Antitrust is not another form of regulation. Antitrust
is an alternative to regulation
and, where feasible, a better alternative.
(em Stephen G. Breyer,
"Antitrust, Deregulation, and the Newly Liberated Marketplace,"
75 Calif. Law Rev. 1005, 1007 (1987).
As the electric power industry moves toward deregulation and a regime of competition, a giant regulatory inquest has begun, invoking antitrust principles to avoid allowing any anticompetitive concentration of ownership and control. The competition that is contemplated for the electric power industry is, of course, in the market for electric generation.
But what has not been much addressed is the crucial circumstance that electric generation has never before operated in a competitive environment.1 We know little about the "natural" structure of the industry. And little of the discussion has looked to experience in other regulated industries that have been deregulated and where there is abundant evidence of the kind of structural change that typically follows upon deregulation.2
What needs to be borne in mind about the process of deregulation is that it provides a whole new environment calling urgently for structural change. One commentator discussing an entirely different, but formerly regulated, industry, has noted that "mergers are nearly inevitable in the deregulated environment. ... To the extent that mergers yield more efficient operations (em or shield [companies] from ... ruinous rivalry (em mergers will be encouraged by the threats to survival."3
Good reason exists in the case of regulated industries to question the classic view that industry structure gives rise to specific types of conduct. In fact, in regulated industries there is reason to believe that the opposite is true. In going from a regulated to a deregulated status, the regulated industry starts from a position far from equilibrium and must develop a new pattern of conduct leading to equilibrium.4
In these circumstances, conduct may dictate the new industry structure as much as structure determines conduct. The analysis must be dynamic rather than static.5
Changing Risk, Changing Conduct
The change of conduct involved here flows from an increase in risk and demand for efficiency.6 A regime of competition among electric generators means building generation without a guaranteed market; there is no precedent for this. Since the very idea of a generator's being completely at risk for a market is novel, one can certainly expect vigorous efforts to seek security in combination.
In the past, markets were guaranteed either by vertical integration, by purchase obligation under the Public Utility Regulatory Policies Act, by long-term contract or by some other means. In Great Britain, for example, when the nationally owned electric system was privatized, extensive efforts were made to protect the new privately owned generating entities against the rigors of a vigorously competitive market. Steve Thomas reports:
"While an unexpectedly large number of new generation companies emerged, all were protected by [contracts for differences]. Thus the Pool price was almost invariably set by the two large generation companies. ... The mere fact of [a price agreement forced on the two large generating companies by the Regulator] proves that the Pool lacks true competition."7
Electrical generation is the most capital-intensive of our industries (with a ratio of fixed assets to annual sales of 3.41)8 and promises to remain such even if natural gas becomes a greater factor in the generation mix. Partly because of its capital-intensiveness, short-run marginal costs tend to fall below average total cost in the electric power business. Particularly when a great deal of excess capacity is overhanging the market, one would expect many industry participants to offer power based on marginal or incremental cost. This strategy would make sense from the point of view of their own immediate business needs: Incremental revenue will exceed incremental cost, and there will be a contribution to overhead. Inevitably, other producers will respond with more sales at incremental cost. But in the longer run everyone will have to make more than contributions to overhead in order to survive. Particularly if there continues to be excess capacity (and this is likely given the general unwillingness to actually retire or scrap capacity), losses may continue all around.9
This rather grim scenario might brighten a bit as regulators
consider arrangements to compensate utilities for uneconomic plants "stranded" in the transition (stranded investment). These arrangements will cushion the transition, but they will probably not affect the tendency to continue to run "uneconomic" capacity because it can make a contribution to overhead even though it won't cover average total cost. And the theoretical capability of the market to achieve equilibrium by discouraging supply through low prices may not be realized (see sidebar on p. 48). Rapid growth in demand for electricity would, of course, cut against this scenario and tend to alleviate any problem of overcapacity. This is why deregulation and competition are most successful in boom times when demand is vigorous.10 Rapid growth would, indeed, seem to militate against some of the factors moving the industry toward merger and consolidation. But rapid growth in energy consumption, in the form of rising electricity demand, might be a mixed blessing in terms of energy conservation.11
The Urge to Consolidate
Since deregulation appears almost universally to be followed by consolidation, a study of other industries could help forecast developments in the electric area.
When deregulation was undertaken in the airlines, many proponents expected a broad proliferation of new entrants, with many competitors active in the market. Instead, concentration in the industry markedly increased. A major part of the first generation of new entrants (em Midway, People Express, Air Florida, and so on (em failed, and the combined market share of American, United, and Delta grew to 60 percent.12 More recently, many additional new entrants, such as ValuJet, have appeared in the industry to broaden competition. However, the ValuJet crash suggests the fragility of these new factors.
Concentration in the deregulated railroad industry is even more dramatic than in the deregulated airlines. There are three major Eastern railroad lines remaining: Conrail, CSX, and Norfolk/ Southern. In the West, a merger between Southern Pacific and Union Pacific has been approved.13 The other Western line is Burlington
Northern Santa Fe. There is concern that approval of the Southern Pacific-Union Pacific merger will provoke one of the Eastern roads to merge with a Western road, thereby creating a railroad of unprecedented size and power. Of course, the railroad industry can claim dramatic cost reductions as a result of consolidation, track abandonment, and crew reduction. But the point is that the structure of both railroads and airlines has changed drastically from its previous regulated form.
Perhaps the structure of power generation in the long run will come to resemble that of the railroads: three Eastern and two Western. Or it might be like that of the airlines: three majors; a few of middling size, like Northwest; and a larger number of startups. But there is no particular reason why, especially given competitive considerations, it should resemble either the railroads or the airlines, or any other existing model for that matter.14
That being the case, the first question is whether the Federal Energy Regulatory Commission (FERC) can accurately forecast what sort of structure will eventually emerge in the electric generating business. I am afraid the answer to that has got to be "No." So the process of evaluating proposed mergers will have to be tentative, leaving as much room as possible for adjustment and correction as the process goes forward.
The next question appears inescapable: Is consolidation inevitable in an electric power generation industry that is moving from regulation to deregulation and competition? And is it just possible that an electric industry that achieves a degree of consolidation will prove more efficient and stable than one that remains widely fragmented?15
The Drive for Efficiency
Might a utility seek a merger for reasons other than a desire for market power? The obvious and most frequently invoked reason will be economies of scale and scope. These benefits have been debated elsewhere, and the point has often been made that many of the same economies could be realized without merger.16 The point has also been made that economies of coordination will flow from the PoolCo model of deregulation (now generally favored over the bilateral model) without need for merger.
Another possible reason, less often discussed, may be the capability for improved planning. The existence of excess capacity in a very capital-intensive industry is a serious economic problem, as is illustrated, for example, by the experience of the railroad industry. Much of the persistent drive of the railroads for consolidation springs from their enduring concern about excess capacity, which has been with them since the Depression. The advent and growth of motor carriers, barges, airplanes, and of course, private automobiles left the railroads with a great deal of capacity that they did not need, and apparently only recently have they succeeded in bringing it under control. With five major railroads left in the country, it must be easier for the survivors to plan the development of their facilities than it was before the consolidation took place. The same principle applies to electric generation. Given the huge sums required for generating plants, concern focuses on building too much and being able to participate only on peak or to recover no more than running costs.
The consuming public shares an equal and reciprocal concern that not enough new plant will be built to provide adequate service. Ordinarily, one would expect more rational long-term planning from stable, diversified operators than from a more fragmented industry subject to a boom-and-bust cycle. Presumably, the industry would eschew excess capacity at all costs, and might, more plausibly, run with inadequate reserves in hopes of recovering maximum revenues in relation to investment (em leaving to tomorrow the risk of unreliability. From both the producer and the consumer perspective, allowing a more "natural" industry structure to develop might improve planning.
If transmission charges are so material that relevant competition will only occur on a regional (power pool) basis, consolidation of generation sources distant from one another should not impair competition.17 By contrast, a consolidation of interconnected or adjacent producers is more problematic than if they are located in different areas of the country.18 (It is interesting that this last principle seems to lie totally at odds with the theory behind the Public Utility Holding Company Act (em that utility consolidations are acceptable only if the parties can be electrically integrated, which implies that the constituents are contiguous.)
Yet it is just this kind of consolidation (em a merger of distant companies (em that might hold advantages for electric generators in terms of diversity of various kinds. A base extending to various parts of the nation would offset and balance regulatory and economic advantages and disadvantages, which tend to vary geographically. Fuel use and availability might be prominent among these factors.
Reliability and Financial Integrity
Other factors may lead the electric power business to greater consolidation as it moves to deregulate. One of these might be an opportunity to create quality features (em such as reliability. It might prove economic to market quality features on a systemwide basis, though this would be impractical for individual plants. In addition, the plants of a system (like a utility) might be developed on a balanced basis (em some base load, some peaking, and some intermediate (em to meet the various needs of a distribution customer: One-stop shopping, so to speak.
Another, perhaps obvious, reason to seek consolidation of electric power generators would be the presumed advantages in attraction of capital and in cost of capital. The reduced risk of a geographically and technologically diversified system would most likely prove a strong factor in attracting capital at a reasonable cost. Risk certainly has been a powerful factor in inducing consolidation in a variety of industries (em particularly capital-intensive businesses. For an early example, one need look no farther than J.P. Morgan's formation of the U.S. Steel Company as the flagship of Big Steel. It may be impossible, or at least expensive, to raise money to build generating plants without a guaranteed market unless they are part of a diversified network with some history of successful operation.19
Similarly, a substantial number of generating plants brought together under one ownership may be able to support a broader and more expert management and a more promising research program. One advantage that the highly consolidated telecommunications industry had over the fragmented electric power industry lies in research support. Telecommunications could afford to be serviced by the unique Bell Laboratories. The electric power companies created the Electric Power Research Institute, but this, whatever its obvious virtues, could hardly compete with the Bell Labs. Hence, a more consolidated power generation industry could better afford sophisticated management and research.
These reasons leading to consolidation may or may not prove substantial or persuasive. They may figure in the pressure for merger and form an integral part of the deregulatory process. Competitive conduct is bound to impact structure. It will take time and study to know precisely the form that this process is taking and how it may best be managed in the public interest. It is a natural process and must be accommodated for a regime of deregulation to prove genuinely viable. t
Judge Richard Cudahy sits on the U.S. Court of Appeals for the Seventh Circuit. Earlier, he served on the Wisconsin Public Service Commission.
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