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Deregulation, Phase II

Recent electricity pricing argues for faster, more extensive deregulation.

Fortnightly Magazine - November 2007

about 25 percent of all electricity generated in restructured states came from natural gas, while in regulated states only 11 percent of generation was fueled by natural gas. The precise percentages vary from year to year, but the 2-to-1 ratio holds fairly steady throughout the 1990s.

Given volatility in energy prices, long-term trends are more meaningful than single-point comparisons. Furthermore, inflation also can show year-on-year variation (see Figure 3, “Inflation-Adjusted Retail Prices: Regulated vs. Restructured States”).

Recognizing the two sets of states had different average power prices at the start of the period—and both sets were under essentially identical regulatory paradigms in 1992—an analysis of inflation-adjusted prices normalizes the data in both areas such that the region-specific 1992 power price is 100. (Thus, an electricity price of 90 indicates a 10 percent reduction, relative to the 1992 price.)

In all regions, the inflation-adjusted price of power has fallen since 1992, when the country first began restructuring the electric grid. From 1992-1997, there was little difference (on a percentage basis) between those states that ultimately restructured and those that did not—consistent with the fact that no states had yet restructured. However, in 1997, Rhode Island became the first state to implement the deregulatory proceedings approved by its Legislature the year before, and a flood of states followed shortly thereafter. And almost immediately, two things happened:

• In the restructured states, the rate of decline in real electricity prices accelerated.

• In the regulated states, the 30-year decline in real electricity prices stopped.

The resulting gap widens and only started to close in 2005, likely due to rising natural-gas prices in the more gas-intensive restructured regions. However, the fact the gap exists at all in spite of higher gas dependency in the restructured states is a remarkable testament to the power of markets. And it’s exactly opposed to the popular view (although exactly in keeping with economic theory).

So what caused the prices to fall? At the state level, a lack of sufficiently detailed data makes quantifying this answer difficult. However, the unbundling of utilities likely created cash flows to regulated arms, stalling rate-case filings in wires-only utilities. At the same time, these cash flows reduced the book value of generation assets and thus wholesale-power prices—since so many of the previously regulated generators sold at fire-sale prices. Additionally, independent system operators (ISOs) likely did a better job of dispatching the lowest-cost generators than integrated utilities did, if only because of the lack of direct economic incentives to control costs in the regulated paradigm.

Moreover, at the federal level, we can obtain macro data that—while not specific to the state-level differences—illustrates the changes electricity grid managers made in response to market pressure (see Figure 4, “U.S. Fleet Capacity Factor by Fuel Type,” and Figure 5, “Nuclear Load Factor by State”).

In 1990, before the wave of restructuring that passed across the country, America’s nuclear fleet operated with an average capacity factor of just 66 percent. As the 1990s progressed, capacity factors on nuclear plants steadily increased, up to nearly 90 percent in 2003. Why?

The