of electricity in the United States dropped by about 85 percent, the U.S. power grid enjoyed a reliability record second to none, and the industry achieved the world’s highest output per employee. Every year, customers consistently ranked their local utilities among the one or two most respected institutions in their communities. All this was achieved under a system where most utilities owned all their own generators, high-voltage transmission lines, and local distribution systems in one vertically integrated, regulated (or government-owned) company.

Given all of this, one might wonder why states across the country embarked several years ago on ambitious plans to unleash the forces of competition on their electric power industries. Most industry observers believe that the transmission and distribution functions are natural monopolies that must have their prices regulated. Electricity generation, on the other hand, is a distributed activity that allows for many independent participants and thus could operate more effectively in a deregulated environment. For example, deregulated industries are generally better at realizing the full benefits of certain efficiencies and cost savings in the way a product is made and sold. Since 1978, when the Public Utilities Regulatory Policies Act (PURPA) began the process of deregulating electricity generation by requiring utilities to purchase power from some independent generators, nonutility and utility companies alike have been able to build power plants more quickly and operate them more cheaply by using standardized designs and outsourcing some functions.

Another theoretical benefit of a deregulated market is its ability to distribute gains and losses that result from good and bad investment decisions in a less political way. In the late 1970s and early 1980s, the regulated industry constructed a number of power plants for which consumers paid too much either because of cost overruns (nuclear power being the best example) or because the plants were built when they weren’t really needed. This seems to be happening less often now that wholesale and in some cases retail competition have been introduced, though any competitive industry makes investment mistakes too. In those cases, however, it is the market that disciplines management and determines the long-term allocation of the costs of unsuccessful investments between shareholders and customers. One of the factors contributing to the California crisis was the presence of retail price caps that prevented a market-based allocation of risks and costs.

The enhanced customer choice provided by power deregulation also is expected to yield a broader array of new products and services and alternative pricing plans. Just consider how innovative the telecommunications industry has been in the 15 to 20 years since it was deregulated, and the possibilities in the electric power industry are clear. Bundled electric and Internet service or electric and long-distance phone service are perfect examples. Down the road we can expect a new emphasis on alternative sources of energy and “distributed generation” through micro-power plants owned and operated by individual companies and institutions.

These arguments, a perception of success in other deregulated utility sectors, and a desire to diversify energy sources led the federal government to start the process of deregulation at the wholesale level of the generation business with passage of the National Energy Policy Act of 1992, which went far beyond PURPA in allowing for independent power generation. States began to take the next logical step–deregulation at the retail level–when California became the first to pass a deregulation bill in 1996. Dozens of states followed California’s lead, particularly in the Northeast, where relatively high prices for electricity also drove policymakers to embrace deregulation as a boon to economic development. Today, 23 states and the District of Columbia have adopted some form of electric restructuring. Full competition is now in place or destined soon for 70 percent of U.S. residential electric customers.

A few short years later, the bloom is clearly off this rose. A series of events over the past year have raised serious doubts concerning the viability of power competition. Though the petals started falling even before deregulation officially went into effect, the rose truly fell apart in California. At its heart, the crisis in California can be traced to an imbalance in the supply of and demand for electricity, brought on by a series of inter-related developments and trends. The rolling blackouts, gigantic electric bills, and teetering-on-the-edge-of-bankruptcy utilities can all be attributed to this imbalance. Many states in the process of deregulation have paused to see what happens in California and elsewhere before going forward. Lawmakers from New York to Los Angeles have called for rolling back deregulation, impossible though it may be. The key questions become: How did we go from the promise of unbounded blessings just four years ago to the unforeseen blemishes of today? And how we can we restore and maintain the balance in supply of and demand for electricity, not just in California, but elsewhere as well?

Too much demand

To understand what went wrong in California, it’s necessary to review the state of the industry before the introduction of wholesale competition in 1992. Partly because of the uncertainties created by the expectation that deregulation was coming, vertically integrated utilities were not building enough generation and transmission capacity during the 1990s to match the growth in demand. Industry observers offered many different explanations for this lack of new capacity, including local opposition to plant construction, environmental concerns, incorrect demand forecasts, a perceived glut of available power in some areas of the country, and regulatory refusal to offer satisfactory rates of return. In the end, it most likely was a combination of these and other factors that led traditional utilities to ratchet back on their power plant construction budgets.

This lack of new capacity would turn out to be more problematic than even the most vocal doomsayers predicted, primarily because few anticipated the rapid rate of growth in the economy and the explosion in the production and use of electronic technologies such as the World Wide Web, e-mail, Palm Pilots, cell phones, and all the other gadgets that have become so ubiquitous in the past several years. Between 1995 and 1999, electric demand increased 9.5 percent–triple the projections made by some analysts–while developers added only 1.6 percent of new generating capacity, and investment in transmission lines actually went down.

Utilities should be required to offer real-time pricing to all large customers.

Even before deregulation had a chance to address the very problem it was designed to solve, this severe short-term capacity shortage knocked the system to its knees in California (and likely would have done the same last summer in the Northeast and parts of the Midwest without the serendipitous cool weather those regions enjoyed). It’s been more than a decade since a major new power plant went “live” in California. The state has long relied on power imported from its neighbors to meet demand at peak periods, but those states now have much less power to sell because of their own growing needs. As the supply side tightened, utilities contributed to the problem by cutting back on their demand-side energy efficiency programs in preparation for a competitive market.

The result is a quasi-market in which too much demand is chasing too little supply. At first, this imbalance sent generation prices as high as $12 per kilowatt-hour during the summer of 2000, compared to a historical price of six cents! And then Mother Nature threw California a curve: cold winter weather that hit just as a substantial portion of the state’s generation capacity was down for routine maintenance during what is supposed to be the industry’s “off season.” This was too much, and the system failed. The only alternative to uncontrolled widespread blackouts was to institute the first deliberate rolling blackouts in the history of the state.

Political power lines

Responding promptly to electric supply needs is made difficult by the jerry-built framework of institutions that collectively manage the nation’s electric system. The New Deal-era Federal Power Act grants the Federal Energy Regulatory Commission (FERC) authority over wholesale rates, mergers, and all rates and terms for high-voltage transmission service. But the law fails to provide FERC with authority over retail rates or low-voltage distribution; these are left to the states, as is most of the authority over the siting of new transmission lines. Even more surprising, no government entity has clear-cut jurisdiction over reliability rules. It often comes as a shock to industry newcomers that the United States achieved the world’s highest reliability rate with very little state regulatory oversight and under a system of voluntary practices developed and administered by a self-regulated industry body: the North American Electric Reliability Council. If all of this were not enough, municipally owned utilities and those owned by their customers are usually exempt from most state and federal regulations.

Policymakers never fully appreciated the implications of this complex jurisdictional framework and failed to address them. This led them to draw too much encouragement from the successful deregulation of the United Kingdom’s electric power industry, which began in 1990. Authority over the United Kingdom’s industry resided with the central government in London, enabling the industry there to be deregulated relatively quickly and easily. Here, because of the way the industry was set up 65 years ago, each state must pass its own statute and establish its own rules. In an industry fully regulated by an overlapping series of state and federal statutes for so long, the balance of interest groups and political power at the state and federal level, as well as substantial structural and institutional differences across the vast U.S. grid, have thus far made it impossible to establish a single set of governing rules and regulations. Finally, when passing deregulation laws, many state legislatures provided state regulators with very little if any guidance on major market design questions and in most cases established unrealistically short timetables.

As a result, we have by far the most complex array of regional market designs and trading arrangements of any developed nation. Congress, FERC, and state policymakers are doing their best to keep up with the pace of change, but the industry confronts numerous technical and economic issues that have barely been studied, much less resolved. One example from the California experience is the issue of price caps on the retail price of electricity. In exchange for being allowed to recoup “stranded costs” from investments made in power plants during the regulated era, the state’s three major utilities accepted a four-year freeze on retail power rates. When wholesale power prices soared beginning in the summer of 2000, Pacific Gas & Electric and Southern California Edison were unable to raise retail power rates to pass on the increased wholesale costs; San Diego Gas & Electric had recovered its stranded costs ahead of schedule and reached a new agreement with regulators that enabled it to raise retail prices. As of mid-February 2001, the first two utilities are on the verge of bankruptcy, unable to pay creditors or power suppliers. Although we know quite a bit about the way price caps affect a variety of industries, there is very little literature relevant to the electric market, in which the product is an essential commodity with no suitable alternative. In this and in many other ways, we’re proceeding on a trial-and-error basis.

The result of all this rapid-fire policy activity has been a climate of constant uncertainty and change in the regulatory structure. This uncertainty has led to protracted regulatory proceedings everywhere, exacerbated the supply shortage, and slowed installation of transmission lines. In fact, the nation’s annual investment in the transmission grid has fallen by 15 percent since 1990. During the California supply crisis, utilities in the north were forced to institute rolling blackouts because there was not enough transmission capacity to move power from the south. As the grid moves from one that was designed to move power from plants to load centers within well-defined service territories and to facilitate occasional wholesale power transactions among neighboring utilities to one that serves as an interstate and inter-regional transportation system, new transmission lines will be essential to the success of a deregulated electric power industry.

Consumer response

In deregulating their respective states, regulators accommodated utilities (and reacted, correctly, to sound policy reasoning) by allowing at least partial recovery of stranded costs. These costs cover investments utilities made under regulation that could not be recovered under deregulation. To recoup these costs, regulators permitted utilities to charge an assessment on all retail sales, regardless of the supplier. But because they were eager to deliver immediate savings to consumers, regulators also forced utilities that took stranded costs to provide “standard offer” or “default” service to all pre-deregulation customers at rates lower than those that existed before deregulation.

In doing so, regulators made a key assumption. They took for granted that this reduced-rate default service would not hamper competition, because competitors would be able to sell at prices far lower than these regulated rates. This was a serious mistake. The default rates were set so low that new suppliers were unable to compete. As a result, in most states, small customers have had no real reason to switch away from default service.

The success of deregulation obviously depends on the willingness and ability of electricity consumers to take advantage of the benefits it offers. Evidence is mounting that a sizeable portion of the population may be unwilling to shop for power in spite of expensive, state-sponsored education efforts. This group apparently finds that the perceived savings and benefits do not justify the hassle of shopping for power and monitoring competitive suppliers.

One important reason why consumers are reluctant to devote time to shopping for a new power supplier is that they are often unable to take advantage of deregulated prices. The true hourly marginal cost of producing power changes dramatically each hour over the day. Yet virtually no electric buyers see these cost differences in their bills. Instead, for all but the largest industrial and commercial customers, today’s electricity rates are essentially the same all day long–indeed, all year round. Regulation prevented these price signals from getting through, because it seemed unfair to charge one family 20 cents per kilowatt-hour for doing their dishes at noon and another family one-tenth as much because they start their dishwasher after 9:00 p.m. Unfortunately, this fixed-rate pricing remains popular in the currently available default service and even in most deregulated sales simply because many consumers are attracted to the predictability of flat rates.

As a result, we almost never adjust our use of electricity in our homes, buildings, and factories in response to changes in the cost of producing power. Instead, we turn to more expensive long-term actions such as installing a more efficient heating system, upgrading insulation, or retrofitting costly equipment. In economic terms, the short-term demand for electricity is nearly perfectly inelastic. Perhaps it is understandable that our electricity-using infrastructure acts this way, given that it developed under a regulatory regime that provided stable, regulated rates. In a competitive market, this has to change if we are to realize the full benefits of deregulation.

Federal action

We won’t know for some time whether electricity will prove to be the one product for which Americans place greater faith in regulated companies than in the free market. While the country makes this collective decision, state and federal policymakers must take steps quickly to preserve and protect system reliability, implement changes designed to make competition work more efficiently than it has so far, and meet many other significant policy challenges. Otherwise, California’s power crisis will be repeated in other states.

No matter how successful we may be in saving energy, we will still need to make substantial investments in natural gas and electricity distribution infrastructure.

The first step is for Congress to pass legislation designed to begin the process of alleviating uncertainty in the market by establishing clear reliability rules and authority. This legislation should include provisions designed to:

  • Give FERC explicit authority to mandate the creation of regional transmission organizations (RTOs). RTOs act like commodity and trading exchanges, providing a conduit for the fair and efficient trading of energy and capacity on a regional basis. Though RTOs are slowly coming into being on a voluntary basis either as not-for-profit entities (as in California) or for-profit companies (as in the Midwest), FERC should be given the authority to force their creation as a way to alleviate the uncertainty that comes when individual utilities set their own rules. FERC should also serve as the oversight body for these RTOs.
  • Place all transmission lines under FERC jurisdiction. The combination of RTOs and expanded FERC authority should remove a great deal of the uncertainty generators face and make it easier to site and build new transmission lines that can provide an extra measure of reliability as electricity demand continues to increase.
  • Enable municipal and coop utilities to participate in deregulated markets without losing the benefits they derive from being publicly owned entities. This would add a level of fairness to the system and allow the often substantial assets of these utilities (such as the Los Angeles Department of Water and Power) to help out when supplies are tight.
  • Take appropriate steps to facilitate the reintroduction of energy efficiency and conservation programs, including the introduction of real-time pricing (RTP) signals. Although not directly responsible for the California crisis, cutbacks in these programs made the problem that much worse when the imbalance in supply and demand began to tip out of control. Had demand been even a few hundred megawatts lower on key days during the crisis, as many as half of the rolling power blackouts could have been avoided.

Today, almost every appliance made has more than enough computing power to be programmed to work more during the hours when electricity prices are low. If utilities send RTP signals to customers with “smart” technologies that can take advantage of these price signals to adjust their hourly use patterns, those customers will save money and stabilize the market by substantially reducing demand for electricity at peak times of the day. These systems can be designed to adjust temperatures in common areas to cut heating and cooling loads; to turn off or dim lights; and to shut down escalators, nonessential elevators, and other equipment during peak times on energy-intensive summer and winter days.

State and federal policymakers should take the following coordinated steps to accelerate the market penetration and use of smart building technologies:

  • Require utilities to offer real-time prices to all large customers (say, demand of 25 kilowatts or more).
  • Use mandates, tax incentives, and other measures to encourage the introduction of smart technologies. Even states that haven’t deregulated their industries can benefit from these actions.
  • Direct government researchers to work directly with the developers of smart building technologies and builders in testing and demonstration projects in a neutral, broad-based way. The first step could be a Smart Buildings Summit that brings together all of the various stakeholders, from the developers and builders to utilities, energy service companies, and state utility regulators.
  • Rejuvenate programs that promote the use of cost-effective electricity-saving technologies and standards, including efficient distributed technologies and combined heat and power systems. Such programs should, among other things, provide financial incentives to encourage the installation of highly efficient heating, air conditioning, and lighting systems in new homes and office buildings. In addition to their direct impact on energy use, such programs help transform markets by facilitating the commercialization of energy-efficient technologies. In this important area, California may again be leading the way. In response to last summer’s events, the California Energy Commission has ramped up a $50 million program to reduce electricity demand.

No matter how successful we may be in saving energy and reducing price volatility with RTP and smart technologies, we will still need to make substantial investments in the infrastructure that brings natural gas to power plants and electricity to homes. The National Petroleum Council estimates that by 2018, we will need to invest $781 billion to install 38,000 miles of new gas pipelines to meet projected demand.

Can it be done?

The paradox is that although these investments are more necessary than ever, it will be extremely difficult to make them. Legitimate concerns about environmental effects and growing public resistance to the siting and construction of gas pipelines and power lines almost always stand in the way. Another barrier is the lack of a coordinated energy infrastructure policy, even though gas pipelines and electric transmission remain largely regulated enterprises. The Bush administration and the 107th Congress should make the development of a coordinated policy in this area a top priority.

Given all of the problems facing the electric power industry, it’s easy to become pessimistic about the future of deregulation. Yet all is not lost. With a lot of patience and some leadership from state and federal policymakers, it is possible to put the bloom back on the rose. In reality, we have little choice. The establishment of competition may be incomplete and beset by severe problems, but it is probably impossible to restore the past structure of the industry and re-regulate its activities in the traditional fashion.

There are signs that some of the necessary actions are already being taken. According to FERC , 190,000 megawatts of generating capacity are under construction in the United States today. Smart building technologies are emerging from their early startup days and beginning to penetrate a larger segment of the market. Pieces of various bills introduced and debated in the 106th Congress could easily be cobbled together into effective comprehensive legislation early in the next Congress.

In California, many changes are under way. Governor Gray Davis recently signed a series of bills that accelerate power plant development, increase demand-side efforts, and take other important steps. After examining the state of the market, FERC has directed the most extensive set of market redesigns, organizational changes, and consumer protections since the California market opened to choice.

Change will not come overnight, just as it never has in the electric utility industry. More than three decades elapsed between the formation of the industry and the creation of the first state electric regulatory agency. Another decade went by and the Great Depression occurred before Congress passed any electric-related federal legislation. The rapid pace at which our economy now functions may give us less time to act than policymakers have enjoyed in the past, but barring any catastrophic power outages or widespread price spikes, most consumers appear willing to allow the market and policymakers the time necessary to address the industry’s underlying structural problems. If so, providers and consumers of electricity in the United States will eventually reap the benefits of a more efficient, cleaner, and competitive industry offering a wide array of interesting new products and services.


Peter Fox-Penner is chairman and Greg Basheda is an associate of The Brattle Group, a network industry and economic consulting firm based in Washington, D.C.