By Robert J. Michaels

The Justice Department's Guidelines don't tell us very much about

today's (or tomorrow's) electric market.

However many electric utilities remain after this merger wave, competition will be forever changed.

Earlier this year, the Federal Energy Regulatory Commission (FERC) issued a Notice of Inquiry (NOI) on merger policy, seeking advice on how to adapt old practices to a changing industry.1 Then, in July, it voted 3-2 to require a hearing on the proposed merger of Baltimore Gas & Electric and Potomac Electric Power.2 The majority expressed concern that applicants had defined relevant markets too broadly and inferred competition where market power might exist. The dissenting commissioners favored approval without hearing, noting that no intervenors had presented substantive claims that the merger would increase market power.

Whether or not the FERC proceeds to a more activist policy on mergers, it must reevaluate the methods it uses to determine their effects on competition.

Competition:

Why Access Matters

In measuring market power, utilities, intervenors, and the FERC generally support use of the Horizontal Merger Guidelines developed by the U.S. Department of Justice.3 In today's environment, however, the FERC should question its continuing reliance on a tool that offers a particularly imprecise match for today's power industry.

Rather than accept a consensus among respondents to the NOI, the FERC should question why those respondents hold dramatically differing interests and yet remain nearly unanimous in their approval of the Merger Guidelines. It may be that the Guidelines just as easily facilitate a showing of competition by a utility with market power as they do a showing of market power by an intervenor that fears competition.

Tomorrow's markets will prove quite unlike today's. If so, the FERC must defend competition both in current markets and those still to be invented, yet the

Guidelines prove unhelpful for either task. If the antitrust agencies defer to the FERC's expertise, they should expect the FERC to build better analytical screens than the borrowed Guidelines. One potentially superior approach would examine a merger's effect on access to transmission. In fact, beyond its voluminous treatment of open access, FERC Order 888 actually contains the basics of a sound merger policy.

The fundamental difference between competition and monopoly is that a monopolist can profit by reducing output and raising prices, while a competitive seller cannot. If lower-cost competitors can easily enter a monopolized market, the monopolist can only continue to profit by blocking its customers and competitors from trading with each other. Open access mitigates monopoly power in transmission by denying the utility discretion over the allocation of lines among users. The open-access utility recovers its costs in contracts for capacity rights, but users can reassign rights among themselves at mutually agreed-on prices. (Order 888 contains price caps on reassignments.) Because open access requires the utility to offer unused capacity for short-term (possibly interruptible) service, any attempt by users to hoard capacity rights becomes self-defeating. The more capacity users try to withhold, the more reliable the line owner's services will be. Open access makes the owner a competitor who instantly acquires all unused capacity and has no choice but to market it.

Monopoly: Why Generation May Not Matter

If generation markets matter in mergers, they should also matter elsewhere. If two utilities can harm competition by merging to form a larger system, so should individual utilities that grew to that size without a merger.

As it does for transmission, regulation ideally constrains a utility from exercising monopoly power in generation, even if it acts as the sole producer, by enforcing a duty to invest prudently and to serve all users in its territory. The utility can earn regulated returns even if its investments were poor choices in retrospect. A customer with open access need not stay around to pay off uneconomic plants if access allows it to reach cheaper supplies. Absent a price-fixing agreement, open access should mitigate monopoly power in generation.

The Guidelines (roughly) ask whether a merger will make it more feasible for generators to fix prices. Fewer sellers might make it easier to collude (e.g., to enforce or detect violation of restrictive agreements), but merger need not always increase the likelihood of collusion. Mergers may produce firms large enough to take risks of aggressive competition, to capture economies of scale, or to invest in innovations that smaller firms will not pursue. Even if a merger materially increases risks of collusion, its costs should be weighed against the possible benefits if things turn out otherwise and competition becomes more aggressive.

What happens after the merger may depend less on supplier concentration than on the institutions governing markets. The behavior of the United Kingdom's mandatory power pool points up the difficulty of generalization. There, denationalization created two large generating entities, who at times bid into the pool using strategies that raise the pool price above the cost of a marginal generator. Some respondents to the FERC's NOI (e.g., the Federal Trade Commission) believe the U.K. experience warns the United States not to let generation become too concentrated.

An alternative strategy would simply avoid implementing institutions that are conducive to collusion or passive competition. With a mandatory system in which all sellers receive the pool price regardless of their individual bids, surreptitious price cuts will prove difficult. Whatever the number of sellers, if they all use the pool every day and individual bids can be seen or inferred, it will not take them long to understand the virtues of being less than aggressive. In contrast to the United Kingdom, the Norway market features a large number of producers and an optional pool. The pool's prices track costs relatively closely, but 90 percent of transactions are bilateral arrangements that do not go through the pool. We do not know whether Norway differs from the United Kingdom because of its more numerous sellers or because its nonmandatory pool fosters more active competition among them. One final case, Chile has a mandatory pool and a more highly concentrated generation sector than the United Kingdom, but markups over cost in Chile appear quite low.

The Relevant Market: Still Emerging and Transforming

Generation and transmission serve as economic complements that must be combined to produce delivered power. A utility with open lines might still be able to compel wholesale customers to take overpriced power, but under universal open access this event becomes less likely.

Open access also turns transmission and generation into substitutes for each other. Instead of using Utility A's lines to carry power from point X, a user can employ Utility B's lines to reach a source at Y. Utility B's lines substitute for both Utility A's lines and for power produced at X. If open access thus mitigates market power in both generation and transmission, market definitions and criteria for monopoly power must change.

The FERC should concentrate on how mergers affect competition for access to transmission. The relevant market is the market for access to the market in which electrical commodities are traded. We do not know today the future shapes and sizes of these latter markets, or the exact commodities that will be traded in them. The public interest requires the FERC to monitor both competition in existing markets and competition to invent new transactions and form new markets. In only a decade, open access to gas pipelines has unified the country's gas markets and spawned transactions beyond the imaginations of both the FERC and the market participants of 10 years ago.4 Open access to electrical transmission will surely do likewise.

Transmission access is the one constant behind whatever markets will come, and it is there that the FERC will likely make its best contribution to competition. Utilities and their customers will surely have disputes over the administration of open access that the FERC is well-suited to arbitrate. Both owners and users of a complex commodity like transmission will sometimes have legitimate misunderstandings and sometimes attempt to capture questionable gains from each other. Whatever the antitrust scrutiny applied to mergers, antitrust alone will neither forestall nor resolve these necessary speed bumps on the road to competition.

What the FERC Does Best

An activist merger policy at the FERC is not necessarily one that follows the Guidelines and interprets their numerical criteria stringently. The FERC would do better to perfect open access in the industry as it now exists instead of waiting for the inundation of retail wheeling and then hacking at the details.

The Guidelines offer, at best, an illusory precision in measuring markets that will likely remain relevant only as long as current federal and state regulatory practices persist. Any utility, intervenor, or regulator will gladly give an opinion about how different tomorrow's markets will be from today's. Each of their visions, however, will differ from those of the others. If so, why apply the Guidelines to markets that everyone knows will not be around long, particularly when no one knows what will replace them? The FERC understands open access, and access is what really matters for competition. t

Robert J. Michaels is professor of economics at California State University, Fullerton, consultant in economics and finance with JurEcon, Inc., and adjunct scholar of the Cato Institute. The views expressed in this article are not necessarily those of his affiliations or clients.

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