[BETA] Fortnightly

In talking to electric utility managers from across the country we have found that most believe direct access will have major repercussions on all aspects of their business by the end of the decade. Not surprisingly, there is an emerging consensus that revenues will drop rapidly as supply options grow for retail customers. Several key factors (among many others) will help determine how much equity owners will lose: 1) the magnitude of the decline in retail prices, 2) how quickly customers will gain access to new suppliers, and 3) the proportion of an electric utility's retail customer base that will participate in direct access.

The Gathering Storm

One of the assumptions many electric utility managers are making is that the move to retail wheeling will be driven by regulators. History has shown, however, that regulatory change is itself driven by market forces and technological advances. Having saved millions through the direct purchase of natural gas, large industrial customers are the strongest advocates for a rapid transition to retail wheeling. They are using their political clout to force new legislation that will allow direct access, ostensibly to promote competitiveness, job retention, and regional economic development. These market forces will only intensify as new technology arises to boost transmission line capacity and cut line losses. The resulting decline in transmission costs will increase the number of suppliers who can profitably serve another utility's customers.

We expect the industry to adopt a structure of bilateral contracts between end users and power marketers/brokers, energy service companies, independent power producers (IPPs), or third-party utilities. While interim solutions (em such as Southern California Edison's proposal for the central, independent dispatch of regional transmission and generation resources (PoolCo) (em will likely be tried in many states or regions, they will only defer the transition to full direct-access markets. The need for a physical operator of the grid will remain, but there will be no need for a central market operator.

With the advent of retail wheeling, prices can be expected to drop significantly for a number of reasons. In fact, utilities may actually choose to sell below cost.

Airlines, for example, frequently sell some seats at prices well below their full cost because they are trying to maximize the contribution margin (em the amount by which marginal revenues exceed marginal costs. Because this incremental revenue helps cover the firm's overhead, earnings for the firm are higher than if such prices are not offered to price-sensitive travelers. In fully competitive electric utility markets, this logic will lead suppliers to offer power to a competitor's customers at progressively lower prices. In the United Kingdom and Norway, the new equilibrium prices are not much higher than the average cost of fuel plus nonfuel O&M costs. We can expect similar market clearing prices in the United States.

The Prisoner's Dilemma

Does a price war make sense for an electric utility? If one utility starts a price war, should others follow along?

The decision to price aggressively to compete for the customers of a neighboring utility can also be a dominant strategy. A "dominant