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 No. 320THE DEREGULATION OF THE ELECTRICITY INDUSTRY
A Primer 
by Peter M. VanDoren
Executive Summary
Several states have enacted and others are contemplat-ing changes in the traditional industrial organization ofelectricity markets. Those changes involve the creation ofstock-exchange-like markets for the sale of electricity andthe treatment of transmission and distribution lines as"common carriers" that deliver power from any generator toconsumers at regulated rates and under regulated condi-tions.Consumers in the Northeast and California have promot-ed such changes because they do not want to pay verticallyintegrated traditional utilities for their expensive elec-tricity. The electricity is high cost because some nuclearplants are terribly expensive, as are some long-term con-tracts signed with independent and renewable power produc-ers. In a competitive market for generation, some high-cost facilities would not be able to earn revenues to paytheir initial capital costs. Shareholders rather than con-sumers should pay for that loss of wealth because share-holders of utilities have already been compensated for therisk created by changes in regulation.The focus on generation has precluded thoughtfulconsideration of the useful role played by vertical inte-gration. Vertical integration, in which generation andtransmission services are jointly owned, is an effectivesolution to the externalities that independent generatorsimpose on a transmission system. Before we take apart ver-tically integrated utilities, we should consider simplederegulation, the elimination of state-granted franchisemonopolies. We should let vertically integrated utilitiescompete without state-provided protection from competition. ____________________________________________________________
Peter VanDoren is assistant director of environmental stud-ies at the Cato Institute.
 
October 6, 1998
 
Introduction
Until recently, the electricity industry largely con-sisted of firms that were state-regulated, vertically inte-grated monopolies. Within each franchise area, one firmgenerated, transmitted, and distributed electricity and wassubject to traditional rate-of-return regulation by a stateregulatory commission.Several states have enacted and others are contemplat-ing changes in the traditional industrial organization ofelectricity markets.
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Those changes involve the creationof stock-exchange-like markets for the sale of electricityand the treatment of transmission and distribution linesas common carriers whose function is to ship the powerdetermined to be cheapest by the activity of the stock-exchange-like auction market. The purpose of transmission,according to those who advocate these reforms, is to allowgenerators to compete to sell electricity to consumers.
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Although the fact that electric generation is notsubject to market failure and, thus, should be subject tomarket forces was recognized over 25 year ago,
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the bigpush for the creation of a "deregulated generation market"has occurred recently because large industrial customers inthe Northeast and California do not want to pay verticallyintegrated traditional utilities for their expensive elec-tricity. The electricity is high cost because somenuclear plants were terribly expensive to build andbecause long-term contracts signed with independent andrenewable power producers as hedges against future highfossil-fuel prices proved to be very unwise. The firstsection of this study describes the factors that placedhigh-cost obligations on the traditional utilities thatwere then vulnerable to competition from lower cost alter-natives.Changes in the policies that regulate markets alwaysincrease the wealth of some at the expense of others.Electricity is not an exception. In the switch to a com-petitive generation market, some high-cost facilities willnot be able to earn revenues to pay their initial capitalcosts. Thus, the market value of such facilities will bemuch lower than their current book value. The second sec-tion of the paper asks whether shareholders or consumersshould pay for that loss of wealth, often described as"stranded costs." It critiques the predominant view thatconsumers should pay and argues that shareholders of util-ities have already been compensated for the risk of a lossof wealth created by changes in regulation and, thus,should suffer any losses that occur.Page 2
 
In the push to restructure electricity regulation, thefocus has been on generation. Most analysts accept theview that generation can become competitive but transmis-sion and distribution still require regulation. Mandatoryopen access, in which all generators have access to thetransmission and distribution system at rates determined byregulation, is now the dominant paradigm.
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Transmission and distribution deserve as much atten-tion as generation. To counter the engineering perspec-tive that now governs discussion of transmission and dis-tribution, the third section of this study asks why trans-mission and distribution exist at all and how they shouldbe priced. The design of efficient electricity transmis-sion prices is difficult because power added anywhere inan interconnected electricity transmission system affectslines and generators everywhere in the system.Three generic solutions exist for the externalitiesthat generators impose on a transmission system: verticalintegration, taxes and subsidies imposed by an omniscientoperator, and decentralized bargaining and property rights.The rush to mandatory open access, a version of the secondsolution, has precluded consideration of the first andthird. Ironically, vertically integrated utilities alreadyexist. Before we take them apart with brute force, weshould consider simple deregulation, the elimination ofstate-granted franchise monopolies.Regulation has not protected consumers in the waysthat populist rhetoric suggests. Regulation has given usexcessively costly nuclear-power and cogeneration con-tracts. We should let vertically integrated utilitiescompete without state-provided protection from competitionand allow the market to discover the most efficient formsof industrial organization. Such a scenario could not beany worse than the status quo.
The Transformation of Electricityfrom Regulation to Competition
Circa 1965, the electricity industry largely consistedof firms that were state-regulated vertically integratedmonopolies.
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Within each franchise area, one firm generat-ed, transmitted, and distributed electricity and was sub-ject to traditional rate-of-return regulation by a stateregulatory commission.Under state regulation, certain economic "truths" gov-erned the design and operation of electric generation
 
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