Technological advances in electric generation and telecommunications make utility competition both possible and inevitable. These economic forces will eventually break down the regulatory structure of the electric industry. However, public policy should play a crucial role in molding and nurturing competition.In recent months, regulators in a majority of the states have opened proceedings to study electric competition. But little agreement exists on how to restructure the industry. I suggest that we now know enough about the issues to take some positive steps. I offer a plan that should introduce the essential elements of competition, while providing recovery of potential stranded investment and flexibility in choosing the final industry structure in the future.

Technology: Cause and Effect

Electric industry restructuring must take advantage of technological improvements in electric generation and telecommunications.

Generation. Technological advances, particularly combined-cycle gas turbines (CCGTs), have sharply reduced the cost of generating electric power and dramatically shrunk the scale required for efficient plant operation. While they cut the cost of producing power by increasing efficiencies in fuel use and operating practices, CCGTs also decrease capital intensity and shorten the period needed to bring a new plant on line. For instance, CCGTs with 200 megawatts (Mw) of capacity cost about $550 per kilowatt (Kw), are capable of 90-percent capacity factors, and have heat rates in the area of 7,500 British thermal units (Btu) per kilowatt-hour (Kwh). With gas priced at $2 per million Btu and a pretax capital cost of 12 percent, the full cost of producing power with these plants is about 2.9 to 3 cents per kilowatt-hour (›/Kwh).

Moreover, CCGT technology is improving rapidly. Thus, the long-run marginal cost of generation should remain favorable even if natural gas prices should rise substantially over the next 10 years. Fuel efficiency can be expected to improve sharply. (Fuel expense now accounts for almost 60 percent of the cost of power of CCGT units.)

Equally important is the efficiency achieved with small CCGTs. A decade ago economies of scale were achieved with coal-fired units that had capacity of 700 to 1,000 Mw and cost $1 to $1.5 billion. New CCGT technology captures most economies of scale with units of 100 Mw that require an investment of only $50 to $60 million. Consequently, CCGTs that serve only a small part of a local market are cost effective. Capital needs no longer represent a barrier to entry.

These small scales evoke a competitive industry, not a natural monopoly. The ease with which small low-cost producers can enter the generating business undermines the monopoly position of the utilities. The emergence of competition in generation is inevitable.

Telecommunications. Technology that permits two-way communication between customer and supplier has become vastly more sophisticated and much cheaper in recent years. Customers can now play a key role in determining the services they buy (em something not feasible until recently. Electric power can be marketed, not just provided on a take-it-or-leave-it basis.

New communications technologies will afford freedom of choice to customers in selecting the electric services they buy. This new freedom will cast both customer and producer in new roles.

Essentials of a Restructured Industry

Capturing the benefits of the new generating and communications technologies will obviously require structural change. These technologies will produce an industry driven by customer choice on the demand side and by competitive pressures on the supply side. Competition is required in the production and marketing of power. Transmission and distribution, the transportation link between generators and marketers, will remain regulated and include dispatch, coordination, and reliability services.

Generators will produce a commodity that is essentially sold in an open competitive market. Marketers will purchase power in this market and compete with each other in selling the power to end users under various terms and conditions. Utilities will provide transmission and distribution services on a common-carrier basis, and the fees they charge will be regulated.

Marketing. The marketing function in the electric power industry is archaic. Customers have virtually no role in determining the type, quality, and price of the electric services they buy. Instead, the utility and the regulator decide through an administrative process that makes little provision for customer input. No mechanism exists to test customer preferences in the tradeoff between price and quality. Customers are disenfranchised.

Competition in marketing will grow through the presence of numerous power marketers that have the ability to piece together various kinds of services. Entry must be made as easy as possible, and marketers must be rewarded for providing service-price combinations that customers consider superior. This step will be achieved by unbundling all services: metering, billing, and ancillary services. This will enable power marketers to combine as many of these services as they desire with the services they produce themselves to produce the product they offer customers.

Much of the benefit will likely occur in metering, where advances in communications technology come into play. Two-way, real-time communications will enable customers to express their preferences and direct product development and pricing. The potential benefits in terms of customer satisfaction and economic efficiency are enormous. For instance, a metering service may arrange to curtail power on certain uses that the customer specifies when the time-of-day prices rise above a certain threshold. Services like this could shrink peak demand, thus lowering rates.

Generation. The ability to generate electric power efficiently with plants that supply only a small portion of a local market suggests that the power generation business can support workable competition. But effective competition requires a number of conditions that do not exist now. First, enough generating companies must enter the market so that none exerts undue market power. The creation of a market that is geographically as large as possible could encourage an adequate number of market participants. Liquidity and price transparency must also exist. Until these conditions arrive, regulation must prevent the abuse of market power, and provide a favorable environment for competitive conditions to develop.

Effective competition also needs market mechanisms that promote vigorous activity in spot transactions as well as longer-term contracts. Simple evolution could fulfill this requirement; or the market can sponsor a pool. Either path would hopefully lead to the same final result: a market that permits both spot transactions and contracts of varying lengths.

The principal advantage of allowing spot and long-term markets to develop without government sponsorship is that the mechanism that emerges should closely reflect the needs of participants. The main disadvantage is that the spot market is not likely to be robust initially. Some participants would probably exert market power. Hence, regulation must again step in until competition becomes strong enough to police itself.

On the other hand, a pool can create spot transactions immediately. But pools take time to set up, which delays the start of restructuring. A pool may also lack a geographical base broad enough to furnish sufficient players to make competition effective. In fact, there are enough problems associated with establishing a pool to argue against rushing into it.

The Wires. Transmission and distribution (T&D) should remain regulated as a natural monopoly. This sector provides the infrastructure for the electric services market. It holds the market together and defines the physical limits of a power market. Since all market participants must use T&D, everyone must have access on nondiscriminatory terms, which means T&D must function as a common carrier.

Market-based pricing must replace cost-of-service pricing in T&D. Services must be unbundled as far as possible. Market-driven pricing is needed to create incentive for utilities to remove transmission capacity constraints when they emerge. Otherwise, constraints could handcuff competition. Unbundling is necessary to provide as much flexibility as possible for the development of new electric services. The ability of power marketers to offer a wide range of services depends on a broad choice of inputs.

Price caps should mark the first step toward market-driven pricing for T&D services. The U.K. experience in regulating distribution companies has demonstrated the advantages of price caps. Under the U.K. system, price reviews occur every five years, when the price-cap formula for distribution services is set for the next five years. The price ceiling for the first year is changed in each of the following four years by a percentage equal to the retail price index less an "X" factor. Allowing utilities to retain whatever they earn during the five-year price review period gives them a strong incentive to innovate and cut costs, especially in the early years of a review period.

Market pricing for T&D helps erase distortions that arise under rate-of-return regulation. Under the current system, regulators take great pains to prevent electric rates from rising too high (em i.e., producing revenues that might exceed the allowed return by 1 or 2 percent (em while turning a blind eye to rate differentials of 40 to 50 percent between contiguous areas of like economic character. What is lost is a concern for efficiency. Price caps would redirect attention to productivity.

The services tied to T&D are to some extent a matter of discretion. It is logical to include ancillary services, billing, and metering with T&D, but it is also desirable to allow power marketers and other third parties to provide them. While these services should be unbundled for pricing purposes, utilities should be required to offer them to marketers on the same basis they offer basic T&D services. Marketers would be free to acquire these services from utilities or third parties, or to produce them themselves.

A Concrete Proposal

My proposed restructuring plan incorporates 1) immediate customer choice, with market-driven pricing; 2) an opportunity to recover stranded costs; and 3) flexibility that does not forestall any particular future industry structure.

1. Utilities file unbundled rates for generation, transmission, distribution, metering, billing, and ancillary services effective January 1, 1997. T&D rates contain no adders above cost of service, but include the cost of coordination, dispatch, and reliability.

2. Price caps begin for each customer class on January 1, 1997, continuing for five years through December 31, 2001, at which time they are reset for another five years. The price caps are set at current rate

levels and are equal to the sum of the unbundled rates. The price caps decline in real terms by an "X" factor each year, adjusting for unforeseen exogenous factors. Utilities may offer discounts below the price cap without authorization.

3. Utilities retain pretax earnings above the amount required to earn their allowed return on equity, as compensation for potential stranded costs. Recovery of stranded costs is limited to this mechanism.

4. Any customers may elect open access effective January 1, 1997, purchasing electric services from their local utility or from any power marketer. Customers that so desire may obtain an all-requirements service from their utility.

5. Utilities unbundle all services (em transmission, distribution, metering, billing, and ancillary services (em on a common-carrier basis. T&D services include dispatch, coordination, and reliability.

6. Power marketers buy unbundled services from utilities and third parties, or produce the services themselves.

7. Utilities may compete as power marketers under the conditions that apply to other power marketers. Utilities enjoy the same freedom as power marketers in constructing new innovative services, which they may offer in addition to all-requirements services provided of last resort.

8. The duty to serve continues if the customer remains on the utility's system. The obligation terminates once a customer leaves the system. All obligations to serve end once competition is fully effective.

At the Heart of It All

The heart of the plan lies in Point 3: The provision for recovery of potential stranded costs. No other issue in restructuring is so divisive. The plan defers any decision on vertical disintegration, or the formation of pools, until regulators and utilities are better equipped to make more informed decisions.

The plan intends to provide utilities with the same incentive that unregulated companies have to cut costs and improve productivity. Price caps are central to this objective. Since utilities will be able to retain all earnings in excess of their allowed return, they will have far more incentive to cut costs and improve productivity than in the past. By retaining any pretax earnings surplus, utilities may receive compensation for potential stranded costs, offsetting undepreciated plant investment and regulatory assets over the next five years. The benefits do not come at the expense of customers, but reflect productivity gains.

It is essential to begin the price-cap regime as soon as possible. Competitive pressures will grow as time passes, and the stronger competitive pressures become, the more difficult it will be for utilities to stay ahead of the competitive pressures and achieve earnings in excess of their allowed returns.

Open access is made available to all customers at the outset as a matter of fairness. A phase-in by customer classes would carry overtones of discrimination. With universal availability of open access, the decision to purchase services from a power marketer rather than a utility would be determined by market forces and customer preferences. Utilities would retain an obligation to offer all-requirements services to all customers. However, utilities would fulfill this obligation as marketers; they would not need to build new generating capacity.

The longer the transition is delayed, the stronger competitive forces will grow. And the more rates will be discounted once open access begins. And the smaller the compensation for stranded costs. t

Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in economics from Columbia University, and specializes in economics and financial research on electric utilities.

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