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Benjamin Zycher: The Modern Case for Competition in Power Markets

Why are Virginia lawmakers stifling competition in electricity markets? Sometimes localized controversies highlight an issue of far broader significance, a truth illustrated well by the ongoing battle over electricity policy in Virginia. The central question in a nutshell: Will power consumers be allowed to purchase electricity by choosing among alternative suppliers in a competitive market? Or will they continue to be constrained by the choices of regulators responding to pressures from concentrated interest groups and allied politicians?

Virginia's state electric utility regulator, the State Corporation Commission, increased rates in anticipation of the adverse cost effects of the Obama administration's Clean Power Plan; when the Supreme Court halted the implementation of the CPP in 2016, it would have seemed reasonable for the Commission to rescind those rate increases. Unfortunately, in 2015, the legislature enacted a law preventing the Commission from reviewing utility rates and earnings — this was called a rate "freeze" — thus preserving the higher costs, with a mandate that rates be used for the "retention and expansion of energy-intensive industries." Translation: Rates were to be structured so that one group of consumers would subsidize another.

In 2018, when those excess consumer payments became too large to ignore, the legislature enacted another law mandating a combination of rate reductions and a "long-term model for . . . investing in sustainable energy." The Virginia Clean Economy Act, which requires the state's utilities to generate 100 percent of their power from renewables by 2045–2050, expanded the use of regulated rates as subsidies to projects favored by politicians.

The traditional argument in favor of the regulated public-utility structure of the electric-power sector was based upon the presence of large-scale economies and the need for a transmission and distribution system linking a relatively small number of large generating plants with a customer base concentrated on a regional basis. Various economic realities — the coordination and "holdup" problems among them — arguably justify the vertical integration of generation, transmission, and distribution of electricity.

And government agencies regulate power rates as a purported means of avoiding "monopolistic" prices higher than those that a competitive system would produce. The recent experience in Virginia demonstrates that this textbook view is inconsistent with the political dynamics of regulation shaped by interest-group pressures. Instead, rates tend to be structured so as to achieve various political goals, with one group of customers forced to subsidize others.

And so we arrive at the national relevance of the Virginia struggle over power rates. A competitive market for bulk power sales into given markets will yield the familiar economic benefits for consumers and for the economy in the aggregate, as demonstrated by the seven regional transmission organizations (RTOs) and independent system operators (ISOs) already operating. Wholesale prices are determined competitively, the Federal Energy Regulatory Commission (FERC) is charged with mandating nondiscriminatory access to transmission services, and customers no longer must be required to purchase electricity from the local utility, instead enjoying the option of purchasing power at the retail level from competing suppliers. Many customers will be interested primarily in low rates, others in enhanced reliability, and others might prefer to purchase only power generated by wind and solar facilities, although it is impossible to know which electrons are being delivered to which customers.

This market structure now is efficient because the growing abundance, reliability, and reduced price of natural-gas supplies have resulted in the widespread adoption of combined-cycle gas plants for power production. These achieve sharply improved efficiency by joining together a combustion turbine and a steam generator, and scale economies are substantially less important for this generation technology. Moreover, such plants, requiring only about 100 acres for 1000 megawatts of capacity, can be sited almost anywhere feasible for a gas-pipeline terminal. (Capacity-equivalent wind and solar facilities: about 150,000 acres and 14,000 acres, respectively.)

Accordingly, gas pipelines in effect have become competitors to long-distance power transmission lines. The siting advantage means that, together with the reduced costs yielded by expanded gas production, the distances needed for transmission lines have declined; transmission and distribution costs have fallen relative to generation costs, thus increasing competitive pressures for bulk power sales into given regional markets.

The traditional assumption of scale economies meant that customers were not allowed to purchase power from alternative suppliers; an ability to choose among competitors would leave the remaining buyers to cover the large fixed costs already sunk in the power-supply capital stock. This would be a particular problem with industrial customers seeking to avoid the substantial costs created by residential and commercial peak users. Rates would rise, more customers would exit, and the rate structure incorporating cross-subsidies among different customer classes would collapse, rendering unattainable the political objectives of electricity-rate regulation.

That is why regulated, vertically integrated utilities traditionally have been given more-or-less exclusive rights to serve a given market. Even as the economic justification for this monopoly structure has collapsed, the political imperative favoring it has strengthened: Only under a monopoly system driven by regulated power rates (and other massive subsidies) can lawmakers achieve their costly political objectives.

Almost by definition, a competitive wholesale market satisfies consumer preferences better than possible for a monopolistic market. A competitive system shifts investment risk in the efficient direction, toward producers making investment decisions and away from customers who are forced under the traditional system of regulated rates to pay for mistakes. Without the regulated utility rate structure, it becomes much more difficult to use power prices to force one group of customers to subsidize other customers and interest groups pursuing ideological goals.

Because an electric grid is integrated as a matter of electrical engineering, mandatory reliability standards must be imposed. A longstanding system of such standards has been developed and enforced by the North American Electric Reliability Council (NERC), with oversight from FERC. Accordingly — for better or for worse — a competitive bulk power market is not "deregulated." Instead, it is wholesale prices that are driven by market forces. Interstate transmission prices are regulated by FERC, which determines as well whether market outcomes in each regional market are "reasonable." States continue to regulate contractual language, customer/supplier relations, sales practices, and on and on.

And indeed: Many states continue to mandate market shares for renewables — there would be no need to do so were they "competitive" in terms of costs and reliability — as well as environmental standards and myriad other factors that shape power markets in crucial ways. But competition at the wholesale level, as already observed in varying degrees in the RTOs and ISOs, in place of the traditional regulated utility structure imposes an important constraint protecting consumer wellbeing and economic efficiency. It is worthy of support from all those favoring market freedom over government bureaucracy.

Benjamin Zycher is a resident scholar at the American Enterprise Institute.

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Posted: June 16, 2021 Wednesday 06:30 AM