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The Fallacy of High Prices

We are better off under restructured electric markets.

Fortnightly Magazine - November 2006

the performance of competitive electricity markets is bound to produce spurious conclusions. Any reasonable analysis must account for both fuel prices and rate caps, and must examine more direct measures of how the electricity industry has been affected by greater competition.

Pay Now or Pay Later

The process of industry restructuring was not a magic wand that, once waived, instantly lowered electricity prices, although that appears to have been the expectation of at least some policymakers prior to the California crisis of 2000-2001. The price reductions that were achieved in some states immediately after restructuring generally were the result of settlement agreements among policymakers, market participants, and other parties; they were not themselves market prices. Indeed, short of a sudden drop in fuel prices, how could a move to competitive wholesale electricity markets result in an instant reduction in rates? Generally, one would not expect substantial rate reductions attributable to efficiency gains to occur immediately, but over a longer time horizon.

It is therefore all the more surprising, and encouraging, that in the relatively short time since electricity market restructuring has occurred, a number of tangible benefits have been realized. First, competition significantly increased efficiencies in the construction and operation of power plants. Since 1996, when restructuring was effectively initiated by passage of the Energy Policy Act, refueling outage times at nuclear power plants decreased dramatically, while operation and maintenance (O&M) expenses were lowered and capacity factors increased. Similarly, heat rates and capacity factors improved at coal-fired plants while O&M costs declined. 2 Average per-unit production costs, or procurement costs in states with competitive procurement, declined 1.1 percent per year between 2001 and 2004. In 2005, when oil prices increased 135 percent and natural-gas prices rose 210 percent, production/procurement costs rose only 5.6 percent. 3 Indeed, if restructured states had used the fuel-cost adjustment pass-throughs common in states with traditional rate regulation, rates would have been 15 percent higher. 4

Second, competition has increased access to lower-cost generation, particularly in the organized markets. Numerous studies have documented this impact, with some studies finding as much as $15 billion in savings in the Eastern Interconnection. 5 Finally, competition has played an important role in shifting significant risks away from captive customers and on to those market participants best equipped to manage those risks—including the risks associated with cost overruns of new construction and risks of economic depreciation. Our studies have found that since restructuring began in the Northeast, the standard deviation of production costs, a measure of price volatility, has declined by 30 percent. 6 This finding is consistent with the observed volatility of real-time clearing prices, as the production costs we evaluated included a portfolio of both short- and long-term physical contracts as well as the financial instruments employed to mitigate market uncertainty.

The path leading to these benefits of restructuring has been far from smooth. In fact, the development of robust competition in the electricity industry arguably has been delayed by numerous transition mechanisms imposed by regulators and politicians. Those mechanisms, especially multi-year price caps that “guaranteed” consumer savings, provided at