BARRIERS TO NEW COMPETITION

IN ELECTRICITY GENERATION

Report to the American Public Power Association

June 2008

John Kwoka
Northeastern University

I. INTRODUCTION
Over the past 20 years the electric power industry in the United States has undergone
massive transformation. An industry previously dominated by large vertically integrated
regional monopolies has, in many states, been transformed into a sector comprised of stand-alone
generation companies, a transmission grid operated independently of its owners, and regulated
distribution utilities. In places, traditional distribution has itself been subdivided into a
potentially competitive retail marketing business and a regulated monopoly wires side.
An important initial motivation for restructuring was to ensure that independent power
producers and independent load-serving entities could access the transmission grid on equal
terms with the integrated firms that largely owned it. That would enable the emergence of
contractual arrangements between these parties, facilitating a wider wholesale market for electric
power. Along the way, restructuring came to be seen as a vehicle to introduce competition more
generally into the electric power industry. That perspective in turn elevated cost efficiency in
production and lower prices to customers as explicit goals of restructuring.
But several things have gone wrong in the pursuit of competitive electricity markets.1
These include inherent differences between electricity and other industries that have undergone
reforms, mistakes in implementing reforms in this sector, and erroneous assumptions about how
the restructured industry would operate.2 This report focuses on one of the latter issues.
Specifically, it examines the beliefwidely held before restructuringthat the generation portion

For an assessment of studies of the effects of restructuring, see Kwoka (2006).

See Kwoka and Madjarov (2007)

of the restructured industry was no longer characterized by decisive scale economies3, so

competition would emerge among existing independent generators and entry would occur when
and where it was necessary. All of this was supposed to ensure adequate supply and protect
against excess price and profit without regulation. As this report will show, those assumptions
have not been borne out. Rather, a number of real-world factors have impeded entry, with the
result that entry has often been constrained and generation is not adequately competitive.
The next section of this report reviews the economics of entry and entry barriers from
both a theoretical and empirical perspective. Section III discusses the recent history of entry and
competition in electricity generation, contrasting experience with what early observers expected.
Section IV applies economic analysis to the facts of the industry to develop an understanding of
the various impediments to entry and analyzes the puzzle of why contracting has failed to resolve
entry problems. Section V summarizes and concludes.

II. THE ECONOMICS OF ENTRY AND ENTRY BARRIERS

The issue of entry is an integral part of both economic theory and empirical
understanding. From a theoretical perspective, the economic model of perfect competition relies
on the assumption of free entry into and exit from a market. From an empirical perspective,
entry conditions differ from theory and vary by industry in ways that real world analysis must
reflect. This section reviews our understanding of both the theoretical and empirical sides of the
entry issue.
A. ECONOMIC THEORY
3

Decisive scale economies would imply that the market might support only one or two
efficient size suppliers. Most U.S. power markets have long been supplied by multiple
generators, indicating that scale economies have been exceeded by growth of market demand.

The economic model of perfect competition is based on several assumptions. A standard

enumeration would be as follows4:
Large numbers of individually small buyers and sellers
Homogeneous product
Perfect information both with respect to current alternatives and future events
No transaction costs, that is, completely frictionless markets
Free entry and exit.
These assumptions effectively require several things: (a) that firms and consumers are price
takers with respect to standardized commodities; (b) that consumers, producers, and markets are
rational and costless; and (c) that firms can start up or shut down operation instantaneously and
costlessly. A fundamental theorem in economics proves that markets satisfying these
assumptions are optimally efficient in both production and consumption.5
The importance of the assumption of free entry to the competitive outcome can readily be
illustrated. Suppose a market is described in Figure 1, with demand initially given by D1 and the
supply curve by S1. This results in an equilibrium with price P1 and quantity Q1. Assume now
that demand shifts from D1 to D2. Since demand D2 exceeds supply S1 at the old price P1, the
higher price P2 arises. P2 elicits somewhat greater quantity Q2.from present producers, and also

This listing is from Waldman and Jensen (2007, ch. 3). Other sources are
fundamentally similar. A related literature on so-called workable competition sets out
somewhat weaker assumptions that result in good, if not perfect performance results. See
Scherer and Ross (1990), pp. 52-55.
5

Technically, such markets are Pareto-optimal, which means that no reallocation of

inputs or outputs can simultaneously make everyone better off. There are, of course,
reallocations that may make some better off, but not sufficiently to offset losses by others. It
should also be noted that Pareto optimality or efficiency is not the only possible objective, so that
even the ability of a market to deliver that end result does not necessarily make it socially ideal.
See Waldman and Jensen, ch. 3.

allocates that available quantity to higher valued uses. The temporary higher price generates
profitsadditional revenues in excess of additional costs--to present producers in the amount
shown by the shaded area. These profits have the market purpose of signaling the need for more
capacity in the long run.
In a smoothly functioning, perfectly competitive industry, entry will occur and shift
supply to the right until the new supply curvedenoted S2intersects D2 at the old equilibrium
price P1. This is shown in Figure 2. At this price, quantity grows to Q3 and the disequilibrium
profits, having served their purpose of inducing entry, are eliminated. A new long-run
equilibrium is established.
Suppose alternatively that entry into this market is impeded by some barrier. To illustrate
the extreme case, assume that entry is impossible due to some prohibitive cost penalty facing the
potential entrant.6 As a consequence, Figure 1 persists and becomes the long-run equilibrium.
The high price denoted P2 and the shaded profit area fail to elicit new supply, so the supply curve
remains stationary at S1. The high price continues to ration available supply, but profits are now
simply a transfer of dollars from consumers to producers, creating long-term windfall gains to
incumbent producers, but not achieving their economic purpose of eliciting new entry.
Other cases involve factors that impede entry but do not completely prohibit it. The
effects of such factorsbarriers to entry--will depend on the particulars of each case, some of
which are discussed below. While in some literal sense, any factor preventing instantaneous and
costless entry might be viewed as a barrier, a more practical definition focuses on those factors
permitting existing firms to earn non-trivial windfall profits in the long run.7 Such barriers are

In Bains terminology, entry is blockaded.

Waldman and Jensen, ch. 4.

conventionally divided into two broad categories: structural barriers, which are naturally arising
and therefore exogenous, and strategic barriers, which are devised by incumbent firms to protect
their market position. Three major types of structural barriers can be distinguished:
Economies of scale. A high-fixed cost, high-scale technology requires an entrant to
begin operation at a large volume in order to achieve reasonable cost per unit of output. Actual
entry at such a high scale will, of course, depress price, so that a firm contemplating entry will
enter only if the pre-entry price is sufficiently above unit cost to absorb the additional output
without depressing post-entry price too much. Knowing that, an incumbent firm8 can price
somewhat above cost without inducing entry.
Absolute cost advantages. These involve differential access to inputs such as capital,
locations, patents or talent. An entrant may not have access to such an input at all, or perhaps
only at some higher cost, implying that entry ceases even though the incumbent retains some
windfall profit (measured by its cost advantage).
Product differentiation. Differentiated products diminish competition among
themselves, since they are imperfect substitutes. Greater differentiation therefore confers an
advantage on the incumbent that an entrant must surmount to compete effectively.
Each of these barriers can serve to protect the market position of incumbent firms from
new entry and allow price to be determined, at least within some limits, solely by the incumbent.
Apart from these naturally arising structural barriers, economics recognizes other barriers
resulting from actions deliberately taken by an incumbent to disadvantage or deter potential
entrants into its markets. These so-called strategic barriers to entry encompass a wide variety of
8

This discussion is in terms of a single incumbent firm. Most of the effects described
could also arise with a small number of incumbents, so long as they did not compete away their
structural or strategic advantages.

possible forms, but have as their common element some sunk cost undertaken by the incumbent
to make credible its threat against a possible entrant.9 Examples include the following:
Excess capacity. An incumbent may build and hold excess capacity that it can use to
make credible its threats against a potential entrant. With such capacity in place, the incumbent
can more readily and cheaply expand output in the face of entry, thereby denying the entrant its
expected market opportunity.
Cost strategies. Over-purchasing necessary inputs, excessive product advertising, and
contracts with excessive terms or other provisions designed to lock up customers may create cost
disadvantages and other obstacles to potential entrants seeking to compete. These are not
naturally arising, but are constructed generally at some cost to the incumbent for the specific
purpose of handicapping small rivals and potential entrants.
Product strategies. Product proliferation, deliberate incompatibility, and excessive
design change practices, among other strategies, may create obstacles for new entrants. These
impose added costs on new firms or their potential customers, or deny them market
opportunities, thereby relaxing the competitive constraint faced by the incumbent firm..
Pricing strategies. Certain types of predatory and strategic pricing practices foster a
firms reputation as an aggressive competitor committed to punishing entrants. Reputation
effects and other asymmetries make credible an incumbents threat against a new entrant,
deterring the latter from seizing a market opportunity.
Obviously, not all cases of excess capacity or product advertising or long-term contracts
represent strategic behavior. It is distortions in these practices at variance with normal business
purposes and threatening to smaller rivals and new entrants that raise competitive concerns. It
9

For discussion, see Salop (1979) and Waldman and Jensen, ch. 12.

should also be noted that some of these strategies may be costly to the incumbent. They can
nonetheless be advantageous in so far as they disadvantage the rival more, thereby relaxing the
competitive constraint faced by the incumbent. Moreover, in some cases the additional cost
incurred to create a strategic barrier may produce some consumer benefit. For example, even
when excessive, product advertising may provide some information that is helpful to consumers.
But since the motivation for such expenditures lies with their entry-deterring potential, it follows
that they are not justified simply based on consumer benefit and hence are properly considered
strategic. In addition, some entry barriers may have both structural and strategic components.
Product differentiation, for example, can arise simply in response to consumer preferences, but it
may also be used to deter entry. The balance of these forces in actual practice is often difficult to
determine.
Next we turn to the empirical evidence regarding entry barriers and entry deterrence.
B. EMPIRICAL EVIDENCE
There is a considerable amount of evidence on entry barriers and entry conditions. The
literature can be summarized by reference to three roughly chronological empirical approaches:
early studies that sought to measure structural barriers to entry directly, the broader literature on
patterns of entry and, finally, studies examining the use of entry deterrence strategies. We
review each of these in turn.
Bain (1956), Pratten (1971), Weiss (1975), and Scherer et al (1975) have all made direct
and detailed assessments of structural barriers to entry in specific industries. Although the total
number of industries thus studied is relatively modest--about 35--these represent prominent cases
about which we now know a great deal. Taking these studies as a body of evidence, we can
summarize their findings as follows:

Most of the industries they studied are not characterized by overwhelming economies of
scale. The minimum efficient scale of operation generally represents less than a 10 percent share
of the relevant market, implying that most industries can support 10 or more firms of fully
efficient size. Naturally concentrated markets would therefore seem relatively infrequent.
In most industries, the cost penalty from entering at less than full scale is only a few
percentage points. With such modest cost penalties, firms may opt for easier suboptimal scale
entry by serving market niches or by growing to full scale more slowly and thereby limit price
decreases from their added output.
With respect to economies of advertising, transportation, and other non-production
activities, these are significant only in a minority of industries. Even where important, they
appear ordinarily to require firms to have at most two or three plants, and rarely do they imply an
efficiently structured industry of few firms.
These early studies were quite informative about major industries in the U.S. economy.
Subsequently, considerable research has used cross-sectional data to develop evidence on entry
conditions, actual entry, and entry barriers.10 Geroski (1995), for example, cites some 70 studies
in providing a very useful synthesis of this evidence. Collectively, this evidence supports the
following stylized facts about entry:
Entry of new firms into industries is common, but so is exit of existing firms. The effect
of these offsetting phenomena is that the rate of net entry in most industries is modest at best.
Entry rates across industries vary from quite slow to very rapid. Rapid entry often
occurs in the early stages of the evolution or transformation of an industry.

10

Examples of such studies include Dunne, Roberts, and Samuelson (1988). Siegfried
and Allen (1995) also provide a review.

Entry by new firms is almost always at a scale smaller than minimum efficient scale.
Entry by existing firms into new markets, however, tends to be at larger scale.
Survival rates for new entrants vary across industries and by type of entrant, but overall,
survival rates are quite low. Moreover, the growth rate of survivors is relatively slow, so that
those new firms that do survive attain significant size with a considerable lag.
Actual entry is more responsive to growth in market demand than to profits per se.
Profits appear to be viewed as less reliable indicators of market opportunity.
High rates of entry in an industry are generally associated with greater innovation and
efficiency. Entrants are often the vehicle for introducing innovations.
The third wave of work in the area of entry concerns strategic entry deterrence. While
much of this literature tends to involve very specific theoretical models, there are some useful
empirical insights. In particular, Smileys (1988) survey of actual business practices remains
among the best sources of information about the use of various strategies, including excess
capacity, advertising, R&D/patents, limit pricing, learning curve, reputation effects, and product
proliferation. His major conclusions are as follows:
Almost all firms use some entry deterrence strategy, at least half reporting that they do
so frequently.
The most commonly used strategies are advertising, patenting and product proliferation.
The least common are limit pricing and excess-capacity strategies, though even those appeared
with considerable frequency.
There are significant differences in strategies used to protect new vs. existing products
from competition. For example, R&D strategies are more frequently used by new entrants, while

10

sellers of existing products rely more on product proliferation and even the simple hiding of
profits.
In open-ended questions, respondents also noted the frequent strategic use of excessively
long-term contracts, product specifications, pre-emptive input purchases, targeting of critical
buyers, premature product announcements, and aggressive attacks on rivals promotional efforts.
This review suggests a wide array of entry barriers into markets generally, and
considerable evidence of their importance in actual practice. Based on this theoretical and
empirical understanding, we turn to the case of electric power generation.

III. BACKGROUND TO ELECTRICITY GENERATION

Beginning with the Public Utility Regulatory Policies Act of 1978, electricity generation
has been undergoing policy-induced changes for 30 years. PURPA required vertically integrated
utilities to purchase surplus power generated by independent producers meeting standards on fuel
use, size, efficiency and reliability as a conservation measure. That reform enlarged what had
been a very closed regime for transactions in bulk power and at the same time demonstrated the
possibility of a true market for wholesale electricity. The Energy Policy Act of 1992 and the
subsequent promulgation of Orders 888 and 889 by the Federal Energy Regulatory Commission
in 1996 accelerated these reforms. These orders required vertically integrated utilities to provide
equal and open access to their transmission grid to independent producers and purchasers. In
2000 FERC promoted the formation of Regional Transmission Organizations to open and
broaden wholesale power markets. 11

11

More comprehensive reviews of this history can be found in Kwoka (2006) and Joskow

(2000).

11

In this section we review some early views about the ease of entry into generation, and
then summarize the recent history of actual entry into the generation sector.
A. EARLY VIEWS OF COMPETITION IN GENERATION
Throughout this period, advocates of electricity restructuring viewed the prospects for
entry and competition in generation with considerable enthusiasm. Some argued that, if
generation were freed of regulation, a sufficient number of suppliers for effective competition
would enter the market. A typical comment, due to one prominent participant in the debates
some 15 years ago, asserted that industry restructuring could be based on:
distinguishing those elements that could conform to the competitive model and operate in
the private market from those elements that are likely to require some form of price and
service regulation...The assumption here is that generation is a market with enough real
or potential participants to enforce workable competition.12
All of these crucial assumptionsa sufficient number of independent generators, ease of entry,
workable competition--have proven problematic in practice.
At about the same time, another academic reviewed (somewhat selectively) the literature
on scale economies in generation and also on entry generally, and concluded that competition
can be substituted for government regulation and state ownership to assure good performance in,
at least, the generation of electricity.13 In support of this conclusion, he appealed to the theory
of contestable markets. That theory predicts good performance in markets regardless of the
number of firms, so long as there are no sunk costs in production, since that would permit

12

Hogan (1993).

13

Moorhouse (1995).

12

costless and instantaneous entry and exit.14 Such ultra-free entry would perfectly constrain
incumbent firmsor even a single incumbent firm--from raising prices. However, this
assumption is not satisfied in any real world market, much less one with the characteristics of
electric power generation.
Another economist and influential participant in the electricity policy debates offered
similarly optimistic views of the potential for competition in generation. His 1997 assessment
was as follows:
Structural and regulatory reform...is following the basic model previously applied to
network industries such as telephones and natural gas. Potentially competitive segments
(the generation of electricity) are being separated structurally or functionally from natural
monopoly segments...15
While he cautioned that the benefits of restructuring would depend upon its details, he later
offered the following optimistic prediction16:
Competitive entry of new unregulated generating facilities owned by developers that
assume construction and operating cost risks and that have incentives to use the lowestcost technologies is likely to be one of the most important long-term benefits of
competitive electricity markets.
In reality, electricity markets differ from other network industries and certainly have not proven
to be systematically competitive. Moreover, this evaluation appears to view the surge of

14

For fuller discussion, see Waldman and Jensen, ch. 5.

15

Joskow (1997), p. 120.

16

Joskow (2000), p. 152.

13

construction and entry around 2000 as indicating good market performance, whereas we shall see
that the surge in fact represented a market mistake of major proportions.
B. THE GENERATION BOOM AND BUST
These structural changes have had a substantial effect on the industry. Regulated electric
utilities, which owned 92 percent of total generating capacity in 1995 and 74 percent as recently
as 2000, saw their share of generating capacity fall to 58 percent by 2006.17 Since the mid1990s, investor-owned utilities (IOUs) divested approximately 100,000 MW of capacity to
unregulated affiliates and another 100,000 MW to independent companies. In addition, about
200,000 MW of capacity was added by independent power producers. Approximately 74
percent of all capacity additions between 1996 and 2004 were made by nonutilitiesa category
that includes both new merchant generation as well as unregulated affiliates of IOUs.18 Output
from these nonutilities accounted for only 7.2 percent of total U.S. electricity generation in 1990,
but that grew to 20.7 in 2000 and 33.0 in 2004.19
Annual additions to capacity by utilities and nonutilities since 1995 are shown in Figure
3. That figure also illustrates a surge in capacity additions in the period starting in 2000
followed by an equally sharp decline between 2002 and 2004. This surge was facilitated by
three factors. The first was the incipient restructuring of electricity markets, which promised
more open markets and a growth in demand for new generation.20 Two additional factors were
17

Calculated from US Energy Information Administration Electric Power Annual 2006,

Table 2.1.
18

Electric Energy Market Competition Task Force Report (hereafter, Task Force
Report), p. 35.
19

Task Force Report, p. 14.

20

As noted previously, prospective demand conditions are perhaps the most important
economic determinant of new entry

14

supply-side influences. One was the ready availability of credit and venture capital in the midst
of the telecom, Internet, and dot-com booms. The other was historically low prices for natural
gas, which came to be seen as the preferred fuel source--cheap, environmentally friendly, and not
requiring large-scale facilities investment.
While this surge represented a response to demand and supply forces, it should also be
noted that little of the new capacity consisted of base load generation plant, and little of that
appeared in the most highly concentrated generation markets. Moreover, all of these favorable
forces came to an abrupt halt around 2000 and 2001. A general economic slowdown, the
California electricity crisis, the huge run-up in natural gas prices, and the bursting of the dot-com
bubble all brought demand growth to a halt and ended the era of cheap natural gas and easy
credit. In fact, since much of the new generation was gas-fired,21 the rise in the wellhead price of
natural gas from $1.55 per thousand cubic feet in 1995 to $7.33 10 years later rendered much of
that generation uneconomical. This in turn caused the market values of numerous generation
companies and energy traders to plummet, with some entering into bankruptcy.
By the mid-2000s, the boom in new generation plant construction had turned into a
trickle, if not an outright bust. Capacity additions in 2005 totaled only 15,000 MW, down from
more than 60,000 MW in 2002. Moreover, most of the additions in recent years came from
municipally owned utilities, traditional vertically integrated utilities, and wind projects. These
were hardly the expected sources of new generation envisioned by advocates of free markets.22

21

Natural-gas fired generation constituted 57 percent of nonutility capacity in 2004,

though less than 20 percent of total U.S. capacity. Task Force Report, pp. 39, 40.
22

Indeed, it is one of the great ironies of electricity restructuring that publicly owned
utilities, overwhelmingly distribution-oriented but now concerned with long-term supply, have
begun to integrate vertically in order to ensure necessary supply. It should be noted that many of
the wind projects are under contract with IOUs.

15

Nonetheless the effect of years of additions to natural gas capacity was evident in the mix of
energy sources characterizing U.S. generation. As shown in Figure 4, natural gas accounted for
nearly 40 percent of generating capacity in 2006, exceeding coal, the traditionally dominant
energy source. Nuclear and hydro account for the bulk of remaining capacity.
C. FROM EXCESS TO SHORTAGE
As the investment bust unfolded, the opposite concern almost immediately arose, namely,
that existing and planned capacity additions might be insufficient to keep up with continuing
increases in demand for power. Projected reserve margins for the various North American
Electric Reliability Corporation (NERC) regions, shown in Table 1, support this assessment.
Between 2006 and 2011, margins are forecasted to decline for the entire United States and for six
of the eight regions. In three regions margins are expected to fall into the single digits. System
operators in the Northeast, California and elsewhere have projected outright shortages by the end
of the decade.23
More troublesome yet is the fact that, despite projected shortages, there appears to be
only a modest amount of new investment under way or planned. Underscoring that, some RTOs
and analysts contend that current pricing does not generate sufficient net revenues from new
generating units to cover their annualized capital cost.24 Two puzzles therefore present
themselves: the reason for the boom-bust cycle of investment in generation, and the reason that
current market signals are apparently inadequate to elicit new investment even in the face of a
shortage. The first of these questions is addressed immediately below; the second is the focus of
the next section.
23

ISO New England (2005), p. 80. See also Joskow (2006), p. 26.

24

See, for example, FERC (2005) p. 60; New York ISO (2005), pp. 22-25; PJM (2006),
p. 124-132), and also Crampton and Stoft (2006)
16

Investment cycles are a constant possibility in the electric generation industry. Industries
that are highly capital-intensive and have long lead times for investment may find that a lack of
coordination among producers decisions leads to persistent market disequilibrium.25 To
illustrate how this may occur, suppose initially there is an excess of new generation capacity in
the industry. This excess temporarily depresses price, which in turn signals an unfavorable
investment environment. Each producer will therefore rationally cut back or cease further
investment, but the effect of their separate decisions is a collective reduction that may well fall
below the optimum amount. In most markets this discrepancy is readily overcome by further
responses by suppliers, but in the presence of large fixed and sunk costs and long lead times,
these separately rational decisions in the present period may result in inadequate total investment
and capacity in the next period.
The process need not stop there. The current shortage results in a high price and
therefore apparently good future investment opportunities. As investors individually respond,
the net effect of this same lack of coordination may well be over-investment for the subsequent
period. In short, in markets such as these, there is no assurance that total investment will match
the socially desirable amount at any point in time.26 Rather, constant fluctuation from overinvestment to under-investment is entirely possible.
If investment cycles are a constant possibility in electricity generation, current evidence
suggests we are entering a period of capacity shortage bred of past over-investment. While
ordinarily a capacity shortage would be accompanied by price signals prompting new
investmentitself a prelude to future excess capacity--a distinctive feature of this present round is
25

See Green (2006) for extended discussion. He suggests oil tankers and copper as
examples of industries exhibiting such cycles.
26

Long-term contracting can alleviate some aspects of this problem. See Green, op.cit.

17

that the apparent shortage and accompanying price signals are not prompting much investment at
all, much less excess investment. This in turn raises the question of Why not? That is, why is
the market not responding to the demonstrable need for more capacity? In what follows, we
enumerate a variety of impediments to new investment in generation, particularly some
impediments that have recently emerged or taken on greater importance.

IV. BARRIERS TO ENTRY AND INVESTMENT IN GENERATION

Conditions of entry into electricity generation markets have some features in common
with other markets, while others are distinctive to this setting. Here we review first some
traditional economic barriers to entry into generation, followed by regulatory barriers and
various types of uncertainty that constitute further barriers to entry into power generation. We
conclude by examining the apparent inability of contracting to resolve these matters.
A. TRADITIONAL ECONOMIC BARRIERS
As reviewed above, traditional economic barriers to entry into a market involve high
economies of scale, large capital requirements, and long lead times. Information on these three
characteristics for each of 19 different generation technologiesfrom nuclear to photovoltaic--is
presented in Table 2.27 We summarize and discuss our findings on these three characteristics in
turn.
The necessary scale of operation for each technology is reported in Column (b) of Table
2. As shown there, new nuclear units involve an efficient scale of operationthat is, the size
necessary to achieve minimum cost per unit of capacity--of 1,350 MW of capacity. This is large

27

EIA (2007), p. 77; see also CERI (2005) and Blanton (2007). Slightly different values
for fossil fuel plants are given in DOE/NETL (2007), Summary Chart ES-5.

18

enough to be a significant addition to the supply serving any geographic market.28 Optimum size
coal units are less than half as large--on the order of 550-600 MWbut still substantial. Gasfired generation offers a wide range of scale possibilities, from 160 MW to 400 MW, all of
which are smaller than coal. Most other technologies operate efficiently at considerably smaller
scale, down to distributed generation at 1 MW.
These data imply that both coal-fired and (especially) nuclear plants must be of
substantial scale to achieve minimum unit cost. Entry by such a generator will therefore have a
significant impact on post-entry market price, and investors will carefully assess the ability of the
market to absorb the large increment to capacity without unduly depressing prices. Due to their
smaller scale, incremental generation using gas and other fuels will depress market price by less.
Hence, such generation is more likely to be able to ease into a market without much of a price
penaltyunless, of course, many such units come online simultaneously.29
Column (c) of this table lists construction lead times for each of these technologies.30 All
require a minimum of two years for plant construction, an interval inconsistent with quick
entry, much less contestable markets. Technologies involving larger scales of operation
generally involve longer construction times, with three years typical for gas plants, four years for
coal-fired generation, and fully six years for nuclear facilities. Such lead times, especially for
coal and nuclear, raise risks for new plants due to the uncertainty about market conditions several

28

Such a nuclear unit would represent 10 percent or more of capacity in approximately

half the states. This is only rough guidance, since actual economic markets are in many
instances larger than a state, and in some others smaller.
29

This is arguably what occurred in the construction boom of the period 2000-02, as
discussed above.
30

These figures do not include any delays due to regulatory actions, which will be
discussed separately below.

19

years ahead, when a planned unit actually comes into service. We shall discuss the nature and
implications of such uncertainty in greater detail below.
These reported lead times are expanded by whatever further period is required to secure
financing for the project. Necessary financing can take as little as six months, but more typically
might be two years. The latter figure applies to sizeable coal and other plants, implying lead
times of six to eight years from the start of financing until the completion of construction.
Column (d) of Table 2 lists estimates of the total capital costs for each technology.
Capital costs are calculated for a physical plant of optimum scale, as described above, and then
adjusted for a series of factors, such as regional wage differentials and the demonstrated
tendency to underestimate the actual costs of a new technology. The resulting total cost for an
efficient scale nuclear plant, for example, is estimated to be $2.8 billion.31 This is nearly four
times as much as the capital costs for a coal plant, which is $775 million. An efficient size gasfired generator is estimated to cost $225 million, with other technologies generally considerably
less. Capital in the amounts required for a coal or nuclear plant will be more difficult to raise,
and hence require a premium to investors.
Another comparison of some interest is provided in Column (e). This divides capital
costs by the capacity of an efficient plant, giving capital cost per kW of new capacity. Not
surprisingly, the results are much more similar across technologies, but nonetheless indicating
unusually large per-unit capital costs for nuclear, photovoltaic, and certain types of coal plants.
These traditional economic barriers can therefore be quite substantial in the case of many
electricity generation technologies. Nuclear plants are extremely large and expensive, and entail
long lead times. Gas-fired generation has much more modest capital costs and efficient size.
31

Recent news reports suggest the cost may be far higher, perhaps $5 to $12 billion. See
New Wave of Nuclear Plants Faces High Costs, Wall Street Journal, May 12, 2008.

20

Coal plants lie very much in between nuclear and gas units. Hydro projects require considerable
capital and lead times for construction, while wind power is capital-intensive but with shorter
lead times.
Two other factors may further handicap possible entry. In some cases, entry into
generation may require new transmission facilities or perhaps even new distribution plant in
order to ensure access to the market. To the extent that viable entry into generation also requires
investment in one of these related activities, barriers are correspondingly greater: More capital,
more know-how, and very possibly longer lead times are required for such two-market entry,
that is, entry into generation plus entry into transmission.
Another complicating factor is certain absolute cost advantages accruing to incumbents.
Most especially, perhaps, is the fact that incumbents often possess the best locations for
generation plants, locations that cannot be replicated by entrants due to environmental,
regulatory and other reasons. The difference between the incumbents cost and what the entrant
would have to pay for a competitive site represents an enduring advantage of and profit to the
incumbent.
In summary, both technology and existing market structures may make entry into
electricity generation costly, time-consuming and otherwise problematic.
B. THE REGULATORY APPROVAL BARRIER
The costs and delays associated with securing regulatory approvals can add to the above
dollar costs and lead times of entry. Good evidence on regulatory delays and cost issues is
contained in a report by the General Accounting Office (GAO, 2002) comparing the regulatory
approval process for new generation plants in California with those of Pennsylvania and Texas.
The GAO report concluded that all three states have roughly similar approval processes: State

21

and local agencies review the application for compliance with environmental, land use and other
requirements before issuing the necessary permits. California adds an additional layer of review
in that the California Energy Commission determines whether the benefits of additional energy
from the proposed facility outweigh its likely environmental and other costs.
GAO collected data on the time lags associated with all power plant approvals from 1995
through 2001 in these three states. As shown in Table 3, the approval process in California and
Pennsylvania takes on average 14 months, compared to 8 months in Texas. The principle reason
for this differential appeared to be that most proposed plants in California and Pennsylvania are
in areas where air quality did not meet federal standards, whereas in Texas most are in areas that
did. As a result, more than 60 percent of the approved plants in Pennsylvania and California are
required to install more advanced pollution control equipment, compared to only 18 percent in
Texas. The process is also more variable in California than elsewhere, with five of its 21
medium-to-large projects taking at least 18 months, but nine completed within a single year (see
Table 3).
In summary, GAO data suggest that the California approval processdespite much
commentary to the contraryis not dissimilar relative to that of other states. Its process has one
additional required approval and the time delays are somewhat more variable, but the real
difference in approval times is simply due to air quality standards. In Pennsylvania, the other
state with a similar degree of noncompliance, approval timing is essentially the same.
One cost item specifically discussed in the GAO study concerned connection to the grid.
Texas requires a new producer to pay only for the direct cost of connection, whereas
Pennsylvania and California require payment for any upgrades to the transmission system
required to carry the additional load. In Texas upgrade costs are paid for by customers through

22

their regular electric bills. An additional factor reported in the GAO study as facilitating entry
in Texas is that states use of a standard contract between the parties. This cuts in half the time
required to sign an agreement in California and Pennsylvania, states that lack such a standard
contract.
More detailed data on interconnection costs underscore its potential importance. Table 4
reports an EIA compilation of the total cost of physical interconnection for generators that started
operation in 2006. These costs include transmission or distribution lines, transformers,
protective devices, substations, switching stations and other equipment necessary for
interconnection. As is evident, these costs are nontrivial, totaling more than $500 million in
2005 and 2006. Clearly, Texass method for recovering these costs makes that state relatively
less costly for a new entrant into generation.
Apart from these specific regulatory issues, some state regulators and legislatures have
indicated varying degrees of interest in having any new generation within their borders. Those
expressing reservations can surely expectindeed, presumably intendtheir message to
discourage potential entrants from those markets.
C. DEMAND AND COST UNCERTAINTY AS A BARRIER TO INVESTMENT
The capital investment decision for any proposed project is in principle straightforward:
initial project costs are compared to the forecasted net revenue stream, and the projects resulting
expected profitability and return on investment are calculated. But evaluations of certain
investments are more complicated. Projects with very long time horizons inevitably entail
market risks, that is, uncertainties about future market conditions and the price that the
projects output will command over the payback horizon. Those that are heavily dependent on
some particular input also raise cost risks due to the uncertainty about the future cost of

23

production and hence the net revenues. Each of these adds uncertainty to the investment return.
Other things equal, investors dislike such uncertainty and will insist on some additional
compensation for financing such projects.
New electricity generation projects entail considerable uncertainties of both types due to
the very long time frames involved.32 The relevant time frame has three parts. The first two
mirror those just mentionedthe delay due to construction and the delay required for regulatory
approval, both of which postpone the start of revenues some number of years after the initial
capital investment. In addition, the 20-40 year lifespan of nuclear or coal units means that, even
after revenues begin to accrue, their full realization is a very protracted process. Investors in
some plants are in effect placing a bet that demand and cost conditions over the three or four
decade period will justify the capital expenditures.
These uncertainties are attenuated to the extent that the capital investment is not entirely
sunk, but rather can (perhaps at some modest expense) be redeployed to an alternative use. In
the limit, if fully fungible, even a long time horizon is not an impediment to financing since
alternative uses and their revenue streams represent a viable fallback position for lenders.
In the case of electricity generation, costs are almost entirely sunk, exacerbating the
inherent uncertainty and risks of investment.33 Nuclear units have very long lifespans, exposing
their large sunk capital costs to substantial market risks (as well as uncertainties about
environmental consequences). Coal-fired plants are nearly as long lived, raising similar market
risks. Gas-fired plants have shorter lifespans and lower capital costs but correspondingly higher

32

There are also short-term uncertainties due to such factors as weather, but these are
much better dealt with through such techniques as hedging, relative to the long-term
uncertainties focused upon here.
33

This discussion borrows in part from Zhang (2006).

24

fuel costs. Their recent experience demonstrates that even they face cost risks, namely, the risks
of a fuel price spike rendering a new plant altogether uneconomic. Neither coal nor gas-fired
units have alternative uses that spare the invested capital from exposure to such risk. In the cases
of hydro and wind projects, the risks derive from their dependence on favorable meteorological
conditions for any production. The absence of rainfall or wind makes them uneconomic for the
period of time when they are unable to produce output.
Thus, each generation technology embodies some mix of market and cost risks for which
investors require compensation. Under traditional cost-of-service regulation, the necessary
compensation takes the form of assured returns on all prudent investments to the utilitys
bondholders and shareholders. The risk is effectively imposed on ratepayers. One of the
benefits often ascribed to restructuring was that this risk would be allocated in a more efficient
manner, specifically, on those most responsible for the risk and best able to bear it. That
principle was expected to result in shifting more of the risk to investors, rewarding good
decisions and penalizing bad ones, rather than the regulatory approach of giving all (or at least
all minimally prudent) investments the same return.34 Why this has not happened is a question to
which we shall return later in this report.
D. OTHER SOURCES OF UNCERTAINTY BARRIERS
Uncertainty from any source will affect market operation and pricing. Here we discuss
several other types of uncertainty that may arise in generation markets, hindering contracting and

34

The Task Force Report, for example, states that under regulation ratepayers were left
to bear much of the investment risk, as they had to pay for regulator-approved projects resulting
in overinvestment as well as any subsequent higher costs from underinvestment. (Report, p.
46). The industry-funded Compete Coalition has stated, One of the most important benefits of
competitive markets is that they shift risk away from customers and toward the shareholders of
competitive companies and those that lend them money. Compete Coalition (2007).

25

requiring compensation for risk-taking. These additional uncertainties can be grouped into four
categories, as follows:
(1) REGULATORY POLICY UNCERTAINTY. Federal and state electricity regulators routinely
set and change regulatory operating rules and even prices themselves. Unpredictable changes in
future regulatory policy that alter the likely revenue stream from a project add to uncertainty
about the prospects for covering its initial costs. While such actions may be desirable and even
necessary, they impose an additional cost for which investors will, at a minimum, insist on being
compensated. For these reasons, investors may even choose to wait out the period of regulatory
transformation of the market.35
One example of a regulatory mechanism affecting investors expectations is bid caps.
While these may assist in mitigating market power, some analysts are convinced that they
arbitrarily chop off some appropriately high prices, that is, prices that correctly reflect transient
shortages. To that degree, bid caps reduce the revenue stream from the entire distribution of
possible price outcomes, creating a shortfall in total returns to investment. Without judging the
merits of any particular experience, it is clear that truncating the distribution of outcomes will
alter overall payoffs to generation.36
Another example involves the possibility of regulatory opportunism, that is, regulatory
actions that extract rents from one party to a transaction that finds itself with little or no
bargaining power. One case of what business views as hold-ups would include federal and

35

See Green (2006) for discussion of the value of delay in funding a project in an
uncertain environment. Essentially, delay provides additional information about the distribution
of possible outcomes and may thereby spare the investor from making a bad bet.
36

For an argument along these lines, see Joskow (2006), p. 38. Joskow notes, however,
that bid caps are less important in suppressing prices than are administrative actions of system
operators during periods of scarcity. The general point regarding regulatory uncertainty remains.

26

state actions sought by utilities that are contingent on compliance with or performance on
extraneous matters, for example, merger approval contingent on a rate freeze. A second oft-cited
concern would be where regulators adjust price ex post explicitly for the benefit of a favored
party, or when they abrogate contracts because the contracts have resulted in unappealing
outcomes (e.g., high price to favored parties).37 The probabilities of such unforeseeable and, in
the view of business, arbitrary actions raises risks of doing business in these markets.
(2) ENVIRONMENTAL POLICY UNCERTAINTY. Environmental concerns with new coal-fired
plants add considerable uncertainty to their economic prospects. Federally-mandated reductions
in greenhouse gas emissions seem quite likely over the next several years, following several
efforts at the state level to initiate emissions caps. The specific levels of controls and hence their
effect on construction and operating costs are unknown, but estimates indicate both may be
substantial.38 In anticipation of such controls, investment capital for new coal plants is becoming
harder to secure. Three major investment banks now require new coal plant proposals to
demonstrate their economic viability even under a stringent CO2 standard.39 This and other
actions have quickly diminished enthusiasm for coal plants. TXU, for example, abandoned eight
of 11 planned coal plants.
Concern over greenhouse gas emissions from coal-fired plants has prompted renewed
interest in nuclear energy. While nuclear plants produce no greenhouse gases, their operation

37

Task Force Report, p. 77. It is noteworthy that this report could not cite any actual
examples, despite the frequent appearance of this argument.
38

Synapse (2006), for example, reports levelized CO2 cost estimates ranging as high as
$50 per ton and annual cost of power effects for a 600 MW plant ranging in the hundreds of
millions of dollars by 2020 and beyond. (Synapse, 2006).
39

Wall Street Shows Skepticism Over Coal, Wall Street Journal, February 4, 2008, p.

A6.

27

gives rise to two other environmental/safety issues. The first issue concerns the safety of nuclear
plant operation itself, while the second issue concerns disposal of waste material. Based on past
experience, the hazards associated with nuclear plant operation represent a small probability, but
one nonetheless with potentially very large adverse consequences. Disposal is an unambiguous
problem without a path to immediate resolution. These and other concerns have contributed to a
long hiatus in new nuclear plant construction in the United States.
With such issues affecting the prospects of both new coal and new nuclear facilities,
some utilities have simply opted for gas plants. As noted, however, such plants have higher
operating costs as well as a history of troublesome price spikes, but among various problematic
alternatives, gas may no longer be the least unattractive.40
(3) RETAIL COMPETITION UNCERTAINTY. Some twenty states have adopted retail
competition, allowing customers to switch retail suppliers. Customer switching, however,
creates uncertainty regarding their future load and supply requirements for competitive
marketers. As a result, they may be reluctant to enter into contracts obligating them to take fixed
amounts of power, at least not without costly opt-out clauses. Relative to a monopoly franchise
world, a fragmented retail supply sector faces inherently greater uncertainty and costs, other
things equal.41
Further evolution of the electricity sector may help moderate this source of uncertainty.
For example, integration of generators and retail suppliersnascent in the United States but much
farther along in the European Unionholds out the prospect of improving information flows and

40

Utilities Turn From Coal to Gas, Raising Risk of Price Increase, The New York
Times, Feb. 5, 2008, p. C1.
41

This is, of course, due to the special characteristics of electricity, e.g., nonstorability.

28

the ability to coordinate operations between the principle non-monopoly players.42 To that
degree, this may help to compensate for some of the costs that de-integration of traditional
electric utilities appears to have caused.43 Importantly, so long as the transmission and
distribution wires businesses remain separated, this re-alignment does not raise the classic access
problems that accompanied earlier integration.
Moreover, as the independent retail supply sector grows, it should allow retail suppliers
to aggregate more diversified portfolios of customers. If these customers can be induced to enter
into long-term contracts committing them to particular suppliers, that would further enhance the
predictability of load and create better opportunities for contracting. Up to this point, however,
small end-use customers have resisted contracts longer than two or three years, and larger loadserving entities have not found suppliers willing to enter into long-term contracts.44
(4) SUPPLIER DEFAULT UNCERTAINTY. Under traditional cost-of-service regulation,
vertically integrated utilities were parties to a regulatory compact with their state public utility
commissions. The regulators would guarantee full recovery of all prudent expenditures, with
perhaps an increment above and beyond the cost of capital, in exchange for which the utilities
assumed an explicit obligation to serve. The latter was viewed as the utilitys commitment to
current and future service by appropriately providing for systems operation and projected needs.
Failure to honor this obligation was a serious matter in the ongoing relationship between state

42

The EU has explicitly endorsed vertical integration of these two operations, even while
insisting on very complete divorcement of both the transmission and distribution functions of
electric utilities.
43

For discussion of these costs, see Kwoka (2002).

44

Task Force Report, p. 74.

29

commission and the regulated utility, virtually ensuring maximum effort by the latter to meet its
obligation.
Vertical separation and the growth of an independent generation sector has profoundly
altered this structure and accompanying behavior. Distribution utilities and the new retail supply
sector are supposed to provide electricity to final customers, but they do not own generation that
they can call upon to follow through on this commitment. Rather, they must secure supply in the
open market through contracts with unregulated merchant generators. The latter are simply in
contractual relationships with load-serving entities, and their obligations are limited by
provisions of their contracts.
The limits of contracting are well known in the economics literature.45 Suppliers may
rationally default on a contract if the penalties from default are less than the costs of fulfilling it.
In the limit, they may even declare bankruptcy based on the same profit-maximizing calculation.
Relative to regulation and vertical integration, these strategies add uncertainty to the transaction
between generators and investors.
(5) TRANSMISSION UNCERTAINTY. The market uncertainties confronting a new generator
include the existence of future demand, as already noted, but in addition the generator must have
assurance of adequate transmission capacity to deliver power to the intended purchaser. The
probability that transmission capacity might be constrained, with the effect of being denied
access to the grid, constitutes an additional element of uncertainty to the prospective generator.
Such constraints may arise for at least two reasonscongestion and strategic behavior.
Over the past several years, portions of the transmission grid have become increasingly
congested. Such congestion is evidenced by the growing number of transmission load reliefs
45

See, for example, Carlton and Perloff (2005), Ch. 12. Indeed, the limitation on
supplier liability is often cited as a factor motivating vertical integration.

30

administrative measures to shed loadas well as dollar values of congestion costs.46 Investment
in new transmission capacity has stagnated, raising the prospect of no improvement or even
further deterioration over the next several years. Faced with uncertainty about future
transmission availability, a new generator will factor into its revenue calculation some risk that
the output may not necessarily find its best market. Investment in such a plant will therefore
require compensation for the risk posed by transmission constraints.47
Another element of transmission uncertainty arises since a great deal of the transmission
grid continues to be owned by vertically integrated utilities. Despite open access requirements
and general FERC oversight, allegations of preferences for own generation and limitations on
carrying power for other suppliers continue. These allegations include strategic calculations of
available transfer capacity and the failure of transmission planning to take into account new
merchant generators locations and sizes. The effect of such actions is to further raise the
probability of a lack of transmission or its availability on nondiscriminatory grounds. This, too,
constitutes an impediment to entry.
Concern over eventual transmission adequacy is, of course, greater for larger generating
units seeking to enter the market, quite possibly tilting generation decisions away from a choice
of the most efficient scale. In addition, any new transmission designed to alleviate congestion
concerns is itself subject to long lead times. Construction and approvals can take five to 10

46

The PJM State of the Market Report 2007, for example, noted that Total congestion
costs increased by $241 million from $1.603 billion in calendar 2006 to $1.845 billion in
calendar 2007...Total congestion costs have ranged from 6 to 9 percent of total PJM annual
billings since 2003. (PJM, p. 303). NERC publishes data on transmission line loading relief,
reporting 3,200 such actions in 2007, up from 1,901 in 2006 and 2397 in 2005. The 2007 TLRs
are triple the 1,020 that occurred in 2000 (NERC, 2008).
47

Another possible response to transmission constraints is for the new generator to alter
its size and siting decisions, but that also implies some added costs due to suboptimization.

31

years, and in some instances may not be possible at all. Thus it may be the case that generation
investmenta multi-year exercise--is dependent for its viability on a parallel multi-year effort to
build adequate transmission capabilities. These factors add to the uncertainty and
unattractiveness of generation.
E. THE CONTRACTING PUZZLE
Despite all of the demand, price, cost and policy uncertainties, in principle the market for
new generation should still function adequately so long as buyers and sellers can agree on price
and other parameters of contracts. The price would certainly include a risk premium on
investments that extend for longer periods and involve greater uncertainty, but other markets
with similar characteristics appear to attract capital and function adequately.48
The market for long-term contracts in electricity generation might be an exception.
Relative to other markets that may deal adequately with substantial uncertainty, electricity
markets are at a much earlier stage of development. This leads to less information about the
distribution of likely future outcomes, which in turn might result in a higher risk premium or
alternatively, a thin or non-existent market.49 By contrast, other markets may deal with
uncertainty better simply because they have had a longer history with it.
Some have speculated that total uncertainty under a restructured regime exceeds the
certainty found under regulation, so that restructuring does not simply shift some portion of the
same overall risk to those who can better bear it, but may actually increase overall risk. One
previously discussed example concerns retail competition. By fragmenting the demand side and
allowing customers to switch, each generator and supplier faces greater uncertainty about future
48

Joskow (2006, p. 40) lists cruise ships and oil refineries as examples of successful
investment in the face of long-term price and profit uncertainty.
49

Task Force Report, p. 76.

32

load. In a related matter, by separating risk from the physical operation of the market,
restructuring may have disturbed efficient bundling of services and thereby caused higher total
cost. Thus, perhaps regulation is indeed a lesser cost method of risk resolution than reliance on
the market.
Whatever the specific reason,50 investors appear to be balking at financing new merchant
generation projects, even with risk premiums attached. Corroborating this is the fact that the
generation plants now attractive to investors appear to be those contracted for by municipally
owned utilities and traditionally integrated utilitiesthe very two types of utilities that have
assured long-term generation needs based on native loads. By contrast, stand-alone distribution
systems cannot offer the same degree of certainty, and therefore must pay risk premiums to
induce investors to finance new generation facilities. At present the required risk premium
apparently exceeds what many borrowers are prepared to pay, resulting in a lack of investment in
new projects.51
There is good evidence of peculiarities in the contract markets for new generation. The
Electric Energy Market Competition Task Force examined available FERC data for 2004-05 on
contracts in New York, the Midwest, and the Southeast.52 New York was selected because of its
consistent single-state data and its existing organized market. The Midwest ISO involved a new
ISO spanning multiple states, while the Southeast represented a purely bilateral wholesale
market with few participants.
50

Other possible explanations for the absence of contracting might be that the investment
problem in electricity has been exaggerated or that there is some other cause of market failure.
51

A similar phenomenon is reported in the UK electricity market. As it switched to a

pure price system from a separate capacity market, investment in merchant capacity plummeted.
See Roques, Newbery, and Nuttal (2004).
52

Task Force Report, p. 74, Appendix E.

33

The data diverged considerably from expectations. With due allowance for the
incomplete coverage of the data, the Task Force Report concluded that contract volumes were
overwhelmingly short-termthat is, less than one year in durationin all three regions.
Moreover, short-term contracts represented a higher percent of total sales in organized markets
91 percent in NYISO, 77 percent in MISOthan in the non-organized Southeast where such
contracts comprised only 60 percent of sales. Indeed, virtually the only contracts in excess of 10
years were in the Southeast.53 The Task Force also reported mixed effects of contract lengths on
prices: in only two of the three marketsMISO and the Southeast, but not NYISO--were longer
contracts associated with lower prices.
The report advances three possible reasons for the failure of contracting to emerge in
these markets, indeed, its apparently greater failure in organized markets. These include the
following:
(1) Generators may be refusing to sign contracts offering power at actual cost. Rather, by
unilaterally withholding their capacity, they are betting on some probability of higher gas prices
resulting in market-clearing prices above their costs, with consequent higher profitability.
(2) Another possible factor limiting this alternative is concern over whether there are
enough participants in these markets to ensure competitive operation and price determination.
Without assurance of competition, some parties may choose to avoid the market.
(3) Finally, there appear at present to be only limited opportunities to hedge the potential
costs of long-term contracts. The inability to protect against contract pricing anomalies
undoubtedly reduces their appeal.
53

There were no such contracts in NYISO, and only 2 percent in MISO, whereas 16
percent of coverage in SERC involved contracts at least 10 years in duration. The Task Force
cautioned that many of the SERC contracts were entered into prior to the emergence of
competitive markets.

34

These factors appear to have limited the role of contracting and prevented it from
emerging as a broad and reliable tool for ensuring adequate generation resources in the longer
term.

V. SUMMARY AND CONCLUSIONS

From a theoretical, empirical, and policy perspective, few things are more important to a
well-functioning market than ease of entry. Freedom of entry limits existing firms ability to
raise price to super-competitive levels. Entry opportunities mitigate market conditions that
might otherwise permit anti-competitive practices. Policies intended to liberalize industries have
generally succeeded in cases where entry was easy, but reforms have a very different record in
markets that new firms were unable to enter or at least credibly threaten to enter.
Electricity restructuring in the United States has been premised in no small part on ease
of entry into generation. Advocates of restructuring expected that competition among existing
generators would be supplemented and perfected by new independent producers entering
generation markets. New entrants would be characterized by more efficient scale, superior
technology, and better plant siting, and thereby achieve lower costs than existing generation
plants. Those forces were expected to hold down generation costs and ultimately prices to
electricity consumers.
This report has documented the large number of impediments to this idealized process of
entry into generation. These include conventional barriers to entry involving economies of scale
and absolute cost advantages of incumbent generators. After all, few production facilities are as
capital intensive and long lasting as coal or nuclear plants. These impediments also include
regulatory issues as well as a variety of demand, cost, and other uncertainties. Both investors

35

and suppliers dislike uncertainty, and restructured electricity markets are characterized by
substantial uncertaintiesindeed, possibly greater uncertainties than under regulationall of
which have delayed or deterred entry by competitive suppliers.
The effect of these impediments over the past decade has been a generation market that
has experienced some success but has also been characterized by a huge investment cycle, overdependence on a single fuel source, and paradoxically, an imminent shortage of capacity. Such a
market does not satisfy reasonable criteria for good performance and deserves further attention
from policy makers.

36

TABLE 1
Reserve Margins by Regions

NERC Region
ERCOT
FRCC
MRO (U.S)
NPCC (U.S)
Reliability First
SERC
SPP
WECC (U.S)
Contiguous U.S.

MARGIN CAPACITY (percent)

2006 2007 2008 2009 2010
11.9
17.6
16.1
15.4
16.0
15.1
9.2
21.1
16.1

Source: EIA, Electric Power Annual 2006, Table 3.3

37

10.5
18.3
13.9
13.7
15.2
13.2
9.6
21.2
15.2

8.4
21.2
11.1
12.7
14.0
13.1
8.4
20.5
14.5

7.0
23.2
9.3
10.9
13.0
13.8
10.7
20.4
14.3

5.8
24.4
8.6
9.4
11.9
13.9
11.3
19.4
13.8

2011
5.1
27.1
7.5
8.0
10.8
13.8
11.5
17.9
13.3

TABLE 2
Cost and Performance Characteristics of New Central Station Electricity Generating Technologies
(a)
Technology

(b)
Size
(mW)

( c)
Leadtimes
(in years)
6

(d)
Total
Capital
Costs ($M)
2,809

(e)
Unit Capital
Costs1
($/kw)
2,081

Advanced Nuclear

1,350

Scrubbed Coal New

600

774

1,290

Integrated Coal-Gasification Combined Cycle (IGCC)

550

820

1,491

Adv Gas/ Oil Comb Cycle (CC)

400

238

594

ADV CC with Carbon Sequestration

400

474

1,185

IGCC with Carbon Sequestration

380

811

2,134

Conv Gas/ Oil Comb Cycle

250

151

603

Adv Combustion Turbine

230

92

398

Conv Combustion Turbine

160

67

420

Conventional Hydropower

500

750

1,500

Solar Thermal

100

315

3,149

Biomass

80

150

1,869

Geothermal

50

94

1,880

Wind

50

60

1,206

MSW- Landfill Gas

30

48

1,595

Fuel Cells

10

45

4,520

Photovoltaic

24

4,751

Distributed Generation Base

859

Distributed Generation Peak

1,032

Capital costs include contingency factors, excluding regional multipliers and learning effects. Interest charges are also
excluded. These represent costs of new projects initiated in 2006.

Source: EIA, Electricity Module, p77.

38

TABLE 3
Regulatory Approval Time Frames for Power Plants in California, Pennsylvania, and Texas

Time for Regulatory Approval

6 months or less
6 months to 1 year
1 to 1-1/2 years
1-1/2 to 2 years
More than 2 years
Total

California
Projects Percent
4
19
5
24
7
33
3
14
2
10
21
100

Note: Percents may not add due to rounding.

Source: GAO (2002), p. 15

39

Pennsylvania
Projects Percent
2
9
12
55
6
27
0
0
2
9
22
100

Texas
Projects
17
43
7
0
0
67

Percent
25
64
10
0
0
100

TABLE 4
Interconnection Cost and Capacity for New Generators, by Producer Type, 2005 and 2006
Sector

2005
Total
Electric Utilities
Independent Power Producers
Commercial
Industrial
2006
Total
Electric Utilities
Independent Power Producers
Commercial
Industrial

Units

Nameplate
Capacity
(megawatts)

Cost
(thousand
dollars)

242
159
60
9
14

19,666
12,708
6,106
34
818

288,826
189,358
93,517
13
5,938

275
113
137
18
7

13,152
6,706
6,265
67
114

251,953
94,574
149,086
1,836
6,457

40

Figure 1

S1

P2
P1

D1
Q1 Q2

41

D2

Figure 2

S1

S2

P1

D1
Q1

Q3

42

D2

Figure 3: Utility and Nonutility Generation Capacity Additions, 19952004

Source: Report to Congress on Competition in Wholesale and Retail Markets for Electric Energy, the
Electric Energy Market Competition Task Force

43

Figure 4: U.S. Electric Power Industry Net Summer Capacity, 2006

Source: Energy Information Administration, Electric Power Annual 2006

44

APPENDIX A
PATTERNS OF ENTRY IN GENERATION

Further evidence regarding the process of entry into generation comes from an analysis of
data collected and compiled by the U.S. Energy Information Administration. EIA-860 is a
generator level database with numerous pieces of information on both newly proposed and
existing generators. Here we examine proposed generation during the years 1994 through 2006,
a period that covers the boom and bust cycle. We define new generationentrants--as the first
appearance of a generator in one of the following three categories: regulatory approval pending
but not under construction, approved but not under construction, and planned for installation but
not under construction.54
As shown in Table A-1, there were 2,715 recorded new entrants in the United States
during this 13-year period. Throughout the mid-1990s, the annual number averaged less than
100. Beginning in 1998, however, the number jumped to around 200 and then spiked at 1,228 in
2001 before falling back to the 100 to 150 range. Thus, entrants in the single year 2001
constituted 45 percent of the overall total during these years. This concentration is similarly
extreme when measured in terms of proposed capacity increases. Over the entire period, entrants
accounted for 389,542 MW of capacity, with nearly half in the single year 2001.

54

Other categories in the data are as follows: Construction complete but not yet
commercial, life extension or repowering, planned for conversion to another fuel, planned new
generator but cancelled or indefinitely postponed, retired, under construction more than 50
percent complete, under construction less than 50 percent complete, generator scheduled for
retirement, generator planned for reactivation, modification planned, and proposed change in
ownership.

Among these entrants, there have been significant differences in the mix of fuel sources.
Tables A-2 and A-3 report the percent of entrants and the percent of proposed new capacity,
respectively, in each year by fuel source: coal, natural gas, fuel oil, water, solar, wind, and
landfill gas.55 Nuclear does not appear since there have been no new nuclear plants in the United
States in decades. Clearly, entry into generation over most of this period has taken advantage of
cheap natural gas. From 1995 through 2002, the percent of proposed capacity based on gas-fired
generation never fell below 84 percent. That figure dropped to 69 percent in 2003 and was cut in
half again by 2005though that percent was of a much smaller total.
Interestingly, coal-fired generation--a trivial percent of both entrants and capacity in the
1990sgrew to be more important after 2001 as natural gas became uneconomic. Other energy
sources were highly variable in the percent of total numbers and proposed capacity that they
represented, particularly in more recent years as the total amount of new generation declined
sharply. The difference between the two seriespercent of entrants and percent of proposed
capacityalso reflects the large differences in the size of generators by fuel source.

55

The category Other is comprised of sub-bituminous coal, waste heat, methanol,

wood, biomass, geothermal, jet fuel, and butane and other gases. With the exception of 2005,
these account for less than 9 percent of the total.

TABLE A-1
Annual Number and Proposed Capacity of Entrants
Year

Number of Entrants

Proposed Capacity

1994

82

11,353

1995

61

6,443

1996

60

7,371

1997

116

25,953

1998

170

21,487

1999

217

25,731

2000

161

14,603

2001

1,228

188,359

2002

150

21,404

2003

108

15,695

2004

90

9,582

2005

130

23,416

2006

142

18,145

TABLE A-2
Percent of Entrants by Fuel Source

YEAR

1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006

FUEL SOURCE
Coal

Natural Gas

Fuel Oil

Water

Solar

Wind

Landfill Gas

Other

1.2
N
1.7
0.9
0.6
0.5
0.6
0.6
2.7
2.8
3.3
4.6
2.1

65.9
73.8
81.7
91.4
55.3
46.1
55.3
83.2
73.3
63.3
55.6
30.8
65.3

19.5
19.7
8.3
2.6
34.7
44.7
15.5
5
16
22
7.8
3.1
8.5

3.7

1.7
0.9
1.2
0
0.6
0.9
0
0.9
1.1
0.8
0.7

1.7
1.7
0.6
0
0

3.7
3.3
1.7
0
0
0.9
16.8
0.5
3.3
1.8
15.6
32.3
9.9

0
0
0
0
0
0
6.2
1.2
0. 7
1.8
8. 9
10. 8
4.3

6.1
3.3
3.3
2.6
7.7
7.8
5
8.6
4
7.3
7.8
16.9
7.1

Note: N means none reported.

0
0
0
0.8
2.1

TABLE A-3
Percent Proposed Capacity by Fuel Source

FUEL SOURCE

YEAR

1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006

Coal

Natural Gas

Fuel Oil

Water

Solar

Wind

Landfill Gas

Other

3.7
N
2.1
0.4
0.2
0.2
1.4
2.0
6.0
10.3
14.7
8.7
12.1

60.3
88.8
87.7
97.8
90.8
84.0
86.3
85.5
88.3
68.6
58.6
29.7
53.9

17.7
10.2
6.7
0.7
2.1
2.9
1.8
0.4
0.7
1.8
0.2
1.8
0.4

0.1
0
0
0
0
0
0
0
0
0
0
0
0

0
0
0
0
0
0

2.6
0.1
0.1
0
0
0.0
0.2
0.0
1.3
0.7
14.8
15.3
8.7

0
0
0
0
0
0
0.1
0
0
0.1
0.1
0.1
0.1

15.5
0.9
3.4
1.2
6.9
12.9
10.2
12.1
3.8
18.5
11.7
44.2
24.8

Note: N means none reported.

0
0
0
0
0.3
0

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