The Effects of De-Regulation on the US Electric Power Market

Table of Contents

II Table of Abbreviations

III Table of Mathematical Symbols

IV Table of Figures
1 Introduction
1.1 Context and Motivation
1.2 Plan of the work
2 The Electric Power Market
2.1 Electric Power
2.2 An Historical overview and description of the Electric Power Market
2.3 Natural Monopoly Markets
2.3.1 Theory of Natural Monopoly
2.3.2 The US Electric Power Market – A Natural Monopoly
3 Economic Regulation
3.1 Historical Overview of Economic Regulation
3.2 The regulatory process
3.3 Theory of Regulation
3.3.1 Normative Analysis as a Positive Theory
3.3.2 Capture Theory
3.3.4 Economic Theory of Regulation
3.3.5 Does Empiricism support the Theories of Regulation?
4 Natural Monopoly Regulations and the Electric Power Market
4.1 Traditional Rate-of-Return Regulation
4.2 Averch – Johnson Effect
4.3 Peak-Load Pricing Model
4.4 Ramsey – Boiteux Pricing
5 Changes in the Electric Power Market
5.1 Critique of the Natural Monopoly
5.2 Degeneration of the natural monopoly’s relevance for the electric power industry
5.3 The effects of technological development on the retail regulation
5.3.1 Digital Communication
5.3.2 Transmission
6 The De-regulation Process
6.1 Political changes favoring the de-regulation process
6.2 The concept and implementation of de-regulation
6.3 Market monitoring
6.4 Empiricism favoring De-regulation
7 California’s de-regulation
7.1 California’s motivation for a restructuring of the market
7.2 The concept and implementation of the de-regulation
7.3 New institutions for the re-structured market
7.4 The collapse
7.4.1 The electricity crisis
7.4.2 The financial crisis
7.5 The subsidence of the crisis and the “life after”
7.6 The consequences for the whole country
8 Conclusion

V Bibliography

II Table of Abbreviations

illustration not visible in this excerpt

IV Table of Figures

Figure 1: From Generation to Consumer

Figure 2: Economies of Scale up to output Q’

Figure 3: Minimum Average Cost Curve for Two Firms, AC2

Figure 4: Peltzman Model

Figure 5: Becker Model

Figure 6: Averch & Johnson Model

Figure 7: Peak – Load Pricing

Figure 8: Deadweight Losses Due to Nonpeak Pricing

Figure 9: Natural Monopoly Cost Structure

Figure 10: Net Electricity Generation by Type (in billion Kilowatt-hours)

Figure 11: Status of Deregulation Activity, June 2000 (EIAd, p. 42)

Figure 12: Physical Flows in the CAISO/PX Market complied by the author, based on Cicchetti et. al., 2004, p. 48

Figure 13: California’s PX Day-Ahead Prices complied by the author, based on Joskow, 2001, p. 375

Figure 14: Status of Electric Utility Deregulation Activity, January 2010 (EIAe)

“I shall make electricity so cheap that only the rich can afford to burn candles.”

Thomas A. Edison

1 Introduction

1.1 Context and Motivation

Thomas Edison and Joseph Wilson Swan revolutionized the use of electricity by inventing the light bulb in 1879 (cf. Center for Solid State Science). With this new invention people finally had the possibility to light their homes and streets at night. Obviously this entailed a wide range of advantages in terms of the standard of economy, security, comfort and much more. However, with the invention and spread of the light bulb another problem occurred simultaneously: the need for nationwide electric power supply. Due to the lack of devices, there had been no need to supply power on the large scale before the invention of the light bulb. Now a solution for providing the populace with electric power had to be found. It was again Edison, who therefore laid the foundation, three years after he had invented the “artificial light”. Simultaneously he intended, as can be deducted from the quotation above, that electricity became available and affordable for everyone.

Both, availability and affordability still shape today’s electric power industry. The challenges are on the hand to secure the supply on a large scale and on the other hand to provide an efficient price in this highly-complex industry. The importance of electric power has made its reliability in supply essential, as large power outages entailed devastating consequences for the whole society. At the same time the government has to maximize the social welfare for society, particularly with supplies like electric power. The special structure of the electric power market as a natural monopoly requires the government to intervene on this market. However, the extent and form of this intervention is difficult to define, due to the complex structure of the market and its high dynamism. The aim of this thesis is to present this market structure, the government’s measures to deal with it and the occurring problems.

1.2 Plan of the work

The thesis starts with the description of the electric power market, by presenting the characteristics of the electric power and their influences on the structure of the industry in 2.1. Section 2.2 describes the history of this industry and the major changes it has undergone during the last century. Chapter 2 concludes with the characterization of the electric power market as a natural monopoly and its definition. From this market form follows the need for regulation, which is presented in Chapter 3. At the beginning the history of the regulation of the market is presented in 3.1, whereas the regulatory process will be discussed in 3.2. Section 3.3 presents several theories that form the basis for regulation, whereas chapter 4 continues with its practical use and the presentation of several models that describe certain effects occurring with regulation. Chapter 5 marks a change in the industry, as it presents the critique on the natural monopoly in 5.1 and also its decreasing importance for the industry due to its changed structure in 5.2. 5.3 presents particular changes and how they affected the structure of the industry. As a consequence of this changed industry structure the de-regulation process was initiated in the USA and is described in chapter 6 that deals with the political changes that favor de-regulation in 6.1, followed by the concept and the implementation of the de-regulation in 6.2 and the introduction of new institutions to control the industry in a different form in 6.3. What effects de-regulation may have in reality is shown in chapter 7 with the example of the restructuring of the electricity market in California and the explanation why it broke down. The thesis eventually concludes with an estimation of the de-regulation process and its use for the electric power market and gives a short trend towards the prospective development in this market.

2 The Electric Power Market

The dominant role of electric power for our modern life remains undoubted, which is why governments feel strongly encouraged to securing the provision of power to the residents of their countries. The market that supplies consumers, both private and business, with electrical power is generally called the electric power market. According to Philipson and Willis (2006, p. 2) the term electric power market contains all activities involved in this market, like the production and the sales of electricity, as well as the delivery and the control of producing and transmitting electricity.

2.1 Electric Power

The biggest difference with electricity as opposed to other goods and even energy itself, is its inefficiency to be stored. Hence electricity should ideally be delivered the moment it is produced. Following Philipson and Willis (2006, pp. 112 – 118) this drawback highly influences the way electricity is sold. The consequences arising from that will be discussed later on. Another feature that is given with the distribution of electric power is its inconsistency in use with the end-consumer. In order to explain this assumption the physical characteristics of electric power are to be defined at this point. From a technical point of view, power is the product of voltage and current. Whereas voltage is measured inVoltsand current inAmps, power itself is measured inWatts(cf. Philipson & Willis, 2006, p. 104). The inconsistency of power demand from customer side, due to peak and off-peak times that will be elaborately discussed later on in this thesis, is solved by the use of electric power systems that vary the current flow but keep voltage as constant as possible. However, the use of electric power has a wide range of advantages, too, as it has successfully established itself for more than one century as the “preferred single energy source worldwide” (Philipson & Willis, 2006, p. 119). Philipson and Willis (2006, p. 123) argue that the flexibility, controllability and its cleanness are the main reasons for the electricity’s popularity.

The last issue that is to be discussed in terms of electric power is its generation that is introduced by Philipson and Willis (2006, pp. 151). In very simple terms electricity is produced by either moving a magnet inside a metal wire or the other way around, moving a metal wire through a magnetic field, which is the very basic principle of electricity generation. In order to meet worldwide demands this process has to happen on a large scale. This is possible by using generators that keep on rotating either the wire or the magnet. Considering the axiomatic law of the conservation of energy, obviously the energy to activate the generator has to be provided. There are several forms to power the generators. One way to convert energy into electricity are fossil-fuel powered generators that, as the name already suggests, convert fossil fuels into electric power. The most prominent examples for this kind of power generation are the steam turbines and the gas turbines that are activated by natural gas and sometimes coupled with a steam turbine in order to even use the “waste”. Another, controversially disputed form of power generation are the Nuclear Power Plants, besides Hydro-Electric Power Generation and Renewable Power Generation. Also the variation of electricity demand plays in important role for generation. It is the reason why utility systems usually consist of several generating units in order to be able to react to any changes in demand, during daytime, weeks and even years.

Having clarified the technical terms of electric power, the electric power market can be described with its components. The primary functions of the electric power market are the generation, transmission, distribution and the retailing of power. After the generation of electricity in power plant it is transmitted at high voltage between 35kV and 75kV depending on design. During its way from the generation site on the transmission lines the power is led through switching station several times, where the power is lowered a bit and afterwards resent on sub-transmission lines. Generally it can be said that the longer the distance the power travels the higher its voltage. The sub-transmission lines end in distribution stations, where voltage is reduced to 2,100 and 25,000 volts. After that the power enters the distribution system and is further distributed on so-called feeders. At those feeders the voltage is further reduced at the level of residential and commercial buildings where it is finally used then. The last level, the retail sales is the direct sale of the electric power. It is measured by the metering equipment that is directly installed at the consumer’s building. Figure 1 shows a simplified depiction of the electric power process from its generation to its consumption. (cf. Viscusi et. al., 2005, p. 453; Philipson & Willis, 2006, pp. 6 – 8)

illustration not visible in this excerpt

Figure 1: From Generation to Consumer

complied by the author based on http://tonto.eia.doe.gov

2.2 An Historical overview and description of the Electric Power Market

The foundation for one of the most important industrial sectors of the modern age was laid in New York City, on September 4th 1882, when Thomas Edison opened his famous Edison’s Electric Illuminating Company on Pearl Street in Manhattan (cf. http://edison.rutgers.edu). One of the most remarkable aspects with this company was that it was the first company to produce electricity in a central place and distribute it to its customers. Above this it was the first plant that provided electricity for the public (cf. Bowers, 1982, p.139). The station that served 85 customers with 400 lamps, was, however not the beginning of a sudden market expenditure. On the contrary, sales and spread of power plants were extremely sluggish. At the end of 1883 there were only two more cities that had central station power. Still electricity was simply too expensive for the populace. Almost a score had to pass until electricity became affordable for the average customer. (cf. Hyman, 1988, p 61) In Edison’s days it was common practice that towns or cities gave franchises to electricity companies. In return for this grant companies were obligated to provide an agreed amount of electric power. As time went by and technological development continued a new form of guaranteeing the supply of electric power became necessary. With serving continuously larger areas ineffectiveness and inflexibility of the franchise system forced the establishment of a new statewide controlling institution. Such a statewide regulatory institution was first established in New York, Wisconsin and Georgia in 1907. (cf. Viscusi et. al., 2005, p. 429) These were necessary as according to Hyman (1988, pp. 59 – 113) the early days of the new industrial branch were marked by confusion and fragmentation. On the one hand the city councils that gave franchises were extraordinarily corrupt throughout the USA, which made it extremely difficult for investors to plan on the long run. And on the other hand there was no common standard, not even within a city, in terms of voltage and frequency.

A last aspect that did its bit to make confusion perfect was the competition between Alternating Current (AC) and Direct Current (DC). DC was the first form that was used, as it was simpler with the current flowing only in one direction. Thomas Edison himself was a strong proponent of the DC concept and even defended it, when all signs of development were against it. The biggest problem with DC was that it was highly uneconomic for transport distances more than one mile. The alternative concept that Edison wanted to suppress at any price, was the introduction of AC. As opposed to DC the current with AC changed its direction on a regular basis. George Westinghouse was the one to introduce the new concept of AC that now allowed transporting current over longer distances more efficiently, on the US electric power market. The only problem now was the both systems could not be linked with each other, which resulted in the two systems existing parallel and thus encouraging confusion (cf. Hyman, 1997, p.16; p. 86).

The only advantage that could be found in this situation was that all the confusion encouraged competition and thus development. Samuel Insull, who worked for Chicago Edison, for example, was the first to notice that one power plant could serve different customers, as they had different loads and thus use power plants more efficiently. Above that he took advantage of economies of scale by building larger power plants.

Another struggle that took place in those days was the one between isolated power plants and electric utilities. As electric utilities were willing to accept lower returns, they were the ones to persist in the end. As a backlash to that current situation the government introduced regulation to fix rates and standardize services. This concept spread quickly throughout the USA and by 1916 already 33 states had their own regulatory agencies.

From that moment on industry expanded. However, as only the power stations themselves were regulated another company form occurred on this market, the so called holdings. Founded in 1900, American Light and Traction was the first company to buy local utilities. The aim of those holdings was to make as much profit as possible, which resulted in overcharging their subsidiaries. With this trend continuing the eight largest holding companies controlled 73% of the investor owned electric business by 1932.

Yet, this was not to last for long. In the course of the Great Depression and due to legislation those “monsters” were shattered into small bits. The legislative basis for this change was introduced by Franklin D. Roosevelt in his well-known New Deal Policy. Considering the power market it had two parts, based on his principle “to encourage the wider use of that servant of the people – electric power” (Roosevelt, The Portland Speech, 1932; http://newdeal.feri.org). The first part was to provide public power, the second one from 1935 was fixed in “the Public Utility Holding Company Act”. In the course of this act 759 companies were separated from the holding system during the next 15 years. All this resulted in better customer orientation at reasonable profits. This policy marked the beginning of a prosperous time for the industry. From 1935 on it grew at roughly twice the rate of the economy. Simultaneously the price fell constantly until the year 1965, which was a watershed for the electric power industry.

From there on the industry had to face increasing trouble. In the changed situation costs began to increase, prices, however, still declined. Reasons for the rising costs were for example rising fuel prices after the oil embargo of 1973/74, the increasing importance of the environmental movement, especially for nuclear power plants, and the cost for building new, more expansive plants that, however, did not work more efficiently than the old ones. Another aspect was that regulators did not recognize the necessity of rising prices until the year 1980 when prices were finally adjusted to the increased costs.

[...]