ML20135C882

Coordination,Competition,And Regulation in the Electric Utility Industry

ML20135C882
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Issue date:	06/30/1975
From:	Delaney J, Honeycutt T, Penn D Office of Nuclear Reactor Regulation
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NUREG-75-061, NUREG-75-61, NUDOCS 8509130008
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90 4 NUREG-75/061 L

Coordination, Competition, and Regulation in the Electric Utility Industry June 1975 United States Nuclear Regulatory Commission Economic Analysis Section Office of Antitrust and Indemnity

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Available from National Technical Information Service J

Springfield, Virginia 22161 Price: Printed Copy $4.25 ; Microfiche $2.25 s

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COORDINATION, COMPETITION, AND REGULATION IN THE ELECTRIC UTILITY INDUSTRY h

by David W. Penn, James B. Delaney, and T. Crawford Honeycutt 1

Economic analysis Section l

Of fice of Antitrust & Indemnity Nuclear Reactor Regulation June 1975 l

N?. h.

Y The authors are staff economists in the Office of Antitrust and Indemnity of the Nuclear Regulatory Commission. The views expressed herein do not necessarily represent those of the Nuclear Regulatory Commission; the report has neither been approved nor disapproved by that Commission.

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l 1

a FOREWORD This economic report has been prepared by research staff members of the Office of Antitrust and Indemnity of the Nuclear Regulatory Commission.

Each application for a nuclear generating facility is subjected to pre-licensing antitrust review. While a nuclear-fueled generating unit represents only a part of a total system that delivers electric energy to ultimate customers, it usually is the lowest cost power supply l

increment and some forecasts estimate that by the year 2000, nuclear 1

generation will grow from about five percent to over fifty percent of l

total electric generating capacity in the United States. Thus, the l

focus of the following report is quite properly on the overall electric utility industry.

The significant contribution of this report is to apply many of the principles of industrial organization theory and antitrust economics to the electric utility industry. Although this report does not explore every avenue of approach to the topic, it does succeed in explaining and reconciling the complex interrelationships among competition, coordina-tion, and regulation in the electric utility industry.

The authors seek to reach regulators and those they regulate, professional economists, and interested laymen. At their respective levels of concern, regulators, industry officials, and laymen should be able to make direct use of the information contained in the report.

Hopefully, professional economists will be stimulated to undertake further studies of the subject that will promote better understanding of the rapidly changing elcetric utility industry. To facilitate the reading of this report by its several audiences, the authors have included careful descriptions of relevant concepts, extensive references to existing literature, and a glossary of electric utility industry terms.

We believe that this report will contribute to a better understanding of an industry which is critical to the smooth functioning of our industri-alized society.

Abraham Braitman, Chief Office of Antitrust & Indemnity Nuclear Reactor Regulation 1

TABLE OF CONTENTS Page FOREW0RD.....................................................

i L I ST O F TAB L E S...............................................

iii I.

INTRODUCTION.................................................

1 II.

ECONOMIC THEORY AND THE ELECTRIC UTILITY INDUSTRY............

3 Perfect-Competition..........................................

4 Imperfect Competition........................................

6 Na tu ral Mo no po ly.............................................

9 Regulation and Competition...................................

10 Summary......................................................

11 III.

OPPORTUNITIES FOR COMPETITION WITHIN THE ELECTRIC UTILITY INDUSTRY.....................................................

13 Retail Load Competition......................................

14 o

1.

Borderline Competition..............................

14 2.

Competition to Locate...............................

16

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Wholesale Load Competition...................................

17 Yardstick Competition........................................

20 Competition Among the Components of Bulk Power Supply........

23 Interfuel Competition........................................

25 Summary......................................................

26 IV.

COORDINATION WITHIN THE ELECTRIC UTILITY INDUSTRY............

28 Benefits of Coordination.....................................

29 The Holding Company Alternative..............................

32 Summnry......................................................

35 V.

COORDINATION AND COMPETITION.................................

36 The Industry Viewpoint.......................................

36 Impact of Coordination on the Opportunities for Co mp e t i t io n................................'................

37 1.

Retail Load Competition.............................

38 2.

Wholesale Load Competition..........................

38 3.

Yardstick Competition...............................

40 4.

Selection Among the Components of Bulk Fower i

supply............................................

40 5.

Summary.............................................

41 Compatibility of Competition and Coordination................

41 VI.

CONCLUSIONS AND RECOMMENDATIONS..............................

43 i

GLOSSARY.....................................................

46 BIBLI0CFAPdY............................'.....................

47 I

11 1

LIST OF TABLES

Paff, TABLE 1 -

SUMMARY

OPPORTUNITIES FOR COMPETITION IN THE ELELTRIC UTILITY INDUSTRY.......................................

27 TABLE 2 - FUNCTIONAL STAGES OF C00RDINATION........................

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Coordination, Competition, and Regulation in the Electric Utility Industry

• I.

INTRODUCTION The electric utility industry serves the threefold function of generating, transmitting, and distributing energy to ultimate customers.

There are nearly 3500 operating systems in the United States, seventy i

percent of them engaged solely in distribution. The dominant segment of the industry consists of vertically-integrated, investor-owned utilities.

In addition to these privately-owned utilities, the industry is made up of public non-Federal systems (commonly, municipalities and public utility districts), rural electric cooperatives, and Federal agencies, such as the Tennessee Valley Authority (TVA) and the Bonneville Power Administration (BPA).

At the retail level, most electric power systems operate as local monopolies subject to regulation by state or local authorities. The rates charged at the wholesale level, and certain conditions of service, are subject to Federal Power Commission (FPC) regulation.

In addition, the Securities and Exchange Commission (SEC) has some jurisdiction over hold-ing companies, the Nuclear Regulatory Commission (NRC) has licensing

• The authors wish to thank the other members of the Office of Antitrust and Indemnity, as well as several outside reviewers, for their helpful comments and suggestions. A special thanks goes to Walter Oliu for his invaluable editorial assistance on the final draft, and to Jeannette Kiminas and her CRESS typing unit for their service throughout the project.

1This paragraph _ draws heavily on the Federal Power Commissien's National Power Survey (1970) (Washington, D.C. :

G.P.O.,

1971), Vol. 1, Ch. 2.

responsibility for nuclear generating facilities, and the Environmental Protection Agency (EPA), Federal Energy Administration (FEA), and like agencies, exercise control over other aspects of company conduct. Against this background of regulation, James E. Neks has described the most common industry pattern of organization as:

... a relatively large, integrated system [ serving] an extensive geographic area, with several smaller private, cooperative, and municipal syster s existing as islands within the larger system's sphere of operation and fre-quently purchasing their power at wholesale from the larger system.2 The purpose of this paper is to assess the role, in theory and in fact, of competitive processes within the electric utility industry.

The interplay between regulation and competition will be analyzed as will the relationship between coordination and competition.

We conclude that, although competition is constrained in the electric utility industry, significant opportuni41es exist for important competitive processes to enhance market performance; that competition and coordina-tion in the electric utility industry are compatible in several important respects; and finally, that the combined use of competition and coordina-tion is superior to the expansion of holding companies or alternative forms of consolidation for furthering the public interest.

2 " Concentration in the Electric Power Industry: The Impact of Antitrust Policy," Columbia Law Review, Vol. 72 (1972), p. 69.

3 This paper does not address questions of rate reform or other modi-fications of the regulatory framework.

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l II.

ECONOMIC THEORY AND THE ELECTRIC UTILITY INDUSTRY i

The relationship between regulation and competition is currently the subject of widespread debate. In order to evaluate this isste, the concept 4;

of competition must be clarified taking account of the existing institu-tional'and historical context of the utility industry. To the economist, 1

a firm is a perfectly-competitive seller if it accepts price as a parameter

" determined by market forces, and not subject to the individual seller's j

conscious control. The parametric character of price to the competitive firm is fundamentally a subjective phenomenon."4 As used by economists the i

term does not conform to the meaning in common use, particularly among businessmen. Businessmen commonly think of competition as a " striving for

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potentially incompatible positions... combined with a clear awareness by the parties involved that the positions they' seek to attain may be incompatible."

The difference between the two concepts may be illustrated as follows.

l In a perfectly-competitive market there are many buyers and sellers of 1

identical products, with market entry unrestricted. A seller does not-j sense market rivalry because he realizes that alone, or-in concert with his neighbor, he will have no effect upon the market price. (A traditional t'extbook example is the Midwest wheat farmer.) By contrast, the business-man's concept of competition is exemplified by the intense rivalry among i

the " Big Three" automobile manufacturers. Here, each producer competes with.his rivals, consciously making production and pricing decisions only

.after;taking account'of their probable production.and pricing actions.

4 F. M. Scherer, Industrial Market Structure and Economic Performance (Chicago: Rand McNally & Co., Inc., 1970), p. 9.

5 Ibid. '

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It is possible, therefore, for there to be vigorous rivalry which cannot be called competition in the economist's sense of the word.

There is one other area of possible semantic confusion.

"There have always been at least two ways of looking at competition...In the first, j-

- competition is thought of as a type of market organization setting severe limits to the power or control exercised by the individual firm...

The i

other way of thinking about competition is in terms of the performance of firms in a market."

The latter concept, with its emphasis on performance (e.g., profitability, efficiency, and technological progressiveness), rather than structure, is the relevant one for purposes of the discussion of

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competition in a regulated industry. "The economic role of competition is

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to discipline the various participants in economic life to-provide their goods and services skillfully and cheaply."

In this report the terms-i

" competition," " competitive,"~and " rivalry," will be used as synonyms for this disciplinary function. The hyphenated forms, " perfectly-competitive" and " perfect-competition,".will refer to the concept contained in the 1

. economist's theoretical description of perfectly operating markets.

1 Perfect-Competition

.The benefits that result from perfect-competition may be-stated t

I briefly as. maximization of consumer welfare and the efficient use of

'In long-run equilibrium resources, within any given resource constraint.-

+

6 Edward S.' Mason, "The Current Status of the Monopoly Problem in the United States," Harvard Law Review, Vol. 62-(1949), pp. 1265-1285, reprinted in A.E.A.-Readings in Industrial Organization and Public Policy (Homewood, Ill.: - Richard D. Irwin, Inc., 1958), p.-377.

kGeorge'J.Stigler,TheOrganizationofIndustry(Homewood,-Ill.:

Richard D..Irwin, Inc., 1968), p. 2.

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there is an equality of price, average cost, marginal revenue, and marginal cost, which result from the free interaction of many buyers and sellers in a market characterized by easy entry.

Even Socialists seem to agree with the potential benefits of perfect-competition.

"There are two basic functions of price; to discourage the buyer of a commodity (or service) from using up too much of it, and to induce the supplier to produce enough.

The ideal output is where marginal social benefit is equal to marginal social cost."

It must be remembered that perfect-competition is only a model. The ideal results necessarily follow from several restrictive assumptions. However theoretical, this model represents an essential starting point for any analysis of the electric utility industry.

d 8 Abba P. Lerner, " Conflicting Principles of Public Utility Price Regula-tion," Journal of Law and Economics, Vol. 7 (October 1964),

p. 61.

Apparently not all Socialists would agree with this statement affirming the value of a price system.

See Paul Craig Roberts, "Oskar Lange's Theory of Socialist Planning," Journal of Political Economy, Vol. 79, No. 3 (May/ June 1971), pp. 562-577.

Lerner does warn against thinking of " perfect competition as an end in itself, rather than as one way in which marginal social benefit may be brought into equality with marginal social cost so that the price mech-anism can carry out its basic social function."

Ibid., p. 64.

This statement, naturally, is directly contradicted by opponents of central planning.

"The kind of economic organization that provides economic freedom directly, namely, competitive capitalism, also promotes political freedom because it separates economic power from political power and in this way enables the one to offset the other." Mil ton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962),

p. 9.

See Mason, p. 377, for a similar statement.

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i A formal proof of the allocative efficiency and maximization of con-sumer welfare in a perfectly-competitive market is given by F. M. Bator.9 l

However, this proof and the theory of perfect-competition, itself, do not include consideration of long-term efficiencies. O We will cae-rn to this point after first briefly discussing the theory of imperfect competition.

Imperfect Competition i

.A less than perfectly-competitive situation exists when a particular 1

seller is aware that.his output decisions will have a direct effect upon the market price.

To sell more-units he must accept a lower price--

t unlike the perfectly-competitive example of the wheat farmer.

In a less than perfectly-competitive situation,.a seller who wishes to maximize profits will not ordinarily select an output level that will result in i

E 9

i Francis M. Bator, "The Simple Analytics of Welfare Maximization,"

American Economic Review, Vol. 47, No. 1 (March 1957), pp. 22-59, reprinted in William Breit and Harold M. Hochman, eds., Readings in Microeconomics (New York: Holt, Rinehart, and-Winston, Inc., 1968),

i pp.- 385-413.

10Some writers question whether the theory is logically connected with maximum technical efficiency.in the static sense. See David Schwartzman,

" Competition and Efficiency: Comment," Journal of Political Economy, Vol. 81, No. 3 (May/ June 1973), pp.L756-764.- However, Schwartzman does' admit that " easy entry encourages efficiency, which therefore may

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be higher under competition than under alternative market structures,"

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p.,761.

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Here the words " imperfect competition" do not. signify a'particular doctrine of competition. They simply mean competition that is other'

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than perfect._

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'We-will' refer to such industries.as oligopolies:if'they have more than one seller, and as monopolies if there is only one seller in the

. industry.

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the price being equal to the average cost. Instead, he will select an out-i put level'that equates marginal revenue with marginal cost.

Consequently, the output of such an industry is less than the perfectly-competitive out-put.- This' implies a loss in society's welfare and an inefficient alloca-(

tion of scarce resources.13 Schumpeter,asearlhas1942,assertedthatthestaticinefficiency j

described above, which results from "large-scale monopcly," is more than, compensated for by the increase in the rate of growth in productivity.

Among his more recent interpreters, Jesse W. Markham views this assertion as_ a threshold theory and posits that "some departure from a state of perfect competition (or the presence of some monopoly) is a necessary concomitant of innovation, but it does 'not follow that twice this volume of departures, somehow measured, should lead to twice the volume of innovations."15 Although an imperfect competitor may earn economic profits which result in a misallocation of resources, technical efficiency is likely.

i 14 Joseph Schumpeter, Capitalism, Socialism, and Democracy (New York:

?

Harper Inc., 1942). Nor are all pricing and capacity decisions of a monopolist necessarily as inefficient as they appear.- See Robert'A.

j; Meyer, "Manopoly Pricing and Capacity Choice under Uncertainty,"

American Economic Review, Vol. 65, No. 3 (June 1975), pp. 326-337, especially p. 336, and Gordon C. Winston, "The Theory of Capital

. Utilization and Idleness," Journal of Economic Literature, Vol. 12, No. 4 (December-1974), pp. 1301-1320.

3

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15" Market Structure, Business Conduct, and Innovation," American Economic Review, Vol. 55, No. 2 (May 1965). pp. 323-332, reprinted in David R.

Kamerschen, ed., Readinas in Microeconomics (New York: John Wiley

& Sonsf nc.,-1969), p. 346.

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The point then is that a limited degree of imperfection in competition may be desirable. 0 In an oligopolistic situation rivalry may arise which results in periodic innovative marketing activity, e.g., pricing policies, advertising, or other promotional programs. There are an unlimited number of specific strategies that may be used to implement this activity. The uncertainty of reaction expected from rivals, existing and potential, will also have a direct effect upon the nature of the marketing activity undertaken.

As a result of experimenting with different strategies, the members of an industry may move toward an implied understanding among themselves regarding the strategies they will use.

This sort of tacit agreement limiting the acceptable behavior patterns in the industry may be termed the " market ethos."1 The market ethos is at least partially determined by psycholog-ical and sociological factors, rather than by strictly economic ones.

Thus, even industries that are structurally similar may not exhibit a similar ethos, and hence, their market performance may differ.

16We need not enter the debate regarding " workable competition" except to take note of the following observation.

"An industry may be judged to be workably competitive when, after the structural characteristics of its market and the dynamic forces that shaped them have been thoroughly examined, there is no clearly indicated change that can be effected through public policy measures that would result in greater social gains than social losses." Jesse W. Markham, "An Alternative Approach to the Concept of Workable Competition," American Economic Review, Vol. 40 (1950) pp. 349-361, reprinted in A.E.A. Readings in Industrial Organization and Public Policy (Homewood, Ill.: Richard D. Irwin, Inc., 1958), p. 94.

See C. E. Ferguson, Microeconomic Theory (Homewood, Ill.: Richard D.

Irwin, Inc., 1972), pp. 334-366, for a discussion of several models that postulate a specific reaction pattern.

See Paul L. Joskow, " Firm Decisionmaking Processes and Oligopoly Theory,"

American Economic Review, Papers and Proceedings, Vol. 65, No. 2 (May 1975), pp. 270-279, for a discussion of market ethos.

s Admittedly, some strategies may involve monopolistic abuses that are socially undesirable.

In these instances, the antitrust laws function to channel rivalry into activities that are considered socially beneficial.

l The antitrust laws arc intended to protect the members of society from the various offenses that may result from these monopolistic abuses, and also to prevent the collusive suppression of desirable competitive tendencies.

The concept of a market ethos is particularly important in an analysis of the electric utility industry because the ethos influences industry performance. This concept and some of its implications, as they relate to competition and coordination within the electric utility industry, will be interwoven into the remi.ining sections of this paper.

Natural Monopoly Natural monopolies arise when the scale economies in an industry are such that the entire market may be served at the lowest long-run average cost by only one firm. The average costs decline continuously with increas-ing scale. ' Typically, these industries are also characterized by high fixed costs, which may by themselves cause the average cost to decrease with increased output. For example, local distribution of electric service requires physical connection to the point of use, thus necessitating duplication of the connective facilities for competition to occur. This usually results in higher costs than if service were provided by only one 19 This implies that marginal cost is everywhere below average cost. The

-proper price in these circumstances has been the source of great con-troversy, which is summarized in Nancy Ruggles, "Recent Developments.in the Theory of Marginal Cost Pricing," Review of Economic Studies, Vol. 17 (1949-1950), pp. 107-126, reprinted in Ralph Turvey, ed., Public Enterprise (Baltimore: Per.guin Books, Inc., 1968), pp. 11-43.

i system. This " natural monopoly"~ argument provided the historical, theo-retical rationale for eliminating most retail competition in the electric utility industry.

)

Milton Friedman points out that there are three options available "when technical con'ditions sudm a monopoly the natural outcome of competi-tive market forces...:

private monopoly, public monopoly, or public j

regulation."20 He goes on to say that private monopoly is preferable to

' the other alternatives because of its greater capacity for accommodating technological change. This conclusion must be altered, however, when the monopoly involves a product whose reliable supply is essential to the infrastructure of a society (e.g., electricity, water, telephones).

In these circumstances, "even the short-run effects of private unregulated monopoly may not be tolerable..."

Regulation and Competition Regulation is sometimes necessary in order to achieve the performance results of perfect-competition and, hence, promote the public welfare.

This is accomplished principally by controls on entry, price setting, prescription of quality and conditions of service, and by the imposition of I

an obligation that the firm serve all applicants under reasonable condi-tions.

The governing principle is that "if monopolies could be made

.)

20 Friedman,.p. 29.

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-22It has.been argued on a theoretical basis that rate of return regula-tion leads profit' maximizing regulated firmsfto overcapitalize.(the i

Averch-Johnson effect) and also to produce.a ' larger output than ' they otherwise would.

(The latter is 'true as long;as capital is not ius inferior input.) A summary'of.the relevant literature'is contained in W..J.lBausol and'A. K. Klevorick, " Input Choices and Rate of Return Regulation: An Overview of the-Discussion," Bell Journal of' Economics-and Management Science, Vol. 1, No. 2 (Autumn 1970), pp. 162-190.

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N to behave as if they were perfectly competitive, we would be able to enjoy the benefits both of large-scale efficiency and of the perfectly working price mechanism."

But this conclusion does not mean that regulation is a perfect substi-tute for competition. In fact, instead of the one substituting for the other, regulation and competition are highly complementary in their effects.

Although regulation may provide for static efficiency, it "cannot force a company to be progressive, to innovate, [or] to be efficient.

In short,

[ regulation] cannot supply the dynamic stimulus that in other industries is supplied by competition."

In other words, the businessman plus monopoly I

plus regulation does not. equal the businessman plus competition.

Summary There are_certain industries, like the electric utility industry,

'that seem to require some form of regulation in order to assure the public J

welfare. This does not mean that regulation by competition is ineffective, a

or worse, inefficient. We have indicated that the spur of competition is particularly important to the dynamic efficiency of industries, and _that regulation does not ~ substitute an effective spur of its own. :Thus, the i

23Lerner, p. 61.._This_ sentiment is echoed by Kahn when he states that "the' single most widely accepted rule for the governance of the-l regulated industries is to regulate them in such a way as to produce the same results as would be produced by effective competition, if it were i

feasible." - A. E. Kahn, The Economics of Regulation: Principles and Institutions, 2 Vols. (New York: John Wiley & Sons, Inc, 1971),

Vol.

1,,p. 17, hereafter The Economics of Regulation.

24. E. Kahn, "Between Theory and Practice: -Reflections of a Neophyte Public Utility Reaalator," Public Utilities Fortnightly, Vol. 95, No.1 (January 2,1975), p. 29. -...., _

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L regulatory process should take full advantage of opportunities to assist competitive forces which promote superior, competitive-like performance in our regulated industries. However,'we do-not take the extreme position that competition, regardless of its possible social-costs,.is.always more 2

desirable than regulation, regardless of its possible benefits. 5 1

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1 25For example, we would not necessarily support the following statement.'

"[T]he search for a more competitive and pluralistic electric power industry should be concerned primarily with preserving a free democra-

. tic society, and only secondarily with getting electric bills reduced."

Horace M. Gray, " Comment on the Impact of Technological Change on Pricing'in the Energy Industries and the Regulatory Response," in Harry M. Trebing, ed., Essays on Public Utility Pricing'and' Regulation (East j

--Lansing, Mich.: Institute of Public Utilities, Michigan-State University, 1

-1971), p. 297.

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III. OPPORTUNITIES FOR COMPETITION WITHIN THE ELECTRIC UTILITY INDUSTRY It is generally recognized that the scope of competition is more limited in the electric utility industry than in other sectors of the economy. Significant economies of scale and regulation of the industry have limited these opportunities. Reguletion of electric service came about in response to a failure of the traditional market mechanism, particularly in local retail markets. The commonly-accepted view was put forth by S. D. Freeman in testim)ny before the Senate Subcommittee on Antitrust and Monopoly:

[R]egulation of the electric powar industry is an outgrowth of the disastrous consequences of direct competition between the early power systems which resulted in vaste through duplication of facilities. The result was... excessive rates and a deterioration of investor confidence which is so essential to this capital intensive industry.

Thus, as Freeman continued, there is little justification for permitting power companies to sub-stantially duplicate each other's facilities or to build small uneconomical plants in order to cotipete for the same customers....

But this certainly does not rule out competition as an important force in the marketplace.26 Although the likelihood of duplication of distribution facilities is minimal in today's electric power industry, it is commonly believed that rate and entry regulation are still needed. However, even within this regulatory framework, there still exist opportunities for competition which may have a desirable impact on the industry's performance.

26" Testimony," in Competitive Aspects of the Energy Industry, Two Parts, Hearings before the Subcommittee on Antitrust and Monopoly of the the Senate Committee on the Judiciary (hereafter Hearings on the e

Energy Industry), 91st Congress, 2nd Session (1970), Part 1, p.115..

Retail Load Competition A retail electric load is generally described as energy sales to ultimate, or final use customers._ As alluded to in the previous section, direct competition between electric utilities for final-use customers on a continuous basis is the exception rather than the rule.

Visual clutter, disruption _from construction and maintenance,.and metering economies, as well as applicable state and Federal statutes, preclude widespread,' direct competition for retail loads. Even though the retail distribution of electric energy for a given area has been considered a

" natural monopoly," certain opportunities for competition do exist at the retail level. The major types are competition at the common border of two systems and competition to attract new loads to a particular area.

1.

Borderline Competition Competition between adjacent electric systems occurs at the fringe of established service areas, particularly for new-residential or commercial developments,-.where permitted.

One vehicle of this competition, municipal annexation of outlying areas, often displaces another utility system.

Quite often this conflict is between a municipal utility and a rural electric cooperative. However, the impact on the industry's long-run

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performance from such competition may be minimal and, in some instances, 27For case studies and related statistical research, of necessity usually confined.to small, local markets, see Richard Hellman, Government Competition in the Electric Utility Industry;'A Theoretical and Empirical Study (New York: Praeger Publishers, 1972),_especially Appendix A; and, Walter J. Primeaux, Jr., "A Reexamination' of the Monopoly Market Structure for Electric Utilities," in'Almarin Phillips, ed., Promoting Competition in Regulated Markets (Washington, D.C.:

The Brookings Institution, 1975),

pp. 175-200.

North Carolina, for example, legally forbids one utility from ent' ring-e another utility's' service areas.

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i can be undesirable. Borderline competition ordinarily has a one-time effect: once a service determination is made, competition for these loads essentially disappears, or is at best sporadic. One group of industry observers'has noted the following:

[C]ompetition at the margin arises between utilities when devel-opments...are built in previously undeveloped. areas. Such competi-tion may also occur when a municipality annexes surrounding areas already served by another stility...Nevertheless, once a determina-tion has_been made of which utility will serve the customers in a l

given area, competition for service to these customers now typically comes to an end.29 i

An undesirable situation in-terms of equity may also arise because of 4

i discriminatory pricing. In order to meet the competition, a utility may offer the same service to new customers that it provides to its existing 1i customers at a lower price, or on more favorable terms.

Existing customers, particularly those in the insulated portion of the general service area, then end up subsidizing new ones, at least in the short run. Meeks has noted that:

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such discrimination is the most likely short-term response if permitted.by the local regulatory commi.ssion.- It wo61d seem to be undesirableinitsownrightandheelessin'.termsofthegoalsof competition.30 1

The utility that lost the fringe load may respond in.the long-run by f

becoming more et

' lent,-but it.is essentially unable to render service

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to the load that was initially lost to the adjacent system, fit is not i

Li 29National Economic Research Associates, Competition in the Energy Markets:

An Economic Analysis, prepared for presentation to the Subcommittee on Antitrust and Monopoly of the Senate Committee on the Judiciary (here--

after NERA Study).- Printed in Hearings on the Energy Industry, Part 1,

.p.

204.

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30 p, 94, j;

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1 clear whether the benefits of competition based on price discrimination t.

are greater.than or less than the potential costs.

In either case, informed regulation should prevent long-term abuses.

2.'

Competition to Locate i

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'Another kind of retail competition involves the attraction of potential

' loads'to a specific. service area. Such loads are usually large industrial or three-phase customers (i.e., those having available the maximum potential service flexibility from a given line system). However, whether the electric rate differential influences an industry's decision to locate in

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4 an area is open to debate. One study indicates that area development f

advertising by electric utilities rarely mentions rates.

As D. B. Mansfield,

- President of Ohio Edison, explained:

i-1 I do not think that electric rates play a very important role in

[where] a company decides to locate...Now, we all engage in very aggressive... programs to try and attract industry. But the factors that...are important are the availability of labor supply, the local tax picture, the local school picture...rather than electric rates.32-l 1

Other observers note that although electric rates may not wholly determine where industry decides to' locate,'they are significant'in determining where it will locate within a specific service area, all else being equal. For

-example, Leonard Weiss notes-that:

While a number of other factors besides electric power costs may be important determinants of the location of a particular industry, those 3bERAStudy,p.205.

" Testimony," in Hearings on the Energy Industry, Part.1, p. ;8.

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other factors c.re likely to be uniform throughout a region.

In such

. cases electric power costs can become the determinative factor.33 r

l In any event, even casual observation suggests that utilities attempt to promota the development of their respective service areas. To this extent, they are engaged in beneficial competition with each other.

In summary, we note that the opportunities for direct competition at the retail level are limited. Borderline competition is likely to have only a one-time salutory' impact on economic performance, and even this may be counterbalanced by short-lived price: discrimination not justified by demand or cost differentials. The most likely form of beneficial retail competition' appears to be competition for the location of large industrial loads.30 Wholesale Load Competition Wholesale loads refer to firm power or energy delivered to a utility which is then resold to final-use customers.

Contrary to the limited 33" Testimony," in Securities and Exchange Commission Administrative

}

Law Proceeding 3-1476, regarding Application by American Electric Power Co. to Acquire Columbus and Southern Ohio Electric Co. (Hereafter SEC Hearings on AEP),.DJ Exhibit 220, p. 6.

Also, see "Brief and Proposed Findings," filed by the U.S. Department of Justice, September 18, 1972, p. 60.

i 34The subject of " franchise competition" has not been considered in this discussion.

If franchises were periodically reviewed and competitively auctioned, it is very likely that distribution performance would be beneficially stimulated. However, the existence of perpetual or long-term franchises (particularly exclusive franchises) improves the debt financing capability of a utility since investors and stockholders are subject to less risk.

In this sense, benefits from franchise competition would have to be viewed alongside the cost of higher interest payment charges to the utility customer. Because franchise competition is not a significant part of the existing institutional framework, it will not be: considered in this report.-

l. -.

. ~ -..

l-A 4

competitive opportunities for retail loads, opportunities for wholesale i

load competition have increased. Technological advances in the generation y

i and transmission of energy, as well as the growth of interconnected i

transmission grids,'have contributed to the likelihood of wholesale load

' competition..At present, seventiy percent of the operating systems in the industry act' solely as distributors, purchasing all of their bulk power requirements.35' Many other utilities purchase part of their bulk power h

to supplement what they generato. With minimal duplication these bulk l

power demands can often be supplied from alternative sources, either 4

].

through line extension and interconnection or through wheeling arrange-0 ments.

A. E. Kahn notes that today's technology provides the opportunity j

for increased wholesale competition "by making it economical for distribu-f tion systems and companies with surplus generating capacity-to reach out l

-farther and farther, the one for-supplies, the other for customers."37 i

t Even though technological changes have increased the likelihood of 1

wholesale competition, the vertically-integrated structure of'the' industry

{

National Power Survey (1970), Vol. 1, Ch. 2. ~ Note from the same source 35 l

however, that these seventy percent of the operating' companies account

. for less than twenty percent of the industry's retail sales.

'36

~

5 Some examples of distributors switching from one wholesale supplier to another~ include Paw Paw and Southeastern Michigan Rural Electric Coopera-4 j;

'tive in Michigan, Troy and Luverne in Alabama, and Braintree and various municipal' systems'in the western section of. Massachusetts.. Reasons' underlying such changes in wholesale. suppliers include differences in

' rates,w capacity of interconnection,' delivery points, or promotion of

. industrial development.

37The Economics of Regulation,;Vol. 2,.p.,318.

'Also see W. B. Comegys, Hearings on the Energy Industry, Part 1 _p. 138.

i

}

[

1 18 -

L t -

leads to extensive " internal wholesaling." This structural characteristic limits the widespread development of wholesale competition.

However, another factor limiting the development of widespread wholesale competition is the persistent refusal of large systems to offer wholesale power outside of their respective service areas. For example, the Ohio Power Co. has refused to offer wholesale power to any municipal electric system that is receiving wholesale service from another privately-owned utility.

G. V. Patterson, Vice-President of American Electric Power Co. (AEP), has stated that Ohio Power, an affiliate of AEP, would not supply a municipal system outside of its own service area, even if it were economically feasible.

A similar example of the prevailing market ethos met with resistance in Florida.

In 1968 the Justice Department charged that the Florida Power Corporation and Tampa Electric Co. agreed to refrain from soliciting whole-sale customers in each other's territory.

In 1971 a consent decree was filed which voided the existing agreement and enjoined Florida Power and Tampa Electric from engaging in such activities in the future.

Competition for wholesale loads is desirable because of the incentive it provides to adopt the most efficient generation and transmission facili-i ties possible for maintaining or increasing wholesale loads. This dynamic pressure is missing from traditional rate' regulation, except where regulatory lag induces cost savings. Again, there may be instances of 38" Testimony," in SEC Hearings on AEP, transcript pp. 11,793-11,795.

39Case 2007, Antitrust Division, Department of Justice, Washington, D.C.

discriminatory pricing placing disproportionate burdens on captive customers.

But this danger may be only a short-run phenomenon and where it persists, regulatory control can bring it to an end.40 On balance, the major factor

= limiting the development of wholesale competition, given the extent of vertical integration, is the widespread industry attitude of unwillingness i

^

to offer wholesale firm power outside of existing service areas (this i

practice constitutes an unwillingness to " wheel").

Yardstick Competition j

Yardstick competition, conanonly believed to play a significant role in i

j' the electric utility industry, refers to a process of performance comparison between and among various utilities within the industry.

These comparisons attempt.to measure the relative success of different operational or marketing i

approaches. Comparisons may be made on the basis of geography (between l

neighboring utilities), on the basis of centralized decision making I

i (between a coordinated system and a holding company), on the basis of type of ownership (between public and private systems), and on the basis of l

differing sizes, or other-system characteristics.

'It should be noted that these yardstick comparisons differ significantly in nature and extent. Comparisons between adjacent utilities may be super-i ficial and involve only one facet at one time, since the regulator or stockholder may be only concerned with the.information necessary for a.

4 specific decision at a specific time.

In contrast, a comparison between or 4

40For a detailed discussion, see' James E. Meeks, p. 86.

s.

41See the Glossary of Terms, page'46 for a definition of wheeling.

See A.~E.'Kahn, Vol. 2, pp. 104-106..

L 20 -

t

,er-e

,c

,-,.,e,,

.,r,,4

among electric systems may involve a consideration of long-term industry performance regarding the timing of investment decisions or technological innovations. Yardstick comparisons may also be thought of in terms of input versus output decisions. Where the consumer, investor, and regulator are traditionally concerned with the utility's output, the managers are more likely to be cencerned with input and technological comparisons.4 I

The managers are likely to use yardstick comparisons in making input deci-sions as to the size and mix of incremental generating or transmission capacity.

There is little doubt, however, that both regulators and utility

)

managers assess the relative performance of electric utility systems.

For example, Donald Cook, President of American Electric Power, has stated that FPC publication of typical public and private utility electric bills has the laudable desire of keeping [ managers]... on their toes so that they can measure their performance one against the other with the hope that it will have an effect on improving the industry's performance.. 44 C. R. Ross, former chairman of the Vermont Public Service Board and former FPC Commissioner, believes that when there is a competition in policies and approaches caused by diverse management viewpoints, regulators are more likely to be aware of the best solutions available for the industry's problems.

Furthermore, There is no getting around the fact that the management of adjoining utilities and [those) in the same region are competing with each other as to who... can do the best job of running that utility.

43Traditional boundaries of concern are being broadened as consumers take a mere active role in debates over nuclear versus fossil plant technology, and as regulators expand their scope of review. See A. E.

Kahn, "Between Theory and Practice...."

44" Testimony," in SEC Hearings on AEP, transcript p. 1020. -

These are chief excutives who don't have the reward of extraordinary profits; but who, nevertheless, want to be ' Number One.'45 Historically, the concept of yardstick competition is grounded in the private-public power debate. The controversy surrounding TVA and Bonneville indicates the partisan nature of the debate.

For exampla, D. 3. Mansfield, President of Ohio Edison, states that TVA rates "have no impact on the rates of investor-owned systems,"

while S. D. Freeman, former employee of TVA, states that "it's hard to wash out the idea that [TVA] rates had no impact on other rates."

Whether in a positive or a negative way, it is clear that management sensitivity to public-private rate performance comparisons is clearly recognized.

A. H. Aymond, former President of Consumers Power Conpany, brings the point home:

The competition comes...in the way the consumer feels about our situation. For example, Lansing [A ounicipal electric system in Michigan]... sells power at a lower rate than us....

This is published in the newspapers.... Pretty soon you will find that people in the environs want to leave and become part of the Lansing system. So this is one thing we are concerned about.48 As an aside, our phone interviews with several key staff members of state public utility regulatory commissions around the country confirmed the coacept and practice of yardstick competition. Although some inter-viewees were reluctant to use that terminology, or to generalize beyond their own areas of jurisdiction, they all regarded performance comparisons 45" Testimony," in Hearings on the Energy Industry, Part 2, p. 412. Also see in the same source, pp. 787-795.

46Hearings on the Energy Industry, Part 1, p. 31.

47Hearings on the Energy Industry, Part 1, p. 132, 48" Testimony," in Atomic Energy Commission Docket Nos. 50-329A and 50-330A, regarding Consumers Power Company's Midland Units 1 and 2, pp. 6060-6062...

5 s

7 as a starting point in their Commission's rate review analyses. They I

further stressed the need to limit such comparisons to similar companies, in the same geographic region, for which they had information on the t

internal workings of the systems compared.

Generally, they thought that public-private system comparisons were less valuable than comparisons between privately-owned utilities. However, comparisons between private systems and municipal or cooperative systems were considered to be of significant analytical value, a

In sum, the process of yardstick competiticn can provide regulators and the public with information about the range of feasible utility perform-

}

ance. In addition, it offers managers a means of evaluating their own 3

market performance. How and to what extent regulators and managers use n

yardstick comparisons varies, but they are a potential tool for improving j

performance in the electric utility industry.

Competition Among The Components of Bulk Power Sepply Many components comprise bulk power supply,, including firm power purchases for resale, self-generation, and numerous coordination arrange-ments and unbundled services. ' These components are not mutually exclusive and may be combined in a variety of ways to obtain the most u

economical bulk power supply for a given electric system. System planners continually evaluate the multitude of available power supply options in order to assure themselves dependable, efficient, long-term sources of 49Unbundled services refer to the availability of the component parts of a package of services rather than the entire package on an all or nothing basis.

- 2

of power and energy. Distribution systems, by definition, purchase bulk power at wholesale, although not necessarily from the same source.

Those utility cystems which generate as well as distribute may seek to combine many types of coordination services in order to obtain a reliable, low-cost power supply. Such component purchases will ultimately be combined with existing system facilities and supply options, or with planned system alterations. For example, future load growth can be met by a unit power purchase from the more economical nuclear generating unit of a neigboring system and then combined with the installation of peaking units, and/or with the purchase of necessary backup support.

Thus, every electric system potentially has available a variety of bulk power supplv options which are interchangeable for purposes of establishing a reliable, long-term bulk power supply package.50 The ability to pick and choose among the various bulk power supply components, by type and source, implies a process that stimulates efficient resource allocation. This process, while not aimed directly at serving a specific electric load, involves substitutions among the bulk power components used to market power.

Such substitutions are possible not only among the various bulk power components, but also among the various physical inputs used to produce these supply systems.

For example, a unit power purchase may be decided on the basis of the generating unit's technology: a nuclear 50While these components themselves may be complementary, the many different combinations of these components may be thought of as substitutes. -_

i versus a fossil fuel unit, or one type of nuclear reactor versus another.

The particular physical inputs used become an important criterion when a system's managers, its stockholders, and/or its customers express strong preferences for or against individual options. The expansion of the j

availability of alternatives throughout a region can improve the region's bulk power supply system by allowing competitive choices to be made by system planners. Thus, freedom of choice from among the various components of bulk power supply and the diffusion of technology on a market-determined basis are consistent with the public welfare.

Interfuel Competition Interfuel competition usually occurs among suppliers of natural resources.

Those who supply electricity, gas, oil, or coal compete to serve the energy demands of an area.52 Interfuel competition between companies focuses primarily on energy demands for space heating, air conditioning, and individual appliances. While this competition is l

extremely important to the consumer, it has little direct bearing on the area coordination of electric utilities and will not be considered I

l further in this report.

l l

51There have been numerous studies concerning combination gas and electric I

companies. This paper does not attempt to deal with many of the specialized problems associated with these firms.

52 For discussions of competition among the various fuel suppliers to l

service the U. S. energy demand, see Thomas D. Duchesneau, Interfuel l

Substitutability in the Electric Utility Sector of the U. S. Economy, j

Federal Trade Commission (Washington, D.C.:

G.P.O., 1972), and Joseph P.

Mulholland and Douglas W. Webbink, Concentration Levels and Trends in the Energy Sector of the U. S. Economy, Federal Trade Commission (Washington, D.C.:

G.P.O., 1974).

l.

Summary Table 1 summarizea the opportunities for competition in the electric utility industry. While the regulatory process plays a significant role, competition complements that role by encouraging electric utilities to be more progressive and more efficient. Although the range of competitive opportunities is limited, there are certain areas of competition that can have a desirable impact on the electric utility industry's performance.

Attraction of industrial loads, wholesale load competition, and competitive yardsticks can ameliorate the adverse impact of the industry's monopolistic structure and they can supplement traditional forms of regulation.

Moreover, the ability of electric utilities to engage in these activities depends upon a reliable, efficient bulk power supply.

Input choice among the numerous components of bulk power supply, while of a slightly differ-ent character, is clearly consistent with the goals of the more traditional forms of the competitive process.

One of the most important organizational changes in the electric utility industry, especially in the last two decades, has been the estab-lishment of varied coordinating groups.

The next section briefly describes this movement and the impetus behind it, including a comparison with the holding company alternative.

53For a unique confirmation of this statement by industry sources, see The Financial Outlook for the U.S. Electric Power Industry, report to the Federal Power Commission by the Technical Advisory Committee--

Finance, Gorden Corey, Chairman, Preliminary release by the FFC in December 1974, especially Chapter 7, Section C, pp. 201-208.

TABLE 1 OPPORTUNITIES FOR COMPETITION IN THE ELECTRIC UTILITY INDUSTRY: A SUK..AY OPPORTUNITY DESCRIPTION 1.

Retail Load Industrial location; Borderline or fringe area loads; Compctition Municipal annexation; Franchise renewals.

2.

Wholesale Load Scles for resale through line extension or wheeling.

Competition 3.

Yardstick Competi-Performance comparisons by regulators, managers, tion or Compara-etockholders, and/or voters, tive Analysis 4.

Competition among Eelection among alternative products / services in the Components of planning a bulk power supply system; also, among the Bulk Power Supply alte: native physical inputs used to produce these services.

m

IV.

COORDINATION WITHIN THE ELECTRIC UTILITY INDUSTRY Economies of scale are a significant factor in the production and delivery of electric power and energy.

In fact, as we noted previously, the existence of substantial scale economies provided the basis for restricting competition and instituting regulation in the industry.

Coordination within the electric utility industry represents one method by which electric systems can move to the technological frontier, while maintaining or improving cervice reliability ar.d reducing the cost of providing that service.54 The coordinated structure of the industry today is the product of an evolutionary process which occurred over the past century. Smaller, isolated electric utilities combined into groups of interdependent systems through transmission tie-lines that permitted the flow of energy between the systems, particularly during periods of scheduled and unscheduled equipment outages. From these early interconnections, utility managers found that they could reduce their operating costs through capacity service transactions and economy energy interchanges.

Concerned that further cooperation would adversely limit their independence and flexibility, the managers did not move from the existing day-to-day cooperation to long-term coordinated planning.

Recently, however, coordinated planning has become more widespread as utilities plan, design, and construct new generation and transmission facilities on the basis of their combined 54For a manageable introductory treatment to coordination and its economic advantages in the electric power industry, see National Power Survey (1970), Vol. 1, Ch. 17.

55Of course, there are a variety of ways to design power pools so that flexibility in coordinated planning is maintained. For example, see the New England Power Pool Agreement, FPC NEPOOL No. 2, on file with the FPC. --

requirements, without completely sacrificing their independence.

Indeed, one of the major goals of the first FPC National Power Survey in 1964 was to describe the advantages of increased coordination and to place the Federal government firmly behind these. efforts.

However, the implementation of coordination efforts has resulted in an abundant variety of coordinating organizations. The 1970 National Power Survey notes that:-

some [ pools] merely provide members with a mechanism for the exchange of information; others deal primarily with day-to-day interconnected operations under normal and abnormal system condi-tions; many engage in coordinated planning and operation for increased economies; and still others are dedicated to improving reliability over broad geographic areas encompt.asing otherwise unaffiliated electric systems.56 In conjunction with these diverse coordinating arrangements there is a vast array of organizational and decision-making structures. Although generalization is hazardous, Table 2 lists the major stages of these coordinating efforts.

Benefits of Coordination As Table 2 indicates, the impetus behind various coordinating arrangements involves improved efficiency and/or reliability where interconnected systems operate, and to some degree plan, on a combined basis. The provision of various services between and among electric 56Vol. 1, Ch. 17, p.

2.-

For a critique of the FPC's effectiveness in stimulating coordination, see Steven G. Breyer and Paul W. MacAvoy, Energy Regulation by the Federal Power Commission (Washington, D.C. :

The Brookings' Institution, 1974), especially Chapter 4.

TABLE 2 FUNCTIONAL STAGES OF COORDINATION WITHIN THE ELECTRIC UTILITY INDUSTRY PURPOSE OF GENERAL TYPES OF STAGES" INTERCONNECTION DESCRIPTION TRANSACTIONS / SERVICE I

Reliability' Decrease probability of Reserve sharing and/or loss of load due to forced emergency support.

outage or other equipment failure (for a.given mix of generation and trans-mission).

II Reliability Minimize cost of serving Economy exchange; daily and Operating a given load at a specified diversity exchange; main-Efficiency level-of reliability with tenance scheduling and existing mix of generation energy exchange; short-and transmission, term power exchange.

III Reliability, Determine the mix of Seasonal ccpacity exchange;.

Operating-generation and transmission staggered construction, Efficiency, and-voltages and configurations including unit power and Joint Planning that minimizes the cost of long-term power exchange.

serving electric loads over time at a given level of reliability.

1. xch-successive. stage represents an increase in the degree of sophistication.- Note, E

however, that they are not mutually exclusive; for example, emergency ' support can irprove' reliability but it can also_ result in cost reduction through reserve sharing.

bEach stage includes the transactions / services provided by the preceding one.

Note that these services are of a general nature and can vary in specific appli-cations.. For definitions of types of transactions / services,' see Glossary of Terms,.

p. 46'.

- 30

. systems can result in significant cost savings without sacrificing service reliability. National Economic Research Associates (NERA) has identified the following major benefits of coordination:57 1.

Emergency and maintenance service, 2.

Reduced reserve requirements, 3.

Economic dispatch and/or economy exchange, 4.

Short-term capacity exchange, 5.

Load diversity exchange, 6.

Flexible maintenance scheduling, 7.

Staggered construction.

All of these arrangements require cooperation among=the pooling partners.

-They must agree on operating standards and procedures,on scheduling energy transfers, on reviewing the size, type, and placement'of new facilities,'and.on delegating each party's responsibilities in carrying l

out the. intent of specific arrangements. Clearly, this process affects

'the industa 's organizational structure, its decision-making mechanisms, and its prospects'for competitive activity.

A prime example'of cooperative effort is the reserve sharing provision among pool members. Initially, a level of pool reserves'is determined-through a reliability' study based on the combined loads and generating capacities of the participants.- Once the u gnitude of. required pool l

l NERA Study,.pp. 210-213.

-58A n e r M -example illustrating reduction.in-reserves can be found'.'in James E. Meeks', p. 103.

31 -

w-we 4

~

a-e r--a w

reserves is ascertained, each member is apportioned its reserve responsibility, usually termed its installed reserve (including operating and non-operating reserve), which it is then required to maintain or purchase. The alloca-tion of pool reserves among the members is generally related to the pro-rata shares of the coincident, annual peak loads. Alternatively, the allocation can be based on the largest generating unit in each member's system. Clearly, the allocation of the reserve responsibility will affect the overall net 6enefits of coordination for each participant, and ulti-mately their relative market position.

The Holding Company Alternative Another organizational form by which electric utilities can realize scale economies is through corporate integration or merger. Historically, the electric utility industry has been characterized by holding company

systems, i.e., companies which control several operating systems through stock ownership. In today's electric utility industry, the holding company still plays a significant role, both in terms of relative size and recognized industry leadership. The 200 largest private electric utility systems control seventy-five percent of generating capacity and serve cighty percent of existing customers. Among these 200, eighty are horizontally joined through thirty-two holding companies and account for thirty-nine percent of the generating capacity of the investor-owned 5

segment of the industry. 9 National Power Survey (1970), Vol. 1, Ch. 2, p. 4.

- 32.-

Many industry observers believe-that corporate integration leads to greater economies than can be expected from coordination or power pooling.

J. R. Henry, Counsel for Ohio Power Co., has stated that:

[ power pooling] is less efficient.

In other'words, if you can get three or four companies to agree on what unit they want to build, and

. agree lon how to operate it, and 'so on, maybe theoretically you would have the same thing. But as a practical matter,...

it just does not. work that way. You have to have a r'rson who has the responsi-bilitgOfor deciding, and with collaboration, it does not work like that; Similarly,_G. S. Vassell, a Vice-President'of system planning for AEP,

~

noted/the advantages of a holding company system:-

' It, has been my, experiedce in day-to -day dealings with many of the f power-pools and: individual systems-of today that.because of the need to function through. cumbersome contractual arrangements, most power pools fall far short' of the'1evel of unified planning and operation that is achievable under one ownership.61 1

/

Th'us, in this view, the' organizational form of a holding company, because

~

,/

of the unified decision-making attainable'under single ownership, gives it

//

an intrinsic planning advantage over power pool arrangements, which must

[;

necessarily resort to compromise solutions in resolving their inherent-

. conflicts of interest..

There is, however, no reason.to believe that the existence of a single decision' center eliminates conflicts of. interest among the operating systema of a holding company. More importantly..there.is no reason to believe that the decisions actually nade are necessarily optimal. The only thing that is certain is that such' organizational structures provide-60" Testimony," in' Hearings on the Energy-Industry, Part 1, p. 334 61,? Testimony" in SEC' Hearings on AEP, Applicant Exhibit J, p.,77..1

f i

s 1

a mechanism for decision-making among the vested interests of the various 3

i

-62 operating systems.

L. H. Roddis,' formerly affiliated with the General Public Utilities 4-l

' holding company, and later a President of Consolidated Edison Co., has 1

commented on 'the." timing of' decision-making" controversy. Tektifying

~

under government subpoena in a recent SEC hearing, he.noted that the i

decisions within' power pools do not necessarily take _a longer time, but they do,necessarily involve more discussion.

During Mr. Roddis' testimony befora the Commission, the following exchange occurred (with Mr. Roddis

~

-answering the questions):

-Q.

Within'the context of the New York Power Pool and the PJM

[ Pennsylvania, New Jersey, Maryland' Interconnection] system, have.you been aware of a variety of inputs and ideas frca the several unaffiliated companies comprising these pools?

A.

There is no question.there is plenty of input from the senior executives of the companies involved, and_that is s

healthy and good....

.I think in general [such inputs]

s.

result in a broader look at'the situation...

Q.

When you say result in a broader look, do you think that the pool taking a broader look-is a benefit?

A.

_Very definitely.

Q.

Do you consider the power pooling concept to be a viable alternative to the attainment of economies and reliability through a singlized management in a holding' company system?

6 A..

.Yes 4 62

~

The Department of Justice outlined this argument in its."Brief and Proposed Findings," in SEC Hearings on AEP,lpp. 180-181.

0 " Testimony," in SEC Hearings on AEP, reproduced in Hearings on the Energy l Industry, Part 2, pp. 755-772..

' 64 Ibid.,fp. 765.

g

.a

re appear to be no inherent advantages to be realized from ntralized decision-making, either by holding companies or power pools, that are not available to diverse management structures. As we have seen above, industry spokesmen themselves cannot settle on a common position in this debate. The preservation of organizational diversification can pre-j vide for innovative changes in operations end structures.

In contrast, the holding company is organizationally inflexible compared with coordinated groupings of smaller companies. Merger decisions, if later found to be in error, are difficult for regulators to reverse. Public neads at the local level are less likely to receive a timely and adequate response if a utility's decision center is not closo by.

The holding company's decision-making process itself is likely to be insulated from diverse opinions and l

to stagnate over time as unquestioned routines emerge. At the minimum, it remains with the proponents of the expansion of large holding companies, or

'l similar forms of consolidation, to establish their advantages over the increased coordination of smaller companies not under the same corporate 1

umbrella.

Summary Coordination among neighboring electric systems will generally reduce the cost of service, or improve reliability for a given cost. However, the various organizational arrangements and the attendant cooperation among the participants, have the potential for reducing the intensity of competition among the coordinating systems. The holding company alternative to coordina-tion, on the other hand, although ostensibly possessing a more structured mechanism for decision making, is fraught with the dangers of inflexibility, insensitivity, and concentraced economic power.

l

V.

C0CRDINATION AND COMPETITION t

We have discussed the advantages and disadvantages of coordinat and have established the limits of and described the opportunities for competition within the electric utility industry. Now we are in a position to annlyze the relationship between coordination and competition.

The formation of regional coordinating groups is an important method by which the scale economies in the generation and transmission of bulk power can be achieved. However, power pooling raises a substantive competitive issue:

does the presence of explicit restrictions or of tacit agreements among the parties detrimentally affect their future market conduct? Are such limita-tions necessary for the effective functioning of power pools and what is the role of competition between electric utilities within such a collabo-rative environment? In short, are these two concepts as irreconcilable as they might appear?

The Industry Viewpoin_t_

Industry spokesmen have noted that utilities are sensitive to the effect that pool arrangements have had on le relative market position of i

the pool members. The fear is that one member may use the advantages derived from the pool to enhance its market position vis-a-vis the other members.

In order to insure that established positions are not altered, pool members may enter into arrangements which specify services areas, allocate customers, and restrict how the energy may be used.

Thus, in this industry view, competition is seen as a barrier to the formation of regional groups for the puposes of coordination.

This view was summarized by the Legal Advisory Committee in the 1964 National Power Survey:

l l

[w] hen systems from different segments of the industry attempt to l

organize a pool... all such systems may want to reach one or more formal agreements which have the effect of eliminating competition for loads. This is particularly the case wherever there is the possibility that a participant who is also a competitor may use the advantages derived from a pooling arrangement to undercut and take over the present or potential customers of one or more other partici-pants. In such circumstances, there will necessarily be a hesitancy to enter into such a pooling arrangement unless there is assurance that it will not worsen established competitive positions.65 On the other hand, the Committee noted that investor-owned companies have a

" mutual respect... of their respective service area boundaries," 6,

situation which has allowed them to participate in the formation of power I

pools without explicit conditions restricting competition among them.

The market ethos of an implied understanding which guides acceptable competitive behavior may be altered when efforts at coordination are under-taken. The uncertainty created by the requirements for effective planning may be an impediment to any change that Liters the acceptable strategies of rivalry. In other words, competitors are unlikely to plan their generation and transmission facilities, to agree on operating procedures, or to allocate savings and costs, when each anticipates that the other may be out to take away his customers.

Impact of Coordination on the Opportunities for Competition The preceding discussion suggests that it is necessary to examine the opportunities for competition in terms of how coordination affects their likelihood and, hence, the overall performance of the industry.

65Federal Power Commission, National Power Survey (1964) (Washington, D.C.:

G.P.O., 1964), Legal Advisory Committee, Vol. 2, p. 367. Emphasis added.

66 Ibid., p. 366.

67Abraham Gerber, " Testimony," in Hearings on the Energy Industry, Part 1,

p. 276........

1.

Retail Load Competition We have noted that beneficial competition for retail loads is probably i

limited to the competition between utilitica for the location of large i

industrial loads, since area-wide coordination tends to equalize bulk power supply costs within a region. These costs may not be exactly equal because e.lectric systems carry different sets of previously incurred costs and they will not necessarily participate in all of the joint projects in the region.

To the' extent that small systems experience cost reductions through coordina-tion, competition for industry location could increase, since a larger number of systems are.able to offer attractive rates. However, when costs and rates become nearly equalized, industry decisions on where to locate I

will be based on other economic and social factors. On the other hand, greater interregional competition to attract industrial loads may result as 4

the various coordinating regions seek to increase their loads.

In sum, there is no reason to believe that competition for new in-dustrial loads will necessarily be precluded by coordinated operation and planning. Although the likelihood of competition may be lessened within a specific area, this effect may be offset by increased competition between and among these areas.

2.

Wholesale Load Competition Even though the expansion of coordination throughout a region is-likely to decrease the number of sources of wholesale supplies, they will

.still represent a valuable bulk power supply option.

If coordination permits the survival of large numbers of smaller, but viable independent

~ - -. - -.

~.. -

i

{

systems'(smaller than the systems probable with the holding company alternative), then this electric power market is more likely to be compet-itive and non-collusive. Not only will coordination preserve diversity of size,.it will also encourage diversity of ownership and organization within the industry.

Although the provision of wheeling services in a coordinated area vill increase the geographic scope of the. wholesale market, planned generation, through staggered construction and long-term reserve planning, will generally determine,the magnitude and location of a coordinated region's excess capacity. As noted previously, staggered construction theoretically provides the future requirements of all participant systems at lower costs through the installation of large units which are designated-to. serve the

.i needs of the entire system. Accordingly, one or several systems in a coordinati.tg group will install generating units larger than their individual load growth requires under an agreement whereby other participating systems commit to purchase specific amounts of capacity or energy. Under such an j

agreement, the number of sources of power available at a given point in time is-limited for those distribution systems which contemplate switching j

suppliers. But if systems have access to the other components of bulk power i

j supply through participation in a coordinated group, the disadvantage of a limited' number of sources is mitigated in terms of the region's long-term i

economic performance.

-In summary, such pooling arrangements may diminish the likelihood of extensive wholesale load competition. But if accompanied by full regional I

participation, these arrangements can achieve the performance resultsj l

associated with wholesale load competition.

I' 39 _.

4 3.

Yardstick Competition 4

The development'of power pools affects yardstick competition primarily by altering the means by which the participating systems are compared.

i-Coordination reorders'the institutional setting in which and the market ethos by which electric utilities interact.

It also caanges the feasible technological opportunities that an individual utility system has available.

That is, in combination with neighboring systems, an individual utility m

can realize greater technical and scale economies.

l Even though the independent character of participating systems will be i

lessened by coordination, access to the benefits of coordination should i

i allow a greater number of systems to operate near the technological frontier.

j

-Rather.than destroying the concept of yardstick competition, coordination i

changes the' specific implementation of the comparative analysis. Thus, the i

i extent and effectiveness of coordination are factors to be Jacluded in the information required for comparative analysis. By comparison, the wide-1 4

spread creation of holding companies of; power pool size would severely j

limit the possible number and quality'of yardstick comparisons.

4.

Selection'Among the Components of Bulk Power Supply j

The expansion of coordination activities throughout a region will:

j generally enhance the availability of bulk power supply options to any system at any: point in' time.. As long as participating-systems can select

' those joint projects they wish to participate in,' the rigidities of a centralized decision mechanism can be avoided. There are increased trans-

-action costs ~ attendant to any negotiation process. involving bulk power supply' arrangements, but.the existence of alternatives is more likely to produce dynamic. pressure'forfefficient operation.

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Summary Coordination has a net positive impact on the competitive opportuni-ties in the electric utility industry. Although it may decrease the likelihood of wholesale load competition for firm power, it can maintain the viability of smaller systems.

It also enhances the opportunity for selection among the components of bulk power supply, thus enabling smaller systems to compete more effectively because of their access to large scale generation and transmission facilities. While the nature of yardstick competition is affected by coordination, comparative analysis becomes perhaps an even more important starting point in performance evaluations.

Industrial loads seem to afford utilities their only important opportunity for retail load competition. Here, even though coordination may lessen competition within a region, it may serve to strengthen it between regions.

Compatibility of Competition and Coordination We have noted that competition and its uncertainty can be thought of as a partial barrier to successful coordination.

It seems clear that the incentive to enter into voluntary coordination arrangements with neigh-boring systens is affected by each party's view of its anticipated benefits versus its expected costs. An increased risk of load incursion by a coordinating partner is an important factor. Moreover, when one system has already realized many of the benefits of coordination, and is contemplating the marginal gain associated with providing coordinating services to another system in its service area, the importance of the possibility of load incursion is magnified. Thus, voluntary coordination may not be realized to the extent necessary for optimal performance.

Coordination, on balance, does not preclude the opportunities for competition that we have specified. However, coordination may lessen the intensity of rivalry within the industry. The likelihood of collusion or parallel behavior is increased when industry participants come together on a regular basis to make joint planning and operating decisions. For example, coordination necessarily involves a certain degree of mutuality in establishing operating standards, scheduling energy transactions, etc.

To the extent that this cooperative behavior extends into otherwise inde-pendent marketing activities, it may adversely affect the dynamic perform-ance of the industry. In short, an established coordinating group may in time stagnate.

In that event, regulation must be used to adjust the market ethos so that it once again allows a competitive intensity sufficient to secure the desired results.

If properly supplemented by regulation, coordination and competition are indeed compatible. Coordination can stimulate the achievement of the many benefits associated with perfect-competition, such as technical efficiency, diffusion of technological innovations, the maintenance of input choice, and diversity of management and ownership. Although the uncertainties of competitive rivalry may present a barrier to coordination, industry regulators with adequate information can help the industry achieve a combination of competition and coordination that benefits both industry and society.

68For a discussion of the failure of regulated companies to coordinate their activities, see A. E. Kahn, The Economir.s of Regulation, Vol. 2, pp. 64-70.

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4 1

VI.

CONCLUSIONS AND RECOMMENDATIONS The forces of coordination, competition, and regulation play complex and' interrelated roles in the electric utility industry. Technical ad-vantages of large size combined with.the importance to the public welfare of reliable service define the central role of effective industry regula-j tion,-and dictate the need for electric power systems to interconnect and coordinate. -Within this framework, perfect-competition exercises its influence by providing a model with idealized goals as a starting point 2

J for an economic analysis of the industry. This model then defines perform-ance characteristics that are benchmarks by which regulators can evaluate j

a market participant's efficiency, technological progressiveness, and i

j freedom to choose among alternative supply options, by type and source.

j Finally, certain opportunities for competitive processes can be used i

beneficially to complement the role of regulation, particularly.in a dynamic sense.

Clearly, coordination in the electric utility industry is a continually.

evolving phenomenon..Beginning with local interconnections, coordination

,i now takes the form of large pools of power systems which reap reliability, i

i operating, and planning advantages..The efficiency andLviability of many separately owned systems are enhanced if they have access to and can-participate in these large pooling systems. This type of coordination is i

less likely to result in undue concentrations of economic power, insensi-tivity to. local. customer interests, or the dangers of inflexibility than.

i l

the consolidation associated with holding companies.

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j As noted, coordination and competition are compatible in terms of i

L their ultimate objectives. - Coordination improves the possibilities for competititve selection among the components of bulk power supply.

It maintains'and possibly strengthens yardstick competition or comparative i

t analysis. Coordination's mixed impact on the likelihood of' wholesale j

[

competition and on the limited opportunities for retail load competition is i

minor if all systems have access to the advantages of'the pool. However, j

this compatibility -is largely a function of effective regulation,: since industry regulators must' preserve and utilize ~possible competitive opportunities while not letting the uncertainties of unfettered competition inhibit' the' development of coordination. To insure effective'compati-f bility,.both voluntary inducements and mandatory action are~ required.

Several general recommendations follow directly from the preceding analysis. 'Even though the electric utility industryfrequires regulation,

(

i the major goals of that regulation should be to encourage the desirable characteristics of perfect-competition and to promote opportunities for l

j competitive processes to. work.

In addition, coordination'should be promoted wherever feasible. However, in combination, competition and coordination are more beneficia1'yet. Regulatory decisions can be improved if l

when their probable impact.on opportunities for competition and coordina-tion is specifically taken into account.

j Government policy at-all levels should reflect the importance of.

access to and participation in area-wide coordinating groups as an industry.

I option. Although the traditional regulatory. emphasis seema capable of addressing the topical issues of rate structure, financing, and regulatory r

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i lag, additional emphasis on access problems will be required to assure the survival of efficient small systems.

Regulators should monitor voluntary arrangements and enforce contracts that provide smaller systems with reasonable access to the increasingly larger and more efficient power facilities being constructed by coordinating groups. Although implicit in the antitrust laws, this regulatory approach based on the access rights of small systems can provide the regulator with the necessary guidelines for interpreting specific market forces in order to judge what is " reasonable."

Finally, the local, state, and Federal regulators of the electric utility industry need effective structure and performance data on which to base their judgments. Government document rooms should make as much information as possible available to the public. Reports like the FPC's National Power Survey should be published and distributed on a regular basis. Ultimate surveillance of the industry rests with the public, which must evaluate the judgments of their chosen regulators.

Both the electric utility industry and the public would be well served by regulators who promote competition where possible, and coordination where efficient.

GLOSSARY OF ELECTRIC UTILITY INDUSTRY TERMS

, Coordination: The joint development and/or operation of bulk power facilities by or among two or more electric systems usually for improved reliability and increased efficiency which would not be attainable if each system acted independently. Coordination need not require all-inclusive participation.

Diversity Exchange: The exchange of power or energy among interconnected systems that results from individual systems having maximum demands occur at different times.

(1) Daily Diversity: Load diversity between electric systems usually across different time zones.

(2) Seasonal Diversity: Load diversity between electric systems which occurs when their annual peak loads are in different seasons of the year.

Economic Dispatch: The automatic loading of generators to meet total load as it rises and falls resulting in the most economical overall supply; ideally, the incremental (or marginal) costs of all generators in operation are equalized.

Economy Energy: Energy produced and supplied from a source in one system which is substituted for energy from a more expensive source on another system.

Emergency Support Service: The provision of capacity and/or supply of energy to an interconnected electric system that'has experienced or may experience a forced equipment outage, generally of limited duration and capacity.

Reserve-Coordination: A process by which interconnected systems agree to allocate capacity in excess of their peak load in order to form a reserve pool from which each system can draw during periods of unanticipated demand fluctua-tion and/or equipment failure, primarily the latter.

Reserve-sharing is the sharing of electric energy from the reserve pool.

Staggered Construction: A technique which involves the construction of capacity by one electric system for its use, and available for the use of other electric utilities over a limited period, with the roles reversed or modified over time.

(1) Excess Capacity and Energy Exchange: A transaction which allows one system to install capacity that exceeds its own immediate needs End to sell capacity and energy to neighboring systems for a limited period.

(2) Unit Power Sales: A short-term capacity and energy sale that is related to a specific unit.

Wheeling Service: The receipt of electric energy by one utility and the simultaneous delivery over its transmission system to another electric system of like amounts (but not necessarily the same energy or involving a third party].

69Definitions based, in part, on the following three sources: National Power Survey (1970), Vol.1, Ch.17; Federal Power Commission, Glossary of Important Power and Rate Terms, Abbreviations and Units of Measurement (Washington, D.C. :

G.P.O., 1965); and Edison Electric Institute, Glossary of Electric Utility Terms, 1970.

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