Consolidation: Key to the Future?


Why integration may win out in the long run.

Fortnightly Magazine - August 2005

In the electric power industry, the urge to merge has gained a new lease on life. American Electric Power Co. (AEP) had thought it successfully wooed distant Central and South West, and despite a setback in the D.C. Circuit on account of the Public Utility Holding Company Act (PUHCA), AEP probably still will achieve a happy coupling. Exelon (itself a product of merger) is taking nearby Public Service Electric & Gas Co. under its wing, and most recently, Duke Power has proposed a merger with Cinergy, a close-by but not contiguous utility.

These combinations are witness to the powerful forces of consolidation let loose when deregulation makes consolidation a preferred tactic in an uncertain world. But to what extent will government policy encourage or resist this trend? What exactly is the regulatory environment that nurtures combinations or, for that matter, supports fragmentation? As we shall see, there are many cross-currents.

PUHCA is a good place to start, for although that statute has lingered on its deathbed for a number of years, it is still alive and kicking as of late June. If repealed, it should be replaced by some policy governing the structure of the industry that will either encourage consolidation or discourage and perhaps virtually forbid it.

In a similar way, for many years the national transportation policy favored the consolidation of railroads,1 but this has now advanced to a point where concern about competition has replaced sympathy with consolidation.

PUHCA incorporates concepts that may continue to be important under any regime that replaces it. The statute was a powerful reaction to the financial (but not necessarily operating) consolidation in the electric power industry in the years before the 1929 stock market crash. This mostly was the work of pioneers in the industry who, as they continued to buy up or launch electric enterprises, were struck by the ease with which they, as seasoned operators, could borrow money to buy or build in pursuit of an empire. This was in contrast to the difficulties and soaring interest rates encountered by owners of individual properties with no track record. The strongest talking point for holding companies was that they could raise money for expansion more cheaply than separate companies relying on their own credit.


The Hon. Richard Cudahy

Samuel Insull, perhaps the most renowned of the holding company promoters, acquired some small electric plants in southern Indiana in 1912 and combined these under the mantle of the Middle West Utilities Co., soon to win prominence as a major holding company. As Insull's holding company empire developed, it grew as a pyramid, with holding companies atop holding companies, all financed with generous portions of debt and preferred stock so that the leverage at all levels-but most markedly at the top-continued to increase as the empire expanded. This pyramidal configuration also enabled control of the company to be exercised with only a relatively small investment.

The service company was another feature of the holding company economy, rendering services of various kinds to the operating companies. This was touted as a major benefit in that it made skilled but expensive experts-otherwise not affordable-available to the operating companies.

So, financing and expertise were the major claims of the holding companies. But they early were criticized for inflating the value of their operating properties and overcharging for services, thereby increasing rates. Later, these massive aggregations of capital drew political fire as the "power trust"-unregulated wielders of economic and political power. But the critique did not become lethal until the stocks and bonds of holding companies, widely held by a public convinced they were "safe investments," lost all, or almost all, their value in the Great Depression. Hundreds of thousands of destitute investors, thinking themselves bilked and defrauded, demanded a death sentence for holding companies, and that is exactly what they got. Section 11 of PUHCA decreed the extinction of interstate holding companies unless they qualified for an exemption-the most important being the possibility of "integration" of the operating utilities so they could achieve the economies and efficiencies assumed to result from combined operations. The goal of the statute was an "integrated public-utility system" that was physically interconnected and might be operated as a singly interconnected and coordinated system confined in its operations to a single area or region. The integrated system was to be not so large as to impair the "advantages" of localized management, efficient operation, and effective regulation.

EES North America

Integration seemed to require that the utilities involved be contiguous, but this requirement became more flexible as the years passed. Because in 1935 no thought was given to the possibility of competition, it was immaterial that combinations of contiguous utilities acquired market power, and that this arrangement appeared to undermine the possibility of competition. At the time, integration was thought to be the ideal condition of yielding efficiencies-and, as we shall see, it remains powerfully attractive. Since the era of the holding companies, of course, the achievement of efficiency through competition has become popular as the royal road to lower rates. But, as has been indicated, the concentration of the electric generation associated with integration is in principle inconsistent with conditions that favor competition in generation. This is not to say that the two concepts cannot be made to co-exist through such measures as divestiture of plants and cession of control of generators or transmission. But, in principle, competition seems to favor a fragmented industry with large numbers of independent players.

Turning to Disaggregation?

Aggregated ownership of scattered utilities was condemned under PUHCA. This involved concentration of capital (with the attendant evils of the "power trust") without the operating benefits of integration. The authors of PUHCA were not impressed with the purported advantages of holding companies in obtaining cheaper financing or in making expertise available to the member companies. In their view, service companies were more a device for overcharging, and the advantages of size were not acceptable unless there was enough concentration to achieve integrated operation.

Now these principles have been turned on their head: Concentration of ownership is acceptable only if there is enough geographic disaggregation to allow vigorous competition. Workable competition presumably is the dominant value, and, reversing the priorities of PUHCA, integration is not an object of government policy, although it may be a goal of private decision making. Presumably, consolidation would be permitted only if it does not interfere with competition. These are the priorities of the economy generally, and they seem to apply equally to electric power. Thus, the merger of oil companies or chain stores will be permitted only to the extent that competition can be maintained. Those steeped in the lore of antitrust could hardly admit of any other priorities.

Yet, I suspect that the lure of integration of electric power generation will, in the end, prove more powerful even than the demands of competition. This may reflect a resurgence of economies-of-scale thinking, since the kind of thinking that formed PUHCA, and its preference for integration, is intuitively powerful and will continue to assert itself. It also may be that this thinking is empirically sound. Integration of a network infrastructure industry, like electric power generation, may indeed yield lower prices (with more reliable operation) than can be achieved by a disaggregated system. In the meantime, competition has yet to produce consistently lower prices, and certainly has not produced superior reliability.

Integration also is more likely to accommodate the expanded use of nuclear generation that appears to be in our future. Nuclear power may well be poised for a comeback because of the very serious problems of fossil fuels with respect to climate change, and better management of nuclear is part of the rationale for the merger of Public Service Electric & Gas into Exelon. The numerous uncoordinated managements and engineering professionals that attempted to install nuclear power may have led to its earlier failure in the United States, while the high level of expertise available only to a very large organization, and the uniformity of approach achievable on that basis, may lead to results in this country comparable with those apparently realized in France and Japan.

Reliability is another factor in support of integration. Almost by definition, interconnected systems with centralized control are most likely to foresee and to deal with stresses leading to failures and to cascading outages. One of the unknown qualities in a system of competition, with fragmented ownership and control of transmission, is the state of reliability. Such a system is experiencing enhanced power flows over longer distances, creating conditions unfavorable to reliability. And various parts of the system stand in competitive rather than cooperative relation to one another. This problem has not been thought through under the present condition, and the solution seems to be more one of hope than of realistic expectation.

Beset by Challenges

In addition, consolidated systems may be able to deal more effectively with the mounting environmental problems facing the industry. From greenhouse gases to mercury pollution, the industry is beset with emissions challenges probably more serious and difficult than at any time in its history. The most formidable problems will demand the finest technical resources and the most capacious financial resources-exactly the capabilities that integrated and consolidated systems are likely to possess. Environmental challenges are probably the most trying of all the multifarious challenges facing the electric power industry. And this in itself may be the most potent factor leading to integration.

Integration also may yield financial benefits, particularly if it demonstrates improved reliability. Capital may be more available on better terms to large systems under firm central control.

The question remains, however, whether consolidation will bring back troubling concerns about a resurrection of the "power trust." Will the burgeoning size of the electric power entities enable dangerous levels of economic and political power? One must bear in mind that the holding companies of the 1920s and 1930s were subject to no public regulation. The states were precluded by the interstate character of these concerns, and there was no federal body to step into the breach. PUHCA invested regulatory power in the Securities and Exchange Commission, but this arrangement was joined with the death sentence, which put an end to "power trust" concerns in its own way.

In the future, as I would envision it, interstate consolidations of electric power providers would have to be subject to strict federal regulation to monitor both the operating and the financial aspects of the business. State regulation also could play a role, but its effectiveness obviously would be limited by the interstate nature of the regulated entity. Hence, there must be a clear understanding that fully empowered federal regulators were prepared to take whatever steps were needed for the protection of consumers, investors, and the public interest. Fearless and forceful regulation could go a long way toward bringing concerns about the "power trust," which was a real and very disturbing source of anxiety in its day, into line with present-day reality. The industry should welcome, and even seek, this sort of regulation, just as Insull in his day advocated state regulation as a bulwark against public ownership.

Tepid Reaction

There will be no outburst of enthusiasm for this analysis, which portends the creation of a set of huge electric power providers impossible to adequately discipline through competition and probably thought to be too powerful to be firmly regulated. I concede that there are obvious criticisms of the outlook presented here that will have a lot of appeal and a degree of validity. But, for a network industry that provides perhaps the most crucial component of the infrastructure, integration is a quality that has recommended itself intuitively since the outset of the industry. That is why it was looked on with approval and exempted from the death sentence in PUHCA.

A good case can be made for the failure of nuclear power in the United States based on the fragmentation of the industry here in comparison with places where it has been regarded as successful. And many of the policies that have accompanied wholesale deregulation-such as the creation of regional transmission organizations and independent system operators-have advanced the values of central and coordinated control of many functions. It seems almost axiomatic that electrical systems are at their best when they are interconnected and centrally coordinated and controlled.

A defense of integration, of course, runs at least superficially afoul of much current conventional wisdom. With the retreat of economies of scale as a guiding philosophy in the generation and distribution of electricity, it has become fashionable (and perhaps wise) to think in terms of "smaller is better." Thus, distributed generation, with relatively small generators deployed near loads, is being promoted as a substitute for complete reliance on a central generator. Although there are technological reasons why distributed generation might now be viable, its use represents a reversal of one of the earliest developments in the growth of the industry-central station generation. Central station power, early advocated by Edison and Insull, became the industry norm, and recent indications of retreat from it reflect a developing preference for smaller and more decentralized sources of power.

Amory Lovins was an early advocate of avoiding huge generators out of scale in relation to loads. Although his views never quite made it to the mainstream, they were influential in reinforcing the trend away from the size concepts associated with economies of scale-illustrated in recent years by the widespread advocacy of natural-gas combustion turbines as a source of generation. But all of these tendencies relate to the size of generators rather than to the scope of the system of which they are a part. The possible benefits of integration, as discussed in this article, involve the scope and coverage and coordinated control of an electric power system, and bear no necessary relation to the scale of the equipment deployed in the system. Hence, "small is better" thinking of the sort we have mentioned is not necessarily relevant.

Enduring Appeal

We are left with the question of what sort of future there will be for the integration of interconnected systems, which has been an appealing objective in the past, as illustrated by PUHCA. As this article suggests, the ancient and enduring appeal of integration as a governing principle, even overshadowing competition as the dominant theme, may take shape in the future, as it once did with the railroads. This tendency would reflect long-held intuitions about the way to achieve efficiency and reliability.

Admittedly, current thinking, although it does not affirmatively reject integration as a goal, primarily favors competition as the process crucial to efficiency. But whether competition actually will yield efficiency is more a matter of supposal than of empirical demonstration. Integration, with its long and important history of usefulness at various stages of electric power development, remains a powerful contender to achieve dominance now and in the future.



  1. See Union Pacific and Southern Pacific Merger Case, Surface Transportation Board Decision No. 44, 1996 WL 467636 (I.C.C.) at 205, *87 (August 12, 1996). (Separate opinion of Member Owen at 489, *213).