Two Utilities are Better Than One

In Lubbock, Texas, two electric utilities are competing for people's business. How does it work? Could competition be the answer to rising electric bills?

Jan Bellamy from the October 1981 issue

(Page 6 of 6)

Yet there is reason to think that Primeaux was too cautious in his assessment of the reach of X-efficiency. Consider once again the example of Lubbock. Electricity rates there are 20 percent lower than in nearby Texas areas. Yet LP&L and SPS together produce over 1.5 billion kwh per year—far higher than Primeaux's cut-off point.

Lubbock was not one of the cities in Primeaux's data base, and when I told him that figure he was quite pleased. "I have every reason to believe that if Lubbock had been in the sample years of data the earlier results would have been even more impressive," he told me. In fact, he pointed out, only 3 of the 23 competitive cities he analyzed had power outputs exceeding 200,000 kwh, so the 222,000-kwh cutoff had been based on very limited data. If more large cities had competition, we might have a lot more evidence in support of X-efficiency.

Not being a whiz at math, I couldn't really assess Primeaux's statistical results. But a chart I picked up at SPS in Lubbock brought home to me what X-efficiency is all about. It showed SPS's cost of building a new coal-fired power plant in the late 1970s versus that for comparable plants in Wisconsin, Oregon, and Pennsylvania (based on calculations by the Electric Power Research Institute). The other three plants averaged $7.39 per installed kilowatt—fairly typical for modern 5()()-1,000 megawatt plants. But here was SPS able to build the same thing for only $296 per kilowatt!

If that's what X-efficiency means in practice, then I'm a believer. Those people really had figured out how to produce electricity cheaper! (In fact, SPS's installed cost per kilowatt is the lowest in the nation.)

There's one final nail in the coffin of the old economies-of-scale argument for regarding utilities as natural monopolies. It is that for large firms—the ones Primeaux tentatively excluded from eligibility for competition —economies of scale no longer exist. It turns out that the economics of producing electricity underwent a fundamental shift in the latter half of the 1960s.

What happened, notes utility analyst Ernst R. Habicht, Jr., was that rising costs of production began overtaking the pace of technological change. The result? Utilities shifted from being a declining-cost to an increasing-cost industry. Each new increment of generating capacity cost so much more to build that the net effect was to raise average costs instead of lowering them. In short—no more economies of scale.

Rate-of-Return Ruin

Conventional public utility regulation is a bad deal for consumers. By forcing a monopoly structure on electricity production, it has raised utility costs by promoting X-inefficiency, has led to higher utility rates, and has restricted consumer choice and the availability of good service. (In Sikeston, Missouri, the competing utilities provide the following customer services al no charge: cutting down trees, providing poles for TV antennas, providing free electrician services, and installing the wiring from the power pole to the building.) Ironically, though utilities fought for and benefited handsomely from regulation, today they are being strangled by it.

As noted earlier, the basic approach to pricing employed by public utility commissions is rate-of-return regulation. Because the system is designed to allow up to a specified return on the company's installed capital infrastructure—the rate base—it is in the company's interest to load everything possible into that rate base. The more it costs to build a power plant—and most coal-fired plants cost $700-$1,000 per installed kilowatt—the more the utility can make at its allowed 10 percent return on the rate base. The utilities have every incentive to build plants as inefficiently as possible—they're rewarded by the regulators for doing so. Without competition as a counteracting force, they've historically done just that, and the consumer takes it in the pocketbook.

This part of the rate-of-return gravy train is still in motion. Another part of it, though, has turned around and now threatens to ruin the utilities. That other part is regulatory lag.

During the 40-odd years when electric utilities were declining-cost firms, the purpose of regulatory rate hearings was to decide on the size of rate decreases. A11 during that period, technological improvements and economies of scale in going to larger power plants led to continuing declines in the cost and price of electricity. The average price dropped from 7.45¢/kwh in 1920 to 6.03¢ in 1930, 3.84¢ in 1940, and 2.88¢ in 1950 (measured in constant 1967 dollars).

Because of this downward cost trend, it was clearly in the utilities' interest to have rate-hearing procedures that were

thorough, complex, and time-consuming— the more time-consuming the better. The length of time between the initiation of a regulatory agency proceeding and its final resolution is referred to as regulatory lag. And for 40 years, regulatory lag worked in favor of the utilities, putting off the advent of rate decreases.

Then came the 1960s, and when utility economics changed, so did the significance of regulatory lag. Now the purpose of a regulatory proceeding was to obtain a rate increase. But the well-oiled gears of the regulatory machinery ground on at their accustomed snail's pace, aided and abetted by consumer and environmental groups who arose to challenge the wisdom of virtually every rate-increase request.

Regulatory lag began cutting off the utilities' access to capital, right when they needed it the most. Faced with skyrocketing prices of oil and natural gas, rising coal prices, and huge increases in construction costs, utilities desperately need the ability to make their own investment decisions in a timely fashion. But regulatory lag means they must spend two years arguing over what was needed two years ago instead of getting on with today's job.

This is no trivial problem. The financial markets have reflected the dramatic decline in the utilities' financial health. Over the past decade, utility bond ratings have dropped from AAA and AA to the A and BBB category, indicating higher risk. By 1981 the value of utility stocks had dropped to 75 percent of book value—that is, to less than the firms' facilities are worth.

According to Harvard energy researcher Peter Navarro, "the root of the problem is electric utility regulation." Because of regulatory lag, Navarro says, rates set by regulators based on outdated cost figures prevented any major regulated utility from realizing its allowed rate of return in 1980. And in nearly every case, the rate of return it did earn was below its cost of obtaining capital—a sure route to bankruptcy. It's not surprising, then, to learn that more than half of the new electric generating capacity scheduled for 1979 through 1988 has been delayed or deferred—the utilities simply can't raise the money.

The solution increasingly being proposed is . . . deregulation. No less an authority than the director of the Harvard Energy Security Project raised the idea on the op-ed page of the Washington Post in April. Reviewing the utilities' sad plight, Alvin Alm concluded that there are really only two ways out: an enormously costly federal bailout, or deregulation. By removing at least new plants from regulation, he suggested, new firms or deregulated subsidiaries of existing utilities would be able to raise capital more easily because the plant's construction and operation would be free of regulatory control.

Alm is not alone in this idea. In his article he pointed out that at a recent conference sponsored by the California Public Utilities Commission, the heads of both the California and New York PUCs, John Bryson and Chuck Zielinski, "both advocated decontrol as the best solution to the utility crisis." And Zielinski, going further than Alm, urged that all generating plants—not just new ones— be freed from regulation. "In the long run," notes 13ryson, "a deregulated market would force rigorous decisions on the most cost-effective means of supplying electricity needs." Even regulators are advocating deregulation!

But it's not just electric utility experts who are coming to favor deregulation. So are authorities on the regulated telephone utility—and for similar reasons. Nina Cornell was chief of the Office of Plans and Policy of the Federal Communications Commission until early this year. In her years at the FCC she saw first-hand how rate-of-return regulation works in the telephone industry. In an article in Regulation in November 1980, she analyzed the assumptions behind such regulation and found them wanting. consumer demand and technology (supply) remained essentially static, she noted, rather than being dynamic and hard to predict. As a result, regulation tends to lock regulated firms into obsolete technologies and to stifle innovation. One explicit way it does this is by encouraging long depreciation periods, matched to the physical life of the equipment rather than to its economic life. Thus, telephone companies are still utilizing huge quantities of obsolete electromechanical relays in their switching systems. Likewise, electric utilities have resisted replacing economically obsolete oil-fired plants and seem unable to cope with the variety of new small-size energy sources (see box, p. 30). As Cornell sums it up: Rate-of-return regulation with price and entry controls has the effect of slowing product innovation and technological change by regulated firms; by firms that might want to enter the market, using a better idea to make the very same output: and by firms that might develop new products to serve the same basic functions.

It seems quite likely that it is because of rate-of-return regulation that the fraction of its revenues that the electric utility industry invests in research and development (0.6 percent) is among the lowest in all of American industry.

In fact, explains Cornell, what we have is a vicious cycle. Due to the possibility of monopoly and its Potential for harm to consumers, regulation was created to guarantee and (supposedly) control the monopoly. But the regulation itself serves to perpetuate the conditions that make for monopoly in the first place—by forbidding the challenges that come from innovation, which in turn spring from competition. Thus, concludes Cornell, "rate-of-return regulation does not work, creates distinctly bad side-effects, and takes on the status of a self-fulfilling prophecy."

Opening Doors

Primeaux, Leibenstein, Cornell—the lesson is that the production and sale of electricity is not a natural monopoly and probably never was. Power plants operate more efficiently when they face competition than when they are monopolies. While regulation has not protected consumers from monopoly, it has managed to protect monopolies from competition at the expense of consumers.

Moreover, there have always been substitutes for power-plant electricity. There are other sources of heat than electricity (oil, coal, gas, wood, solar), other sources of cooking fuel (gas, wood), and decentralized sources of electricity as well (cogeneration, small hydro, windmills, etc.—see box).

In addition, as economist Harold Demsetz pointed out in 1968, even if a single utility firm had significant economies of scale in an area, there is good reason to think that the potential for competition from rival firms moving into the area would serve to keep prices below monopoly levels. And if individuals or consumer groups owned the local distribution lines, Demsetz noted, they could seek competitive bids from electricity generating companies rather than being stuck with a monopoly supplier.

Movers and shakers are starting to take electricity deregulation seriously. Justice Department antitrust chief William Baxter told the Wall Street Journal in June that he thinks the idea is worth exploring. A congressional subcommittee headed by Rep. Richart Ottinger (D-N.Y.) is advocating local experiments in electricity deregulation. Even the Edison Electric Institute, the industry's rather staid trade group, has launched a study. "Deregulation is going to be a major item of the next decade," predicts Edison Vice-President Terry Farrar.

But what most of these people mean by deregulation is exemption of electricity generation from controls. Distribution systems are still viewed as natural monopolies. Yet as we have seen in Lubbock and 22 other cities, actual head-to-head competition in production and distribution not only is possible but is actually more economical, thanks to the discipline forced on companies by competition (that good old X-efficiency).

Today, more than ever, with the rebirth of cogeneration, the rush into small-scale hydropower turbines, the revival of wind energy systems, and future prospects for fuel cells and solar panels, the dead hand of monopoly and rate-of-return regulation is the last thing we need. There's a dynamic, competitive industry lurking in the shadows of the smokestacks and cooling towers, waiting to step forth into the sunshine—if only the politicians and bureaucrats will let it.

"When should an industry be subject to classical public utility regulation?" asks Nina Cornell. "The answer is 'never.' This form of regulation, widely viewed as protecting the public from abuse of monopoly power, in fact has never done so, never could, and never will....It is both a snare and a delusion—and an unacceptable fraud on the public." With electric utilities fighting for survival and with energy entrepreneurs waiting in the wings, the time to end that fraud is now.