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The Fallacy of High Prices

We are better off under restructured electric markets.

Fortnightly Magazine - November 2006

and capital costs. This specification of an econometric model allows us to derive a preliminary estimate of the benefits of wholesale competition and retail access, controlling for differences in fuel mix and other factors. Again, it is our view that a more robust estimate of the benefits of competition will require additional time, as many of the benefits of competition are inherently long-term in nature. Nevertheless, despite the relatively short time period since electricity restructuring was implemented, our econometric analysis indicates that the introduction of wholesale competition has resulted in an average reduction in the price of electricity by $6.50/MWh for all retail customers. Considering Maryland alone, as the state in which recent price increases arguably have caused the most political controversy, our analysis shows that the benefits of wholesale competition to Maryland consumers are more than $300 million per year.

Risk and Reward

Another benefit of wholesale competition has been the shift of significant risks from consumers to power producers. Prior to restructuring, if a regulated utility built too much generation (surplus capacity), most if not all of the costs would have been passed through to consumers. However, with a competitive wholesale market and competitive procurements by regulated distribution utilities—such as auctions for provider of last resort (POLR) or standard offer service (SOS)—significant risks are shifted away from captive customers to other market participants with the incentives and ability to assess and manage those risks. In particular, developers of new generation capacity assume the risk associated with that project coming in on time and on budget. In such a scenario, cost overruns and delays cannot simply be shifted to captive ratepayers as frequently occurs when incumbent utilities pursue “self-build” strategies under traditional cost-of-service rate regulation. In a competitive market, only those developers that can appropriately assess and manage the risks associated with building new capacity are able to earn a profit and attract capital; those who cannot are eventually forced to exit the market. Likewise, with a load auction for POLR service, wholesale suppliers can better insulate utility customers from fuel and purchased-power price risks, which otherwise would be passed through to customers along with the risks of capacity development. Such risk transfers stimulate new market entry and help drive down the ultimate costs to consumers.

A “Free” Market

In the event that it is not by now painfully obvious, competition is not a guarantee of low electricity prices. Rather, competition is a means for efficiently allocating scarce resources, sending appropriate price signals to guide investment and consumption decisions, and providing incentives for various market participants to act in ways that maximize social welfare. In a market economy, the main economic rationale for applying traditional rate-of-return regulation to any industry is in the case of a “natural monopoly,” in which a good or service is provided most efficiently by a single firm. This characterization may apply to certain aspects of electricity transmission and distribution, but certainly does not apply to electricity generation. It is this contention, which we support strongly, that justifies efforts to restructure electricity markets.

We do not argue,