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Fourth Power Plan
Chapter 3: Capturing the Benefits of Competition
The introduction of competition into the Northwest electricity industry
is the overarching consideration motivating the Comprehensive Review of
the Northwest Energy System. Both the reality of wholesale competition,
with much of its focus on the Bonneville Power
Administration, and the anticipation of retail competition have
captured the attention of the electricity industry and those interested in
its effects on the region. Competition in some form will happen. However,
how competition evolves in the region will certainly influence how fully
the potential benefits of competition are achieved; how the benefits and
costs are distributed; the cost and reliability of our power supply; the
effects on the environment; and the future role of current institutions,
including public and investor-owned utilities, the Bonneville Power
Administration and the Council. In the words of one authority on
electricity industry restructuring, "You don't just say ?We're
going to have a competitive market.? You have to think very carefully
about how the pieces fit together with different mixes of regulation and
deregulation." [Hogan, William, "it's all in the
Structure," The Electricity Journal, November 1995, p. 60.]
3-A. Benefits of Competition
A fully competitive market for energy services has the potential to
create tremendous benefits for the electricity consumers of the Northwest.
Competition drives producers to become more efficient, thus lowering
prices. It also spurs the creation of new products tailored for specific
market niches, providing a greater range of choice to consumers. There are
indirect benefits of competition that are equally significant.
Historically, low electricity costs have been a major factor in the
economic growth of this region. Competition promises to continue that
trend and sustain the expansion of the Northwest economy. Competition in
electricity markets will result in more transparency of electricity prices
and of what is included in these prices. For example, it will be much
easier to tell how much of an electric bill is paying for kilowatt-hours,
how much is for distribution services, how prices are different at
different times and so on. This should lead to greater efficiency. For all
these reasons, competition should be embraced. The tricky part will be
restructuring the current electric power industry so that effective
competition, not just deregulated oligopolies, emerges to benefit all
consumers.
3-B. Principles for a Competitive Electricity Market
A well-accepted definition of a perfectly competitive market is a
market where no individual participant is large enough to influence the
market price of the product. [Samuelson, Paul A., Economics, Seventh
Edition, p. 41.] Although we in the United States like to think of ours as
a competitive economy, in reality we have a mixed economy. This is because
the conditions for perfect competition are seldom met in an industry. Some
industries are inherently monopolistic and have traditionally been subject
to regulation. For other industries, there is antitrust legislation,
enforced in the federal courts, to ensure that a reasonable degree of
competition is maintained.
This draft assumes that the portion of the electric utility industry
that is opened to competition will be governed by antitrust laws. However,
these laws do not apply to federal agencies. This creates a unique issue
for the Northwest because more than half the power generated in the region
comes from federal sources.
As the Comprehensive Review progresses, it is important to remember
that the act of deregulating does not guarantee that adequate competition
will result. Without adequate competition, the region will not see the
benefits expected from deregulation. The proposed new structure of the
electric utility industry should foster and protect competition where it
is feasible, and separate competitive markets from non-competitive markets
that require continued regulation. In addition, the inherent limitations
of fully competitive markets need to be acknowledged.
Absence of Market Power
The absence of dominant market power is the key to fair and effective
competition. That is, no player has the ability to control prices and
profits. Excessive market power can arise from several factors, all of
which require consideration in the course of any restructuring. The
sources of market power are: too few sellers; restricted access to
markets; mixing of regulated and unregulated activities; and, more
generally, situations in which not all participants are subject to the
same rules and requirements.
Many Sellers
Market power exists when there are so few sellers that those sellers
are able to manipulate prices. [Newberry, David M., "Power Markets
and Market Power," The Energy Journal, Vol. 16, No. 3, 1995, pp.
39-66.] Where there are too few sellers, deregulation may just trade
regulated monopolies for unregulated oligopolies. Many critics of the
results of privatization/industry restructuring efforts in the United
Kingdom point to the fact that too much of the generating capacity was
held by very few producers, allowing those companies to manipulate prices
In efficiently functioning competitive markets, producers are no longer
"price givers," who can set prices to recover costs and, in the
case of investor-owned entities, earn an assured rate of return. Producers
must accept the prices set by the interplay of supply and demand, or
choose not to operate. Those prices will trend toward the marginal
operating cost of the most expensive unit to operate in a given time
period. From the standpoint of economic efficiency, this is what society
wants to see. Consumers get to trade-off the benefit they derive from
their marginal unit of consumption against the producer's cost of
supplying that marginal unit.
It is also important to recognize that electricity is not a homogenous
product. There are many other products associated with the sale of
electricity, such as load following capability and reserves. There may be
many sellers of some services, but too few for others. Similarly, the
market may have many sellers generally, but transmission constraints can
limit market entry in some areas. The problem is just as severe if there
are many sellers, but a few dominate the market due to their size or other
advantages.
Market Access
For a market to function efficiently, suppliers must have access to the
market; suppliers must be able to deliver products to consumers. When the Federal
Energy Regulatory Commission mandated open, nondiscriminatory,
electricity transmission access and functional unbundling, it intended to
put this market principle in place by assuring suppliers equal access to
potential wholesale customers. The intent of functional unbundling is to
separate the generation and transmission functions within a utility's
organization to minimize the opportunity or temptation to use control of
transmission to the advantage of one's own generation.
Functional unbundling and open access tariffs might provide
nondiscriminatory market access. Open access tariffs require an owner of
transmission to provide access to others under terms and conditions
comparable to those the owner applies to itself. However, leaving
generation and transmission under the umbrella of a single organization
runs the risk of that organization using its transmission branch to
benefit its own generation. It may be very difficult, moreover, for
regulators or competitors to demonstrate that anti-competitive behavior
actually took place. Many utilities in the Northwest have expressed
concern, for example, that Bonneville, which owns so much of the region's
high-voltage transmission system, could exercise subtle restraint on
transmission access, to benefit its own generating resources.
There are at least three preventative steps beyond those described
above that might be taken. Each offers increased certainty that
nondiscriminatory open access will be achieved, but each is increasingly
complex. The first step is to spin off generation or transmission to an
affiliate. While this further separates the two functions, it does not
guarantee that transmission decisions would not be influenced by the
interests of the generating affiliate.
The second step is to vest decisions over transmission operation in an
independent operator with no financial interest in generation. Ownership
in the transmission system would not necessarily change hands, only
responsibility for operation of the system would change. Many
restructuring proposals being considered across the country feature an
independent grid operator who would run the transmission systems of
multiple owners as a single system. An independent grid operator may offer
some operational efficiencies, as well. The independent grid operator
could also be responsible for transmission system expansion decisions.
The third, and most certain, but also most difficult step is
divestiture, i.e., selling off the generation or transmission assets.
Divestiture is certain because the new owner of the transmission would
have no interest in generation. It is most difficult because of the legal
and financial transactions involved in divestiture. What are the assets
worth? How are the proceeds to be allocated? How will the transaction be
taxed? These and a host of other issues complicate divestiture, but do not
make it impossible. While these difficulties are complex, this alternative
would result in a lower ongoing regulatory burden than that associated
with continued common ownership of generation and transmission. [Zeigler,
Belton, "Affiliate Transactions and Electric Industry
Restructuring," The Electricity Journal, October 1995, pp. 20-27.]
Consumer Choice
Consumer choice is the ability of consumers to choose among different
products and different suppliers. Choice is a basic requirement for
efficient competitive markets in that it is a corollary of having many
suppliers with open, nondiscriminatory market access. Consumer choice
drives competitive markets. In the case of wholesale competition, it is
the ability of wholesale customers to choose among suppliers. In the case
of retail competition, it is the ability of retail consumers to choose
their supplier directly. In either case, it is consumer choice that forces
suppliers to bring down their costs and make innovations in their products
and services. Without consumer choice, regulation is needed to substitute
for the discipline of the market and protect consumers from the abuse of
monopoly power.
Separation of Regulated and Unregulated Activities
If a supplier were able to subsidize its competitive position by
shifting costs to its regulated activities, it would unfairly gain market
power. For example, there is a consistent complaint from the Bonneville
Power Administration that its investor-owned competitors are able to
recover the fixed costs of their resources from their regulated retail
business and compete for Bonneville's wholesale customers on the basis
of variable operating costs alone. Whether this is entirely true is not
known, but it does illustrate the concern.
A second concern arising from the mix of regulated and unregulated
functions is that the regulated function will take second place in the
internal competition for scarce capital resources. Given the choice
between investing scarce capital in an unregulated business that can earn
an unregulated rate of return and investing it where it can only earn a
regulated return, most businesses will be drawn to the higher return. If
that is true, the consequence could be that investment needed to ensure
the reliability and efficiency of transmission or distribution will go
begging. In the telecommunications industry, which is further along in the
deregulatory process, recent experience has raised concerns about the
quality of local phone service, the part of the business that remains a
regulated monopoly.
There are arguments to be made in favor of continued vertical
integration of regulated and unregulated activities. In addition to the
transaction costs involved in divesting, there is the possibility that the
increased transaction costs between the now-separated portions of the
business, (e.g., the need to contract for transmission services) could
outweigh the competitive benefits achieved by limiting the market power
associated with vertical integration. [Kaserman, David L. And John W.
Mayo, "The Measurement of Vertical Economies and the Efficient
Structure of the Electric Utility Business," The Journal of
Industrial Economics, V XXXIX, N. 5, September 1991, pp. 483-502.]
However, the principle of minimizing market power is, in the opinions of
many people, so important that the burden of proof should rest with those
opposing divestiture.
Consistent Rules
Relative market power can also be affected if different competitors are
subject to different ground rules. For example, different regulatory
regimes, different tax liabilities, different costs of capital and other
factors can affect relative competitiveness. The Northwest, with its mix
of federal, investor-owned, and local publicly owned entities, has
significant potential for these kinds of market distortions.
3-C. Characteristics of Competitive Markets
Although perhaps not as fundamental as the principles discussed above,
there are also some characteristics of competitive markets that should be
kept in mind in the course of any restructuring process.
Risk and Reward
Competitive markets imply the possibility of business failure and
capital loss. A positive return on capital investment can only be
guaranteed by substantial market power (historically, monopoly power for
utilities). In the regulated monopoly environment, investors trade low
risk (the relatively assured recovery of capital investment from franchise
customers) for relatively low regulated rates of return. In the
competitive environment, investors have no assurance that costs can be
recovered. Competitive markets, however, also imply the possibility of
success and profit. Investors take on risk in return for the possibility
of a higher, unregulated rate of return.
The structure, rules and institutions of a competitive electricity
market have to accommodate the possibility of both market success and
market failure. Is there the ability to absorb loss? If there is a
"profit," how and to whom is it to be distributed? The answers
to these questions are fairly clear for investor-owned utilities.
Stockholders should realize that their stock might go up or down. The
issue is potentially most difficult for the publicly owned part of the
industry ? Bonneville and the consumer-owned utilities that don't have
stockholders to take profits and losses.
Markets are Dynamic
It is tempting to think we know the conditions competition will bring
and that if we can adjust the existing legal and regulatory system to fit
those conditions, everything will be fine. In reality, however, we can't
know what future conditions will be. The interplay of markets and
technological advances can stimulate changes that alter the competitive
landscape. For example, continued improvements in the cost and performance
of small-scale generation and energy storage could result in a very
different picture of the competitive future than the one that seems likely
today. On the other hand, unforeseen resource constraints or environmental
restrictions could turn the market in entirely different directions. In
considering the restructuring of the industry it is important to put in
place structures and systems that are consistent with the overall
principles of competitive markets, not the specifics of the electricity
market as we foresee it today.
3-D. Limitations of Competitive Markets
Competitive markets are not without limitations. These limitations also
have to be kept in mind as restructuring is considered.
Markets are Rarely Perfect
Markets do a wonderful job of allocating society's resources when all
relevant costs are reflected in prices and when market barriers are
minimal. However, there frequently are environmental costs that are
external to the market process. For example, the health and environmental
costs of sulfur dioxide pollution were external to the power industry
until federal emissions standards and caps were established.
In addition, customers often lack complete knowledge of their
alternatives. Poor information about the cost, performance and reliability
of some conservation measures, for example, makes it difficult for them to
compete against better understood resources. Some firms also might have a
degree of market power in some part of their customer base.
These are imperfections that are not resolved now and can never be
resolved fully. They exist to various degrees in most markets. It would be
erroneous to assume that by moving from a regulatory environment to a
market environment, all misallocations of resources would be eliminated.
The move to competitive markets requires continued attention to issues of
market externalities and other market imperfections.
Efficiency Not Equity
Markets, even when they perform well, are about efficiency, not equity.
There may be societal goals, such as addressing low-income consumers,
providing rate relief to groups or areas that would otherwise experience
higher costs, or providing stimulus to a socially desired economic
activity that may not be met by the competitive market. These can be
entirely legitimate policy goals.
This region, and in particular, the Bonneville Power Administration,
has frequently used power system revenues or rates to support these kinds
of goals, including reducing irrigation and river transportation costs.
This type of implicit subsidy was possible in a regulated monopoly.
Competitive markets, however, cannot sustain cross-subsidies. One customer's
subsidy is potentially another customer's greater-than-market price.
With choices among alternative suppliers, a customer will usually find a
way to undercut such prices.
This does not mean that revenues from the power system cannot be used
to address non-market purposes. If, for example, the Bonneville Power
Administration is allowed to charge market prices, and those prices exceed
costs, the net revenues can be used for whatever purposes are deemed
appropriate ? a rebate to customers, low-income services or other
purposes. But delivering the dividend in the form of subsidized prices
puts the subsidizer at a competitive disadvantage and sends an inefficient
price signal as well.
3-E. The Transition Matters
The transition to competitive markets will be neither instantaneous nor
easy. Much of the difficulty of the transition has to do with reconciling
the consequences of past decisions, made in an era of regulated
monopolies, with the new competitive market. Competition has much to offer
in the form of lower costs and better products and services. However, it
will be difficult to make the transition if some groups ? investors or
customer groups ? believe they would be made worse off because of
competition. In addition, the timing of the transition for various
customer groups will be important. For example, with an unstructured
transition, large industrial customers will likely gain access to lower
market prices sooner than individual residential customers.
The debate about this transition has focused primarily on the issue of
stranded investment. Stranded investment is investment that cannot be
fully recovered at competitive market prices. Most, but possibly not all,
of that investment is in generating resources. If some customers can
purchase electricity from the competitive market, instead of from their
historic supplier, they may "strand" their "share" of
the unrecoverable portion of the utility's investment, leaving it with
those customers who don't have access to alternative suppliers, with the
utility's investors or both.
Stranded investment could occur at the wholesale level, as a result of
open transmission access, or at the retail level as a result of opening up
retail competition. Even without actual retail wheeling, the special
accommodations that are likely to be made for large customers who can
threaten to leave the system can effectively strand costs on customers
with less market power.
The stranded investment issue tends to generate a great deal of heat
and not very much light. Customers who think they can take advantage of
the competitive market brand suggestions for some kind of stranded cost
recovery as "anti-competitive." Customers who believe they will
have less ability to take advantage of the market fear they will have to
pay an unfair share of stranded investments. Utility stockholders, arguing
that investments were made in good faith expectation of continued utility
monopoly and obligation to serve, see failure to provide for stranded
investment recovery as unfair to them.
The challenge is to get beyond these polarized positions to a
competitive market. Some observations that may help move the debate:
- The amount of potentially stranded generation investment depends on
the difference between the cost of existing generation and the market
price. In the Northwest, the amount of stranded generation investment
is presently thought to be small relative to other parts of the
country.
- The amount of stranded investment cannot be figured on an individual
resource basis, but rather on the basis of an owner's entire system.
Where utilities have been averaging the cost of their high-cost and
low-cost resources in determining their regulated rates, stranded
investment must be determined on the same basis. One cannot just pick
out the high-cost resources and recover stranded investment for those
resources, while at the same time receiving market prices for (and
making windfall profits from) existing low-cost resources.
- Any stranded investment recovery mechanism should build in
incentives to minimize stranded investments. For example, if owners
must share in the stranded investment, there is an incentive to work
hard to minimize stranded investments. Similarly, stranded investment
recovery should not reward inefficient operation. Recovering fixed
costs is necessary to some degree. Subsidizing above-market operating
costs is neither prudent nor necessary.
- It is difficult to make an argument that all stranded investments
should be recovered from customers (although that is what the Federal
Energy Regulatory Commission has recommended for wholesale stranded
investments). [Bradford, Peter, "A Regulatory Compact Worthy of
the Name," The Electricity Journal, November 1995, pp 12-15.] The
decisions made in a regulated monopoly environment were perceived to
have relatively low risk, but certainly not zero risk. Stranded
investment recovery should be shared between customers and investors.
The fact that Bonneville does not have investors in the usual sense
makes this more difficult, but not necessarily impossible.
- Virtually every electricity industry restructuring process in this
country has recommended some level of stranded investment recovery. It
is the norm, not the exception.
It should also be recognized that there is a flip side to stranded
investment. Stranded investment occurs when total costs are greater than
market prices. But for many utilities in this region, existing system
costs are well below market prices or could be in a few years. The
transition to competitive markets and market prices means that unless some
provision is made for existing customers to share in the return, the
benefits will all go to investors ? a windfall profit. Stranded
investment recovery is based on the principle of equity. Investors who
received a near-certain, but low rate of return in the regulated
environment may be entitled to some level of stranded investment recovery.
If existing customers are also to be treated equitably, they are also
entitled to some share of the windfall profits. They, after all, helped
pay for the below-market resources and accepted the risks associated with
those resources. [Cearley, Reed and Lance McKinzie, "The Economics of
Stranded Investment -- a Two-Way Street," The Electricity Journal,
November 1995, pp. 16-23.]
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