[BETA] Fortnightly

The case against re-regulating the electric industry.

The California debacle has sent ripples across the country throughout the electric industry , building a wave of enthusiasm for re-regulation, and at just the time that policymakers have forgotten why they wanted to deregulate in the first place.

California itself is revamping its restructuring plan in fundamental ways without any clear vision of where it wishes to go. Elsewhere, it is doubtful that many other states that adopted restructuring plans will proceed in the way they would have if California had not imploded first. The policymakers likely will follow one of two paths: (A) Go ahead with restructuring, but with some safeguards to prevent the kinds of problems that have plagued California, or (B) Retreat to re-regulation of some kind.

As a short-term solution, re-regulation appears quite attractive. But that strategy overlooks the long-term failures of regulation.

We Could Return to the Status Quo

I admit that traditional, cost-based utility regulation appears to offer at least some obvious short-run advantages, given the current climate in California.

In theory, setting rates according to cost yields the same short-term static market equilibrium as under competition—but only if we can assume that all buyers and sellers are price takers, and only if the costs are no different under regulation as with competition. Regulation incorporates all bona fide costs in rates, but excludes increments related to market power. Market power would be neutralized, and the incentive to game the system would be minimal, since regulators would have the power to punish transgressions. Moreover, there would be less price volatility than under competition, since prices are set by administrative process and remain fixed for extended periods of time.

Also, a return to cost-of-service regulation clearly would enable regulators to stop any undesirable exercise of market power, as long as the basic fabric of the industry has not been impaired as it has been in California. Rates would be cost-based, not capped. Producers would recover all of their costs, plus a return on investment. This phase could be temporary. The state could reintroduce restructuring once conditions were deemed appropriate. And the simple, constant threat of re-regulation certainly would exert the salutatory effect of limiting the extent to which generators would use market power under restructuring.

The Federal Energy Regulatory Commission (FERC) could have contained the California problem by re-imposing cost-of-service rates at any point until late January. It would have been an easy and effective solution last summer. Incidentally, the need to build power plants cannot be used as a reason for not re-imposing cost-of-service rates, since building new plants could be made attractive by authorizing transmission and distribution (T&D) utilities to enter into life-of-the-plant purchase power agreements with new combined-cycle gas turbines (CCGTs) that covered fuel costs, plus a return. The question is whether a temporary return to traditional regulation would be temporary.

And Repeat Our Mistakes

All the same, the appeal of re-regulation ignores the inherent long-term shortcomings of traditional regulation that originally led to restructuring.

In the short-run, regulation provides price stability and prevents prices from becoming