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.
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