CHAPTER

7

Making Electricity Markets Competitive

How Fast and by Whom?

by Timothy J. Brennan

Expanding competition in historically regulated markets has been a stunning (and largely bipartisan) policy success story over the last 25 years. But thus far, electricity has not been as amenable to similar initiatives. Moreover, recent events, such as the California crisis of 2000–01 and the Northeast blackout in August 2003, have led many to voice concerns about our electricity systems.

We hope that the following provides a useful short guide to help balance the claims these different interests express. In our view, the need to control costs, ensure reliability, and prevent market power in this crucial sector implies that although competition may be politically and economically appealing, presidential leadership should be applied cautiously with regard to opening electricity markets. Successful competition in wholesale electricity markets will require continued regulation and oversight by the Federal Energy Regulatory Commission (FERC). Despite resistance from state regulators and incumbent utilities, this regulation will quite likely require new legislation to require utilities to join regional transmission organizations (RTOs). These RTOs should be empowered not only to coordinate the interstate and international transmission of electricity across the grid, but also to establish enforceable reliability standards. To ensure effective competition, RTO operations must be fully independent from any generation owner; mandatory divestiture of transmission from generation may be the best means to this end.

On the other hand, states should continue to exercise authority over “retail competition,” that is, the extent to which households and businesses can choose their own electricity supplier. Local economies bear the costs and reap the benefits of opening retail electricity markets, and each state can learn from others what works and what does not. Moreover, the benefits of extending deregulation beyond large industrial and commercial users to household customers may not be worth the trouble.

Implementing Competition

Opening electricity markets follows a deregulatory trend going back to at least the Carter administration. Economists long had recognized that regulation was handicapped by the difficulty faced by the government in getting the information necessary to set reasonable prices. In addition, the process tended to respond more to the needs of the regulated firms rather than to those of the customers.

Replacing regulation with competition has been very successful in sectors that are workably competitive, most notably airlines, trucking, and banking. In other sectors, introducing competition has been more difficult because segments within those industries retain tendencies toward monopoly. The telecommunications sector, for example, includes competitive markets in services (long-distance telephone, Internet access) and goods (customer telephone equipment, large-scale switching systems). All of these markets, however, depended on access to local telephone service, viewed during the 1970s and 1980s as a monopoly to remain regulated. The antitrust-based divestiture by AT&T of these local monopolies in 1984 was predicated on the belief that the competitive markets required some insulation from regulated monopolies, to ensure nondiscriminatory access and prevent the use of monopoly revenues to engage in inefficient or predatory cross-subsidization.

These concerns strongly influence electricity policy. Generation (the production of electric energy) and marketing (the sale of electricity to final users) have become amenable to competition. Long-distance transmission systems and local distribution grids used to move electricity from generators to users, however, remain regulated monopolies. Opening generation and marketing segments to competition requires some degree of separation from the regulated transmission and distribution segments that typically had been provided by integrated utilities. Introducing competition into electricity has come to be known as “restructuring,” reflecting the need to “restructure” utilities to provide at least functional, if not formal, separation between the competitive and regulated markets.

The stakes are high. The electricity sector constitutes about 2 to 3 percent of the gross domestic product in the U.S. economy, comparable to, if not exceeding, the sizes of the automobile manufacturing, agricultural, or television industries. But this 2 to 3 percent figure, large as it is, vastly understates electricity’s importance. As the August 14, 2003, Northeast blackout reminded us, our economy and society grind to a halt absent electricity to provide light, refrigeration, heating and cooling, communications, transportation, and the energy to power our factories, businesses, and homes.

Numerous groups have stakes in whether and how competition is implemented. Incumbent utilities and new independent power producers are each major players with conflicting motives. Large manufacturing firms want to use competition to obtain electricity on favorable terms and conditions. Because electricity generation is a leading emitter of greenhouse gases, nitrous oxides, sulfur dioxide, and other pollutants, environmental advocates have a strong interest in the sector’s performance. Suppliers of generation using “renewable” fuels espouse policies to promote their technologies as a way to cut down national consumption of fossil fuels. Most of all, the general public cares very much about ensuring that electricity supplies continue to be reliable and affordable.

Setting Policy

The intricacy of the decades-long policy puzzles presented by this sector follows from electricity’s inherent nature. Besides the fact that it is crucial, electricity possesses two other properties that make it inherently difficult to manage. The first is that unlike virtually all products, at any moment the amount of electricity consumed must just equal the amount produced, neither exceeding nor falling short. Electricity cannot be stored economically for times when demand exceeds supply. Excess supplies of electricity cause lines to overload. Shortages are costly, in that they lead not to minor inconveniences, but to blackouts. Second, because the grid is interconnected, a failure of one supplier to meet demands from its customers leads to a blackout for everyone. This makes the reliability of the electricity system a “public good” that an unregulated market is unlikely to provide adequately.

The intricacy of U.S. regulatory institutions may rival the engineering complexity of the system. Both states and the federal government play significant and legally intertwined roles. Federal authority, exercised primarily by FERC, covers “wholesale” electricity markets—the sale of electricity from generators to load-serving entities (LSEs), primarily local utilities, which provide electricity to end users. FERC’s jurisdiction over wholesale markets extends to the transmission system used to carry electricity from generators to the LSEs. “Retail” electricity policies, affecting prices customers pay and whether customers get to pick their LSE, rest in the hands of state legislatures and public utility commissions.

Wholesale and retail markets have separate histories with regard to restructuring initiatives. Wholesale competition began as an unintended by-product of the 1978 Public Utility Regulatory Policy Act (PURPA), passed in response to concerns over energy independence. PURPA’s nominal goal, to promote conservation by requiring utilities to purchase electricity from a limited set of approved generators, was notoriously expensive. However, PURPA showed that the grid could work with nonutility generators. Congress enacted the Energy Policy Act in 1992 to open access to the transmission system to any independent power producer wishing to compete in the wholesale market.

Four years later, FERC issued the enabling regulation toward this end, Order 888. Since then, through its Order 2000 (issued in 1999) and more recent proposals to standardize wholesale markets, FERC has encouraged the development of RTOs. Ideally, RTOs would have sufficient breadth to reflect the growing geographic areas over which electricity is bought and sold, and sufficient independence to ensure that access to the grid is open to all suppliers without discrimination. However, energy legislation introduced in the last Congress would have limited FERC’s ability to require utilities to join RTOs and to mandate specific wholesale market designs. In addition, the August 2003 outage has raised questions about whether federal authority is sufficient to ensure that the transmission system can limit the frequency of blackouts and prevent them from spreading across the continent.

In contrast to wholesale markets, retail electricity sales are under the control of fifty-one jurisdictions (including the District of Columbia). Roughly half the states have not pursued retail competition at all. The strongest efforts have been in the Northeast and California, states with relatively high electricity prices and thus the strongest sense that competition might improve local economic conditions. When first proposed and put into practice, California’s initiative was the most celebrated, implemented in the spring of 1999 following extensive study and publicity and a unanimous vote by its state legislature. At the same time, Congress saw efforts from both sides of the aisle to encourage, if not force, states to open their retail markets.

These efforts in Congress and by the states to open retail markets to competition were slowed, halted, and in some places reversed by the meltdown of the California market in the summer of 2000. Momentum shifted despite reasonable performance in California’s retail markets for more than two years before the crisis and retail competition that has worked without major problems in other states. Determination of all the causes of the California crisis and final disposition of how its costs will be borne by consumers, generators, utility stockholders, and California taxpayers remain open controversial matters.

Issues and Options

Wholesale and retail markets present different problems and fall under different jurisdictions in a federalized regulatory system. Hence, the pertinent policy options for the two are quite different.

A first issue at the wholesale level involves the degree to which the RTO needs to be independent from the utility sector—whether so-called functional unbundling suffices, or whether a more radical full divestiture and creation of a stand-alone transmission company is required. At present, RTO membership is voluntary. Utilities should be forced to join and accept the RTO’s authority over the design of wholesale markets, management of day-to-day operations, and ability to require investments to expand the grid to alleviate congestion and facilitate competition in one area from generators some distance away. Transmission expansion is a particularly difficult matter. High prices on congested lines desirably encourage shifting the generation of electricity to sites where transmission capacity is available, but allowing high prices for congestion can create perverse incentives to limit capacity.

This leads to the fundamental and crucial issue of reliability. Traditionally, reliability has been promoted through voluntary standards set by regional power pools and the North American Energy Reliability Council (NERC). Voluntary reliability processes, however, may not suffice as we move from an era in which utilities had geographically separate monopolies to one in which utilities compete against each other to sell electricity to LSEs. NERC may continue to play the major role, but independent RTOs or FERC may need to step in.

A third issue is the control of market power, the ability to profit by withholding output in order to raise price. Although the magnitude of the market power problem in electricity remains controversial, it is widely agreed that at peak demand times when electricity capacity is stretched to the limit, individual generation companies, without colluding with others, may find it profitable to cut energy supplies. Additional restructuring to deconcentrate generation markets, or vesting stronger divestiture authority with FERC, may be required, as our antitrust laws do not themselves keep any individual firm from charging what its market will bear. The profitability of withholding will be even greater in some settings, as in California during its crisis, when retail prices were largely fixed, ensuring that the public would continue to demand electricity regardless of its wholesale price.

On the retail side, a threshold issue is whether to expand the federal role over the segment of the sector that has long been left to the states. Were Congress to exercise more authority over retail markets, FERC or any other regulatory body would face numerous options on a multitude of dimensions. One includes the breadth of retail competition—whether to thrust it upon everyone or to emphasize industrial and larger commercial users with a greater stake in the outcome. Reluctant to cast everyone to the market, state regulators have faced difficult choices in setting a “default service” rate not so high as to impede retail uses of electricity, but not so low as to discourage competition from new LSEs. So far, the balance has tilted largely against the entrants, particularly in sales to households. Consumers have shown little interest in choosing new electricity suppliers, partly because regulators have held down the old utilities’ prices, but perhaps because they simply do not want to be bothered. Other issues include the extent to which customers should be encouraged or required to install “real-time” meters, so that they have appropriate incentives to reduce consumption during peak periods, when electricity may be upward of 100 times more expensive to produce than off-peak.

Recommendations

With regard to the retail sector, it remains best to leave decisions on opening markets to the states. Efforts to expand the federal role have met considerable political resistance from states and the utilities they regulated. More substantively, uncertainty over how and whether to open retail electricity markets, and the fact that the consequences of retail decisions fall largely within states, justify keeping retail market decisions under state jurisdiction.

Any federal role (or for the states, their continuing role) should include allowing distribution companies to pass through wholesale costs, to prevent the bankruptcies and financial uncertainties that made a bad California situation far worse. Regulators should also consider leaving households and small commercial users under regulation. Efforts to open markets could be focused on those users with enough at stake to make them willing and able to choose among competing providers and adopt “real-time” prices that could vastly improve the performance of the electricity sector.

At the wholesale level, my main recommendation is to give RTOs the geographic scope and independence necessary to match the size of the wholesale markets they manage. Appropriate RTOs may be very large and perhaps international, such as including Canadian utilities in the Northeast. With growing competition, incentives for individual utilities to open grids to competitors and to adopt standards to ensure reliability are likely to be inadequate. RTOs should be able to set mandatory reliability rules and perhaps be fully divested from the generation and marketing arms of member utilities.

The choice of competition over regulation should be a matter not of ideology, but of the degree to which one or the other better serves consumers and the economy. The jury remains out on whether transmission and distribution grids can be managed apart from generation to achieve cost recovery, ensure reliability, encourage short-term supply-and-demand response to congested lines, and provide appropriate incentives to increase generation, transmission capacity, and the use of innovative control systems. Effective counters to the incentive to withhold power at times when demand stretches generation capacity to the limit, especially solutions that do not involve reregulation of wholesale markets, remain elusive. While reasons for optimism exist, policymakers should always keep in mind that electricity’s crucial nature and unique characteristics may render it unsuitable for extensive competition.

T.J.B.