Regulation and Rates

Stephen DeAngelis

October 23, 2006

In an earlier post [The Coming Blackouts], I wrote about how utility companies are failing to keep up with demand because they are not bringing new power plants and distribution grids on line fast enough. That post discussed some of the challenges facing the utility industry including the fact that while people want electricity they don’t want the plants or transmission lines in their backyards. Those challenges are part of the reason that supply isn’t keeping up with demand. Cynics, on the other hand, believe that the utility industry is deliberating ensuring that new supplies lag behind demand to keep prices high, especially with possibility of some federal regulation coming to an end. A New York Times article by David Cay Johnston explores the consequences of deregulation as the last of federal rate protections are poised to expire next year [“Competitive Era Fails to Shrink Electric Bills,” 15 Oct 2006].

A decade after competition was introduced in their industries, long-distance phone rates had fallen by half, air fares by more than a fourth and trucking rates by a fourth. But a decade after the federal government opened the business of generating electricity to competition, the market has produced no such decline. Instead, more rate increase requests are pending now than ever before, said Jim Owen, a spokesman for the Edison Electric Institute, the association for the investor-owned utilities that provide about 60 percent of the nation’s power. … About 40 percent of all electricity customers — those in 23 states and the District of Columbia where new competition was approved — mostly paid modestly lower prices over the past decade. But those savings were primarily because states, which continue to have some rate-setting power, imposed cuts, freezes and caps at the behest of consumer groups that wanted to insulate customers from any initial price swings. The last of those rate protections expire next year, and the Federal Energy Regulatory Commission and other federal agencies warn in a draft report to Congress that “customers may experience rate shock” as utilities seek to make up for revenue they did not collect during the period of artificially reduced prices and to cover higher costs of fuel. They warned that “this rate shock can create public pressure” to turn back from electricity prices set by the market to prices set by government regulators.

Normally, market forces ensure that prices remain fair and competitive, but Johnston notes that a truly competitive market has not emerged. As result, states are getting involved in a big way.

Concerned about rising prices, California and five other states have suspended or delayed transition to the competitive system. And voters around two California cities, Sacramento and Davis, will decide next month whether to replace investor-owned utilities with municipal power in hopes of lowering rates. Drives are under way to expand public power in Massachusetts. In Portland, Ore., the city council tried and failed to buy the local utility company. Electric customers in other states are facing rude surprises. In Baltimore, an expected 72 percent rate increase in electricity prices has aroused so much protest that the state legislature met in special session, where it arranged to phase in the higher costs over several years. In Illinois, rates are about to rise as much as 55 percent. The three New York area states opened their electricity markets to competition, with different results. In Connecticut, residential electric rates rose up to 27 percent last year to an average of $128 a month, and are expected to go up as much as 50 percent more in January. In New Jersey, rates rose up to 13 percent this year, and are poised to go much higher.

New York has been a bit of an aberration due a combination of regulation, nuclear power, and excess production elsewhere in the region.

New York residential customers, by contrast, paid an inflation-adjusted average of 16 percent less in 2004 than in 1996, a state report said. It is not known how much of that is attributable to government-ordered rate cuts, but the state benefited from huge increases in power generated by its nuclear plants and by buying power from New England plants that, starting next year, may have less electricity to sell to New York.

That is part of the problem. Traditionally power companies generated most, if not all, of the power they sold. Today power producers and distributors are often separate companies.

In most areas, the number of power producers is small. In New Jersey, for example, only six companies produce power, and not all of them sell to every utility. Some utilities have decided to buy electricity not from the cheapest supplier but from one owned by a sister to the utility company, even if that electricity is more expensive. That has been the case in Ohio. And if electricity is needed from more than one producer, utilities pay each one the highest price accepted in the bidding, not the lowest. This one-price system, adopted by the industry and approved by the federal government, is intended to encourage investment in new power plants, which are costlier than older ones.

The new power plants are certainly needed, but the system has not only failed to deliver them in a timely fashion, it has spawned some of the most notorious business scandals this country has known. The most famous of these scandals involved Enron. When California was in the midst of a heatwave five years ago, Enron manipulated this auction system “to drive up prices, with the increases passed on to customers.” Analysts discovered that utility companies act a lot like OPEC, increasing or decreasing production to affect prices.

What is more, companies that produce electricity can withhold it or limit production even when demand is at its highest, lifting prices. This happened in California, and the federal commission has found that it occurred in a few more instances since then. Critics say that more subtle techniques to reduce the supply of power are common and that the commission shows little interest in investigating.

The end result of manipulation, rising prices, and increasing brown outs is consumer outrage. Eventually, politicians will feel that outrage, but as of now they are not sure whether the competition regime needs more time or whether they should re-regulate the industry.

Advocates of moving to the new system say that, in time, the discipline of the competitive market will mean the best possible prices for customers. Alfred E. Kahn, the Cornell University economist who led the fight to deregulate airlines and who, as New York’s chief utility regulator in the 1970’s, nudged electric utilities toward the new system, said that he was not troubled by the uneven results so far. “Change,” Professor Kahn said, “is always messy.” But some advocates of introducing competition to the electric industry have soured on the idea. They include the Cato Institute, a leading promoter of libertarian thought that favors the least possible regulation and that concluded earlier this year that government and electric utilities have made such hash of the new system that the whole effort should be scrapped. “We recommend total abandonment of restructuring,” Cato said. If the public rejects a greater embrace of markets, Cato wrote, the next best choice would be a “return to an updated version of the old” system.

Whether the industry remains unregulated will largely depend on how investors and utility companies conduct themselves over the next few years. Electrical power sits at the very heart of globalization and keeping it affordable is critical. No economy can remain resilient when the industry most critical to its health is riddled with greed, corruption, and inadequate strategic investment.