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A Low-Voltage Energy Bill

While a few provisions are worth embracing, most of its 1,724 pages represent a waste of good timber.

Fortnightly Magazine - October 2005

fact, SMD is dead, but Congress allowed FERC to save face with the understanding that the commission got the message.

The repeal of the Public Utility Holding Company Act (PUHCA) eliminates the disincentive to be a vertically integrated utility by ending the special accounting and merger treatment of such companies. But repeal should not be viewed as pro-business and anti-consumer. PUHCA made investment in utilities subject to more scrutiny (and thus, subjected investors to higher costs) than investment in other sectors of the economy. Because investors have choices about where to invest, the result was that returns in utilities had to be higher than they otherwise would have been to compensate investors for the greater scrutiny and cost. Thus the repeal of PUHCA, which will eliminate the barriers in the capital markets between the electric utility and all other sectors, reduces costs and risks, and lowers the cost of capital for the utility sector. The upshot is that the capital market for traditional utilities will become more competitive.

How should we feel about this contradictory grab bag of policy changes? In this journal (February 2004) and in a later Cato Policy Analysis 2 we outlined our views on restructuring. Briefly, we argued that the current ownership and regulatory structure of the transmission system creates problems that are analogous to the balkanized ownership patterns of some oil reservoirs and that one could draw on the theory and history of unitization contracts in crude oil markets to provide insights for electricity transmission. 3

In the electricity context, the use of the unitization contract analogy leads us to ask the following questions:

  • 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 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?
  • If they are high, is coercion by FERC likely to achieve the same outcome?

The most pertinent question is the first. Are the unexploited gains to trade large enough to allow payoffs to all existing players in electricity transmission and still leave a surplus? The Energy Policy Act of 2005 hopes to secure gains to trade through the encouragement of new transmission investment and the adaptation of real-time pricing.

New transmission investment enhances efficiency only if it connects underused generation capacity that has lower marginal costs than the plants available under existing transmission constraints. And capacity with such characteristics is likely to be available only at existing coal plants. Once that underused capacity is gone and the marginal sources of electricity-both local and long-distance-are natural gas, gains from trade exist only if the transmission costs are less than then higher fixed costs (land and labor) of locating generation near urban consumers. To the extent that current price differences across states represent weighted-average rather than marginal-cost differences, improved transmission connections represent wealth transfers between states rather than efficiency