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The State of U.S. Electricity Restructuring
Sally Hunt is a Special Consultant to National Economic Research Associates (NERA), where she was previously head of the U.S. Energy Practice. Over her many years in the energy industry, she has held positions in both the public and private sectors and has studied a variety of issues relating to restructuring the industry, transmission pricing, incentive regulation, contract structure, stranded costs, tariffs, competition, and alternative market arrangements. In the United Kingdom, Ms. Hunt led a team of five NERA economists for six years, advising the Central Electric Generation Board and later National Power as the U.K. industry was restructured from a nationalized monopoly to a privatized, competitive industry. She then spent two years in California at the beginning of the restructuring there, working with Southern California Edison on multiple issues arising in the process. She led a NERA team advising the Mexican Ministry of Energy over a period of three years, on restructuring and tariffs. She has worked with several U.S. companies on the regulatory issues involved in direct access, and has submitted testimony in state, federal, and court proceedings. In recent years, Ms. Hunt has also worked on industry structure issues in Spain, Sweden, Venezuela, China, Thailand, Australia, and Argentina. During her career, Ms. Hunt has also served as Corporate Economist at Con Edison, Deputy Director of the New York City Energy Office, and Assistant Administrator of the New York City Environmental Protection Administration under Mayor John V. Lindsay. Ms. Hunt holds an M.A. in Philosophy, Politics, and Economics from Oxford University. Her book Competition and Choice in Electricity (co-authored with Graham Shuttleworth at NERA London) was published by Wiley in 1996 and was reprinted three times, once in paperback. This article is adapted from Ms. Hunt's new book, Making Competition Work in Electricity (Wiley).
June 2002
The State of U.S. Electricity Restructuring Ten years after federal legislation began the electricity restructuring process in 1992, the United States is stuck in the middle, with some states regulated and some deregulated. In an excerpt from her new book, Making Competition Work in Electricity, the author argues that there is still no clear policy at the national level for where we are trying to get to, and no roadmap for getting there. Sally Hunt
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he restructuring of the electric industry in the United States has had a short but bumpy history. The 1992 legislation required open access to the transmission network for some transactions, and removed some roadblocks to independent generators. Since 1994, the states have been deregulating one by one. Most state plans were stalled by the debacle in California, which cost the citizens of that state, as taxpayers and as customers, billions of dollars out of pocket, 40 percent rate increases, and the first set of rolling blackouts in the
memory of most citizens of the U.S. Deregulation is widely viewed as a failed experiment, competition as a rip-off. Countries as far away as China and as close as Mexico put their plans on hold because of the risks exposed by California. This does not have to be the case. The industry is technically complex and also institutionally complicated, but there is by now, after a decade of international experience, a ``standard prescription'' to deal with the complexities: a checklist of what is required for this industry to
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become competitive. The technical complexity can be solved: The institutional issues are at the root of the problem in the U.S. he basic problem is the split of regulation between the federal government and the states. It is a thoroughly interstate industry, but no one has overall authority to decide what needs to be done. This has resulted in a plethora of incompatible initiatives. What is required is to develop the conceptual framework, make a plan, and to implement the institutional changes necessary to make it happen.
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system operators coordinated the generating plants, telling them when to run and when to back off so as not to overload the transmission network. The customers received a bill that had all these functions ``bundled'' into a single tariffÐthe vertically integrated company was the retailer as well as the producer. The vertically integrated companies had monopolies in their own areas, and because of this prices
The basic problem is the split of regulation between the federal government and the states.
I. The Functions of the Industry Electric systems around the world are physically and operationally very similar. The physical functions of the industry are generation (production), system operations, transmission, and distribution. The merchant functions are wholesaling and retailing. Transmission and distribution are transport functionsÐthe transmission wires are networked and serve large areas; the distribution wires are local. The typical organization of the industry prior to deregulation was vertically integrated companies, incorporating all these functions. These companies built their own generating plants and coordinated the planning of generation with the planning of transmission. In real time their 12
were regulatedÐin the U.S. mostly by regulators at the state level, in other countries by the government. The integrated companies built to serve their own customers, and had to build enough to serve them all, at all times. ompetition in the electric industry generally means competition only in the production (generation) of electricity and in the commercial functions of wholesaling and retailing. These are the functions that would be deregulatedÐtheir prices would be set in competitive markets and not by regulators. The transportation functions
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(transmission and distribution) cannot be competitiveÐthey are natural monopolies. It doesn't make economic (or environmental or esthetic) sense to build multiple sets of competing transmission systems; everyone has to use the same wires.1 They have to serve everyone, and they have to be regulated. System operations also has to be a monopoly, since the system operator has to control all the plants in a control area, or the system will not function. The worry is that in restructuring, the competitive parts need to be separated from the regulated parts, and the coordination that was working well in the integrated companies under regulation may be lost. Institutions have to be designed to replace the previous internal coordination without losing its important efficiencies. This has been done successfully in parts of America, and also abroad, but it is still the major challenge.
II. The Case for Competition The need in the U.S. is to refocus on introducing competition into the production markets, because this is where most of the longterm bene®ts of restructuring will accrue. Competition in the retail markets will not produce low prices if the production markets are not competitive. It was in the production end that the problems of the old U.S. system were mainly observed2Ða highly The Electricity Journal
politicized process of investment, inef®ciencies in choice of technology, construction, and maintenance, and dif®culties in regulation and pricing, that led to a desire to reorganize the industry. Since these are the places that competition can help, introducing competition in production makes sense for the U.S. ompetition is the basis upon which the U.S. economy was built. It is not an end in itself. It is generally supposed to bring a whole bundle of good things that we as a society valueÐefficiency and technical progress among them. In general, a monopoly held in check by regulation is considered a poor substitute for a competitive market and is only to be adopted where, for reasons of natural monopoly or some overriding public interest, competition is not feasible or performs poorly without government controls. We now know from experience elsewhere and in parts of the U.S. that competition in electricity production is feasible. We know that many of the reasons the industry was organized as regulated monopolies for so long no longer apply. So competition is the standard to beat. Competition is what bene®ts consumers. And in the ®nal analysis, bene®ting consumers should be what public policy is all about. Consumers want, and should expect to have: low prices (although they know they have to pay enough to keep suppliers in business);
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reliable service; fairly predictable bills; and the opportunity to benefit from value-added services that may come available. So far, except in the notorious case of California, competition has managed to provide these things where it has been introduced in electric industries around the world. Many other countries, and some jurisdictions in the U.S., have successfully
We now know from experience in the U.S. and elsewhere that competition in electricity production is feasible. introduced competition in production and open access to transmission. There is by now a decade of international experience good and not so good, but not one of the countries that introduced competition has gone back to the old monopoly ways. This, in its own way, is a ringing testimonial to the bene®ts of competition.3 However, there are certain technical details that have to be attended to for competition to be able to produce these results. There are cogent reasons why electricity was a monopoly for so longÐelectricity is indeed different from other commodities.
It cannot be stored; it is transported at the speed of light, following laws of physics unique to this commodity, over a fragile and interactive transmission network. The instant you ¯ip the switch, something happens at a generating plant somewhere, and the electricity gets to you in a millisecond. The network requires the constant vigilant control of a system operator. The penalty for inattention is to black out a whole area, as has happened twice on the East Coast of the U.S. But the technical complexity exists everywhere there is electricity. We know what to do, and we know what we don't know. We also know that restructuring this industry is harder than most people think. The airline, gas, banking, and telecommunications industries have been made competitive, with considerable success. They were a piece of cake in comparison to electricity. One thing has been made clear from experience both at home and abroad: you cannot simply cease to regulate the industry and walk away from it, expecting a competitive market rush in and work its magic. The introduction of competition poses some really dif®cult problems, and rational solutions depend upon understanding these complexities and designing ways to account for them. The institutional changes must, in the end, permit competitive markets in electricity to meet the ordinary requirements of commerce. Many buyers and many
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sellers must be able to access each other easily; they must be able to make contracts in advance and at spot prices; and they must be able to transport the electricity with a high degree of certainty as to the price and availability of the transmission network. fficiency is the goal, competition is the means. Open access, restructuring, and deregulation are terms sometimes used to describe the reforms, but they are the tools to achieve it. We now turn to what these terms mean.
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A. Open access Competition in production requires open access to the transmission and distribution wires so that any competing producer can use them. Transmission is an essential facilityÐeveryone has to use it. Open access means that everyone gets the same deal, with no discrimination in the opportunity to use the wires or in the cost to use them. But making this happen requires major institutional changes. First, real-time coordination of generation with transmission is a necessity. In the old vertically integrated industry, they were coordinated internally by the companies. In the competitive industry new trading arrangements have to be set up to ensure realtime coordination in a disaggregated world, because if coordination fails, we will all be literally in the dark. When potential competitors (the old monopolies who owned both transmission 14
and production facilities) own the transmission wires, it is important to ensure that the real-time coordination is not discriminatory, favoring the sale of power by the transmission owner at the expense of sales by other competitors. This has been accomplished in most of the world by complete separation of system operations into a separate independent organization, and by trading arrangements that do not give
If transmission expansion is in the hands of competing generators there are issues of discrimination; in too many hands, issues of coordination
issues of coordination. These are the main areas where even internationally there is no standard institutional design. Retail access,4 or more accurately ``customer choice,'' refers to the opportunity for individual consumers to choose from among competitive electricity suppliers. Traditionally, customers have been able to purchase electricity from just one supplier; i.e., their local, vertically integrated monopoly. Under deregulation they are given the opportunity to choose their supplier, and ``retail access'' refers to the ability of suppliers to reach customers over local distribution wires. This (unlike transmission) is not a technically complex matter, but can run into many political complications, such as how much protection to afford the smaller consumers. B. Restructuring
priority to the transmission owner. n addition to short-term coordination, open access requires arrangements for longterm control of the transmissionÐ the transmission business model. Before deregulation, the utilities built for themselves, and never had to set prices for use. Who will plan and build for competition? What are the right prices? What rights do those who built the transmission for their own use retain in the new world? If transmission expansion is in the hands of competing generators, there are issues of discrimination; if it is in too many hands, there are
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Restructuring is about changing existing companiesÐseparating some functions and combining others, and sometimes creating new companies. The aim is to prevent discriminatory behavior, or to create more competitors, or to consolidate transmission over a wide region. The theory is fairly simple. Some functions must be separated; some should be kept together, while for some there is room for signi®cant policy choices. There are various degrees of and approaches to separation. There may also be questions of regional consolidation, both separating and combining companies as part of a restructuring. The Electricity Journal
The offset to dividing up the functions is the loss of the economies inherent in the traditional monopoly structure, and the cost of all the lawyers needed to set up new companies. estructuring is time-consuming, even when the government owns the company and the legislature wants competition. Dividing physical and financial assets between new companies is often the major element on the critical path for restructuring, even when everything else is agreed. (The normal time is about two years.) But the decisions about restructuring are complicated in the extreme where, as in the U.S., many companies are privately owned, and a significant portion of the industry is in the ownership of thousands of different government bodies, from the federal government to municipalities. It is not exactly clear who has or should have the authority to order necessary restructuring. The U.S. telephone monopoly was restructured as the result of a massive antitrust case, but we are not talking antitrust cases here. What has been done so far in the U.S. is that state regulators have offered carrots and brandished sticks to encourage voluntary restructuring, and some state legislatures have acted, although so far without their actions being tested in the courts.
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C. Deregulation Deregulation means ceasing to regulate. Regulation is about June 2002
controlling prices of monopoly suppliers and restricting entry to the markets, so the standard de®nition of deregulation is to remove controls on prices and entry of competing suppliers. This would be simply disastrous for consumers in the electric industry if it were done without necessary safeguards or supportive market conditions. Just declaring the industry deregulated and providing open access
Just declaring the industry deregulated and providing open access to the transmission system cannot produce competitive markets. to the transmission system cannot produce competitive markets in electricity.5 The existing suppliers are local monopolies with 100 percent of a local area both at the production and at the retail level. It would hardly be surprising if they were dominant suppliers after such a ``deregulation.'' So something else has to happen for deregulation to produce competition. In fact, for competition to work in the electric industry, there is a long list of conditions that ought to be in place before deregulating. Summarizing, the ®ve major changes required include the following:
1. Demand side: Hourly metering for most of the consumption, and tariff designs that expose customers to the spot price for some of their consumption. 2. Trading arrangements: System operations separate from traders and regionally consolidated. Trading arrangements based on an integrated model, with central dispatch and locational energy prices. 3. Transmission business model: Control of transmission separate from traders; pricing and expansion arrangements. Our preference is for regional profit-making regulated transcos incorporating the system operator. 4. Supply side: Remove barriers to entry. Buy out of the old regime by valuing assets. Expand market areas by improving transmission. If necessary for control of market power, divest utility generation into smaller parcels. 5. Retail access: When production markets are working, choice for all customers. This needs an extensive settlement mechanism and customer education, and decisions about default provision. This is a standard prescription, and it is never quite like this. As any doctor can tell you, the standard prescription may not apply if there are complicating factors. All those years in medical school teach you to understand not only the straightforward case and the best treatment, but also the underlying anatomy and physiology so that you can treat the
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complications that arise in real cases. ach country has its own preexisting conditions or political necessities, and most of them have to muddle through in some way or another. It is certainly much easier to start from a situation where the government owns the industry and also has the legal power to change things, generally in the run-up to privatization. This at least assures a fairly consistent plan, and a unitary design that can hold up under stress. All plans involve winners and losers, and when the government can accept being the short-term loser, because it has the longer view of the benefits of change, everyone else can be kept happy. In the long run, as Keynes did not say, we are all dead except the government.
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III. The United States The United States is enormousÐit contains one-quarter of all the electric capacity in the world. One of its strengths is that for two centuries it has managed to walk the line between the bene®ts of national standardization and state and local autonomy. The electric industry began locally, and federal legislation from the 1930s actually kept it fragmented. But today it is so fragmented thatÐeven leaving aside competitionÐef®ciency is suffering. Two hundred or more private companies submit to divided and sometimes contra16
dictory regulatory jurisdiction. Each of the 50 states has its own plan to deregulate, or not. The public sector includes 3,000 or so entities that operate, uncoordinated, at federal, state, and municipal level. These government entities are not subject to most of the state or federal regulation applied to the private entities. Transmission is owned
by over 200 public and private entities. There are 140 or so local system operators. ll these complications bring their own problems for implementation of reforms. Private ownership complicates restructuring of companies; fragmented operational control inhibits efficient trading arrangements; fragmented transmission ownership permits states or companies to hold up expansions that would benefit neighboring states or competing generators. Public ownership can stand in the way of regional consolidation of the network. There has never been a national policy or regional framework other than a vague desire on the
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part of Congress and the federal regulators to see the industry competitive. There are no regional bodies to coordinate over wide areas. It is hardly surprising then that reforms have so far been con®ned to the big states and states with preexisting regional agreements. California, New York, and Texas were big enough to go it alone, and Texas has the distinct advantage of unitary regulation. Texas is not electrically interconnected with the rest of the U.S. and therefore is not regulated by the Federal Energy Regulatory Commission (FERC). In two other cases in the Northeast,6 preexisting interstate agreements (the ``tight pools'') have been the springboard for coordinated actions by states. These states can be considered to have created the basis for more or less competitive markets, but these are the lowhanging fruit, and even these would not meet our checklist in all respects. In the rest of the country, natural market areas clearly cover more than one state, but there are no national or regional plan. If there were, there would be no authority to impose them. The rest of the country is at an impasse; markets are bigger than a single state and states cannot go it alone. Any further developments are stymied, and probably would be even without the well-publicized problems in California. The central problem for the rest of the country is that jurisdiction over the industry is divided The Electricity Journal
between federal and state governments in a way that was established in 1935, when the industry was mainly a local industry. Now the transmission networks have expanded and interconnected so much that electricity is clearly in interstate commerce, but the 1935 jurisdictional split remains. Referring to our ®ve big issues on the checklist: The first (metering and tariff design) and the last (retail access) are in the jurisdiction of the individual states. The second and third (the trading arrangements and the transmission business model) are mostly in federal jurisdiction, but FERC has7 insufficient authority to require the changes it says it wants. The metering necessary to get competitive wholesale markets working well is in the hands of the states. The supply side is divided. Only the states can deregulate; no one can expand transmission over wide areas to create larger and more competitive markets. No one can require divestiture if it is needed to control market power. The states control siting of generation and transmission. The centerpiece of competitionÐensuring competitive production marketsÐis in no one's jurisdiction. The states alone can deregulate production and free customers to choose; but they cannot put all the underpinnings in place to make sure the markets are competitive. They cannot control market June 2002
power over wide areas. They cannot require other states to install metering; they cannot implement trading arrangements or require consolidation of transmission. The situation in the U.S. is a complicated muddle. Implementation has got far ahead of policy. Professor Paul Joskow of the Massachusetts Institute of
Technology, a long-time and respected observer of the industry, puts it this way:8 I do not believe that . . . the elec± tric power sector can exist and prosper with a checkerboard of competitive and non-competitive states taking power from the same transmission networks, or even with a large number of competitive states which have adopted a wide array of different rules and institutions for wholesale and retail competition.
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t is a fair question, and often asked: Why bother when it is so complicated? What was wrong with the old system? Under regulation, the U.S. electric industry had a good history, by interna-
tional standards of the time, of innovation, low prices, and reliable service. The vertically integrated monopolies had reasonably good arrangements for short-term coordination of system operations with production; and good arrangements for expanding transmission, that took into account the trade-offs between transmission and generation. But while it might be instructive to consider the problems of regulation and how competition will ameliorate them, that is no longer the issue. We cannot ignore the fact that some changes are already well underway. Open access was ordered in 1992, but a decade later the trading arrangements have not been resolved; regional organizations have not been put in place; metering and rate design have not been attended to; transmission investment has mostly ground to a halt; detection and mitigation of market power is rudimentary. We do not have the option of going back a decadeÐ the appropriate comparison is what is happening now, which in many cases is not as good as it was pre-1992. We have taken the regulated industry apart and have put nothing comprehensive in its place. The reason to resolve this impasse speedily is that the customers are at risk. If they are let loose, given ``retail access'' and told to choose, without the production markets being truly competitive, or even tolerably competitive, they are at great risk of being ripped off. This may be
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why state regulators have intuitively built in so many protections for small consumers, which they would not need if the production markets were competitive. Competition at the production level is what protects consumers. But the states cannot create competitive markets by themselves. Natural market areas are bigger than single states. The answer lies with broader regional solutions and clear cohesive national policies. he changes since 1992 have forever changed FERC's role. All independent generating plants are in FERC jurisdiction, and some companies have rearranged their structure to place the generation under FERC jurisdiction. States that deregulate find that in doing so they cede much of their jurisdiction to the federal authorities since under deregulation, all sales from generating plant and all transmission pricing fall to federal jurisdiction. FERC also has to determine whether the new trading arrangements are efficient, and whether the markets are competitive before approving the resulting wholesale prices as ``just and reasonable.'' The result has been, paradoxically, that the federal regulators, with a limited legislative mandate, have had more and more responsibility thrust upon them. FERC now has much more responsibility for the industry than it ever had, but however much authority it has acquired, it still does not have the role of national leader in these matters. It has enunciated a vision of com-
petition, but it has no authority to implement it. Key parts of the private industry are under divided jurisdiction; key players like the large federal generating organizations are outside FERC's control. FERC may need more staff (staff has been reduced from 1,500 to 1,200) and it may need different skills, particularly more engineers and economists, than it
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the ef®ciency of the current industry even if nothing further were ever done about introducing competition. For the metering and tariff design issues, there is further precedent in federal legislation from 1978, the Public Utilities Regulatory Policies Act (PURPA), which mandated the states to take certain actions, based on a national need to conserve energy. n addition, we believe the legislation should give the federal regulator jurisdiction over the entire supply side, and not just the ad hoc portion that has fallen there haphazardly. This would allow the federal regulator to order generating companies to dispatch their plants into a regional system. It would consolidate jurisdiction over the changes that are necessary to get to competition, while leaving the decision about retail access for small customers in the hands of the states. These are fairly radical solutions, but it is hard to see how to get out of the impasse without it. The U.S. needs to complete the tasks it has started. It has permitted open access; it has encouraged independent generators. But it has not completed the essential underpinnings for competitive generating markets, which the states cannot do alone. Ideally the U.S. should take three bold steps. 1. It should adopt a coherent national model of what it is trying to do. It needs an overall framework, a national model of
currently has. Clearly it needs more sophisticated experienced players than it now has. What should be done? There is a strong ease for federal legislation to give the federal regulator (or some successor body9) authority to get ahead with metering, trading arrangements, and the transmission business model (the ®rst three of our ®ve essential items on the checklist). These items are valuable for their own sake if only because they would resolve the current confused situation. These changes would make it feasible to get to competition. They are needed to underpin competition in market areas that are wider than the single state. They would improve
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The Electricity Journal
trading arrangements, and a full checklist of requirements for competition. 2. It should accept the need for, and legislate to require, restructuring of privately owned companies, and for including the government-owned entities in the national plan. 3. It should revise the line between federal and state jurisdiction so that coherent regional decisions can be made and wholesale trading arrangements established, permitting generation to be deregulated at the wholesale level with some confidence that it would be robust.& Endnotes: 1. This is in contrast to telephone, where competition in long-distance provision did involve competing
methods of transmission (such as microwave transmission and fiber-optic cables) owned by different providers. 2. Paul Joskow, Deregulation and Regulatory Reform in the U.S. Electric Power Sector, MIT Department of Economics, Working Paper, Feb. 17, 2000. 3. The United Kingdom (actually England and WalesÐScotland and Northern Ireland work under different systems) was an early adopter of competition and has a decade of experience with it. It has made mistakes, but the overall result has been positive. 4. Retail access is a term used more in the U.S. than anywhere else. It is a holdover from the terminology used in the disputes of the 1980s over whether municipal utilities and cooperatives should be given access to the transmission wires to purchase competitivelyÐthis was called ``wholesale access'' to distinguish it from permitting final customers to choose their suppliers, which was called ``retail access.''
5. In the best case, nothing happens at all. The United Kingdom had a law on the books permitting competitive entry and requiring open access from 1984 onwards; but since it did not provide the ``trading arrangements'' for access to the transmission that we mention above, there were no takers at all until the industry was totally restructured in 1990. 6. The New England states, through NEPOOL and its offspring, and the Pennsylvania±New Jersey±Maryland Interconnection (PJM). 7. The extent of FERC's actual authority in these matters is still being tested in the courts. 8. Paul Joskow, Deregulation and Regulatory Reform in the U.S. Electric Power Sector, MIT Department of Economics, Working Paper, Feb. 17, 2000. 9. Robert Marritz, an Attorney and founding Editor of The Electricity Journal, has suggested to me that there is room in the Constitution for federal± state compacts.
Ideally, the U.S. should adopt a coherent national model of what it is trying to do.
June 2002
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June 2002
The State of U.S. Electricity Restructuring Ten years after federal legislation began the electricity restructuring process in 1992, the United States is stuck in the middle, with some states regulated and some deregulated. In an excerpt from her new book, Making Competition Work in Electricity, the author argues that there is still no clear policy at the national level for where we are trying to get to, and no roadmap for getting there. Sally Hunt
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he restructuring of the electric industry in the United States has had a short but bumpy history. The 1992 legislation required open access to the transmission network for some transactions, and removed some roadblocks to independent generators. Since 1994, the states have been deregulating one by one. Most state plans were stalled by the debacle in California, which cost the citizens of that state, as taxpayers and as customers, billions of dollars out of pocket, 40 percent rate increases, and the first set of rolling blackouts in the
memory of most citizens of the U.S. Deregulation is widely viewed as a failed experiment, competition as a rip-off. Countries as far away as China and as close as Mexico put their plans on hold because of the risks exposed by California. This does not have to be the case. The industry is technically complex and also institutionally complicated, but there is by now, after a decade of international experience, a ``standard prescription'' to deal with the complexities: a checklist of what is required for this industry to
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become competitive. The technical complexity can be solved: The institutional issues are at the root of the problem in the U.S. he basic problem is the split of regulation between the federal government and the states. It is a thoroughly interstate industry, but no one has overall authority to decide what needs to be done. This has resulted in a plethora of incompatible initiatives. What is required is to develop the conceptual framework, make a plan, and to implement the institutional changes necessary to make it happen.
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system operators coordinated the generating plants, telling them when to run and when to back off so as not to overload the transmission network. The customers received a bill that had all these functions ``bundled'' into a single tariffÐthe vertically integrated company was the retailer as well as the producer. The vertically integrated companies had monopolies in their own areas, and because of this prices
The basic problem is the split of regulation between the federal government and the states.
I. The Functions of the Industry Electric systems around the world are physically and operationally very similar. The physical functions of the industry are generation (production), system operations, transmission, and distribution. The merchant functions are wholesaling and retailing. Transmission and distribution are transport functionsÐthe transmission wires are networked and serve large areas; the distribution wires are local. The typical organization of the industry prior to deregulation was vertically integrated companies, incorporating all these functions. These companies built their own generating plants and coordinated the planning of generation with the planning of transmission. In real time their 12
were regulatedÐin the U.S. mostly by regulators at the state level, in other countries by the government. The integrated companies built to serve their own customers, and had to build enough to serve them all, at all times. ompetition in the electric industry generally means competition only in the production (generation) of electricity and in the commercial functions of wholesaling and retailing. These are the functions that would be deregulatedÐtheir prices would be set in competitive markets and not by regulators. The transportation functions
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(transmission and distribution) cannot be competitiveÐthey are natural monopolies. It doesn't make economic (or environmental or esthetic) sense to build multiple sets of competing transmission systems; everyone has to use the same wires.1 They have to serve everyone, and they have to be regulated. System operations also has to be a monopoly, since the system operator has to control all the plants in a control area, or the system will not function. The worry is that in restructuring, the competitive parts need to be separated from the regulated parts, and the coordination that was working well in the integrated companies under regulation may be lost. Institutions have to be designed to replace the previous internal coordination without losing its important efficiencies. This has been done successfully in parts of America, and also abroad, but it is still the major challenge.
II. The Case for Competition The need in the U.S. is to refocus on introducing competition into the production markets, because this is where most of the longterm bene®ts of restructuring will accrue. Competition in the retail markets will not produce low prices if the production markets are not competitive. It was in the production end that the problems of the old U.S. system were mainly observed2Ða highly The Electricity Journal
politicized process of investment, inef®ciencies in choice of technology, construction, and maintenance, and dif®culties in regulation and pricing, that led to a desire to reorganize the industry. Since these are the places that competition can help, introducing competition in production makes sense for the U.S. ompetition is the basis upon which the U.S. economy was built. It is not an end in itself. It is generally supposed to bring a whole bundle of good things that we as a society valueÐefficiency and technical progress among them. In general, a monopoly held in check by regulation is considered a poor substitute for a competitive market and is only to be adopted where, for reasons of natural monopoly or some overriding public interest, competition is not feasible or performs poorly without government controls. We now know from experience elsewhere and in parts of the U.S. that competition in electricity production is feasible. We know that many of the reasons the industry was organized as regulated monopolies for so long no longer apply. So competition is the standard to beat. Competition is what bene®ts consumers. And in the ®nal analysis, bene®ting consumers should be what public policy is all about. Consumers want, and should expect to have: low prices (although they know they have to pay enough to keep suppliers in business);
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reliable service; fairly predictable bills; and the opportunity to benefit from value-added services that may come available. So far, except in the notorious case of California, competition has managed to provide these things where it has been introduced in electric industries around the world. Many other countries, and some jurisdictions in the U.S., have successfully
We now know from experience in the U.S. and elsewhere that competition in electricity production is feasible. introduced competition in production and open access to transmission. There is by now a decade of international experience good and not so good, but not one of the countries that introduced competition has gone back to the old monopoly ways. This, in its own way, is a ringing testimonial to the bene®ts of competition.3 However, there are certain technical details that have to be attended to for competition to be able to produce these results. There are cogent reasons why electricity was a monopoly for so longÐelectricity is indeed different from other commodities.
It cannot be stored; it is transported at the speed of light, following laws of physics unique to this commodity, over a fragile and interactive transmission network. The instant you ¯ip the switch, something happens at a generating plant somewhere, and the electricity gets to you in a millisecond. The network requires the constant vigilant control of a system operator. The penalty for inattention is to black out a whole area, as has happened twice on the East Coast of the U.S. But the technical complexity exists everywhere there is electricity. We know what to do, and we know what we don't know. We also know that restructuring this industry is harder than most people think. The airline, gas, banking, and telecommunications industries have been made competitive, with considerable success. They were a piece of cake in comparison to electricity. One thing has been made clear from experience both at home and abroad: you cannot simply cease to regulate the industry and walk away from it, expecting a competitive market rush in and work its magic. The introduction of competition poses some really dif®cult problems, and rational solutions depend upon understanding these complexities and designing ways to account for them. The institutional changes must, in the end, permit competitive markets in electricity to meet the ordinary requirements of commerce. Many buyers and many
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sellers must be able to access each other easily; they must be able to make contracts in advance and at spot prices; and they must be able to transport the electricity with a high degree of certainty as to the price and availability of the transmission network. fficiency is the goal, competition is the means. Open access, restructuring, and deregulation are terms sometimes used to describe the reforms, but they are the tools to achieve it. We now turn to what these terms mean.
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A. Open access Competition in production requires open access to the transmission and distribution wires so that any competing producer can use them. Transmission is an essential facilityÐeveryone has to use it. Open access means that everyone gets the same deal, with no discrimination in the opportunity to use the wires or in the cost to use them. But making this happen requires major institutional changes. First, real-time coordination of generation with transmission is a necessity. In the old vertically integrated industry, they were coordinated internally by the companies. In the competitive industry new trading arrangements have to be set up to ensure realtime coordination in a disaggregated world, because if coordination fails, we will all be literally in the dark. When potential competitors (the old monopolies who owned both transmission 14
and production facilities) own the transmission wires, it is important to ensure that the real-time coordination is not discriminatory, favoring the sale of power by the transmission owner at the expense of sales by other competitors. This has been accomplished in most of the world by complete separation of system operations into a separate independent organization, and by trading arrangements that do not give
If transmission expansion is in the hands of competing generators there are issues of discrimination; in too many hands, issues of coordination
issues of coordination. These are the main areas where even internationally there is no standard institutional design. Retail access,4 or more accurately ``customer choice,'' refers to the opportunity for individual consumers to choose from among competitive electricity suppliers. Traditionally, customers have been able to purchase electricity from just one supplier; i.e., their local, vertically integrated monopoly. Under deregulation they are given the opportunity to choose their supplier, and ``retail access'' refers to the ability of suppliers to reach customers over local distribution wires. This (unlike transmission) is not a technically complex matter, but can run into many political complications, such as how much protection to afford the smaller consumers. B. Restructuring
priority to the transmission owner. n addition to short-term coordination, open access requires arrangements for longterm control of the transmissionÐ the transmission business model. Before deregulation, the utilities built for themselves, and never had to set prices for use. Who will plan and build for competition? What are the right prices? What rights do those who built the transmission for their own use retain in the new world? If transmission expansion is in the hands of competing generators, there are issues of discrimination; if it is in too many hands, there are
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Restructuring is about changing existing companiesÐseparating some functions and combining others, and sometimes creating new companies. The aim is to prevent discriminatory behavior, or to create more competitors, or to consolidate transmission over a wide region. The theory is fairly simple. Some functions must be separated; some should be kept together, while for some there is room for signi®cant policy choices. There are various degrees of and approaches to separation. There may also be questions of regional consolidation, both separating and combining companies as part of a restructuring. The Electricity Journal
The offset to dividing up the functions is the loss of the economies inherent in the traditional monopoly structure, and the cost of all the lawyers needed to set up new companies. estructuring is time-consuming, even when the government owns the company and the legislature wants competition. Dividing physical and financial assets between new companies is often the major element on the critical path for restructuring, even when everything else is agreed. (The normal time is about two years.) But the decisions about restructuring are complicated in the extreme where, as in the U.S., many companies are privately owned, and a significant portion of the industry is in the ownership of thousands of different government bodies, from the federal government to municipalities. It is not exactly clear who has or should have the authority to order necessary restructuring. The U.S. telephone monopoly was restructured as the result of a massive antitrust case, but we are not talking antitrust cases here. What has been done so far in the U.S. is that state regulators have offered carrots and brandished sticks to encourage voluntary restructuring, and some state legislatures have acted, although so far without their actions being tested in the courts.
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C. Deregulation Deregulation means ceasing to regulate. Regulation is about June 2002
controlling prices of monopoly suppliers and restricting entry to the markets, so the standard de®nition of deregulation is to remove controls on prices and entry of competing suppliers. This would be simply disastrous for consumers in the electric industry if it were done without necessary safeguards or supportive market conditions. Just declaring the industry deregulated and providing open access
Just declaring the industry deregulated and providing open access to the transmission system cannot produce competitive markets. to the transmission system cannot produce competitive markets in electricity.5 The existing suppliers are local monopolies with 100 percent of a local area both at the production and at the retail level. It would hardly be surprising if they were dominant suppliers after such a ``deregulation.'' So something else has to happen for deregulation to produce competition. In fact, for competition to work in the electric industry, there is a long list of conditions that ought to be in place before deregulating. Summarizing, the ®ve major changes required include the following:
1. Demand side: Hourly metering for most of the consumption, and tariff designs that expose customers to the spot price for some of their consumption. 2. Trading arrangements: System operations separate from traders and regionally consolidated. Trading arrangements based on an integrated model, with central dispatch and locational energy prices. 3. Transmission business model: Control of transmission separate from traders; pricing and expansion arrangements. Our preference is for regional profit-making regulated transcos incorporating the system operator. 4. Supply side: Remove barriers to entry. Buy out of the old regime by valuing assets. Expand market areas by improving transmission. If necessary for control of market power, divest utility generation into smaller parcels. 5. Retail access: When production markets are working, choice for all customers. This needs an extensive settlement mechanism and customer education, and decisions about default provision. This is a standard prescription, and it is never quite like this. As any doctor can tell you, the standard prescription may not apply if there are complicating factors. All those years in medical school teach you to understand not only the straightforward case and the best treatment, but also the underlying anatomy and physiology so that you can treat the
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complications that arise in real cases. ach country has its own preexisting conditions or political necessities, and most of them have to muddle through in some way or another. It is certainly much easier to start from a situation where the government owns the industry and also has the legal power to change things, generally in the run-up to privatization. This at least assures a fairly consistent plan, and a unitary design that can hold up under stress. All plans involve winners and losers, and when the government can accept being the short-term loser, because it has the longer view of the benefits of change, everyone else can be kept happy. In the long run, as Keynes did not say, we are all dead except the government.
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III. The United States The United States is enormousÐit contains one-quarter of all the electric capacity in the world. One of its strengths is that for two centuries it has managed to walk the line between the bene®ts of national standardization and state and local autonomy. The electric industry began locally, and federal legislation from the 1930s actually kept it fragmented. But today it is so fragmented thatÐeven leaving aside competitionÐef®ciency is suffering. Two hundred or more private companies submit to divided and sometimes contra16
dictory regulatory jurisdiction. Each of the 50 states has its own plan to deregulate, or not. The public sector includes 3,000 or so entities that operate, uncoordinated, at federal, state, and municipal level. These government entities are not subject to most of the state or federal regulation applied to the private entities. Transmission is owned
by over 200 public and private entities. There are 140 or so local system operators. ll these complications bring their own problems for implementation of reforms. Private ownership complicates restructuring of companies; fragmented operational control inhibits efficient trading arrangements; fragmented transmission ownership permits states or companies to hold up expansions that would benefit neighboring states or competing generators. Public ownership can stand in the way of regional consolidation of the network. There has never been a national policy or regional framework other than a vague desire on the
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part of Congress and the federal regulators to see the industry competitive. There are no regional bodies to coordinate over wide areas. It is hardly surprising then that reforms have so far been con®ned to the big states and states with preexisting regional agreements. California, New York, and Texas were big enough to go it alone, and Texas has the distinct advantage of unitary regulation. Texas is not electrically interconnected with the rest of the U.S. and therefore is not regulated by the Federal Energy Regulatory Commission (FERC). In two other cases in the Northeast,6 preexisting interstate agreements (the ``tight pools'') have been the springboard for coordinated actions by states. These states can be considered to have created the basis for more or less competitive markets, but these are the lowhanging fruit, and even these would not meet our checklist in all respects. In the rest of the country, natural market areas clearly cover more than one state, but there are no national or regional plan. If there were, there would be no authority to impose them. The rest of the country is at an impasse; markets are bigger than a single state and states cannot go it alone. Any further developments are stymied, and probably would be even without the well-publicized problems in California. The central problem for the rest of the country is that jurisdiction over the industry is divided The Electricity Journal
between federal and state governments in a way that was established in 1935, when the industry was mainly a local industry. Now the transmission networks have expanded and interconnected so much that electricity is clearly in interstate commerce, but the 1935 jurisdictional split remains. Referring to our ®ve big issues on the checklist: The first (metering and tariff design) and the last (retail access) are in the jurisdiction of the individual states. The second and third (the trading arrangements and the transmission business model) are mostly in federal jurisdiction, but FERC has7 insufficient authority to require the changes it says it wants. The metering necessary to get competitive wholesale markets working well is in the hands of the states. The supply side is divided. Only the states can deregulate; no one can expand transmission over wide areas to create larger and more competitive markets. No one can require divestiture if it is needed to control market power. The states control siting of generation and transmission. The centerpiece of competitionÐensuring competitive production marketsÐis in no one's jurisdiction. The states alone can deregulate production and free customers to choose; but they cannot put all the underpinnings in place to make sure the markets are competitive. They cannot control market June 2002
power over wide areas. They cannot require other states to install metering; they cannot implement trading arrangements or require consolidation of transmission. The situation in the U.S. is a complicated muddle. Implementation has got far ahead of policy. Professor Paul Joskow of the Massachusetts Institute of
Technology, a long-time and respected observer of the industry, puts it this way:8 I do not believe that . . . the elec± tric power sector can exist and prosper with a checkerboard of competitive and non-competitive states taking power from the same transmission networks, or even with a large number of competitive states which have adopted a wide array of different rules and institutions for wholesale and retail competition.
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t is a fair question, and often asked: Why bother when it is so complicated? What was wrong with the old system? Under regulation, the U.S. electric industry had a good history, by interna-
tional standards of the time, of innovation, low prices, and reliable service. The vertically integrated monopolies had reasonably good arrangements for short-term coordination of system operations with production; and good arrangements for expanding transmission, that took into account the trade-offs between transmission and generation. But while it might be instructive to consider the problems of regulation and how competition will ameliorate them, that is no longer the issue. We cannot ignore the fact that some changes are already well underway. Open access was ordered in 1992, but a decade later the trading arrangements have not been resolved; regional organizations have not been put in place; metering and rate design have not been attended to; transmission investment has mostly ground to a halt; detection and mitigation of market power is rudimentary. We do not have the option of going back a decadeÐ the appropriate comparison is what is happening now, which in many cases is not as good as it was pre-1992. We have taken the regulated industry apart and have put nothing comprehensive in its place. The reason to resolve this impasse speedily is that the customers are at risk. If they are let loose, given ``retail access'' and told to choose, without the production markets being truly competitive, or even tolerably competitive, they are at great risk of being ripped off. This may be
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why state regulators have intuitively built in so many protections for small consumers, which they would not need if the production markets were competitive. Competition at the production level is what protects consumers. But the states cannot create competitive markets by themselves. Natural market areas are bigger than single states. The answer lies with broader regional solutions and clear cohesive national policies. he changes since 1992 have forever changed FERC's role. All independent generating plants are in FERC jurisdiction, and some companies have rearranged their structure to place the generation under FERC jurisdiction. States that deregulate find that in doing so they cede much of their jurisdiction to the federal authorities since under deregulation, all sales from generating plant and all transmission pricing fall to federal jurisdiction. FERC also has to determine whether the new trading arrangements are efficient, and whether the markets are competitive before approving the resulting wholesale prices as ``just and reasonable.'' The result has been, paradoxically, that the federal regulators, with a limited legislative mandate, have had more and more responsibility thrust upon them. FERC now has much more responsibility for the industry than it ever had, but however much authority it has acquired, it still does not have the role of national leader in these matters. It has enunciated a vision of com-
petition, but it has no authority to implement it. Key parts of the private industry are under divided jurisdiction; key players like the large federal generating organizations are outside FERC's control. FERC may need more staff (staff has been reduced from 1,500 to 1,200) and it may need different skills, particularly more engineers and economists, than it
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the ef®ciency of the current industry even if nothing further were ever done about introducing competition. For the metering and tariff design issues, there is further precedent in federal legislation from 1978, the Public Utilities Regulatory Policies Act (PURPA), which mandated the states to take certain actions, based on a national need to conserve energy. n addition, we believe the legislation should give the federal regulator jurisdiction over the entire supply side, and not just the ad hoc portion that has fallen there haphazardly. This would allow the federal regulator to order generating companies to dispatch their plants into a regional system. It would consolidate jurisdiction over the changes that are necessary to get to competition, while leaving the decision about retail access for small customers in the hands of the states. These are fairly radical solutions, but it is hard to see how to get out of the impasse without it. The U.S. needs to complete the tasks it has started. It has permitted open access; it has encouraged independent generators. But it has not completed the essential underpinnings for competitive generating markets, which the states cannot do alone. Ideally the U.S. should take three bold steps. 1. It should adopt a coherent national model of what it is trying to do. It needs an overall framework, a national model of
currently has. Clearly it needs more sophisticated experienced players than it now has. What should be done? There is a strong ease for federal legislation to give the federal regulator (or some successor body9) authority to get ahead with metering, trading arrangements, and the transmission business model (the ®rst three of our ®ve essential items on the checklist). These items are valuable for their own sake if only because they would resolve the current confused situation. These changes would make it feasible to get to competition. They are needed to underpin competition in market areas that are wider than the single state. They would improve
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The Electricity Journal
trading arrangements, and a full checklist of requirements for competition. 2. It should accept the need for, and legislate to require, restructuring of privately owned companies, and for including the government-owned entities in the national plan. 3. It should revise the line between federal and state jurisdiction so that coherent regional decisions can be made and wholesale trading arrangements established, permitting generation to be deregulated at the wholesale level with some confidence that it would be robust.& Endnotes: 1. This is in contrast to telephone, where competition in long-distance provision did involve competing
methods of transmission (such as microwave transmission and fiber-optic cables) owned by different providers. 2. Paul Joskow, Deregulation and Regulatory Reform in the U.S. Electric Power Sector, MIT Department of Economics, Working Paper, Feb. 17, 2000. 3. The United Kingdom (actually England and WalesÐScotland and Northern Ireland work under different systems) was an early adopter of competition and has a decade of experience with it. It has made mistakes, but the overall result has been positive. 4. Retail access is a term used more in the U.S. than anywhere else. It is a holdover from the terminology used in the disputes of the 1980s over whether municipal utilities and cooperatives should be given access to the transmission wires to purchase competitivelyÐthis was called ``wholesale access'' to distinguish it from permitting final customers to choose their suppliers, which was called ``retail access.''
5. In the best case, nothing happens at all. The United Kingdom had a law on the books permitting competitive entry and requiring open access from 1984 onwards; but since it did not provide the ``trading arrangements'' for access to the transmission that we mention above, there were no takers at all until the industry was totally restructured in 1990. 6. The New England states, through NEPOOL and its offspring, and the Pennsylvania±New Jersey±Maryland Interconnection (PJM). 7. The extent of FERC's actual authority in these matters is still being tested in the courts. 8. Paul Joskow, Deregulation and Regulatory Reform in the U.S. Electric Power Sector, MIT Department of Economics, Working Paper, Feb. 17, 2000. 9. Robert Marritz, an Attorney and founding Editor of The Electricity Journal, has suggested to me that there is room in the Constitution for federal± state compacts.
Ideally, the U.S. should adopt a coherent national model of what it is trying to do.
June 2002
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