The spectre of retail competition in electricity presents some difficult but solvable technical problems in creating new markets. It could lead to a new world of regulation. At the least, it will expose some currently protected utilities to potential losses that could prove substantial.
This prospect of losses has inspired some high-cost utilities to mount a formidable defense of the status quo, coupled with an aggressive offense to shape the transition. But in buying time, these utilities have not stopped simply at defining the agenda. No. By coining the "S" Word (ends with "tranded," begins with the letter between "R" and "T") and by creating the notion of a regulatory "Compact" (which guarantees a full recovery), these loss-threatened companies have cornered the debate with a brilliant strategy designed to minimize losses at the expense of others. They invoke the "Compact," while letting the "S" Word to the damage.
And here's the decidedly clever aspect of the plot: Once the "S" Word finds its way into everyday conversation, it will prove most difficult to eradicate.u1d
When Mother said never to use foul language, she might just as well have been talking about the "S" Word. It's offensive-particularly so as it rolls off the tongue of the regulator, in phrases that include such terms as "costs," "assets," "revenues," "investment," "benefits," "contracts," or "full recovery." Be fore-warned: Use the "S" Word and your integrity will be compromised. No one will respect you.
But more past the "S" Word and one can expose the vulnerability of the "Compact." Vociferous denouncement of the "S" Word is not nearly as effective as is a certain studied disregard, coupled with the use of the correct term.u2d
In fact, regulators should refuse to use or even acknowledge the "S" World-even in dealing with the Federal Energy Regulatory Commission (FERC), which has officially embraced not only the "S" Word, but full recovery, and therefore stands beyond salvation.
The "S" Word carries no standing in economics. It exists only to serve a special interest. The correct term-and the word that respects accepted usage in economics-is LOSSES.
Never, never use the "S" Word! Always say LOSSES!
Genesis (birth of monopoly)
In the beginning (the early 1900s) there was natural monopoly. It existed as a necessary evil, and excelled at exploiting economies of scale. Competition was futile (one producer would always emerge as dominant), so why waste resources in competition? Why not just go ahead and recognize the inevitable?u3d
Also, electricity was said to be "different," owing to the nature of its required capital investment (long gestation period, long life) and its unique network characteristics. Electricity was also deemed vital for safety, health, and the general well-being. Special treatment was required to mitigate risk. These factors led to the creation of an exclusive franchise with an obligation to serve. Utilities accepted those conditions in exchange for the opportunity to earn a fair return on investment-an arrangement not unlike a cost-plus contract for government defense procurement.
Then came the sabbath-a "day" of rest in the utility industry that lasted for some 50 years.
More important, however, the sabbath ushered in new technology and a long-term decline in energy pricesu4d that together produced 50 years of economic benefits, despite the fact that regulation probably encouraged excess investment, offsetting some consumer gains.
Then, during the 1970s, some unfortunate but unavoidable events began to occur. Global energy prices and interest rates soared. Utilities did their best to cope. The fault lay with no one in particular, but by the 1980s the hallowed "Compact" had undergone a facelift. Instead of simply providing an opportunity for a fair return, it now obligated ratepayers in all circumstances to reimburse utilities for LOSSES incurred in the event of competition. This obligation was said to grow out of a need for fair play. Economic efficiency in a static sense was said to require full recovery of potential LOSSES. How else could the honor of contracts be upheld?
This revised "Compact" drew its strength from warnings of apocalypse from high-cost utilities. Approve full recovery of all potential LOSSES, they said, or face paralyzing litigation, plus bankruptcies, loss of reliability, and other untold disasters.
Dead Sea Scrolls (origins of the "Compact")
What is the true nature of the "Compact"? From what source does it draw its authority?
From 1879 to 1907, the electric utility industry operated without price regulation. In its place, municipal regulation sanctioned multiple franchises within the same city, allowing competition, which depressed prices and profits and expanded output.
Reacting to these low prices and profit, Samuel Insull led the industry to create a state-centered regulatory regime to restrict competition through exclusive franchises, with the idea of "natural" monopoly providing a key argument. However, natural monopoly was not correctly represented in the debate. Exclusive franchises restrict competition and contestability (the possibility of entry by competitors that must be defended by setting a price that precludes entry), but do not follow inevitably from natural monopoly really existed, it would eliminate any competition without assistance. True natural monopoly should require no protection from competition. Of course, an exclusive franchise may not be completely exclusive; bad behavior may force the incumbent to loose his franchise rights. Therefore, the possibility of replacement ought to restrict the all-out exploitation of the franchise.u5d
Utilities have already received compensation for risk that includes LOSSES and even the possibility of bankruptcy.
Webster's Dictionary tells us that a "compact" is a "contract." A contract takes account of all pertinent contingencies. If the "Compact" had really existed, then surely the bondholders of the failed Washington Public Supply System would have invoked the "Compact" in an attempt to recover their LOSSES. But that proved impossible. Just try to find the clause in the "Compact" that specifies the terms of recovery of LOSSES in the event of competition.
Should fair play imply that captive ratepayers must pay for LOSSES as penance for having been denied access to competition for all these years? Does fair play imply that captive ratepayers must be left holding LOSSES as a price for competition? The obligation to serve was not matched by an obligation to purchase.
Revelations (will the lights stay on?)
"Keeping the lights on," a noble and valued calling, need not remain a secret known only to a natural monopoly priesthood. Vows of poverty or monastic reliability are not required. The electricity industry will adapt quite nicely to competition. Any necessary adjustments required by the uniqueness of electricity can be designed via real contracts. Customers, reborn from ratepayers, will adapt ever more easily.
Recovery of bad investment (LOSSES) was never explicitly or implicitly guaranteed. Many obvious signals of the growing storm were sent and received. Energy market upheavals in the 1970s provided signals, as did the Public Utility Regulatory Policies Act of 1978 (PURPA). Cost disallowances in the 1980s and price disparities in the 1980s and 1990s threw up yet more signals. After 1980, everyone, including the cloistered priesthood, knew that investment might not be recovered.
Returns to electric utility investors over the last 25 years have equaled or exceeded those to other industrial investors. Utilities have already received compensation for risk that includes LOSSES and even the possibility of bankruptcy.
Risk happens! the market does not cause LOSSES, it merely reveals them. In fact, ratepayers have experienced LOSSES for many years. Cost-plus monopoly prices typically exceed market prices. Sunk costs are sunk. Bygones are bygones. Cut your LOSSES. If the price is too high, lower the price.
Old habits die hard, however. In this case, utilities, regulators, and central planners may all suffer LOSSES. Each may come to recognize the others as potential allies.
The Reformation (updating the old economicsu6d
A yarn of very recent origin has been spun in support of the economic necessity of the recovery of LOSSES. However, after having decided to approve recovery of LOSSES, regulators cannot then justify recovery after the fact by claiming that there may exist a least-offensive static method to redistribute such LOSSES. The argument's circularity is obvious. It takes no account of dynamic market adjustments. What remains is just another special interest piece-work that is not founded, as advertised, on economic principles. The FERC's advocacy of full recovery of LOSSES can be described only as a horrendous mis-step and a dangerous precedent.u7d
No economic rational warrants the recovery of LOSSES. However, several important economic reasons justify a denial of recovery.
First, recovery of LOSSES impedes market entry and exit, which serve as essential components for competition. To have successful businesses, some businesses have to fail. If failure is possible, businesses have a strong incentive to exercise care. Therefore, in this context, failure is good. Fortunately, neither a business failure nor bankruptcy has anything to do with reliability of the network, as has been shown in previous cases of electric utility bankruptcy and business distress.
Second, recovery of LOSSES rewards inefficiency and penalizes efficiency. Competitive markets operate in the opposite fashion. Recovery would send distorting signals to newly minted competitors, which might alter efficient outcomes.
Third, recovery of LOSSES fosters organizational schizophrenia. Are we a protected utility or are we becoming a competitive business? In this vein, it may be good utility strategy to threaten present and future captive ratepayers with recovery of LOSSES, but bad market strategy to repeat the same threat to any ratepayer who may in the future become a customer. Recovery of LOSSES may discriminate against those who choose a competitive supplier and those who leave for other reasons (business relocation, business distress, or self-generation).
Fourth, recovery of LOSSES triggers an incentive to maximize artificially defined LOSSES and minimize mitigation. Fiddle with the numbers. The utility has the information, the resources, the experience, and the overwhelming advantage in negotiations of this type. Commission monitoring leads to continued uncertainty and delayed dynamic benefits.
Fifth, recovery of LOSSES simply guarantees full employment for ... lawyers.u8d
Exodus (flight from regulation)
Zero recovery of LOSSES marks an admittedly strong regulatory position. Yet, with mitigation, time, and a price cap allowing unlimited profit potential, coupled with specific minimum phased-in percentage price reductions, this zero-recovery policy should create a fair process that can allow rates to approach market prices.
The goal must focus on achieving competitive benefits for all.u9d With federal and state legislation looming on the horizon, action taken today by regulators may preserve options that otherwise might soon be lost to the lawmaker's pen.t
Christopher Garbacz was a professor of economics for 25 years before joining the Mississippi Public Utilities Staff in 1994. This article is drawn from a paper presented in Chicago in August at a conference sponsored by Global Business Research, Ltd. The author wishes to tank Herb Thompson, Mike McCool, Ken Rose, and Jerry Taylor for their helpful comments, although the article does not necessarily reflect their views, nor the position of the Mississippi PSC.
u1dEven if one might ban the "S" Word in written work, the spoken word would prove more problematic. Ask yourself how many times you have used the "S" Word in a recent week. Even the author, who has practiced diligently for months, occasionally slips.
u2dA few tricks are useful. Pause before you speak. Practice in front of a mirror and with colleagues. Re polite but firm with those who refuse to acknowledge your wisdom. Diligence will one day bring you to the ultimate state of bliss when you pleasantly say to a utility executive: "Never, never use the 'S' Word! Always say 'LOSSES!'"
u3dToday, however, retail competition recognizes that electricity generation is not necessarily a monopoly element. Some argue that generation should never have been treated as such. If there is enough competition to assure the absence of market power, it may not be necessary for government to regulate generation. Nevertheless, transmission and wires services likely should remain a government regulated monopoly, but by granting full access to transmission system ("wheeling") for competitive suppliers.
u4dThe deflation of the 1930s was not a factor in this price decline.
u5dIf natural monopolies were in place, why would one find such a disparity in price around the country as is seen today? Some differences might stem from fuel mixes, special interests, or diverse regulators, but not all. Such a range of outcomes should not persist where natural monopoly rules.
u6dThe Econ tribe speaks in a dense language that requires a careful translation.
u7dThe question of the refund of LOSSES presents an intriguing corollary for advocates of recovery. Suppose the utility has overcharged ratepayers inadvertently and without malice since 1980. Now, in 1996, the error is discovered. Should the utility refund the excess or is this situation simply a case of retroactive ratemaking? Or, suppose captive ratepayers have suffered LOSSES by being denied access to competitive markets. Should symmetry require a recovery of these opportunity cost LOSSES, in parallel with a refund of uneconomic costs. Steven Parsons, of INDETEC, suggested this idea to me when I presented some of the other ideas in this article at a conference: "Successful Strategies for Pricing Unbundled Services," Global Business Research, Ltd., Chicago, Aug. 8, 1996.
u8dOr fill in the blank with your favorite group of unintended beneficiaries.
u9dPublic power creates market and jurisdictional inconsistencies that would disappear with privatization.
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