Social goals and electric-utility deregulation

Issues in Science and Technology, Spring 1996 by Hirst, Eric, Tonn, Bruce

During the past several months, the spot price of electricity on the West Coast has averaged about 2 cents/kilowatt hour (kWh). At the same time, utility customers in California were paying double and triple that amount. Such a sharp discrepancy between market prices of electricity and the regulated prices that consumers pay is the primary driving force behind efforts to restructure the U.S. electric-utility industry to open it up to competition. The industry has already begun to evolve from a highly regulated, vertically integrated system of retail-monopoly franchises to a less regulated, diversified group of companies in a competitive market. This change is part of a larger economic trend that includes deregulation of U.S. banking, telecommunications, trucking, airlines, and natural gas industries, as well as the worldwide transition of many centrally planned economies to market systems.

Many utilities, customers, regulators, and other industry participants are frustrated by several factors. First, because regulated prices bear little relation to current costs and are independent of market forces, they send economically inefficient price signals to customers. Large industrial customers are especially upset by the large regional disparities in electricity prices, which range from more than 8 cents/kWh in some New England states to less than 3 cents/kWh in the Pacific Northwest. They also know that recent declines in natural gas prices and improvements in combustion-turbine technologies have substantially cut the cost of producing electricity from new gas-fired power plants, and they want to be able to buy this less expensive power. Second, proceedings before state and federal regulatory agencies are complicated, expensive, and slow to yield decisions. Finally, the current system allocates to customers many risks that in other industries fall on industry shareholders. For example, customers rather than investors have borne most of the costs of past decisions to build large nuclear plants that turned out to be much more expensive than initially anticipated and that sometimes were not even needed.

Federal legislation, especially the 1992 Energy Policy Act, is also encouraging restructuring of the electricity industry. The act created a new class of generating companies that is free of much federal regulation, and many new firms have been formed to tap this opportunity. The act also requires the Federal Energy Regulatory Commission (FERC) to ensure that all generators and wholesale electricity customers have open and fair access to the nation's transmission networks. FERC established a "comparability" standard, which requires a transmission; owning company to provide others with the same prices, terms, and conditions for the use of its transmission system that it provides itself. FERC's actions are doing much to eliminate vertical barriers to competition.

With the momentum for change building, it is easy to overlook one important characteristic of the industry. As a regulated monopoly, the electric utility industry has been asked to do more than provide electricity. In exchange for a reasonable return on invested capital, regulators require utilities to provide quality service at reasonable rates and to advance certain public-policy goals. In the interest of promoting values such as economic progress, social equity, and environmental stewardship, regulators have required utilities to undertake a variety of activities, including:

* Resource-portfolio management that aims to reduce economic and environmental risks and that must incorporate a wide range of technologies and fuels for generating electricity;

* Cooperation among utilities to maintain electric-system reliability through means such as sharing generating and transmission resources in emergencies;

* Support for research and development on new energy supply and demand technologies;

* Use of demand-side management (DSM) programs and acquisition of electricity from renewable resources to reduce electricity costs for consumers and to improve environmental quality.

The challenge to society is to design a new electricity industry that will produce the economic benefits of greater competition without sacrificing the valuable social functions now provided by the industry. In particular, we need to decide which societal functions can safely be left to competitive markets, which require some government oversight, and which no longer merit provision by the electricity industry.

RESTRUCTURING PROPOSALS

Numerous options for restructuring have been proposed. They differ in the pace of change, the desirability of competition at the retail and wholesale levels, and the regulatory status of the various components of the industry from electricity generation to customer service.

For purposes of discussing public-policy responsibilities, the existence of retail competition is critical. With retail competition, individual consumers would be free to select their electricity supplier. With wholesale competition only, local distributors would be free to choose their suppliers, but retail customers would still be required to buy electricity from their local distribution company. If only wholesale competition is allowed in a restructured industry, the local distribution utilities would still hold retail-monopoly franchises and remain fully regulated by state commissions. These distribution utilities could, in principle at least, continue to carry out all the public-policy functions that today's vertically integrated utilities do. On the other hand, if retail competition is allowed, state and federal regulators (as well as legislatures) may need to identify new mechanisms for meeting these societal functions.