[An updated version of this article can be found at Electricity and Its Regulation in the 2nd edition.]
Most electricity in the United States is generated by steam from burning fossil fuels or from nuclear fission. Under pressure the steam turns a turbine, whose rotation induces an alternating current. In 1991, 68.2 percent of electricity was generated by fossil fuel, 21.6 percent in nuclear power plants, 9.8 percent by hydroelectric plants, and 0.4 percent from sources such as wind, solar, and biomass conversion. Newly generated power is transmitted at high voltage and distributed to residential and business users at lower voltage. These users spent $178.2 billion for it in 1990. Households consumed 34.6 percent of delivered electricity.
Two characteristics of electric power make utilities different from most other industries. First, both high-voltage transmission and low-voltage distribution are most economically performed by a single line or a single network of lines. Because a single high-capacity line minimizes both capital costs and losses to electrical resistance per unit of power carried, transmission and distribution are natural monopolies.
Second, because electricity cannot be stored cheaply, it must be produced instantaneously on demand. Failure to adjust production to demand can cause brownouts or blackouts over a large region. Reliable supply, therefore, requires operating generators to be backed up by "spinning reserve" units that can begin producing instantaneously. Generation must be operated as a network, centrally dispatched (usually by computer programs) to meet both predictable changes and unforeseen contingencies.
Not surprisingly, given these characteristics, the typical electricity supplier is a large integrated owner of generation, transmission, and distribution. It holds a monopoly granted by government in return for which it has a legal obligation as a public utility to serve all customers in an area. It (or several utilities) is responsible for the operation of a control area, within which it must maintain reliability and dispatch generation economically.
Most control areas are interconnected with adjacent control areas. These interconnections allow emergency support, coordination of operations, and purchases of low-cost power by higher-cost utilities. In 1990, 267 corporate utilities generated 76 percent of America's electricity (down from over 2,000 such firms in the twenties) and served 77 percent of final users. The remaining users were served by one of 2,011 municipal or 953 cooperatively owned entities. Some of these, such as Los Angeles and San Antonio, generate their own power, but most only resell power purchased from others.
Purchases and sales of high-voltage power between utilities, known as the bulk power market, have grown substantially since 1970. Facilitated by improved interconnections and control technologies, they have grown because of regional imbalances between production and demand, and because of price differences among fuels. In 1990, 17.5 percent of all power sales were for resale by others. Most bulk power transactions are based on long-term contracts rather than on day-to-day "spot" markets. Transactions may be for energy (power produced by another) or capacity (ownership interest in a plant) and may be firm (interruptible only in emergencies) or interruptible, with varying contract durations. Also included in bulk market transactions is the transmission of power by one utility for another, called wheeling.
State and federal governments extensively regulate corporate utilities. The states' power to regulate municipal utilities varies greatly. The federal government has almost no power to regulate municipal utilities, except as they are parties to certain contracts that must be filed with the Federal Energy Regulatory Commission (FERC).
Ideal regulation would pass the economies of natural monopoly and network reliability on to customers while providing shareholders with a fair return. At the state level an appointed or elected commission sets allowable rates upon application by the utility, with other affected parties allowed to present testimony. By law the utility must recover its cost of service, which includes "prudently" incurred expenses and a "fair" return on equity. Rates for customer classes are designed to cover the costs of serving each. Because allocating the costs of a utility-owned facility that jointly benefits several classes is an inherently arbitrary procedure, regulators face frequent claims that one class is subsidizing another.
The return on equity must be high enough to attract capital, but an inefficiently run utility may make less than the approved rate of return. Whether certain expenses are prudent is arguable, and regulators sometimes disallow unpopular ones (e.g., nuclear related) on these grounds in calculating recoverable costs.
At the federal level the Federal Energy Regulatory Commission (formerly the Federal Power Commission) regulates rates charged for sales of bulk power between utilities, even if they are in the same state. It also regulates the pricing and use of transmission for wheeling, and asset transfers, including mergers. Prior to the Comprehensive National Energy Policy Act of 1992, FERC's legal power to compel wheeling was modest. In the late eighties, it began to condition its approval of mergers and power marketing plans on transmission access commitments, although the Federal Power Act did not allow it to issue wheeling orders. The new law will permit power generators, including nonutilities, to request that FERC order utilities to wheel power they produce. The commission can order wheeling only if it finds that doing so is in the "public interest" and only if the charges recover the cost of the facilities used. The Nuclear Regulatory Commission oversees construction and operation of nuclear plants, and utilities are subject to the panoply of environmental and safety regulation.
Regulators have in some ways facilitated the growth of electricity markets. Although FERC requires cost justification, it generally approves bulk power and wheeling contracts if no third parties intervene. In other ways, the law does not give FERC sufficient power to foster the growth of markets. It has yet to deal with the serious technical problems of parallel or loop flows. Loop flow impedes the market because electricity does not flow solely over a contracted path from buyer to seller. Rather, it flows over all interconnected lines, including those of other utilities. This involuntary reduction in the victim's transmission capacity can foreclose beneficial transactions. Voluntary agreements on compensation for loop flows have been few and difficult to enforce.
Competition provides incentives for efficient production, but in electricity the coordination of operations also contributes to efficiency. Many utilities, for example, are members of regional power pools. Pooling agreements enable them to coordinate activities such as reserve scheduling, emergency service, maintenance, and sometimes the planning of new facilities. Regulators must frequently rule on the appropriate scope of coordination relative to competition, an issue that cannot be settled by appeal to economic theory alone.
In the past most utilities owned all of their own generating capacity, but competition is now rapidly transforming electricity generation. The Public Utility Regulatory Policies Act of 1978 (PURPA) requires utilities to purchase power from "qualifying facilities": small plants, owned by others, which generate electricity as a by-product of heat. The price must reflect the "avoided cost" of the utility-owned generation it replaces.
Further diversification of power sources will result from recent regulations in some states that require utilities to procure new generation by competitive bids. Bidders can include the utility itself, other utilities, and so-called independent power producers (IPPs), nonutilities that might also be industrial cogenerators. The Energy Policy Act of 1992 further facilitates entry into the market by relieving an important set of power producers from the onerous operating and reporting provisions of the Public Utility Holding Company Act of 1935. Over the next ten years, between 33 and 50 percent of new generating capacity will come from IPPs. As an alternative to new construction, some regulators now also entertain proposals for "demand-side management" programs ("negawatts"). These programs treat investments in conservation symmetrically with investments in generation for rate-making purposes.
Industry experts have some disagreements about the future roles of competition and regulation. As examples, they disagree on the amount of open access to transmission that is consistent with sound engineering practice. They disagree on the likely cost savings if bidding for IPP generation replaces centralized planning by regulated utilities. They debate whether large power users should be allowed to make their own bulk market transactions, which might adversely affect the bills of those smaller customers who remain "captives" of the utility.
Because certain laws intervene, we cannot always presume that an increase in bulk power trades will benefit all electricity consumers. For example, federal law stipulates that power generated at federal dam sites must be preferentially sold to municipal and cooperative utilities at low prices. There has been extensive litigation over the possible obligation of corporate utilities to wheel this power to municipals. This litigation results from the fact that such power is underpriced by law. If a municipal utility wins access to it, its customers gain at the expense of whoever lost access to it. Thus, adding the municipal to the bulk market leads to a zero-sum redistribution of benefits among subsets of consumers rather than an increase in benefits to consumers as a whole.
Utilities currently are not required to wheel power for individual customers (e.g., large industrial users and cogenerators) who wish to take service from others. These customers have sometimes found inexpensive external sources whose prices are less than those of the local utility. They have accordingly attempted to gain the use of transmission in the name of competition. But they have simultaneously asserted a right to return to the status of ordinary customers at regulated rates in the event that market prices turn against them.
Utilities claim that granting transmission access might leave them with "stranded investments" (useless facilities built in the anticipation of continued service to the departed customer). Their costs would have to be paid by the utility's remaining customers or borne as losses by shareholders. Customers who desire transmission service minimize the importance of stranded investments, claiming that they are difficult to measure and will quickly be absorbed by normal utility growth. This problem promises to loom larger as independent power production grows.
The benefits of expanded bulk power markets have been substantial under the pre-1993 transmission regime, with its voluntary, albeit somewhat restrictive, access policy. The gains from further opening transmission are uncertain. According to some experts utilities are already competent at searching out economic opportunities, and therefore, few cheap sources of power are overlooked. Other experts believe that a monopoly utility could not possibly see all of the opportunities in the expanding bulk power sector, and that only a market will find the best of them. These experts accordingly prefer that new bulk power investments be evaluated by the market (to the extent engineering allows it), as they are in other competitive industries.
Robert J. Michaels is a professor of economics at California State University, Fullerton. He has advised corporate utilities and governments on electricity markets and regulation.
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