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Electric Restructuring: An Urgent Proposal

Fortnightly Magazine - November 1 1995

a market that permits both spot transactions and contracts of varying lengths.

The principal advantage of allowing spot and long-term markets to develop without government sponsorship is that the mechanism that emerges should closely reflect the needs of participants. The main disadvantage is that the spot market is not likely to be robust initially. Some participants would probably exert market power. Hence, regulation must again step in until competition becomes strong enough to police itself.

On the other hand, a pool can create spot transactions immediately. But pools take time to set up, which delays the start of restructuring. A pool may also lack a geographical base broad enough to furnish sufficient players to make competition effective. In fact, there are enough problems associated with establishing a pool to argue against rushing into it.

The Wires. Transmission and distribution (T&D) should remain regulated as a natural monopoly. This sector provides the infrastructure for the electric services market. It holds the market together and defines the physical limits of a power market. Since all market participants must use T&D, everyone must have access on nondiscriminatory terms, which means T&D must function as a common carrier.

Market-based pricing must replace cost-of-service pricing in T&D. Services must be unbundled as far as possible. Market-driven pricing is needed to create incentive for utilities to remove transmission capacity constraints when they emerge. Otherwise, constraints could handcuff competition. Unbundling is necessary to provide as much flexibility as possible for the development of new electric services. The ability of power marketers to offer a wide range of services depends on a broad choice of inputs.

Price caps should mark the first step toward market-driven pricing for T&D services. The U.K. experience in regulating distribution companies has demonstrated the advantages of price caps. Under the U.K. system, price reviews occur every five years, when the price-cap formula for distribution services is set for the next five years. The price ceiling for the first year is changed in each of the following four years by a percentage equal to the retail price index less an "X" factor. Allowing utilities to retain whatever they earn during the five-year price review period gives them a strong incentive to innovate and cut costs, especially in the early years of a review period.

Market pricing for T&D helps erase distortions that arise under rate-of-return regulation. Under the current system, regulators take great pains to prevent electric rates from rising too high (em i.e., producing revenues that might exceed the allowed return by 1 or 2 percent (em while turning a blind eye to rate differentials of 40 to 50 percent between contiguous areas of like economic character. What is lost is a concern for efficiency. Price caps would redirect attention to productivity.

The services tied to T&D are to some extent a matter of discretion. It is logical to include ancillary services, billing, and metering with T&D, but it is also desirable to allow power marketers and other third parties to provide them. While these services should be unbundled for pricing purposes, utilities should be