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Over the last two decades, we have witnessed extensive industrial reforms, restructuring, and deregulation around the world. The business of restructuring industry, it turns out, is best learned by example. But few examples are good and many are bad. In Great Britain, the recent debacle in restructuring the passenger rail industry has left a trail of poor service and alarming safety problems. In the U.S. airline industry, serial bankruptcies are commonly associated with airline deregulation. The business of electricity, still in the shadow of the California experiment and Enron’s relentless manipulation of energy markets, has now joined these ranks. In the face of miscalculations about the path and speed of restructuring in formerly regulated industries, one doesn’t hear the term deregulationused much anymore. Even the stoutest advocates of free-market nirvana have toned down their rhetoric. A badly needed adjustment in perspective has taken the primary emphasis off the unrealistic goal of laissez faire competition. The new perspective directs public policy attention toward the process of the transition — ultimately to markets likely to be characterized by a relatively permanent mix of lighter-handed regulatory oversight and elements of competition. Broadly defined, transitionis the set of ongoing regulatory and legislative initiatives, antitrust enforcement actions, industry consolidation and repositioning, technological advances, and market development that occur in response to a triggering policy intervention. These components don’t necessarily fall into any given order, but are crucially interrelated with feedback effects, which are the subject of much economic analysis. In the case of electricity, transition was triggered by the 1996 transmission “open access” order of the Federal Energy Regulatory Commission. (Some would go back even further to the Energy Policy Act of 1992.) Open access was the first step in fostering competition in wholesale electricity markets — the markets around which the restructuring controversy now swirls. Industry players and policy-makers have quickly realized that the transitional phase of restructuring is very important. But they may still wonder when it will end. The reality is that transition never completely stops. Nor should it, since markets are always in flux. Transition may, however, slow down while the industry grows more stable and markets become more competitive, producing periods of quiet when it will be easier to assess the results of restructuring. Success can be judged by price trends, emergence of new products and services, antitrust enforcement actions, long-term financial health of industry players, mergers and acquisitions, and entry of new firms. THE STATE WE’RE IN To examine the restructuring problem in electricity more carefully, let’s first look at the current state of affairs, next at how the problem developed, and finally at how to better manage the transitional process in the future. Taking stock of the restructuring experience thus far is revealing. Consider three specific events: (1) The Enron debacle. How did the market-expanding mavericks turn into bad guys, and how can we prevent it in the future? (2) The California debacle. Can we predict whether the “perfect storm” will happen again in another market? And (3) the widespread retrenchment on retail access. Consumers don’t really seem interested in anything but one-stop shopping, thus revealing their preferences by notchoosing retail choice. Now consider a second set of observations that expose more fundamental problems: (1) We are coming to accept the unique economics of electricity. Volatile demand and lack of storability make it a commodity that doesn’t fit neatly into the competitive market model. (2) We are very worried about the adequacy of transmission infrastructure. Heavier utilization of the grid in the face of decentralized state-level siting decisions and chronic under-investment bodes ill. (3) Most important, we continue to struggle with the existence of market power. Identifying it and redressing its abuse is the lynchpin of realizing the benefits of restructuring for consumers. HOW WE GOT HERE With all this said, how did the electricity industry drift into this morass? At the risk of oversimplifying, it is probably safe to say that policy-makers did not anticipate the complexity of the transitional phase. Nor were provisions made for managing the transitional process. This was an honest mistake, but potentially avoidable if policy-makers had more carefully considered the lessons from other restructuring experiences. Many entered the restructuring process with high hopes for quickly reaching the goal of unfettered competition. Rapid development of wholesale electricity markets, some success with market-based rates, entry of the independent power producers, and limited head-to-head competition at the transmission level all perpetuated the view that workable competition would quickly emerge. It was in this heady environment that laissez faire competition became the credo of deregulation advocates. In retrospect, miscalculating the importance of the transitional phase can be linked to a diverse set of problems. Collectively, these got restructuring off to a rocky start and created sometimes intractable situations for policy-makers. One problem was a less-than-adequate cache of policy tools. For example, federal policy-makers went the functional(as opposed to structural) unbundling route, thus preserving the linkage between generation and transmission that creates bad incentives for vertically integrated firms to discriminate against their rivals in wholesale markets. Utilities were also asked(as opposed to required) to give up control of their transmission systems to regional organizations — something no clear-thinking, profit-maximizing firm would entertain. Political considerations also hobbled the process. A decision to allow recovery of stranded costs and promises not to raise retail rates introduced distortions that skewed market outcomes in inefficient and inequitable directions. Add to the mix the burden created by decentralized decision-making for siting new transmission facilities and the unexpected gaming of the system, which eroded benefits for consumers. And then there was a lack of consistent criteria at the regulatory level for identifying and remedying market power abuse. Under the Sherman Act, antitrust agencies cannot pursue the exercise of market power by a generator that simply raises prices or restricts output (although they can pursue exclusionary conduct and coordination). What that means is that FERC and state regulators must take on what appears to be the bulk of enforcement — something they may not be equipped to do. Now consider two major factors that created an environment conducive to successive rounds of strategic repositioning in the industry, thus complicating and protracting the transitional process. The first was an unprecedented wave of energy mergers and asset churn that lasted from the early 1990s through the early 2000s. There were around 100 major mergers involving electric utilities, gas pipelines, and distribution companies. Several hundred billion dollars in assets changed hands through mergers motivated by the pursuit of market power, risk management, and regulatory uncertainty. Only a handful of transactions were investigated because of anti-competitive concerns, and in many cases, consolidation fundamentally altered the structure of regional electricity markets. A second source of ongoing transition was a series of well-planned but rapid-fire FERC initiatives necessary to push the goal of open access. On this list are the open-access Orders 888 and 889 (1996), the Electric Merger Policy Statement (1996), the regional transmission organization rule (1999), proposed standardized generator interconnection policies (2001), proposed transmission codes of conduct (2001), and proposed standardized market design (2002). A stark contrast emerges between the antiquated view that restructuring can produce a quick result and the emerging reality that restructuring is ongoing. Now, what can we learn from the past, and what policy approaches would get things back on track? HOW WE GET OUT A first step is one that has already been taken — abandoning the laissez-faire mind-set and adopting a mixed-system model. This model features a combination of regulatory oversight and antitrust enforcement in electricity markets. Thus, policies must be geared to utilize and accommodate the dual functions of regulation and antitrust. Another needed step is to reconcile the multiple business models that now characterize the electricity industry. There are vertically integrated utilities, independent power producers, pure power marketers, and dedicated transmission entities. Financial markets have always been eager to accept the monopoly rents embedded in the traditional vertically integrated model. But slowing the capital flight from the industry today means accepting a mixed-business model and its attendant risks. Alternatively, we must return to the heavily regulated utility model. Another step is to acknowledge that demand-side response is no panacea for disciplining electricity markets. This is particularly true when incentives for power generators to hike prices by withholding capacity from the market remain so powerful. Even with real-time pricing, the responsiveness of demand to changes in prices is likely to remain low. Moreover, it is difficult to feed consumers’ price preferences back to suppliers in time to avoid dispatching unneeded generators and resource additions. Electricity market dynamics may therefore continue to be controlled largely by the supply side, so policies should respond accordingly. Finally, someone needs to be at the restructuring helm. The role of federal oversight in transitional electricity markets needs to be better defined and centralized under FERC. Federal regulators should do most of the heavy lifting, while regional organizations such as market monitors serve as “field offices,” reporting in on market conduct and performance. Part of FERC’s heavy lifting should be to track changes in regional market structures so that the competitive effects of future merger activity can be more accurately assessed. Another task is to work cooperatively with antitrust agencies in developing market power identification and enforcement criteria. A third is to judiciously enforce laws against market power abuse. A fourth is to better coordinate with the states on transmission siting and regional market problems. Critical discussions are now proceeding on Capitol Hill about the future of the electricity industry and FERC’s role in restructuring. What those discussions produce will set the stage for further transition, determining both the ease of that transition and the benefits that ultimately flow to consumers. One hopes that Congress will focus on dealing effectively with the real issues that have already been revealed. This would be infinitely preferable to pursuing policies that assume the remaining distance to more competitive markets can be easily bridged or, alternatively, that try to put the genie back in the bottle of regulated monopoly. Diana L. Moss is vice president and senior research fellow at the American Antitrust Institute, and also adjunct professor at the Georgetown University Graduate Public Policy Institute. She was formerly a senior economist at FERC, where she coordinated competition analysis for electric utility mergers. Moss can be reached at [email protected].

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