Rethinking Vertical Integration in Electricity

							Rethinking Vertical Integration
         in Electricity
               Robert J. Michaels
     California State University, Fullerton
           rmichaels@fullerton.edu

                         18th Annual Western Conference
                         Center for Research in
                            Regulated Industries
                         San Diego, California
                         June 24, 2005
        The Economics that
        Electricity Forgot
   Restructuring is about replacing vertical
    with market relationships
   Most traditional reasons for vertical
    integration continue in force
   Disregard of large literature on economies
    of integration
       And inadequate studies of benefits of markets
   Restructuring history almost entirely about
    vertical abuses, not benefits
       With permanent institutional consequences
        The Old Economics of
        Vertically Integrated Utilities
   Interdependence of generation, transmission,
    distribution as rationales
       Second-by-second coordination for efficiency
       Responses to system stress, risk management
       Rationalizes investment planning
       Regulation and generator market power
       Implicitly, markets are unnecessary or pernicious
   In 1970s and 1980s utilities show that market
    transactions possible
       And then PURPA, EPAct, Order 888, Blue Book, etc.
     Some Intellectual History of
           Restructuring
   1970s – Lawyers assume no reason for
    vertical integration without evidence
   Otter Tail finds vertically integrated
    utility can use transmission to harm
    competition for distribution franchises
   1980s – Continued emphasis on
    franchise competition without efficiency
    considerations
        What Economists Know about
            Vertical Integration
   Econometric work between 1985 and present,
    various samples back to 1970, U.S, Japan,
    Italy
   Near 20 studies, methods usually
       Testing separability of translog or quadratic cost
        functions for utilities
       Estimating production functions for stages and
        seeing if integration with earlier stage cuts cost of
        later stage.
   Other studies of integration into fuel supplies,
    generator maintenance
Vertical Integration and Reliability
   No public studies re vertical integration and
    reliability
   NERC and FERC concerns:
       Grid design and generator locations not
        coordinated, underinvestment in grid
       Market-induced variability in flow patterns may
        cause operating problems
       Increase in transmission loading relief calls may
        reflect competitive and reliability concerns
       Participant funding of transmission as solution or
        worsening of the problem?
Vertical Integration and Restructuring

   California 1994: Regulators and experts
    say vertical integration unnecessary,
    makes competition impossible
       Minimal discussion of efficiency aspects of
        integration
   State law and FERC market power
    standards for PX and ISO call for
    divestiture of generation
California and After
   Pre-2001 prices in state’s markets usually
    track cost fairly closely
   Utility generation divestitures held as partial
    causes of market collapse
   New economic models claim that vertical
    integration can constrain generator market
    power
   Utilities taking advantage of transition to
    attempt vertical re-integration
       IPP overbuild adds to their incentives
        What Did We Learn About
              Integration?
   Few studies of operating efficiency under
    RTOs as alternatives to integration
   Other state’s transitions handled stranded
    cost and divestiture differently, generalization
    hard
   View growing that partial integration is
    appropriate for utilities with POLR obligations
    under retail choice
       Vertical market power now conspicuous by
        absence from the discussion
        Estimating the Benefits of
            Markets and RTOs
   Verified economies of integration and scope,
    but little on markets
   Numerous studies claim benefits for RTO-
    based markets
       Mostly just efficient dispatch models and not
        analyses of new institutions
       Most of projected long-term savings comes from
        technological progress
       Most do not net out lower consumer bills against
        decreased generator wealth to get welfare gain
       Remarkable cost increases in most RTOs finally
        coming to light