Monopoly rents? Not in the short run. The real enemy is a price war, fueled by indifference to stranded costs. And when that happens, antitrust laws won't offer much help.Competition has formally begun in the electric service industry. The Federal Energy Regulatory Commission (FERC) has issued Order 888, giving generators access to wholesale loads throughout the nation. California's investor-owned utilities have filed applications with the FERC to establish an independent system operator and a Power Exchange, through which generators will receive market-based prices for their dispatched generation.
Regulators, to their credit, are not blind to the task. It can prove difficult to jump start competition in an industry that has operated, nearly from inception, as a klatch of government-mandated monopolies. The fear lurks that, notwithstanding open access and transparent bidding, incumbent utilities will exploit their vestiges of market power to restrict supply and achieve supra-competitive prices.
Yet, if history offers any guide, the most likely result in the short run will be a price war in those segments of the market that lie open to competition. Prices could fall dramatically, with stranded-cost recovery schemes perhaps perversely fueling price-cutting strategies.
Do the antitrust laws have a role to play?
The antitrust laws rose from a societal impulse to outlaw
predatory pricing. However, for doctrinal and structural reasons, antitrust precepts may fail to limit predatory pricing in the electric services industry. This failure could threaten nonutility generation at a disproportionate rate. Moreover, with "stranded" costs defined as the immediate differential between a utility's fully allocated rate and the market price, utilities may actually receive encouragement to adopt prices that are predatory in effect, in order to maximize recovery of uneconomic costs.
Some economists argue that an industry can be fully competitive with as few as five sellers. Others envision substantial gains in efficiency by reducing the number of electric service providers. If regulators prove comfortable with a market dominated by a handful of mega-utilities, an unrestrained price war may be welcomed by some for the salubrious effects of encouraging mergers to eliminate weak utilities and reducing excess capacity. However, if regulators see consumers as best served in the long run by a diversity of generators operating the most efficient facilities on a total-cost basis, they may wish to consider mitigating predatory price.
And, should regulators favor this idea, they must embrace the task as their own, for the antitrust laws cannot otherwise fill the void.
and Legal Remedies
Both the Sherman Act and the Clayton Act prohibit "predatory pricing," which may be defined as pricing below "an appropriate measure of cost" for the purpose of eliminating competitors in the short run and forestalling new market entrants in the long run.1 Although "cost" is the touchstone that underlies liability, no consensus has yet been reached as to the appropriate measure of cost against which pricing conduct should be assessed. Some courts have held that pricing above marginal or average variable cost is presumptively legal.2 Others have held that pricing between average variable cost and average total cost may be deemed unlawful upon a showing of predatory intent.3 And some courts have suggested that in industries in which barriers to entry are extremely high, a plaintiff can prevail by showing that the defendant is "charging a price below its short-run, profit-maximizing price."4 To date, the Supreme Court has declined to "consider whether recovery should ever be available . . . when the pricing in question is above some measure of incremental cost."5
At the turn of the century, certain titans of industry engaged in vicious but selective price wars to destroy competitors. Their conduct, in large measure, supplied the impetus for the antitrust laws. In responding with national legislation, Congress solved a political need (em to curb the power that had, in the view of many, allowed certain individuals and corporations to dominate the economy. As Sen. Sherman explained: "If we will not endure a king as a political power, we should not endure a king over the production, transportation, and sale of any of the necessaries of life."6 So too, the Clayton Act prohibition on price discrimination was designed to outlaw "[a] most common practice of great and powerful combinations engaged in commerce . . . to lower prices of their commodities, often times below the cost of production in certain commodities and sections where they had competition, with the intent to destroy and make unprofitable the business of their competitors."7
In the ensuing years, however, predatory pricing has taken on a primarily economic flavor and, indeed, the very concept is regarded with great skepticism by many courts, including the Supreme Court. The high court has openly questioned whether predatory pricing is ever economically rational conduct, venturing that "predatory pricing schemes are rarely tried, and even more rarely successful."8 In large part, the Court's aversion to predatory pricing allegations stems from the fact that the same mechanism used in predatory pricing (em lowering prices (em stimulates competition and benefits consumers, the intended beneficiaries of the antitrust laws.
Under the present doctrine, two elements must be proven to establish actionable predatory pricing: 1) pricing below "an appropriate measure" of cost, and 2) a reasonable prospect that the predator could recoup its investment in below-cost prices (em i.e., a subsequent ability to recover monopoly rents or collect supra-competitive prices. The first element provokes sharp disagreement among the various federal Circuits as to what the appropriate measure of cost should be, and what role, if any, subjective intent to destroy competitors plays in alleging and proving predation. The Supreme Court has noted the controversy among the Circuits, but has specifically declined to take sides in the debate (see insert, "Proof and Presumptions in the Federal Courts: A Conflict Among the Circuits").
in the Electric Industry
Most newly deregulated industries follow a familiar pattern during the onset of competition. A rush of new entrants, fierce competition, the failure of inefficient existing firms and many of the new en-trants, followed by a
consolidation of market position by the survivors. This pattern played out when the airline industry was deregulated, and is ongoing in the telecommunications industry. However, the electric service industry displays three attributes that may encourage predatory pricing to a degree unparalleled in other deregulated industries: 1) sharply differing capital/operating cost ratios between established and new generators, 2) excess capacity, and 3) imperfect markets. Whereas price warfare eliminates the inefficient in most industries, structural anomalies in the electric service industry may eliminate the most efficient and accelerate the concentration of resources in the less efficient.
This potential for predatory pricing is hardly hypothetical. As noted by a recently retired utility executive, "With the advent of retail wheeling, prices can be expected to drop significantly for a number of reasons. In fact, utilities may actually choose to sell below cost."9 That executive cautioned that an unrestrained price war between neighboring utilities would be harmful to both, and accordingly counseled "cooperation among the participants. While collusion is illegal, there are strategies that will effect similar outcomes." Should a renegade utility or nonutility generator (NUG) break ranks, "a 'retaliatory strike' capability should be developed as a contingency plan. ... This will reduce revenue and profitability throughout a region. Utilities should try to maximize the monopoly rents they can extract for as long as possible under the current regulatory environment, recovering otherwise uncollectible asset values from those segments least at risk."10
Municipal entities have offered an interesting glimpse of future competition in comments filed before the FERC.
In an affidavit attached to the initial comments of Louisiana Energy and Power Authority ("LEPA"), on the FERC's Notice of Proposed Rulemaking (NOPR) on open-access transmission services, Sylvar Richard, a former general manager of and current consultant to LEPA, testified that the five utilities controlling 87 percent of the market in Louisiana rarely compete to gain load served by one of the others. However, while those utilities serve their native load with power priced in the range of 80 to 90 mills per kilowatt-hour, they would vigorously compete with LEPA to serve municipalities "at discriminatory prices far below the utilities average cost and, at least in one instance, easily shown to be below" the utilities' marginal cost.11
Commenters have argued that reliance on average variable cost to determine predation is inappropriate in industries that employ different technologies to produce the same product.12 One firm may use capital-intensive facilities with low variable costs, while its competitors may have substantially lower fixed costs but higher variable costs. The capital-intensive firm, which may not be more efficient, might attack its competitors with "predatory" pricing that lies above its average variable cost but below their average variable cost.
In Order 888, the FERC observed that new generation
facilities can produce power on the grid at a cost of 3 to 5 cents per kilowatt-hour (¢/Kwh), while costs for larger plants constructed and installed over the last decade typically ran 4 to 7¢/Kwh for coal plants and 9 to 15¢/Kwh for nuclear plants. Although not specifically articulated by the FERC, these figures appear to represent fully distributed costs. The marginal cost of the operation of these types of facilities is probably exactly the reverse. The high costs of nuclear power are attributable largely to the immense initial capital costs and higher maintenance costs. On a marginal-cost basis, however, nuclear facilities probably meet the initial expectations of producing power "too cheap to meter." Similarly, coal plants tend to be capital intensive, but on a pure Btu (British thermal unit) basis coal enjoys a substantial price advantage over natural gas. By contrast, most new generation facilities are gas-fired, because they entail substantial lower capital costs and higher variable costs. Accordingly, while gas-fired generation calculated on a total-cost basis may be the superior provider of electric power in a market that has reached equilibrium, such facilities may prove early and disproportionate casualties in a marginal-cost price war.
The disparity between capital/operating cost ratios will be exacerbated by excess capacity. In industries with excess capacity, marginal costs fall as production increases. In such situations, each competitor attempts to lower prices and expand output to reach a lower point on its marginal-cost curve. This attempt, in turn, drives the other competitors back up their
marginal-cost curve and increases their losses at the new lower price. Again, notwithstanding their greater efficiency, smaller-scale
combustion-turbine facilities with their high average variable costs would be severely disadvantaged in a race down a marginal-cost curve.
Finally, the electric power market will remain imperfect for the foreseeable future. Under most restructuring proposals, existing utilities will continue to serve their "core" customers essentially on a "franchise" basis. The competitive markets will consist of large industrial customers, aggregated commercial entities, and municipalities. Thus, existing utilities will be presented with a partially competitive market that will remain largely closed to competitive forces. In such circumstances, the rational utility will offer very competitive prices to entities that enjoy price elasticity through the availability of competitive alternatives, while maximizing its return through higher charges to its less price elastic customers. Therefore, the rational utility may occupy a position where it can meet and beat competition for highly elastic customers (large industrial users) by selling power at or slightly above marginal cost, while fully recovering the bulk of its fixed costs through rates to captive residential customers. With a captive customer base, a utility should be able to outlast a NUG in competing for industrial loads at a pure marginal-cost rate, even assuming identical capital/operating cost ratios, since no portion of the NUG's fixed costs can be recovered from captive customers.
These factors may lead some utilities to believe that, while a price war may be painful in the short-run, they may successfully out-compete NUGs by pricing at average variable costs, which are likely to be lower than average variable costs for NUGs. Moreover, even assuming similar marginal costs, incumbents may reason that, with their larger capital bases, they can withstand a war of fixed-cost attrition against NUGs, most of whom are thinly capitalized compared to established utilities. Some utilities may then conclude that once NUGs are driven from the market, remaining utilities will tacitly observe the old rules of the game, in which competition for loads within another's service territory is deemed declassé.
Although price-cutting in response to these factors would be predatory in effect, such conduct would not be actionable, in most instances, when accessed against prevailing antitrust doctrine. Prices will be conclusively or presumptively legal in most jurisdictions. If prices are above average variable cost but below average total cost, challenges may be raised in jurisdictions that follow the Inglis Transamerica test, but the prospect of adducing extrinsic evidence of predatory intent would be daunting. Proof of predation would be particularly problematic where utilities bid into a power pool and distant generators can reach the market through open-access transmission.
Should Regulators Intervene?
Whether predatory pricing should be proscribed on a regulatory basis depends, in large part, on the complexion of the future electric service industry that regulators hope to achieve.
On the one hand, the objective of restructuring is to lower prices. Regulators wish to encourage vigorous competition between generators, which will be manifest in slashing prices to maintain existing load and gain new load. In some cases, utilities may find it economically rational, during certain periods, to offer power below cost (em indeed, even at a negative price (e.g., to avoid temporary shutdowns). The existence of excess capacity represents economic inefficiency. A vigorous price war may quickly eliminate excess capacity and encourage mergers that provide greater operational efficiencies. And consumers, or at least some consumers, will benefit from perhaps drastically lower prices for power.
Three factors, however, may warrant some degree of regulatory oversight, at least during the transition process.
First, in its NOPR on open-access transmission policy, the FERC observed that from 1989 through 1993, facilities owned by independent power producers (IPPs) and other nontraditional generators (other than qualifying facilities (QFs)) increased from 249 to 634, and their installed capacity increased from 9,216 megawatts (Mw) to 13,004 Mw.13 In fact, in 1992, IPPs added more generating capacity than utilities.14 The vast majority of nonutility capacity additions are gas-fired; established utilities rely primarily on coal-fired and nuclear generation. The FERC further found that the emergence of these new nonutility generation sources created the competitive alternatives that make restructuring possible. Moreover, the FERC has found that the facilities brought to the market by nonutilities tend to be the most efficient providers of electricity on an average total-cost basis. But, as discussed above, the electric service industry fits the paradigm of radically different capital-/operating-cost ratios. New competitors and potential entrants remain the most vulnerable to predation through marginal-cost pricing. Moreover, although nonutility generation additions have been impressive over the last several years, existing utilities continue to own approximately 90 percent of the capacity in the United States. To the extent that generation diversity forms an essential predicate to restructuring, regulators may wish to consider whether unbridled pricing competition, which will likely claim new entrants as its first casualties, is consistent with their long-term objectives.
The New Construction Cycle. Second, the present surplus of capacity will likely vanish in the reasonably near future. At the end of 1993, fossil-fueled steam capability accounted for 72 percent of U.S. electric utility net summer generating capability; however, by 2003, a large percentage of steam-electric capacity will have reached or exceeded 30 years of age. By 2003, the average age of the nation's coal-fired units (weighted by nameplate capacity) will be 32 years, and the average age of oil-/gas-fired units will be 36 years. Nuclear plants are somewhat younger, with an average age of 23 years in 2003, but their functional lifespan may be substantially curtailed by relicensing strictures.
Once the "capacity bubble" (not to be confused with the apparently immortal natural gas bubble) bursts, where will new competitive generation come from? It is highly unlikely that utilities will construct new generation facilities without regulatory assurance of capital-cost recovery, particularly given the unpleasant experience they face to recover "stranded costs" for their existing facilities. The FERC has largely vitiated the incentives under the Public Utility Regulatory Policies Act (PURPA) to construct new facilities, and Congress may well repeal prospectively the empty hulk that PURPA has de facto become. Without the mandatory purchase requirement of section 210 of PURPA, IPP developers will find it difficult to secure the long-term capacity-purchase obligations that form the sine qua non of project finance. That leaves future capacity additions largely to those willing to construct merchant plants and to finance such projects internally. However, the specter of predatory pricing by incumbent utilities may dull the ardor of the most adventurous developer. Moreover, to the extent that long-term contracts remain available for independent
project development, most opportunities will prove limited to existing utilities issuing requests for bids to replace retired generation capacity. Construction of such projects will not increase generation diversity, and will leave the decision of capacity supply largely in the hands of existing utilities. Thus, surviving utilities may not be required to take any affirmative action to reduce output; rather, they may find themselves the passive beneficiaries of an eroding capacity base. To avoid prospective capacity shortfalls, with the attendant risk of further concentration of generation resources and an increase in market power, regulatory authorities may wish to create an environment conducive to the orderly replacement of capacity by new entrants.
Stranded-cost Recovery. Third, the mechanisms for stranded-cost recovery may render utilities indifferent to contributions to capital cost and, in fact, provide an incentive to push prices in the competitive market as low as possible. Since utilities will be compensated for the difference between market price and embedded-cost rates, and since such recovery will be putatively guaranteed and may take the form of a lump sum based on a current spot-market price, utilities could achieve a triple whammy by adopting a bare-bones, marginal-cost pricing strategy: 1) eliminate competitors with high variable cost, 2) maximize recovery of fixed cost through stranded-cost recovery, and 3) create a stranded-cost amount sufficiently large to discourage existing customers from leaving the system. This course of action would not only skew the competitive market terribly, but would significantly drive up aggregate stranded costs, thus delaying the projected benefits of competition to most consumers.
If "Yes," Then How?
Given recent unhappy experience of directing the electric service industry, particularly as to matters of price, regulators may be forgiven if they approach the subject of active intervention in a dynamic market with some degree of trepidation. Yet, a strong case can be made that the appropriate means to mitigate predation would lie in fixing a price floor equal to long-run incremental cost, below which sales are proscribed. Easy to say, but perhaps devilish to administer. Setting the floor price too high may provide an unacceptable safe harbor for the inefficient. Setting the floor price too low would defeat the objective of the exercise. Moreover, even if the floor price were set just right, periods might occur in which it would be both economically rational and nonpredatory for utilities to sell below short-run marginal cost (em i.e., to avoid temporary shutdowns in nonpeak periods.
Regulators have been down the path of calculating long-run incremental costs before. In implementing PURPA, the FERC held that "avoided cost" (em i.e., incremental cost (em includes both energy and capacity cost.15 Energy costs are variable costs associated with the incremental cost production of electric energy (em in antitrust parlance, approximate short-run marginal cost or average variable cost. Capacity costs are those associated with providing the capability to meet the demand for electric energy. The FERC specified that capacity costs must be based upon "those costs associated with a new kilowatt of capacity addition and the next kilowatt-hour that needs to be generated."16 Accordingly, historic and sunk costs are excluded. The combination of energy and capacity cost approximates long-run incremental costs or average total cost, as those terms have been defined in the antitrust context. However, many in the industry blame the miscalculation of avoided cost as the principal contributor to overcapacity and above-market obligations to QFs.
Although fraught with peril, the effort may still be worth the candle. If the objective is to promote long-term generation diversity, but only among the most efficient, regulators might consider setting a floor price at the long-term incremental cost of the most efficient new generation technology available. Such a price would not protect the inefficient, but might prevent the elimination of existing or potential efficient competitors that simply lack the deep pockets necessary to survive a price war of attrition. Moreover, the floor rate could be applicable only to some measure of long-term sales, and only during defined periods. Finally, the floor sales price could be adopted either formally or practically as the lowest "market price" upon which stranded-cost recovery could be predicated.
New Jersey, for its part, has elected to establish a regulatory constraint upon predatory prices. In legislation establishing the predicate to retail competition, the New Jersey legislature established guidelines that allow electric utilities to negotiate "off-tariff" rates with individual retail customers. An "off-tariff" rate may not exceed the cost-of-service rate, but can fall no lower than the sum of "the utility's marginal energy and capacity cost over the term of the off-tariff rate agreement, the per-kilowatt-hour contribution to demand-side management program costs ... and a floor margin to be specified by the Board [of Public Utilities]."17
The Last Dance
They say you should "dance with the one that brought you." In electric restructuring, the IPP represented the new kid on the block. Yet, this new suitor may vanish from the scene unless regulators take action. Unless the courts adopt a sui generis approach to the established rules governing "predatory pricing," regulators will find themselves unable to safely cede their active oversight to the antitrust cop on the beat.
In the long run, industries naturally assume the optimal size for the market. Predatory pricing flourishes only in the short term, during periods of market upheaval, such as that now occurring in the electric service industry. During this period, at least while stranded costs are recovered (and perhaps as the quid pro quo for stranded-cost recovery), regulators might consider affirmative action to mitigate price predation that may prove economically undesirable in the long run. t
Stephen L. Teichler is a partner in law firm of Metzger, Hollis, Gordon & Alprin (based in Washington, DC), which represented Hitachi in the Matsushita antitrust litigation.
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