An Electrifying Proposal

Sunday, January 30, 2000

Thanks to state deregulation, consumers in seven states can now shop for electricity as they do for insurance or long-distance phone service. Massachusetts and Rhode Island permit full competition and customer choice, California allows choice for most consumers, while Arizona, Montana, New York, and Pennsylvania offer choice to select groups. Consumers in fourteen other states (Arkansas, Connecticut, Delaware, Illinois, Maine, Maryland, Michigan, Nevada, New Hampshire, New Jersey, New Mexico, Oklahoma, Vermont, and Virginia) are awaiting implementation of already approved electricity market restructuring agreements. In the remaining twenty-nine states, officials are studying reforms that would bring competition to their retail electricity markets.

R. Charles Moyer, dean of the Babcock Graduate School of Management at Wake Forest University, argues that "the big winner from the deregulation process will be electric utility customers, who should reap the benefits of substantially lower costs of electric power over the next five to ten years." But how much will consumers save?

The electric industry is the last of the traditionally regulated industries to be targeted for reform. States have only recently begun to deregulate retail electric markets. In January 1998, Rhode Island became the first state to allow consumers to choose an electricity supplier other than their local monopoly. Since competition is too recent to measure consumer savings reliably, the best estimates of the potential benefits to electricity consumers come from research that examines the experience of other "network" industries that have previously undergone deregulation: airlines, trucking, railroads, long-distance telecommunications, and natural gas. In each of these five industries, as in electricity, customers are connected to suppliers through a vast network of routes, roads, rails, wires, or pipelines.


Deregulating the electric utility industry could save consumers at least $24 billion per year.


Although calculations of the total consumer benefits from deregulation of one industry are not directly comparable to another due to differences in demand, the percentage change in prices provides the best prediction of the likely effect of competition on electricity rates, absent studies of the industry itself. Investigations of these five network industries indicate that consumer savings from deregulation of the $219-billion-a-year U.S. electric utility industry would be substantial—most likely, annual price reductions of 11 percent and consumer savings of at least $24 billion a year.

AIRLINES

Before the Airline Deregulation Act of 1978, airfares were set according to a fare formula administered by the U.S. Civil Aeronautics Board (CAB). In a 1986 study, Steven Morrison of Northeastern University and Clifford Winston of the Brookings Institution calculated what airfares would have been in 1977 if airlines had been allowed to engage in price competition rather than abide by the CAB fare formula. After controlling for factors that influence fares, such as fuel prices, wage rates, flight distances, and service quality, Morrison and Winston report that deregulation would have lowered 1977 airfares by 29 percent. In a more recent study, Morrison and Winston used a different statistical approach to examine data over a longer time period. They concluded that airfares were 22 percent lower, on average, between 1978 and 1993 (i.e., following deregulation and price competition) than they would have been under continued CAB control. Despite occasional complaints (mostly about crowded planes as a result of the lower fares) consumers have benefited greatly from the competitive air travel market.


Regulations that purportedly keep monopolies from gouging consumers actually insulate utilities from competition and maintain artificially high prices.


TRUCKING

The Motor Carrier Act of 1980 virtually eliminated the authority of the U.S. Interstate Commerce Commission (ICC) to set freight rates and restrict entry in the interstate trucking industry. John Ying of the University of Delaware and Theodore Keeler of the University of California at Berkeley examined the response of freight rates to trucking deregulation in a 1991 study. After controlling for factors that influence trucking rates (such as shipment size, length of haul, and fuel, insurance, and labor costs), Ying and Keeler reported that freight rates of common carriers were 22 percent lower in 1983 than they would have been under continued ICC regulation. They also demonstrate that new competition, improvements in productivity, and flexible pricing that resulted from deregulation produced increasing annual price reductions: 8 percent in 1981, 15 percent in 1982, and 22 percent in 1983.

RAILROADS

The Staggers Rail Act of 1980 greatly reduced ICC control over pricing, exit, and operations in the rail industry. Mark Burton of the Tennessee Valley Authority looked at the response of rail freight rates to competition in a 1993 study. After controlling for factors such as the availability and pricing of substitute transport modes, shipment and route characteristics, and the cost of capital and labor, Burton reports that rail freight rates for seventeen commodities were lower in 1985, by an average of 11 percent, than they would have been under continued ICC regulation. Shipping rates for high-value manufactured goods fell up to ten times more than rates for low-value bulk commodities, reflecting the ICC’s past use of "value-of-service" rate setting. For example, rates for fabricated metal products were 34 percent lower in 1985, furniture and fixtures were 31 percent lower, and machinery was 17 percent lower. In contrast, coal, chemical, and scrap material rates were only 3 percent lower. The 1980 deregulation of trucking and railroads created a more competitive shipping environment, thereby lowering the price of products on the shelf and giving consumers access to a greater variety of goods.

LONG-DISTANCE TELECOMMUNICATIONS

Robert Crandall of the Brookings Institution and Leonard Waverman of the University of Toronto examined the response of long-distance telephone rates to increased competition following the divestiture of the seven regional "Baby Bells" from AT&T in January 1984. First, Crandall and Waverman note that inflation-adjusted access charges paid by the long-distance carriers to the local phone companies to connect long-distance calls fell from 22.4 cents per conversation minute in 1985 to 6.8 cents in 1993. Even after controlling for this exogenous fall in access charges, however, real interstate long-distance rates net of access charges declined from 18.4 cents per minute to 7.4 cents, an 8 percent annual reduction.

Not only did increased competition reduce long-distance phone rates, it also caused the rates of the three leading competitors to converge. In a 1995 study, Yu Hsing of Southeastern Louisiana University examined inflation-adjusted rate differences between AT&T, MCI, and Sprint for five-minute long-distance calls. Hsing finds that rate differences between higher-priced AT&T and its major competitors fell about 4 cents per year between 1980 and 1991, even in the years before divestiture. Increased competition after divestiture, however, caused even greater rate convergence. Rate differences between AT&T and MCI fell an additional 23 cents, and rate differences between AT&T and Sprint fell an additional 30 cents. Increased competition and customer choice have substantially lowered long-distance rates. Many phone bills have not fallen, however, because customers are calling more frequently and talking longer at the lower prices.

NATURAL GAS

A series of orders by the Federal Energy Regulatory Commission (FERC) had by 1985 decontrolled natural gas wellhead prices and the interstate pipeline network. In a 1994 study, Michael Doane of PM Industrial Economics, an economic research and consulting firm, and Daniel Spulber of Northwestern University studied the response of natural gas prices to a 1985 FERC decision that allowed pipelines to transport gas for customers who had purchased the gas directly from wellhead producers at decontrolled market prices. Thanks to this decision, local gas companies, electric utilities, and other customers could now buy gas directly from the least-cost producer anywhere in the country rather than from only one designated pipeline merchant.


Regulation that purportedly keep monopolies from gouging consumers actually insulate utilities from competition and maintain artificially high prices.


Deregulation lowered prices for gas customers: Monthly average wellhead spot prices per million cubic feet of natural gas, adjusted for inflation, for the five major producing regions fell significantly from 1984 through 1991. Prices fell 47 percent in Appalachia and Oklahoma, 56 percent in Louisiana, 57 percent in Texas, and 61 percent in the Rocky Mountains, for an average annual price reduction of 7 percent. Gas prices had begun to converge and move together by 1988, after most major interstate pipelines became open-access transporters (i.e., pipelines that transport gas to customers who purchase their gas directly from a producer located anywhere in the country). Today, prices at separate points in the pipeline network track each other so closely that market analysts talk of a single, integrated national market for natural gas. FERC’s decision to permit open pipeline transportation of decontrolled natural gas enables customers to substitute low-cost gas for high-cost gas and reap the benefits offered by the lower, deregulated price of natural gas at the source.

CONCLUSION

Scientific studies document the substantial consumer savings from deregulation of network industries. Calculations of annual price reductions range from 7 percent for natural gas to 8 percent for long-distance telecommunications, 11 percent for railroads, 22 percent for trucking, and 22–29 percent for airlines. Based on these findings, annual consumer savings from deregulation of the U.S. electric utility industry would total between $15 billion and $64 billion, with the most likely (median) savings at $24 billion. Assuming a conservative price reduction of 11 percent, average annual savings would total $96 for residential customers, $572 for commercial customers, and $8,872 for industrial customers, for whom electricity bills constitute up to a third of their operating expenses. In addition, commercial and industrial users would pass on their energy savings to their customers in the form of lower product prices. The studies also predict that annual price reductions for electricity consumers would initially grow as deregulation spurs new competition, improvements in productivity, and flexible pricing. Rate differences between electricity suppliers would converge.

Jessie Knight Jr., former commissioner of the California Public Utilities Commission, observes that "competitive markets inherently produce competitive prices and an increase in providers. Providers in turn offer consumers new products and services, and it is consumer choice that then drives the growth of the market." Consumer choice is already making a significant impact on California’s retail electric market. In the first six months of choice, new energy service providers garnered more than 13 percent of the state’s $23-billion-a-year electricity market—a level of business that new telecommunications companies didn’t reach until eighteen months after that market was opened to competition. This switching to new suppliers by electricity customers reveals that for too long they have been paying artificially high prices for inferior service. Regulations that purportedly kept monopolies from gouging consumers actually insulated utilities from competition and maintained artificially high prices. Consumers will be the big winners from the "power politics" of electricity deregulation.

Federal Mandates a Mistake

For the past three years, Congress and the Clinton administration have proposed legislation to deregulate retail electric markets on a national scale rather than rely on the current state-by-state approach. Thankfully, Congress has not passed any of these bills.

Recent proposals, both from the Republican Congress and the Democratic administration, would have increased rather than decreased federal regulation of electric power markets. The proposals, while differing in detail, would have enhanced the regulatory authority of the Federal Energy Regulatory Commission (FERC), created new regulatory agencies, and failed to eliminate federal impediments to retail competition.

A federal mandate to the states to open their retail electric markets to competition would require that FERC write complex regulations dictating the criteria that state plans must meet. This lengthy process would needlessly delay competition, create a rigid regulatory framework, and enhance FERC’s authority.

Recent proposals would also create new regulatory agencies. Regional planning agencies would oversee the planning of future generation, transmission, and distribution facilities. Independent system operators (ISOs) would operate transmission networks. Reliability agencies would develop and enforce mandatory standards. FERC would oversee most of these new agencies.

Finally, recent proposals would fail to eliminate current laws that impede retail competition. For example, the Public Utility Holding Company Act inhibits the ability of firms to enter new retail markets and reorganize themselves to remain competitive. The Public Utility Regulatory Policies Act locks utilities into contracts to purchase or sell electricity at above-market prices.


Real electricity deregulation requires that Congress shut down the federal regulatory agencies that oversee electric markets.


Real electricity deregulation requires that Congress eliminate federal impediments to retail competition and consumer choice, shut down the federal regulatory agencies that oversee electric markets, as it previously shut down the Civil Aeronautics Board and the Interstate Commerce Commission, and allow state-by-state deregulation to proceed, thereby gradually infusing competition into a historically protected industry. The Clinton administration’s blueprint for electricity restructuring, released last April, would simply substitute one regulatory regime for another. Of the six bills pending in Congress that claim to promote competitive electric markets, only one approximates real electricity deregulation.

—Lawrence J. McQuillan

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