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Stranded Utilities: How Demographics, Not Management, Caused High Costs and Rates

Fortnightly Magazine - June 1 1997

will prevail on an equity-based argument, wholly uncompromised by contrary opinion.

Economic Efficiency:

Long and Short Term

Implicit in the antitrust argument against stranded cost recovery through, say, a power distribution charge, is the hypothesis that such a tying arrangement reduces economic efficiency. Critics argue that such a charge restricts the sales of the incumbent utility's competitors in the market for the "tied product" (em in this case, electric power before transmission. %n4%n The resulting allocation of sales between the incumbent and its competitors is held to reduce social welfare. This issue often arises in evaluating alternative pricing schemes proposed in the context of deregulation.

Nevertheless, if the distribution charge that recovers stranded costs is the same for all generators, it should not affect electricity prices at the generation level in the short run. Similarly, it should not affect the market shares of the incumbent or its competitors. Assuming open access to markets for bulk power, the price of that power will equal its marginal cost, whereas stranded costs remain preponderantly fixed. %n5%n

In a dynamic or long-term sense, however, recovery of stranded investment may indeed influence bulk power prices and market shares. However, its effect would differ from that predicted by the static analysis that antitrust arguments against recovery entail. Specifically, such recovery might serve to maintain needed generation capacity that would otherwise be lost, thus lowering electricity prices.

To see how this follows, first recognize two of the central assumptions underlying the static analysis of competition:

1 The products of rivals in each market are completely homogeneous; that is, all consumers view them as perfect substitutes for each other; and

2 All social costs of a product or service are reflected in the private costs that those supplying it must incur, and that all social benefits are reflected in the revenues they receive. %n6%n

In electric power, both of the above assumptions are violated. Moreover, the second part of assumption No. 2 is violated to a degree that may greatly exceed the norm. For while electricity itself is homogeneous, the terms and conditions under which it is delivered, including reliability, are vitally important to customers. These terms and conditions vary significantly, rendering electric service a differentiated product. Meaningful distinctions prevail among the following categories of service, at least: (a) power sold by reliable suppliers, on either an interruptible and noninterruptible basis; or (b) power sold by unreliable suppliers. Moreover, as

regulation is lifted, service differentiation can be expected to grow.

Similarly, regarding the second assumption and its applicability (or inapplicability) to regulated industries, Alfred Kahn has noted that: "[T]here exists a wide range of situations in these industries in which the total benefits that society derives, or thinks it derives, from the continued provision of their service exceeds what can be collected from their several customers at prices equated to marginal cost." %n7%n Such situations may be broadly characterized as instances of (competitive) "market failure."

One kind of market failure discussed by Kahn arises from what he terms "the tyranny of small decisions," under which a service is eliminated contrary