The PJM Interconnect’s Reliability Pricing Model generally has succeeded in attracting and retaining low-cost generation and demand resources to maintain resource adequacy. But sluggish demand and...
A Call for Consolidation
Electric utility mergers loom as the next step in restructuring.
Despite the cost advantages enjoyed by large producers, at present the electric utility delivery system resembles a "cottage industry," consisting of many relatively small firms. Mergers and acquisitions of electric utilities, in which smaller companies combine to form larger ones, have been noticeably lacking.
Yet under a true rationalization of the industry, mergers would be expected to play a role similar in effect to electric industry restructuring. Mergers would produce benefits in terms of more efficient and effective organizations, resulting in increased productivity and as a consequence lower prices. And given the large size of the electric utility industry, the macroeconomic gains could be substantial.
Why have we not seen more electric utility mergers?
In fact, the electric utility industry in the United States is comprised of a large number of relatively small firms most of which were formed years ago based on factors such as geographic boundaries, legal concerns or political considerations, but usually not based on economic efficiency. The graph labeled "Distribution of Investor-Owned Electric Utilities by Market Capitalization" (see Figure 1 ) will illustrate this fact. It is based on data from the Edison Electric Institute and includes data on United States based investor-owned utilities.
Figure 1 shows that approximately 45 percent of the companies have a market capitalization of between $1 billion and $5 billion. That's a size very much suitable for a merger or an acquisition by private equity or an infrastructure or sovereign wealth fund. Approximately 20 percent of the companies have a market capitalization between $10 billion and $20 billion - a size suitable for a merger of equals with another electric utility or an acquisition by an entity such as Berkshire Hathaway.
Even though not every company would be available to merge, the current structure of the electric industry (which is primarily comprised of relatively small firms) is not economically efficient. Given the large overall size of the electric utility industry, consolidation of the industry resulting in better resource allocation and lower prices for utility services has the potential to materially increase income, output and economic growth. 1
Impediments to Consolidation
There are two primary reasons for this lack of consolidation - why the industry has tended to maintain its current inefficient structure:
• The pricing mechanism, known as cost of service, which has prevailed in the industry for many years; and
• Regulatory protectionism, with effects similar to trade protectionism.
The first factor, cost-based regulation, sets prices based directly on the costs of the regulated firm. It is meant to produce prices that would exist in a properly functioning market. Rate of return regulation, the predominant form of cost-based regulation, establishes the return on equity a utility can earn.
Depending on the jurisdiction, the rate of return on equity can be used to set rates initially,