T.R. Standish's letter ("NUGs Take the Cake," May 1, 1995) in response to our article ("How State Regulators Should Handle Retail Wheeling," Feb. 15, 1995) reflects the views of those who believe that the full benefits of competition in the electric power industry do not require retail competition. Mr. Standish, in fact, believes that retail competition is bad and not inevitable. We would like to address several of his points:

Reasonable people can certainly debate the inevitability of retail competition. But unlike Mr. Standish, we feel that competition in the electric power industry will penetrate the retail sector. Once competition begins in an industry, it quickly spreads to all facets. We have seen this in the telecommunications and the natural gas industries; there is no reason to believe it will not happen in the electric power industry. We feel that as competition develops in the electric power industry the distinction between wholesale and retail wheeling will increasingly become blurred. The retail seller will face increasing competition from "bargain" sellers, and will, in turn, pressure the retail utility to tailor its services to the individual needs of customers (em which, in essence, is what retail competition is all about.

E We agree that small (core) customers should not suffer from retail competition. In fact, we believe that if retail competition is to be socially desirable, all customers should have the opportunity to benefit. We disagree with Mr. Standish and others that retail competition is merely a ploy of industrial customers to shift costs to other customers. Clearly, industrial customers will benefit from retail competition. We believe that retail competition will enhance pressures to improve the overall economic performance of the electric power industry.

I We agree that nonutility generators (NUGs) will prefer to sell their power directly to retail customers. These customers will benefit as long as NUG prices are below the utility's embedded generation costs. NUGs will prefer selling power to retail customers when the price these customers are willing to pay exceeds the local utility's avoided cost. Such incentives are, after all, consistent with the operation of competitive markets.

There can be a problem, however, if the local utility is unable to lower its price in response to competitive forces, leading to what economists call "uneconomic bypass" (em where the purchaser makes a rational decision to buy from a higher-cost, but lower-priced, power producer. Assume, for example, that a utility's embedded rate equals 7 cents per kilowatt-hour (›/Kwh), its marginal cost equals 4›/Kwh, and the NUG's marginal cost and price each equal 5›/Kwh. In this scenario, the customer would buy from the NUG even though the utility has the lower marginal cost. Although pricing flexibility would largely avoid this problem, the utility would find its revenues and profit margins decreased. We strongly suspect that Mr. Standish would not object to pricing flexibility, but would oppose having to reduce costs or having utility shareholders shoulder the lost revenues.

I We cannot dispute Mr. Standish's comment that many utilities have paid excessively for power from qualifying facilities (QFs). Mr. Standish is incorrect, however, to measure this overpayment by the difference between the utility's marginal cost and the QF's marginal cost. In an open marketplace, producers make economic profits whenever they are able to sell power above their marginal cost. The market price represents the marginal cost of the least inefficient producer that supplies power to the marketplace. The most efficient and lowest-cost producers make higher profits.

The "overpayment" problem actually stems from an erroneous assumption that you can get the prices "right" (em first by mechanically and administratively measuring a utility's avoided cost, and second, by requiring the utility to take all available power at that price. A not-too-surprising outcome is that utilities will pay more than their avoided cost, and retail customers will overpay for QF power. The "right" price is much more likely to result from the utility (em first, determining how much new capacity it will need, and second, executing some form of market-based procedure to establish the market price of this capacity. Utilities and state regulators are moving in this direction as exempt wholesale generators and other NUGs enter the marketplace.

I We seriously question whether retail customers would be best served by the absence of retail competition. Mr. Standish presumes that the utility can act as an effective middleperson in looking after the interests of retail customers. However, proponents of retail competition argue that only customers know what is in their self-interest; therefore, they should have the right to deal directly with generators, brokers, and other market participants. This means that retail customers, large and small, can only receive the full benefits of a competitive and more efficient market if they have the right to choose among services and service providers. We find this argument persuasive and consistent with the experiences of other regulated and unregulated industries.

I We disagree that the intent of Congress was clearly to prohibit the state from ordering retail wheeling. As mentioned in our article, we believe that the federal courts will ultimately decide this matter.

D The fact that state PUCs and legislatures are hesitant "to be first" perhaps most reflects the perception that retail competition will produce significant changes in the electric power industry. Historically, PUCs have tended to act cautiously. Those who have studied this issue know that "things won't be the same" after retail competition. Although some PUCs may be convinced that retail competition will only "redistribute costs," others are most concerned about the unknown. PUCs, as well as almost everyone, are uncertain about how retail competition will affect, say, future utility planning, operations, and pricing. They may consider retail competition unnecessary as long as the electric power industry seems to be performing reasonably well.

Overall, Mr. Standish's comments reflect a reactionary view of the changes occurring in the electric power industry. More and more of his colleagues in the electric power industry see retail competition coming and are preparing for it. Contrary to Mr. Standish, we also believe that retail competition is inevitable and, if done correctly, good public policy. The last point underscores the need for regulators and legislatures to realize that retail competition, per se, may not be socially desirable. Only when combined with reforms in pricing, obligation to serve, planning, and other regulatory rules will retail competition enhance the industry's economic performance.

We agree that retail competition in an otherwise unchanged regulatory world can produce adverse results. But such a world would likely be unsustainable, since market pressures would engender the necessary procompetitive reforms in regulatory rules.

Kenneth W. Costello and Robert E. Burns

The National Regulatory Research Institute

Youssef Hegazy

Energy Management Associates/EDS

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