The introduction of competition into the Northwest electricity industry is the overarching consideration motivating the Comprehensive Review of the Northwest Energy System. Both the reality of wholesale competition, with much of its focus on the Bonneville Power Administration, and the anticipation of retail competition have captured the attention of the electricity industry and those interested in its effects on the region. Competition in some form will happen. However, how competition evolves in the region will certainly influence how fully the potential benefits of competition are achieved; how the benefits and costs are distributed; the cost and reliability of our power supply; the effects on the environment; and the future role of current institutions, including public and investor-owned utilities, the Bonneville Power Administration and the Council. In the words of one authority on electricity industry restructuring, "You don't just say "We're going to have a competitive market." You have to think very carefully about how the pieces fit together with different mixes of regulation and deregulation." [Hogan, William, "it's all in the Structure," The Electricity Journal, November 1995, p. 60.]

3-A. Benefits of Competition

A fully competitive market for energy services has the potential to create tremendous benefits for the electricity consumers of the Northwest. Competition drives producers to become more efficient, thus lowering prices. It also spurs the creation of new products tailored for specific market niches, providing a greater range of choice to consumers. There are indirect benefits of competition that are equally significant. Historically, low electricity costs have been a major factor in the economic growth of this region. Competition promises to continue that trend and sustain the expansion of the Northwest economy. Competition in electricity markets will result in more transparency of electricity prices and of what is included in these prices. For example, it will be much easier to tell how much of an electric bill is paying for kilowatt-hours, how much is for distribution services, how prices are different at different times and so on. This should lead to greater efficiency. For all these reasons, competition should be embraced. The tricky part will be restructuring the current electric power industry so that effective competition, not just deregulated oligopolies, emerges to benefit all consumers.

3-B. Principles for a Competitive Electricity Market

A well-accepted definition of a perfectly competitive market is a market where no individual participant is large enough to influence the market price of the product. [Samuelson, Paul A., Economics, Seventh Edition, p. 41.] Although we in the United States like to think of ours as a competitive economy, in reality we have a mixed economy. This is because the conditions for perfect competition are seldom met in an industry. Some industries are inherently monopolistic and have traditionally been subject to regulation. For other industries, there is antitrust legislation, enforced in the federal courts, to ensure that a reasonable degree of competition is maintained.

This draft assumes that the portion of the electric utility industry that is opened to competition will be governed by antitrust laws. However, these laws do not apply to federal agencies. This creates a unique issue for the Northwest because more than half the power generated in the region comes from federal sources.

As the Comprehensive Review progresses, it is important to remember that the act of deregulating does not guarantee that adequate competition will result. Without adequate competition, the region will not see the benefits expected from deregulation. The proposed new structure of the electric utility industry should foster and protect competition where it is feasible, and separate competitive markets from non-competitive markets that require continued regulation. In addition, the inherent limitations of fully competitive markets need to be acknowledged.

Absence of Market Power

The absence of dominant market power is the key to fair and effective competition. That is, no player has the ability to control prices and profits. Excessive market power can arise from several factors, all of which require consideration in the course of any restructuring. The sources of market power are: too few sellers; restricted access to markets; mixing of regulated and unregulated activities; and, more generally, situations in which not all participants are subject to the same rules and requirements.

Many Sellers

Market power exists when there are so few sellers that those sellers are able to manipulate prices. [Newberry, David M., "Power Markets and Market Power," The Energy Journal, Vol. 16, No. 3, 1995, pp. 39-66.] Where there are too few sellers, deregulation may just trade regulated monopolies for unregulated oligopolies. Many critics of the results of privatization/industry restructuring efforts in the United Kingdom point to the fact that too much of the generating capacity was held by very few producers, allowing those companies to manipulate prices

In efficiently functioning competitive markets, producers are no longer "price givers," who can set prices to recover costs and, in the case of investor-owned entities, earn an assured rate of return. Producers must accept the prices set by the interplay of supply and demand, or choose not to operate. Those prices will trend toward the marginal operating cost of the most expensive unit to operate in a given time period. From the standpoint of economic efficiency, this is what society wants to see. Consumers get to trade-off the benefit they derive from their marginal unit of consumption against the producer's cost of supplying that marginal unit.

It is also important to recognize that electricity is not a homogenous product. There are many other products associated with the sale of electricity, such as load following capability and reserves. There may be many sellers of some services, but too few for others. Similarly, the market may have many sellers generally, but transmission constraints can limit market entry in some areas. The problem is just as severe if there are many sellers, but a few dominate the market due to their size or other advantages.

Market Access

For a market to function efficiently, suppliers must have access to the market; suppliers must be able to deliver products to consumers. When the Federal Energy Regulatory Commission mandated open, nondiscriminatory, electricity transmission access and functional unbundling, it intended to put this market principle in place by assuring suppliers equal access to potential wholesale customers. The intent of functional unbundling is to separate the generation and transmission functions within a utility's organization to minimize the opportunity or temptation to use control of transmission to the advantage of one's own generation.

Functional unbundling and open access tariffs might provide nondiscriminatory market access. Open access tariffs require an owner of transmission to provide access to others under terms and conditions comparable to those the owner applies to itself. However, leaving generation and transmission under the umbrella of a single organization runs the risk of that organization using its transmission branch to benefit its own generation. It may be very difficult, moreover, for regulators or competitors to demonstrate that anti-competitive behavior actually took place. Many utilities in the Northwest have expressed concern, for example, that Bonneville, which owns so much of the region's high-voltage transmission system, could exercise subtle restraint on transmission access, to benefit its own generating resources.

There are at least three preventative steps beyond those described above that might be taken. Each offers increased certainty that nondiscriminatory open access will be achieved, but each is increasingly complex. The first step is to spin off generation or transmission to an affiliate. While this further separates the two functions, it does not guarantee that transmission decisions would not be influenced by the interests of the generating affiliate.

The second step is to vest decisions over transmission operation in an independent operator with no financial interest in generation. Ownership in the transmission system would not necessarily change hands, only responsibility for operation of the system would change. Many restructuring proposals being considered across the country feature an independent grid operator who would run the transmission systems of multiple owners as a single system. An independent grid operator may offer some operational efficiencies, as well. The independent grid operator could also be responsible for transmission system expansion decisions.

The third, and most certain, but also most difficult step is divestiture, i.e., selling off the generation or transmission assets. Divestiture is certain because the new owner of the transmission would have no interest in generation. It is most difficult because of the legal and financial transactions involved in divestiture. What are the assets worth? How are the proceeds to be allocated? How will the transaction be taxed? These and a host of other issues complicate divestiture, but do not make it impossible. While these difficulties are complex, this alternative would result in a lower ongoing regulatory burden than that associated with continued common ownership of generation and transmission. [Zeigler, Belton, "Affiliate Transactions and Electric Industry Restructuring," The Electricity Journal, October 1995, pp. 20-27.]

Consumer Choice

Consumer choice is the ability of consumers to choose among different products and different suppliers. Choice is a basic requirement for efficient competitive markets in that it is a corollary of having many suppliers with open, nondiscriminatory market access. Consumer choice drives competitive markets. In the case of wholesale competition, it is the ability of wholesale customers to choose among suppliers. In the case of retail competition, it is the ability of retail consumers to choose their supplier directly. In either case, it is consumer choice that forces suppliers to bring down their costs and make innovations in their products and services. Without consumer choice, regulation is needed to substitute for the discipline of the market and protect consumers from the abuse of monopoly power.

Separation of Regulated and Unregulated Activities

If a supplier were able to subsidize its competitive position by shifting costs to its regulated activities, it would unfairly gain market power. For example, there is a consistent complaint from the Bonneville Power Administration that its investor-owned competitors are able to recover the fixed costs of their resources from their regulated retail business and compete for Bonneville's wholesale customers on the basis of variable operating costs alone. Whether this is entirely true is not known, but it does illustrate the concern.

A second concern arising from the mix of regulated and unregulated functions is that the regulated function will take second place in the internal competition for scarce capital resources. Given the choice between investing scarce capital in an unregulated business that can earn an unregulated rate of return and investing it where it can only earn a regulated return, most businesses will be drawn to the higher return. If that is true, the consequence could be that investment needed to ensure the reliability and efficiency of transmission or distribution will go begging. In the telecommunications industry, which is further along in the deregulatory process, recent experience has raised concerns about the quality of local phone service, the part of the business that remains a regulated monopoly.

There are arguments to be made in favor of continued vertical integration of regulated and unregulated activities. In addition to the transaction costs involved in divesting, there is the possibility that the increased transaction costs between the now-separated portions of the business, (e.g., the need to contract for transmission services) could outweigh the competitive benefits achieved by limiting the market power associated with vertical integration. [Kaserman, David L. And John W. Mayo, "The Measurement of Vertical Economies and the Efficient Structure of the Electric Utility Business," The Journal of Industrial Economics, V XXXIX, N. 5, September 1991, pp. 483-502.] However, the principle of minimizing market power is, in the opinions of many people, so important that the burden of proof should rest with those opposing divestiture.

Consistent Rules

Relative market power can also be affected if different competitors are subject to different ground rules. For example, different regulatory regimes, different tax liabilities, different costs of capital and other factors can affect relative competitiveness. The Northwest, with its mix of federal, investor-owned, and local publicly owned entities, has significant potential for these kinds of market distortions.

3-C. Characteristics of Competitive Markets

Although perhaps not as fundamental as the principles discussed above, there are also some characteristics of competitive markets that should be kept in mind in the course of any restructuring process.

Risk and Reward

Competitive markets imply the possibility of business failure and capital loss. A positive return on capital investment can only be guaranteed by substantial market power (historically, monopoly power for utilities). In the regulated monopoly environment, investors trade low risk (the relatively assured recovery of capital investment from franchise customers) for relatively low regulated rates of return. In the competitive environment, investors have no assurance that costs can be recovered. Competitive markets, however, also imply the possibility of success and profit. Investors take on risk in return for the possibility of a higher, unregulated rate of return.

The structure, rules and institutions of a competitive electricity market have to accommodate the possibility of both market success and market failure. Is there the ability to absorb loss? If there is a "profit," how and to whom is it to be distributed? The answers to these questions are fairly clear for investor-owned utilities. Stockholders should realize that their stock might go up or down. The issue is potentially most difficult for the publicly owned part of the industry – Bonneville and the consumer-owned utilities that don't have stockholders to take profits and losses.

Markets are Dynamic

It is tempting to think we know the conditions competition will bring and that if we can adjust the existing legal and regulatory system to fit those conditions, everything will be fine. In reality, however, we can't know what future conditions will be. The interplay of markets and technological advances can stimulate changes that alter the competitive landscape. For example, continued improvements in the cost and performance of small-scale generation and energy storage could result in a very different picture of the competitive future than the one that seems likely today. On the other hand, unforeseen resource constraints or environmental restrictions could turn the market in entirely different directions. In considering the restructuring of the industry it is important to put in place structures and systems that are consistent with the overall principles of competitive markets, not the specifics of the electricity market as we foresee it today.

3-D. Limitations of Competitive Markets

Competitive markets are not without limitations. These limitations also have to be kept in mind as restructuring is considered.

Markets are Rarely Perfect

Markets do a wonderful job of allocating society's resources when all relevant costs are reflected in prices and when market barriers are minimal. However, there frequently are environmental costs that are external to the market process. For example, the health and environmental costs of sulfur dioxide pollution were external to the power industry until federal emissions standards and caps were established.

In addition, customers often lack complete knowledge of their alternatives. Poor information about the cost, performance and reliability of some conservation measures, for example, makes it difficult for them to compete against better understood resources. Some firms also might have a degree of market power in some part of their customer base.

These are imperfections that are not resolved now and can never be resolved fully. They exist to various degrees in most markets. It would be erroneous to assume that by moving from a regulatory environment to a market environment, all misallocations of resources would be eliminated. The move to competitive markets requires continued attention to issues of market externalities and other market imperfections.

Efficiency Not Equity

Markets, even when they perform well, are about efficiency, not equity. There may be societal goals, such as addressing low-income consumers, providing rate relief to groups or areas that would otherwise experience higher costs, or providing stimulus to a socially desired economic activity that may not be met by the competitive market. These can be entirely legitimate policy goals.

This region, and in particular, the Bonneville Power Administration, has frequently used power system revenues or rates to support these kinds of goals, including reducing irrigation and river transportation costs. This type of implicit subsidy was possible in a regulated monopoly. Competitive markets, however, cannot sustain cross-subsidies. One customer's subsidy is potentially another customer's greater-than-market price. With choices among alternative suppliers, a customer will usually find a way to undercut such prices.

This does not mean that revenues from the power system cannot be used to address non-market purposes. If, for example, the Bonneville Power Administration is allowed to charge market prices, and those prices exceed costs, the net revenues can be used for whatever purposes are deemed appropriate – a rebate to customers, low-income services or other purposes. But delivering the dividend in the form of subsidized prices puts the subsidizer at a competitive disadvantage and sends an inefficient price signal as well.

3-E. The Transition Matters

The transition to competitive markets will be neither instantaneous nor easy. Much of the difficulty of the transition has to do with reconciling the consequences of past decisions, made in an era of regulated monopolies, with the new competitive market. Competition has much to offer in the form of lower costs and better products and services. However, it will be difficult to make the transition if some groups – investors or customer groups – believe they would be made worse off because of competition. In addition, the timing of the transition for various customer groups will be important. For example, with an unstructured transition, large industrial customers will likely gain access to lower market prices sooner than individual residential customers.

The debate about this transition has focused primarily on the issue of stranded investment. Stranded investment is investment that cannot be fully recovered at competitive market prices. Most, but possibly not all, of that investment is in generating resources. If some customers can purchase electricity from the competitive market, instead of from their historic supplier, they may "strand" their "share" of the unrecoverable portion of the utility's investment, leaving it with those customers who don't have access to alternative suppliers, with the utility's investors or both.

Stranded investment could occur at the wholesale level, as a result of open transmission access, or at the retail level as a result of opening up retail competition. Even without actual retail wheeling, the special accommodations that are likely to be made for large customers who can threaten to leave the system can effectively strand costs on customers with less market power.

The stranded investment issue tends to generate a great deal of heat and not very much light. Customers who think they can take advantage of the competitive market brand suggestions for some kind of stranded cost recovery as "anti-competitive." Customers who believe they will have less ability to take advantage of the market fear they will have to pay an unfair share of stranded investments. Utility stockholders, arguing that investments were made in good faith expectation of continued utility monopoly and obligation to serve, see failure to provide for stranded investment recovery as unfair to them.

The challenge is to get beyond these polarized positions to a competitive market. Some observations that may help move the debate:

  • The amount of potentially stranded generation investment depends on the difference between the cost of existing generation and the market price. In the Northwest, the amount of stranded generation investment is presently thought to be small relative to other parts of the country.
  • The amount of stranded investment cannot be figured on an individual resource basis, but rather on the basis of an owner's entire system. Where utilities have been averaging the cost of their high-cost and low-cost resources in determining their regulated rates, stranded investment must be determined on the same basis. One cannot just pick out the high-cost resources and recover stranded investment for those resources, while at the same time receiving market prices for (and making windfall profits from) existing low-cost resources.
  • Any stranded investment recovery mechanism should build in incentives to minimize stranded investments. For example, if owners must share in the stranded investment, there is an incentive to work hard to minimize stranded investments. Similarly, stranded investment recovery should not reward inefficient operation. Recovering fixed costs is necessary to some degree. Subsidizing above-market operating costs is neither prudent nor necessary.
  • It is difficult to make an argument that all stranded investments should be recovered from customers (although that is what the Federal Energy Regulatory Commission has recommended for wholesale stranded investments). [Bradford, Peter, "A Regulatory Compact Worthy of the Name," The Electricity Journal, November 1995, pp 12-15.] The decisions made in a regulated monopoly environment were perceived to have relatively low risk, but certainly not zero risk. Stranded investment recovery should be shared between customers and investors. The fact that Bonneville does not have investors in the usual sense makes this more difficult, but not necessarily impossible.
  • Virtually every electricity industry restructuring process in this country has recommended some level of stranded investment recovery. It is the norm, not the exception.

It should also be recognized that there is a flip side to stranded investment. Stranded investment occurs when total costs are greater than market prices. But for many utilities in this region, existing system costs are well below market prices or could be in a few years. The transition to competitive markets and market prices means that unless some provision is made for existing customers to share in the return, the benefits will all go to investors – a windfall profit. Stranded investment recovery is based on the principle of equity. Investors who received a near-certain, but low rate of return in the regulated environment may be entitled to some level of stranded investment recovery. If existing customers are also to be treated equitably, they are also entitled to some share of the windfall profits. They, after all, helped pay for the below-market resources and accepted the risks associated with those resources. [Cearley, Reed and Lance McKinzie, "The Economics of Stranded Investment — a Two-Way Street," The Electricity Journal, November 1995, pp. 16-23.]

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