| Summary of our Findings |  For far too long, the U.S. economy has suffered the waste and wanting of electric utility regulation. Across the country, price is higher than cost. Worse, price in one area is different, often far different, than price in nearby locales. This failure of 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 a single kilowatt hour of electricity to light even one light bulb. Yet, amazingly, the consumers who live in LILCO’s exclusive franchise area are paying the company the highest prices in the country for this unused asset. This 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. 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 production. Some people claim this is a compact between the people and the company where the regulators are the voice of the people. Maybe so, but if so, the time for change has come. The electric utility industry is a vital sector of the U.S. economy. It is an input to virtually every manufacture and consumable. We can hardly comprehend what life would be like without electricity. However, this fact alone does not mean that price regulation is necessary. Workers, just as important to the economy as electricity, are allowed to compete with each other for jobs and wages. No one seriously believes that students should have to apply to the government for certificates of convenience before they attend college to become engineers, nurses, or teachers, or that laborers should be allowed to recover, by law, their fixed costs of college preparation. Why should electricity be any different? Any reasonable observer would say, it should not. 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 face higher cost producers. The losers are buyers of power who have their choices restricted by regulatory fiat. Competition is a better watchdog. There is considerable under-used capacity in the generation and transmission capital stock of the United States. We estimate that it is possible to produce at least 13 percent additional output yearly and possibly as much as 25 percent additional power without adding one new generator or one new transmission wire. This capacity can be put to use by more flexible pricing plans that will emerge via competition. There is considerable variation in the demand for electricity from month to month, but regulations do not allow price to vary along with this ebb and flow. Competition will allow price to adjust to various demand conditions. Along the way, the price of power will fall as additional output is produced. We estimate that, in the short run, competition will cause price to fall by at least .9 cents per kilowatt hour on average across all classes of consumers in the United States. This price decline could be as much as 1.8 cents if all capacity is utilized. Based on current use rates, the minimum estimate for the decline in power bills is $9.50 per month for residential consumers, although savings could be or more $18 per month for them. Individual commercial and industrial customers would gain more then this off their monthly bills owing to their relatively large purchases. In the long run as new and more efficient capital is put into place, additional gains will accrue. The long run price decline of electricity could reduce residential consumer bills by as much as $30 per month. Based on the current $69 per month bill, the decline is substantial, at least 43 percent. Lower prices mean lower incomes for producers. Yet the impact will vary because the producers in the industry are not homogeneous. 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 view the losses to the producers in a negative light, we argue that competition is good for the economy. The consumers 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 suffer the consequences of rivalry. That there might be losers when the doors to competition are opened is the heart and soul of a free and open market. The real question should be, Do the gains to the winners overcome 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 less 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 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 gain to the economy is at least $1.9 billion annually and quite possibly as much as $24.3 billion each year. Effects on the Aggregate Economy Our analysis suggests annual 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. The dynamic gains from allowing competition to serve the market for electric power are likely to be many times the magnitude of the static gains of $1.9 billion to $24.3 billion identified earlier. These 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 will stimulate productivity growth in many industries. We live in an era in which many are concerned with the competitiveness of American industry. Many proposals to increase international competitiveness involve trade policies which threaten to restrict consumer choice and raise prices. Deregulation of electricity involves no such deleterious effects on consumers and would immediately increase American competitiveness relative to the rest of the world. Moreover, competition in electricity will have a one-time reduction in consumer prices of between 0.7 and 2.3 percent. Employment is anticipated to increase by 1 million to 3.1 million new jobs. Labor productivity will increase at the same time. 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 price of electricity. Since both systems, distance transmission and local distribution, have capacity to carry the extra power that competition will provoke, the current cost is not expected to increase. In fact, competition between transmitters could conceivably reduce transmission expenses marginally. There is reason to believe that advancing technologies in meter reading and billing might lower the cost of local distribution. A major concern about the coming of competition is the problem with local monopoly distribution. If a buyer can contract with almost any producer to generate and supply electricity, but that same buyer has to receive the power from a single, monopoly distributor, the distributor stands to be able to extract 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 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 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 generate the efficient result. 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 paid based on their historical costs times 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 by a competitive-bid based process. The electricity grid operator bids on terms of transmission price. 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 will be tied to generation capacity and consumer line size. The access fees will 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 power marketers 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. Which method of organizing transmission and distribution is better? 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. We repeat our earlier concern that wholesale shifts of authority to FERC, NERC, or other Federal agencies should proceed with the utmost caution. A single powerful regulator at the federal level may not be much of an improvement over existing regulations at the state level, and under the wrong set of circumstances can be worse than the current situation. 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, and consumers bear too large a share of the risk and 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. |
