[BETA] Fortnightly

My subject today is regulation and competition in the electric utility industry.

You all know only too well what's happened to this industry in the last decade or so: Inflation accelerated, interest rates rose, productivity growth slowed, fuel prices rose dramatically, growth in demand stopped, and the cost of meeting environmental and safety regulations soared. For utilities that was truly a devil's brew. Unless conditions change and change soon, our financial infirmities will destroy our ability to provide reliable electric service.

But nowadays new building programs are carried out reluctantly, in defiance of economics and common sense. No unregulated business would invest in a project that will earn less than it costs, or punish stockholders by issuing stock at a fraction of book value. Electric utilities are doing so only in deference to their legal and moral obligation to serve.

Some observers believe that the underlying causes are transitory or correctable within the existing regulatory system. But I remain skeptical. The deficiencies of regulation go beyond its current effect on industry finances.

The Case for Change

Under regulation, the industry does not operate with optimal efficiency. Apart from integrated holding companies and the most highly integrated power pools, the industry is not using existing generating capacity to produce electricity at the lowest possible cost. This situation is conspicuous among independent companies outside power pools. Even in pools, the goal of completely economic dispatch is often frustrated by transmission bottlenecks and other constraints. Operating practices that are best for the pool as a whole may not be best for individual companies.

And new capacity has not been built where and by whom it can be built most efficiently. It has often been built by each utility for its own needs within that utility's service area. Thus, the real cost of electricity is higher than it needs to be.

One response by utilities is to diversify into unregulated businesses. But some regulators simply took the profits of nonregulated subsidiaries into account in setting electric rates. Thus, the benefits of diversification got expropriated to further subsidize rates. Diversification may be the answer for a few companies, but it can't solve the problem of the whole industry.

Instead, I think the answer lies with competition. Electric power generation is no longer a natural monopoly. Let's open electricity generation to competition (em with free entry, no franchises, and no obligation to serve. Here's a scenario for competition in electric power generation that I believe would be practical:

s Generating companies, consisting of new entrants as well as companies formed from existing utilities, would be linked to regulated distribution companies through regional energy brokers.

s Generating companies would be free to charge whatever they can get in the competitive market.

s The brokers would own the transmission systems. They would make long- and short-term markets in energy and power (em not only within but among the regions.

A Competitive Scenario

A competitive model will work as well for electricity generation as it does for other unregulated industries with large capital requirements and long lead times. The oft-repeated claims