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October 13, 2008
Series Editor: Ian Parry
Managing Editor: Felicia Day
Assistant Editors: John Anderson and Adrienne Foerster

Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.

The electricity sector in the United States is a critical piece of the American economy, upon which our society depends heavily. Over the past 10 to 15 years, electricity markets have been opened, restructured, and competition introduced. This week, RFF Senior Fellow Tim Brennan provides a thoughtful discussion of the U.S. electric power industry, and how the changes have affected prices, consumers, and reliability.

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Assessing Electricity Markets: Prospects and Pitfalls

Timothy Brennan

electric lines   The electricity sector garners considerable attention and deservedly so. On size alone, it represented about 2.4 percent of gross domestic product in 2005—more than we spend on motor vehicles or gasoline. Large as it is, the sheer size of the sector belies its significance to our society and economy, which literally cannot operate without it. Perhaps the most reported aspect of natural disasters such as the recent hurricanes Gustav and Ike, following casualty figures, is the extent and persistence of power outages. It is therefore crucial to study and assess the effects of policies that, over the last 10 years, have introduced competition into the previously regulated electricity sector.

Prior to the mid-1990s, the sector was dominated by regulated private utilities that generated, transported, and sold their own electricity. Following the wave of largely successful moves from regulation to competition in other sectors such as telecommunications and transportation—finance is looking a little shaky these days—electricity markets were opened. The federal government began by setting rules for allowing independent generators access to still-regulated transmission networks. A number of states followed by opening retail markets under their control, giving consumers choice over competing retail providers, although generally leaving the traditional utilities in place.

Has opening markets led to better (not necessarily lower) prices? 

Whether opening electricity markets has helped or hurt consumers is a matter of considerable controversy. From the public’s perspective, the case for competition has taken three significant hits:  the California market meltdown in 2000–01, the Northeast Blackout in August 2003, and the rapid rise in electricity rates in many states. Maryland, for example, saw increases in excess of 70 percent in 2006–07. Partly for these reasons, much of the country retains traditional regulation of monopoly utilities. Only Texas, Illinois, Michigan, and most of the mid-Atlantic and northeastern United States (except Vermont) currently have open electricity markets, and many states, including California and Virginia, have suspended their deregulatory policies.

The public controversy is matched by disagreement among researchers as to the effects of opening electricity markets. Contrary to what competition advocates might expect, a number of studies have found higher prices in areas of the country where electricity markets were opened. Such studies, however, face considerable difficulties. Among these are that the states and regions opting to open markets are likely to be those where prices would have been above average in the first place, creating a spurious correlation between competition and high prices.

Moreover, higher electricity prices under open markets aren’t necessarily bad. Because electricity cannot be stored, it has to be produced exactly when needed to avoid blackouts. Consequently, generation capacity has to be in place, to be used only for those few summer hours when demand peaks to run all of our air conditioners. To cover the cost of that capacity, prices in these critical few hours have to be very high, up to 50 times the price at more normal “baseload” times.

 

Tim Brennan is a Senior Fellow at RFF and a professor of public policy and economics at the University of Maryland, Baltimore County. His research interests include antitrust and regulation, particularly in electricity, telecommunications, and intellectual property. This commentary is based on a recent talk given at a Technology Policy Institute Conference on “Powering the Future: Key Energy Issues for the Next Administration.”

These higher prices need not reflect dysfunctional markets or monopoly power, anymore than do high summer rates for beachfront hotels. Rather, they can provide suppliers and users with the right signals, so we might turn down our air conditioners and defer optional uses when electricity becomes extraordinarily expensive to generate. A virtue of competition is not that it makes prices lower, but that it ties prices to the costs of producing the electricity needed to meet demand, whether those costs are high or low. But because every supplier gets to charge the high price, this economic virtue comes at a political cost, as electricity bills and generator profits rise. Voters may not have the patience to wait for new generators to come online and drive overall rates and profits back down to competitive levels.

Do consumers want more choices?

Consumers may be upset about losing their regulatory insulation from facing high prices, but they may also simply not find competition worth the trouble. In most jurisdictions where residential users have been given the opportunity to choose new electricity suppliers, few have done so. A recent Maryland Public Service Commission (MDPSC) study reported that entrants supplied only about two percent of residential electricity use in that state.

Although residual rate regulation may have something to do with this, consumers simply may not want to be bothered. A measure of the hassle is the “helpful” assistance many states provided, which effectively told consumers that determining whether they would save money by switching suppliers was about as simple and pleasant as filling out a tax return. It is hardly surprising that most consumers would rather stick their old utility rather than go to the trouble of switching to save a few dollars a month. That said, the rate of switching by commercial and industrial users is far higher—almost 70 percent of their load, according to that MDPSC report. On that score, the “electricity competition” glass is considerably more than half full.

Has competition threatened reliability?

The biggest impediment to opening electricity markets, however, has long been the potential conflict between the independence necessary to realize the fruits of competition and the cooperation potentially needed to maintain reliability. Because electrons take all available paths to get from where electricity is generated to where it is used, the grid operates as a single entity even if different utilities own different lines. If one supplier fails to meet its customers’ needs, not only will those customers lose power—the entire grid may go down.

The grid’s vulnerability implies the need for some degree of central control—but how much?  Ensuring reliability may need only relatively minimal rules, such as reserve requirements, enabling transmission and distribution system operators to obtain energy to get over unexpected emergencies. The challenge to competition is whether control needs to go deeper.

Fostering competition would require undoing the traditional integrated utility structure. Both local distribution lines and regional transmission systems are monopolies. Regulation is unlikely to replace competition of those “wires” in the foreseeable future. If companies owning generation control these lines, they may be able subvert competition by denying reasonable access to rivals. This concern has motivated regulators to limit such control by requiring separate, independent operation of transmission lines—why opening electricity markets is called “restructuring.”  On the other hand, needing to coordinate large-scale transmission and generation investments may undercut the entrepreneurial initiative that drives the benefits of competition.

The fundamental question in assessing electricity markets is if they are consistent with keeping the grid efficient, growing, and reliable. The fact that today’s controversies about the merits of electricity markets focuses on prices, and not on repeats of the California meltdown or the Northeast outage of five years ago, suggests that the worst fears regarding reliability have not come to pass—so far. Whether we have been skillful or lucky remains to be seen.

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Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.


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Additional Resources:

 Brennan, Timothy, “Alleged Transmission Inadequacy: Is Restructuring the Cure or the Cause?” Electricity Journal, 19(4) (May 2006): 42-51

Brennan, Timothy, “Preventing Monopoly or Discouraging Competition? The Perils of Price-Cost Tests for Market Power in Electricity,” in Kleit, Andrew N. (ed.), Electric Choices: Deregulation and the Future of Electric Power (Lanham, MD: Rowman and Littlefield, 2006): 163-79.

Brennan, Timothy, “Consumer Preference Not to Choose: Methodological and Policy Implications,” Energy Policy, 35 (2007): 1616-27.

Brennan, Timothy, Generating the Benefits of Competition: Challenges and Opportunities in Opening Electricity Markets, Toronto: C. D. Howe Institute, Commentary 260 (April, 2008).

Brennan, Timothy, Karen Palmer and Salvador Martinez, Alternating Currents: Electricity Markets and Public Policy (Washington: RFF Press, 2002).

Joskow, Paul, “Markets for Power in the United States: An Interim Assessment,” The Energy Journal 27(2006), 1-36.

Taylor, Jerry and Peter Van Doren, “Rethinking Electricity Restructuring,” Policy Analysis no. 530, Cato Institute, (November 30, 2004).

 

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