| Summary of our Findings
Effects on the Aggregate Economy |
 Good intentions aside, regulators' efforts to ensure a dependable, affordable supply of electricity have in fact left consumers with an expensive, clumsy structure that is substantially inferior to what consumers could bargain for in a free and open marketplace. In the case of electric utilities, the visible hand of regulation has failed to replicate the effects of the invisible hand of competition. This point is most obvious when comparing electricity prices across geographic regions. Prices paid in one jurisdiction are often much higher than prices in nearby areas. Moreover, the prices of power in some regions are higher than necessary when compared to power available from other regions, even taking into account the cost of transportation. The isolation of regional markets has created a hodge podge of prices and rates that defies economic logic and destroys the gains from specialization and trade that competition would bring. The failure of electricity to respond to what economists call the Law of One Price is owed to rate of return regulation that allows firms to recover their capital costs irrespective of the opportunity cost of that capital. Consider the following horror story. Long Island Lighting built a nuclear power plant, Shoreham, that has never yet produced even a single kilowatt hour of electricity. Yet, amazingly, the consumers who live in LILCO’s exclusive franchise area are paying the company the highest prices in the country since they are forced to pay LILCO for this unused asset. This simply could not happen in a competitive environment. If an unregulated company made the mistake of constructing a plant that could not legally or physically produce any output, competition from rivals would preclude the firm from charging a price to recover the errant capital expenditures. As in all other industries the owners of the firm would have to bear this cost. Yet by the quirk of utility regulation, LILCO got permission not only to build this imprudent plant, but to recover its costs even though it never went into commercial production. Some people claim this is because of a compact between the people and the company, where the regulators are the voice of the people. If so, the time has come for consumers to speak with another voice. Around the country, there are some very efficient producers of electricity. These firms are currently restricted in the ways that they might sell the power they can produce cheaply to consumers who are stuck with higher cost producers. The losers are buyers of power who have their choices restricted by regulatory fiat. Competition is a better watchdog. The capital stock of electricity generation and transmission in the United States is considerably under used. Industry production rarely reaches its nation-wide capacity constraint. This occurs only in the two peak summer months, July and August. The rest of the time, the industry is producing at reduced load. This is where competition will initially change the industry. Economic researchers have noted the tendency for regulators, for whatever reason, to approve rates that are too high in the off-peak times. The nationwide averages of peak and off-peak rates are nearly the same. Regulators do not impose the efficient prices that would equate consumption levels between peak and off-peak periods. The move to competition will remedy this inefficiency. As casual observation reveals, the price of gasoline is lowest in the winter months, when miles driven are the lowest, and price is highest in the summer when good weather and vacations induce increased family travel. In the case of gasoline, the price varies from season to season to ration fluctuating demand. This does not currently happen in electricity. Regulations keep the prices artificially high in the off-peak periods which discourages its use. Therefore, there is considerable idled capacity in the generation of electricity. Competition will break the price barrier and put unused capacity to work. For instance, while some consumer choice exists now, the normal residential consumer has to pay the same price during the morning and evening peak periods to heat water as she or he pays on the weekends or during the low-demand early morning hours. Under competition this regulatory induced intransigence will fade and the prices during off-peak hours will fall. Competition will encourage residential consumers to buy larger electric hot water heaters with timers that heat during the lower-priced, late night or early morning hours, idling the heating elements during the high-priced daily peaks. As competition stimulates consumers to respond in this way, total cost per unit of hot water falls. This argument obviously extends to all consumers and across days and months. We expect that entrepreneurs with new ideas and approaches will enter as resellers and marketers to ensure that what is currently idled capacity gets efficiently used throughout the day/month/year. What this means economically is that price will be driven down by competition until consumption pushes up to the limit of what can reliably be produced. At a minimum, we see no impediments to pricing electricity in a way that smooths consumption over the seasonal cycle. There is 13.4 percent variation in consumption between the peak months and the average off peak. Based on our analysis of the flexible pricing deregulation will bring, we predict production will grow by at least this amount. Smoothing the seasonal cycle of consumption is imminently feasible. Expansion of output will create no additional system control requirements. Monthly consumption in January and February is no more volatile than monthly consumption in July and August. The system is currently able to price July and August in advance and then handle the spikes that occur around average monthly consumption. We argu e that the system can handle consumption of this same magnitude in the other ten months. The only thing that needs to change is the rate consumers are charged for electricity each month. In a free and open competitive power market, it will be a relatively simple matter for competitive power marketers to sell power on a monthly basis, even to residential consumers. There is no reason why a residential consumer cannot negotiate directly with a power producer. If Georgia Power wants to sell electricity to residential customers in Charlotte, it can pay Duke Power for the cost of transmitting and distributing the power. This is the same model employed in modern long-distance telephony. In the broader context of general capacity utilization, we can reasonably forecast a competitive increase in electricity production in the range of 25 percent based on analysis of capacity availability. This gain can be accomplished by full utilization of conventional steam generating facilities. Generating facilities are currently idled a substantial portion of the year because demand is insufficient given current prices. There is 684 billion kwh of reserve power in conventional steam generation, which is 25.5 percent of total production. Fully employing this brings the capacity utilization of conventional steam-driven plants up to about 70 percent, which industry experts agree is an achievable production rate given scheduled and unscheduled maintenance requirements. In the short run, we estimate it is possible to produce at least 13 percent and possibly as much as 25 percent additional power yearly without adding one new generator or one new transmission wire. In order to induce consumers to buy this extra electricity, we estimate that competition will cause price to fall by at least 0.9 cents per kilowatt hour on average across all classes of consumers in the United States. (The current average price across all users is 6.9 cents/kwh.) Nine-tenths of a cent is the price decline necessary to smooth the seasonal cycle. The price decline could be as much as 1.8 cents if all base-load capacity is fully utilized. Based on current use rates, the minimum estimate for the immediate decline in power bills is $9.50 per month for residential consumers, and they could save $18 dollars or more. Individual commercial and industrial customers would gain even more off their monthly bills. A table at the end of this introduction summarizes these findings. In the long run, as new and more efficient capital is put into place, additional gains will accrue. Modern technology gas turbines have improved fuel efficiencies even greater than those achieved by conventional steam generation. The best estimate is that new capacity can come on line at a price of 3 cents/kilowatt-hour. This is long-run average cost including operation, maintenance, and capital costs. Adding distribution costs to this, we estimate the long-run price of electricity to be around 3.9 cents/kwh on average. Even so, conventional capacity will be able to compete effectively with new capacity. Existing capacity has an average production cost of 2.9 cents/kwh. If long-run competition, implemented by the use of new and improved gas-fired or coal technologies drives the average price of power to 3.9 cents/kwh, average consumption will increase 42 percent. This decline in price will bring an increase in consumer welfare of $107.6 annually billion which is the result of lower expenditures for current consumption plus the value to the consumer of the additional electricity used because of lower prices. For the economy as a whole (considering both consumer and producer effects) the net welfare gain is $24.3 billion annually. The long run price decline in electricity would likely reduce residential consumer bills by as much as $30 per month holding consumption constant at current levels. Based on the current bill of $69 per month, the decline is substantial, at least 43 percent on average. Of course, in individual cases some will fall even more and others something less. Table I reports the current and projected prices of electricity under competition for the nation as a whole and each state individually. Lower electricity rates mean lower incomes for producers. Yet the impact will vary because some producers in the industry are more efficient than others. Some have very high costs, while others have low costs of production. Some firms have extremely high overhead costs, as much as one cent per kwh. Others have virtually no overhead expenses. Competition will drive the fat out of the overhead where it exists. Competitive firms cannot afford or sustain programs and employees who do not carry their weight. Ineffective or inefficient management will have to suffer the consequences of rivalry as more efficient firms traipse on their previously exclusive territory. Efficient firms will expand, and the high-cost firms will contract. While some may focus their attention on the losses to producers, we argue more broadly that competition is good for the economy. The consumers held captive in the service territories of these utilities have been the true losers for far too long. The biggest problem with the electric power industry today is that it does not face competition. It is precisely the threat of losing out to a competitor that is the driving force of a free and open market. The real question should be, Do the gains to the winners outweigh the losses to the losers? In the case of electricity deregulation, our answer is a resounding "Yes." We estimate that approximately 35-40 existing publicly-traded electric utility firms will suffer significant equity losses because of price declines when deregulation comes. A similar number of low-cost producing firms will increase in value as they expand into regions and areas currently closed to them by regulations. There are fewer than 10 firms where the current book value of assets exceeds the current market value and about 10 more that are close to this margin. These firms are the only ones who might legitimately be candidates for the recovery of so-called "stranded costs." All the remaining producers have equity values in excess of their book value of assets by a substantial margin and even though they will experience equity declines in the age of competition, the fair market value of their assets will be larger than their historical book value. In sum, the estimates of the gains from deregulation are both substantial and redistributive. Consumer welfare will be greatly enhanced by lower prices. At the same time, the stock market value of many sellers will be diminished. The important point to keep in mind is that the gains to consumers far outstrip the losses to producers. We estimate that the net welfare gain to the economy in the short run is at least $1.9 billion annually and quite possibly as much as $24.3 billion each year in the long run. The declines in equity value predicted for utility companies in the move to competition have led many observers to claim that the electric power industry will collapse into chaos if some compensation is not paid to the companies. This compensation is labeled "stranded costs recovery." There is considerable rhetoric surrounding this issue, and the rhetoric obscures the simple fact: Stranded cost recovery is an issue of fairness, not economic efficiency, so long as stranded costs recovery, if done at all, is done correctly. There is no scientific economic necessity for the recovery of stranded costs. First, if financial failure of some utilities is the result of deregulation without stranded cost recovery, it will have no impact on production. Production is a cash flow question, not an equity/debt ownership issue. If electricity price is greater than average operating cost, then plants will generate electricity regardless of who owns them. Our estimates of price and cost suggest that there will be very few plants shut down because of deregulation. There have been several bankruptcies in the history of the industry, and in no case has system reliability ever been compromised or production curtailed. Second, the absence of stranded cost recovery may cause the cost of capital in the industry to increase. This is good, not bad. Under the mantle of regulation, the industry has operated for too long with an artificially low cost of capital. As a consequence there has been an alarming level of investment in economically risky projects. It is partly the cost of these failed investments that have saddled consumers with excessively high prices. A similar misplacement of risk is what led to the Savings & Loan crisis. In the S&L crisis, government-subsidized deposit guarantees led managers to take on excessively risky projects. So, too, in the regulation of electricity. Rate regulation has shifted part of the financial risk of investment to consumers because regulators have stood ready to raise prices when faulty investments fail. As a result, financial investors were willing to undertake excessive investment in things like nuclear power. The experiences of Long Island Lighting and the Washington Public Power Supply System are notable examples of excessive investment and the disastrous consequences for consumers who were unwittingly, and therefore inefficiently, sharing the risk. There are other elements to the stranded costs issue such as high-priced power contracts imposed on utilities by regulatory authorities. Some argue that utilities should be made whole because past regulation creates a one-way "compact" that requires compensation when new laws change the rules. The Court has rejected this claim before: "[w]e find no basis in constitutional history, judicial interpretation, political history, legal scholarship, or persuasive argument to conclude that [a right to trust the federal government and to rely on the integrity of its pronouncements] exists under ... any ... provision of the Constitution of the United States." note 1 Moreover, as a question of fairness we take the position that any "compact" between a government and its citizens is two-sided. In the case of electric utility regulation, consumers were to be offered and producers were to supply electricity at competitive prices. No matter how this question of fairness is resolved, stranded costs will have no impact on the competitive operation of the industry so long as their recovery, if it occurs, is done correctly. The essential point is that any stranded costs that are recovered must be recovered by means of a lump-sum payment or access charge for the use of electricity. The access charge should be based on user capacity. There should be no unit-charge tacked onto price to recover stranded costs. A unit-charge recovery fee will distort the relation between marginal cost and price, and this will decrease the gains from competition. In the limit, stranded cost recovery in the form of a unit-charge would offer little different from the current system. If policy makers choose to offer utilities stranded cost recovery out of sense of political fairness, the gains from competition are maximized by stranded cost recovery in the form of access charges. Effects on the Aggregate Economy Our analysis suggests that with competition, annual Gross Domestic Product (GDP) is projected to be 2.6 percent higher annually in the long run. To gain some perspective, had we reached long-run competitive prices and use of electricity in 1995, GDP would have been higher by $191 billion. Each year that competition is delayed costs the American economy output of this magnitude. Therefore, delaying competition for, say, ten years in the interest of providing a "smooth transition" must be weighed against lost economic growth during that period on the order of two trillion dollars. Figure 1 charts the cumulative, lost GDP from continuing regulation. The chart reveals that even a short period of transition imposes substantial opportunity costs on the economy. For instance, a five-year wait is estimated to cost the economy as much as three-quarters of a trillion dollars over that time period. Figure I
The dynamic gains from allowing competition to serve the market for electric power are likely to be many times the magnitude of the annual static gains of $1.9 billion to $24.3 billion in net social welfare and $191 billion in GDP. These dynamic gains come from many sources; electricity costs will decline as the return to innovation are enhanced in a competitive market. Declines in the price of electricity have been shown to stimulate productivity growth in many industries. We live in an era in which many are concerned with the competitiveness of American industry, and lower prices for electricity enhance American competitiveness. Many proposals to increase international competitiveness involve trade policies which threaten to restore consumer choice and raise prices. Deregualation of electricity involves no such deliterious effects on consumers and will immediately increase American competitiveness relative to the rest of the world. Transmission gets power from one region to another. Distribution puts the transmitted power into use at the consumer level. Currently, these two factors contribute about one cent to the overall cost of electricity. Since both systems, distance transmission and local distribution, have capacity to carry the extra power that competition will provoke, the current cost of these services is not expected to increase. In fact, competition between transmitters could conceivably reduce transmission expenses marginally. There is also reason to believe that advancing technologies in meter reading and billing might lower the cost of local distribution as well. A major concern about the coming of competition is the problem with local monopoly distribution. A buyer can contract with almost any producer to generate and supply electricity, but that same buyer has to receive the power through a single, monopoly distributor. In the absence of effective local regulation, the distributor stands to be able to extract a monopoly charge robbing the consumer of most or all of the gains from competition. A similar concern is raised about transmission. If interleaving transmitters are allowed to place a charge on every kwh that might pass over their lines, then so-called transmission fee "pancaking" reduces both the geographical reach and the viability of competition. Since electricity does not flow in a direct path between any two interconnected points, it is illogical and uneconomical to force transmitters to pay a fee based on straight-line distance between any two points. Since in this case, distance does not matter in physics, it should not matter in economics either. There is some reason to believe that open competition in transmission can produce an efficient market. That is, deregulation of transmission, in the same fashion that deregulation is proposed for generation, may be sufficient to bestow the fruits of competitive market efficiency on consumers. So long as a transmitter can create a "contract path" for power to flow regardless of the actual movement of the electrons, then buyers and sellers are free to make deals with the various competing transmitters as they choose. To the extent that duopoly and collusion might prevent the competitive result here, the existing antitrust agencies have authority to intervene. Alternatively, we would propose that FERC impose rules that recognize the exact nature of electricity transmission. That is, cost is not distance related. Moreover, since the marginal cost of transmission of electricity is essentially zero, the prices paid for access to the transmission grid should be lump sum and not unit based. Access fees are superior to unit based fees for transmission and distribution as they do not distort the real cost of producing and delivering electricity. Most observers see the transmission system continuing to be regulated in some form or another. One approach is for transmission facilities to be separated from generation facilities and transmission to continue to face rate regulation. They would be paid based on their historical costs multiplied by an allowed rate of return. An obvious improvement on this would be to compensate them on the basis of true economic replacement cost. Another approach is for an independent system operator to be created for each unified electricity grid region. The idea is that this agency is franchised out in a competitive-bid based process. The electricity grid operator bids on terms of transmission price and system operation. The lowest qualified price wins the contract. The system operator contracts with transmission facility owners for the use of their lines and equipment. Regardless of which system is adopted, there are some considerations that are important in designing the perfect pricing structure for the use of the transmission facilities. Except during peak-load periods, the transmission system has no opportunity cost, and hence the efficient marginal price is zero. Consequently, the appropriate form for payment is access fees. These fees should be tied to generation capacity and consumer line size. The access fees should be designed to recover the fixed costs of installation and the continuing costs of maintenance and operation. Similar arguments are made concerning local distribution. There are choices. First, generators and bundling repackagers can be left to their own devices to contract with local distributors. In spite of the local monopoly in distribution, the offer of reciprocity and other techniques can be used to provide open access. Alternatively, local regulators can mandate open access with regulated tariffs based on audited cost of delivering power. Again, access fees and charges are economically superior to unit-cost based tariffs for transmission and distribution Which method of organizing transmission and distribution would better serve the free and open market desired? Should we simply open the door to free contracting, or should rates be mandated by FERC and local PUCs? The answer is not clear, and further study is warranted, but for now, both systems appear acceptable. The electric power industry is a vital cog in the U.S. economy. It touches the lives of every firm and person. For most of the 20th century, state and federal regulators have been charged with making this industry work efficiently. Their efforts have been noble if not perfect. Over the past 25 years, changing conditions have made it increasingly difficult for well-intentioned regulators to emulate the effects of competition. The time has come to unleash competition. Prices are too high, and they are not uniform across the land. Inefficient producers are not punished as they would be by competition, nor are efficient producers rewarded. And consumers bear too large a share of the risk and therefore the cost of capital. If regulation ever was the right way to organize electricity production and consumption, it is no longer. As deregulations in airlines, trucking, and telecommunications amply demonstrate, a free and open market offers consumers and producers lower prices and more options. The economy is the winner. We close with a review of our major conclusions:
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