Electric Visions.

Unleashing the market for power

Electricity isn't just one of the nation's largest industries. It's one of the most heavily regulated. More than a century's worth of federal, state, and local laws have straitjacketed it, stifling innovation, raising prices, and wasting resources. The industry that fuels the rest of American industry is in dire need of reform.

Congress recognizes this. But a lot of special interests are at work in Washington, pushing different ideas about what that reform should look like. Under America's complex regulatory regime, electricity has become a labyrinth of public and private sub-industries, each governed by different rules, each with its own interests--and each with its own lobby.

Outside the industry, several more lobbies have joined the debate, from environmentalists to retirees. The North American Electric Reliability Council, for instance, creates voluntary rules for the industry, and would like to make them mandatory. There's even a National Alliance for Regulatory Utility Commissioners, to represent state regulators' interests.

With so many voices, it can be difficult to discern the real issues at stake. But there is general agreement on--or reluctant acceptance of--one point: Like it or not, competition is already coming to the industry.

Small, entrepreneurial companies have found tiny cracks in the regulations where they can innovate and compete. Plug Power, for instance, is developing a fuel cell technology that could allow homes and small businesses to produce their own energy. Trigen Energy has found ways to dramatically improve efficiency in power production--and claims a competitive industry would have every incentive to follow its lead. Such enterprises represent the possibilities of a dynamic, less regulated marketplace. It's unclear, though, whether there is room in Washington for a bill that would unleash all the creativity of companies like Trigen and Plug.

It's not as though the electricity market has never been competitive before. For a long time, policy makers assumed that it was a natural monopoly--that only one firm could operate profitably in each market. But over the last two decades, Burton Behling, Harold Demsetz, and other economists have discovered that the early industry was remarkably competitive. In the first 10 years of the century, in cities across America, consumers could choose from more than one electric company. In that environment, production quadrupled and prices fell 26 percent.

In 1907, with competition eating into their profits, the oldest firms began lobbying to consolidate the industry. States passed laws guaranteeing exclusive franchises to those utilities and propping up their prices. Unnaturally large holding companies began to develop, channeling their monopoly profits (as high as 2,000 and 3,000 percent in exceptional cases) into other industries and spreading into other states (thus partially shielding themselves from state takeovers).

The federal government responded by passing interstate legislation. In 1935, the Public Utility Holding Company Act prevented utilities from entering other energy-related businesses and severely restricted their capacity for growth. (A 1995 study by Paul Carpenter and Frank Groves of the Central and South West Corporation estimated that this law costs the industry $3 billion to $12 billion each year.) Also in 1935, Congress established the Federal Power Commission, later reorganized as the Federal Energy Regulatory Commission; to this day, its complex rate and merger regulations delay and contort changes within the industry. Finally, the feds instructed the Army Corps of Engineers and the Bureau of Reclamation to erect the Tennessee Valley Authority and five Power Marketing Administrations, offering tax-subsidized and regulation-exempt power to different parts of the country. That, combined with even more stringent regulations on the state level, is how the industry was regulated until the 1970s, when a new law inadvertently opened the door to change.

In the late 1970s, the new Department of Energy was eager to develop environmentally sound, renewable resources. To that end, in 1978 Congress passed the Public Utility Regulatory Policies Act (PURPA), which required utilities to purchase a portion of their electricity from environmentally friendly producers.

At that time, the industry was dominated by huge, vertically integrated firms. These companies owned electric generation plants, vast networks of electric lines (known in the industry as the transmission grid), and local distribution facilities; they produced, moved, and distributed electricity in one bundle to consumers. PURPA forced those utilities to let small, independent nonutility generators sell energy to other producers over the transmission grid. Suddenly, hundreds of companies could produce and sell their electricity in the wholesale market.

PURPA caused a number of problems: It gave states the power to set prices, for example, and it saddled many utilities with incredibly expensive long-term contracts. But its most notable (and unintended) effect was to show the government that wholesale competition was possible. In 1992, Congress passed the Energy Policy Act (EPAct), which allowed the Federal Energy Regulatory Commission to open wholesale markets to a wider array of companies. In response, the commission adopted Orders 888 and 889, which required utilities owning transmission lines to provide open access to all electricity generators. New firms flooded the market, and a new class of middlemen, known as power marketers and power brokers, arose to sell electricity from generators to local distributors.

Partly because of the new competition and partly because of changes in technology, such as the advent of the natural gas turbine, the underlying structure of the market began to change as well. Economies of scale came full circle: It was now as cost-effective to run small on-site or local generators as to run large regional ones. The notion that the market would always be dominated by huge, consolidated monopolies began to unravel. Businesses and legislators began to wonder if competition could thrive in the retail market, too.

The states have more regulatory authority in this industry than the feds do, and so far they've taken the lead in reform. But while 23 states have begun the process of deregulating or reregulating electricity, only five have actually passed legislation. Congress still has to decide whether the states should keep leading the way in restructuring the industry or whether the feds should step in.

On Capitol Hill, the buzzword of the day is competition, a term that's often used rather nebulously. Almost everyone agrees that competition is possible and that it would be good. But what it means is less certain, and that's the core issue in the debate.

Congress faces roughly three options: deregulate, reregulate, or let the states decide.

Predictably, most of the proposals favor reregulation. Such plans would institute "open access" laws, requiring the established utilities to let all generators sell electricity over their transmission wires. Whereas past open access legislation, such as PURPA and EPAct, allowed generators to sell their electricity to other power suppliers, the new proposals would let generators sell their electricity directly to consumers.

Such plans require a huge new regulatory mechanism to ensure that the generating companies are being allowed to compete. Many of the proposals essentially call for regulators to take over existing transmission facilities and run them on a "fair and unbiased basis." Others call for "functional unbundling," which would make it illegal for vertically integrated firms to produce, transmit, and distribute electricity in one package.

Open access is supported by manufacturers, who would benefit--especially in the short run--from dropping prices. It is also popular with federal regulators, who fear that the transmission grid is still a natural monopoly and that vertically integrated utilities would have no incentive to let other firms use their wires. Alan Richardson of the American Public Power Association voiced this fear in his congressional testimony: "Competitive markets do not require heavy regulatory or antitrust scrutiny. But we do not now have an effective and efficient market in electricity. If Congress decides to remove all constraints on these dominant market participants, the market won't determine its future-- the current monopolists will."

Another concern is that deregulation, by removing the government's overseers, would lead to lower reliability. Many fear that a deregulated industry would ignore rural customers.

Reregulation is understandably unpopular within the industry. The Edison Electric Institute, which represents the investor-owned utilities that own 75 percent of the transmission grid, naturally opposes any statute that would wrest control of the grid from its owners. Recognizing that some sort of federal legislation is coming, Edison has pursued a strategy of delaying the inevitable. Instead of arguing against open access legislation, Edison has suggested that broad reregulation decisions should be left to the states.

The American Public Power Association, representing the state-owned utilities that compete with Edison's constituency, agrees, though for different reasons: Although it supports open access, it is reluctant to let decision-making pass from state to federal regulators. Most state legislators and regulators concur, arguing that the federal government should simply make it easier for states to enact their own legislation. One way to do this to eliminate laws, such as the 1935 Public Utility Holding Company Act (PUHCA), that interfere with interstate trade.

But whither deregulation? The vested industry interests don't like it: They'd much rather keep the status quo and its guaranteed monopoly profits. Public-interest advocates don't want to risk releasing power to the monopolies built up by past legislation.

Even groups that generally favor less regulation, such as the Heritage Foundation, worry that, in the absence of government oversight, the owners of the transmission grid will stifle competition. Few in Washington like the idea of completely deregulating electricity.

But some do. Perhaps the most notable is Wayne Crews, an economist at the Competitive Enterprise Institute. Crews became a well-known player in the debate in 1998, when he put out a joke press release claiming that he had built a tiny generator on his desk and personally wanted access to the transmission grid. "The pervasive thinking among so-called reformers is that just because somebody spins magnets, they have a right of access to utility wires property," the press release announced. "Well, we're tired of fighting that idea. We want in on some of this money.

The prank communicated Crews view that "the mere act of generating electricity does not create a right to force some-one else to deliver it." According to Crews, what really hampers competition are the exclusive franchise rights the government gives to selected distributors. Abolishing those would open up the market and allow firms to innovate.

The deregulationists strongly dispute the idea that the transmission grid is a natural monopoly. Under deregulation, they argue, those who now own transmission wires would not monopolize the market. New entrants would build overlapping wires instead, allowing competition to thrive. After all, that's what happened in other industries with expensive transmission facilities, such as phone lines and railroad tracks.

Electricity, they add, is undergoing a sea change. Regulators assume that huge, centralized generators will always move power over vast distances to distributors, which will always transmit it to homes and businesses. Regulation has preserved this model, and reregulation would do the same. But in the least regulated corners of the market, innovators like Plug Power are developing technologies that would do away with the need for a transmission grid altogether.

According to RKS Research & Consulting, the industry is undergoing a "major shift from the model of central station plants and poles and wires to a new paradigm of small decentralized power and networked control systems. The shift could rival the change in computing from the mainframe to desktop and network server in social and economic significance." If this is so, reregulation would only get in the way.

Any bill that passes the House of Representatives will be a compromise. Whatever bill is passed will probably repeal both PUHCA and PURPA, standardize technical specifications, and allow tax-subsidized companies such as the co-ops to sell electricity on the national transmission grid. It's also likely to set up Regional Transmission Organizations, which would expand the feds' power over the transmission grid. A Senate bill being prepared by Frank Murkowski (R-Alaska) is expected to be significantly more deregulatory.

Since 1979, five major industries--trucking, long-distance telephone service, railroads, natural gas, and airlines--have been opened to some degree of competition. Most of them were at some time considered either natural monopolies or essential public services that could not be trusted to market forces. Most of the old regulations had been installed at the behest of the industries themselves, which saw them as a way to fend off competition. Before deregulation, all five industries suffered from stifled flexibility, soaring prices, and generally poorer service.

According to an oft-cited and influential study by economists Robert Crandall and Jerry Ellig, after 10 years of deregulation in those five industries, consumers saved over $50 billion. Airfares fell 33 percent, and service improved. Long-distance telephone prices fell 47 percent, and new technologies such as fiber optic networks emerged. In the natural gas industry, service reliability shot up and prices dropped 57 percent. Railroad shipping prices fell 44 percent, and productivity improved to the point where half the employees produced several times the output. In the early '90s, a study by economists at Clemson University suggested that electricity prices could drop by as much as 26 percent in a competitive environment.

Deregulation could also be good for the environment. Under the current system, stringent laws keep companies from selling the excess electricity they produce to other energy users. As a result, argues Trigen Energy President Thomas Casten, we waste two-thirds of all the fuel expended in producing electricity. "If a hospital has a generator and at some point produces an excess of electricity," he points out, "it is illegal under current law to run a wire across the street and sell it to a school." Casten and others believe that the sum benefits of deregulating and desubsidizing the electric industry would lead to an automatic, nonregulatory drop of carbon dioxide emissions to below even the Kyoto protocol's stringent levels.

What further improvements might be possible? Who knows? Most utilities run on 40-year-old technology; with propped-up prices and guaranteed profits, they have little incentive to adopt anything better. While legislators draft their bills, the industry's entrepreneurs are struggling under the old rules and slowly trying to make a revolution. But for now, a century of regulation is holding most of the industry in stasis.

Ryan Oprea ([e-mail]) is a research associate for the National Center for Policy Analysis.