Why the DOE's recent report suggests we need new antitrust rules for "deregulated" utility markets.
In a report issued in March, the Department of Energy raised the specter of market power haunting electric markets in the United States. Secretary Richardson summed up the findings of his agency in the report, "Horizontal Market Power in Restructured Electricity Markets."
"[E]lectricity supply in certain areas of the country is highly concentrated in the hands of only a few companies," said Richardson, citing the document. "This [finding] raises a warning flag that these companies will be able to dominate the market and raise prices." The secretary continued that if consumers are to realize "the full benefits" of electric competition, then federal and state legislation on electric restructuring must supply "the necessary tools" to address market power.
In issuing this report, DOE has shined a searchlight on a longstanding and highly controversial aspect of restructuring - the role of antitrust law, and especially the lack of a clear mandate from Congress on how regulators should apply laws and regulations aimed at controlling unfair competition.
For over a century, the United States built a massive electric power grid organized around a single concept: In each area of the country there is one supplier that owns all of the plants and power lines leading to every customer in that area. Utilities strived to build one kilowatt of power plant and one kilowatt of delivery capacity for every kilowatt of customer demand, plus an appropriate safety margin in case of outages.
When we discovered that we could securely reduce the safety margins by tying individual utilities together with transmission lines, and sometimes ship power from cheap sources to distant cities, we expanded the transmission grid. We did not build a national grid to ship power anywhere we wanted. Instead, our local systems were simply interconnected for reliability; the basic approach remained to provide power from the local franchise utility to its local customers. Indeed, our efficiency at creating a lean electric power grid led to the lowest amount of excess capacity, and therefore the lowest power rates in the world - under regulation. Even as wholesale power transactions among utilities became much more common, we still did not expand the high voltage very much because additional lines often are more expensive than the savings in generation costs that further interconnectedness could achieve.
It should come as no surprise, then, that in many parts of the country, the system is not engineered to make competition work. For any market to be competitive, a customer has to be able to shop from among several roughly comparable suppliers. Our electric system wasn't created to enable individual electric buyers to be able to transmit power from many different power plants over a wide area.
Since this finding isn't new, policymakers have taken some steps already to address the problem. First, the Federal Energy Regulatory Commission long ago required that all transmission lines be opened to all generation suppliers to facilitate competition. These policies are controversial and evolving, e.g., with regard to how flow congestion and access rights should be managed. In any event, the current policies are only the first step.
The Present Laws Are Unequipped
Many states that have proceeded with deregulation have studied market power carefully and taken steps to monitor and limit its impacts.
California, which DOE cites in its report, has known about this problem from the start. In addition to creating a transparent, cost-based power exchange for its large generators, California initially placed 80 percent of its power plants under special contracts designed to limit their profitability, hence their market power. The DOE report notes that California has set up its own in-house committee of "market monitors," a highly skilled group whose sole function is to monitor California's new power markets for signs of adverse impacts. Other states and independent system operators have taken similar measures, such as imposing bidding price caps and authorizing rapid changes in market participation rules. Yet all is not well. As DOE observes in its report, "In both the United Kingdom and California, where data from competitive electricity generation markets are now available, researchers have found that wholesale power prices have been as much as 75 percent above competitive levels at times."
Another tool in the market power toolbox that has been used to some degree is divestiture. Generating plants in one area can be sold off to several different owners, and generation owners also can be discouraged from owning both generation and transmission. One concern with these solutions is that electric utilities long have been recognized as having substantial economies of scale and vertical integration. To some degree, we will raise costs and sacrifice efficiency for the sake of creating competition, the benefits of which must overcome this loss of scale and coordination economies. For example, we already have seen that it is not cheap to set up an ISO or a power exchange, but this infrastructure is essential if competition is to succeed.
While it is true that we do not lack awareness or tools, DOE does have an important point to make. The present laws that address market power and electricity regulation - primarily the antitrust statutes and the Federal Power Act - are singularly unequipped to answer market power questions surrounding electric restructuring.
And Merger Review Won't Fix All Problems
The antitrust statutes prohibit the creation of monopoly power by merger or by engaging in certain forms of anticompetitive
conduct. However, these laws were never designed to deal with an industry that tries to jump immediately from regulated monopoly to competition and can't manage to get there right away. Principal Deputy Assistant Attorney General A. Douglas Melamed said as much directly to Congress last May in a hearing before the House Subcommittee on Energy and Power. On that occasion, Melamed testified on how the Justice Department lacked obvious legal authority to address the monopoly power that wasn't created by a recent merger, but which was there all along, almost from day one:
"The authority of the Department of Justice to enforce the antitrust laws with respect to the electric power industry does not sufficiently address the ability of electric utilities to exercise market power that can thwart free competition within the industry. The antitrust laws do not outlaw the mere possession of monopoly power that is the result of skill, accident, or a previous regulatory regime. Antitrust remedies are thus not well-suited to address problems of market power in the electric power industry that result from existing high levels of concentration in generation or vertical integration. In the Administration's [proposed] electricity bill we have, therefore, granted regulators the tools to remedy market power problems that may be found to exist."
Market Power POEMS
DOE says a 75 percent share in the local grid rewards gaming behavior.
Study. In its March report on utility market power, the U.S. Department of Energy used its POEMS method (Policy Office Electricity Modeling System) to analyze the market power of hypothetical utility firms with both low and high ownership shares in regional transmission capacity. It conducted the study by simulating bidding strategies for mid-merit generating plants (plants in the middle of the dispatch queue).
Assumptions. Any single utility company owning more than 75 percent of the transmission capacity in the power control area was deemed a firm with "high" market power potential. Utilities owning 20 percent to 50 percent of grid capacity in the power control area were classified as having "low to modest" market power potential.
Modest Grid Control. None of the firms in the group with low to modest potential could raise profitability by bidding their mid-merit units at 150 percent of competitive bids. (They lost more by not running during periods when slightly above market than they gained during price-spike periods.)
Greater Grid Control. Firms in the "high potential" class generally were able to boost profits by bidding above market and exercising their power to raise prices. When they bid their mid-merit units at 150 percent of competitive bids, they increased their operating surpluses by 25 percent to 75 percent, and caused wholesale power prices to rise by 8 percent to 30 percent within the power control area.
Federal regulators face much the same problem under the Federal Power Act. This law gives regulators strong authority over mergers, but in the case of electricity rates, it allows for a public interest review only in the most general terms. Under the FPA, all wholesale electric rates simply must be "just and reasonable."
So here's the problem: Without giving added authority to regulators, we must learn to live with price spikes and high volatility.
Right now, electricity is a non-storable good that is a necessity for health, safety, and virtually every activity in our economy. Short-term demand for power is very insensitive to price, meaning that consumers must keep buying it even if prices spike upward. And supplying electricity remains capital-intensive, with very high fixed and sunk costs. Elementary economics and decades of evidence from other commodity markets teach us that introducing competition into a market with these attributes must yield price volatility and occasional high prices. Because no one retains an obligation to build power plants and sell power at regulated prices, the forces of supply and demand henceforth will govern how many power plants are built. Without occasional high hourly, weekly, or even monthly prices - much higher than we are used to seeing under regulation - there simply won't be enough capacity built to meet demand.
Of course, the mere presence of occasional high prices does not constitute socially harmful market power. And there are lots of good reasons why prices may rise for some customers some of the time under restructuring. Examples are changes in rate structures and pricing plans, the accelerated amortization of standard costs, and new costs like marketing and advertising by third parties.
Does Incentive Alone Threaten Competition?
Notes from the FERC's AEP merger case.
The Fox-Penner Testimony. In a case before the Federal Energy Regulatory Commission involving the proposed merger between American Electric Power Co. and Central and South West Corp., Peter Fox-Penner testified in April 1999 that a merger should raise competitive concerns if it increases an incentive to exercise market power that an applicant possessed prior to the merger:
Repudiation. In November 1999, in his initial decision, Administrative Law Judge Joseph R. Nacy rejected Fox-Penner's argument, describing his theory as "fanciful."
Redemption. On March 15, the FERC reversed the initial decision and ruled (with Commissioner Curt Hébert dissenting) that the AEP-CSW merger would enhance market power. The FERC OK'd the deal only upon condition that the two halves of the merged company would transfer operational control of their transmission facilities to a fully functioning, commission-approved regional transmission organization. Also, the FERC appeared to endorse Fox-Penner's ideas:
Yet without an adequate incentive to invest, competition cannot work. If we are going to let competition reign in electric markets, we cannot legislate away the occasional price jump without legislating away competition itself.
Instead, our notions of what constitutes "success" under restructuring may have to change, or else we may become our own worst enemy.
Enormous Discretion, But No Guidance
One problem not directly addressed in the DOE report is that no federal agency has a clear legislative mandate to draw the line between the positive, efficiency-enhancing role of occasional high prices and the harmful effects of markets that are too concentrated and prices that are only apparently "too high." Such an inquiry will require balancing the benefits of scale economies and vertical integration with competition, and will confront a host of new questions.
The antitrust laws award enormous discretion to the antitrust agencies, as does the public interest mandate to the FERC. However, economics and the law offer little to these agencies to help guide them in an open-ended inquiry into the proper degree of "competitiveness" in deregulated utility markets, or what to do to create it. Nor do these agencies feel they have a mandate from Congress to do all this - a problem made difficult by the overlap of state and federal regulation of the power industry. This jurisdictional quagmire marks a critical factor in our current inability to achieve rapid, substantial expansion of the transmission grid.
DOE deserves credit for highlighting an oft-misunderstood issue. If Congress cannot summon the will to confront this issue, prepare for a long period of litigation, market surprises, and soul-searching in the antitrust community.
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