Competition in the Electric Industry: Emerging Issues, Opportunities, and Risks for Facility Operators (1996)

Timothy Brennan

University of Maryland

My primary industry experience is in telecommunications rather than electricity, yet there are some lessons from the former that apply to electric competition issues. Two involve the speed at which competition comes into an industry and the controversial nature of competition in traditionally regulated industries. Regarding those controversies, I want to address three topics: discrimination (or "comparable treatment") issues, mergers, and stranded costs.

The history of the regulatory reform in the telecommunications industry provides some useful insights into the speed, or lack thereof, at which competition comes to regulated industries. In 1959, the Federal Communications Commission inadvertently opened the door to long-distance competition when it gave firms the authority to set up private microwave systems to serve their internal needs. After firms realized that these networks could be used to provide commercial long-distance service, the Justice Department filed its antitrust case against AT&T, claiming that AT&T had anticompetitively abused its local exchange monopolies to prevent long-distance competition from developing. This case took until 1982 to settle; it was never litigated to a conclusion.

In accord with that settlement, AT&T spun off its local telephone operations, creating the Regional Bell Operating Companies (RBOCs). The court also imposed restrictions on the RBOCs to prevent them from

reinstating the former AT&T's vertically integrated structure. These "line of business" restrictions kept the RBOCs out of long-distance service, equipment manufacturing, and information services.

By late 1986, the Justice Department changed its mind about the merits of much of what it had been attempting to achieve in antitrust litigation against AT&T, not just in this case, but in earlier cases going back to at least 1949. This change showed up most noticeably in a 1987 court review of the line of business restrictions, which the Department advocated repealing for the most part. The court reviews of those restrictions took until mid-1991 to resolve; the resolution resulted in the elimination of the information service restrictions but retention of the equipment manufacturing and long-distance bans.

This decision, in turn, set off a new round of attempts and negotiated arrangements to enter these markets. Various tries in the courts and Congress eventually resulted in passage of the Telecommunications Act of 1996. The Act establishes conditions under which the RBOCs can enter these markets, but with various structural and regulatory provisions that remain in place until 2001. Moreover, most of the extensive state public utility regulation of telephone service, like that of electricity, remains in place.

The point of reviewing this history is that competition in telecommunications, in fits and starts, took at least 42 years to achieve (1959 to 2001), and may not be finished yet. Similarly, implementing competition in electricity may not happen instantly and smoothly. Electricity is, in many ways, more complicated than telecommunications. Information is much easier to move around than power. Telecommunications deregulators did not have to deal with loop flow, load balancing, and the system's blowing up or browning out—although they did have to ensure that phone calls would still go through. And, notably, there wasn't a $200 billion stranded cost issue to resolve.

We therefore cannot expect that competition in electricity will be achieved overnight. It is by no means simply a technical problem to which people in some government office can work out details with the automatic assent of the utilities, independent power producers, industrial users, consumers, environmentalists, and regulators. The proceedings will be contentious. Three of the most prominent matters of contention are issues of discrimination, mergers, and the recovery of stranded costs.

Discrimination is an issue because the utilities that own transmission and distribution grids might unduly give preferential service in a variety of dimensions to the generators they own, and lower quality service to independent power producers. The primary reason to worry about discrimination is that the transmission and distribution grids will still be regulated. A utility would have a financial incentive to evade the regulation by, say, using its transmission monopoly to favor its own generation company and impose lower quality service on others. Such a move would allow the firm to reduce competition from these independent power producers, raise the price it charges for its own generated electricity, and thus capture indirectly the profits it can generate because it is the only transmission provider in town.

From my experience in antitrust matters, I believe that there is nothing wrong in general with firms, integrating into other businesses and favoring their own affiliates. However, regulation creates particularly anticompetitive incentives to do so. Those harmful incentives were a major reason for the break-up of AT&T and the consequent line of business restrictions placed on the RBOCs.

Regulation presents a similar cause for concern here. Will we have to adopt such extreme remedies as divestitures in the electricity industry? It is hard to be optimistic about preventing discrimination solely through regulations and laws. For example, some may believe that we need not worry about discrimination because the Energy Policy Act and Federal Energy Regulatory Commission (FERC) will take care of the problem. Relying on statutory language alone, however, is too optimistic. Mitigating discrimination requires diligent regulators who have the resources, ability, and will to ensure that firms realize they cannot successfully discriminate. Clear and ready implementation cannot be guaranteed, and years of subsequent litigation are predictable. I would like to be wrong about this, but the experience in telecommunications does not give me much comfort.

One irony is that we are considering regulatory or structural boundaries separating transmission from generation to prevent discrimination while at the same time, via the Telecommunications Act, we

are allowing telephone companies to reintegrate. But there is a facet of that Act directly affecting utilities—electric utilities' entry into telecommunications and video markets. I wonder whether the recent FERC order imposes rules separating the operations of generation and transmission that are as stringent as those the Telecommunications Act imposes between local power distributors and their telephone or cable television operations.

A second issue is that, if purely functional unbundling of transmission and generation would really be effective, why should the nation not go all the way and order a divestiture? The point of vertical integration is to encourage coordination in production and operation, to reap what economists call economies of scope. But coordination with one's affiliate necessarily implies discriminating in favor of that affiliate and not offering competitors comparable treatment. If companies are allowed to remain nominally integrated, what can they gain if we impose rules that are going to prohibit this coordination? This debate was at the heart of the AT&T divestiture and continues to dominate telecommunications policy today.

A final point about discrimination is that many regard it as a substitute for price regulation. It is not. If a utility is charging the same monopoly price to everyone, it is not discriminating, yet it is fully exercising its market power. Yet if this is so, why are anti-discrimination rules so popular?

To understand this issue, one must assume the perspective of the industrial users who compete with each other in other product or service markets. To oversimplify a bit, these buyers do not care much about the absolute price they pay for electricity so long as their competitors are not paying less. It is the competitive advantage created by relative prices that matters to them. If my competitors get a better deal than I do, I lose in the market, but if the price is higher for everyone, markets will pass that cost on to consumers.

If industrial buyers are better organized in lobbying FERC and state regulators, they may lobby very hard for nondiscrimination rules regarding power delivery, but not lobby nearly as hard for lower rates for transmission and distribution. The end-users, who really do care about absolute prices, such as residential users or the federal government, may

not be able to benefit by letting this regulatory process run its course. One cannot assume that, when industrial buyers protest at government hearings about something a regulated utility is doing, they are necessarily speaking for consumers or the economy as a whole.

The Justice Department and Federal Trade Commission traditionally do not care whether a proposed merger is a good idea from the standpoint of the merging companies. I can see why FERC or a state regulator might want to oversee investment decisions by regulated companies, but the antitrust authorities are not equipped to second-guess capital market decisions.

What those authorities do care about is competition. How to judge the effect of utility mergers on competition presents some peculiarly difficult policy issues. In both the electricity and telephone industries, mergers are being proposed before the regulations are settled. The determination of the economic effects of those mergers depends on whether the merging utilities will compete more than they do now in their separate franchise areas, and whether other power generators will also be able to compete effectively against them in those service areas.

These crucial issues depend very much on the rules for transmission pricing that have yet to be promulgated, litigated, and settled. A speculative concern is that utilities are merging because they have predicted that they will be each other's primary future competitors. One way or the other, because policy decisions will make the future substantially different from the present, it is not clear how antitrust authorities and courts will effectively protect prospective competition. I hope they can do so.

Last and not least is the hotly contested matter of the $150 to $200 billion in stranded costs. This issue need not be regarded as solely a matter of fair allocation of a payment burden between stockholders and consumers. There is an efficiency issue here, particularly when we take long-run regulatory policy into account.

On the one hand, we want rules that force the government to honor its commitments. Otherwise, investors are not going to supply the capital

necessary to provide services to the public, through either government procurement or regulated industries. That statement is as true for electric power companies as it is for firms that build aircraft carriers. On the other hand, if the rules are too generous, overspending may occur—also equally true of utilities and defense contractors. Consequently, cost recovery policies are not simply a matter of fairness. They determine whether investors put too little or too much into the facilities used to supply regulated (or publicly procured) goods and services.

When the terms of the contract between the investors and the public are explicit, there should not be a real debate. With regard to stranded costs, for example, if FERC (or a state regulator) and a utility both agree that there was a contract that included a commitment to compensate utilities if the government adopted procompetitive open-entry policies, it would be difficult for someone to claim that there was no such thing. But when the contingency is only implicit—and the fact that advocates of cost recovery invoke a "regulatory compact" rather than point to a contract suggest that the contingencies here are implicit—we have a problem in contract interpretation.

What Does One Do? The economics of contracting suggests two factors for courts and policy makers to consider in addressing how the utilities and government would have specified how the costs of competition to utilities would be borne. The first is to ask who was in the best position to predict whether competition would occur, and thus be in the best position to adapt to it or insure against it. The second is to ask who had the most influence over whether competition would occur.

There are certainly some fairly strong arguments for assigning an obligation to the government to provide for stranded cost recovery. The government certainly had some influence over policy developments in this area, and also may have forced utilities to incur costs that they might not have otherwise incurred had they been free to take the risk of future competition into account. Contracts for high-cost renewable power sources mandated by the 1978 Public Utility Regulatory Policies Act (PURPA) may well fall in this category. However, there is another side as well. For example, utilities may have been in a better position than regulators to predict the technological changes that would lead to competition.

To provide some answers to this question, it might be interesting to look at speeches utility executives made in the early 1980s, following

PURPA, when the prospects of future competition became significant. They might have said that utilities would like to respond to competitive prospects, but that regulators were controlling most of their investment decisions. Alternatively, they might have implied that utilities are forward looking enterprises, initiating and implementing grand ideas at the cutting edge of technological development.

Would the utilities have seemed back then to be the puppets of the regulators, as advocates of stranded cost recovery now intimate? Or were they continuing to make investments on their own in the face of the possibility of future competition from independent power producers? If the former, the government is the breaching party here and should be liable, but the government presumably ought not be held to an implied promise to cover all expenses the utilities initiated.

Do These Efficiency Considerations Really Matter? In the end, these remarks may be only the musings of an idealistic economist. The case for stranded cost recovery may have more to do with political realities. Today, some of the utilities essentially reminded us that if stranded costs are not covered in some way, they will tie up competitive initiatives in the courts until the 22nd century.

Other commentators have suggested that a failure to ensure stranded cost recovery is akin to an unconstitutional "taking" of property. While that issue, too, is usually couched as a matter of fairness, some research I have done with colleagues at Resources for the Future suggests that we might want to compensate parties with political clout specifically to persuade them not to oppose policy changes that would lead to a more efficient marketplace. We may not like having to pay that price, but in reality, we may be in a worse place if we do not.

This conference has shed a great deal of light on the issues facing the electricity industry, its regulators, and federal facilities managers as we proceed down the path to competition. A similar history in telecommunications warns that the trek will be slow and bumpy. Discrimination concerns, mergers, and cost recovery are three major problems to be settled, but others are certainly crucial: retail marketing,

load management, transmission pricing, and environmental protection, to name a few. I hope that these and other discussions will lead to the collective knowledge and wisdom to let us avoid the mistakes of the past and move expeditiously to a competitive and vibrant electricity industry.