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Generation, Deregulation, and Market Power: Will Antitrust Laws Fill the Void?

Fortnightly Magazine - October 15 1996

attributable largely to the immense initial capital costs and higher maintenance costs. On a marginal-cost basis, however, nuclear facilities probably meet the initial expectations of producing power "too cheap to meter." Similarly, coal plants tend to be capital intensive, but on a pure Btu (British thermal unit) basis coal enjoys a substantial price advantage over natural gas. By contrast, most new generation facilities are gas-fired, because they entail substantial lower capital costs and higher variable costs. Accordingly, while gas-fired generation calculated on a total-cost basis may be the superior provider of electric power in a market that has reached equilibrium, such facilities may prove early and disproportionate casualties in a marginal-cost price war.

The disparity between capital/operating cost ratios will be exacerbated by excess capacity. In industries with excess capacity, marginal costs fall as production increases. In such situations, each competitor attempts to lower prices and expand output to reach a lower point on its marginal-cost curve. This attempt, in turn, drives the other competitors back up their

marginal-cost curve and increases their losses at the new lower price. Again, notwithstanding their greater efficiency, smaller-scale

combustion-turbine facilities with their high average variable costs would be severely disadvantaged in a race down a marginal-cost curve.

Finally, the electric power market will remain imperfect for the foreseeable future. Under most restructuring proposals, existing utilities will continue to serve their "core" customers essentially on a "franchise" basis. The competitive markets will consist of large industrial customers, aggregated commercial entities, and municipalities. Thus, existing utilities will be presented with a partially competitive market that will remain largely closed to competitive forces. In such circumstances, the rational utility will offer very competitive prices to entities that enjoy price elasticity through the availability of competitive alternatives, while maximizing its return through higher charges to its less price elastic customers. Therefore, the rational utility may occupy a position where it can meet and beat competition for highly elastic customers (large industrial users) by selling power at or slightly above marginal cost, while fully recovering the bulk of its fixed costs through rates to captive residential customers. With a captive customer base, a utility should be able to outlast a NUG in competing for industrial loads at a pure marginal-cost rate, even assuming identical capital/operating cost ratios, since no portion of the NUG's fixed costs can be recovered from captive customers.

These factors may lead some utilities to believe that, while a price war may be painful in the short-run, they may successfully out-compete NUGs by pricing at average variable costs, which are likely to be lower than average variable costs for NUGs. Moreover, even assuming similar marginal costs, incumbents may reason that, with their larger capital bases, they can withstand a war of fixed-cost attrition against NUGs, most of whom are thinly capitalized compared to established utilities. Some utilities may then conclude that once NUGs are driven from the market, remaining utilities will tacitly observe the old rules of the game, in which competition for loads within another's service territory is deemed declassé.

Although price-cutting in response to these