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The Fallacy of High Prices

We are better off under restructured electric markets.

Fortnightly Magazine - November 2006

Since the Federal Energy Regulatory Commission (FERC) first issued Order 888 1 more than a decade ago, the restructuring of electricity markets, both at the wholesale and retail level, has provided significant benefits to electricity customers. Unfortunately, rising retail electricity rates, resulting from sharp increases in fuel prices and, in restructured states, the end of years of artificially capped rates, have caused consternation among consumers, which in turn has raised the ire of politicians, some of whom are demanding a return to traditional models of rate-of-return regulation.

Yet, despite the headlines, our research—and that of several others—has shown that wholesale competition has been successful, especially in markets in the eastern United States, and will foster lower, more stable electric prices over the long term than a retreat to traditional rate regulation.

How can this assertion be reconciled with recent rapid increases in electricity prices, particularly in areas of the country where restructuring has been implemented? The answer is that consumers, politicians, and even some regulators have focused far too much on the shorter-term independent system operator (ISO) market-clearing prices and not enough on portfolio-derived prices and long-term trends. Just as one day’s change in the stock market should not be the basis of a comprehensive investment strategy, short-term price increases brought about by unprecedented increases in the prices of fossil fuels, as well as the removal of price caps that kept retail electric rates at unsustainably and artificially low levels for years, do not negate the real benefits that wholesale competition has provided.

Analyzing the benefits of competitive electricity markets is a challenging exercise, not because the benefits are small but because the restructuring process in this industry has been so complex, and because rate caps and changing fuel prices obscure the effects of increased competition. Restructuring efforts undertaken in different states and regions were disjointed, applied to different ratepayers at different times, and were fraught with negotiating and horse-trading over rate discounts, stranded cost recovery, transition periods and so forth. Rate caps and discounts kept retail prices low for varying periods of time, while wholesale prices followed volatile fuel prices. In some states, rate caps ended just as fuel prices were rising to unprecedented levels.

Considering the recent sharp increases in retail electric rates, it is little wonder that many individuals have questioned the benefits of competition. To the average ratepayer in states that undertook restructuring, and to many a policymaker in those states who has failed to appreciate the meaning of a rate freeze, it must indeed seem that competition has been the cause of recent rate increases. As discussed further below, such a simplistic assessment of

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