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Energy Retailing: Setting a Standard Offer for Every Season

Sending Price Signals, Without Illegal Tying
Fortnightly Magazine - August 2000

always wanted from deregulation: the reliability of adequate capacity, lower prices, and greater innovation. Even utility shareholders are better off, as their companies are removed from the untenable situation of buying high, selling low, and bearing risk.

Sending Price Signals, Without Illegal Tying

Regulators across the United States are deregulating electricity and gas markets based on two premises that guide market economies: First, individual customer choice is preferred to government selection of providers of products and services, and, second, competitive markets achieve more efficient outcomes, typically seen as lower costs and greater innovations. As recognized in U.S. anti-trust law and regulation by the Federal Trade Commission, the critical element in allowing competitive markets to work is to ensure that pricing is both transparent and free of cross-subsidization by monopoly products or services ( "illegal tying"). 1

Transparency enables consumers to select lower-cost goods and services that are provided more efficiently. Prohibiting cross-subsidization of competitive services by monopoly services enables consumers to choose freely. The combination provides proper price signals to consumers, because such prices constantly encourage consumers to make the right (more efficient) choices. Failure to provide proper price signals means encouraging consumers to make the wrong choices.

In all deregulating states so far, rates charged by regulated utilities are a major part of the deregulation equation. These regulated utilities are allowed or required to continue selling electricity or gas, at least during a lengthy transition period. Because the regulated utility starts out with 100 percent of the customers, its price becomes the target against which consumers judge all competitive offers. Energy pricing is complex and unfamiliar to consumers (with customer charges, per kilowatt-hour or British thermal unit rates, and so on), so it is simplest for competitive entrants to express prices in comparison--typically a percentage discount--to the regulated utility's price.

Because the regulated utilities retain a monopoly on distribution service, policymakers must exercise special care in setting energy prices for them. That is because regulated utilities have a natural financial incentive to include all possible costs in monopoly distribution rates. Customers are forced to pay those rates, so regulated utilities are guaranteed to receive those revenues. In addition, some utilities believe there may be greater assurance of stranded-cost recovery if the customer remains with the regulated utility, even though regulations typically are designed to guarantee such recovery independent of whether the customer selects a competitive supplier.

Where there are elements of both competitive and monopoly markets, price-setting becomes more complicated. In the competitive world, federal anti-trust laws exist that, for example, prohibit one company from charging below-cost prices to force a competitor out of business, then raise prices dramatically once the company dominates the market (becoming an actual or monopoly). The same danger exists for regulated utilities selling energy, except that it is exacerbated by the utility's ability to collect its below-cost amounts through monopoly distribution rates. 2 Moreover, since regulators approve the regulated utility's energy price, competitive providers have no access to the protection of the laws normally preventing such anti-competitive behavior.

Including Overhead, Flux Lends Transparency

The fundamental principle