Power Play

Deregulation of the nation's electric power industry gets underway this year. Electric power is being deregulated for a number of reasons: it has become technologically possible; deregulation generally is fashionable; and some analysts believe that under carefully crafted policies, competition in electricity generation and wholesale trading can drive rates down for all customers. But there are important policy questions to consider: How will deregulation affect existing energy conservation programs? Will it lead to increased air and water pollution? And will it significantly benefit consumers and small businesses or simply be a windfall to the utilities and other large corporations?

Just as the development of microwave transmission of telephone signals forced competition on the long-distance telephone industry, de reg u lation of electric power is said to be warranted by the development of more efficient gas turbines. The economies of scale that dictated construction of large generating plants no longer apply because the new combined-cycle gas turbine (CCGT), developed over the last ten years, has enabled relatively small generating plants to be more cost-effective than any existing technology.

Many large manufacturers today can generate their own electricity at a cost lower than local utility rates. In addition, entrepreneurs want to build "merchant" power plants using CCGTs and then sell the electricity in the new wholesale markets that have sprung up. Because of these developments, most current proposals call for deregulating only the generation, not the retail sale, of electricity. To fully open this market, most states are requiring that the utilities sell their generating plants, most of which are less efficient than these new competitors. Long-distance transmission and local distribution of electricity would remain monopoly functions of the existing utilities and would continue to be regulated by federal and state agencies as operators of the local grid.

Nuked!

Unlike the deregulation of other industries, however, the deregulation of electric power is complicated by the utilities' large outstanding commitments to nuclear power plants, most of which would not be competitive in a deregulated environment. These plants were either abandoned in the early 1980s as too expensive or completed with cost overruns of as much as 700 percent. The bonds issued to build the reactors were underwritten on the assumption that there would be a stream of guaranteed income from a known number of ratepayers; deregulation opens up the prospect of a utility suddenly losing a significant portion of its customer base to competitors, and very likely defaulting on its bonds. Under deregulation then, the unpaid portion of these debts would become "stranded" because payoff would no longer be possible—thus, the utilities refer to these costs as "stranded investments" or "stranded assets."

Critics contend that these costs are losses caused by management mistakes, and ought to be paid by the shareholders through reduced dividends, as in any other industry. The question of who absorbs these losses—consumers, stockholders, or taxpayers—is one of the driving forces of the deregulation debate. Indeed, deregulation has been adopted first in states like California, Massachusetts, Connecticut, Rhode Island, Pennsylvania, and Illinois, where most of the major utilities must charge higher-than-average rates to pay for their abandoned or expensive nuclear plants. In states like Minnesota, Wisconsin, Iowa, and Florida, which have lower rates because they have no nuclear power burden, deregulation is barely on the radar screen of the legislatures.

Paying for the failure of nuclear power has especially rankled the members of the Electricity Consumers Resource Council (ELCON), a trade association of 37 large corporations including the Big Three automakers and most of the major oil, chemical, and steel companies. These corporations together use 6 percent of the nation's electricity in their manufacturing processes, and some say electricity is 50 percent of their operating costs. The organization argues that the electric power industry should be deregulated so that ELCON's members and other big industrial and commercial customers can shop the nation for the lowest-priced electricity instead of being forced to buy their power from local monopolies whose rates are burdened by their nuclear mistakes.

For their part, the utilities have said that they will litigate as long as possible any deregulation plan that does not provide for 100 percent recovery of their stranded investments from consumers. The utilities maintain that since state regulators approved the construction plans for the nuclear plants, customers, not shareholders, should take the hit. Lawsuits have already been filed in New Hampshire and Pennsylvania, where legislation requires stockholders to share in the payment of the stranded investments. The National Law Journal says that stranded investment recovery has set off a "litigation explosion" that promises to make the issue one of the top ten sources of new lawsuits in 1999.


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The stakes are huge: a new study by the Safe Energy Communication Council reports that utilities in 11 states—California, Illinois, Massachusetts, Michigan, Montana, New Hampshire, New Jersey, New York, Pennsylvania, Ohio, and Texas—have a total of $112 billion in stranded investments in nuclear plants and in other stranded costs, such as long-term contracts to purchase power from high-cost alternative energy projects that were signed before the CCGT technology was developed. Estimates for the nation's total stranded investment bill run as high as $300 billion—about twice the amount of the savings and loan industry bailout.

Most deregulation plans include financing mechanisms to accelerate the payoffs of the stranded costs, since these costs must be fully paid off before true competition can take place. Even the staunchest advocates of deregulation concede that residential and small-business customers will not see significant benefits until the payoffs are completed—in four to ten years, depending on the individual state deregulation plan. In states that have adopted deregulation laws, however, big industrial and commercial customers are already experiencing significantly lower rates.

Who Benefits?

Most analysts agree with Amory Lovins, vice president and director of research at the Rocky Mountain Institute, who says that almost all the economic savings to be realized through industry deregulation are captured at the wholesale level, which was deregulated by the Federal Energy Regulatory Commission (FERC) in 1996 as part of its implementation of the Energy Policy Act of 1992, which mandated open access to the nation's transmission grid and called for the deregulation of wholesale power trades.

As Lovins wrote in the Christian Science Monitor in the fall of 1994, deregulation of the retail electricity market "is really an attempt by a few big industrial customers to grab the cheapest power sources and stick everyone else with the costlier ones, rather than sharing costs equitably. . . . It is not about reducing costs so much as shifting them to the smaller and weaker customers. Indeed, virtually all its claimed savings would already have been captured by wholesale competition."

Mark Cooper, an economist with the Consumer Federation of America and Consumers Union, goes even further, saying that consumers will actually see their rates rise because of deregulation. Cooper has reviewed the significant scholarly literature on the industry's economics and analyzed the effects of the recent deregulation of other industries. He calculates that deregulation of the electric utilities will mean rate increases for residential customers ranging from 31 to 60 percent. Approximately 7 to 10 percent would cover the stranded investment payments; another 12 to 22 percent is necessary to offset the loss of the efficiencies of vertical integration when the utilities are forced to divest their generating plants; 10 to 22 percent results from the anticipated price discrimination against customers with a low elasticity of demand (all residential and most small-business owners); and 9 to 23 percent is the expected result of market power being used against these same customers. These increases, Cooper said, will be offset by only a 5 to 15 percent decrease in rates through efficiency gains brought about by deregulation.

In both California and Massachusetts, new deregulation laws implemented last spring were accompanied by mandatory 10 percent rate cuts as inducements to win public acceptance of deregulation. However, the rate cut in California is being financed by bonds whose payoff will be charged to customers' utility bills. After the dust settles, the real savings will amount to only 1 percent. In Massachusetts, the rate reduction is being financed by deferring the collection of the total amount of the rate reduction, $550 million, until the end of the four-year transition period. After that, the accrued charges will be paid off by customers who do not choose a power supplier other than their existing utility. Rob Sargent, director of the energy project for the Massachusetts Public Interest Research Group (MassPIRG), says that this financing scheme means the rate cut will be paid for mostly by elderly, low-income, and other customers who are overwhelmed by the complexities of the new power market and therefore choose to stay with their current utility.

Deregulating the Environment?

The impact of deregulation on conservation, renewable energy development, and environmental pollution may well be negative. In early October the Environmental Working Group and World Wildlife Fund released a study showing that since the Energy Policy Act of 1992 launched the deregulation process, utilities have reduced investments in energy-efficiency programs from $1.6 billion to $900 million in 1997, a drop of 45 percent. Moreover, the utilities had projected in 1992 that they would invest $2.7 billion in conservation and energy-efficiency programs in 1997 but in fact spent only $894 million—one-half of 1 percent of their revenues for the year, $272 billion.

The study found that if the projected amount had been invested in 1997, customers would have saved $1 billion and the utilities' plants would have avoided emitting 11 million tons of global-warming gases and 79,000 tons of soot and smog-forming particles. The report states:

Some utilities have explicitly stated in their filings with the Department of Energy that they have cut their energy-efficiency programs to prepare for the deregulation of the electricity market. . . . Deregulation produces price competition, which has two main effects on utilities. First, it puts pressure on utilities to cut programs like energy efficiency that are no longer seen as profitable in the short term. Cuts in energy efficiency compound the need for more power. Second, as utilities search for more power, deregulation drives them to produce or buy the cheapest power available. Utilities often use heavily polluted coal-fired power plants to meet this demand. . . . Many of these . . . plants are exempt from the Clean Air Act's most stringent requirements.

The Department of Energy is forecasting an increase in air pollution over the next ten years because its analysts expect deregulation to increase the amount of power produced by coal, still the cheapest fuel for steam generators. However, as these coal plants face more stringent emission-control regulations, they could become as inefficient as nuclear reactors. Indeed, one New England environmental organization, the Conservation Law Foundation (CLF), helped broker the deregulation laws in Rhode Island, Massachusetts, and Connecticut because its staff was certain that deregulation would render the region's coal plants uncompetitive because of the cost of installing mandatory emission controls.

So far, the strategy seems to be working. One new owner of coal-fired plants around Boston plans to replace one of the dirtiest plants with a CCGT generator. In September the Environmental Protection Agency directed 22 eastern and midwestern states to significantly reduce nitrogen oxide emissions, producing howls of protest from utilities that use coal to produce cheap electricity. To be assured of success in the long run, however, this strategy depends on congressional action to decrease permissible emission limits even further, a prospect that appears remote given the Republican leadership's opposition to the 1997 Kyoto Accords on greenhouse gas reductions.

Lifeline Rates

Consumer groups like the National Consumer Law Center, MassPIRG, and California's Utility Reform Network (TURN) have been somewhat successful in incorporating existing subsidies for low-income ratepayers and energy conservation programs into the new laws in California and New England. The California law subsidizes these programs at a level slightly below what the state required under regulation, but the subsidies have sunset provisions, so the battles will be re-fought in 2001. The Massachusetts subsidies are funded at 75 percent of current levels but are not encumbered by time limits. In Conn ecticut, environmental groups won significant increases in permanent funding for development of renewable-energy projects.

The laws have sparked a new small industry of "green" (renewable) electricity marketers. But Nancy Rader, an energy consultant in Berkeley who has represented TURN and the American Wind Energy Association, says that the prospects for authentic green power under the California law are dim. "Competitive markets," she says, "that have been intentionally skewed to favor the incumbent utilities, as California's has, leave very thin margins for new competitors. The transaction costs to sign up green consumers are astronomical."

The most contentious issue in both California and Massachusetts is the new laws' requirements that consumers pay 100 percent of the stranded investments. In California, the stranded investments are estimated to be $28 billion, and in Massachusetts about $12 billion. In both states, consumer groups, aided by Ralph Nader's Public Citizen organization, placed initiatives on the November ballots to repeal the deregulation laws, and in both states the initiatives lost by wide margins largely because the utilities and their business allies outspent the consumer groups on television advertising by factors approaching 25 to 1. In California, where almost $200 million was spent in the campaigns for ten ballot propositions, the deregulation initiative accounted for one-fifth of that amount. The state's three major privately owned utilities, Pacific Gas & Electric ($17.6 million), Southern California Edison ($17.3 million), and San Diego Gas & Electric ($4.1 million), were joined by Commonwealth Edison Co. of Chicago ($250,000), the Morgan Stanley & Co. brokerage firm ($250,000), the national utility trade association, Edison Electric Institute ($200,000), and the Planning and Conservation League ($110,000), one of California's largest environmental groups. In Massachusetts, the lopsided victory and spending for television advertising was comparable.

Because customers must pay the stranded investment and other transition charges, would-be power marketers who want to compete against the utilities have found that they are unable to beat the utilities' price for power. Enron, a large Texas-based gas and electricity marketing and development firm, reportedly spent $10 million trying to break into the Cali fornia market before abandoning the idea; Enron's effort failed in Massachusetts, when it became apparent that consumers perceived no advantage in signing up with the newcomer. As of October, fewer than 1 percent of the customers in both these states had opted to sign up with a new provider.

Some history is instructive. Regulation of the utilities was adopted by the states beginning in 1907, after 25 years of cutthroat competition had produced widespread bribery of municipal officials by power company owners seeking or renewing franchises; wasteful duplication of services and resources (including instances of gangs from one company chopping down the distribution poles of competitors); and monopolies that restricted customer choice. It's not necessary to demonize the owners of these companies to explain their actions; they were simply obeying the imperatives of the free market and trying to maximize their profits in a fragmented industry that had many characteristics of a natural monopoly. Regulation was adopted because electricity had already become an essential service—a public utility—and the public interest demanded consumers be protected from abuses and excesses. Some early players in the industry saw regulation as a lesser evil, necessary to rationalize the chaos, and a force that they hoped to capture, though in practice there was a tolerable balance between public and private interests. In the era of regulation, utilities earned a normal return but not an exorbitant one, and the cost of power steadily dropped.

Today, with deregulation of just the generating component of the industry, the early history may well repeat itself. Even with the recent technological changes, the electric power industry retains economies of scale and resists ruinous price competition. Left to the rules of laissez-faire capitalism, a deregulated electric power industry will be tempted to recreate giant utility holding companies similar to those that controlled much of the nation's wealth two generations ago, in the same way that deregulated phone companies, cable companies, and airlines are currently re-combining.

In 1929 ten utility holding companies controlled 75 percent of the nation's electric power through their ownership of approximately 2,400 utilities. In 1932 the J. P. Morgan Co. investment bank forced the holding companies controlled by Samuel Insull of Chicago into bankruptcy, and the Morgan bank ended up controlling a total of 44.9 percent of the nation's electricity. Speculation, pyramiding, and stock watering—and the concentration of wealth they combined to produce—were so widespread that in 1928, the Federal Trade Commission started what became a seven-year investigation of the industry. The commission produced a 72-volume report, which laid the basis for much of the New Deal's utility, banking, and securities legislation. When Franklin Roosevelt took office, one of his top priorities was to break up the holding companies to keep them from ever again having so much control over the nation's economy. The result was passage of the Public Utility Holding Company Act (PUHCA, pronounced POO-ka) in 1935, and the forces that created the effects it seeks to prevent have been trying to get it repealed ever since. Today, the complete repeal of PUHCA is a major part of the deregulation agenda for ELCON, for some politicians, and for some of the largest utility holding companies.

PUHCA forced the owners of multistate holding companies to divest their out-of-state operating companies in order to prevent the parent companies from juggling the books of their subsidiaries so as to obfuscate their true financial condition when they asked for rate increases. Because of the enormous control J. P. Morgan Co. and other investment banks exerted over the utility holding companies, PUHCA prohibits Wall Street firms from owning controlling shares in them. It also contains regulations governing industry mergers. PUHCA is the key to an industry structure designed to forestall monopolistic abuse.

Merger Mania

As deregulation moves forward, perhaps the most important challenge facing FERC and the Securities and Exchange Commission (SEC) is how to deal with mergers, acquisitions, and joint ventures in a manner that protects the public interest. The rules creating the new structure of the industry will determine whether some players have open access to compete against established interests and whether any group of players will be able to achieve market power and engage in gaming and other predatory practices. FERC's merger policies, last updated in 1996, are feeble. What's needed is a standard declaring that mergers, to be approved, must promote competition and reduce market power. Otherwise, ratepayers—like airline passengers—will increasingly become captives of new monopolies.

The rate of mergers in the industry has increased from two in 1992, when the passage of the Energy Policy Act signaled the coming of competition, to 15 in 1997. Including acquisitions, the value of consolidations in the industry has increased from $633 million in 1992 (30 deals) to $46 billion (114 deals) in 1996, according to Houlihan Lokey's Mergerstat, an industry reporting service. The pace has fallen since 1996, but the potential remains huge. Currently before the FERC and the SEC is a merger application by the American Electric Power Corp. (AEP), one of the nation's largest utility holding companies, with headquarters in Columbus, Ohio, and operations in ten midwestern states, and the Central and South West Corp. (CSW), a holding company with headquarters in Dallas and operations in three other states. The proposed company would be the third largest utility holding company in the nation, with almost five million customers and $29.2 billion in assets. If this and the other proposed mergers announced in 1997 are approved, the total value of all the assets involved would come to $173 billion. The proposed merger of AEP and CSW is the exactly the kind of merger PUHCA was designed to head off, because it is a merger of two potential competitors. Both utilities conduct wholesale operations in Texas and Oklahoma, and AEP is one of the nation's top five power traders by volume. CSW has been working, by its own admission, to develop a "significant electric power trading and marketing business." If the SEC approves this merger, it is hard to imagine that it would not approve other large mergers of this sort—even those contemplated by some industry executives and securities analysts who are confident that the nation's 243 private utilities will be reduced to 50 in five years, and to 15 to 20 giant utility holding companies over the following ten years.

In addition to the mergers, there are strategic spin-offs from existing utility holding companies that, competition or no, bode ill for consumers. Utility-affiliated "independent" power producers have numerous advantages over their stand-alone competitors. In 1995, 6 of the top 11 so-called independent power firms, and 10 of the top 20, were actually electric utility affiliates. Mission Energy, a subsidiary of the Edison International holding company—which also owns the operating utility Southern California Edison—is the nation's largest independent power producer in terms of ownership in nonutility generating projects. The PG&E Corp., the holding company that owns the Pacific Gas and Electric utility, is also now the sole owner of a subsidiary called the U.S. Generating Co. (USGen), which has developed and manages nearly 8,600 megawatts nationwide and is the second largest producer of power in New England. Mission Energy and USGen have been busy buying and building power plants around the world while their sister utility operating companies have had to sell much of their fossil-fuel generating capacity in California to independent power companies of other, out-of-state holding companies (like Duke Energy of North Carolina) in order to comply with California's new deregulation law.

Holding companies' "independent" power producers have advantages over their competitors because they have access to the deep pockets of their parent companies for financing projects and can use the construction, marketing, and management services of other subsidiaries of their parent-owners. The PG&E press release on its acquisition of the remaining stock of USGen, for instance, boasted that the holding company is "making USGen the Corp or ation's vehicle for power plant development, asset acquisition and plant operations in the competitive energy market. USGen is also responsible for the Corporation's wholesale electricity marketing activities. . . . [The PG&E purchase] joins USGen, PG&E Trading, PG&E Energy Services and PG&E Gas Transmission together to create a top-notch competitor."

Heat on Consumers

Reliance on market dynamics can produce other perverse results. Last June, a heat wave struck the Midwest, sending demand for electricity soaring as people turned on their air conditioners. Over a three-day period the spot price for wholesale electricity in that market shot up from its normal summertime level of $20–50 per megawatt hour to $7,500 per megawatt hour for baseload power to be delivered in the next hour. For power to be delivered the following day, the price jumped to $2,600 per megawatt hour. As a result, several big utilities who buy on the spot market—like Commonwealth Edison of Illinois, FirstEnergy (which includes Ohio Edison and others), Northern Indiana Public Service Co., and the Southern Company of Atlanta—lost tens of millions of dollars. The biggest loser by far was the holding-company parent of Louisville Gas and Electric Co., LG&E Energy Corp., which dropped $225 million. The company has since discontinued its merchant trading and sales businesses.

FERC, which regulates wholesale trading, investigated the price spikes in mid-August amid calls for and against price controls and charges of manipulation of the market. The commission found "no direct evidence" of outright market manipulation. However, the FERC staff did find evidence that some wholesale traders and utilities were gaming the system by various techniques that "diminish confidence that market institutions are working in a fair and nondiscriminatory manner." FERC mandated open access to the transmission grid in 1996, but its investigation this summer found evidence that some utilities did, in fact, shut out competitors from using their transmission lines.

Mark Cooper, the analyst for Consumers Union, has a 20-point list of suggestions for policies to protect residential customers. One proposal is to require stockholders to pay a fair share of the stranded investment. Another is to authorize regulators to require nondiscriminatory access to the transmission and distribution systems and to investigate market conditions, including the ability to gather evidence, hold hearings, and order corrective actions such as penalties and restitution. Cooper says regulators must have the authority to apply any condition or limitation on a merger or acquisition necessary to protect all ratepayers and promote competition.

One other suggestion by Cooper is already being carried out by scores of municipalities, nonprofit organizations, and other groups around the nation. The idea is to "aggregate" small customers—that is, to group all the residents of a town or county, for instance, or all the members of all the credit unions in a state, into a large and sophisticated customer with bargaining power. Scott Ridley, a consultant to state and municipal governments trying to devise strategies for dealing with deregulation, is the father of this "community choice" form of aggregation. In this model, local governing boards act as the purchasing agents of electricity for the residents of the jurisdiction; individual residents are not required to be part of the new entity and can choose a different power provider if they wish. The community choice district is not the same as a municipal utility because the district does not own any physical assets; the substations, wires, and poles are leased from the utility. The district's governing board simply buys the cheapest power available and uses the distribution system already in place to deliver electricity to the residents.

For example, in Falmouth, Massachusetts, Select man Matt Patrick worked with Ridley and local officials and legislators to get a provision authorizing community choice districts included in the Massa chusetts deregulation law in 1996. Patrick helped organize the Cape Light Compact, a district that covers all 15 towns on Cape Cod and the six towns on Martha's Vineyard. The Cape Light Compact is currently reviewing proposals to supply the area with power, and other towns and counties in Massa chusetts are in the process of setting up similar districts. Ridley writes,

For a market to function effectively, it must be balanced between consumer and supplier interests. Options that provide consumers with statutory power, leverage, and autonomy [to organize such districts] are critical to the ultimate standards and benefits that will emerge from a restructured industry. . . . If we look at the lessons of history, we can see over and over again that state regulators need the presence of well-organized consumers to be able to counter the influence of those that they are regulating.

On balance, deregulation will do little for environmental goals and may increase costs to small consumers. Deregulation requires that consumers give up the codified protections for reliable delivery of an essential service at an adjudicated cost—in exchange for a system in which the delivery, affordability, and reliability of the product is no longer guaranteed but is trusted to market forces. The only undisputed benefit of deregulation is that it will reduce prices for large corporate customers, many of which, like the Raytheon Corporation in Massachusetts, have used the threat of relocation to an area of cheaper power in order to force lawmakers to deregulate the industry in their state.

Congress should face the stranded asset problem directly, rather than letting it be the engine of a form of deregulation that may not serve the public interest. Since most regional differences in the price of electricity are due to nuclear power losses, the best solution to this problem may be for Congress to eliminate the disparities by mandating that utility stockholders and taxpayers split the stranded asset cost down the middle—in exchange for retention of regulation and the protection of the public that it provides.

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