A Shock to the System.

This book marks the first of a proposed program of research at Resources for the Future on electricity restructuring. The book's purpose is to provide a highly accessible treatment of major economic issues so that participants in the restructuring debate will know the right questions and seek the right answers. At the same time, the authors believe that there are presently few answers regarding how the electric industry will evolve. There are additional issues either not treated in this book or not yet anticipated. In the last part of this review, I suggest unsolved problems that remain for economists and writers.

The book succeeds admirably in laying out clearly the major issues in the restructuring policy debate. These issues are at the forefront of the economic debate. Electric utility executives would cite other problems as primary, which may center on fairness rather than the efficiency criteria to which they are subject.

The book undertakes six issues at the heart of the debate:

1. The industry today (Chapter 2): this chapter outlines the history and legislation that brought the electric utility industry to its present state;

2. Generation (Chapter 3): this chapter discusses changes in legislation and technology that made competition feasible in the generation of electricity;

3. Transmission (Chapter 4): transmission continues to have natural monopoly characteristics, but open access to generation of electricity by companies other than the owner of transmission is necessary for competition;

4. Divestiture (Chapter 5): competition may necessitate separate ownership of generation and transmission to avoid potential abuses when one side of a company (transmission) is regulated and one side (generation) is deregulated;

5. Stranded costs (Chapter 6): utility decisions to construct capacity that were approved under regulation may not pay in a competitive environment; utilities maintain that they should be compensated for decisions made under a regulatory compact; and

6. Environment (Chapter 7): the means for achieving environmental goals when electric utilities are subject to regulation will have to be adapted to a competitive environment in order to achieve society's environmental targets.

Chapter 2 reviews the current structure and history. Utilities have evolved over the last 90 years through complex federal and state legislation. The Public Utility Holding Company Act (PUHCA) of 1935 established the current system of state-regulated utilities. Today's Federal Energy Regulatory Commission (FERC) was reconstituted in 1977 from the Federal Power Commission first created in 1935.

The Public Utilities Regulatory Policy Act (PURPA) of 1978 required utilities to purchase power from nonutility generators known as qualifying facilities. The Energy Policy Act (EPAct) of 1992 created another category of generators exempt from PUHCA that has been a stimulus for the current restructuring movement. Chapter 3 addresses generation, which is the stage of electricity production where competition is most feasible. New generation sources operate efficiently on a much smaller scale than was once necessary; this provides impetus for competition. This chapter notes unique aspects of electricity production that make competition more difficult: electric flows cannot be directed and electricity cannot be stored; overlapping state and federal legislation also impede competition. After recognizing these complexities, one must then consider whether wholesale competition, where electric utilities can turn to a competitive generating market, is enough to produce the benefits of competition. Retail competition, where the ultimate buyer has choice of supplier, may be necessary for the cost savings and efficiency of competition to be realized. The matching of supply and demand is more difficult with retail competition.

Chapter 4 concerns transmission, or "the grid" (in industry parlance), where regulation is likely to change but not disappear. Transmission exhibits natural monopoly characteristics, so the scale of transmission will remain large for the foreseeable future. While some competition may occur between different transmission systems, the main issue is the pricing of transmission services. FERC Order 888 requires open access to the grid at a nondiscriminatory price. But it takes much work to determine the real-time cost of transmission services, which varies with distance, congestion, and other factors, and to guard against selling the services of the grid to alternative suppliers at a higher price than the internal price to the utility that owns the grid.

Chapter 5 considers the advantages and disadvantages of vertical integration in the electric industry. Restructuring necessitates the separation of generation from transmission and distribution, and there may be separation of transmission and distribution as well. Vertical integration can have anticompetitive effects when one stage of production is regulated, that is, transmission, while another stage, that is, generation, is competitive. The producer may load fixed costs onto the regulated side, where the regulator provides a return on capital, allowing an artificially low price on the competitive side, thus foreclosing competition.

Chapter 6 provides some suggestions for dealing with stranded costs, also known as stranded assets. Estimates of these costs, which are investments that took place under a regulatory compact but will be rendered obsolete as a result of inefficiency in a competitive environment, range widely from $20 to $200 billion. The chapter asks why utility-stranded costs deserve different treatment than similar costs in competitive markets, such as the typewriter manufacturer caught with inventory when personal computers were introduced. The difference is the regulatory compact. In deciding who should pay for stranded costs - consumers, shareholders, or customers - one must rule on how to interpret the regulatory compact. Did shareholder value reflect anticipated stranded costs? Should the utility have anticipated industry changes and constructed fewer plants? The distribution of who pays is likely to be political, but by knowing the economic responsibilities, the political solution can minimize the economic damage.

Chapter 7 provides an overview of the impact of competition and restructuring on the environment and mechanisms for achieving a socially efficient outcome. Predicting whether the environment will suffer or improve is an extremely difficult issue that will require future work. However, even this undecided verdict may come as a surprise to those who would expect pollution to be lower with regulation. Some reasons why doom and gloom may not apply are: (i) electric use will increase due to lower prices, in place of more polluting fuels, (ii) entry of new generators will replace older, more polluting, generators, and (iii) emissions trading will be more effective when firms are strongly motivated to minimize costs.

In the Epilogue, the authors cite additional issues that need to be addressed, including merger policy, as mergers may undo competitive benefits; entry of electric utilities into other industries, such as telecommunications and cable; research and development; social programs such as universal service; and tax implications.

As stated at the outset, the book's objective is to clarify economic issues surrounding electricity generation. Electric utility executives cite issues of fairness and politics, such as universal service requirements that put them at a disadvantage to new entrants with no such social mandate. Also, the utilities invoke fairness and accounting practices when discussing stranded costs, with less attention to efficiently interpreting the regulatory compact.

What are the unsolved problems remaining for economists? As stated at the outset of the book, none of the issues in restructuring has yet been resolved. What are the overall gains from competition, and what percentage can be achieved from wholesale competition alone? What is the most efficient mechanism for competitive generation, bilateral contracts arranged between generators, or a power pool operator (POOLCO), where buyers and sellers of generation are matched up in a centralized market? Real-time transmission costs have yet to be agreed upon. Little has been determined about environmental consequences.

What about unsolved problems not considered in this book? One topic of discussion is whether electricity will be reduced to a commodity or whether there will be opportunities for product differentiation. If electricity becomes a commodity, like wheat, prices that recover marginal costs may leave fixed costs uncovered. Who will be the winners and losers from restructuring? Industrial customers have been the impetus for competition; will there also be benefits for residential customers, or will they subsidize industrial customers? Will electric prices approach uniformity throughout the U.S. and beyond? If so, how will consumers in electricity-exporting locations gain? And what prices will emerge with varying degrees of regulation and competition at the generation, transmission, and distribution stages?

Economists need to consider how to improve new forms of regulation as well as anticipate increased competition. Just as economists endorsed price caps and emissions trading as improved forms of regulation, new mechanisms will likely be needed with future electricity restructuring and recombinations.

Peter M. Schwarz University of North Carolina at Charlotte