A critical assessment of electricity and natural gas deregulation.

Author:Trebing, Harry M.

Electric and natural gas utilities are an integral part of a nation's infrastructure. When performing properly they constitute a platform that provides a necessary service for all sectors of society, thereby assuring conditions for economic growth and an improved quality of life. As society advances, dependence upon these energy utilities will become even more important.

Traditionally, most electric and gas utilities have been privately owned but regulated by government in the United States and Canada, while service has been provided by publicly owned monopolies in Europe. Institutional economists contributed significantly to the creation of the regulatory framework in the United States. In fact, economic regulation of public utilities was a centerpiece of John R. Commons' approach to Institutional economics.

A series of recurrent crises beset the public utilities in the years following 1969. There were fly-ups in the cost of power generation, retail rates increased faster than the Consumer Price Index, shortages appeared in interstate natural gas markets, and the regulatory response to inflation was strongly criticized. As a consequence, militant consumer advocates believed regulation provided little or no protection, large industrial buyers anticipated considerable savings by exercising their oligopsonistic buying power through departures from regulated rates, and utility executives saw great potential profits in deregulated markets. These groups argued strenuously for the substitution of pluralistic supply options for regulated monopolies. Mainstream neoclassical economists were employed to considerable advantage to make the case for substituting free markets for commission regulation. These economists ignored the possibility of reforming regulation, which would have been consistent with the Institutionalist approach, (1) and instead called for a major shift to free markets that would allegedly produce lower consumer prices, greater choice, and a more dynamic infrastructure. The few monopoly focal points such as transmission networks could be neutralized by requiring open access while subsequent free entry, contestable markets, and technological advance would aggressively wipe out the market power of incumbent utilities.

The campaign for free markets was remarkably successful at both federal and state levels in the United States. The Federal Energy Regulatory Commission (FERC) became the champion of market-based wholesale electricity and gas rates while 21 state legislatures enacted some form of deregulation for electricity and natural gas. In Europe, privatization was undertaken to promote efficiency and innovation through increased reliance on market forces. Privatization was also assumed to be a strong force for attracting private capital into these industries. In both the United States and Europe, so much faith was placed in market forces that it was not surprising that public policy makers failed to appreciate the need to consider other options if deregulation and privatization programs failed to achieve the promised goals of lower prices, greater choice, and more innovation.

The 2000 Crisis

Beginning in 2000, a series of traumatic shocks dealt a major blow to public confidence in electricity and natural gas deregulation. These shocks took three forms. First, there was the exposure of fraudulent behavior by corporate executives in the utility field that culminated in prison sentences and the two largest bankruptcies in U.S. history. (2) Second, there was a dramatic fly-up in electricity prices in the first states that deregulated. The effects were particularly devastating in California, where the average price went from $30 per megawatt hour to $1400 per megawatt hour on December 14, 2002. There was also growing evidence in California and other deregulated states that power traders and deregulated generators were withholding low cost power during peak periods, and manipulating the bidding process to drive prices up. At the same time, there was considerable evidence that competitive entry in residential and small business markets was inconsequential following deregulation. (3) The third and perhaps most significant factor affecting public confidence in deregulation was the extraordinary increase in deregulated electricity prices with the expiration of interim price caps. Over the period 2002 to 2007, electricity prices in regulated states increased 19.4 percent, but for eight deregulated states the expiration of price caps brought about a price increase of 39.7 percent (Rose 2007, Chart 13). The percentage increase in price for individual classes of consumers attracted further attention. Residential customers in Maryland, for example, were confronted by a phased-in 72% increase in retail prices. As a consequence, five states suspended or withdrew from deregulation programs and another five states failed to act on deregulation laws that were under consideration. Virginia restored regulation and reregulation was being hotly debated in Ohio and other states in 2007. Only FERC retained its unqualified commitment to market-based rates.

Dimensions of Market Failure

Three major areas of market failure can be identified. First, deregulation has produced two classes of energy utilities. The first is the strong asset-based firms, which are vertically integrated or which incorporate power generation through deregulated affiliates. In either case the total enterprise is integrated within a holding company format that is beyond direct state commission regulation, but is still readily able to exploit FERC's permissive merger and...

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