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Routing 
Electric utility restructuring was initiated inthe 1990s to remedy the problem of relatively high electricity costs in the Northeast andCalifornia. While politicians hoped that reformwould allow low-cost electricity to flow to high-cost states and that competition would reduceprices, economists wanted reform to eliminateregulatory incentives to overbuild generatingcapacity and spur the introduction of real-timeprices for electricity.Unfortunately, high-cost states have seen lit-tle price relief, and competition has had a negli-gible impact on prices. Meanwhile, the California crisis of 2000–2001 has led many states to adoptpolicies that would once again encourage excesscapacity. Finally, real-time pricing, although thesubject of experiments, has yet to emerge.Most arresting, however, is the fact that restruc-turing contributed to the severity of the 2000–2001California electricity crisis and (some scholars alsoargue) the August 2003 blackout in the Northeast,without delivering many efficiency gains.The poor track record of restructuring stemsfrom systemic problems inherent in the reformsthemselves. We recommend total abandonmentof restructuring and a more thoroughgoingembrace of markets than contemplated in cur-rent restructuring initiatives. But we recognizethat such reforms are politically difficult toachieve. A second-best alternative would be forthose states that have already embraced restruc-turing to return to an updated version of the old, vertically integrated, regulated status quo. It’slikely that such an arrangement would not bethat different from the arrangements that wouldhave developed under laissez faire.
 Rethinking Electricity Restructuring 
by Peter Van Doren and Jerry Taylor
_____________________________________________________________________________________________________
 Peter Van Doren is editor of 
Regulation
magazine and Jerry Taylor is director of natural resource studies at theCato Institute.
Executive Summary 
No. 530November 30, 2004
 
Introduction
Throughout most of the 20th century, theelectricity sector in the United States wascharacterized by balkanized regional andstate supply systems with significant barriersto trade between them. Those supply systemswere vertically integrated (that is, the samecompany owned the power generation facili-ty, the transmission lines that delivered thepower to local transfer stations, and theneighborhood power lines that brought elec-tricity from transfer stations to the home),unchallenged by competitors, and regulatedevery step of the way by state public utility commissions. By the early 1990s, however,those systems (hereinafter the “old regime”)produced large discrepancies in both pricesand costs between states. Large consumers of electricity located in high-cost states de-manded policy changes to reduce electricity prices.
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The policy response has been the nationalderegulation of the interstate wholesale mar-ket to allow generators access to transmissionsystems owned by others. Some high-coststates went further and encouraged verticaldisintegration to separate ownership of gener-ators from ownership of transmission and dis-tribution systems. Some states have alsoimplemented retail choice programs to allow consumers and generators to contract directly using transmission and distribution systemsowned by others to transmit the electricity.
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States with low-cost electricity haveresponded by resisting those policy changesand attempting to maintain the old regime fortwo reasons.
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First, while costs could conceiv-ably be lower if market forces were introduced,the costs in “traditional” states have beenacceptable to consumers even without the useof market forces, largely because the low-coststates avoided two high-cost strategies under-taken by other states: nuclear power andexpensive long-term contracts undertaken atthe behest of the Public Utilities Regulatory Policy Act of 1978.
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Second, the California meltdown and theNortheast blackout have drastically reducedpoliticians’ appetite for electricity regulatory reform. To average voters and the politicianswho listen to them, change away from the oldregime is associated with bad outcomesbecause the states that introduced the mostwide-ranging regulatory changes also experi-enced the most problems over the last severalyears. Accordingly, restructuring has been anuneven process. Although competition wasintroduced on interstate electricity systems,the old regime still exists in most states. Andthose states that have restructured their reg-ulatory systems have also suffered embarrass-ing adverse outcomes.
The Case for Restructuring
Electric utility restructuring was a politi-cal answer to the problem of high rates in theNortheast and California. Firms threatenedto leave high-cost states, so those statesattempted to bring the low-cost electricity tothe firms. Under restructuring, local electric-ity generators would no longer have a monopoly over local customers. In theory,distant (lower-cost) generators could com-pete for business and rates would go down. Academic arguments for generation com-petition were somewhat different. First,because investment in capital received a guar-anteed return, total generation investmentwas excessive and skewed toward capital-intensive facilities. The enthusiasm in the1960s for nuclear power was the product of excessive optimism about costs (progressivesregarded nuclear as an energy source thatwould be “too cheap to meter”), the growinghostility to coal-fired generation for environ-mental reasons, and the guaranteed rate-of-return regime that encouraged capital inten-sity. But nuclear power costs, for the mostpart, were much higher than anticipated.
5
 According to economists, introduction of market forces into the generation side of elec-tricity markets would eliminate the biastoward capital-intensive projects by intro-ducing uncertainty about returns.
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Electric utility restructuring wasa political answerto the problem of high rates in theNortheast andCalifornia.
 
Second, prices for electricity did not servetheir usual role of signaling to consumers themarginal costs of additional consumption,which vary by time of day and season.Instead, the commonly used fixed ratesserved solely as a device to recover costs. Thuselectricity prices were wrong all the time.They were too low on peak and too high off peak. Market forces, it was hoped, wouldintroduce marginal-cost pricing and as a result reduce peak demand, increase off-peakdemand,
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and reduce the needless politicalfighting (most notably, the eternal fight overmore supply versus less demand) thatinevitably arises in electricity marketsbecause of the absence of prices as a signalingdevice.Thus, for economists competition betweengenerators was supposed to discipline the costof generation and introduce the use of pricesignals to allocate electricity rather than justrecover costs.The deregulation of interstate wholesaleelectricity markets in 1992 and the restruc-turing of state-level regulation, where it hasoccurred, have induced owners of generatorsto think about costs and risk. CatherineWolfram reports that owners of generators instates that have restructured have reducedtheir fixed costs.
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 And if investors were notaware of risk, they certainly are now. In the1992–2002 period investors added too muchcapacity resulting in low wholesale prices andwidespread bankruptcy in the electric gener-ation sector.
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Prices to retail customers have been affect-ed by restructuring in two ways. First, to theextent that state public service commissionsnow solicit bids from generators to serve so-called default customers (those who do notchose their own generator through retailchoice), consumers presumably benefit fromthe competition. Yet the lower prices securedthrough such programs are largely due to theglut of generation capacity added over the lastseveral years, meaning that restructuring isplaying less of a role in those cost savings thanmight appear to be the case.
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Lower wholesaleprices are also passed on to consumers inthose states that retain traditional regulation.The original objective of economists, howev-er—real-time pricing—has not been imple-mented on a large scale anywhere.
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Restructuring has delivered some of itspromised benefits, but most Americans asso-ciate markets in electricity with bad out-comes because of California and the 2003Northeast summer blackout. Accordingly,anyone who believes market forces ought toplay a larger role in electricity has to argueconvincingly that
•
the California meltdown and the North-east blackout were not the result of mar-ket forces;
•
the low costs of the states still under theold regulatory regime are not the resultof regulation;
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gains to trade (efficiency improvements)not possible in the regulated status quowould take place in a truly deregulatedworld; and
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the “commons” nature of the alternat-ing current (AC) transmission systemcan be managed in a deregulated world.Unfortunately, we would be lying if weclaimed that would be easy.
The California Story 
During 2000–2001 a large supply reduc-tion in hydropower together with weather-related demand increases (a hot summer and very cold winter) raised electricity and natur-al gas prices in California.
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Those priceincreases were exacerbated by the regulationof nitrogen oxide emissions in the Los Angeles basin, some design features of theCalifornia auction bidding system, and retailprice controls.The retail price controls were particularly harmful in that they encouraged generatorsto price high in the wholesale market becausethere would be no reduction in demand atthe retail level as a consequence of their pric-ing behavior. In addition, because retail pricecontrols prevented utilities from passing ontheir higher costs to consumers, the utilities
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Competitionbetweengenerators wassupposed todiscipline thecost of generationand introducethe use of pricesignals to allocateelectricity ratherthan just recovercosts.
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