Electric Industry Restructuring:
Opportunities and Risks for West Virginia

Interim Report No. 4:

Implications for West Virginia Electricity Consumers

Submitted to:
Director of Operations, Governor's Office
1900 Kanawha Boulevard East
Charleston, WV 25305




Submitted by:
Electric Industry Research Group (EIRG)
West Virginia University
P.O. Box 6064
Morgantown, WV 26506



September 1998

The West Virginia University Electric Industry Research Group (EIRG) gratefully acknowledges financial support from the Office of the Governor of West Virginia, the WVU Coal and Energy Research Bureau, the WVU National Research Center for Coal and Energy, and the U.S. Department of Energy: Office of Industrial Technologies.

The EIRG has benefitted enormously from meetings and interactions with the Public Service Commission of West Virginia, the Harvard University Electricity Policy Group, the Carnegie Mellon University Department of Engineering and Public Policy, the West Virginia Coal Association, the West Virginia Development Office, the U.S. DOE Office of Electricity Policy, Allegheny Power Company, and American Electric Power Company.

Muhammad A. Choudhry
Computer Science & Electrical Engineering
Telephone: (304)293-6371 x524
Email: mchoudhr@wvu.edu

Stratford Douglas
Economics
Telephone: (304)293-7863
Email: sdougla2@wvu.edu

David Greenstreet
Bureau of Business and Economic Research
Telephone: (304)293-7829
Email: dgreenst@wvu.edu

Caulton L. Irwin
National Research Center for Coal & Energy
Telephone: (304)293-7318 x5403
Email: cirwin2@wvu.edu

Ronald L. Klein
Computer Science & Electrical Engineering
Telephone: (304)293-6371 x5l8
Email: klein@cemr.wvu.edu

Thomas F. Torries
Resource Economics
Telephone: (304)293-3752 x4475
Email: ttorries@wvu.edu

Table of Contents

Executive Summary

4.0 Issues and Introduction

4.1 Efficient Markets and Pricing

4.2 The Effects of Deregulating Generation and Pricing Mechanisms

4.2.1 Fixed and variable costs

4.2.2 Monopoly and competitive pricing

4.2.3 Deregulation impediments and solutions

4.2.4 Rate caps and freezes

4.3 Market Power

4.4 Competitive Transition Charge

4.5 Design of Market Institutions

4.6 Reliability

4.7 Environmental Issues

4.8 Effects on Consumer Classes

4.8.1 Residential

4.8.2 Poor and rural customers

4.8.3 Industrial

4.8.4 Commercial

4.8.5 Cooperatives and distributors

4.9 Will Deregulation Work in West Virginia?

4.10 Conclusions

References

List of Figures and Tables

Figure 1: Variable, fixed, & total costs for three producers

Figure 2: Cost curves for system generating units

Figure 3: Downward shift of supply curve & prices

Figure 4: Pricing under regulation, competition, & monopoly conditions

Table 1: Key ancillary services & their definitions

Table 2: Average electric utility revenue per kilowatt hour from industrial sales (1995)

Table 3: Fifty industries with largest electricity input coefficients-1994

Table 4: Twenty-five largest electricity-consuming sectors in West Virginia-1994

Table 5: Size of selected West Virginia manufacturing industries 34

 

Electric Industry Restructuring: Opportunities and Risks for West Virginia

Interim Report No. 4: Implications for West Virginia Electricity Consumers

Executive Summary

West Virginia University Electricity Industry Research Group

November 11, 1998

Deregulation of the electricity generation industry in West Virginia presents opportunities to lower electricity prices for all consumers so long as the resulting power markets are truly competitive. However, poorly designed restructuring of the electricity generation industry could fail to achieve lower electricity prices for all consumers. Many complex issues exist which combine to make the outcome of electricity generation deregulation in West Virginia uncertain. These issues are not always well understood and some are consistently misrepresented. In addition the public, private industry, electric utilities, government, and others all have vested and sometimes conflicting interests in the outcomes of the deregulation process.

The purpose of this report is to identify and describe key issues important to electricity consumers in West Virginia, and to recommend appropriate action when possible. This study builds on previous reports of the West Virginia University Electricity Industry Research Group (EIRG(1)) that address electricity production and distribution (see EIRG 1997a, 1997b, 1997c, 1998).

Findings in this Executive Summary include page references to the body of the report, where the reader will find more detailed information. Observations and conclusions are grouped in order of appearance in the report.

Competition and deregulation:

What can go wrong?

Possible remedies:

Market power:

Competitive transition charge (CTC):

Design of market institutions:

Reliability:

Environmental issues:

Effects on residential consumers:

Effects on poor and rural customers:

Effects on industrial customers:

Effects on commercial customers:

Effects on cooperatives and distributers:

Other major conclusions:

 

Electric Industry Restructuring: Opportunities and Risks for West Virginia

Report 4. Implications for West Virginia Electricity Consumers

4.0 Issues and Introduction

Deregulation and competition in the electricity generation industry will improve the efficiency of electricity pricing. Having efficient pricing, i.e., pricing that reflects true costs, is important because efficient pricing leads to the greatest benefits to society as a whole. Efficient pricing is not always an apparent or an immediate goal of all consumers because efficient pricing may cause previously subsidized prices of certain consumers to increase. However, if there are sufficient gains in economic efficiency as a result of deregulation, it is possible for all consumers to experience lower prices.

The effects of deregulation on consumers and producers depend first on the nature and degree of the deregulation of the electrical generation industry. If, as is presently the case, we allow only the wholesale generation prices to be market-based, regulatory changes will be minimal and the effects of deregulation on consumers will be small. However, if we go further and deregulate retail rates to final consumers as well, regulatory changes and the effects on the consumers will be greater. It is also possible to achieve compromises between these two models of deregulation but at the cost of reduced competitive benefits.

Because of the change in pricing mechanism and the differences among electricity consumers, deregulation also presents different sets of opportunities and risks for different classes of electricity customers. These customer classes include residential, commercial, and industrial, as well as small electrical cooperatives which purchase power for distribution to their members. The current pricing structure for each class of consumer is different and all pricing structures will change when the deregulation process is completed. This means the present position of each customer class must be compared with the potential new position under deregulation in order to understand the implication for West Virginia electricity consumers.

Changing electricity generation pricing from a regulated to an unregulated and competitive structure also involves a number of time frames. The effects of deregulation change over time, so the short run effects on consumers will be different from the long term effects. Therefore, a description of the effects of deregulation on the consumer must also take into account the time frame.

The major issues of concern to consumers include the following. (1) Is electricity generation deregulation good for consumers, producers and the West Virginia economy as a whole? (2) What might go wrong with the deregulation process to reduce or eliminate gains to consumers? (3) Will deregulation treat all present customers favorably? (4) Which customers may be made worse or better off and why? There are also a number of cross cutting issues that concern electricity consumers, such as the role of education of electricity customers and politicians in making deregulation work successfully, the effects of deregulation on the environment, the future of electricity reliability, the social welfare aspects of supplying electricity to the poor, and the effects electricity generation deregulation will have on economic development.

These topics are discussed in this report in the following sections. There is a broad overlap of a number of topics identified in the previous paragraph, which complicates the task of categorizing and discussing topics by specific categories. Also, portions of this report refer to previous reports of the West Virginia University Electricity Industry Regulation Group (EIRG(2)) that address electricity production and distribution (see EIRG 1997a, 1997b, 1997c, 1998).

4.1 Efficient Markets and Pricing

Deregulation of the electricity generation industry can increase economic efficiency in the pricing of electricity and thereby provide economic gains to the economy. The mechanism by which this occurs is not readily apparent to the general public. A good deal of misunderstanding exists about the reason for regulation of the industry, the costs of regulation, and the benefits of deregulation.

From the late nineteenth through the mid-twentieth century, electric utilities developed as separate, vertically integrated monopoly franchises serving clearly defined service areas. "Vertically integrated" means the same company controlled the entire process of generation, production, transmission, distribution, and marketing of electric power to the end use customers in its service area. Because it is uneconomical to have more than one distribution network in any service area, each electric utility served a single service area and owned and operated the transmission and distribution system in the area it served. Since there was only one utility per service area and it was uneconomical to have more than one transmission and distribution system per service area, each utility had a natural monopoly in the sale of electric power.

A monopoly seller of electric power has the ability and the incentive to raise electricity prices above the level that would prevail in a competitive market. This exercise of market power increases profits to the monopoly utility. It also decreases the amount of electricity sold in the market, since higher prices cause consumers to purchase less power. Consumers pay more in a monopolized market, and monopolies collect higher profits for their stockholders (which typically include many of the utility's customers). If the existence of a monopoly simply meant that there was a one for one transfer of wealth from customers to the utility stockholders, there would be no loss of overall efficiency due to monopolization, and hence no economic efficiency justification for government regulation of electric utilities. However, this is not the case.

Monopolies are economically inefficient and therefore undesirable precisely because there is not a one-to-one transfer of wealth as the monopoly increases its price. Every sale of electricity by an informed buyer to an informed seller provides a net gain to both, or it would not happen. An increase of the price of electricity without a corresponding decrease in sales would no doubt be obnoxious to customers, but it would not reduce the efficiency of the market -- it would just redistribute this net gain. But as the monopoly uses its market power to raise its price it necessarily decreases the quantity of power sold, which reduces the net benefit to society from generation and sale of electric power. Economists refer to this net reduction in social benefit as the "dead weight loss" due to monopoly market power.

Regulation can reduce the dead weight loss by forcing price down. Regulators drive price below the level that would maximize the monopolist's profit, but they also have an obligation to allow the monopoly to recoup its capital costs. In the case of a natural monopoly, the requirement to recoup capital expenditures forces regulators to hold the price above the level that would prevail under competition. Thus, even the most efficient regulation of a natural monopoly will result in some dead weight loss, as it raises prices above competitive levels. Efficient regulation of a natural monopoly will yield lower prices and higher social benefit than the unregulated monopoly would, but higher prices and less overall social benefit than a competitive market. Because competition is not sustainable in a natural monopoly, we have historically chosen regulation as a second-best solution.

During the second half of the twentieth century, however, advances in generation technology and transmission interconnection have eliminated the natural monopoly in the generation of electricity, and therefore eliminated the rationale for regulation of electricity generation. The expense of building and operating small generation plants has declined to become competitive with large central power plants. At the same time, the transmission system has grown more interconnected, increasing the potential geographical market for the output of large plants, and increasing the potential for competition among many previously isolated plants. Thus, for the first time it has become possible to envision generation markets that are much larger than any individual generating firm. If there are many firms in a market, each small relative to the market, conditions are ripe for competitive markets to appear.

Accordingly, open and competitive wholesale markets for power have recently begun to appear. But institutional barriers to the full development of these markets remain. The major electric utilities are still vertically integrated and operated as regulated monopolies. This regulation is appropriate for the transmission and distribution activities of the utilities, which are still natural monopolies, as establishing multiple competitive systems of wires would be inefficient. Consequently, in the last ten years state and federal regulators have moved to formally deregulate the generation portion only of the electricity industry.

4.2 The Effects of Deregulating Generation and Pricing Mechanisms

It is necessary to discuss the formation of prices under monopoly and competitive pricing in order to discuss the possible effects of deregulation and to understand what may go wrong to prevent the full gains of deregulation. The concepts to be discussed in this section are (1) fixed and variable costs, (2) pricing of a commodity under a competitive market with overcapacity, (3) monopoly pricing of electric power, and (4) competitive pricing of electric power.

4.2.1 Fixed and variable costs

Costs experienced by any producer can be classified as being fixed or variable. Fixed costs (FC) are those that do not change with output in the short run, such as capital costs. Variable costs (VC) vary with output, and include costs for fuel, materials, and labor. Total cost (TC) is the sum of the fixed and variable costs. Each regulated electric utility submits its fixed and variable costs to a public utility commission for rate approval based on a determined acceptable rate of return. Since rate of return is applied to capital costs, it is appropriate to include the minimum rate of return as a part of capital or fixed costs.

Figure 1 shows hypothetical fixed and variable costs for three electricity generating units labeled A through C. Costs per generating unit are shown on the vertical axis and capacity of each plant is shown on the horizontal axis. Therefore, each rectangle represents the cost per unit to produce and the capacity of each plant, and the area of the rectangle represents the total costs to produce (unit costs times capacity). Each rectangle is divided into two parts: the shaded portion is variable cost (VC) and the unshaded section is fixed cost (FC). Adding the VC to the FC gives the total cost (TC) of production for each generating unit.

In Figure 1 producer A has the lowest VC and TC, but also has the smallest capacity. Producer C has the largest capacity and highest VC, but has a smaller FC than producer B. The TC for producer C is also less than the TC for producer B. Note that the plants are presented in Figure 1 in order of increasing variable costs.

Now, add more producing units and arrange the position of each unit to account for continuously accumulating capacity to create Figure 2. Figure 2 shows the variable, fixed, and total costs for eight generating units (labeled A through H) arranged in order of increasing variable costs. The features of each generating unit shown in Figure 2 are the same as those in Figure 1 except that total costs for each producer is shown as the dashed line TC. Note that fixed costs for the plants are not always in proportion to the variable costs due to differences in construction costs or ages of the plants. Unit D has the greatest production capacity and unit H has the greatest total costs. Assume all generating units belong to the same utility and serve a single service area.

Figure 2 also includes a demand line (D) that represents the amount of electricity consumers would buy at each price. Our analysis in this section will treat demand as constant. In the real world, of course, demand shifts constantly as demand changes, from minute to minute, seasonally, and over the long term. Understanding the effects of these shifts is essential to a full understanding of the electricity business. For example, investment in reserve generation capacity is necessary because of the essentially unpredictable level of peak demand. Also, customers may pay separately for capacity and energy, a distinction that disappears when demand is held constant.

But other facts about the electricity business are true regardless of whether or not demand varies, and a simplified analysis, with constant demand, can explain these facts more clearly than the more complicated analysis would. Accordingly, to explain these facts in this section of the report we will treat demand as though it were fixed and constant at an average level. We will explain the following points:

4.2.2 Monopoly and competitive pricing

The regulated rate approved by the Public Service Commission for a monopolistic utility is based on the average total costs of all generating units for the utility, which includes fixed as well as variable costs. Therefore, a regulated utility has the opportunity to recoup all capital(3) and operating costs for its plants plus a minimum rate of return on capital. The average of the total book costs for all eight plants is shown by the dotted line Pr. This is the regulated price determined by the Public Service Commission. This price and the demand curve indicate the quantity of electricity used will be Qr.

Now assume all plants in Figure 2 have different owners but serve the same service area in a competitive electricity generation market. In the case of a competitive generation market in which overcapacity exists (generation capacity exceeds the demand for power), the price of power is determined by the variable cost of the individual plant that has the highest variable cost needed to meet demand. In Figure 2, plant E determines the competitive price Pc. Since Pc is less than the variable costs for plants F, G, and H, these higher costs plants must shut down (ignoring for now the benefits of reserve margins). As a result, Pc is less than the TC of most of the producing plants which means Pc is not sufficient for all existing plants to recoup their invested capital, let alone obtain a rate of return. On the other hand, plant A with low fixed and variable costs is able to obtain profits in excess of the minimum rate of return.

The trace of the variable cost curve, as shown by the heavy VC line in Figure 2, in conjunction with the demand curve, determines the market price. In other words, the heavy VC line is a simplified representation of the industry supply curve, and its intersection with D will determine the price and quantity of electricity sold in the market. If demand increases sufficiently, the market price will rise and plant F will begin producing. If, on the other hand, demand decreases, the market price will fall and plant E will shut down. Also, if the owners of plant F find a way to reduce its variable cost below that of E, F will displace E in the supply curve, and the market price will fall.

At this stage of this scenario shown in Figure 2, increased competition obviously benefits consumers partly at the expense of the producers. The purpose of deregulation is not to transfer wealth from producers to consumers but to increase economic efficiency. As a result of the increase in economic efficiency, consumer gains are larger than producer losses, and the economy as a whole gains. However, deregulation and the response to deregulation takes place over a number of years and does not happen instantaneously. It is necessary to investigate the stages that follow the initial deregulation as well.

Competitive pressures encourage high cost producers to invest in cost saving technologies to recapture market share. This action, in turn, makes the next highest cost producer unable to sell profitably and prompts this producer to invest in cost saving technologies. Incremental investment in an existing facility, either to increase production or to utilize new technology, or both, is often achieved at a fraction of the cost to construct a new plant. Industries such as the steel, copper, and nickel experienced this type of cost reduction since the early 1980's (Torries, 1988). While almost no totally new production facilities were built during this time frame, production expanded significantly and costs and prices declined by half through incremental investment and expansion of existing facilities.

It is not unreasonable to expect the same type of investment and cost decline pattern for the electric generation industry. Arguments that the electric industry is sufficiently different from these other industries to prevent such incremental improvements are not persuasive. These are the same arguments that other industries made prior to becoming competitive. Opportunities for incremental improvements in the electricity generation industry will become more obvious as competition increases.

In a competitive industry any newly constructed facility must have a total cost less than the market price, which is the variable cost for the highest existing producers, in order to enter into production. However, as soon as a new plant is constructed, operating decisions concerning the new facility depend on its variable, not total, costs. Since the total cost of the new facility is less than the market price, variable cost of the new facility must, by definition, be less than the market price by an even greater margin. Repeated cycles of cost savings among the producers and introduction of new capacity makes the cost or supply curve shift down and to the right, as is shown in Figure 3. As the supply curve shifts down, going from S1 to S2, and to the right, prices indicated by the intersection of the demand and supply curves decline from P1 to P2. In response to the price declines, consumer consumption increases from Q1 to Q2. Consumer prices initially decline because of the initiation of deregulation but then continue to decline steadily over time because of the ongoing incentive to invest in cost saving technologies.

Clearly, costs cannot continue to decline indefinitely or negative costs would be reached. However, as has been shown in other industries, costs can continue to decline for periods of ten, fifty, or more years before leveling off. Given the experience in other industries, it is doubtful there will be a flare up in electricity prices over the next five years as a result of increased capital cost required to install new capacity.

It can be argued that increased environmental regulations will cause the total cost of producing electricity to increase significantly. Given the uncertain nature of the final regulations and the uncertain impact of marketable pollution permits, it is not clear what effect changing regulations will have on the costs to produce electricity. However, the effect that changing environmental requirements may have on electricity production costs will take place with or without deregulation. Furthermore, as discussed in the environmental cost section of this report, it is probable that deregulation will decrease the cost of environmental compliance.

There are three important ideas to obtain from this portion of the discussion. First, in a competitive market with excess demand, price is set by the supplier that has the highest VC required to meet demand. Second, in a competitive market, capital spent in the past does not influence decisions concerning the future operations of a plant. This means recoupment of capital, or stranded costs as they are now termed, is not necessary in a competitive market. The market will work fine even if some investors do not obtain their anticipated return on investment. This holds equally well in the case of negative stranded costs where consumers want to be reimbursed for utility profits in excess of regulated levels. Lastly, competition fosters investment in cost saving technologies so that in the longer run, even lower prices can be anticipated. As a result of these three principles we expect the competitive price of generation to be considerably less than its regulated price.

One of the concerns of West Virginia citizens is that deregulation will allow less expensive West Virginia power to be exported to neighboring states, which would cause an increase in price of power to West Virginia customers. Figure 4 illustrates why this is not likely to happen.

Figure 4 shows supply (Swv) and demand (Dwv) curves for power generated and consumed in West Virginia. The current regulated price of power paid by West Virginia users is indicated on the price (P) axis by Pwr. At this price, a quantity of power Qwr is demanded by West Virginia consumers. The price Pwr includes the operating costs plus an allowance for past capital investments plus a regulated rate of return. The unregulated monopoly price for power in West Virginia would be much higher, as represented by price Pm in Figure 4.

If generation of West Virginia power is deregulated and no sales are allowed outside the State boundaries, the competitive price would decrease to Pwc. This price includes only an allowance for operating costs which, as explained above, would be the price response under competition under a condition of excess generation capacity.

A similar condition exists in states outside of West Virginia, except their operating costs and prices are higher. The current regulated price for power in states neighboring West Virginia is shown as Por in Figure 4. Since there is excess generating power in neighboring states as well, deregulation would cause the price to decline to Poc, which, as with Pwc, does not include capital or a minimum rate of return.

Capital represents a sizable portion of generation costs. Therefore, the difference between Por and Poc, as well as between Pwr and Pwc, is sizable. If power from outside West Virginia were allowed to be sold in West Virginia at competitive costs, the price of power would be set by the highest cost producer required to meet the demand. This would come from producers outside West Virginia and would be priced at Poc. Poc would be less than Pwr because Pwr is a regulated price based on average total costs, which includes capital, and Poc is a competitive price based operating costs, and does not include capital. Since Poc is less than Pwr, consumers in West Virginia achieve lower electricity prices as a result of deregulation of the electricity generation market.

4.2.3 Deregulation impediments and solutions

Now, what can go wrong to prevent the gains offered by a competitive electric generation industry? There are many problems and concerns as will be discussed in the remainder of this report, but three problems are immediately evident. The first has to do with open access to the West Virginia market. If transmission constraints (caused by either physical capacity constraints or anticompetitive operation of the grid) impede the supply of power for sale in the State, the market will be less competitive and prices will be higher. This is a particularly serious problem. To the degree that electric power is prevented from being delivered to West Virginia from outside sources, the difference between Poc and Pwr in Figure 4 will dwindle.

The second problem has to do with allowing deregulated utilities to recoup all capital invested in existing plants through the rate base. If recoupment of the stranded assets by utilities is allowed, the regulated price will be determined by the total cost of the home utility. As we have already seen, in a deregulated and competitive market, the price will be set by the variable cost of the highest-cost producer required to meet demand. The only way a regulation allowing the recoupment of stranded assets by utilities will work is if there is some impediment to the competitive process. One such impediment described above is a lack of open access to the market. Another impediment could be the implementation of an exit charge imposed by home utilities on customers wishing to switch power sources. Such an exit charge, which is designed to prevent customers from switching and to pay the stranded asset costs is one variety of Competitive Transition Charge (CTC). An alternative, nondiscriminatory CTC for all customers would result in everyone paying the same charge. In any case, allowing utilities to recover stranded assets reduces the benefits that competition offers. However, the amount of reduction may be small depending on the design of the CTC. CTC schemes allowing differential charges among customers would result in fewer benefits. Note that from the standpoint of economic efficiency, the undesired effect of the CTC charge is not that there is a transfer of wealth from consumers to utilities, but that losses to the entire economy occur because of the decrease in competitiveness of the market. CTCs are discussed further in a later section of this report.

The third problem has to do with the idea that allowing low cost power produced in West Virginia to be sold to customers in other states will increase the price of power to West Virginia customers. A variant of this idea is that industrial customers within the State will have more bargaining power than residential customers and will buy all the inexpensive power at the expense of residential customers. One proposed solution to these problems is to have the Public Service Commission place a ceiling on the price at which power is to be sold to West Virginia customers, and particularly residential customers. Some other proposals, such as the "Alberta Plan" (in which the regulator, on behalf of consumers, and the owners of previously regulated generation facilities enter into a long-term contract at a rate sufficient to recover the book cost of those facilities) are really variants of the rate cap idea. There are a number of ramifications of any of these regulatory interventions that need to be explored.

If competition is allowed to happen, we expect prices to customers in West Virginia to decrease because prices will be determined by variable costs of existing plants, not total costs. However, not all classes of customers will receive the same reduction in price. Since residential customers are more expensive to serve than industrial customers, residential customers may not see as great a savings from deregulation. Also, there is the possibility that industrial customers will be able to achieve greater price reductions by having greater market power than a block of residential customers. Finally, it has been suggested that residential prices in West Virginia may now be subsidized by industrial prices and the deregulation of the generation industry will cause these subsidies to decrease and residential prices to increase. However, if a subsidy does exist, its size appears to be small and insignificant in relation to expected changes in prices from other causes related to deregulation.

4.2.4 Rate caps and freezes

Residents of West Virginia worry that residential prices may increase in an absolute sense as a result of deregulation. There are a number of proposed reasons for a rate "fly-up" to occur, as has been previously discussed in this report. First, if the size of the economic gain from deregulation is sufficiently small, certain customers, such as West Virginia residential customers, may face higher prices because of the market power exerted by industries and electric power consumers in high cost areas outside the State. Second, if the process of deregulation is faulty, utilities may retain sufficient market power to cause increases in prices and utility profits. Third, if declining prices cause the demand for electric power to increase, the capacity to produce power may be inadequate, which would require the construction of new, more expensive generating plants. Lastly, new and existing plants may face higher fuel prices because of environmental constraints on the operations of generation plants. As is explained elsewhere in this report, none of these events are expected to result in higher absolute prices to residential customers in West Virginia.

However, because of the many variables in generation and transmission costs and regulatory options, it not possible to tell at this time what the deregulated market in West Virginia will actually look like. Consequently, it is not possible to say with certainty that residential prices will decrease as a result of deregulation actions. What may be said is that our analysis leads us to expect that all prices will decrease, including residential prices, because of the expected large effect of increased competition and the conversion from average total cost to marginal cost pricing.

Higher electricity prices would have serious economic consequences for less wealthy residents of West Virginia. However, it is almost certain that industrial prices would decrease. One must not forget the potential benefits of having lower industrial power prices, which should increase economic development and provide much needed jobs. Clearly, a middle path which protects the more needy residents needs to be investigated. Free market pricing promotes economic efficiency and development, but we in this nation have chosen to forego some degree of economic efficiency to gain increased comfort of the less wealthy.

Some West Virginians are concerned that in a competitive market some of the higher cost generating plants in West Virginia will be shut down and cheaper power will be purchased elsewhere, such as in Mexico or the western United States. If this scenario were to become reality, it would benefit West Virginia electricity consumers and hurt workers engaged in supplying coal, electric power, and ancillary products and services in the State. But the likelihood and effect of any plant shutdowns will be limited by electricity transmission costs and constraints. While it is possible that certain small and old generating units in West Virginia may be shut down, it is more likely that the overall effect of deregulation would be to increase the incentive to modernize our high-cost plants, and to increase West Virginia's production of electric power and coal. Coal fired power plants in West Virginia are now low cost operations and will be even lower cost with greater output.

To remove the uncertainty associated with the possibility of an absolute price increase to residents, the Public Service Commission has considered implementing a rate cap, which would prevent prices from increasing, but would allow prices to decrease. Such a cap should do little if any harm to the competitive process, since competition will tend to drive prices down. Some electricity producers have proposed as an alternative a rate freeze, which would prevent prices from decreasing. Such a rate freeze would have a much greater potential than a rate cap to decrease the benefits available from competition.

4.3 Market Power

All of the benefits usually attributed to a market system are diminished or neutralized entirely if the markets are not sufficiently competitive. One likely scenario is that the function of state regulatory authorities will increasingly move toward antitrust-style market analysis such as: define the relevant market, analyze its structure (including the number and market share of competitors), and enforce remedies such as merger denial, divestiture, or even compensatory damages when competition is found to be insufficient.

Market power exists when power generators can charge more than the competitive price for electricity by restricting the available supply. The simplest form of market power is monopoly -- where the only producer of a product (e.g. electricity) restricts its level of output in order to charge a higher price. Similarly under oligopoly, a small number of producers can collude (explicitly or implicitly) to restrict production and raise prices. The key to market power is that there is some barrier preventing additional producers from entering the market in order to take advantage of the high prices. These additional producers would increase production and competition, and thus reduce prices. In the electricity industry the most important barriers to competition have been economies of scale in generation plants and utility control of the transmission and distribution system. Changes in technology have removed the first barrier to competition and FERC is now requiring utilities to provide open, nondiscriminatory access to transmission for competing power generators. However, transmission capacity constraints and pricing can still create market power in regions with a small number of suppliers by restricting the quantity, and raising the cost, of power purchased from outside the region.

There is increasing discussion about the competitiveness of electricity generation markets in the academic literature, in the trade press, and in pronouncements by the FERC, the Federal Trade Commission (FTC), the Antitrust Division of the U.S. Department of Justice (DOJ), and various state regulatory authorities. The importance of transmission constraints and their ephemeral nature, the difficulties of analysis of the transmission system, the impracticality of electricity storage, the availability of alternative energy and conservation, and the rapid rate of change in generation technology, all militate against an easy definition of either the relevant market or the number of competitors in that market.

A growing number of articles in the academic economics literature explores the theory of how market power might be exercised in power markets. For example, Oren (1997) shows how the existence of a transmission constraint can lead to market power in a market with several suppliers located on the "wrong" side of a transmission bottleneck (i.e., the opposite side from consumers), even if there is no explicit collusion. The basic idea is that all the suppliers will know the capacity of the constraint, and they will know the maximum price that consumers will be willing to pay for the amount of power that can be transmitted over the constrained transmission system, and their bids will tend to stick at that maximum feasible price. (Some recent experimental work done at the Economic Science Laboratory at the University of Arizona supports this theory.) The upshot is that the suppliers (and perhaps some large consumers) will capture all of the economic rents from the transmission constraint, keeping prices high without providing a price signal to transmission owners to relax the constraint. Oren suggests that if transmission rights were tradable their prices would signal the need for more transmission.

West Virginia's situation on the west side of a significant transmission bottleneck to PJM makes Oren's work relevant. It suggests that the severity of the transmission constraint may not be apparent in a generation market with few competitors unless transmission pricing is responsive to congestion. It also illustrates a mechanism by which an integrated transco/genco owner of bottleneck transmission facilities could use its market power in transmission to favor its generation business without any explicit act.

The best documented real-world example of market power in deregulated electricity markets is found in the British electricity industry. Green and Newbery (1992), and Newbery (1995) found evidence of pricing well above marginal cost in the British spot market, which they say is due to there being only two competitors in the system. In West Virginia we also have only two major suppliers of generation, AEP and APS. Although interconnections clearly make it easier for outside suppliers to enter the West Virginia market than the British market, those outside suppliers would have to wheel over transmission lines belonging to APS and AEP. FERC's Order 888 makes it clear that APS and AEP must provide the necessary transmission access, but to ensure that this access creates real competition it is crucial that transmission tariffs do not overstate the real costs associated with the wheeling. Also, the transmission grid was constructed primarily to serve the native load of traditional utilities, and is not optimized for providing the flows needed for competition.

Transmission pricing and responsibility for investments to upgrade transmission capacity have been a subject of debate during the design of the Independent System Operators (ISOs)(4) that will be responsible for operating transmission grids in the restructured electricity industry. A variety of transmission pricing schemes have been proposed. Flat "postage stamp" rates would apply to any source/load pair in an ISO's service area. Locational marginal prices, such as in the transmission tariffs PJM has introduced, are based on the differences in short run competitive prices at different points on the transmission system. These prices will differ when constraints on the transmission system prevent the arbitraging that would ordinarily equalize those prices. There is general agreement that transmission prices should not be held artificially high through "pancaking" of wheeling charges by each service areas on the contract path from generator to consumer. While high transmission prices raise consumer costs and can create market power, they can also be too low, as happens with a "postage stamp" rate in the presence of capacity constraints. Where there are capacity constraints, economically efficient transmission prices would be set high enough to ration demand for transmission capacity in the short term and create incentives for capacity-increasing investments in the long term.

Transmission constraints and pricing provide a barrier to market entry by generation competitors, but only to a point. Large industrial customers (and aggregated small commercial or even residential customers) have the option of installing their own generators in response to suppliers' attempts to raise prices. Because the cost of such generators has declined significantly in recent years, this option provides a real constraint on the ability of producers to raise prices to customers with the self-generation option. However, the cost of these generators (between $30 and $40 per mWh) is 50% to 100% higher than marginal cost. Thus, there is considerable scope for suppliers to exercise market power without raising their prices to the point where distributed generation becomes economically attractive. Also, customers who are not prepared to exercise a credible threat of self-generation due to their small size and lack of sophistication are not protected by this option. Those who are able to credibly threaten self-generation will still require backup services, which may be subject to the exercise of market power. Finally, self-generation is often not an efficient option, given the pre-existence of a transmission and distribution system.

Divestiture of generation assets by the transmission and distribution utilities is one remedy for market power that has been advocated by the Public Service Commission staff, the Federal Trade Commission, and the Consumer Advocate.(5) This remedy has several advantages, and several disadvantages. One advantage is that the sale of generation assets to several different firms would almost certainly eliminate any domination of the West Virginia generation market due to the large generation capacity of Allegheny Power and American Electric Power ("horizontal" market power). Very little time and effort would then be required for establishing the competitiveness of the market, since the presence of many independent sellers, each with a relatively small market share, along with interstate access to the grid, would create a strong presumption that the market is indeed competitive.

Divestiture would also remove once and for all the troublesome issue of the possible use of transmission assets to create market power in the generation market (so-called "vertical" market power). Although FERC Orders 888 and 889 deal explicitly with this issue, it is difficult to envision an Open Access Same Time Information System (OASIS) information system quick and accurate enough, or a "China wall" between transmission and generation subsidiaries high enough, to satisfy potential entrants that the market is indeed free and open. A market works much more smoothly and efficiently if there is no question as to its fairness and openness, since disputes over issues of fairness and openness will likely bring the parties before the courts and regulatory authorities early and often.

The third advantage of divestiture is that it would establish the market value of generation facilities. In other states, where the book value of generation assets exceeds their market value, utilities generally are allowed to recoup at least part of the difference through a non-bypassable Competitive Transition Charge (CTC) added to the distribution portion of the bill. If stranded costs are negative, as has been alleged in West Virginia, the same policy would seem to dictate that a Competitive Transition Credit should be subtracted from the distribution portion of the bill. Such a credit would help maintain West Virginia's edge as a low-cost electricity state. However, the amount, if any, of this excess market value of West Virginia plants is a matter of great uncertainty and hot debate. Divestiture would settle the question, since the market price of power plants is set by agreement of the buyer and seller, and both buyer and seller have a stake in finding the most likely true value of the plant.

The primary disadvantages of forced divestiture involve the question of its legality, and the political problem of implementing it in the face of fierce utility opposition. Legal questions center around whether it would constitute an unconstitutional taking of utility property, and whether it would prevent the performance of contractual obligations by owners. West Virginia's utilities have indicated that they will vigorously oppose any restructuring plan that involves forced divestiture of utility generation assets.

4.4 Competitive Transition Charge

West Virginia utilities have proposed a competitive transition charge (CTC) that would be "based upon" (American Electric Power) or "equal to" (Allegheny Power) the difference between the market price for generation and the regulated rate. The logic behind this rate structure is clear. Under traditional regulation each utility would have collected the regulated rate from all consumers in its service area. If the utility loses a sale due to competition, it will be able to sell the power on the market at the market rate. The CTC as proposed would reimburse the utility for the difference between that market rate and the regulated rate, which represents the loss it incurs due to competition.

Unfortunately for West Virginia consumers, the CTC as proposed would also remove the incentive for competitive sales to occur in the first place. To enter a market, an entering firm must usually offer a substantially lower price than the incumbent firm. Under the CTC described by AP and AEP, if a new entry wishes to obtain the market price it would have to charge its customer about the same price as the incumbent. In order to beat the incumbent's price, the entering firm would have to accept less than the market price. If the entering firm can obtain the market price elsewhere on the market, why would it want to offer a lower price to West Virginia customers? Therefore under the proposed CTC there would be little incentive for market entry, therefore little or no competition, therefore little or no benefit to West Virginia consumers. Instead of being a time of market development, the transition period would be a waiting period during which the incumbent utilities would continue to serve their traditional market.

Another problem with the CTC is more technical, but potentially just as significant: How would the Commission calculate the market price? There is no central market, such as the Chicago Board of Exchange, in which all power sales will occur; rather, "the electricity market" will consist of a large number of bilateral transactions (along with any regional spot market exchanges that might be instituted). The prices associated with these transactions will vary from day to day, from hour to hour, from location to location, by degree of firmness, and according to transmission line loading, fuel prices, and any number of other factors. How does one derive a single market price from these myriad transactions, with such wide variability over time and space?

The validity of publicly available benchmarks such as the Continental Power Exchange Electricity Price Index (CPEX) is questionable for several reasons. First, these indices reflect only transactions that are surveyed, which may be either misreported or unrepresentative. Second, they may cover a broad geographical area, and transmission constraints and line losses will limit the comparability of transactions at different places. Third, the CPEX and other indices vary hour by hour, making it difficult to determine a single price. Fourth, the indices typically track short-term, non-firm transactions, and their usefulness for other types of transactions is questionable at best. Finally, even if a perfect index were available, it would be of little use in a very thin market such as would undoubtedly result from the CTC advocated by the utilities.

One alternative, to base the CTC upon the difference between the regulated price and the price actually paid by the departing customer, may be even worse. This method of calculation almost certainly would be an even greater deterrent to entry by new sellers. It would have the perverse effect of penalizing low-cost sellers more than high-cost sellers, thus encouraging inefficiency. In addition, a CTC based on the departing customer's price would have no necessary relationship to the actual loss incurred by the incumbent utility because the incumbent might have an alternative purchaser willing to pay a higher price than the departing customer is paying.

If the transition period is to be truly a period during which markets develop and deepen, the CTC must not be designed to prevent entry. There are better ways to structure the CTC. The CTC should be predictable. Customers can intelligently shop among alternative suppliers only if suppliers can quote the full delivered price for the electricity, including the CTC, before the sale.

Second, the CTC should not distort relative prices. Efficient suppliers should have an advantage in the market, and they should be able to pass their low costs on to customers. Third, the CTC should be universal. All sellers, including the incumbent utility, should have the same CTC included explicitly in their charges.

On the basis of these considerations, we would propose a CTC structured as a fixed charge per distributed kWh, explicitly levied on all distribution regardless of generation source. The CTC should be set at a level that will allow the incumbent utility to recover some fixed percentage, perhaps 100%, of its costs as promised under regulation. It would thus be the average (per expected kWh of distribution) difference between expected utility revenues for the time period and the revenues promised under traditional regulation. It should also be allowed to be negative if the Commission finds that the utility is recovering more than its costs in the market.

To achieve true-up, the CTC might vary periodically, perhaps every two years, throughout the transition period. For a five-year transition period, this would mean that the CTC would be reset twice. At the beginning of the second and third periods it would be set as described above, and then the Commission would add a portion (perhaps 100%) of the utility's revenue shortfall from the previous period, or subtract the same proportion of the utility's revenue excess from the previous period. To prevent inequities that might result from the true-up if one class of customers achieves greater market savings than another, it may be necessary to vary the CTC and true-up amount by customer class. At the end of the transition period the CTC must end.

4.5 Design of Market Institutions

There are a number of considerations having to do with the design of the deregulated electricity marketing system that will directly affect electricity consumers. These include the basic design of the electricity generation sector, the structure of ISOs and power exchanges, the specifics of the remaining rules and regulations, the existence of harmful political interference caused either by actions of special interest groups or ignorance, inappropriately designed transition charges, and the need to certify and monitor power marketers.

One option being considered for deregulation is the development of a hybrid system that allows competition while maintaining some degree of control over the market through regulation. The hybrid regimes most often considered allow anyone who wishes to participate in the market to purchase electric power competitively, but regulate prices for those who do not wish to participate, while protecting the investment of utilities. This means that industrial customers with market alternatives will abandon local utilities to purchase power at the cheapest price available, which in a competitive generation market would be near variable cost. This leaves residential customers with even higher bills because the regulator will allow the utility to recoup the fixed portion of its cost by spreading it across all remaining customers. The apparent protection offered by a hybrid regime will therefore turn out to be chimerical, and remaining residential customers will most likely be worse off with a hybrid system than they would be in the market. Because of intense economic development pressure to allow industry access to market rates for power, a hybrid system is likely to occur by default if West Virginia does not implement a restructuring plan.

Electric Industry Restructuring: Opportunities and Risks for West Virginia
Interim Report No. 4 CONTINUED