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Take No Prisoneers? A Price-War Strategy for Electric Utilities

Fortnightly Magazine - July 1 1995

strategy" is one that gives an individual (or organization) more of an advantage than any other strategy, regardless of the strategy employed by an opponent.1 An aggressive marketing posture outperforms a passive approach for competing utilities. But this approach produces the worst set of outcomes for the industry as a whole. This situation is known as the prisoner's dilemma (em a situation all too familiar to airline industry executives.

Resolving the prisoners' dilemma requires cooperation among the participants. While collusion is illegal, there are strategies that will effect similar outcomes. The "tit-for-tat" strategy was found superior to all others in a study conducted by University of Michigan political scientist Robert Axelrod.2

An electric utility's response to another's initiatives may also rely on brinkmanship. Brinkmanship involves deliberately increasing the level of risk, initiating actions intended to take you and your opponent to the brink of catastrophe. For example, President Kennedy's blockade during the Cuban missile crisis raised the level of uncertainty, making the possibility of nuclear war more credible. Utility managers using a brinkmanship strategy will try to make the costs associated with a price war more salient to their competitors before it is too late.

Relevant Examples

However, the dynamics of power markets are not entirely captured by the prisoners' dilemma. IPPs represent a wild card in that they may have no existing customers to lose. Keep in mind, also, that collusion has always ultimately given way to market forces. In the power industry, the first utilities to break ranks will be the least profitable firms. Price competition in the cigarette industry, for example, began when the least profitable firms introduced generic cigarettes. (Actions that may at first seem rash are often dominant strategies for firms with one foot in the grave.) Supplier rivalry will, in turn, exacerbate market price instability initiated by buyers. Mergers will be pursued both during and after this shake-out period to reestablish shareholder earnings.

Another major factor will be the proportion of customers given the opportunity to participate in retail wheeling. The California Public Utility Commission (CPUC) has proposed retail wheeling through a six-year phase-in period beginning with the largest customers; residential customers would be able to choose their energy suppliers by 2002. [Editor's Note: On

May 24 the CPUC issued Decision 95-05-045, proposing two new alternative restructuring plans for electric utilities.] What regulators will allow, however, is not the only determinant of which customer classes will be affected by retail wheeling. Equally important is the potential savings small users will be able to realize in direct-access markets. For example, if the cost of billing a residential customer, tracking the customer's purchases and consumption, and so on is greater than the savings a new supplier or broker can deliver, residential retail wheeling will not develop, regardless of what regulation will allow. Consortia of small users may develop, however, to achieve the scale economies necessary to make serving these markets profitable.

Two aspects of the move toward retail wheeling will hold true irrespective of the future structure of the industry. The first (em the critical importance of controlling