Upgrading the national power grid: electric companies need an economic incentive to invest in new technology.

• Author: Franklin, Joshua J.

1. INTRODUCTION

   On August 14, 2003, 50 million Americans lost power (1) in what marked the worst blackout in United States and Canadian history. (2) The cascading power outage first hit Toronto, then Rochester, Boston and, finally, New York. (3) It took just 13 minutes for the blackout to spread throughout the 80,000 square-mile Canada-United States Eastern Interconnection power grid. (4)

   Industry analysts have been predicting a failure of this magnitude for some time. In 2001, the North American Electric Reliability Council warned Congress that the grid was not designed to be used the way it is being used today. (5) The grid was originally built to transfer power from monopolistic utilities to local customers, a movement of relatively small amounts of power over short distances. (6) But deregulation of the electric power industry over the last decade has created a market-driven system in which power can be immediately traded over long distances from a region with a temporary surplus to a region with a temporary deficit. (7) This system was intended to provide consumers with access to cheaper electricity from various suppliers. (8) However, the resulting increase in the flow of electricity over congested transmission lines drastically increased the risk of major power outages and ultimately led to the blackout of August 14, 2003. (9) Currently, there is "[n]o single authority ... in charge of the grid, and few have an incentive to invest the money needed to improve its reliability." (10)

   In this note, I examine the effects and possible causes of the blackout that occurred on August 14, 2003. I look at the regulatory history that led up to this event, as well as the case history surrounding similar events in the past. Finally, I determine: (1) whether utility companies will be held liable for damage caused to consumers for the August 14, 2003 blackout; (2) whether such liability will provide power companies with an incentive to improve the power grid; and (3) whether current regulation should be altered to provide power companies with a greater incentive to invest in the power grid.

2. BACKGROUND

   This section will examine the regulatory history in the electricity industry as well as the case history surrounding the 1977 blackout.

   1. The History of the Electric Utility Industry

      Capitalist societies such as the United States are based on the premise that free market industry serves a valuable economic function. Free markets foster economic efficiency, technological innovation, and the creation of wealth. (11) However, in some industries, market imperfections prevent the realization of such benefits. When the market fails, the government provides regulation intended to mend the imperfections. (12) But regulation, like any human invention, is also flawed and, over time, will inevitably fail to properly balance the industry so that the desired economic effects are realized. When government regulation fails, it must be replaced with more effective regulation, or the industry must be deregulated. (13) As a natural monopoly, (14) the electricity industry only survived a short time before government regulators stepped in to curb the market power that electric companies wielded over consumers. (15) In the last century, this industry has moved from its inception, when it was totally unregulated, through periods of regulatory buildup and reform, to its current status where governments have begun to deregulate the industry. (16)

      1. Competition and Consolidation

         In the late 1800s, the electricity industry was an unregulated competitive market. (17) It began when Thomas Edison powered up the Pearl Street Station in New York City on September 4, 1882, thereby providing electricity to eighty-five consumers. (18) Demand for the new technology grew rapidly and investors raced to enter the market. By 1922 there were 3,774 different companies producing and distributing electricity. (19) Competition among them was fierce and firms soon began to consolidate in order to realize economies of scale and capture greater market share. Within a few years, eighty-five percent of the electric industry was controlled by just sixteen holding companies. (20) "Concentration provided benefits not only to utility investors, but also to consumers, to the extent the technology ... allowed use in ways that enhanced availability and reliability of power supply and minimized costs." (21) While this consolidation led to technological advances and greater efficiency, the holding companies "were susceptible to stock manipulation and shareholder abuses." (22) With the costs of such abuses being passed on to consumers, politicians at both the federal and state level took notice. The free market period had run its course and regulation was on the horizon. (23)

      2. Regulation

         In 1935, the federal government passed the Public Utility Holding Company Act ("PUHCA"), (24) which required electric utility holding companies to register with the Securities and Exchange Commission ("SEC"), (25) and the Federal Power Act ("FPA"), (26) which gave the Federal Power Commission [the predecessor to the Federal Energy Regulatory Commission ("FERC")] authority to regulate the "transmission of electric energy in interstate commerce and the sale of such energy at wholesale in interstate commerce." (27) With this new authority, and as part of the New Deal, the federal government sought to promote growth in the industry in order to benefit both consumers and investors; "the so-called 'regulatory compact' between government and utilities was formed" to further this aim. (28) Under this compact, the government set electricity rates such that a well-managed utility could earn a reasonable profit. Each utility was given exclusive control over a given service area. That utility became the only firm allowed to sell electricity in that area, but it had an obligation to serve everyone. (29) This compact allowed the industry to grow steadily over the next thirty years. Consumers enjoyed low rates and shareholders enjoyed a reasonable return on their investments. (30) However, by the mid-sixties, "the industry reached technological and financial plateaus at which industry expansion slowed considerably; economies of scale were not being realized, costs were increasing, generation was overbuilt, (31) and alternative providers were coming into the market." (32) In short, traditional regulation was failing both consumers and investors, and policymakers began thinking about reform. (33)

      3. Reform

         The political and economic factors that caused electricity rates to rise continued throughout the 1970s. (34) By 1978, the country's energy situation was considered a national crisis. (35) The Carter Administration responded with the National Energy Act. (36) Among its various purposes, this Act was intended to "increas[e] energy efficiency, moderniz[e] utility ratemaking, stimulat[e] conservation, [and] encourag[e] the creation of a new market in electricity...." (37) One piece of this Act, known as the Public Utility Regulatory Policies Act ("PURPA"), (38) specifically targeted the electricity industry and sought to reduce rates through use of alternative generation facilities, conservation, and a shift to marketbased rates. (39) In line with these three goals, PURPA encouraged independent power production and the growth of non-utility owned generation facilities known as "qualifying small power production facilities" ("QFs"). (40) PURPA required the utility companies to buy power from non-utility power producers and required them to pay what it would have cost them to produce it themselves. (41) The non-utility producers were able to generate this electricity at a lower cost than the utility could have produced it. Thus, the non-utility companies had a great incentive to produce as much power as they could (the statute limited this amount), use what they needed for their own business, and sell the rest to the utilities. (42) Traditional utilities, forced to buy power from low-cost producers, no longer enjoyed the government-sanctioned regulated monopoly that had served investors and fostered growth since 1935. (43) Once the regulatory structure (created by FPA and PUHCA in 1935) failed to maintain low rates, shareholder profits, and industry growth (including technological development), regulatory reform was needed to help restore the goals that the initial regulation had sought to provide. (44) PURPA allowed more efficient electricity suppliers to enter the market, thereby reconnecting with the above goals. PURPA marks the beginning of deregulation and the point at which electricity generation became a competitive sector of the industry. (45)

      4. Deregulation

         While PURPA marks the point at which "the window to competition opened" (46) within the electricity industry, this competition did not immediately benefit the consumer. QFs succeeded in conserving power and generating electricity at a lower cost than the utilities, but neither of these benefits affected consumer rates because QFs could not sell their lower-cost power to consumers. Instead, they had to sell it through utilities. (47) Needless to say, consumers saw a cheaper source of power and wanted to reap the benefits. (48)

         "It is at this point in the regulatory story that transmission became noticeably important and that regulators began to rethink their regulation. While QFs could sell their power to the local utility, they did not have access to the utility's transmission lines to 'wheel' their power to any other utility or end user." (49) Even as regulation over generation and wholesale electricity sales began to loosen, there still existed a natural monopoly over transmission. In other words, there was no reason to construct a duplicate set of transmission lines in order to deliver power produced by QFs to consumers. (50) Thus, in order to get power from QFs and other non-utility power producers to the consumers, there were two...