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Should the Federal Government Sell Electricity? November 1997

Policymakers considering the future of federal power assets must examine the costs as well as the benefits of federal ownership. An important component of cost is how efficiently the government generates and markets power. Could the private sector supply power more efficiently? An affirmative answer has two implications, both favorable. First, a transfer to the private sector would improve the overall performance of the economy. Second, the greater the potential gain in efficiency from a transfer to the private sector, the greater would be the price that private interests would be willing to pay for the facilities and the more likely that such a sale would generate long-term budgetary savings for the government.

In principle, government could operate as efficiently as the private sector. The power agencies are already supposed to operate in a businesslike manner, and new management reforms, such as creating "performance-based organizations," will help to move further in that direction. But government probably does not operate the commercial aspects of the production and marketing of power as efficiently as the private sector--perhaps, as economists believe, because private and government managers face different objectives and incentives. Although evidence to support that theory is difficult to come by, there is some indication that federal power operations might run better by transferring ownership to the private sector.

Market protection and lack of competition can allow inefficient management to survive in either the public or the private sector. But electricity markets are becoming more competitive, largely because of regulatory reform. That competition is already prompting managers of some federal power programs to look for cost savings and change the ways in which they set rates. Any failure to keep pace with growing competition may necessitate increasing taxpayers' support for federal power.
 

Does Federal Management Impede Efficient Operations?

The organization and financing of federal power operations can make it hard for government managers to function efficiently, even when they are motivated to do so. The first of three impediments to efficient operations involves the division of responsibilities among agencies and the Congress and the role that the budget and appropriation process plays in that division. The second stems from the availability of low-cost federal financing, unrestrained by independent assessments of economic merit. And the third is the lack of independent oversight of pricing and investment decisions by the power marketing administrations and the Tennessee Valley Authority. The division of responsibilities diminishes the government's incentives to minimize costs; the other impediments remove potential checks on poor decisionmaking.

Divided Responsibilities and the Budget Process

Efficient, businesslike management requires good flows of information, proper incentives, and accountability. Responsibilities within the government are divided among groups with varying interests, however, and information does not flow smoothly. Such conditions can lead to inefficiency--and probably do.

The problems arising from divided responsibilities are probably most acute for the power marketing administrations. Those problems stem from two sources: interagency coordination and the flow of money (and the information it conveys). First, the need to coordinate efforts is essential because one agency (the PMA) sells the power and another (the Bureau of Reclamation or the Army Corps of Engineers) produces it. Although the agencies try to coordinate their efforts, they also have interests and agendas that may conflict. Sales and production are also often handled by different departments or divisions in the private sector, and coordination can be a problem. But the profit motive helps keep private managers focused on the principal objective. Under government ownership, the PMAs lack that incentive.

The second source of management problems is the flow of money. In the private sector, prices and receipts carry much useful information that aids management decisions: Should output be raised or lowered? Should prices change? Should new capacity be built or maintenance increased? In private business, money talks. In the public sector, however, information provided by the flow of money is muted. In general, receipts from power sales go directly to the Treasury, not to the operating agencies. Thus, a drop in current or expected receipts, for example, would not signal the need for those agencies to scale back on spending; nor would an increase provide the direct wherewithal to raise spending. Instead, expenditures by the Bureau of Reclamation and the Army Corps of Engineers on the power-generating facilities depend on appropriations. When the Administration requests appropriations and the Congress grants them, the power receipts certainly influence the amount of money that goes to each agency and activity. But appropriations are often constrained by the need to keep federal spending down, and they compete with other spending needs within each appropriation bill or agency.

Even if managers of power agencies had the proper incentives to increase production, the process of budgeting and setting appropriations would make it difficult to plan such an increase in a least-cost manner. In deciding how to raise production, the federal manager is not free to make a least-cost choice between additional expenditures on operation and maintenance and additional expenditures on capital equipment. New, highly visible construction projects are often easier to fund than is additional maintenance for existing projects. And once the agencies obligate appropriated funds for multiyear capital projects, spending commonly continues until completion, even if the economic prospects for the project change. Funds for operation and maintenance are obligated for shorter periods, often less than a year, and are more exposed to changes in the budget priorities of parent agencies and the Congress.

The TVA avoids some of those problems because it combines under one management the functions of generating and marketing power. Furthermore, under the Tennessee Valley Authority Act Amendments of 1959, the TVA has direct control over its expenditures and rate setting and has the authority to reinvest excess earnings in its power program. Its decisionmaking, however, shares other problems with the PMAs.

Easing Financial Restraints on Decisionmaking

In the private sector, businesses face limits on their ability to make and repeat unprofitable operating and investment decisions. If they do not operate at the lowest cost possible, a competitor with a higher profit margin can expand production and take away customers. If businesses try to borrow money to finance capital projects, repay outstanding debt, or cover operating losses, financial markets insist on security for the loan--often in the form of evidence of future earnings or other marketable assets. Generally, businesses require new investments to demonstrate an earnings potential that is at least as high as the cost of borrowing or the return they could earn from spending those funds elsewhere.

The federal power agencies are not subject to those constraints. The agencies may benefit from subsidies for construction costs--that is, from allocating less than the correct share of the total costs of certain multipurpose projects to power users. They may also benefit from the ability to exclude certain capital expenses (such as work in progress) or operating expenses (such as benefits for PMA employees) from their rates.⁽¹⁾

Furthermore, financing requirements do not impose the same discipline on federal spending that they do on private businesses. Federal agencies' cost of external borrowing is generally below the cost of money to private borrowers, and for the agencies with some discretion over their spending, the cost of internal funds is effectively zero. As a result, some otherwise unprofitable ventures appear economic, and the government (and society) spends some funds on power that it could better use to address other problems.

Congressional appropriations are the main source of financing for the power marketing administrations, Reclamation, and the Corps. In general, the Congress establishes the interest charge, if any, that the PMAs should recover in repaying appropriations for power-related construction. Those mandated charges are commonly far below market rates. The Bonneville Power Administration has access to additional funds from the Federal Financing Bank at the government's low cost of borrowing for financing investments in transmission facilities and certain environmental programs. The Tennessee Valley Authority is also repaying some debt to the bank and a small amount of appropriated indebtedness, but the public bonds that the agency issues are its main external source of financing. The TVA is able to borrow from the public at low rates, too, reflecting the implicit backing of the federal government rather than the viability of the project.⁽²⁾ (The federal government protects the TVA from outside competition, allows the agency to set its own power rates and secure them by requiring that customers provide 10 years' advance notice before leaving the TVA system, and assures private lenders that they will be repaid first.)

Subsidies for financing stem from several sources. They are the result not only of low rates of interest but of generous repayment schedules (based on estimated service lives of up to 90 years), the ability to defer scheduled payments, and the practice of allowing power agencies to repay their highest-cost loans first (regardless of maturity).

Some agencies have access to internal funds--the revenues they earn by generating and distributing power--which they may spend without the need for Congressional appropriations. The possibility that the agencies may earn a greater return from spending that money on nonpower programs, however, does not restrict their investments in power, since they cannot spend those internal funds elsewhere. The TVA, for example, must pump all its revenues back into the power program or use them to repay debt. The same is true for BPA spending on its transmission program. The remaining PMAs have relatively little spending discretion; except for revolving funds on some projects, all power revenues go to the Treasury.

All of the power agencies, however, have demonstrated some ability to avoid the limits that Congressional appropriations or borrowing limits would otherwise impose. For example, by means of such accounting devices as net billing and net power exchanges, an agency can enter into a long-term arrangement with a nonfederal entity that will supply power or build, maintain, or operate facilities to supply power for federal sale. The agency can "pay" for those services by purchasing the nonfederal power or by selling federal power at a discount to the nonfederal entity.

The cost to the federal government of that type of third-party financing is the difference between what the agency gets and what it gives up. The BPA originally obligated the federal government to finance investments by the Washington Public Power Supply System by guaranteeing to purchase its power. The Alaska Power Administration pays a private utility to operate its Snettisham project with discounted power. The Congress authorized the Western Area Power Administration to obtain customer financing for upgrades at the Hoover Dam, and that agency is now investigating similar arrangements to pay for upgrades at other sites. And the TVA recently contracted to purchase power on a long-term basis from a newly constructed brown-coal plant in Mississippi.

No Independent Oversight of Federal Power Rates

For electric utilities, federal and state regulations and oversight by public utility commissions (including the Federal Energy Regulatory Commission) have long taken the place of the discipline of the market. And in recent years, competition in wholesale markets has begun to provide a check on the unprofitable activities of those utilities. By contrast, the federal power agencies have not been subject to the regulatory oversight imposed on public and private electric utilities and remain largely isolated from the rigor of market pricing and financing.

On paper, the FERC is responsible for approving electricity rates that are set by the power marketing administrations. In practice, the PMAs set their own rates for long-term contracts, subject only to review by the FERC for final rates or by the Department of Energy for interim rates. (Long-term contracts establish rates for more than one year.) That review is limited to assuring that PMA rates reflect reported costs. The FERC and the Department of Energy do not have authority to challenge the basic cost estimates underlying the PMAs' rate calculations. Moreover, the PMAs are completely free to set rates for short-term contracts (generally for sales of interruptible power to nonpreferred customers), subject only to political and competitive pressures and the requirement that changes in revenues from nonpreferred customers be reflected in the rates for preferred customers, which the FERC does review. No federal or state agency has even token oversight for any TVA rates.

The lack of substantive oversight was by design. The Congress did not want to invest the FERC with that task because of the agency's separate responsibility for approving rates for privately owned utilities operating in interstate commerce.⁽³⁾ To some Members, a regulatory responsibility that would include public and private suppliers who were potential competitors represented an opportunity for conflict of interest. If the FERC set public power rates too high, that would benefit private companies, and vice versa.

Today, such concern about capricious pricing rules at the FERC is unwarranted. The rules directing the composition of interstate wholesale rates are well established in federal regulations. Arbitrary pricing policies are more of a problem for the federal power agencies than for private utilities. One of the arguments made in favor of a federal power program in the 1930s was the need to have public prices as a yardstick against which to measure the reasonableness of private power rates. In the 1990s, that argument has turned around: private rates now serve as a yardstick to gauge federal performance and help guide the federal program regarding trends in demand.

As competition in wholesale power markets grows, the protections enjoyed by federal producers will diminish. Competition will impose increasingly stringent constraints on federal pricing and investment decisions, which will heighten the need for changes in federal management.
 

Inadequate Maintenance and Its Effect on Capacity Utilization

The inadequate maintenance of power assets and the resulting low use of power-generating capacity show how high the costs of supplying federal power are. The government could reduce its production costs by performing more maintenance, perhaps by diverting some funds from new construction.

The federal government spends significantly less than investor-owned utilities and other publicly owned power systems on maintaining its generating and transmission facilities. Over the past 10 years, the ratio of expenditures for maintenance to total revenues from power sales for investor-owned utilities averaged nearly two-thirds higher than that for federal utilities--7.2 percent versus 4.5 percent (see Figure 4). The average ratio over that period for publicly owned utilities was 6.8 percent. That difference is not accounted for by the large number of hydropower facilities in the federal program; even the TVA, which generates more than 80 percent of its power from coal, nuclear energy, and natural gas, spends only about 5 percent of its revenues on maintenance. Indeed, the disparity in maintenance costs per unit of power generated by federal and other utilities is even greater than those ratios suggest, because federal agencies--other than the TVA--generally sell electricity at a lower rate.
 

Figure 4. Ratio of Maintenance Expenditures to Power Revenues for Federal, Publicly Owned, and Investor-Owned Utilities, Calendar Years 1986-1995

SOURCE: Congressional Budget Office using data from the 1986-1995 issues of Energy Information Administration, Financial Statistics of Major U.S. Publicly Owned Electric Utilities, DOE/EIA-0437/2, and Financial Statistics of Major U.S. Investor-Owned Electric Utilities, DOE/EIA-0437/1.

One consequence of inadequate spending on maintenance is an inability to generate and transmit power at design capacity. Data from the past five years showing differences between the power output per unit of generating capacity for federal and nonfederal hydropower show the potential for raising federal output (see Table 6). Over that period, nonfederal dams produced an average of 20 percent more electricity per unit of capacity than did dams supplying the power marketing administrations. That particular measure of efficiency suggests that in 1995, when rainfall and reservoir levels were at or near normal in most parts of the country, PMA hydropower sales could have been more than 30 percent higher if federal dams had operated at the same utilization rates as nonfederal dams. (More precise estimates of the generating potential would require additional information about differences in water flows for individual federal and nonfederal dams. Those differences stem from the availability of local water and the constraints of nonpower activities on operators.)
 

The experience of the Bureau of Reclamation adds evidence of the potential economic gains from greater spending at existing generating facilities. As long ago as 1977, the General Accounting Office recommended that Reclamation upgrade the generating capacity of existing power plants.⁽⁴⁾ Power output can be raised by increasing the capability of penstocks (gates for regulating water flows), turbines (for using water flows to turn generators), generators, transformers, and transmission systems. For example, the amount of electricity from many old generators could be increased by rewinding their armature wirings. (Much of the additional capability would supply only peak demand because year-round water flows still affect output.)

Reclamation did not begin to pursue those recommendations until 1990. By 1995, it had raised, or was in the process of raising, the generating capacity of 55 power-generating units at 14 different power plants.⁽⁵⁾ Before the work began, those units accounted for 773 megawatts of manufacturer's specified capacity, or about 6 percent of the total capacity of the 190 generating units at Reclamation's 52 power plants.

The capacity from those upgrades cost much less than the capacity that newly constructed units could have provided. In 1991, Reclamation estimated that the total contract cost for the upgrades it performed between 1978 and 1995 was $154 million--about $9 million a year. For the projects it had completed by 1991, that small effort yielded an additional 1,137 megawatts of peak capacity (roughly the size of a large nuclear power plant) at a cost of only $49 per kilowatt (or, accounting for inflation since that time, about $55 per kilowatt today). That figure compares very favorably with cost estimates for the other sources of additional capacity. In 1995, several gas-turbine plants came into service at an average cost of $333 per kilowatt, one small hydroproject cost $761 per kilowatt, and a large coal plant cost $1,366 per kilowatt.⁽⁶⁾
 

New Competition Is a Mixed Blessing for Federal Power Agencies

Federal power agencies are facing more competition in wholesale markets. Competition generally benefits consumers, bringing lower rates and better service. But for federal power agencies, greater competition may mean lost customers and lower revenues. Exposing the federal power agencies to that kind of competition makes the cost of inefficient production clear and raises the cost of continuing government ownership. Sustaining the status quo would probably require increased support from taxpayers. That support would come only at a high political cost, particularly in today's tight budgetary situation.

Even so, increased competition can have a positive effect--namely, that the incentives of federal managers and policymakers to improve efficiency are made much stronger. Competition leaves less latitude for inefficient operations in the public (or the private) sector. Accordingly, the federal agencies involved, as well as the Congress, see more clearly the need for improvements.

The potential for new competition that federal suppliers could face is already strong in some markets. For example, the rates that the Tennessee Valley Authority charges its preferred customers (publicly owned utilities and cooperatives) are higher than the amount that investor-owned utilities nationwide charge that same class of distributors (4.2 cents and 3.8 cents per kilowatt-hour, respectively). The fact that all federal sales to preferred customers take place at the average rate also opens opportunities for private utilities and independent suppliers to underprice federal agencies, especially for interruptible and off-peak power. The Bonneville Power Administration has already encountered such competition from nonutilities in the Northwest. In response, it has proposed lowering rates (or guaranteeing long-term rates). The BPA is also working to contain its costs for power it purchases, for the subsidies it provides to some investor-owned utilities, and for the environmental programs it supports, in order to avoid losing customers.⁽⁷⁾

1. General Accounting Office, Power Marketing Administrations--Cost Recovery, Financing, and Comparison to Nonfederal Utilities, GAO/AIMD-96-145 (September 1996).

2. See, for example, Standard & Poor's, "Tennessee Valley Authority Bonds Rated AAA," Creditweek Municipal, May 22, 1995.

3. Bonneville Power Administration, Columbia River Power for the People: A History of Policies of the Bonneville Power Administration, DOE-BP-7 (Portland, Ore.: no date).

4. General Accounting Office, Power Production at Federal Dams Could Be Increased by Modernizing Turbines and Generators, PB 269 2254 (March 16, 1977).

5. Bureau of Reclamation, Hydropower 2002: Reclamation's Energy Initiative, Technical Document (November 1991).

6. Energy Information Administration, Financial Statistics of Major U.S. Investor-Owned Electric Utilities, 1995, DOE/EIA-0437(95)/1 (December 1996), Table 4.

7. See the 1995 annual report of the Bonneville Power Administration. Also see the Comprehensive Review of the Northwest Energy System: Final Report (1997), a report prepared by a working group appointed by the governors of four northwestern states, available at http://www.newsdata.com/enernet/review/document/bull27doc1.html.

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