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Perspective

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

The most commonly discussed possibility is aggressive regulation by FERC through regional transmission organizations and standard market designs to eliminate the discrepancy between the commons nature of the transmission system and the current fragmented system that governs it.

The problem with this solution is that it employs lots of lawyers to create a half market that leaves retail, state-level regulation intact. It also confuses rather than clarifies incentives in the governance of transmission by separating ownership from control. 6

This problem manifests itself most clearly when it come to the subject of transmission investment. Given the inability of investors to capture the full benefits of their investment, won't investment in transmission capacity always prove sub-optimal?

Nobel laureate economist Vernon Smith believes the problem is surmountable. 7 He argues that new transmission is a "club good" that facilitates the ability of generators to get their product to market. Consortia of generators could fund new investment and, in turn, get rights to inject or take power from the system in proportion to their financial contributions. If existing generators lose money because the new transmission investment alters their ability to sell power, so be it.

MIT economist Paul Joskow, however, is skeptical:

"Transmission investment decisions do not immediately strike me as being ideally suited to relying entirely on the invisible hand. Transmission investments are lumpy, characterized by economies of scale and can have physical impacts throughout the network. The combination of imperfectly defined property rights, economies of scale and long-lived sunk costs for transmission investments, and imperfect competition in the supply of generating services can lead to either under- or over-investment at particular points on the network if we rely entirely on market forces." 8

A second possibility is drawn from petroleum economics: a unitization contract. Petroleum producers, after all, faced a problem analogous to the commons nature of the AC transmission system because surface property rights often did not coincide with the geological characteristics of petroleum reservoirs. This created incentives to drill and pump fast before other surface owners did the same, because no one represents the interests of the entire petroleum-rich geologic formation.

A unitization contract is a set of payoffs to all existing surface owners that induces them to give up their production autonomy. It is a genuine improvement if operation of the reservoir by one operator produces so much more revenue in present value that it compensates all existing owners to give up their rights and still leaves a surplus. 9

Many tough questions, however, remain. Is there a set of payoffs to all existing players in electricity transmission (including state regulatory regimes and incumbent utilities) that would induce them to go away and turn over operation of their systems to a welfare-maximizing operator in return for a contractually determined share of the increased profits? What plan would the welfare-optimizing operator implement? Is the plan achievable through private action, or are transaction costs prohibitively high? And, if they are high, is coercion by FERC likely to achieve the same outcome?

First, how large are the unexploited efficiency gains in the existing