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Two Cato analysts suggest a return to the past-vertical integration, but now with no state regulators.
Fortnightly Magazine - February 2004

induce increased demand that must be met by state regulatory systems. The cost of that extra supply is paid for through excessive off-peak prices to cover the capital costs of generators that are underutilized at all times except peak.

In a free market, peak users would pay much higher costs. But, in turn, they would reduce peak demand and the variance between peak and off-peak use would be lower, resulting in less total capital investment and fuller utilization of the capital stock invested in generation. The owners of inframarginal assets, like old hotels on the ocean in July, would receive rents only during peak demand periods, and those rents would pay for the capital costs. In off-peak periods, generators, like hotels on the ocean in December, would price very close to marginal cost. 4

Efficiency Gains

In regulated markets, economists usually can easily demonstrate that little or no efficiency rationale ever existed for regulation, and that efficiency gains suppressed by regulation would occur if deregulation occurred. But electricity regulation is more complicated. The old regime described above would appear to benefit consumers whose use is much more on peak than the average user (to the detriment, of course, of those consumers whose use is more off-peak than the average user, and to the overall efficiency of the system).

And unlike most other markets, electricity markets have characteristics that are difficult to manage through property rights and contracts. Regulation therefore has at least the possibility of a plausible rationale. For example, the alternating current (AC) grid is a commons. That is, the physical reality of the grid does not coincide with current private property rights or the 50-state regulatory schemes that govern the grid. Because power added by any generator on an AC transmission system follows all paths, favoring those with least resistance rather than the shortest distance between generator and customer, bilateral contracts between any willing seller and buyer of electricity affect all other buyers and sellers within each interconnected system in ways that are not captured by prices. The proper way to manage those externalities is the subject of great dispute.

Also, transmission additions confer benefits across all generators and consumers on the grid and thus have public-good characteristics. 5 But developing property rights and prices that internalize those characteristics is difficult.

Traditionally, the commons problem was addressed through monopoly-franchise vertical integration. Trade between vertically integrated utilities was never very large and was governed by barter arrangements rather than markets. And where trade was extensive, voluntary arrangements such as the PJM arose to manage the flows across separately owned transmission systems through contract. Thus, historically, the commons characteristics of the grid did not create large externality issues.

But since the Energy Policy Act of 1992 and FERC orders 888 and 889-which facilitated the development of widespread trading on the grid, particularly by non-vertically integrated merchant generators-the mismatch between the physical reality of the grid and its current governance structure have become an important problem.

Solving the Public-Good Problem

What are the possible solutions to the public-good nature of the transmission system?