by Tim Considine and Andy Kleit
Pennsylvania State University
January 2002

This study provides a primer on electricity deregulation for state policy makers in the Appalachian Region. Restructuring the electricity sector promises a more competitive industry that over the long run would generate efficiency gains. Producers of electric power would more efficiently utilize primary fuels, labor, and other resources to generate power. Power transportation networks would be better planned and managed so that the grid is supplied with the lowest cost combination of plants. On the demand side, consumers would make more efficient choices because they would be paying the true incremental cost of electric power, which could vary by time of day.

Unlike the deregulation of many other industries in which government involvement was phased out completely, as with price controls on natural gas and oil, deregulation of electricity is more complicated. In many ways, electricity markets are not really deregulated but restructured. The unique aspects of electricity, both real and perceived, are discussed in this report to provide some insight into what electricity restructuring actually means.

The comparative analysis of restructuring efforts in California and Pennsylvania raises a number of broader regulatory policy issues. These issues include monitoring markets for excessive markups over marginal cost, consumer protection and marketing, nuclear power re-licensing and permitting, and some rather thorny issues involving market coordination between generators and transmitters of electric power.

Findings for the Appalachian Region
States within the Appalachian Region have responded in different ways to the possibility of electricity restructuring. In Pennsylvania, Maryland, West Virginia, Ohio, and Virginia, the legislature has passed bills requiring restructuring. (West Virginia's plan is currently on hold.) Pennsylvania's restructuring is complete. In addition, the regulatory commission in New York has approved restructuring, and restructuring in that state is underway.

In contrast, North Carolina, South Carolina, Kentucky, and Mississippi have investigations on restructuring pending, but none has implemented restructuring. No official actions on restructuring are taking place in Tennessee, Georgia, or Alabama.

More than 70 percent of electricity generation capacity in the Appalachian Region is coal-fired steam generators, reflecting the relative abundance of coal in the Appalachian Region. Another 15 percent of capacity is hydroelectric power while nuclear capacity comprises 12 percent of total capacity. The remaining 2 percent of capacity is primarily steam generators using fuel oil and natural gas. This mix of power is likely to create far less volatility in market prices than a sector based largely on natural gas generation, such as in California.

It is important to understand that there is no one method to undergo electricity restructuring. We examine closely the two most prominent examples of electricity restructuring in the United States, in California and Pennsylvania, as well as the experience with restructuring in England and Wales. Each of these systems has their advantages and disadvantages. Recent events in California have shown the disadvantages of the approach chosen there. All four systems have acted to limit opportunities for retail choices.

Findings on Deregulation Policy
A combination of factors contributed to the spike in wholesale electricity prices in California from June 2000 through early 2001. The chief culprits were an unanticipated surge in electricity demand and a lack of low-cost electricity supply. For over a decade, it had been extremely difficult to site new power plants in California. The state had become highly dependent on hydroelectric sources, power from natural gas plants, and imported power. To exacerbate the problem, available supplies from hydroelectric facilities were greatly reduced during this time period. The regulatory system, which froze retail rates, contributed to blackouts and utility company bankruptcies. Much, though not all, of the increase in price can be attributed to the reduced supply of power and the increase in the price of natural gas. The exercise of market power (market power refers to the ability of firms to profitably affect price by restricting supply) is a natural candidate for the remaining part of the price increase. It is important for policy makers in the Appalachian Region to understand, however, that the structure of electricity supply in Appalachia is much different than it is in California.

Many unanswered regulatory questions still remain for restructured markets. The future role of nuclear power is unclear and may depend on how issues of waste disposal and insurance indemnity are dealt with by the Congress. Market power issues remain important, and regulators continue to learn more about the potential for the exercise of market power in electricity markets. The creation of independent system operators, and their continued effective governance, is important in the efficient operation of electricity markets. It is unclear how markets to build new transmission capacity will evolve, and how new transmission lines will gain regulatory approval.

The regulated electricity system has a number of important structural deficits. Most importantly, it provides poor incentives for cost-reduction, as well as acting to reduce choices that are available to consumers. By putting the production and marketing of electricity into a competitive market, restructuring offers the opportunity for substantial gains for society.

Policy Recommendations
This is not to say, however, that electricity restructuring is a panacea. The gains from restructuring will take substantial time to accrue. In this sense, we suspect that its proponents oversold restructuring. We suggest that real price reductions and increases in consumer choice will occur, but that they may not take place immediately upon the beginning of restructuring. Further, any new efforts at restructuring must take into account the results of previous restructuring efforts. In this light, we have several recommendations for any state wishing to restructure its electricity market:

• Restructuring should not place any limits on trading in wholesale markets, as occurred in California.
  
  
• Restructuring plans often call for the use of price caps to deter the exercise of market power in both wholesale and retail markets. Unfortunately, price caps have significant negative consequences, in that they send the wrong price signals to both consumers and producers.
  
  
• An integral part of any restructuring plan is the recovery of utilities' stranded costs. Unfortunately, the method chosen for doing so in California and Pennsylvania had important drawbacks. We suggest that a stranded cost "tax" be attached to every kilowatt-hour of power sold in relevant areas. This would act to encourage innovation in the retail market for power.
  
  
• Part of the rationale for restructuring is to allow new firms into the market for generation of electricity. This requires that environmental and zoning restrictions on generation should allow for the construction of new power plants within a relatively short amount of time.
  
  
• Independent System Operators serve to facilitate trade between parties in wholesale power markets. We, therefore, applaud the Federal Energy Regulatory Commission's (FERC) efforts to create such organizations, though this may prove difficult.
  
  
• Any gains from restructuring can be diminished by the exercise of market power. We therefore suggest that regulators review carefully the ownership structure of generation in the industry prior to the onset of restructuring and require the appropriate divestitures.