How to Short-Circuit the Utility Monopoly

The road from utility regulation to a free market is strewn with consumerist objections. A futuristic scenario shows a way through.

Good evening, and welcome to the "Nightly Report" for January 1, 1995.

In a special session today the California legislature passed a far-reaching bill to decontrol the state's electric-utility industry. The bill, which allows consumers to opt out of the regulatory structure, is based on legislation already in place in the state of Sasnak.

It was 10 years ago today that Sasnak undertook its unprecedented experiment, allowing each consumer to decide whether he or she wants to be "protected" by state regulation of the electric-utility industry. Thus began the gradual decontrol of the industry through the use of so-called consumer market options.

With me tonight is John Berry, the head of Sasnak's Public Utility Commission. Berry was instrumental both in pushing for the enabling legislation and in assuring that the plan was well understood. He now presides over a commission whose duties shrink yearly. "That, " he says, "was precisely my intention when I took this job 10 years ago."

Reporter: Well, Commissioner Berry, Sasnak certainly has taken a different direction from other states in treating electric utilities. How far has deregulation moved in 10 years?

Berry: Currently, 70 percent of the state's electric-power sales are not regulated in any way. These purchases are generally made through private contracts between sellers and buyers. By the way, the producers in this industry now are simply firms. The "utility" tag is a description of how government has historically treated them and is really inappropriate.

R: How so? The problem in this industry is monopoly power, isn't it? Aren't the three basic components of the electric industry—generating plants, transmission lines, and local distribution systems—all controlled by one firm in a given area because that's the way to get the lowest-cost service?

B: You're right in part. Generation stations, whether powered by coal, oil, or nuclear fuel, have to be pretty big to be economical. And operators of both transmission lines and the systems that distribute power to the end users also can lower their costs by carrying large volumes. In a nutshell, however, the industry's so-called problems are largely consequences of the massive investments required for constructing generation, transmission, and distribution facilities. These investments are "sunk"—if things go sour in the future, the firm can't pick up assets or shift them to some other use. The transactions in this industry—from plant to transmission system, transmission system to distribution system, and distribution system to consumer—are highly specialized. No one link in the production and distribution chain has an obvious "fall back" strategy to protect its sunk investments.

These sorts of "transactions" problems are precisely why we should expect "vertically integrated" producers—that is, one firm owning generation, transmission, and distribution facilities.

R: That seems to solve the producers' problems all right. But you just explained that consumers are caught up in the same unique problems—they don't have many alternatives to a single supplier. Isn't this why we have public utility regulation—to protect consumers, who must rely on one electric-power company?

B: Perhaps. The consumer does face a very knotty buying problem in a market free of government regulations.

R: Then how in the world has Sasnak deregulated this industry? Isn't it just sending lambs to the slaughter?

B: Decidedly not. No user in this industry is forced to accept deregulation unless he assents. That was the rationale for the "market option."

R: We've heard a lot about this "market option" device. Perhaps you could explain how it works.

B: Gladly. Although it sounds abstract, the thing is very real. When we started deregulation 10 years ago, nothing was "done" to the industry other than the following. First, we eliminated the exclusive aspect of a utility's franchise agreement—that is, an electric-power company was no longer protected from competition. Second, we did not halt our existing regulatory practices; service and price controls were continued. But, third, we gave all utility customers a little piece of paper that we call a "market option," and we told consumers that if they wished to continue with regulation, then they should not sign these options. Once signed and publicly recorded, an option is "exercised." By exercising an option, a property owner is saying: "From this day on, all my buying and selling of electricity for this particular property—house, factory, etc.—will not be subject to government regulation of price or service. Moreover, if I later wish to put this property back under regulation, I cannot." In other words, if you exercise the option, you're on your own—free in the open marketplace.

R: And people really took you up on this? It's hard to imagine anything but losses from using the option.

B: Well, at first not many did exercise their option. You're quite right to suggest skepticism and caution about using such an option. But nobody threw them away either! Unlike the typical sort of option traded on a commodity exchange, the market option became a perpetual right of the consumer. So why toss it out? Many people figured that it may someday, somehow, have a use.

R: The market options were a flop then?

B: Hardly. You're missing a point. Everybody holding these little pieces of paper made the electric utilities very nervous. What if people actually did use the market option? Utilities stood to lose customers because of competition, so they tried to buy unsigned options from consumers.

R; That's legal?

B: Absolutely. You can transfer your unsigned market option to anybody you wish, thereby giving up the right to exercise it. That right, however, is specific to the property for which the option was first assigned—if any other holder of the option signs it, then the property to which the option attaches is thereby exempted from regulation.

R: Okay—a lot of utilities went around and grabbed a lot of options so that public utility regulation would go on.

B: Yes. In some areas, they bought many market options, but not as many as you might think. Consumers sensed, quite rationally, that the hefty prices often offered for their options suggested that the options might be worth more than consumers first thought. So most played a waiting game. But where utilities did grab up and hold unsigned options, they were keeping the door open to a future departure from regulation.

R: Sounds like a case of the utility winning out over the consumer.

B: Consumers who sold their options to utilities did perhaps bear a large risk. But they were compensated for it and voluntarily accepted it. Perhaps some did err in judging the long-term cost of their actions. But Sasnakan legislators decided that if we wish to have the potential for an open market, we must also allow risk taking.

Another thing happens even when no one exercises these options but instead just holds them. It's a sign to everyone—consumers, current utilities, potential electricity producers, and utility commissions—that the road to an open market remains open and can be taken. This makes a lot of people nervous—including utility commissions!

R: You?

B: Well, frankly, one can get very comfortable in a job like this, even though I entered office on a pledge to move the industry out from under commission regulation. I'm human—I'm not immune to the likely benefits that come from running a large, well-budgeted commission, nor is anyone else. The point is, with unexercised options lying all over the place, our commission stood to lose its clientele, the consumers. Clearly, that's a great stimulant to the public utility commission to improve its performance. For the first time, I think, we really did serve a marketplace: if option-holders were dissatisfied with our performance, then we could lose them. I'm firmly convinced that if nothing else had happened—if we just kept the potential for market action open in this way—we would have accomplished a great deal.

R: Then something else did happen?

B: Yes, and rather quickly, too. Several large industrial firms in the state began negotiating long-term contracts with their serving utilities—even before the law for market options was signed. Then, not long after the law became effective, all of the firms but one signed their options. They are now dealing on a contractual basis with electric-power suppliers. These contracts are fairly complex and quite specific to the user in question. Generally, the contracts run for 10 to 20 years and allow for renegotiation at some point before the contracts expire.

R: Don't these contracts still leave these firms dangling at the time of renegotiation?

B: Certainly there are risks to consider—for both sides. These firms aren't defenseless little creatures. Some can generate much of their own power, and most have a good bit of flexibility in the choice of energy. They can, for example, switch over to natural gas or oil. And if push comes to shove, some could find another supplier. In fact, one of the industrial firms, Plummer Industries, did just that. Instead of "signing up" with the old utility, it found that another power company, with a previously exclusive service territory 25 miles away, was interested in the Plummer account. The two firms negotiated a deal by which transmission lines were extended to Plummer. Part of the contract, of course, required exercising the market option.

R: You mean anybody can build transmission lines? Sounds like we're headed for wires jumbled all over the place. Isn't that ugly and costly?

B: Yes, anybody can build a transmission system but must now do so in an open marketplace. The government no longer uses its eminent-domain power to give transmission-line operators automatic rights of way. So building lines has become a bit more complex. Yet it's hardly impossible and sometimes profitable, especially when only a short link-up is needed to serve a large-volume customer or a densely packed group of users.

We really haven't seen a proliferation of wires. Yes, duplication of transmission and distribution lines connecting a power plant to a user is more costly than just one. But remember, we have other costs to consider if we legally prohibit such duplication. For example, the regulation that supposedly was protecting Plummer was not, in their eyes, doing such a good job. Plummer and its new supplier were willing to bear the costs of linking up as a means of reducing the costs associated with continuing with regulation. Realistically, that's a productive investment.

R: I see how large, industrial users might come out on top, but isn't the major concern of public utility regulation protecting the small guy? How in the world could a household ever fight back?

B: This concern is an important one and, frankly, was the argument used most often against deregulation. To be most effective, small users must combine into "user groups." And this is precisely what happened. Take a city where the local distribution system has many users per square mile. This compact group could be very powerful if users formed a cooperative. One purpose of a cooperative—or "user group"—is to bundle members' market options to negotiate with suppliers. Another purpose might be to acquire productive assets in the industry. In particular, the user group might buy the local distribution system from its current owner, the power company. From that stance, the group has much more flexibility in negotiating service contracts.

R: But why would any utility sell its local distribution systems to user groups?

B: Some wouldn't. On the other hand, there were plenty of electric utilities in this state that were most eager to get rid of regulatory shackles. One way to do so was to negotiate a long-term contract for service to a user group, allowing the group to buy the local distribution system as a condition for the contract. Giving up its distribution systems was part of the power company's price of getting to an open market.

R: So a user group has bought the local distribution system and has signed a long-term contract for service with the group's original supplier. How is anybody—other than the utility—better off? Won't power companies eventually squeeze more out of consumers when the contract is renegotiated—or even before?

B: Both consumers and suppliers can be significantly better off. There's enough evidence from the economics profession about the inefficiencies of public utility–style regulation: unresponsiveness to changing supply and demand conditions, excess capital expenditures, and inefficient choices of fuels.

Politically, the regulatory system has become a game of redistribution. We have seen large and costly nuclear projects, like Marble Hill (Indiana), Zimmer (Ohio), and Shoreham (New York), discontinued or delayed. Who bears these "costs" has become a supercharged political issue, with everyone pointing fingers at the other guy. If regulators approve rate hikes and thus force consumers to absorb the costs, it's "rate shock." And if the utilities must absorb the costs themselves, shareholders of the utilities' stock are hit with "equity shock."

The risks of building more capacity became so great that no utility would step up to the task, fearing it could never attain a reasonable return on investment. The punch line to this story, of course, is that eventually consumers must either pay much higher rates for "emergency" capital investments or suffer inferior service—brownouts and such.

Public utility regulatory practices directly caused these results. Utility executives were lulled into thinking that their costs would always be covered by rates—that whatever they built, the regulatory system would guarantee them their cost plus a margin for profit. But that only works if users' demand for electricity does not fall significantly as the price rises and if everyone is willing to abide by the old "cost-plus" formulas.

R: There's a better way?

B: Most assuredly. The success of Sasnakan user groups in acquiring their distribution systems suggests how anxious the utilities were to get out from under regulation. For every area in which power companies could move into market contracting, they apparently anticipated tremendous savings. Let me give you an example. The Garden City user group obtained all of its local distribution system for no direct outlay by recontracting with the group's utility, ConKan Power. One of ConKan's financial analysts figured that by contracting, instead of remaining under public utility regulation, ConKan could net a minimum of $400 per residential account in expected profits over the next 15 years. The Garden City group held only 100,000 market options, but the cumulative value of $40 million is pretty hefty. The bottom line is that the Garden City user group now owns the distribution system and contracts with ConKan for electricity.

R: How does the city government enter into this?

B: In some cases, as with Garden City, it didn't. Local officials were willing to let user groups form privately. They have no problem with the current user organization functioning as a private local distributor owned directly by the people it serves.

In other cities, however, local governments eagerly claimed the right to negotiate contracts for all consumers in the area. Alternatively, some selected a franchisee to negotiate service contracts and to operate the local distribution system, should one be purchased or built.

R: That seems a much easier way to use the market options.

B: Easier for the government officials, maybe. But this gets us back into the little games of political bargaining and abuse we see with local cable-TV franchising. Government officials often use the franchised operator for purposes other than to satisfy consumer demands. Nevertheless, such city-franchised systems have done many of the same things as the private residential user groups.)

R: How do contracts between residential user groups and electricity suppliers work?

B: First, they invariably will be long-term commitments. Few electricity generating firms would risk adding capacity unless they had some assurance of sales over the life of a plant. Second, the contracts are subject to adjustments under changing circumstances. For example, if fuel prices were to accelerate rapidly, rates could rise correspondingly. Precisely how this works depends on the individual contract.

Most contracts have a built-in arbitration feature so that disagreements over the life of the contract can be quickly handled without recourse to the courts. Some of our critics have pointed to this as evidence that we have recreated regulation in the private sector. I do not disagree. The critical difference between such contractual "regulation" and public utility regulation is who's involved. Under commission regulation, the number of players actively seeking to influence each decision is large. We're playing a multiperson redistributional game. With private contracting, each player has a direct economic interest in outcomes and, consequently, has an incentive to use great care in his actions toward the other party.

I guess, in a sense, we have created a private institution capable of replacing public utility regulation. We have finally come up with the "institutional inventiveness" that over 60 years ago economist Harold Gray predicted would depose public utility regulation. Gray had the right idea—he just underestimated how deeply entrenched various interest groups were becoming.

R: How about recontracting for residential user groups? Isn't that a big problem?

B: A problem, certainly. Remember that these user groups are large, potentially attractive markets. Like industrial firms, they will continue to search for suppliers with the best deals to offer. The current supplier has no assurance that he will not face a new rival that connects transmission lines into the group's distribution system. Clearly, for a generation firm looking to provide service to a new user group, that move is far more attractive when the firm does not have to duplicate an existing distribution system. That's precisely why user groups find ownership of the distribution system so useful.

There are other strategies, too. For example, one Sasnakan user group owns its own distribution system but had a difficult time renegotiating a supply contract. So the group planned to build an integrated electricity system jointly with a nearby city user group. Both would have ended up owning transmission and generating facilities, and the cost was expected to be reasonable.

R: Did they build it?

B: No—the contracting supplier suddenly became more pliant, and the local groups were able to renegotiate contracts.

R: Is that a very likely move for user groups—toward owning everything?

B: Maybe in some cases. It has been done in a few areas. The strategy, known as "backward integration," has been used in the electricity industry in the Rural Electrification Administration's system of user cooperatives. The difference here, however, is that the locals must make a go of it without the sizable subsidies that used to be available to the REA co-ops.

R: Have any developments under market-option deregulation surprised you?

B: Plenty. In fact, even when we began, it was clear that we could not foresee the way things would unfold. Given the opportunity, people are innovative. What makes it especially tough to be a forecaster is that this entrepreneurship acted to change institutional structure, not just modify behaviors. As the frame was rebuilt, completely new opportunities opened up that nobody foresaw. This is precisely what makes an open market in electricity so attractive. You can discuss models of "optimal regulation," but it means very little because the "market" benchmark, against which these models are compared, never stands still—it evolves as individuals experiment and learn, creating new technologies, new arrangements, and so on.

R: Let's be specific—what developments were unexpected?

B: Well, take the ownership of transmission systems as an example. Today, many lines are jointly owned by several power companies in the state; but before deregulation, each utility solely owned the transmission lines carrying electricity to the retail markets for which it had the exclusive franchise. Of course, the lines were interconnected, into what are called "pools," so that individual utilities could exchange electricity. Nevertheless, each utility had strong property rights in its transmission lines.

That ownership structure has gradually changed, and for good reason. Under market-option deregulation, each electricity firm's customers became the potential customers of many other firms. However, for a user group to switch to a new power company, the new firm would have to connect a transmission line to the group's distribution system. It could be done, but the threat of still other power companies entering markets increased the risk for any one firm to singly own a transmission system. When a transmission-line operator loses a major account, that line is used at a rate far below its capacity, and that's costly. Each firm realized that such risks could be reduced if all opened themselves to each other. Thus, through extensive joint ownership of transmission "grids," generating firms found they could more effectively deal with such risks.

R: Now you have collusion on a grand scale?

B: Just the opposite. With transmission lines owned jointly by these major users, each user gains from having an efficient transmission-pricing system, which allows each to send power anywhere within the grid. The great benefit of this, ultimately, is to the consumers: for them, it's easy to find a competitive threat to an existing supplier, since all the transmission-system owners may connect to customers anywhere in the grid. Perhaps this development, more than any other, has stimulated the consumer emigration from public utility regulation to an open market.

R: How would you characterize Sasnak's electricity industry today compared to 15 years ago? More or less concentrated? More or less efficient?

B: The concentration concern is baseless. You can now see that what sparked competition here was a change in the structure of ownership. We don't have more generating firms in the state than 10 years ago, but we surely have more competition for any given marketplace. How do you evaluate concentration of transmission lines—in local distribution systems? What has stimulated competition is not the number of separate entities acting in the marketplace, but the rearrangement of ownership. This has evolved from market-option deregulation.

Efficiency is in the eye of the decisionmaker. Judging from the stampede toward the open-market door, I would say we have definitely improved matters. Service quality is excellent, prices have fallen—and all this with much higher use of generating capacity.

R: Let's talk for a moment about the little people out there who don't live in a city and can't expect to bargain for electricity through user groups. What of them?

B: Please remember that this state's public utility commission still operates and will continue to do so for any consumer who wishes to remain under regulation. Our view has always been that since regulation is allegedly protecting the consumer, it would be unfair to abruptly end it.

Indeed, many of our remaining clients are small rural users, although many of them have now organized just as in the cities. Also, don't forget that for many years, REA cooperatives have owned much of the rural electricity-distribution systems.

Still, we have seen some remarkable developments in our rural areas. Clearly, these are costly places to bring electricity to. Thus, they will bear in an open market much higher prices than under the old style of regulation, through which rural users were effectively subsidized by nonrural users. But now with deregulation moving full-steam ahead, the cost-plus pricing of public utility regulation can no longer hold rural rates down. There simply is no one left to subsidize rural users. So regulated prices rise, because as more users choose the market arrangement, there are fewer users under the regulatory wing over which producers spread their costs. In response, many areas have started experimenting with other electricity technologies that were overlooked when electricity prices were subsidized. For example, wind-turbine power is extensively used in several remote counties. Such innovation in another big payoff.

R: There must be some political reaction to this forceful deregulation?

B: I would hardly categorize our program as forceful, if you mean that coercion was applied to any party. We simply allowed consumers free choice and removed many barriers to an open market. The rest was up to the individuals and firms.

But, of course, we have experienced brutal criticism from all sides and even attempts to reregulate the industry. That I had anticipated. Any consumer group that saw its electricity bills initially rising was actively opposed. Some still are. Some utilities were also against this plan. They contended it was financially risky and difficult to implement, because they had no direct control over the transformation process. Accounting problems were always a major concern—what's regulated, what's not?

I think, gradually, we worked through most of these concerns. And many utilities were quite anxious to move in the market direction, balancing off the foot-draggers. It's difficult for managers who have spent their careers learning how to survive under the gimmickry of public utility regulation to face a competitive marketplace. Those firms whose managers most quickly developed market-oriented sensitivity have grown, while others have shrunk and some have gone into bankruptcy.

R: Commissioner, we have time for only one more question. After all is said and done, is all this competition really good for an infrastructure industry, one that provides a basic component of the country's productive capacity? Can we, as a nation, afford the risks?

B: Your question implies that under public utility regulation, "we" take no risks. Surely, recent history shows that tremendous uncertainties are the result of public utility regulation. Our state's experiment suggests that a more stable, flexible, and responsive electricity industry is emerging. And we've done it without forcing consumers out into the cold. Sasnak led the revolt. We're happy to see California taking the next step. Let's hope it catches on elsewhere, too.

Douglas Houston is an assistant professor of business economics at the University of Kansas School of Business. He has written a monograph on electric-utility deregulation through "market options," forthcoming from the Cato Institute.