Transforming the electricity business.

Electric utilities have changed from state-regulated monopolies into competitive free-marketers, but the jury is still out ont he results.

When James Fontanilla of San Francisco, Calif., got his April electric bill last spring, it wasn't like any electric bill he'd ever seen before. It was longer and more detailed, for one thing, and listed charges for things he didn't know he paid for.

It had separate charges for energy, transmission, distribution, public purpose programs, a competition transition charge and some other new line items. All of these added up to 10 percent less than his old electric charges. Fontanilla's new, "unbundled" bill was the most obvious sign that a much-heralded revolution in the electric industry had started in California.

Likewise, customers in Rhode Island, Massachusetts and Pennsylvania have started to receive electric bills that reflect the century's most important change in the previously staid business of generating and delivering electricity. Over the next two years, 10 more states will join with this first wave in giving electricity customers the chance to choose their electricity provider, and other states continue this protracted debate.

A QUICK LOOK BACK

When the United States was in the midst of its post-World War II economic boom, the electric industry was racing hard to keep pace, building ever larger power plants, the most economical way to feed the nation's burgeoning [TABULAR DATA OMITTED] desire for electric power. The trend continued through the early 1970s. The costs involved in building the huge plants were enormous, so only big companies with strong financial backing could play in the game of generating and delivering electricity. Justifying their mammoth investments was the knowledge that costs would be recovered from their "captive" customers, who had no alternative but to buy from them. Thus, almost everyone agrees, at that stage in the industry's history it made sense for electric companies to be state-regulated monopolies.

In 1978, federal law changed to allow a new type of power generator, often known as a nonutility generator, to sell power to the regulated electric utilities. These generators could not sell directly to retail electricity customers, but only to the utilities, who would then sell to retail customers. This was the first crack in the old electric utility mold.

Since the early 1980s, the electric utilities' world has turned upside down. New technologies like gas turbines have lowered the cost of generating power, and made it economically possible for smaller generators to jump into the business without huge sums of capital and even without the guarantee of captive customers. Yet the regulations that established the concept of captive retail customers still would not let these generators sell directly to retail customers, like homes or businesses.

Beginning in the early 1990s some states with particularly high electricity rates began to look seriously at the idea of opening their retail electricity markets to competition so homeowners and businesses could choose their own suppliers. The California Public Utilities Commission laid out its plan in a blue-covered book, known to industry insiders as the "blue book." It defined a system in which power generators would compete with each other to supply electricity, while monopoly utilities would continue to own the power transmission and distribution lines that ran into people's houses and businesses. The blue book plan sent a shock through the industry, starting what some people thought at the time was an inevitable march toward a dismantling of the nation's last major monopoly.

WILL IT WORK?

It hasn't been an easy march, and it's still not clear if it will inevitably lead to competition in every state. New Hampshire, with homeowner electricity rates sometimes exceeding 12 cents per kilowatt hour, pushed into the lead, passing even California in enacting legislation to bring competition to its electric industry. But states like Wyoming and Idaho that enjoy electric rates far below the national average aren't so willing to jump on the bandwagon.

It's still not clear if competition will help everyone. Rural electricity customers and low income customers fear it will bring them little benefit. Even residential customers question the necessity of competition. How much benefit, they ask, will they derive?

Supporters of competition say it will doubtless reduce electricity prices for many users, and should benefit everyone. They point out that competition is designed not for a short-term advantage, but as a way to improve the way the electric industry makes its decisions in the long term. Regulation, they say, has had its opportunity to direct the marketplace, and the free market could do a better job of it.

"We have no idea now of the array and combination of services that companies in competition with one another will provide," says Brent Alderfer, a public utility regulator from Colorado and an advocate of competition.

As of early this year, almost every state with high electricity rates has enacted legislation to restructure their industries, as have a handful of states with lower rates. Montana Senator Fred Thomas says that even though his state had low rates, he sponsored an electric industry restructuring bill hoping to bolster the states' economic development climate. He also feared that a federal mandate could come along and push the state into a restructured market on the federal government's terms instead of its own.

But interest has waned in other states over the past year. Although it may still be said that every state eventually will pass its own version of an electricity restructuring package, many have adopted a wait-and-see posture, as they observe the early action in the first 14 states to opt for competition.

But those who choose to wait and see may have to wait a while. Only a handful of states with legislation have begun to make the transition from regulation to competition. Massachusetts, Rhode Island, California and Pennsylvania are in the midst of the transition, but the other 10 states still await the date for competition to begin. The results will be slow coming in.

One of the surest early returns has little to do with legislation, and more to do with the industry's reaction to and preparation for this new environment. The industry has not waited for competition and is in the midst of a rapid-fire change, acting as if competition were already in place. This, more than anything else, could end up being the force that pushes states to enact electricity reform. Two manifestations of that change are consolidations in the industry and sales of power plants.

Many utility industry analysts feel that small electric utilities will be unable to survive the rigors of competition. Some theorize that the minimum optimum size for an electric utility in the competitive industry is 1 million customers. As a result, the pace of mergers has picked up to a speed previously unseen in the industry.

As the industry moves closer to competition, many of the utilities have decided to sell off their power plants in order to concentrate on the less risky monopoly business of transmitting and distributing power.

Some of these asset sales have been the result of legislation or regulations requiring partial or full divestiture. Some of the states felt that selling off the assets would establish a true market-based value for the utilities' old power plants. Some propounded the idea of divestiture in order to guarantee that the owner of the power plant would indeed be a separate company from the owner of the power transmission and distribution lines, which are, after all, the only highways to bring power from plant to customer. Some also felt that divestiture would increase the number of power companies competing in the marketplace.

But most have been business decisions by the companies themselves. The interesting trend among all these power plant sales has been that they sold for far more than most observers expected. When Massachusetts' utilities sold their power plants, the unexpected additional proceeds sent the utilities' stranded cost amounts down by 50 percent.

But parallel to the changes in the structure of the industry are the first slow movements toward choice for consumers. A year after California opened its markets to competition the results are mixed. Residential customers have been slow to switch from their electricity providers although the larger power users have been a little quicker to move. In large part, this slow movement among residential customers results from the structure that California established to manage the transition from monopoly to competition. This transitional structure gave the major utilities through the year 2001 to recover as much as possible of their investments that are too pricey to recover in a competitive market. For example, if the market price for power is 3 cents per kilowatt hour (kwh), but a utility had signed a long-term contract with a power producer at 8 cents per kilowatt hour, the utility can continue to honor the contract but recover the 5 cent per kilowatt hour difference over four years from all its customers. California also gave all residential electricity customers a 10 percent rate cut, whether or not they switched from one provider to another. Since they could receive this rate cut immediately and without switching providers, there remained little incentive for residential customers to switch providers during the transitional period.

WHO SWITCHED IN CALIFORNIA
(AS OF JANUARY 1999)

                                Residential   Commercial   Industrial
Percent of customers buying
from alternative supplier          0.9%           7.1%        18.1%

Percent of kwh bought
through alternative suppliers      1.1%          16.1%        27.4%

Source: California Public Utilities Commission

The development of the Massachusetts and Rhode Island competitive market has been similarly slow. At this point, only a small handful of marketers are even trying to sell power to customers in these two states.

Does this mean that competition is failing in these early test states? "No," says Massachusetts Senator Mark Montigny. "We're in a transition at the moment. We won't see the real results of competition for another year or so."

That, in fact, is probably the case. The Massachusetts Department of Telecommunications and Energy, the state's public utilities commission, set up a system designed to offer all customers a price break immediately upon the advent of competition. The commission set a price of energy at 2.8 cents per kwh for every customer. Yet at the time, prices for electricity on the open market were about 3.2 cents per kwh.

All utility customers could buy power from one source, their traditional electric utility, for 2.8 cents. But if they wanted to buy from someone else they would have to pay at least 3.2 cents. There has been little reason for customers to switch or competitors to enter the market last year or even this year. But as the regulated price is phased upwards toward 5.1 cents, competitors will start to enter the market. This year and especially in the years to come, we are likely to see some significant competition in the utility market, but for now both states are clearly in a transition that allows only limited competition.

PENNSYLVANIA'S APPROACH

Pennsylvania offers a different model that set out a shorter transition period and a quicker move to competition. The state set up a series of very large-scale pilot programs for each utility that eventually will lead to an opportunity for all the state's electricity customers to choose their electricity provider. The state did not give every customer an automatic rate reduction. Instead, all customers were given a price that they would pay if they didn't switch power providers, called a "shopping credit." The customers could then compare that rate to the offers from any alternative providers.

Because the Pennsylvania Public Utility Commission set this "shopping credit" rate at a higher level than, for instance, Massachusetts with a 2.8 cent transitional rate, competitors have been more able to compete in the market. As a result, current estimates are that 475,000 people have signed up for an alternative provider.

THE GREEN POWER MARKET

The success story hidden in these early results lies in green power markets, or the market for electricity generated from renewable resources like wind, solar energy, geothermal energy, biomass or some kinds of hydro power. As power marketers tried to distinguish otherwise indistinguishable electrons from one another, many hit upon the idea that customers prefer to support renewable methods of generating electricity. Many now offer green electricity products. Green Mountain Energy offers several products in California including: Wind for the Future, which commits the company to build new wind turbines; 75 percent Renewable Power, which features power generated from small scale hydro plants, biomass and geothermal facilities; and Water Power which features large scale hydro facilities. Customers in Pennsylvania can buy products from Green Mountain Energy that feature renewables mixed with natural gas or hydro power.

A MARKET IN TRANSITION

The early results from California, Rhode Island, Massachusetts and Pennsylvania show a market in transition, and it's too early to tell what a fully competitive market will yield. But a few conclusions can be drawn:

* Most residential customers are slow to choose a new electricity provider.

* Larger electricity users are more apt to pick another provider than small power users.

* Those who do sign up prefer to buy green electricity.

* The speed with which competition develops depends on the rules set up for the transition period.

* The benefits for all types of customers, both businesses and residential, depend on the rules that a state establishes for the market.

The mixture of promising results from the early stages of competition coupled with the concern that the majority of customers will be slow to respond makes it difficult to draw any conclusion except that the jury is still out on competition's success.

RELATED ARTICLE: IT'S STRICTLY A BUSINESS DEAL

Switching electricity providers implies to some people that the electrons delivered into the customers' homes or businesses come from a different power plant. This is not the case. The act of switching providers is a financial transaction and has no effect on which electrons cross the customers' meters. In all likelihood the power plant that served a customer before changing providers will be the same that serves the customer after the switch. In the case of green power, the green electricity retailers sign a contract to buy electricity generated from some green resource. That electricity is then pumped into the electric grid, traveling over power lines over the path of least resistance until it reaches a customer. Green power marketers thus increase the amount of electricity generated from green resources that is circulating on the power grid.

As these products that emphasize the means of generating electricity have emerged, many states have decided to impose some discipline on the accuracy of information that consumers receive by requiring a standard disclosure of the sources of power, price and terms of the agreement with the power company.

Matthew H. Brown runs the NCSL Energy Project, which offers on-site assistance on utility restructuring to state legislatures, a national e-mail discussion group and an array of other resources. Call him to participate in the discussion group or to arrange technical assistance, [phone].