Regulation: Power Moves

What the other new superhighway means for the nation's utility monopoly.

Americans have been barraged in recent months by prophecies of an emerging "information superhighway," a national telecommunications grid that promises everything from instant visual communication to long-distance sex. But there is little awareness yet of the burgeoning electricity superhighway, a sprawling network of power lines that links most Americans to hundreds of electricity producers.

Growing demands for consumer access to the electricity superhighway could soon revolutionize the power business, replacing the old system of regulated monopoly utilities with a competitive electricity market. In such a market, customers could shop around for the best deal. A factory in Michigan, for example, could buy power from a plant in South Carolina, which would transmit the electricity over the national network and through the local utility.

But an emerging coalition of electricity utilities and environmentalists opposes deregulation. Both groups are fighting to maintain the old regime—the former to preserve their protection from competition, the latter to maintain energy conservation programs subsidized through the monopoly system. The two forces are fighting a state-by-state battle to block consumer access to the superhighway.

The increasing pressure on the industry to relax or eliminate the monopoly system stems not from new technology but from a growing awareness among industrial power consumers that open competition through transmission networks has long been technologically feasible. Public utilities have maintained small local networks or "power pools" among themselves since the 1920s, and in recent decades they have become increasingly interconnected in a national system. The development of efficient long-distance transmission lines has allowed utilities to link together in a patchwork of local grids, power pools, and pool interconnections. Most utilities in a region are ultimately joined to one another through this superhighway, as are their customers.

Hundreds of utilities and wholesale power producers buy and sell electricity over the superhighway every day, in an increasingly competitive wholesale market. The system can be envisioned as a complex of water pipes, in which pressure must be maintained within a certain range. In a typical transaction, an electricity seller increases its level of power production, raising the "pressure" and causing electricity to flow into the network, while the buyer decreases its power production proportionately, lowering its "pressure" and thereby drawing a roughly equivalent amount out of the system. The process is known as "wholesale wheeling."

The main impetus for the rapid development of this national wholesale power market was a series of federal regulations imposed on the industry during the early 1980s. In an attempt to subsidize "alternative" energy sources, the government required electricity utilities to purchase power from independent producers using solar, wind, and cogeneration sources. This program drew the attention of utilities to the possibility of avoiding risky power-plant projects by purchasing new power from wholesale suppliers. Independent power producers, which exist solely to provide electricity for public utilities, proliferated rapidly over the next decade and now represent more than half of new electricity production in the United States.

Wholesale competition was further encouraged by the Energy Policy Act of 1992, which requires utilities to let other parties wheel electricity over the transmission grids in their service territories. The law also allows utilities to provide electricity to the wholesale market through "exempt wholesale generators," which are free of many federal utility regulations. Today hundreds of independent power producers, exempt wholesale generators, and public utilities can sell electricity to one another over a relatively unobstructed network.

Large industrial electricity buyers have recently begun to demand access to the superhighway. They want what electricity utilities and other power producers already have: the right to purchase power from any producer in the system. "Retail wheeling" would allow electricity consumers to purchase power from the seller of their choice through the local utility. The seller would transmit the electricity to the buyer's local power company, which would reduce its own electricity production proportionately. The retail customer would continue to consume power transmitted by the local utility but would be charged only for electricity consumed in excess of the amount wheeled from the seller, plus a small transmission fee. This would mean the end of the local utility monopoly.

Industrial electricity purchasers, represented by the Electricity Consumers Resource Council, are particularly impatient with the inefficiencies of the current system, which are illustrated by dramatic rate disparities among utilities. Some industrial consumers pay only 4 cents per kilowatt-hour, while others pay up to 12 (the national average is 6 cents). Gerhard Stein of General Motors estimates that his company would save more than $1 billion a year if electricity rates fell by a third. Electricity consumers as a whole would save $59 billion a year, or $614 a household.

Many electricity utilities oppose deregulation for the same reason power consumers support it: The current system allows inefficient power companies to stay in business, despite the availability of cheaper electricity. Many utilities are producing electricity at rates significantly higher than the national average. Some are stuck with inefficient plants and warn that if large electricity consumers are able to bypass local utilities in favor of competitors, residential customers will be forced to pay for those plants through higher rates. But the real threat is that the utilities themselves will sustain the losses, just as many power companies did when they suffered cost overruns in the 1970s.

Although utilities generally oppose opening the superhighway, several have embraced the prospect of competition. Louisville Gas and Electric has appointed ex-phone company executive Roger Hale as its new president in an attempt to gain from the experience of telecommunications deregulation. "I believe there will emerge in the near future a fungible, price-competitive electric highway transportation system that includes point-to-point and network routes," says Hale. He has already split LG&E into two divisions, one for traditional monopoly sales, the other for aggressive buying and selling on the burgeoning electricity market.

Environmentalists have a different reason for keeping the superhighway off-limits to retail consumers. They want to protect "demand-side management," an increasingly popular scheme that uses the utility monopoly as a tax-and-subsidy system to promote energy conservation. Demand-side management programs seek to improve the energy efficiency of utility customers and thereby reduce their electricity consumption. The programs typically offer subsidies for the purchase of energy-efficient heating, air-conditioning, and ventilation systems, low-energy fluorescent lighting, and additional building insulation. Often the utility will send coupon books to customers, giving them substantial discounts on the devices, financed by the utility. In some programs, the utility actually installs the devices for the customer.

The utility pays for the improvements in energy efficiency by raising its rates, in effect taxing all customers to subsidize energy efficiency for a few. Proponents of demand-side management dismiss this as "neutral transfer" between individuals. Such rate increases don't seem "neutral" to the people who pay them.

Demand-side management surcharges impose a substantial burden on energy-intensive businesses such as steel and paper, for which electricity bills represent up to one-third of operating expenses. In New York state, some companies have paid more than $1 million in demand-side management surcharges in a single year, while receiving almost no energy efficiency subsidies. A Michigan program will cost General Motors more than $10 million over the next decade. Firms that had already invested in energy-efficient equipment are largely ineligible for the subsidies and may be forced to pay for energy efficiency improvements for their competitors. Ultimately, such costs are passed on to consumers.

Advocates of demand-side management argue that their approach is more cost-effective than the traditional practice of simply meeting the electricity demands of customers. But as Larry Ruff, an economist with the consulting firm of Putnam, Hayes, and Bartlett, points out, no utility planner can possibly account for all of the costs involved in improving the energy efficiency of consumers. "The cost-effectiveness of any specific DSM device," he says, "depends on the details of the device, the consumer, the application, the timing, the delivery method, etc., in ways that are not directly observable or controllable by the utility."

The cost-effectiveness of energy-efficiency improvements has been vastly exaggerated by their proponents. In a recent study published in Science, MIT economists Paul Joskow and Donald Marron estimate that utilities pay, on average, 500 percent more to reduce their customers' demand than the estimates of energy-conservation advocates would suggest. Furthermore, demand-side management invite free-riders-companies that receive subsidies for improvements they would have made even without the program. Some programs have free-rider rates of 80 percent. Joskow and Marron found that many utilities simply ignore this issue.

Given the inherent problems of demand-side management, a competitive electricity market would spell doom for the concept. Any power producer that attempted to raise its rates to pay for such programs would quickly lose customers. And a recipient of energy-efficiency subsidies would be able to switch suppliers at will, in which case state regulators would not allow the utility to recover the cost of the subsidies through rate increases. Demand-side management and competition simply cannot coexist.

In a March press conference, a coalition of environmental groups, including the Natural Resources Defense Council and the Sierra Club, announced their intent to block consumer access to the electricity superhighway. Parroting a common argument advanced by power companies, they denounced retail-wheeling arrangements as "fictional," because "in actual fact the power from generators attached to a transmission system is totally intermingled throughout the grid."

John Hughes of the Electricity Consumers Resource Council scoffs at such criticism, observing that the same argument could be applied to the existing wholesale electricity market. "The lights are still on," he notes. "Something is happening in those wires."

Furthermore, a fully competitive electricity system already exists for large power purchasers in England and Wales, which began deregulating their system in 1988. Today, any electricity buyer who consumes more than one megawatt of power each year can purchase electricity from any power producer on the England-Wales superhighway.

The process is coordinated through a massive spot market, the "power pool," in which all electricity is bought and sold. The spot price fluctuates on a daily basis, but individual buyers and sellers can set long-term contracts at a specified price. The two parties buy and sell to the pool at the spot price. If the spot price is higher than the contract price, the seller refunds the difference to the buyer; if the spot price is lower, the buyer compensates the seller. The government plans to relax the one-megawatt minimum requirement soon, allowing small electricity buyers to exchange through the pool as well.

Undaunted by successful examples of wholesale and retail electricity competition, the Natural Resources Defense Council is conducting a state-bystate campaign with local utilities to convince state regulators to prohibit retail wheeling. In 1993 the NRDC declared victory in New Mexico, when a bill to open the state superhighway to retail-wheeling arrangements was shunted off to an interim committee for a two-year study period. But other states, including Nevada and Minnesota, are seriously examining competition as a way to retain large industrial firms that threaten to leave in search of cheaper electricity.

Perhaps the most telling indication of the future of the superhighway can be found in the reports of investment houses, which have millions riding on the outcome of the debate. Merrill Lynch has already conducted an extensive survey of utility operating costs to sort out the utilities that can compete on an open network from those that can't. The survey's cover declares, "Competition Comes!" For consumers languishing in a stagnant and inefficient monopoly system, that will be welcome news.

Matthew C. Hoffman is a policy analyst at the Competitive Enterprise Institute in Washington, D.C.