Restructuring Minnesota's Electric Industry

Michael T. Maloney
David W. Riggs
Raymond D. Sauer¹

March 10, 1998

Introduction

Across the country, the provision of electricity is changing fundamentally. States such as California, Montana, New Hampshire, Oklahoma, Pennsylvania, and Rhode Island have passed legislation mapping out their transition to a competitive electric power market, while many others-Minnesota among them-are considering electric restructuring proposals. In moving from regulation-enforced monopolies to competitive electric markets, consumers no longer will be limited to one electric utility in their energy decisions.

Minnesota stands at a crossroads. Under the current system, utilities have their rates regulated in exchange for an exclusive customer territory. As a result, customer choice and consumer value are severely limited.

Electric restructuring, which seeks to capitalize on the merits of market competition, will deliver lower prices, new services, and efficient production and investment. Competition will generate benefits and increase efficiency in nearly every reach of Minnesota's electric industry. Where it is feasible, competition should be adopted throughout the entire industry because it is the most efficient form of economic organization.

A Restructured Electric Industry

The system that brings electric power to consumers is composed of three parts: generation, transmission, and distribution. Generation is the production of electricity through such means as coal-fired, gas-fired, hydroelectric, and nuclear plants. Approximately 74 percent of a consumer's electric bill is attributed to generation.² Transmission is the high-voltage network that carries electricity from generators to the distribution system, which, in turn, is the low-voltage network that carries electricity to end users. Transmission accounts for about 7 percent of a consumer's electric bill, while distribution makes up the remaining 19 percent.³

Throughout their history, electric utilities have been regulated as vertically integrated monopolies controlling all three components. In a restructured market, the three components likely would be unbundled and performed by separate entities. (Although the precise form of unbundling is open to speculation.) Of the three, the generation component, which has proven to be highly competitive in the wholesale electricity market, would be open to full competition in a deregulated, retail market. Likewise, competition in the transmission and distribution markets provides additional opportunities if deregulated.

What will Deregulation Bring to Minnesota?

Conventional wisdom suggests that competition will allow prices to fall in high-cost states and, by inference, suggests that prices may actually rise in low-cost states, i.e., electric prices in a low-cost state may rise to the national average price after deregulation. This raises the question of how much benefit, if any, consumers in a low-cost state like Minnesota will enjoy from competition? The short answer is that competition has proven itself to be an extremely strong force in economic life and would surely generate a wellspring of benefits that we can only begin to imagine.

Economic theory tells us that prices will tend to equalize across regions and service territories, and will tend to converge at the true cost of production. Of course, there may be great debate about what the true cost of power is. However, in searching for the truth in this debate we should pause and reflect on the extensive price differences across the country, as well as in the Midwest region and within Minnesota. The lowest prices around the country, region, and state are a compelling estimate of the true cost of power.

Table 1: Minnesota Electric Prices per Kilowatt Hour

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For example, Minnesota Power has an average price of power delivered to final customers of 4 cents per kilowatt hour (kWh).⁴ (See Table 1.) This compares to a national average price of 6.9 cents per kWh; a Minnesota-wide average of 5.6 cents; and an average price of 5.75 cents for Northern States Power.⁵ These prices differ from each other by a substantial margin. It is entirely reasonable to expect that if the service territories throughout the state were opened up to competition, the average price of power would be set by the low price producer, Minnesota Power. We pose the question: If they can do it in their current service territory, why can't they do it in all service territories in the state? If they can, it would mean a price decline of 29 percent on average across the state

In the short run, competition will cause prices to converge and to decline. In the longer term, the cost of the most efficient production technology will determine market price, and only low-cost producers will survive the market test.

The Short Run. Although some regional variation will remain to reflect differences in cost and transmission constraints, the economics of the situation strongly imply that replacing regulation with market forces will dramatically reduce the current variation in the price of electricity among service territories. This is not mere speculation. Real-world evidence from the experience of deregulating natural gas markets shows exactly this result.⁶ In short, it is entirely reasonable to expect electricity prices to converge-and to converge to the true cost of production.

Let's apply the logic of what economists call the "Law of One Price" to a market where there is (1) a hierarchy of efficiency among current generators ranging from low-cost producers to high-cost producers; and (2) substantial underutilized capacity as does, indeed, exist in the industry today.

Consider the situation where deregulation allows all existing generators to sell electricity in any market. To simplify things, suppose that each producer has constant marginal cost up to a fixed peak capacity.⁷ Assuming the marginal cost of transmission is zero, the price of generation will converge to the marginal cost of the highest-cost producer left in the market. Producers with marginal cost in excess of this would no longer remain in business. All remaining plants would operate at full capacity. In other words, those generators that cannot produce electricity at the same or lower-cost than their competitors, will cease production; those that can, will utilize all of their plant's capacity and sell at the price determined by the marketplace.

In their quest to fully utilize their existing production facilities, producers will continually seek to enter new markets where opportunities present themselves. These new market entrants will compete with incumbent firms in that market, applying downward pressure on the price of electricity. This process of competition among generators to allocate underutilized capacity will be responsible for the decline in electricity prices in the short term.

The Long Run. In the long run, price will fall for two reasons. First, competition among firms will force price to equal the average cost of production. Any excess of price over cost represents a profit opportunity that can be exploited by entry of new firms, a process that is short-circuited by the current regime of regulation. Second, high-cost firms cannot survive the pressures of competition. Price will be driven down to the average cost of the efficient producers.

In the absence of transmission constraints (e.g., regulation impediments or the Rocky Mountains), price will fall to the level of the lowest cost producers in the country. While it is true that sources of generation such as hydroelectric power are naturally limited in scale and cannot be expanded, this observation does not hold for the standard coal-fired generation facilities. There are high-cost coal plants and low-cost plants. Competition clones successes and discards failures. Successful firms such as Minnesota Power will have the opportunity to expand in the competitive marketplace. In addition, other firms, out of necessity, will copy methods that are successful at delivering power at low-cost.

Moreover, it is important to recognize that in the long run, the competition for a low-cost firm like Minnesota Power is not the higher-cost firms that they can easily displace. Instead, it is firms with lower-costs in other regions of the country that comprise the relevant competition. The utilities, for example, adjacent to coal mines in Kentucky and West Virginia that currently sell regulated power at prices less than 4 cents per kWh can and will be expanded. Large developments in Wyoming and Montana are in the planning stages that will bring new sources of power to midwestern cities. Gas turbines that utilize the latest technology of improved fuel efficiency are hailed as the standard benchmark for the long-term cost of power. Competition also will unleash the utilities that are selling conventional steam power at low regulated rates and allow them to expand their efficient production. These types of enterprises are a bellwether of the firms in the long-term competitive market.

"Current" Questions

Stranded Costs. One of the more contentious issues in the electric deregulation debate is what to do with a utility's "stranded costs," which represent past investments that are not economically viable in a competitive market.⁸ Allowing for the recovery of stranded costs is central to the electric restructuring debate.⁹ Although many different issues have been raised in the debate, we believe the main question is how do stranded costs affect a competitively determined price? Stated differently, how will stranded costs affect the consumers of electricity?

Deregulating electricity brings a paradigm shift in the pricing of electricity. Under the regulated system, price is determined on a cost-plus basis. That is, rates are determined based on a utility's cost plus a normal rate of return on investment. Because regulation determines price based on the past, all costs-including those investments that prove to be stranded-are relevant to regulated prices. But in a competitive market the determination of price is based on today's marginal operating cost, not yesterday's sunk cost. The threat of entry by efficient, low-cost firms will render the stranded cost of less efficient firms irrelevant to the determination of the market price.

Stranded costs are also irrelevant in the longer term because price will be driven down to the average cost of the efficient producers. In a competitive market, high-cost firms cannot survive the pressures of competition. The rewards and penalties from innovation and cost reduction will be magnified as prices are removed from the purview of the regulator and subjected to market forces. Competition forces firms to be efficient or die. Firms that make mistakes are forced by competition to absorb the costs rather than passing them on to the consumer in the form of higher prices. As a consequence, fewer mistakes will be made in a competitive marketplace than under regulation.

Because stranded costs are irrelevant to the determination of market price, there is no scientific economic necessity for their recovery. Stranded cost recovery is an issue of fairness, not economic efficiency. If recovery is allowed out of a sense of political fairness, it should be done in a manner that maximizes the gains from competition.¹⁰

The Environment. The first law of demand states that holding all else constant, a decrease in price will lead to an increase in quantity demanded. Hence, the price reductions that result from competition likely will generate an increase in energy consumption, which in turn may employ more coal- and oil-burning plants. How the environment will be affected by these circumstances is seen by some as a concern.

However-and this point is central-new technological developments in energy production are cheaper, cleaner and more efficient than older systems. Because competition, as noted, reproduces successes and discards failures, it stands to reason that new market entrants will employ these new technologies, including gas turbines instead of older coal- and oil-fired plants of the past. Moreover, because competition encourages innovations that we can only begin to imagine, the efficient and clean technologies of the future hold great promise.

Under the current regulatory system, electric consumers cannot choose from different power sources. They are held captive to purchase only the electricity provided by their local utility. With electric deregulation, if people demand environmentally benign or "green" power, the market will be given the opportunity to respond and fill that demand. A competitive market provides an incentive structure for utilities to achieve the things that customers value and allows consumers to purchase products from the company that best meets their priorities and values.

Conclusions

Regulation stifles market forces and inhibits innovation. With many other states moving toward deregulated markets, continued reliance on regulation is risky for Minnesota, whereas the alternative of competition holds great potential. In the short term, competition will undeniably lower prices because existing generators will compete to employ underutilized capacity. The forces of supply and demand cannot be contravened.

In the long run, the true cost of electricity cannot be reduced by regulation. The best that regulation was designed to achieve and the best it can hope to accomplish is to emulate the competitive price, which is based on true cost. No one can reasonably argue that regulation has even remotely approached this goal. Although Minnesota consumers may have fared relatively well in the past under a system of regulated prices, they should take heed of the lessons from regulation both within our state and elsewhere. Regulation does not impose sufficient pressure on firms to keep costs low. As a result, regulated pricing provides the benefits of efficient technologies and management practices to only a minority of fortunate consumers.

In sharp contrast, a competitive market provides these benefits to all. The price variation that exists both within the state and throughout the country is the singular fact that demonstrates the failure of regulation to deliver electricity to consumers at competitive prices.

While it may appear at first glance that deregulation is an unnecessary gamble for a low-cost state like Minnesota, this view crumbles on close inspection. Minnesota has nothing to gain from continued regulation of electricity generation. The greater risk lies in holding on to an inefficient system while other states enjoy the dynamic gains that competitive markets create for their citizens.

¹ Maloney and Sauer are professors of economics at Clemson University, Clemson, SC. Riggs is Senior Fellow for Economic and Environmental Studies at Center of the American Experiment.

² Energy Information Administration. Annual Energy Outlook, 1997. DOE/EIA-0383(97). Washington, DC, Dec. 1996 cited in Ellig, Jerry. A Legislator's Guide to Electricity Industry Restructuring. Center for Market Processes, George Mason University, November 1997.

³ Ibid.

⁴ The average price to all final customers is total revenue received from residential, commercial, industrial, street lighting, and other final customers divided by kWh sales to these users. It excludes sales for resale, which are sales to other utilities such as municipal power authorities.

⁵ These data come from Dept. of Energy, Energy Information Adm., Form 861, 1995.

⁶ This evidence is discussed in Arthur DeVaney, which is cited in Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice: Lessons for the Electric Industry, Fairfax: Center for Market Processes, GMU, 1996.

⁷ Marginal cost is the cost of producing an incremental unit of electricity, excluding, for example, the sunk costs of building the generation facilities.

⁸ For more on this see, Maloney, Michael T., Robert E. McCormick, and Raymond D. Sauer. "Customer Choice, Consumer Value: An Analysis of Retail Competition in America's Electric Industry." Washington, D.C.: Citizens for a Sound Economy Foundation, 1997.

⁹ Generally, the recovery of stranded costs will be made by charging electric consumers a fee that is paid to utilities.

¹⁰ For example, a lump-sum payment or access charge based on customer (user) size will not distort the efficiency gains from deregulation. If stranded cost recovery is allowed, the gains from competition are maximized through an access charge. Conversely, a unit-charge tacked onto the price of electricity will distort the relation between marginal cost and price, and this will decrease the gains from competition. (See, Maloney, McCormick, and Sauer. "Customer Choice, Consumer Value.")