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Restructuring in the electric utility industry: old and new paradigms.

To undestand the potential future courses of the electric utility industry, one must understand the traditioonal industry paradigm and the reasons for the collapse of this paradigm. Mr. Collier then discusses the formulation of a new industry paradigm based on competition for retail customers, resources and return for investors.

Summary

The electric utility industry began in the late 1870s, and was characterized by rapid technological development. The industry was essentially technically mature by the early 1900s, and operated within a constant and stable paradigm for some sixty years into the 1970s. That longstanding paradigm involved a regulated, monopoly structure with sustained growth and significant economies of scale. Utilities operated essentially as organizational islands, serving their own loads with their own resources. However, a dramatic paradigm shift is occurring as a result of a series of disruptions and changes in the industry in the 1970s and the 1980s.

A long-time, stable, growth industry went through a period of disruption and regulation in the 1970s and 1980s. Now the industry is restructuring as competition becomes the order of the day. Not only has the old paradigm largely crumbled, one or more new paradigms are forming. This is causing profound restructuring in the industry at large and in individual utility companies. The new paradigms involve increased competition in retail markets, resource markets and investment markets. An increasingly complex business environment is affecting all aspects of utility operations. New approaches are required for planning, financing, operations, service and pricing. New objectives must be met, including better anticipation and satisfaction on the customer's side of the meter, acquisition of the best and most flexible resources, and reorganization of the management and even the ownership of utility companies.

Understanding the Old Paradigm

A Period of Technological Development

The first significant electric experiments began in Europe in the 1730s, and the first practical applications began to be invented in the early 1800s. By the mid 1800s rotating dynamos were being demonstrated, and arc lighting was being used in industries. The first commercial electric utility in the United States began with arc lighting service in downtown San Francisco in 1879 at the California Electric Light Company.

About this same time, Thomas Edison perfected the incandescent light bulb. Within three years he had the Pearl Street Station providing reliable lighting service in downtown New York City. According to his journals, much of Edison's motivation to develop commercial electric service stemmed from dissatisfaction with the service he had received from the gas company!

A period of rapid technological development followed these initial events. By the turn of the century, there were some 3,000 electric utility companies. Self generation by industry accounted for about sixty percent of the installed capacity in the country and about forty-eight percent of annual energy production. Central station power was the prevailing technological paradigm by the 1920s. The industry was essentially mature technologically by this time, and several decades of sustained growth followed.

The Regulated Monopoly Structure

Samuel Insull was a key figure in the development of the most important industry paradigm. He can properly be deemed the founder of the investor-owned, regulated monopoly structure of the industry. Having begun in the industry as part of the Edison team, a falling out resulted in his relocation to Chicago where he formed the Chicago Edison Company. By 1929 his electric utility holding company empire controlled some 65 utilities in 13 states. His electric utility holding companies, along with others, were major contributing factors to the stock market crash of 1929.

Electric utilities formed as monopolies from the very start. The investment intensive nature of the business precluded proliferation of competitors. The possible abuse of these developing monopolies was a public policy concern. Monopolies might gouge on price, and would not always provide adequate service to every customer. On the other hand, Insull and other industry leaders were equally concerned that they not have to face profit eroding competition.

Insull led in the striking of an informal public policy bargain which ultimately became the law of the land. This bargain has been known as the social contract, or the regulatory compact. It was composed of three important features. First, electric utilities would be allowed to remain "natural" monopolies. Second, the utilities would agree to price regulation. Third, they would agree to an obligation to serve all customers upon demand. (From Insull's viewpoint, this was really a guarantee of an opportunity to serve every customer.)

The type of price regulation was most significant, however. The price for electric service would be set at cost plus a reasonable profit. This "cost plus" method of pricing became the standard of the industry. When coupled with sustained growth and significant economies of scale, such pricing proved acceptable. The demand for electric service was high and largely inflexible during several decades of electrification of industry, commerce and residences. The real cost of electricity was actually declining under this regime due to economies of scale.

A Period of Sustained Growth and Improving Economy

The demand for electric service was high and largely inflexible during several decades of national electrification. Load was pretty much doubling every decade with compound growth of about 8% per year. An industry that had three million kilowatts of installed capacity at the turn of the century grew by more than two hundred times to over 600 million kilowatts by the 1970s. From 1950 to 1990, annual per capita consumption of electricity increased from less than 2,000 kilowatt-hours to more than 10,000 kilowatt-hours.

The real cost of electricity was actually declining under this regime due to economies of scale. In constant 1980 dollars, the price of electricity was on the order of $30.00 per kilowatt-hour at the turn of the century (i.e., about 25 cents per kilowatt-hour in 1900 dollars). This declined by almost a thousand times to about four cents per kilowatt-hour in 1970. This declining real price, resulting from economies of scale, displaced most industrial generation. By 1930, industrial generation had dropped to only twenty percent of the nation's total installed capacity and annual energy.

The industry developed largely as an investor-owned one. That is, the majority of the market came to be served by companies which were owned by investors. The predominant objective was generating value for stockholders. Economy and quality of service was important, but subordinate to return for investors.

The Prevailing Paradigm

A simple word picture can help summarize the prevailing paradigm of the industry leading into the 1970s. Consider a hefty industry seated firmly on a three-legged stool inside a comfortable house built on a firm foundation. The three-legged stool is the three part social compact. The foundation is sustained growth with inflexible demand for electric power. The house is economy of scale that props up cost-plus pricing and benefits from sustained growth.

Shifting From the Old Paradigm

Disruptions and Changes in the 1970s

A dramatic series of events in the 1970s steadily eroded the traditional paradigm. In terms of our word picture, the foundation was cracked, the house was destroyed, and the three legs of the stool were broken off.

Reaction to the 1965 Blackout--Public reaction to the great northeast blackout in September of 1965 led to a threat of government intervention in the predominantly privately owned bulk power system. To forestall this threat to the investor-owned monopoly, utilities voluntarily formed regional reliability councils. These reliability councils fostered increased transmission interconnections between utilities, and caused a new emphasis on constructing substantial reserve generation.

The Arab Oil Embargoes--The effects of the original Arab embargo of 1973 were strongly reinforced by the repeat embargo of 1979. Severe disruptions in domestic oil and gas markets resulted, with potent impacts on the national economy. Oil prices more than doubled from a longstanding level of $10 per barrel to $25 per barrel almost immediately after the onset of the 1973 embargo, and increased further to almost $50 per barrel after the 1979 embargo. As a result, electric energy prices increased sharply. As utilities moved to reduce reliance on oil and gas with more expensive solid fuel plants, the increase in prices became permanent.

Economic Crises--The oil embargoes and other factors led to economic difficulties for the country and for electric utilities throughout the 1970s. Inflation remained at an all-time high, and interest rates increased dramatically. This made the already expensive fuel substitution generation expansion by utilities even more costly than expected. It also caused consumer dissatisfaction with prices in general, and with energy prices in particular. The economic disruption resulting from the oil embargoes and the inflation crisis resulted in a more fragile national economy, with less stability in prices, interest rates and inflation.

A Social and Philosophical Shift--Unprecedented social unrest was the hallmark of the 1970s. The Viet Nam war and the Watergate scandal were catalysts for the manifestation of a change in attitudes toward technology and energy industries. While not likely the cause of these changes, the war and the scandal facilitated the communication of a loss of confidence in government and public institutions as well as a shift in tolerance for environmental and economic impacts of electric utility expansion.

The National Energy Act and PURPA--President Carter's five-part National Energy Act of 1978 ("NEA") was the national policy response to the oil embargo crisis. The legislation was intended to reduce reliance on imported oil through renewable energy resources, and to increase efficiency of utilization when oil and gas must be consumed. The Public Utility Regulatory Policies Act ("PURPA") was arguably the most significant portion of the NEA. It provided for non-utility entities to construct new generation free from the constraints of regulation and advantaged by extremely favorable terms and pricing for sale of their power output.

Regulatory Prudence Reviews--Increasing electric prices and corresponding consumer dissatisfaction caused immense pressure on regulators. No longer would they simply agree to the cost-plus compact. Regulatory commissions began to more closely examine costs for inclusion in rate base as well as the profit levels granted to utilities. Prudency reviews became common. In these proceedings, the regulators examined whether costs were prudently incurred on the basis of after-the-fact review of planning, construction and rate impact. In many cases profit margins were reduced, and in some cases costs were simply disallowed. Rate increases were limited through mitigations and phased-in strategies.

The Aftermath

The effects on the electric utility industry of these disruptions and changes have been enormous, even draconian. Decades of declining prices were reversed, with retail rates tripling from 1970 to 1985. Decades of sustained growth ended with an actual drop (i.e., -0.1%) in energy sales in the year after the first oil embargo. Utilities that had been planning and constructing for loads anticipated to double every decade experienced staggering surpluses of generation capacity. This further exacerbated the upward pressure on prices as costs of unneeded generation were ploughed into the traditional cost-plus paradigm.

Utilities which needed generation additions found it impossible to complete plants on schedule and within budget. Nuclear plants were particularly susceptible to delays and cost overruns. Delays were as long as a decade, and cost overruns as much a ten times the original estimates. Public concerns over environmental impact, safety, rising costs and corporate profits heightened controversy and litigation, causing further delays and increased costs. Utilities' financial performance deteriorated, aggravating shareholders to demand changes in management and policy. Those utilities which did complete plants found they could not always get all of the costs included in rates. Some utilities began to be reluctant to construct new generation.

The advent of the regional reliability councils resulted in transmission interconnections between and among utilities. While constructed for reliability and emergencies, these paths began to be used for purchase and sale of surplus generation capacity. Other developments, including nuclear plant license conditions, antitrust lawsuits, joint venture power plants and PURPA reinforced the move toward transmission access for utilities and non-utility producers.

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New, non-utility companies began to account for most of the new generation being constructed. Non-utility generators ("NUGs") account for more than five percent of installed capacity and are expected to account for more than ten percent by the end of the decade. While NUGs were initially mostly PURPA qualifying cogeneration and small power facilities, various utility and non-utility entities began to contemplate and clamor for the ability to field unregulated generation projects. These new independent power producers ("IPPs") became a redoubtable force, demanding opportunities to sell in wide utility markets and rights to move their power over the utilities' transmission lines.

The End of the Traditional Paradigm

The events of the 1970s, and their aftermath, were the beginning of the end of the traditional paradigm. The foundation of sustained growth and inflexible demand was fractured. The comfortable house of economy of scale was consumed by increasing risk of regulatory disallowance, environmental impact, planning uncertainty and unstable national energy policy. The three-legged stool was demolished as PURPA broke the monopoly, prudency reviews and competition broke the cost-plus price bargain, and risk and competition broke the obligation (or opportunity) to serve guarantee. Now the electric utility business is considerably more complex. Decisions and actions are constrained by environmental concerns, more volatile economic circumstances and uncertainty in public policy. The old approaches that worked well in a stable, regulated monopoly environment did not suffice during the calamitous transition period, and are not likely to be any better under newly developing paradigms.

Anticipating the New Paradigm

The Beginning of Restructuring

During and immediately after the disruptions and changes of the 1970s, a period of policy development prevailed. New laws and regulations were promulgated, and litigation proliferated. By the end of the 1980s many were beginning to suggest that regulation had essentially failed in energy resource markets. This was paralleled by a general move away from government intervention and regulation throughout the world. Strong pressure developed for deregulation of the industry, particularly in the wholesale power markets. This was a natural consequence of the competition that was initiated with PURPA.

Not only have the components of the old paradigm deteriorated, but strong pressures exist for continued deregulation and restructuring. Existing utilities are pressing for ways to increase market share to replace the growth that had propped up the industry for decades. New entrepreneurs in the form of NUGs and investors in traditional utilities are seeking profitable business. More aware and aggressive customers are demanding more price and service options. Lawmakers and regulators seek market forces to establish price discipline and to encourage the development of new energy resources. All this has led to national energy legislation expanding competition and mandating transmission access.

As has been the case in every other industry that has undergone the shift from regulated monopoly to market driven (e.g., airlines, trucking, telecommunications, natural gas), basic restructuring can be expected in the electric utility industry. Other industries saw corporate reorganization, mergers and acquisitions, new market entrants, and fundamental changes in pricing and operations. This is doubtless unavoidable in the electric utility industry as well.

A New Paradigm of Competition

Perhaps the most concise definition of the emerging paradigm is competition. It is helpful to consider three Rs of competition: Retail customers, Resources, and Return for investors.

Retail customers are less and less captive to the old monopoly paradigm. Electric utilities, non-utility electric producers and alternative energy suppliers are intensifying competition to serve. Customers themselves increasingly turn to conservation and load management, and may even unilaterally bypass the local utility for another competitor. Conservation and load management vendors and service suppliers also seek business with the ultimate retail customer. Resources will be the object of competition in the restructuring industry. Capital, staff and services, generation, fuel, transmission access and end-use applications will all be sought. There will even be competition for the right to impact the environment (e.g., emissions trading under the Clean Air Act). The most able competitors will succeed in acquiring the best and most economical resources. The others will find that failure to compete successfully in this area will lead to failure to win in the competition for retail customers and for investors. Return for investors will also be the focus of competition. Shareholders seek the best return. Companies will be bought and sold as this competition grows. There will be sellouts and takeovers as the more able competitors gain the advantage on the others. Some companies will voluntarily restructure through consolidations in some cases, and divestiture in others, to compete for investors. Diversification by some companies into complementary and synergistic businesses is also likely.

A Global Perspective

In the new paradigm of competition, a global view must be maintained. The United States has the highest standard of living and the highest productivity of any industrialized nation. This is largely due to the intensity of its use of energy, particularly electricity. The United States accounts for one third of all installed generation capacity in the world and uses more the one fourth of all of the world's energy. This results in the production of about one fifth of all the world's pollution. Yet, the United States accounts for less than six percent of the world's population. As the developing countries (where most of the world's population resides) seek the benefits of intense energy utilization, and particularly electrification, the competitive consequences will be keen. The disproportionate advantage of this country in the utilization of resources for its own citizens will be assailed. Competition for retail customers, resources and return for investors will likely intensify even more.

Conclusion

A dramatic shift is occurring in the electric utility industry. The longstanding regulated monopoly structure is giving way to market driven circumstances. A new paradigm seems to be competition for retail customers, resources and return for investors. This paradigm shift will necessitate restructuring in the industry at large and in individual utility companies.

* Steve Collier is the Director of Power Supply and Regulatory Affairs for Cap Rock Electric, located in the Permian Basin of West Texas, at Stanton. Working out of Cap Rock's state capitol office, Steve directs the utility's power supply, regulatory and legislative activities.

Mr. Collier has been active in electric utility planning and analyses for almost twenty years. He continues to assist utilities and large utility customers as an expert consultant in planning, contract negotiations and regulatory activities. Steve lectures frequently throughout the United States, including as an instructor on the NRECA Management Internship Program and Advanced Management Program.

Mr. Collier graduated summa cum laude with a BSEE from the University of Houston and received his MSEE from Purdue University. He is also a registered professional engineer.
COPYRIGHT 1992 National Rural Electric Cooperative Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Collier, Steven E.
Publication:Management Quarterly
Date:Sep 22, 1992
Words:3087
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