| The Issues |
 The electric power and distribution system in the United States stands on the verge of major change. An industry regulated by local, state, and federal government for the best part of the past 75 years is about to switch to some form of competition. The move to competition brings with it a host of questions. The purpose of this study is to address and analyze these critical issues. note 1 In the end, we call for the unleashing of competition to bestow its generous benefits on consumers of power in the United States. Competition in electricity will serve the public interest in much the same way that deregulation in trucking, airlines, and telecommunications has served the American economy. Electric utilities have been regulated in the United States virtually from their inception. Early regulation took place at the municipality level as most power poles and distribution systems used public streets and roads. However, in 1907 Wisconsin and New York legislators created state utility commissions, and by 1914, 27 states had electric utility regulatory commissions. The Wisconsin law became a prototype for other state enactments. All existing utility franchises were converted to indeterminate franchises. Each new franchise was required to have a certificate of convenience and necessity. State public service commissions were authorized to set service standards and rates and they were given the ability to control the issuance of new financial securities. The sharp distinction between private firm and government enterprise had vanished. The economic theory of natural monopoly has been used to justify the apparent need for regulation of electric utilities. A natural monopolist is a firm that enjoys falling average cost as it expands output. By virtue of declining average cost, one firm can produce any given level of output more cheaply than any other number of firms. This line of argument dictates that the free market will fail. As one firm grows to take advantage of declining average cost, it loses itscompetitors, and consumers do not reap the rewards of economies of scale. With just one seller, the magic of competition is missing, and price is not forced to cost. Early on, pundits, academics, and politicians latched onto the natural monopoly story. The public interest theory of regulation was the outcome. In such a regime, regulators control investment and pricing decisions by natural monopoly electric utilities. The public utility regulators attempt to capture the gains of decreasing average cost and prevent the welfare losses of monopoly. In the perfect world, regulators set price equal to average cost. The economy enjoys the benefits of economies of scale, electric utilities are compensated for their costs of production, and something akin to economic efficiency attains. In practice, public utility commissions faced with the nearly impossible task of assessing the true average cost of production resorted to rate-of-return regulation. Public utility companies have been allowed to make what regulators judge as prudent capital investments and charge prices that recover operating costs plus a "fair-rate-of return" on these investments. While acknowledged by both sides of the debate to be imperfect, this system has been the essence of electric utility production and distribution for the past 75 years or so. The time has come to end the cross-subsidies, inefficient production, and higher prices—in some places much higher prices—than dictated by production costs. As many have noted, regulation produces little incentive to minimize costs. Production processes in the electric power industry have changed. The old and questionable claim that the industry is characterized by declining average cost is now nothing more than a thin veil. The reality of politics has consistently overcome the logic of economic theory in the process of rate regulation. Regulated firms that make imprudent investments are often allowed to recover their investments when comparably situated competitive firms would have had to suffer the consequences of poor managerial decisions. Firms that build power plants that are too costly are not punished by the forces of competition that preclude cost recovery in competitive industries. Symmetrically, firms that operate efficiently and build cheap plants are required to pass some of those cost savings onto consumers in the form of lower prices. The risk of investment has been inefficiently shifted from producers to consumers, artificially reducing the cost of capital and over-stimulating investment. The visible hand of regulation has failed to replicate the effects of competition. This point is most obvious when comparing the dispersion and distribution of prices across geographic regions. Prices paid in one jurisdiction often bear little resemblance to prices in nearby areas owing to the strange way that regulation allows for recovery of costs. Moreover, the prices of power in some regions are higher than necessary when compared to power available from external sources including the cost of transportation. The closing 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. In addition to the fact that regulation succumbs to politics, mounting evidence accumulated by economists has essentially erased the original idea that electricity production is a natural monopoly in the first place. There never really was a natural monopoly in generation. To the extent that there appeared to be one, natural monopoly was in transmission, distribution, and system control. note 2 For a while the size of generating facilities grew, but this trend seems to have reversed. Indeed, the newest innovations in electricity production suggest that small, natural gas fired turbines may become the efficient production margin in the industry. The large steam driven power plants may become the relatively inefficient capital. It now appears that the forces of competition will be released from their regulatory chains. Our goal here is to define the relevant issues and present an analysis of the changes under way. The transitions to competition in airlines, trucking, and telephony demonstrate the wide variety of issues that plague change. The economic theory of regulation paints a fairly clear picture of what is involved. Regulation has allowed public utilities to exchange their acceptance of rate of return regulation for the grant of an exclusive (monopoly) franchise territory. The utilities have been insulated from competition. Regulators have been only too happy to supply the required legal mandate and oversight, and they have used the regulatory authority to provide some benefits to politically sensitive groups. The existence of the state public service commissions has acted like a lightning rod to collect political forces. For instance, citizens with environmental concerns have brought pressure on public service commissions to subsidize windmill electricity production. While some argue that past regulation creates a "compact" that requires compensation when new laws change the rules, the Court has said in this context:
Any compact between a government and its citizens is, of course, a two-sided compact. In the case of electric utility regulation, consumers were to be offered and producers were to supply electricity at competitive prices. Deregulation portends to turn the regulated world of electricity on its head. The basic outline of our analysis of electricity deregulation is to:
What will be the price of electricity? Which firms will produce? What types of firms will be most successful under competition? What types of facilities will be most affected by deregulation? Will the industry become more concentrated or will additional producers come on line? What are the welfare changes associated with deregulation? What institutional structures are necessary to assure deregulation passes the baton to a competitive market? These are the major questions that we attempt to answer. Notes:
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