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Debates on restructuring the U.S. electricity industry are often about the degree to whichmarket relationships should replace transactionsthat formerly took place within regulated, verti-cally integrated utilities. Markets for the pur-chase of energy by vertically unintegrated distri-bution utilities are clearly feasible, but verticaldeintegration of existing systems may eliminatesome operational and reliability benefits that areimportant in light of the unique characteristicsof electricity.Politicians and policy analysts have almosttotally disregarded a large body of academic lit-erature regarding the efficiencies that are gainedthrough vertical integration in the electricity sec-tor. At the same time, those parties have enthusi-astically embraced other studies that purport toestimate the benefits of switching to a so-calledrestructured regime consisting of independentgeneration and integrated transmission and dis-tribution. The result has been the passage of elec-tricity utility restructuring laws that may createproduction inefficiencies that shrink the netbenefits of any move toward market provision of power supplies. A review of the debate surrounding electricutility restructuring in California—the first stateto embrace restructuring—reveals that legislatorsand regulators regarded vertical integration pri-marily as a tool that incumbent utilities coulduse to perpetuate their market power. They thusdisregarded the benefits that might accrue from vertical integration and used the force of regula-tion to encourage the sale of generating plants toindependent power producers. The idea was tocreate a competitive market structure in the elec-tricity generation sector. Unfortunately, the costsassociated with this experiment in California and elsewhere have yet to be compared with ben-efits in any economically meaningful way. A proper comparison of the two suggests thatrestructuring is presently off course.
Vertical Integration and the Restructuring of the U.S. Electricity Industry
by Robert J. Michaels
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 Robert J. Michaels is a professor in the Department of Economics at California State University, Fullerton, and anadjunct scholar at the Cato Institute.
Executive Summary 
No. 572July 13, 2006
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Introduction: VerticalIntegration and Electricity 
The past 30 years have transformed theeconomic theory of the business firm.
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In-stead of assuming that the scope of a firm’sactivities is fixed, economists now treat itsboundaries as matters of choice. The eco-nomics of organization asks such questionsas whether the firm should purchase its raw materials in markets or produce them in a facility that it owns and whether its productshould be sold by salaried employees or by independent retailers. A rational decisionabout producing raw material or buying itfrom a third party requires that the firm con-sider alternative ways to hedge price uncer-tainty and ensure deliveries, its ability tocoordinate production and use of the raw material in question, and its competence inmanaging the dissimilar activities of raw material and output production. Almost since their origin, electric utilitieshave been vertically integrated, with genera-tion, transmission, and distribution com-bined in a single firm. The operational ration-ale for vertical integration was largely relatedto the physics of electricity delivery. In orderfor electricity to be transmitted from the gen-erator to the consumer, electricity supply andelectricity demand must remain in precisebalance at every instant over a wide area. Thatchallenging task requires a central authority to govern both the supply of and the demandfor electricity along the power grid.
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There were also economic incentives for ver-tical integration. Low-cost production requiresthe simultaneous optimization of both gener-ator dispatch and transmission capacity. Long-run efficiency requires the coordination of investment decisions at all stages of the chainfrom generators to low-voltage distributionlines.In the mid-1970s scholars first argued thatgeneration could be organized as a competi-tive market.
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Superficially, the case for verticaldeintegration is clear: changes in technology have turned generation into a potentially com-petitive market, and efficiency would beenhanced if that market were allowed to oper-ate. Transmission and distribution, however,remain most efficiently organized as monopo-lies, and those activities should continue to beregulated.In reality, the case for deintegration isproblematic. Its advocates often argue frominappropriate analogies with other industriesor nations and disregard a large body of econometric research on the efficiencies of  vertically integrated utilities.
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If both integra-tion and competitive markets have desirableeconomic properties, industry restructuringshould focus on facilitating the most effi-cient mix of the two. Unfortunately, the valueof integration between generation and trans-mission has been conspicuously unexplored,and thus restructuring threatens to produceinstitutions that foreclose the realization of important efficiencies.The economically efficient degree of dein-tegration is not obvious. Vertical deintegra-tion could remedy discrimination againstcompetitors by an integrated utility, but socould a policy that requires integrated utili-ties that transmit their own power to honorrequests from others to use their lines on thesame terms. Note that the latter remedy doesnot change the organizational structure of the company whereas the former does justthat. Of course, there may not be a problemto remedy in the first place—favoring genera-tors that one owns may be efficient. Various gradations of deintegration havebeen proposed. The least extreme form man-dates a functional separation of generation,transmission, and distribution into differentadministrative divisions within the firm. A stepbeyond that lies structural separation, whichcreates subsidiaries that must deal at arm’slength and in a nondiscriminatory mannerwith each other. A step beyond that lies the pre-ferred policy of the Federal Energy Regulatory Commission, which encourages an opera-tional separation of generation and transmis-sion services and a surrender of the control of the power grid to a nonprofit, public-privateindependent system operator (ISO) or regionaltransmission organization (RTO).
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The most
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The case fordeintegration isproblematic.Its advocatesoften argue frominappropriateanalogies withother industriesor nations anddisregard alarge body of econometricresearch on theefficiencies of  vertically integratedutilities.
 
extreme deintegration breaks generation andtransmission into separate corporations, asoccurred in the United Kingdom.To better understand vertical integrationand electricity markets, this paper summarizesthe economics of vertical integration and itsapplication to electricity. I then confront therecord of economic and legal thought onrestructuring with the econometric evidenceconcerning integration. That research almostunanimously concludes that vertical integra-tion is an efficient form of organization forelectric utilities. Research on the role of com-petitive markets in electricity has been lesscomplete and often less rigorous.
The Economics of Vertically Integrated Utilities
Economic activity can be organized inthree basic ways: markets, contracts, or verti-cal integration. The merits of each vary de-pending on the nature of the enterprise.Markets are places or institutions wherebuyers and sellers compare their valuationsof goods. Prices are discovered as informa-tion about offers and other market condi-tions becomes public. The cost of using a market instead of contracts or vertical inte-gration will be lower the easier it is (1) to con-tact potential counterparties, (2) to comparetheir offers, and (3) to perform the transac-tion, whose costs may include the determina-tion of product quality and buyer creditwor-thiness.Buyers and sellers are more likely to usemarkets to exchange relatively standardizedgoods in situations in which informationabout their characteristics and the character-istics of counterparties is easy to obtain. Thecost of using markets is also affected by thecost associated with changing buyer-sellerrelationships. Markets characterized by sub-stitutable products and uncommitted buyersand sellers work smoothly. For instance, a seller who stops dealing with buyer A andstarts dealing with buyer B does not need tomake any investments specific to the rela-tionship with B or lose any that were specificto the relationship with A.Contracts will supersede markets, howev-er, when a nonstandardized product is par-ticularly valuable, when durable and specificinvestments are necessary to realize that value, or when the allocation of risk the par-ties prefer cannot be obtained in the market.For instance, assume a buyer wants a fuelsupply with flexible deliveries, which requiresthat the supplier construct a specialized stor-age facility the cost of which is unrecoverableif the buyer stops taking fuel from the firm(there are no comparable buyers nearby). Thebuyer gets value only if the facility is built,and the seller builds it only if the buyer com-mits to a long relationship. A contractbetween them may prohibit the buyer fromprocuring fuel elsewhere and the supplierfrom selling it to others when the buyerexpects delivery. Vertical integration is an efficient organi-zational choice if (1) assets are highly specificto a given use or location, (2) assets are uti-lized in activities that must be coordinated,and (3) if the best uses of an asset depend oncontingencies that are hard to predict.
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Whether governance of a relationship will beby integration, markets, or contracts dependson the benefits and costs of each option, possi-bly including the cost of changeover from oneto another of the three. Markets may becomemore attractive if they offer better alternativesthan the buyer could self-provide at the samecost or if the cost of using markets decreases(Internet access, for instance, allows quickworldwide shopping with lower risks of nonde-livery). The benefits of contracting may likewiserise (health insurance is more valuable to me,for instance, if medicine is more advanced) if itscosts become lower (without standardizedautomobile insurance, for instance, liability risks are so high that I choose not to drive).Integration can become a more attractive orga-nizational form (if the market for a raw materi-al input, for example, becomes more unstableand the costs of writing contracts to managethat instability are prohibitive). It can alsobecome less attractive (for example, if growth of 
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Economic activity can be organizedin three basicways: markets,contracts,or verticalintegration. Themerits of each vary dependingon the nature of the enterprise.
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